Warning signs for Brazil’s economy force Lula into spending overhaul!

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Brazil’s exchange rate to the dollar has dropped to a record low, heaping further pressure on the leftwing government to introduce spending cuts quickly and calm mounting investor concerns over its commitment to fiscal discipline. After weeks of the currency declining, president Luiz Inácio Lula da Silva’s administration on Monday confirmed it would soon unveil long-anticipated measures to curb expenditure.The government’s decision to accelerate the announcement is viewed in part as a reaction to a sharp fall in the real, which has been under strain as fund managers fret over the management of the public finances of Latin America’s largest economy. The currency is down a fifth against the dollar and is the third worst-performing major currency on a total return basis. It hit a record low on Wednesday, as the greenback surged following the election of Donald Trump. A 3.6 per cent fall took the real through the psychologically-important level of six to the dollar for the first time, according to Bloomberg data.“Investors, market agents and companies are worried because the government has not shown it is really committed to achieving fiscal sustainability,” said Luiz Figueiredo, chair of Jive Investments in São Paulo and a former central bank director.“They’re taking it more seriously, no doubt. But I’m a little sceptical as to whether it will calm the crowd down,” he added.The real has suffered from a sustained dollar rally, similar to other “carry trade” currencies like the Mexican peso. But asset managers say the Brazilian currency has also been hit by fears that a loose fiscal policy under the Lula administration will feed inflation, and force the central bank to keep interest rates higher for longer.Swaps markets are pricing rates for the South American nation to reach more than 13.5 per cent by the middle of next year, a sharp contrast to the current basic lending benchmark of 10.75 per cent. In parallel, Brazilian stocks have fallen nearly 5 per cent since late August.With addressing the issue now the main domestic priority, finance minister Fernando Haddad cancelled a trip to Europe this week at Lula’s request to focus on the cost reduction proposals. Thierry Larose, emerging markets bonds portfolio manager at Swiss bank Vontobel, said a savings figure in the middle of a R$30bn-R$50bn range suggested by local media would be well-received by markets.“The US dollar getting close to six against the real and all-time highs has been instrumental in why the government is now changing its attitude, promising finally to cut expenditure,” he added. “The sell-off has been overextended so it wouldn’t need much to have a rebound in Brazilian assets in general.”Stock markets bounced on Monday when Haddad said the measures would be presented this week. The Bovespa equities index registered its strongest one-day rise since February, paring losses to 3.5 per cent so far in 2024, but the real’s losses resumed after the US election result. Haddad on Wednesday said discussions with cabinet colleagues over the proposals had concluded yesterday and that Lula would in turn send the matter to Congress.“The ministers are all very aware of the task we have ahead to reinforce the fiscal framework and the predictability and sustainability of the finances in the medium and long term,” he told reporters.Mainstream economists warn that Brazil’s gross government debt, which at 78.5 per cent of GDP is relatively elevated for an emerging country, risks reaching unsustainable levels without more significant fiscal adjustments.Lula has pursued a tax-and-spend approach in his third non-consecutive term as president, boosting welfare payments to the poorest and help for homebuyers and debtors. The veteran leftist’s ministers had already pledged to eliminate the budget deficit before interest payments in 2024 and generate surpluses thereafter, but until now this has been primarily premised on higher tax revenues. The IMF recently upgraded Brazil’s growth forecast to 3 per cent and unemployment is near a record low. Yet investor calls for spending restraint have mounted as inflation runs close to the official target’s cap of 4.5 per cent, leading the central bank to raise interest rates. Under consideration are cuts to obligatory expenses such as pensions and social benefits, which are mandated by the constitution and consume 90 per cent of Brazil’s budget. Ministers aim to ensure compliance with a “fiscal framework”, introduced by the Lula administration last year, which limits spending growth to 2.5 per cent.Alberto Ramos, chief Latin America economist at Goldman Sachs, said the measures were unlikely to reduce overall government expenditure, given that the fiscal rules also stipulate the budget grows in real terms annually.“The fiscal targets are way too lax and leading to a significant increase in public debt. The central bank is hiking again because the economy is overheating. The main reason is excessive fiscal activism,” he said.The spending worries reflect pressures on governments across the region, including Mexico and Colombia, said Eirini Tsekeridou, fixed-income analyst at Julius Baer. “Fiscal discipline will remain an important topic for Latin America in 2025, as consolidation efforts are challenged by . . . both high interest rates (and) also high public debt levels,” Tsekeridou said.Additional reporting by Beatriz Langella