IS FISCAL REFORM POSSIBLE UNDER LULA

IS FISCAL REFORM POSSIBLE UNDER LULA? Elizabeth Johnson / João Pedro Fachetti

◼ With the nominal deficit at around 8% and the debt-to-GDP ratio on track to reach 83.2% by yearend, fiscal reform is of paramount importance ◼ Regardless of the election result, we think some fiscal reforms will be approved later this year, not least owing to the expected squeeze in discretionary spending in 2027 ◼ The Lula camp has already mapped out potential reforms that would help stabilize the debt-to-GDP ratio ◼ The growing public debate about government spending will help pave the way for the approval of structural reforms that address spending, even under Lula IV Fiscal reform is likely, even if Lula is re-elected. With just under 50 days until the first round of the presidential election and with President Lula leading the polls, our base case remains that he will be re-elected to a fourth term. The prospect of another Lula government has fuelled anxiety that he will be loath to pass unpopular fiscal measures and will keep Brazil on a path leading to a fiscal crisis. Although Lula – like his main rival in the polls, Senator Flávio Bolsonaro – has not presented a detailed economic plan that includes fiscal proposals, we are confident that, if re- elected, the incumbent president will move forward with a fiscal adjustment. While a fiscal adjustment under Lula IV will probably be more gradual than an opposition-backed reform, we still believe that he understands that spending cuts are necessary.

Chart 1: Brazil’s debt-to-GDP ratio is on an unsustainable trajectory % of GDP

Brazil’s fiscal accounts are reaching a tipping point. Brazil has not posted a primary budget surplus since 2013, and a combination of economic recessions, rising public expenditures and out-of-control tax breaks has led to sustained fiscal deficits. Brazil’s gross debt-to-GDP ratio reached 81.9% in June 2026, up more than 30pp from 51.5% in 2013 and up by over 10pp from 71.7% when Lula took office in January 2023. Based on TS Lombard calculations, Brazil’s debt- to-GDP rate will rise to 117.6% in 2036 in a business-as-usual scenario, resulting in unsustainably large debt-servicing costs that could put the country on the path to default. The government’s lack of credibility in managing the fiscal accounts is evident from the sizeable mismatch between its primary-surplus and debt-to-GDP projections and the market consensus.

Chart 2: Diverging consensus and government long-term projections underscore the lack of credibility in fiscal policy % of GDP

Primary fiscal result Govt projections Consensus Source: Finance Ministry, TS Lombard.

it is this lack of credibility and the assumption that, if re-elected, Lula will not address the fiscal elephant in the room that triggered the recent selloff. While the fact that Lula is ahead in the polls comes as no surprise to anyone, the MDA/CNT poll released on 11 August appeared to hit a nerve among the already jittery investment community. The poll showed Lula ahead in every signal scenario, with the incumbent capturing 42.4% of voter intentions compared with 28.7% for Flávio in the first round (4 October) and leading Flávio 48% to 39.1% in a potential runoff.

Chart 3: Lula leads Flávio both in the first round... Chart 4: ...and in a potential runoff

Apr/26 (%) Jun/26 (%) Aug/26 (%) 45 60 Lula Flávio Lula Flávio Others Blank / Undecided 0 Null Apr/26 (%) Jun/26 (%) Aug/26 (%)

Source: CNT/MDA. Source: CNT/MDA.