Political division makes Brazil risky for investors

Brazil’s recent political polarization, exemplified by the invasion of top government buildings in the capital city by supporters of former president Jair Bolsonaro, is causing concern for investors in Latin America’s largest economy. Historically, Brazil has seen peaceful transitions of power following elections since the end of two decades of military regime in 1985, but this recent event is a reminder of the challenges that newly sworn president Luiz Inacio Lula Da Silva will face after his narrow win in the October vote.

Investors and analysts are focusing on fiscal issues when assessing the new government in the long term. The new government will aim to unify a working coalition in congress to pass legislation but will also be careful not to impair its popularity with unpopular fiscal measures, potentially delaying the timeline for announcing fiscal adjustment measures.

Lower inflation could allow the central bank to start cutting rates in the second half of the year, further boosting the economy. However, this is also dependent on the new fiscal framework. If the new parameters are considered weak by the market, it could renew fears of fiscal dominance and prevent the central bank from easing.

The short-term impact on markets looks contained, but the spread of Brazil’s hard currency debt over safe-haven US Treasuries widened on Monday, pulling further away from pre-pandemic levels. Creditors will keep a close eye on the political and social dynamics in the coming weeks as the deep social and political polarization pre- and post-election keeps risk premia high and could undermine overall governability.

Brazil is no stranger to political turmoil, but this recent event is a reminder of the challenges that Lula’s administration will face in controlling the risks of institutional shock and maintaining investor confidence. The main conclusion from the recent protests is that there is a mobilized opposition with the potential to turn violent. Social tension could rise if Lula’s government loses popular support in a context of greater economic difficulties.

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