Debt, inflation and a hostile Congress: the economic challenges of Lula’s fourth term

Luiz Inácio Lula da Silva will assume his fourth term as Brazil's president on January 1, accompanied by an economy that has exceeded expectations and an unemployment rate at a record low. However, the country's fiscal imbalances heavily impacted financial markets on the first day of trading following his re-election. The U.S. dollar surged more than 12%, reaching a peak of 5.60 reais per dollar, while the Ibovespa index halted trading automatically upon opening and long-term interest rates climbed nearly two points.

Investors bet on the victory of Senator Flávio Bolsonaro, who pledged substantial spending reductions. On Friday, the dollar closed at 4.99 reais, and the Ibovespa index stood at 205,082 points, nearing the record high achieved after the first round of voting. Experts agree that Lula's initial challenge will be assembling his economic team and establishing a fiscal framework.

Fiscal imbalances have worsened during Lula's term, with public debt increasing by over ten points and now accounting for 82% of GDP. This rise is mainly due to mandatory spending, leaving less than 8% of the federal budget for discretionary items. Lula has dismissed debt concerns, asserting that robust growth will resolve the issue.

His administration pledged to uphold the existing fiscal rules, which cap spending growth and set primary surplus targets. However, implementing these rules will be more difficult due to commitments to raise the minimum wage above inflation and the introduction of new benefits during his campaign.

The Central Bank has lowered the Selic rate five times consecutively to 13.75%, but annual inflation surpassed the 4.5% threshold in September, exceeding the 3% target. The Monetary Policy Committee convenes on November 4, and the real's depreciation complicates further rate cuts. Lula proposes lowering rates through enhanced fiscal discipline without compromising social programs, while most economists argue that a quicker decline would necessitate spending cuts.

According to credit agency Serasa, nearly 84 million Brazilians and 9.3 million companies are in arrears, a record attributed to high interest rates. The government is preparing relief measures, such as purchasing distressed mortgages from banks at a discount and waiving tax debts for small business owners, seen by analysts as temporary respite.

Bolsonaro's Liberal Party will control the most significant bloc in both the Chamber of Deputies and the Senate, representing the most conservative Congress since the return to democracy. This dominance will impede the government's plans to eliminate tax exemptions and approve appointments to the Central Bank, regulatory bodies, and the Supreme Court, which were already challenging during the current term. Bolsonaro also claims the election was fraudulent and intends to challenge its legitimacy.

The new value-added tax, enacted in 2023, will commence in January, but the government has yet to determine its effective rate, estimated by independent analysts at approximately 28%. Additionally, the government postponed during the campaign a bill for a selective tax on products harmful to health or the environment, such as tobacco and alcohol.