Brazil passed the elections test. What now?

Brazilian institutions faced their biggest challenge since the re-democratization of the country in 1985. Concerns of a potential unconstitutional regime change, widespread unrest or a Capitol-like incident did not materialise following the run-off presidential election on 30 October. However, companies and investors will continue to face limited institutional and political instability at least until the next administration is inaugurated in January 2023. Until then, all eyes are on what the new government means for the business environment.

Government transition

Lula has appointed Vice-President-elect Geraldo Alckmin to coordinate the government transition. Despite Bolsonaro’s silence in the week following the vote, his Chief of Staff Ciro Nogueira has taken the initial measures for the transition to occur according to Brazilian legislation.

Alckmin’s track record as a centrist politician who used to oppose Lula and the Workers’ Party (PT) make of his appointment an effort to effectively implement a coalition government. It also helps to ease concerns among centrist allies and financial market participants that Lula’s next administration would be dominated by leftist, radical appointees or the PT alone.

Relatively limited risks on the unrest and institutional fronts will likely help reduce financial volatility. The main triggers to shift market sentiment will come from the government transition process and the appointments to cabinet positions.

So far, Brazil’s main stock index Ibovespa gains and a strong performance of the real indicate positive expectations of Lula’s third administration – especially among foreign investors. While local investors are unlikely to give the new government the benefit of the doubt, foreign capital inflows are likely to remain positive amid the absence of political turmoil coupled with a nod to fiscal discipline and an ESG-oriented rhetoric. Such an environment is likely to position Brazil ahead of its emerging markets, such as Russia or China, when it comes to investors’ sentiment.

Lula’s ESG approach will starkly contrast with Bolsonaro’s disregard for deforestation, Indigenous populations and overall human rights. The president-elect will likely enhance the country’s standing before the international community and investors. The quick reaction of foreign governments in acknowledging his electoral win and his participation in the United Nations’ Climate Change Conference (COP 27) in Egypt indicate a clear path for a reduction in overall ESG-related reputational and operational risks for companies operating in Brazil. However, fiscal constraints will continue to undermine oversight, and the burden of ensuring compliance to ESG best international practices will still fall on the private sector.

Policymaking outlook

Lula will be pragmatic vis-à-vis the economy and the business environment. He is unlikely to significantly change Brazil’s monetary, fiscal and trade policies. Brazil’s Central Bank (BC) will remain autonomous and current Governor Roberto Campos Neto will be able to finish his term in 2024 (should he wish so). That means that interest rates will likely remain stable over the coming months, only starting a gradual easing cycle in 2023.

The constitutional spending cap (introduced in 2017 to limit public expenditure and work as a fiscal anchor) will be replaced by a new framework. These rules are highly likely to be more flexible and make room for social spending. That said, Lula will seek to demonstrate fiscal discipline to avoid markets’ negative reactions. A waiver for extraordinary spending in 2023 followed by a clear roadmap of attainable rule for the following years is likely to ease concerns. Moreover, Brazil’s USD 326bn reserves will also limit any risks of default.

On the regulatory front, sector-specific agencies will remain mostly independent, while public banks will occasionally be used for economic policy purposes, such as for subsidized credit in an attempt to boost consumption and growth.

Given that fiscal constraints will continue to limit public investment capacity over the next four years, the government will rely on the private sector to modernize and expand the country’s infrastructure. That will result in moderate progress of the concession agenda and other public-private partnerships mechanisms. Likewise, contract risks will be very low. Lula is highly unlikely to reverse the privatization of electricity company Eletrobras. 

Renewable energy will continue to be a priority amid efforts to diversify the Brazilian energy matrix (and reduce the role of hydroelectric power plants). That will also help reinsert the country into the global arena as an important player in discussions around climate change and energy transition. In this sense, tax incentives or subsidized credit lines for the construction of wind farms and solar parks are likely. 

The strategic nature of the oil and gas industry will likely result in occasional political interference. Petrobras – and other state-owned companies – will once again be used as policymaking tools. Measures to increase tax collection (such as the introduction of a “windfall tax”) are also likely. In a price shocks scenario, the government is also likely to adopt extraordinary measures to mitigate impacts on inflation. The government is also likely to increase mining taxes or royalties especially with global commodities prices remaining elevated.

More broadly, the administration will seek to introduce taxes on dividends and wealth as part of its tax reform to fund increased social spending. The tax reform will be a priority in 2023. The proposal will seek to substitute several existing taxes with a VAT-like levy, simplifying the country’s complex tax system. That is also likely to entail a shift in terms of tax collection from consumption to income. Top salaries are likely to face higher taxes, while those at the bottom of the payroll pyramid will be exempted from income taxes.

Economic growth, job creation and income distribution will likely be key to reduce the social inequality exacerbated by the COVID-19 pandemic. It is also Lula’s chance to reduce his rejection rates (currently at 45% of the electorate) and try to reduce heightened political polarization levels. The question now is whether Lula will pass the test.