Brazil currency rout risks worsening unless Lula delivers fiscal reforms

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Brazil’s currency rout will continue to escalate unless the country’s central bank steps up its emergency measures and Luiz Inácio Lula da Silva’s government delivers fiscal reforms, investors and analysts have warned.

The Brazilian real has fallen almost 2 per cent this week alone, touching a record low of 6.21 against the dollar on Tuesday despite a barrage of foreign exchange interventions by the country’s central bank.

The Banco Central do Brasil (BCB) sold more than $3bn in back-to-back operations on Tuesday, its third consecutive day of wading into currency markets as policymakers seek to prop up the embattled real. The central bank has sold nearly $6bn this week, according to Financial Times calculations based on BCB disclosures.

Those aggressive dollar sales staved off heavier selling in the real, which traded at around 6.16 against the US currency on Wednesday. But investors argued that stronger actions were needed to ease anxieties about the public finances of Latin America’s largest economy.

The sell-off is compounding a delicate moment for the leftwing Lula administration, which is attempting to push through cost savings after its tax-and-spend policies provoked mounting resistance in the business world.

“The market is very concerned regarding [Brazil’s] fiscal accounts and especially the government’s response to it,” said Eduardo Cohn, portfolio manager at Heritage Capital Partners in São Paulo. “The only way the market has to call the attention of the government is through the [exchange rate].”

While emerging market currencies have broadly struggled since Donald Trump’s US election win last month, investors said much of the real’s woes stemmed from worries about rising government spending and debt levels under Lula. The stimulus measures have been a boon to growth but have also contributed to higher levels of inflation and prompted questions about fiscal sustainability.

The real’s decline this week has taken its year-to-date fall to 21 per cent, making it this year’s worst performer in JPMorgan’s widely followed emerging market currency index. Brazil’s benchmark Bovespa share index has dropped 27 per cent in US dollar terms this year, compared with a 7 per cent rise for MSCI’s broad EM gauge, FactSet data shows.

The BCB has attempted to ease investors’ nerves and push back against the jolt of inflationary pressure by boosting borrowing costs. The bank lifted its main interest rates by a greater than expected 1 percentage point last week, taking the Selic benchmark to 12.25 per cent.

Policymakers have signalled further increases of the same magnitude at the bank’s next two rate-setting meetings in 2025. Higher rates may help protect the real by enticing foreign investors, but they will also cool demand across Brazil’s $2.2tn economy, economists say.

“They’re going to have to deliver economic pain to slow the economy down and then try to cut rates in 2026, maybe,” said Mark McCormick, head of FX and EM strategy at TD Securities. “There’s going to be urgency because they have to protect the currency now.”

Ed Al-Hussainy, senior rates analyst at Columbia Threadneedle Investments, echoed that sentiment, saying, “the shorter-term solution is to hike rates much more aggressively”.

He added: “But even that’s not enough . . . Any durable solution needs to be some form of credible commitment to reducing the deficit.”

Brazil’s nominal fiscal deficit is close to 10 per cent of GDP, which mainstream economists say risks pushing public debt to unsustainable levels. A promise by the leftwing government last month to find R$70bn in spending cuts in order to meet its own budget targets also failed to calm the nerves of traders, who saw the parallel announcement of tax breaks for lower earners as undermining the commitment to fiscal discipline.

Paul McNamara, investment director at GAM Investment Management, said the country’s debt level was “high, but not dangerous”, adding that Brazil’s total borrowings were “lower than most G7 countries relative to GDP.”

However, he said: “The problem is that Brazil pays very high real rates to borrow and G7 countries don’t; the sustainable level of debt for Brazil is always going to be a good bit lower.”

The government’s fiscal adjustment plans remain uncertain as many of the proposals require approval by Congress, which breaks for recess after this week. Lula was directly involved in negotiations with lawmakers but has been out of Brasília since undergoing emergency surgery to remove a brain bleed last week. He is expected to return to the capital on Thursday.

The 79-year-old leftist, who previously ruled from 2003-11, returned to power last year on pledges to boost welfare and public works programmes.

The BCB’s next policy meeting is scheduled for late January. In the interim, McCormick said policymakers could “try to jawbone the currency” — using rhetoric to keep the real from sinking further — and “keep fighting using market mechanisms”.

Al-Hussainy said the “odds are rising” that the central bank would raise rates prior to its next meeting through an extraordinary measure. “That is probably the most credible way the central bank can come in and shock markets to stabilise the currency.”

Additional reporting by Beatriz Langella