Will Lula take Brazil back to the past?

Adam Patterson, our correspondent in Curitiba, Brazil, worries about the economic implications of the country's presidential elections...

By Adam Patterson, our correspondent in Curitiba

After an extraordinarily atypical and polarized election cycle, Brazilians went to the second-round polls on Sunday 30th October to choose their next President. With 50.9% of the votes cast, former head of state Luiz Inácio Lula da Silva, known as Lula, was declared the winner, with incumbent President Jair Bolsonaro receiving 49.1%, the tightest margin in Brazilian election history. That despite Bolsonaro taking the largest share of the votes in four out of five Brazilian regions.

Controversial victory

Lula, a two term President between 2002-2010, was convicted on corruption and money laundering in one of the world’s largest graft scandals and only served three years of an initial 12-year sentence before being controversially freed on a technicality by a supreme court judge his Worker´s Party nominated, allowing him to run again in 2022.

That apparent bias on the part of the judicial system set the scene for a polemic election marked by what many commentators labelled censorship, attacks on freedom of expression and partisanship by the powerful Federal Electoral Court (“TSE” in Portuguese). Major newspapers and media channels were banned from reporting on Lula´s passed convictions, association with organized crime and friendship with regional dictators. The National Association of Newspapers (ANJ) and the Brazilian Association of Investigative Journalism (Abraji) criticised the measures, which the Wall Street Journal described as “Brazil’s Left Tries to Gag Political Speech”. Even Bolsonaro´s campaign was prohibited from calling Lula a “criminal”. One of Brazil´s leading broadsheets, O Estadão argued that "never before in the history of elections has the TSE become a political faction in favour of one candidate".

It seems plausible that these factors could have had an impact of a few percentage points in in the final voting tally. That context helps explain why post-election Brazil is its most fractured and divided for decades. After the results were announced, protests broke out all over the country.  There is a risk that the arbitrary nature of legal decisions could impact on the future business environment.

A key overlooked development from the first round of voting was a huge and historic “Bolsonaro wave” in congress. Bolsonaro´s Liberal Party (PL) elected the largest contingent in the lower house (99 out of 513 seats) and in the Senate — where it now has 14 of the 81 senators. Added to together with centre right parties like PP, Repulicanos and União Brasil and both legislative houses have the most conservative make-up in a generation. Centre-right governors in Every Southern and South-East region state – which total more than 75% of Brazilian GDP – also provide a barrier to radical policy.

According to researcher Oliver Stuenkel, professor of International Relations at Fundação Getúlio Vargas (FGV) "The right has triumphed. The Lula government will have many difficulties with Congress, a lot of resistance. Bolsonarism will be very present in Brazilian political life over the coming years". However, analysts expect negotiation and horse-trading.

And yet, as the saying goes, life can only be understood looking at the past but must be lived in the future. Thus, as the dust settles attention turns to what the economic outlook is for the Latam giant with a Lula government.

Economic prospects

First let us look at the economy Lula inherits. Despite being hamstrung by a weak majority in Congress, dependent on centrist parties, and COVID there has been marked progress. Central bank independence was formalized, corruption vastly reduced, and pension reform was passed which put Brazil on a more sustainable fiscal footing. There have also been incremental advances in regulation liberalization, digitalization of government services and privatization. Almost 14 million new companies have been opened since 2019, a record amount.  Brazil also had a much smaller economic downtick during the pandemic due to one of the world´s largest fiscal and monetary support packages. The Legal Framework for Sanitation helped bring clean water to millions of people.

Brazil remains attractive relative to the original BRICS countries and other emerging markets

These macroeconomic measures, supported by early monetary tightening to counter inflation, have put Brazil in an attractive economic position. Real GDP growth is expected at close to 3% in 2022, and with inflation around 5%, it’s never been so low relative to the US and Europe.  Unemployment at 8.9% is the lowest for a decade. The government reduced more than 4000 taxes, including on energy and imported goods. The business community would have liked to see more administrative and tax reforms passed but, overall, the economy has advanced from Brazil´s worst recession left by the outgoing PT government in 2016. There has also been progress at the social level, murder rates are at the lowest 20 years, as are rural property invasions and burnt areas in the Amazon Forest. It seems likely that history will give Bolsonaro much more credit than the media has over the last few years.  

Yet two major economic challenges await Lula. Firstly, the global scenario: energy shocks and rising interest rates increase the chance of recession in some of the main world economies. China, Brazil´s biggest trade partner is confronting multiple economic crises.  The second challenge is internal, and based on fiscal pressures, driven by expenditures already undertaken by the current government and new campaign promises by the incoming PT party which must be managed carefully so as not to lead to upticks in the deficit and public debt dynamics.

State intervention

Few details about the president-elect's proposals surfaced during the election campaign. At the time of writing the new economic team has not been announced. However, at the macro level, based on PT´s economic program submitted to election authorities and their “Letter to Brazil of Tomorrow”, the new administration plans to expand the role of the State in the economy, suspend privatizations, modify the market friendly labour and social security legislation, reformed by both the Temer and Bolsonaro governments, and repeal government spending limits via a more flexible fiscal policy. The plan also seeks to review tax policy – Lula has talked about “taxing large fortunes” – and increase social benefits and the minimum wage.

Concerns around these interventionist policies and u-turning on privatization weighed on shares of state-controlled companies in the days since the result was announced. Oil giant Petrobras, fell more than 20% in the first three days. Xavier Hovasse, head of emerging equities at Carmignac, said he prefers to stay away from state-owned companies due to expected higher intervention by the government.

However, using the past as a guide. Equities in education, construction and retail sectors, for example, could benefit from the possible expansion of student and housing financing programs and a potential easing of credit, especially by publicly owned banks. There is also talk of reinstating a reformed Growth Acceleration Program (PAC), with the objective of reactivating civil construction and social infrastructure such as housing and urban mobility. Launched in 2007, at the beginning of Lula's second term, the PAC increased public investment in infrastructure, but was marked by delays, abandoned projects and corruption.

PT have said they will aim for fiscal responsibility, with "clear and realistic rules". The market is however suspicious of how such a leftist economic wish-list can be financed. For Alejandro Arevalo, head of emerging markets debt at Jupiter Asset Management: "How do they plan to fund social spending? Are we going to see some tax reforms, or where is the windfall going to come from to be able to keep the fiscal deficit in check?"

In summary Lula will face not only a vastly different domestic political climate but an international economic scenario. Gone are the heady days of his first mandates when Brazil, surfed a commodity cycle and global economic stability.

But on the other hand, at least over the near term, Brazil remains attractive relative to the original BRICS countries and other emerging markets. The stock market remains cheap and there is a clear lack of alternatives in terms of a sizable EM equities market. For investors it remains a country too big to ignore.

Assuming Lula can conclude his term given political pressures, Brazil will have to wait for 2026 for an economically liberal President who can help pass the needed macroeconomic reforms and put Brazil back on a market-friendly growth path. Until then it seems that it has chosen to go back to the past.