Brazil: Tight runoff for presidential elections amid high inflation and fiscal policy issues
Crédito y Caución (Atradius) | On October 2, general elections were held in Brazil to elect all the seats in the lower house of Congress, one-third of the seats in the Senate, the 27 state governors and the president.
The presidential race will be decided in a runoff on October 30, featuring far-right incumbent Jair Bolsonaro and leftist former president Luiz Inacio Lula da Silva. During a polarized first-round campaign, Lula garnered 48% of the vote, but failed to secure the majority needed for an outright victory. Bolsonaro won 43%, exceeding previous expectations in most opinion polls. Additionally, Bolsonaro’s right-wing Social Liberal Party (PSL) won 99 seats in the 513-member lower house, down from 77, and PSL candidates won 13 of the 27 seats up for election in the Senate.
We expect the campaign for the second round of the presidential election to be polarized again. The election could even be a test for Brazilian institutions, especially if Lula ends up winning by a narrow margin and Bolsonaro refuses to accept the result. As the first round approached, Bolsonaro repeatedly questioned the integrity of Brazil’s electronic voting system and suggested he could not back down if he lost.
Continued political uncertainty could weigh negatively on investor sentiment. Regardless of the outcome of the second round of elections, we expect that deep divisions within Brazilian society and strong polarization between left and right political forces will remain serious issues at this time.
High interest rates remain a major problem
The Brazilian economy returned to pre-Covid levels in the first quarter of 2021, ahead of schedule. With a 3.2% year-on-year increase in the second quarter of 2022, GDP growth exceeded forecasts. Private consumption grew by more than 5%, due to rising employment and increased social transfers, while higher infrastructure investment also supported economic activity.
However, the economic recovery since last year and rising energy and food prices (partly due to a severe drought in 2021) have led to a rapid rise in inflation. The war in Ukraine and increased pre-election government spending also fueled the surge, with inflation rising from less than 2% in mid-2020 to over 12% in April 2022. As a result, the Central Bank raised from aggressively the reference interest rate (Selic) since March 2021, from 2% to 13.75% in August 2022.
Meanwhile, consumer prices appear to have passed their peak, falling to 8.7% in August. This allowed the Central Bank to suspend the tightening cycle and keep rates unchanged in September. However, we expect interest rate cuts to not occur until the second half of 2023 as uncertainty remains high and inflation will only gradually converge to the central bank’s target range of 1.75% to 4.75% for next year.
An economic slowdown expected in 2023
Tight credit conditions, weaker external demand and heightened political uncertainty are expected to dampen economic activity in the coming months. We expect GDP growth in 2022 to reach 2.6%, supported by pre-election spending (eg cash transfers to consumers) and temporary tax cuts (mainly on energy). However, economic expansion will slow to 0.5% in 2023. Persistently high interest rates are expected to slow domestic demand and increase debt service costs for both consumers and businesses. Private consumption, which accounts for around 60% of GDP, is expected to grow by only 0.4% next year. Fixed investments will stagnate as corporate margins are squeezed by high energy and other input prices.
Non-performing loans on the rise, but a solid banking sector
In 2021, non-performing loans (NPLs) increased only slightly to 2.3% from 2.1% in 2020, partly cushioned by loan restructuring and debt moratoriums. With the expiry of these measures, the NPLs increased to 2.7% in June 2022. At 1.5%, the NPLs of businesses were lower than those of households (3.5%). Due to rising interest rates and a slowing economy, we expect NPLs to rise further in the fourth quarter of 2022 and into next year. However, the provisions are sufficient.
The banking sector (37% of assets owned by the state; 16% owned by foreigners) is well regulated and supervised. Low dollarization of domestic credit (15%) and low dependence on wholesale funding protect the system from negative shocks. Banks have well-developed credit risk assessment systems and increased provisioning before the pandemic. Capitalization remains sufficient (solvency ratio of 16.2% in Q2 2022 compared to 16.8% in 2020).
