The unexpected re-election of leftist politician Lula triggered a massive market selloff, sharply intensifying investor worries about Brazil's economic governance. President Luiz Inacio Lula da Silva is now under pressure and must roll out a budget-cutting plan.
Markets are concerned about the fiscal position of the government under Lula. The Brazilian real plunged 8% against the US dollar in a single day, its worst performance since 1999; the benchmark Bovespa index tumbled 13.9%. Pablo Riveroll, head of Latin American equities and a fund manager at Schroders, said: "A credible fiscal plan must both improve tax collection and cut spending."
Brazil's fiscal deficit is enormous, reaching 9.5% of gross domestic product (GDP), with debt levels also high. Fund managers and economists believe this is precisely what is keeping the country's interest rates elevated. Previously, investors had bet on a business-friendly Flavio Bolsonaro camp coming to power, and the concentrated unwinding of such positions also fueled Monday's selloff; but what truly ignited market anxiety were the welfare spending promises Lula made during his re-election campaign.
The Independent Fiscal Institution, a nonpartisan body attached to Brazil's Senate, estimates that these measures, covering debt relief and higher welfare subsidies, amount to about 298 billion reais (US$55 billion) this year. Riveroll added: "The social spending programs announced during the campaign have no clear funding source, let alone funding to support a fiscal surplus."
JPMorgan analysts said in a Monday report that relying on spending restraint alone is "not enough." The report wrote: "We believe that to improve fiscal performance, reforms must be carried out to address the growing pressure from rigid spending," while also acknowledging that such reform bills face numerous obstacles to winning presidential approval.
Rigid spending items such as social security and public-sector salaries consume nearly 90% of Brazil's budget; without changing legislation, the government has almost no room to adjust. Lula previously governed Brazil from 2003 to 2010, and in this third term he has expanded taxes and increased spending to drive economic growth. But critics argue that the loose fiscal stance has forced the central bank to maintain tight monetary policy, with the benchmark interest rate at 13.75%.
Economists say the budget gap must be narrowed to prevent debt from climbing further. Brazil's government debt has reached 83% of GDP, a relatively high level for a developing country. Bolsonaro had previously promised to cut spending equivalent to about 2% of the economy. According to local media reports, Lula's team was at the time drafting a spending-control plan aimed at improving the debt trajectory and restoring investor confidence, though the government did not respond to requests for comment.
Thomas Haugaard, an emerging market debt portfolio manager at Janus Henderson, said that for the real's exchange rate to recover sustainably, it depends on spending cuts and a "credible" path to stabilizing public debt, rather than one-off emergency measures or simply "changing the narrative." He added: "All eyes are now on Lula's economic team and fiscal plan. The market will expect credible appointments, political support, and an adjustment plan with quantified targets, focused mainly on spending cuts, and able to secure congressional backing."
The choice of finance minister is crucial. One name circulating within the Workers' Party is Piaui Governor Rafael Fonteles. He told Brazil's Globo News on Monday: "The president is committed to achieving balance in public finances."
Although Bolsonaro lost the election, the right wing made substantial gains in this month's congressional elections, giving investors a glimmer of hope that Congress may be able to check the government's tendency toward lavish spending. Eurasia Group analyst Leonardo Mela Rice expects Lula to introduce a "moderate" fiscal adjustment plan, but he also noted: "We believe the first round of spending cuts will not be enough to reassure the market."
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