Brazil stocks plunge after Lula’s re-election. Why investors are worried

Brazilian financial markets faced a sharp sell-off in early overseas trading on Monday after President Luiz Inácio Lula da Silva won re-election, disappointing investors who had favoured a victory for right-wing challenger Flávio Bolsonaro.

An exchange-traded fund (ETF) tracking Brazilian equities fell as much as 16 per cent in Japan, its steepest intraday decline since 2020, Bloomberg reported. Meanwhile, a currency derivatives contract traded on the CME exchange indicated that Brazil’s real could weaken by more than 10 per cent against the US dollar from Friday’s close.

The moves were early signals from overseas trading rather than confirmed closing prices in Brazil’s domestic markets.

Lula defeated Bolsonaro in Sunday’s presidential runoff, reversing the momentum from the first round of voting, when the opposition candidate had finished ahead. Investors had viewed Bolsonaro as more likely to pursue tighter fiscal policies and lower corporate taxes.

The result has raised questions about whether Brazil can rein in public spending and stabilise its debt burden while maintaining Lula’s commitments to welfare programmes and increases in the minimum wage.

Why investors are worried about Brazil’s fiscal outlook

Brazil’s public debt has risen by more than 10 percentage points during Lula’s current term to over 82 per cent of gross domestic product (GDP), increasing borrowing costs and adding pressure on government finances, according to Reuters.

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Years of rising mandatory expenditure have left the federal government with limited flexibility to adjust its budget. Less than 8 per cent of the federal budget is adjustable, restricting the scope for spending cuts without changes to existing commitments.

Lula has pledged to maintain the government’s fiscal framework, which limits spending growth and sets targets for the primary budget balance. The primary balance measures government revenue against expenditure before interest payments on public debt.

However, his commitments to raise the minimum wage faster than inflation, expand social benefits and introduce additional spending measures could make those targets harder to meet.

Investors are watching whether the government will strengthen its fiscal rules or rely on economic growth to improve public finances.

The concern is that if government spending continues to outpace revenue, borrowing requirements could remain high, keeping pressure on interest rates and the currency.

High interest rates and inflation add to the pressure

Brazil’s monetary policy presents another challenge for the incoming administration.

The country’s benchmark interest rate stood at 13.75 per cent, while annual inflation was 4.6 per cent, above the central bank’s tolerance range of 1.5 per cent to 4.5 per cent, according to Reuters.

The central bank cut rates for a fifth consecutive meeting in September amid signs of an economic slowdown. However, inflation is expected to remain above the official 3 per cent target for an extended period.

High interest rates make borrowing more expensive for households and businesses. They can also increase the government’s debt-servicing costs and weigh on investment and consumption.

Lula has promised to bring borrowing costs down while protecting social spending. Economists have argued that faster rate cuts will be difficult without stronger fiscal discipline, creating a challenge for the government as it seeks to balance growth and welfare commitments.

A weaker real could complicate the task if it raises the cost of imported goods and adds to inflationary pressures.

Households and businesses are already struggling with debt

The pressure extends beyond government finances.

Nearly 84 million Brazilians and 9.3 million businesses were behind on debt payments, according to credit bureau Serasa, Reuters reported. High borrowing costs have added to the burden on consumers and companies.

The debt stress has persisted despite favourable labour-market indicators, including record-low unemployment and wage growth outpacing inflation.

Lula has proposed another round of debt relief, including discounted purchases of distressed household loans from banks and tax debt forgiveness for some small business owners.

However, analysts have warned that such measures could offer temporary relief without addressing the underlying cost of credit.

The government has also discussed ways to curb heavy reliance on expensive consumer borrowing, including credit cards and unsecured loans, although detailed proposals have yet to emerge.

A conservative Congress could complicate economic reforms

Lula’s next term will also face political constraints.

Although he won re-election, conservative parties are set to control both chambers of Congress, making it more difficult for his administration to secure approval for economic legislation.

The government has sought to reduce tax breaks and broaden revenue collection, but lawmakers have repeatedly resisted measures that increase the effective tax burden.

This could complicate efforts to strengthen public finances and implement changes to the tax system.

Brazil is also preparing to introduce a new value-added tax in January following a sweeping consumption-tax overhaul approved in 2023. The government had yet to disclose the effective rate, which independent analysts estimated could be around 28 per cent, Reuters reported.

Delays in legislation covering additional taxes on products considered harmful to health or the environment could further affect the timing of expected revenue.

What investors will watch next

The immediate market reaction will be tested when Brazil’s domestic financial markets reopen. Overseas trading can signal investor sentiment, but the scale and durability of the sell-off will depend on subsequent trading and policy announcements.

Investors will look for signals from Lula’s economic team on spending, debt stabilisation and the government’s commitment to its fiscal framework.

The relationship between the administration and Congress will also be important. A credible plan to control borrowing requirements could help ease concerns about public finances, while signs of additional unfunded spending could sustain pressure on Brazilian assets.

Brazil’s economy has performed better than expected in recent years, but the new term begins with a difficult combination of high public debt, elevated interest rates, persistent inflation and heavily indebted consumers.