Brazil faces economic mini crisis due to policy missteps

Brazil central bank struggles with inflation expectations and political pressure

by Faruk Imamovic
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Brazil faces economic mini crisis due to policy missteps
© Getty Images/Mario Tama

Worried about the recent softness in the US labor-market data, Jay Powell bucked the Fed's recent "hawkish" tone when he noted the risk that the Fed may have tightened too much. That has given a spur to stocks and FX this morning, although not to the forward OIS rate curve.

The EUR is also being helped by a fading prospect that the populist-right National Rally will lead a majority in France's National Assembly. Still, the influence of the populist-right or the far-Left in designing profligate fiscal policies can't be ruled out in a best case scenario. It's hard to see a EUR/USD rally past 1.08 that becomes durable in the medium term.

Stocks are bouncing back in Europe this morning, and the major G-10 currencies (EUR, GBP, AUD) are also sturdier, except the JPY. One important cause for the good feeling seems to be the "dovish" remarks made by a few Fed officials at the ECB's symposium in Sintra, Portugal since yesterday. Undoubtedly worried about the softer data in the US, Jay Powell said that the US labor market had made "a pretty substantial move toward better balance", and that the Fed had made "quite a bit of progress" in suppressing inflation. Powell acknowledged the prospect of an overshoot with regard to the amount of tightening already conducted when he said that "it's very much understood by us that we have two-sided risks".

Brazil's Mini-Crisis

Brazil is in a mini-crisis caused by the administration's own making. A lack of fiscal responsibility, politically-motivated calls for lower policy interest rates, and heavy-handed industrial policy agenda have led traders to "give up" on the BRL. We need to watch for whether this mini-crisis itself leads to a definitive change in policy direction, but an FX intervention alone won't be that curative, and isn't likely anyway.

Fiscal Concerns

As often happens in EMs, worries about public budgets and excessive public debt has been brought back into the spotlight. That's largely because the "fiscal framework" that the administration of Inacio Luiz "Lula" da Silva introduced last year has failed to meet the targets for primary deficits, and Brazil's debt-to-GDP ratio has been drifting higher again, as a result.

At the time of the fiscal framework was introduced last year, we had believed that its underlying assumptions (for growth, interest rates, and revenue collection) were too optimistic, and as such the framework has been subject to the risk of revisions ever since. That notwithstanding, the most recent data shows the primary deficit expanding as a share of GDP, and moving away from the 0% target of the fiscal framework. The consolidated deficit is now at 9%, very high even by EM standards. And the debt-to-GDP ratio is also drifting higher again, following an inflation-induced decline in 2021-2022.

Alongside this development, the administration has been unable to convince the Congress to close the deficit by raising taxes, primarily on businesses, as the administration had wished to do. Of course, the erosion in fiscal balances had begun well before Congress and the administration failed to agree on a tax increase. Expanding the tax base or raising tax rates generally is tough to do in an election year (Brazil's municipal election is in autumn).

Brazil faces economic mini crisis due to policy missteps
Brazil faces economic mini crisis due to policy missteps© Getty Images/Mario Tama
 

Central Bank Challenges

The rising deficit has been an issue for the central bank (BCB) too as it sees:

  • 1. A rising deficit contributing to stimulus at a time when inflation (near 4%) unable to converge toward the target (3%)
  • 2. A rising deficit contributing to a drift higher in inflation expectations
  • 3. A higher risk premium embedded in USD/BRL, on the premise that the BCB may have to eventually monetize Brazil's debt, or rely on inflation to support debt-servicing

The BCB's most FOCUS survey shows that the median economist sees inflation in 2025 at 3.87%, or about 35 basis points higher than in April, when Lula had conceded that the fiscal framework's primary budget deficit target would not be met. The policy rate is at 10.50%, and the real ex post policy rate is near 6.5%, but the BCB has recently "interrupted" its easing cycle, largely because of the rise in inflation expectations.

Political Pressure

All this is made more intricate because of Lula's pressure on the BCB to cut the policy rate nonetheless, and because of the looming BCB transition, wherein President Roberto Campos' term ends and he'll be replaced at the end of 2024. Lula's incessant political interference in monetary policymaking suggests that he will choose someone who is "compliant", auguring a structural shift toward a more "dovish" central bank that is willing to accommodate profligate fiscal policies.

Because of these pressures, too, the BCB has chosen to signal its "hawkishness" (while it still can). Indeed, should the survey median inflation expectation for 2025 rise further, the BCB may move into a hiking cycle to help "re-anchor" expectations, but that would anger the administration even more, thereby raising further the prospect that Lula will choose a more compliant BCB president.

That's a vicious cycle, of course, but speaks directly to why the BCB's recent hawkishness has failed to break the path of a higher USD/BRL. Although a majority of the policy Board (the Copom) officials wanted to slow the pace of rate cuts to -25bps in May, four officials wanted a -50bps cut again, and they were Lula's appointees to the Board. But even the unanimous (9-0) decision in June to keep the policy rate on hold has failed to stabilize the BRL. Traders understand that by 2025, Lula will "control" a majority of the Copom, through his appointees.

Potential Solutions

Can FX intervention help the BCB stabilize the BRL? Perhaps it could if it came alongside fundamental support from a fiscal adjustment. But alone it is is likely to be rather useless, if not counterproductive, as a sign of panic on the part of the BCB.

What would work to stabilize the BRL is a more definitive effort to raise fiscal revenue or reduce expenditure, perhaps by delinking certain benefits from the minimum wage, or by revisiting widening the tax base. But that's tough with municipal elections set for the autumn.

An alternative would be to make the BCB less subject to Lula's whims and pressure in the long term. That can only be done by appointing a replacement for Campos who is not a crony of Lula, and to do so soon. We see this as a likelier outcome than a near-term fiscal adjustment in response to the mini-crisis. One course of action in that regard may be to signal that Gabriel Galípolo will be the next BCB president and have him advocate convergence to the 3% target more strongly. But it would be better if a more "hawkish" nominee - not associated with Lula's administration - be chosen.

Conclusion

The Bottom Line is that Brazil is in a mini-crisis of its own making - through a lack of fiscal responsibility, politically-motivated calls for lower policy interest rates, and heavy-handed industrial policy agenda - all of which have led traders to "give up" on the BRL. We need to watch for whether this mini-crisis itself leads to a definitive structural change in policy direction - either fiscal or monetary - but an FX intervention alone won't be that curative, and isn't likely anyway. The alternative - a fiscal or monetary path adjustment - would be an opportunity to short USD/BRL, but only when it happens.

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