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Brazil’s financial markets have plummeted this year as investors grew worried about the spending plans of the government of leftist President Luiz Inacio Lula da Silva.
The Brazilian real is the second-worst performing emerging market currency against the U.S. dollar so far this year, falling 10 percent behind only the Turkish lira and troubled neighbor Argentina’s peso, while the country’s Bovespa stock index is down 8.6 percent over the same period.
Emerging markets across the board have been hit by investors sharply scaling back expectations for a U.S. interest rate cut this year, while asset managers and economists say concerns are also growing about the feasibility of Brasilia’s plan to balance its budget through extra taxes and increased spending.
“The biggest weight on the Brazilian economy and markets right now is the fiscal risk,” said Ricardo Lacerda, CEO of Brazilian investment bank BR Partners and former head of Goldman Sachs in Brazil. “The situation is not out of control yet, but the government is betting on an unsustainable model of fiscal adjustment without cost cutting.”
Lula returned to power last year promising to boost welfare spending and expand the state, hoping to repeat the political success of his rule from 2003 to 2011. His government has tried to reassure investors by promising to eliminate the so-called primary budget deficit, which does not include interest payments on debt.
But the government has already relaxed its target to achieve a surplus from next year onwards, pledging to raise real spending each year, leaving some investors and analysts worried that it may not be able to eliminate the deficit this year as planned.
Public debt levels are already relatively high for an emerging market, at 76 percent of gross domestic product, and are not expected to fall until 2028, according to official estimates.
Market volatility has risen since the government failed to back in parliament a proposal to cut corporate tax credits after protests from businesses earlier this month, increasing pressure on Finance Minister Fernando Haddad and forcing Lula to later defend him.
“This shows that we are reaching the limits of the fiscal adjustment model proposed by Haddad,” said Helder Soares, chief investment officer at Sao Paulo-based asset manager Principal Claritas SA. “The structural fiscal situation is not hopeless, but it is delicate.”
Brazil has a history of running budget deficits, which have often had a negative impact on inflation, interest rates and economic activity.
Critics say the loose fiscal stance limits the central bank’s ability to cut its base interest rate, which President Lula has criticized as 10.5 percent, saying it is harmful to growth.
Economists now expect GDP growth to slow to 2% this year from 2.9% last year. Consumer price inflation is slowing, but full-year inflation expectations have risen to 4%, above the official 3% target.
“The primary budget deficit is unlikely to reach zero in 2024 and could widen in 2025,” said Rafaela Vitoria, chief economist at Banco Inter, adding that fiscal policy was starting to have an impact on inflation.
She calculated that public spending was growing at about 6 percentage points above the rate of inflation each year since Lula took office in early 2023, adding that there was “no containment mechanism heading into 2025.”
Analysts and market participants say concerns about the budget deficit and fears of political interference in central bank decisions have led investors to demand higher yields on the country’s debt holdings, pushing up borrowing costs.
In opposition to President Lula, the central bank paused its easing cycle on Wednesday. The unanimous decision of the Monetary Policy Committee helped ease a potential credibility crisis at the central bank after committee members appointed by the leftist president pushed through a sharp rate cut in May.
The next day, despite a slight rise in the Bovespa exchange rate, the real hit 5.46 per dollar, its lowest level since President Lula took office. The real pared its losses on Monday to close at 5.39.
“Any rise in asset prices will be short-lived unless the government finds a more sustainable solution to address budget imbalances,” said John Stavriotis, portfolio manager at Antipodes Partners.
Bulls argue that Brazilian stocks, trading at seven times forward earnings, are historically cheap.Through the end of May this year, the FTSE Brazil All Cap index ranked 49th out of 50 country indexes tracked by the data provider.
Responding to investor fears and a failure to win support for a corporate tax cut plan, Haddad has raised the possibility of cutting spending in certain areas, but has faced resistance from within the ruling Workers’ Party and Lula has said he needs to convince ministers of the need.
Government supporters and some investors argue Brazil’s primary budget deficit, projected by the IMF to be 0.6 percent of GDP this year, is relatively small compared with countries such as Mexico, where budget shortfalls are expected to reach closer to 6 percent.
Still, critics say the government has little appetite for making deep cuts ahead of municipal elections in October.
“[Lula] “The honeymoon period of the first year is coming to an end,” said Jan Van de Walle, chief investment officer at family office Sycamore Capital. “We’re going to see more conflict. [between] “Financial Orthodoxy and Government Ambition”
Additional reporting by Mary McDougall in London