The large budget deficit is expected to widen further in 2022 and 2023
A large budget deficit was already Brazil’s main economic weakness before the coronavirus outbreak, with consistently high annual budget deficits over the past two years. A constitutional amendment to eliminate automatic growth in fiscal spending in line with rising inflation passed in 2016 and the adoption of a comprehensive pension reform in 2019 were necessary steps towards greater fiscal sustainability. That said, additional structural reforms are needed to put public debt on a sustainable path and to maintain investor confidence over the long term. The next administration will have to take up this challenge.
Fiscal developments were positive in 2021, as rising revenues, the withdrawal of most Covid-related support measures and wage moderation sharply reduced the public deficit to 4.4% of GDP, from nearly 12 % of GDP in 2020. However, we expect the deficit to widen again in 2022 and 2023, to 6.2% of GDP and 8.3% of GDP respectively. This is due to higher interest charges (40% of public debt is linked to the Selic benchmark interest rate), as well as pre-election tax breaks and spending measures.
As a result, we expect public debt to decline from 80% of GDP in 2021 to 87% of GDP in 2023. For now, currency, refinancing and sovereign default risks are mitigated by the fact that most of the debt is financed on the domestic market. (89%), in local currency (94%) with an average maturity of more than five years, and that the government is a net external creditor.
Fiscal policy and next administration – concerns remain
Investor concerns over the fiscal framework have grown, particularly that a temporary waiver to comply with government spending rules could be extended. Even Bolsonaro’s pro-business government announced that if he were to be re-elected, he would support a “more flexible” fiscal rule.
If Lula wins the second round of elections, we expect him to pursue less market-oriented policies, with higher social spending and more state intervention. While he appears to support the idea of a new fiscal framework that allows for more short-term borrowing, he also showed good pragmatism during his previous presidency. At the same time, the fragmented composition of Congress, where a group of centrist parties (centrão) traditionally hold the balance of power, will limit the risk of an overall shift in economic policies. The success of Bolsonaro’s PSL and allied parties in congressional elections would further limit Lula’s scope for major policy changes, should he become the next president.
Whoever wins the presidential election will face the challenge of rebuilding fiscal credibility to bolster business and investor sentiment.
Vulnerable to changes in investor sentiment, but resilient to major shocks
Brazil is vulnerable to changes in investor sentiment, due to a relatively high level of non-resident portfolio investment flows. However, a solid financial sector, large official reserves, relatively low external refinancing needs and the use of exchange risk hedges allow the flexible exchange rate to act as a shock absorber.
The exchange rate has been quite volatile this year due to political uncertainty, fiscal concerns and an unfavorable global risk environment. After a sharp depreciation in 2020 and into 2021, the Brazilian real remains undervalued, despite a further overall appreciation in 2022 (supported by high commodity prices and rising domestic interest rates). We expect currency volatility to continue for now, especially ahead of the second round of presidential elections. Moreover, a narrowing of the interest differential with the United States will prevent any further strengthening in the short term.
Solid external finances and manageable foreign currency debt
Brazil’s external financial position is expected to remain strong, keeping transfer and convertibility risks low. Despite a drop in official reserves during 2022, liquidity remains more than sufficient to cover imports (more than 12 months) and external refinancing needs. The current account is benefiting from high commodity export prices and is expected to show only small deficits of 0.7% in 2022 and 0.9% of GDP in 2023. Foreign direct investment flows, averaging of 3.1% of GDP in 2022-2023, will fully cover these deficits.
Companies represent 63%, banks 20% and the government 17% of foreign currency debt. This year, the foreign currency debt will increase slightly in nominal terms. The ratios are low and are expected to decline to 30% of GDP and around 140% of exports of goods and services in 2023, from 36% and 164% respectively in 2021. Most externally indebted companies have hedged their foreign exchange risk . Refinancing risk is also mitigated by a large share of intercompany debt, which accounts for two-thirds of non-financial corporate foreign currency debt.
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