Brazil's Fiscal Woes Plunge Real to Record Low Amidst Investor Fears

A surge of panic in Brazil's financial markets has exposed deep-seated investor anxiety over President Luiz Inácio Lula da Silva's handling of the country's finances, as reported by the Financial Times. The crisis, marked by a record low for the Brazilian real against the US dollar and aggressive central bank intervention, underscores the mounting pressure on Lula's administration to stabilize public finances in Latin America's largest economy.

The Brazilian real plummeted to an all-time low on Wednesday, triggering a wave of central bank action to prop up the currency. This sell-off also impacted share prices and broadened the government's borrowing costs.

"Right now there’s absolute fear in the market, driven by fiscal concerns," says Edwin Gutierrez, head of emerging market debt at Abrdn, to the Financial Times. "It’s not just the real – even in the external sovereign bond market there’s contagion. It’s irrational despondency."

The market turmoil stems from concerns that insufficient measures are being taken to address Brazil's persistent budget deficit. This fear intensified despite Finance Minister Fernando Haddad's efforts to secure congressional approval for R$70 billion (US$11.3 billion) in spending cuts before the holiday season.

Economists warn that without more decisive action, Brazil's public debt risks spiraling out of control, potentially triggering negative consequences for inflation, interest rates, and ultimately, economic growth.

"The lack of meaningful signals on fiscal moderation has thrown Brazil into crisis mode again," notes Mariano Machado of consultancy Verisk Maplecroft, to the Financial Times.

This crisis presents a significant challenge for Lula, marking a stark contrast to his first term (2003-2010), when he earned praise for improving living standards while maintaining fiscal discipline. Upon his return to power last year, Lula promised increased spending on infrastructure, public services, and welfare, leading to historically low unemployment and a projected GDP growth of 3.4% in 2024.

However, critics argue that this economic performance is fueled by excessive government stimulus, creating a path toward unsustainable debt levels. Some business leaders, disillusioned with Lula's spending policies, draw parallels to his handpicked successor, Dilma Rousseff, whose administration is widely blamed for contributing to a severe economic downturn.

Rousseff's policies, characterized by increased spending and tax breaks aimed at stimulating growth, created imbalances that exacerbated the impact of a global commodities downturn. Brazil's economy contracted by nearly 7% between 2014 and 2016, culminating in Rousseff's impeachment for violating budget laws.

"We are repeating the mistake made by Dilma’s government, which led to a significant rise in inflation and the biggest recession in our recent history," says Solange Srour, director of macroeconomics for Brazil at UBS Global Wealth, to the Financial Times. "The result of the current crisis of confidence is one of the lowest investment rates [recorded in official data] and a very high real interest rate."

Lula's supporters counter the market turbulence, arguing that the broader economy is healthy, pointing to reductions in poverty and lower inflation since his return to office.

"The only thing wrong in this country is the interest rate, which is above 12 per cent," Lula stated last weekend, following his discharge from hospital after emergency surgery.

Lula has consistently criticized the central bank's high borrowing costs, claiming they hinder economic growth. With a new central bank governor, Gabriel Galípolo, chosen by Lula, taking office on January 1, questions have arisen regarding the institution's independence at a crucial juncture.

Despite inflation exceeding the targeted upper limit of 4.5%, the central bank raised its Selic benchmark by 100 basis points this month, with two further increases of the same magnitude scheduled for early next year. Government officials, however, downplay concerns of an overheated economy.

Guilherme Mello, a senior figure in the finance ministry, acknowledged that this year's GDP forecast is slightly above the economy's potential but expressed confidence that a projected slowdown to 2% in 2025 will prevent overheating.

"Fiscal stimulus fell significantly in 2024 and it will be even less in the next two years," Mello stated, as reported by the Financial Times. "Inflation would have been lower if not for climate events like floods and drought. Next year a much better harvest is forecast, therefore a moderation of growth in food prices."

Government officials also insist that significant fiscal adjustments are underway, aligned with Haddad's objective of eliminating the primary budget deficit. This deficit, excluding interest payments on existing debts, is expected to be around 0.5% in 2024, compared to 2.1% in 2023.