Lula's comeback leaves Brazil's fiscal question unanswered

Three weeks after finishing second in the first round, he won Sunday's run-off with 51.8% of valid votes against 48.2% for Flávio Bolsonaro. He’s the first candidate since the return of democracy to win the presidency after trailing in the first round, and the first Brazilian to be elected president four times. His new term begins in January.

Markets will take a very different view. Brazilian stocks and the real plunged following the announcement. The dramatic fall even triggered an automatic 30-minute circuit breaker on equity markets for the first time since the 2020 pandemic. Investors had leaned heavily towards a change of government: the Ibovespa rose more than 8% in early trading after the first round and long-term interest rates fell sharply on hopes of a shift in fiscal policy. What happens next rests squarely with the re-elected president.

A comeback with a fiscal price tag

The concern is not simply who won, but how. 

In the three weeks between the two rounds, the government brought forward a 15% increase in Bolsa Família, the flagship cash-transfer programme, with the higher payments starting on 19 October. It cut federal taxes on petrol to zero and increased subsidies for ethanol and imported diesel. Lula signed into law the forgiveness of federal tax debts owed by micro-entrepreneurs, a measure the government says could reach more than 3.6 million people, and raised the revenue ceiling for their simplified tax regime. 

The campaign promised non-repayable cash transfers of up to R$5,000 for small businesses, a new monthly stipend for low-income university students and a new round of the Desenrola household debt-renegotiation scheme. Days before the vote, the government sent Congress a constitutional amendment for free public transport at weekends and on public holidays, to be funded by redirecting part of the budget amendments controlled by lawmakers. Congress also promulgated the end of the six-day working week, one of Lula's flagship pledges, which cuts the maximum working week from 44 to 40 hours without any reduction in pay.

Some of these measures are temporary, and the government says the fuel tax cuts will be offset by extraordinary oil revenues. Several still need approval from Congress. Others, such as the student stipend, would be permanent commitments in a budget with almost no room left. Taken together, they send an unmistakable signal: when votes were at stake, fiscal prudence came second.

Lula's campaign did pledge fiscal consolidation, but at a slower pace than his rival and with the explicit condition that spending cuts should not fall on lower-income Brazilians. The government's own projections show the primary balance improving only gradually, to a surplus of 1.3% of GDP by 2030. His running mate, Geraldo Alckmin, pointed to campaign funding and excessive public-sector salaries as areas for savings. Neither comes close to the scale of the problem.

The numbers do not leave much room

Brazil has little room left for this kind of politics. Gross public debt has climbed to around 83% of GDP, up more than 10 percentage points during this administration, and a deficit close to 10% of GDP is now almost entirely interest. Brazil pays one of the highest real interest rates in the world on a debt that keeps growing. That is the definition of an unsustainable path, and the bill falls on companies and households as much as on the Treasury.

A hostile Congress: constraint or gridlock?

Lula will govern facing a Congress dominated by his opponents. Bolsonaro's Liberal Party won the largest single-party bloc in the Chamber of Deputies since the 1988 Constitution, almost twice the size of Lula's Workers' Party, and is the biggest force in the Senate. The Senate has already rejected one of his Supreme Court nominees, the first such rejection in 132 years, and the centrist Centrão parties will set a high price for their support.

For investors this cuts both ways. A hostile Congress may block the most expensive campaign promises, such as free public transport, which needs a constitutional amendment. But it is just as likely to block revenue-raising measures and structural reforms, and to extract costly concessions in exchange for votes. Gridlock is not consolidation.

What markets need to see

The first signal will be the composition of the economic team for the new term. Beyond names, investors need a revised fiscal framework that delivers primary surpluses large enough to stabilise debt, rather than targets that are adjusted when they bind, together with measures on benefit indexation, mandatory spending and tax expenditures, and a clear commitment to the central bank's independence.

The prize is still there

None of this changes Brazil's underlying strengths. It’s an agricultural and energy superpower and among the world's largest exporters of soybeans, beef, coffee, sugar and cotton. Its external accounts are solid, with foreign direct investment more than covering the current account deficit; its currency floats, unemployment is near historic lows and its central bank has proved its credibility. Few emerging markets combine scale, resources and institutional depth.

Lula knows better than most what fiscal credibility can buy: his first two terms combined primary surpluses with strong growth and won Brazil its first investment-grade rating. If his fourth term starts by putting debt on a declining path, interest rates can fall substantially, private investment can recover and public money can go to infrastructure and services rather than to creditors. Brazil would then be well placed to become the standout story in Latin America and across emerging markets. 

If not, it will remain a country with excellent fundamentals that pays one of the highest real interest rates in the world, and the next correction will be forced by markets rather than chosen by the federal government.