Another crash-landing for Brazil’s economy?

[LONDON] Brazil has an unfortunate habit of disappointing. Despite the country’s exceptional natural-resource endowment, its growth trajectory resembles what Brazilians call the flight of a chicken (”voo de galinha”): A brief flutter followed by an inevitable fall back down to earth.

President Luiz Inacio Lula da Silva’s surprise re-election raises the risk of another let-down.

By the time he leaves office in 2030, Lula will have occupied the presidency for 16 (non-consecutive) years.

Today, Brazil’s public finances are already precarious, following nearly four years of loose fiscal policy. Public-sector debt has risen from 73.8 per cent of gross domestic product in 2023 to a projected 86.6 per cent by the end of 2026.

Stabilising debt at this level would require a sustained primary fiscal surplus of at least 1.5 per cent of GDP. Instead, Brazil is expected to run a primary deficit of around 0.5 per cent of GDP in 2026.

The government’s fiscal targets exclude some expenditure that contributes to borrowing requirements.

Adjusting for the economic cycle and temporary fiscal measures, the International Monetary Fund puts Brazil’s structural primary deficit at an estimated 1.3 per cent of potential GDP in 2026.

Without fiscal adjustment, Brazil’s debt could increase by another 10 percentage points over the next four years. But there is no sign Lula will pursue the necessary changes.

In the final weeks of the campaign, he promised additional benefits, subsidies and tax relief that local estimates suggest could cost 0.4 to 0.6 per cent of GDP in 2027. Some measures can be implemented without new legislation, but their continued financing will require parliamentary agreement.

With the government’s “expenditure ceiling” already fully allocated, new spending requires offsetting cuts, additional revenues or further exceptions to its fiscal framework. None will be easy.

Congress, with more than 20 parties represented, has expanded its influence over Budget allocations in recent years. Legislators have strong incentives to defend existing benefits and spend any additional resources.

Furthermore, at 32.4 per cent of GDP, Brazil’s tax burden is already unusually high for an emerging economy. Congress has repeatedly resisted the government’s revenue-raising efforts over the past two years, and the newly elected legislature is substantially more right wing.

Lula faces a choice between adjusting fiscal policy proactively or waiting for financial markets to force his hand. The political incentive to delay is considerable.

Former president Dilma Rousseff’s attempt at fiscal tightening following her 2014 re-election alienated parts of her political base and failed to prevent her impeachment in 2016. Lula may prefer to let market pressure provide the political justification for unpopular measures.

But markets have an incentive to test that reluctance, raising borrowing costs and potentially forcing a more painful adjustment later.

Pressure on institutions

The new Congress will also test Brazilian institutions. Over the next four years, Lula can nominate replacements for four of the Supreme Court’s 11 justices and fill all nine seats on the central bank’s governing board. These appointments all require Senate confirmation.

Historically, this has been little more than a formality, but the Senate’s rejection of Lula’s Supreme Court nominee, Jorge Messias, in April – the first such rejection since 1894 – suggests that the days of rubber-stamp confirmations may be over.

Both institutions will be subject to intensifying political tensions. The Supreme Court will adjudicate disagreements over executive authority, congressional spending powers, and constitutionally protected expenditure. The central bank will face pressure to accommodate a fiscal position that the political system appears unwilling to correct.

This pressure is already evident. The central bank’s Lula-appointed governor, Gabriel Galipolo, frustrated elements of the ruling party by resisting faster interest-rate cuts before the election. Lula now has an opportunity to reshape the bank’s leadership.

Yet, financial markets have moved in the opposite direction.

Following Lula’s victory, interest-rate futures began pricing renewed tightening, rather than the cuts expected before the election. The conflict between political demands for lower rates and market demands for tighter policy could become a major test of the bank’s independence.

Inflation has exceeded the upper bound of the central bank’s target range for nearly two-thirds of the months since it was granted operational independence in 2021. Deteriorating fiscal credibility could raise inflation expectations and real interest rates, while weakening the currency.

The resulting pressure on the banking system is also growing, with non-performing loans already rising. Further monetary tightening could aggravate credit losses and constrain lending.

Brazil’s floating exchange rate, substantial foreign-exchange reserves and strong commodity exports, together with the fact that its debt is denominated predominantly in its own currency, reduce its exposure to a balance-of-payments crisis. But these do not eliminate the domestic costs of fiscal deterioration.

As investors demand higher compensation for inflation and fiscal risks, borrowing costs will rise, worsening debt dynamics. Persistently high real interest rates depress private investment and weaken growth.

Political polarisation makes consensus around fiscal restraint especially difficult. Brazil might face a prolonged period of high inflation, currency weakness, high real interest rates and mediocre growth.

As in the past, the Brazilian chicken will be unable to gain any lift, no matter how hard it flaps its wings. PROJECT SYNDICATE

The writer, a former global strategist at Pimco, is a senior visiting fellow at the London School of Economics and a non-resident fellow at Bruegel