(Bloomberg) -- As the currency craters in Brazil, thrusting the country’s markets into the international spotlight for the first time in years, a grim reality is setting in for top economic aides to President Luiz Inacio Lula da Silva. They are, they fear, powerless to do much to stop the panic.
Lula, convalescing at his home in Sao Paulo after back-to-back emergency brain surgeries, has no interest in adding to an austerity package that could, if executed boldly enough, calm investors’ worries about soaring debt and stem the capital flight that has sent the currency to record lows.
His advisers had to plead with him for weeks to do it in the first place. And lawmakers, they note, are opposed to it, too. The tweaks they’re making to the bill as it wends its way through Congress are aimed at weakening the package of cost cuts.
It’d been years, dating all the way back to the run-up to Lula’s very first election in 2002, since Brazilian markets were convulsed by fears of a debt crisis. And while this one may still pale in comparison to that one — the country’s foreign bonds yield a fraction of what they did back then, and there’s a lot less dollar debt outstanding now — in its essence, that’s what it is. Just like in France, investors are no longer in the mood to finance deficits that exploded during the pandemic and barely inched back lower in the years since.
Intervention
The central bank has ramped up intervention in currency markets to try to stem the losses amid what Governor Roberto Campos Neto called an “atypical” outflow. It has stepped in either directly or through swaps almost every day for the past week, spending close to $14 billion to give some support to the real, the worst performing major currency in the world this year.
On Thursday alone it sold $8 billion in back-to-back spot auctions — that’s the biggest daily sale of dollars since at least 1999, when Brazil adopted a floating exchange rate regime, according to central bank data compiled by Bloomberg. It announced it will step in again Friday with a credit line auction of as much as $4 billion, and another spot auction of as much as $3 billion.
The blitz worked. The real jumped 2.4% Thursday after the sales, leading emerging market gains, while swap rates retreated as the central bank pushed back on bets on even steeper rate hikes than it signaled ahead.
But on most days, the impact of such interventions has largely faded within hours.
That’s because regardless of how many dollars the central bank sells or how fast it pushes up interest rates, offering ever-juicier returns on local assets, investors will just keep pulling money out until they’re confident the deficit will be brought down. There will be starts and stops in the outflows, analysts say, but the concerns are too real to paper over with 15% bond yields.
“The government lacks credibility,” said Daniela Da Costa-Bulthuis, who helps oversee €200 billion ($207 billion) of assets at Robeco Institutional Asset Management. “The stock market and the real are starting to price in a very complicated economic situation that will be difficult to resolve.”
Lula’s aides are doing what they can. Finance Minister Fernando Haddad has been publicly talking up the government’s spending cuts, and dangled the idea of enhancements to come. And the government’s main liaison to Congress is making reassuring statements about his intention to persuade reluctant lawmakers to accept the austerity.
But according to people close to the highest ranks of the leftist government, who asked not to be identified discussing internal debates, Lula’s view is that his proposal to slash 70 billion reais ($11.2 billion) of spending through 2026 by limiting growth in the minimum wage and tightening rules on welfare payments is more than enough. Analysts disagree, saying the package could free up a little over half that, according to a central bank survey.
The intransigence even as the markets convulse is raising concerns among traders that the country may be heading toward a scenario known as fiscal dominance. In fact, such speculation is all the rage at banks in Sao Paulo and trading floors in Rio de Janeiro.
A growing chorus of Brazil watchers, from veteran investor Luis Stuhlberger and former central banker Arminio Fraga to Goldman Sachs and Morgan Stanley, is warning of the country falling into a trap in which fiscal expansion undercuts the impact of the central bank’s attempt to tighten policy with higher interest rates.
The central bank is one of few worldwide to be raising borrowing costs. This month, Campos Neto boosted rates by a full percentage point to 12.25% and the board of directors — in a unanimous decision — signaled two additional, similar hikes by March, in a message that surprised even the most hawkish of the predictions.
