(Bloomberg) -- The dangers were crystal clear. Top economic aides to President Luiz Inacio Lula da Silva had pointed them out to him again and again: Any moves to water down the fiscal-austerity plan in the works will spark a selloff — another selloff — across Brazilian financial markets.
And yet, Lula decided he did not care. He ordered his staff to weave a series of tax-relief measures for the poor into the package unveiled late last week, thereby dulling the much-needed savings the plan would generate. Markets, as advertised, plunged immediately, wiping 2.4% off a stock market that had already been falling for months and sending the currency to a record low against the dollar.
Nearly two years into his return to power, Lula suddenly finds himself at a critical moment. At 79, he is not, as last week’s events revealed, the pragmatic political operator, willing to make crucial sacrifices to keep investors on his side, that he was two decades ago. The question is whether he is now so dogmatic that he’ll continue to resist his aides’ calls for a deficit-cutting package aggressive enough to stabilize markets and, in turn, the entire Brazilian economy.
Last week’s tumble in the real already has traders predicting the central bank will have to raise the benchmark rate as high as 15% — at a time when many other countries are cutting borrowing costs — to keep inflation in check.
“The government is not willing to face the political cost needed to improve the outlook for public accounts,” said Milena Landgraf, a partner at Jubarte Capital in São Paulo. “It missed the window of opportunity to change expectations.”
The plan calls for cutting some 70 billion reais ($11.6 billion) through 2026 by limiting hikes to the minimum wage, earnings for the highest-paid civil servants and salary bonuses to low-income workers. It sets a minimum age for military retirement and bans both the creation and the expansion of tax cuts when there’s a primary budget deficit — which excludes interest payments.
Marketing Adviser
When it came time to unveil the spending cuts, Lula was so worried about how they would be perceived that he demanded ways to soften the impact among the electorate, according to people with knowledge of the matter.
The presidency went as far as getting Lula’s campaign marketing adviser to make recommendations on the national address Finance Minister Fernando Haddad — seen as the president’s would-be successor — would make about the package, said two of the people, who requested anonymity because the information isn’t public.
The solution was to exempt workers with monthly salaries of up to 5,000 reais from paying income taxes. To help offset revenue losses from that change, the government will charge higher levies on incomes above 50,000 reais.
Lula’s move was a defeat for his economic team and left its members hoping investor sentiment will improve by the time congress votes on the measures.
“There was a broader frustration not only because the package fell short of expectations, but also because it came with a complex measure that has the potential to worsen fiscal results in the short term,” said Tiago Sbardelotto, an economist at XP Inc.
Within 24 hours, many of Brazil’s most influential officials were already shifting into damage-control mode.
The lower house of Congress is committed to upholding Brazil’s fiscal rules, Speaker Arthur Lira wrote Friday morning on X. At almost the same time, the press office for Senate President Rodrigo Pacheco released a statement saying changes in income tax rules won’t be implemented immediately, and will only happen if budget conditions allow.
Then, speaking at an event organized by Brazil’s main banking association, Haddad said the fiscal package by no means represented a “grand finale.” He said the government could review expenditures in crucial areas such as disability benefits and social security again in the future. Later, he recognized in an interview with local media that the announcement of tax exemptions alongside the cuts was bad.
The comments helped fuel somewhat of a rebound in assets — but the damage was done. The real ended the week 2.8% lower, while stocks slumped 2.7% to the lowest since June. Swap rates are pricing in almost one percentage point of rate hikes in each of the next two central bank meetings.
For Guido Chamorro, a senior portfolio manager at Pictet Asset Management, while local assets are still attractive because of high yields, the measures were a disappointment.
“For investors, the fiscal question is the cloud in the horizon that doesn’t go away,” he said.
Bad Optics
Indeed, after crunching the numbers, many private sector economists came up with drastically smaller figures on how much public spending would fall as a result of the government’s plan.
Banco Santander said reductions would total 40 billion reais in two years — just over half the administration’s estimate. Bradesco sees actual cuts of 10 billion reais in 2025 and 22 billion reais in 2026, with other savings generated more indirectly.
In addition to the income tax exclusion, investors scowled over what they described as timid changes to rules governing minimum wage hikes, as well as reductions to bonuses for low-income workers that are too gradual.
As time goes by Brazil’s fiscal situation will become more complicated, especially as the central bank raises borrowing costs. Public debt stood at nearly 7.1 trillion reais in October, just shy of an all-time high.
The government’s overall budget deficit equaled 9.5% of gross domestic product in the 12 months through October, according to the most recent central bank data. That compares to 4.9% when Lula started his term in January 2023.
“The government hyped up the market for several weeks, and then tried to combine the spending cuts with the tax exemption,” said Gordian Kemen, head of emerging markets sovereign strategy at Standard Chartered, who has an underweight recommendation on Brazil’s dollar bonds. “It’s just very bad optics.”
--With assistance from Vinícius Andrade and Leda Alvim.
