Brazil's Economic Outlook Under Lula

(Photo by DOUGLAS MAGNO/AFP via Getty Images)

Brazilian President Luiz Inacio Lula da Silva (L) greets Tarciana Medeiros (R) during her inauguration ceremony as the new chair of Brazil's Central Bank on Jan. 16, 2023.

While Brazil is not at risk of an economic crisis, largely thanks to a solid external financial position, growth will remain slow in 2023 due to its large public debt, high social welfare spending, and state intervention in sectors including agriculture and oil and gas. When Luiz Inacio Lula da Silva was inaugurated on Jan. 1 for his third term as Brazil's president, he inherited an economy whose real gross domestic product growth averaged only 1.2% over the past decade, with per capita incomes virtually unchanged following a number of domestic and external shocks. But the recent past was not completely negative, as the Brazilian Central Bank is now fully independent, which has enabled the country to react swiftly to increasing inflation. Brazil also managed to avoid broader financial instability despite the global COVID-19 pandemic and the Russia-Ukraine war due to a solid external financial position and in spite of high government debt.

Brazil's recent external shocks include a 2018 corruption scandal involving major companies and a large number of politicians, which effectively paralyzed infrastructure investment for years, and COVID-19.
Inflation fell to 5.9% in November 2022 from 6.5% in October 2022, 7.2% in September 2022 and double-digit levels during the first half of 2022. Inflation has been much less of a problem in Brazil than in many other countries thanks to timely and decisive Central Bank tightening, which has seen cumulative rate hikes of 1,200 basis points since early 2021.
Brazil is rated sub-investment grade. This suggests medium default risk, but the risks attached to Brazil's external position are quite manageable, given a large stock of foreign-exchange reserves, a small current account deficit fully financed by net foreign direct investment inflows and a low level of short-term external liabilities.

A weak fiscal policy and high government debt, combined with rising interest rates and slowing global growth, will increase Brazil's financial and debt sustainability risks over the long term. According to the International Monetary Fund (IMF), Brazil's real economic growth will average only 2% or less over the next five years due to low investment and savings rates, as well as a large fiscal deficit of 7.5% of GDP and a primary deficit. These constraints will continue to increase Brazilian government debt in the coming years, and rising real interest rates will increase pressure on government interest payments, further complicating the medium-term outlook for government debt sustainability. However, the IMF does not foresee significant changes to Brazil's external financial indicators, in part because Brazil's current account deficit will remain comparatively small (less than 2% of GDP in 2022 and 2023) due to its status as a net commodity and food exporter amid higher commodity prices related to the Russia-Ukraine war. Additionally, Brazil's foreign exchange reserves and flexible exchange rate enable the country to adjust to external shocks with relative ease.

Government debt will fall slightly in the short term due to high inflation but will continue to increase over the medium term due to higher interest rates. Brazil's gross government debt increased from just over 60% of GDP in 2010 to nearly 90% of GDP in January 2023, and it is set to reach 100% of GDP by 2030.

Lula will almost certainly seek to increase social welfare spending, leading to investor concern over a ballooning debt-to-GDP ratio. While the government already received an exemption from the country's constitutionally mandated spending cap — which pegs state expenditure to the previous year's budget (accounting for inflation) — for a costly social welfare program for the duration of 2023, Lula will almost certainly seek to change the fiscal rule for the remainder of his tenure or find other exemptions that undermine the effort to curb high public expenditures. This move will likely add volatility to Brazilian markets and the country's currency (as investors rely on the spending cap mechanism to stave off fiscal concerns), which could lead businesses, investors and households to halt spending decisions. The resulting economic volatility would likely further hinder Brazil's economic growth and prompt even more fiscal spending as the government seeks to spur the economy.

In late December 2022, Brazil's Congress approved a constitutional amendment to maintain monthly payments of 600 reais (about $150) to the poor under the cash-transfer program Bolsa Familia through 2023.

It will likely be difficult for Lula to pass economic and tax reforms since centrist and right-wing lawmakers control part of Congress, but he will implement his policy platform through regulatory changes, which will particularly impact the agriculture and oil and gas sectors. The Lula government will likely seek to implement a tax reform to simplify the country's notoriously complicated tax structure and increase the tax burden on the wealthy. However, Congress may not pass this tax reform because the center and far-right opposition control the body's lower house and have little interest in helping the new left-wing government. As such, Lula's most impactful economic changes will likely take place through the regulatory sphere as his Cabinet enacts changes through the regulation and enforcement dictated by state-run agencies. This will likely include efforts to change the country's environmental regulations to strengthen anti-deforestation efforts, potentially hindering the growth of the country's agriculture sector, which relies on more access to arable land that comes mainly from deforestation. Similarly, Lula will likely push to change the state-owned oil and gas company Petrobras' oil price policy, which alters the price of fuels every two weeks to reflect global prices, to artificially lower prices, especially if global fuel prices remain high or rise. Such a change could lead to a higher frequency of one-time price increases and broader volatility in the country's pricing model, as well as suppress the profit margins of oil and gas companies operating in the country.

Following legislative elections held on Oct. 2, 2022, right-wing parties secured a simple majority in the lower house of Brazil's Congress, which is needed to pass most legislation, but fell just short of securing the two-thirds majority required to pass constitutional amendments.