But traders continued to dump Brazil assets — calling for concrete action from the government to address the fiscal side. The real extended year-to-date losses to 20%, while yields on local government bonds climbed to the highest levels since former President Dilma Rousseff was impeached in 2016. What’s more, the local curve of swap rates sold off, with longer-dated maturities being hit harder.
Fiscal dominance is “becoming part of the conversation,” said Katrina Butt, a senior economist at AllianceBernstein in New York. “Fiscal policymaking is clearly affecting monetary policy decision making.”
The problems plaguing Brazil also have a lot in common with an old-fashioned, emerging-market debt crisis. The country is running an annual budget gap equivalent to about 10% of gross domestic product — one of the widest across the globe — while its gross debt has started expanding again, recently reaching 78.6% of GDP.
Some economists say it’s too soon to declare the central bank’s tools have completely lost their effectiveness. They point out that Gabriel Galipolo, soon to take over the helm of the bank, is pledging to tighten policy as much as needed to tame inflation.
The government thinks so too. Brazil’s economic team doesn’t see fiscal dominance happening now. They say monetary policy is effective and will slow down economic growth. Campos Neto dismissed the notion on Thursday as well, saying the foreign exchange interventions are not tied to fiscal dominance concerns.
What Bloomberg Economics Says
“We don’t think there’s sufficient evidence to declare that Brazil is going through fiscal dominance - that is, that monetary policy lost its ability to tame inflation or influence the currency. Asset price swings of recent days reflected a number of non-economic factors, ranging from news on President Lula’s health conditions to developments on the fiscal front, reducing their value as evidence of how rates impact prices. Brazil’s public debt is high and the outlook warrants some concern, but we’re nowhere near material chances of default.”
— Adriana Dupita, Brazil and Argentina economist
Yet others say the risks of a monetary policy flop are on the rise.
In a recent letter to investors, hedge fund manager Stuhlberger said Brazil policymakers are now acting “under the shadow” of the fiscal-dominance risk. To Alberto Ramos, the chief economist for Latin America at Goldman, the country is “flirting” with such a scenario. Morgan Stanley strategist Ioana Zamfir wrote in a note earlier this month that the real could plunge as much as as 11% from current levels to 7 per US dollar if the central bank isn’t effective.
Central bankers have pushed back against those fears for the past few months, saying monetary policy hasn’t lost its power and they won’t remain passive as the scenario gets more adverse. Above-goal estimates for inflation cause “discomfort” among all board members and “must be tamed,” they wrote in minutes to their latest rate decision.
They also warn about the effects of excessive government spending, especially the social support programs that transfer money to the poor. Emerging research reviewed by the central bank shows those cash transfers can fan the economy more than previously understood.
“The slowdown in structural reform efforts and fiscal discipline, the increase in earmarked credit, and uncertainties over the public debt stabilization have the potential to raise the economy’s neutral interest rate, with deleterious impacts on the power of monetary policy,” board members wrote in their most recent monetary statement.
Even with the rate hikes, Brazil’s economy has continued to grow, with unemployment near record lows and wages gaining. And fears of a default are limited by the fact the country boasts about $360 billion in international reserves and little foreign debt. But inflation expectations have deteriorated significantly — with economists forecasting that price increases will remain above the country’s target through 2027.
Of course it’s possible that Lula will come around should the market rout grow untenable. There’s some speculation that the president could make some conciliatory remarks on the matter as soon as Friday, when he’s scheduled to hold a ministerial meeting. But it’s likely any measures won’t be enough to change how markets see his government.
Investors, many of whom were burned by bullish wagers on Brazil assets throughout the year, aren’t willing to give him the benefit of the doubt.
“It’s certainly a worry for everybody that we are on the path of fiscal dominance,” said Pramol Dhawan, head of the emerging markets team at Pacific Investment Management Co. “And in a country like Brazil, you don’t need to be there. You just need to smell the cooking in the kitchen for people to start worrying.”
--With assistance from Giovanna Bellotti Azevedo, Simone Iglesias and Zijia Song.
(Updates with new central bank intervention in sixth paragraph)
