For much of this year, the Brazilian real has lagged the broader move higher in LATAM FX. Weighing on the currency has been uncertainty over President Lula da Silva’s fiscal framework, which was seen as crucial in allaying fears of ballooning government debt after the newly-elected president gained congressional support to bypass spending rules once he assumed office, and the risks that would create for the BCB which was actively trying to depress economic growth to bring inflation back to target.
In the absence of the fiscal measures being made public, the central bank was a lame duck that could only stress its willingness to increase the Selic rate further from 13.75% should fiscal policy take a more expansionary path. However, in doing so, BCB Governor Roberto Campos Neto caught the ire of the new government, who then threatened to redefine the BCB’s inflation mandate to induce looser monetary policy. Even as investors awaited the details of the fiscal framework, the public feud between government members and the BCB undermined investor confidence and the real’s ability to benefit from carry trade inflows during periods of relative calm in broader markets. This saw BRL underperform LATAM high yielders for much of this year, with investors instead preferring exposure to the Mexican peso and Chilean peso due to their more stable political backdrops.
The Brazilian real had underperformed LATAM high yielders for much of this year due to uncertainty over the fiscal framework and ongoing tensions between the central bank and government, but conditions soon began to improve
*LATAM HY includes Colombia, Mexico and Chile. With an interest rate of just 7.25%, Peru is omitted.
Towards the end of Q1, the tides began to change for the Brazilian real as some of the parameters of the fiscal framework were announced. Not only that, but having privy access to them, these details were also somewhat endorsed by the BCB, with their March meeting minutes stating that the measures could reduce upside risks to inflation. The backbone of the fiscal plan was a so-called spending cap rule that limited the growth of public expenditures to the rate of inflation. This includes a ceiling and a floor to the expansion of public spending. The ceiling is set at 70% of revenue growth, should the government meet its budget surplus targets, or 50% if it does not. The proposed framework also aimed to eradicate the government’s primary fiscal deficit by 2024 and target a primary fiscal surplus of 0.25-0.75% of GDP for 2025 and 0.75-1.25% of GDP for 2026. While the measures lacked any tangible detail, they were a welcome sign for investors as they safeguarded against further fiscal slippage – a key hindrance for investors towards BRL local assets.
Compounding the positivity from the initial fiscal announcement was inflation data for March. Although disinflation was still evident in the headline measure as it fell from 5.6% in February to 4.7%, it was evidence that core inflation was finally starting to turn as it fell from 8.4% to 7.7% which set about another wave of positivity towards BRL assets. With core inflation finally starting to soften, the prospect of a sustained truce between the BCB and the Lula administration looked on the horizon. The conflation of the two dynamics, alongside cheaper entry levels and a higher exposure to stronger-than-expected Chinese growth, led BRL to outperform LATAM peers with the exception of COP.
All good things must come to an end
Following the announcement of the broad fiscal parameters on March 29th, USDBRL fell over 4% to trade consistently below the 5.00 handle for the first time since June 2022, hitting a fresh 10-month low of 4.8960. Momentum lower in USDBRL soon began to peter out as short positioning became saturated and the currency pair hit key technical levels. At which point, focus soon turned back to the fiscal framework as market participants awaited the details of the earlier-announced proposal. Originally scheduled for release in March and promised to receive wide-spread support amongst Congress, the delay in the legislation’s release started to raise questions over its viability and the likely level of support it would receive. This provided little support for what had quickly become a rich BRL.
Finally, just as investors had become nervous about the overpricing in optimism from the initial fiscal announcement, President Lula delivered his full proposal to Congress. The details of which provided a bit more meat for markets to chew on. The new framework entails a rule linking real primary spending growth (thus excluding interest payments) to a shore of the previous year’s real revenue growth, an upper-and lower-limit for real primary spending growth, a separate target path for the central government primary fiscal balance, a recalibration rule should primary spending growth exceed the upper or lower thresholds, and a set of secondary rules governing public investment, education, and healthcare spending.
While initially the market reaction to the draft legislation was lukewarm, which could have merely been a by-product of the legislation being so dense, the view taken by markets soon started to turn more negative as it became apparent there were 13 areas of spending that are exempt from the fiscal framework and revenue generating measures such as tax on items under $50 were also scrapped. This underscored the interpretation that while the bill was likely to pass through Congress, marking the first successful piece of legislation under the latest Lula administration, it would likely receive some further pushback on proposed revenue generating policies and is ultimately unlikely to stabilise Brazil’s public debt profile. In response, the Brazilian real sold off close to a percentage point, with the pair squeezed back close to the 5.00 handle, only to break above it this morning in local trading.
The emphasis for markets is now on the navigation of the legislation through the lower house and any likely amendments, while some attention will also be paid to the BCB’s reaction and projected economic losses from the removal of tax exemptions. In essence, we don’t think the fiscal framework in its current form should generate sustained BRL weakness, as it doesn’t deviate too heavily from the initial announcement towards the end of March at a fundamental level, but its passage in the coming weeks is likely to keep the currency’s volatility high.
USDBRL climbs back above the 5.00 handle as markets aren’t overly satisfied with the full details of the fiscal framework
Simon Harvey, Head of FX Analysis