Brazil’s quest for a balanced budget

Even with a steady increase in revenues, Brazil’s federal government accounts closed the first half of 2024 with a deficit of BRL 70.6 billion (USD 12.7 billion), a 66 per cent increase compared to last year’s first semester, as shown in Graph 1. The numbers prove that the government is challenged in achieving its self-imposed zero deficit target this year. Finance Minister Fernando Haddad has made efforts to raise revenue collections, however, public spending posted a faster expansion. So far, this year has seen revenues climb by 10 per cent. The economics team’s last forecast is that the federal government will close this year with a deficit of BRL 29 billion, equivalent to 0.25 per cent of the GDP – already the upper bound of the government’s target range.

Uncertainties regarding the attainment of Brazil’s fiscal policy goals were one of the main drivers of the Brazilian real’s depreciation against the US dollar, which weakened by 12 per cent end-September compared to its 2023 closing level. These developments do not suggest the occurrence of an immediate financial crisis, but there is no space for complacency.

Strained ties

Increasing doubts about the Brazilian market are fuelled by the looming replacement of the Central Bank of Brazil’s (BCB) board members as Governor Roberto Campos Neto, along with eight others, will finish their term by year-end. Campos Neto has been repeatedly criticized by President Luiz Inácio Lula da Silva, the latter insisting that interest rates are too high that it is stifling growth. The BCB has insisted on its independence and is proceeding with caution regarding further rate actions. In return, the BCB also stressed the importance of the national government meeting its fiscal targets, saying it will help rein inflation expectations.

The lack of fiscal prudence effectively raises government debt, as shown in Graph 2. Brazil needs to manage its budget gap as high public debt could be inflationary. Public resources will benefit if debt is kept under control, paving the way for increased government spending that, in turn, will lead to additional economic activity and revenues. However, signs such as parliamentary amendments, a Congress hungry for more budgetary power, and spending involving freebies for special interests, point to a steady ascent in government debt. Lula is better off sticking strictly to the fiscal framework his government drew up.

It will be up to the left-wing president to nominate new BCB members and appointments are subject to Senate approval.

Lula will have appointed most of the BCB board members if the nominations are accepted, and this could be perceived as providing increased support for bigger interest rate reductions. This was evident from May’s Monetary Policy Committee (COPOM) meeting, wherein Lula-nominated members voted for a rate cut worth 0.5 per cent instead of 0.25 per cent.

Market watchers took positively Campos Neto’s insistence on an independent monetary policy despite political pressure by basing rate decisions on technical parameters. However, his impending departure raises uncertainty about the BCB’s policymaking, already reflected in higher yields for future contracts and rising risk premia on long-term notes issued by the Brazilian government. These could potentially reduce the attractiveness of Brazilian debt papers.

Despite these challenges, there are still opportunities in the Brazilian market. Short-term fixed-rate bonds present a promising avenue. Financial agents have factored in a 100-basis point increase in the Selic rate in one year given the changes in the BCB’s leadership. Opportunistic investors can then take advantage of this situation and consider fixed-income assets, IPCA+6%, and government bonds as attractive options.

Taking advantage of US rate cuts

The start of monetary easing in the US can pique stronger interest towards investments in Brazil, but the course of the US presidential race can change everything.

The direction of monetary policy in the US is evident. In September, the Federal Reserve cut interest rates by 50 basis points, with the possibility of up to three cuts until end-2024. Data over the past couple of months show the American economy is growing steadily, with a declining unemployment rate and slower inflation.

Maintaining a certain interest rate differential attracts foreign capital. Assuming that the COPOM is inclined towards keeping Brazil’s key policy rate unchanged in its next meeting after a quarter-point rate hike in September, the rate differential must prop up the real against the USD, reducing import prices and inflationary risks.

The Fed’s actions also create a ripple effect in Brazil’s stock market. Historically, a rate cut in the US is followed by a rise in Brazilian stocks a year later, with valuations rising by an average of 30 per cent when expressed in the US dollar and 20 per cent in Brazilian real as seen in Graph 2, which shows the Bovespa Index (IBOV) through the years. Investors should take advantage of this and buy Brazilian shares now before the US Fed’s expected rate cuts are implemented. There is no certainty on how the market will respond this time around, but investors are probably aware of historical trends; it should not come as a surprise if Brazilian stocks will follow the same track again.

There is also the upcoming US presidential race and how each candidate will maintain bilateral ties with Brazil. On one hand, a Republican victory would mean loose company regulations and lower taxes, which would boost the US dollar against emerging market currencies and commodity exporters. Former President Donald Trump’s return to the White House could keep long-term interest rates in the US high and make it harder for the Brazilian real to appreciate. This would also place Brazil and the US in very distant ideological positions, although the foundations of the bilateral relationship between the countries remain.

On the other hand, the US under Vice President Kamala Harris would see more expansionary economic policies. Her proposals include raising minimum wages and more infrastructure investments that would raise public spending. A fiscal expansion may be inflationary and could force the Fed to keep or increase interest rates to rein prices in, and this would be disadvantageous for Brazil. Meanwhile, greater trade openness would potentially ease pressure on the dollar, benefiting global trade and stabilizing the US currency.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.