As if things were not difficult enough for markets in Brazil, whose stocks and currency are among the world's worst-performing this year, an unexpected twist in the country's fragile politics threatens to make the situation even tougher.
Brazil's Congress voted late on Wednesday to overturn an earlier veto on spending by right-wing President Jair Bolsonaro, adding an as yet unbudgeted 20 billion reais a year (US$ 4.2 billion) to social assistance for elderly and disabled people, known locally as BPC.
Brazil's government is in its seventh consecutive year of budget deficit, which is pegged at 124 billion reais this year. If the 20 billion-reais additional spending cannot be clawed back from elsewhere, the budget will be blown.
Bolsonaro's administration has made it an economic priority to fix the nation's public finances, in large part via aggressive spending cuts.
While the extra spending will provide a welcome fiscal boost to the struggling economy, analysts say it puts the government's budget goals and economic reform agenda in serious peril, greatly diminishing the appeal of holding Brazilian assets.
The economy and markets will suffer from a lack of confidence in the government, and the president's capacity to deliver at a time of crisis, said Creomar de Souza, founder of Brasilia-based consultancy Dharma Political Risk and Strategy.
This appearance of division between the president and Congress is not good at all, he said.
Analysts at Morgan Stanley said the vote marked a major turning point and recommended clients reduce their exposure to Brazilian credit and the currency.
The timing of this decision could not be worse. Such a serious setback for the reform agenda along with a more-than-challenging global backdrop will keep Brazilian local assets under
pressure in the weeks to come, they said.
On Thursday morning, Brazil's real slumped below the 5.00 per dollar level for the first time ever, bringing its depreciation so far this year to a staggering 20%.
Only a week ago, when the real was trading around 4.60 per dollar, Economy Minister Paulo Guedes said the real could sink as low as 5.00 per dollar ”if we (politicians) really mess up.”
Guedes and his team argue that shrinking the budget deficit, national debt and public sector would lay the foundation for lower borrowing costs and a surge in private-sector investment, confidence, spending and ultimately economic growth.
The government cut its 2020 economic growth forecast on Wednesday, but insisted it would not relax its fiscal discipline, particularly an existing spending cap, to give a boost to an economy hit by coronavirus outbreak and tumbling oil prices.
Analysts at Barclays said the BPC vote marked the most serious blow yet dealt by Congress to the Bolsonaro government, noting that the new expenditure, coupled with plunging oil prices, could put the deficit well above target.