Lula v. the Bond Market

This article originally appeared in The Brazilian Report (January 19, 2023).

James Carville, the legendary political consultant for the U.S. Democratic Party, once said: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now, I would want to come back as the bond market. You can intimidate everybody.”?

The Brazilian bond market has been indeed quite intimidating since Luiz Inácio Lula da Silva was elected president for the third time in October of last year. In November, the ten-year benchmark annual yield for local government bonds rose from 11.9 percent to a peak of 13.9 percent, a huge risk repricing for such a short span.?

Future interest rates have been very volatile and reactive to political headlines ever since. The narrative moved from the post-election euphoria — when it seemed that Henrique Meirelles, a highly respected former central banker and finance minister, would be Lula’s pick to run the economy — to reluctance, with the nomination of a Finance Ministry team with no first-rank names linked to traditional orthodox academic centers or financial markets.?

Then, it hit outright depression in the first week of 2023, with a cacophony of voices linked to the new government asking for more unfunded expenses and even calling for the revocation of some of the pro-market reforms enacted during the Michel Temer (2016-2018) and Jair Bolsonaro (2019-2022) administrations.

Market rates got some relief after the first general cabinet meeting summoned by Lula on January 6, and kept falling on Fernando Haddad’s announcement of a short-term fiscal plan that aims to more than halve this year’s primary (i.e., excluding debt service) public deficit from the 2.2 percent of GDP implied by the budget law.

However, risk premia remain high across Brazilian assets.?

A one-year real interest rate market proxy stands at 7.5 percent, whereas in a December survey by the Central Bank among market economists, the neutral (i.e., more structural) real rate stood at 4.5 percent.?

Two-year-ahead inflation expectations, cleaner of short-term noise, are 5.3 percent at market rates (derived from inflation-linked bonds) or 3.7 percent in the weekly Central Bank report on market economists’ expectations — both significantly deviating from the 3-percent target.?

According to Goldman Sachs’s proprietary Dynamic Equilibrium Exchange Rate Model, the Brazilian Real is more than 25 percent weaker against the U.S. dollar than it should be, given current differentials in inflation, productivity, and terms of trade. In short, investors are asking for fat margins of safety to park their money in Brazil.

Part of those penalty rates is not directly associated with the Workers’ Party government.?

Who’s afraid of the Workers’ Party?

Inflation this year is likely to be boosted by the end of some tax breaks (mostly on fuel prices) granted by the Bolsonaro administration in an attempt to regain popularity ahead of last year’s elections.?

That same electoral drive all but destroyed the fiscal framework sustained by the constitutional spending cap: to almost triple the average social transfer benefit to poor families and not cut it abruptly at the year’s turn, Congress had to amend the Constitution once again in December, and further erode the rule’s credibility.?

Whoever got elected would have to deal with those issues, which are hard to solve without some degree of fiscal slippage.

What is left, the “Workers’ Party risk,” in my view, has two distinct sources: one warranted and the other less so.?

The first is the memory of catastrophic economic management, mostly during Dilma Rousseff’s years as president. The mantra “Lula is not Dilma,” continuously repeated by allies of the new president, is true. The organic, conciliatory, seasoned leader in no way resembles his inflexible, technocratic successor.?

Still, many people associated with the “new economic matrix” — a mix of policies enacted under Ms. Rousseff’s years — are back to key positions of the administration or serving as Lula’s advisors.?

Likewise, ideas that are viewed to have led to the deep 2015-2016 recession and successive corruption scandals — such as using state-owned banks to boost credit or investing in new oil refineries — are again being openly discussed. Several members of the current economic team diagnose the causes of that recession focused more on external factors and “political sabotage” than on poor policy choices, implying that they can be repeated and expected to work, under more favorable circumstances.?

Guedes hagiography

Among market agents, though, there is a myopic nostalgia for the “good times” under Jair Bolsonaro — longing for what we have not yet had, to paraphrase an old meme phrase coined by football star Neymar. I believe markets give former Economy Minister Paulo Guedes much more austerity credentials than he deserves.?

In 2021, he looked on as the first big breach of the spending cap not justified by pandemic relief occurred. In 2022, he jumped on the re-election bandwagon, selling the notion of “excessive tax revenue” that justified tax cuts and new spending that now erode the government’s capacity to balance its budget.?

Neither he openly defended any fiscal framework during the campaign, so there is no unambiguous evidence that the transition to a new regime would be any smoother in a second Bolsonaro term.?

Furthermore, Mr. Bolsonaro can plausibly claim good management over most state-owned firms, but there was no guarantee of continuity in a second term. Especially with Petrobras and its widely criticized fuel pricing policy.

That nostalgia can be quickly dispelled should the new government start delivering on credible short- and medium-term fiscal plans.?

Market participants are, first and foremost, profit-driven, so even the most cutting critiques of the Workers’ Party would be forgotten if prices start to point towards a different narrative. That may happen even under a set of good external conditions and mediocre reforms — arguably the same one that prevailed during a good part of the previous Lula governments.?

I have been long referring to some easy wins that a smart finance minister could get in the short term, merely by creating conditions for the Central Bank to reduce policy rates from extremely high to merely “high.”?

Those rewards are clearer now that the world economy is escaping from the stagflationary mood that prevailed for most of 2022, and risk-taking is being rekindled by potentially lower interest rates and better growth prospects in Europe and China.

Markets’ capacity to intimidate politicians is higher when their signals (in the form of prices) are ignored. In little more than two months since the end of the elections, wild price swings showed what kind of policies will be rewarded and which will be punished.?

Of course, bond markets are not good judges of overall government policies, but knowing how they behave, deliberately driving up borrowing costs can only be conducive to such policies if there were extraordinary alternatives available to finance them.?

At higher enough borrowing costs, such alternatives start to look more viable, but other more palpable costs are likely to emerge in the form of inflation, and overall instability — Argentina and Turkey are good examples of countries that, in the past decades, decided to cut loose from the market-induced austerity framework.?

A chronic basket case and a dictatorship at risk of turning into one should not be role models for countries aspiring to revive any kind of past economic glory.