🇪🇺 Deal spoilers

Good morning! Today, we discuss the potential impact of the EU Parliament election on the bloc’s deal with Mercosur. Why a rout on the Brazilian real? And the latest inflation figures.

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EU Parliament election: a nail in the Mercosur deal’s coffin?

If the free-trade deal between the European Union and Mercosur (the trade alliance between Brazil, Argentina, Paraguay, and Uruguay) seemed elusive until last week, the results of the EU Parliament election may very well have delivered a death blow to any possibility of the agreement being ratified. 

• Even though the center held (only just), the far-right made serious gains in countries such as France, Germany, and Austria.

EU earthquake. The results led French President Emmanuel Macron to call a snap legislative vote for the end of the month, and Marine Le Pen’s far-right National Rally party is leading early polls.

 Why it matters. France has been a roadblock to the deal’s ratification, as groups from across the political spectrum try not to disrupt the country’s strong agricultural lobby. Even Mr. Macron, who is more in favor of free trade than most French politicians, has been against the deal — if Ms. Le Pen’s party gets even stronger, the protectionism dial should ramp up several notches.

Remember. As we showed ahead of the French election in 2022, opposition to the free-trade deal with Mercosur was one of the very few issues on which Mr. Macron and Ms. Le Pen agreed. In a runoff debate, they had strong words about the deal:

• Le Pen: “There are a number of [EU] rules I don’t agree with, like the multiplication of free-trade agreements, in which we sell cars from Germany and sacrifice [French] farmers, the competition from Brazilian poultry and Canadian beef.”

• Macron: “You mentioned something important: Brazilian poultry. I’d like to inform you that France opposed Mercosur because I put a clause that holds [farmers from other countries] to the same standards as our own.”

Sticking to his guns. During a visit to Brazil in March, Mr. Macron said the current draft deal is “terrible” for both sides and that he had taken a “position of principle” against the agreement, which he said was separate from his country’s positive bilateral relations with Brazil.

State of play. A report by French newspaper Le Monde shows that French EU lawmakers are more protectionist than those from other countries. That is particularly true among the far-right groups that made gains in the recent European elections.

Hope alive. Senator Nelsinho Trad, the head of the Brazilian delegation at the Mercosur Parliament, has taken a careful stance on the deal’s ratification possibilities. 

• “With the results in the European Parliament, we need to conduct a new analysis of whether that position [against the deal] will prevail. I would wait to see how these new lawmakers will perform,” he told Brasília correspondent Cedê Silva.

Grievances. The EU claims that South American farmers do not abide by the same environmental standards as European ones and wants tighter rules on the issue — which Brazilian officials have denounced as “green protectionism.”

• But Brazil has created additional hurdles to the deal, as well. Under the Lula administration, the country has sought to revisit a provision allowing EU companies to take part in Mercosur procurement processes. 

• The government has also raised concerns about the deal’s impact on Brazilian family agriculture.

Brazilian inflation ticks up in May

For the second straight month, the rise of consumer prices in Brazil has gained steam. Inflation reached 0.46 percent in May (a bit higher than the median projection of 0.42 percent, according to Bloomberg). In 12 months, the country’s benchmark inflation gauge has increased 3.93 percent.

• The inflation acceleration was driven by a jump in the cost of food and energy, expenses that people simply cannot avoid.

 Why it matters. The numbers for May highlight the difficulties that policymakers at the Central Bank face in bringing inflation down to their goal of 3 percent (with a tolerance band of ±1.5 points). Inflation peaked north of 12 percent in 2022.

Side effect. Itaú economists say they do not see any room for further cuts to Brazil’s benchmark interest rates this year, which are currently at 10.5 percent. According to the Focus Report, a weekly survey by the Central Bank with top-rated investment firms, the median year-end interest rate projection rose from 9.75 to 10.25 percent in the past month.

Inflation for all. Consumers from all income brackets felt the pinch in May. While food and energy prices weigh proportionately more on the budgets of poor families, rich Brazilians saw significant jumps in health insurance premiums (+0.77 percent) and airfares (+5.91 percent).

Flood inflation. Porto Alegre, the capital of southernmost state Rio Grande do Sul, saw the biggest inflation jump among all metro areas surveyed at 0.87 percent. According to André Almeida, the inflation survey manager at the Brazilian Institute of Geography and Statistics, the numbers reflect the impacts of the massive floods that hit the state on food and energy costs. 

Fiscal risks lead to currency rout

The Brazilian real lost 0.6 percent in value against the U.S. dollar on Monday, with the foreign exchange rate reaching BRL 5.35 to the greenback. It was an 18-month low for the Brazilian currency amid growing concerns about the country’s fiscal outlook. Other emerging currencies also felt the blow.

Context. Monday’s trading session opened under the influence of disastrous statements made by Finance Minister Fernando Haddad on Friday, when he met with Santander Brazil’s chief executive and executives from other asset managers. 

• Mr. Haddad told investors that he would need to make significant spending cuts to hit the country’s fiscal target if Congress does not approve the revenue-boosting measures he has proposed. 

• Many of the executives in the meeting took his words as an indication that the government could abandon the current fiscal framework. The finance minister called rumors about his abandonment of fiscal rules “irresponsible and inaccurate.”

Global factors. Expectations surrounding still-steady inflation in the U.S. (data for May will be published on Wednesday) and the Federal Reserve’s resistance to short-term rate cuts added to the uncertainty scenario.

By the numbers. The DXY index, which measures the dollar against a basket of strong currencies, registered an increase of 0.25 percent to 105.15 points.

What they are saying. “Higher interests attract financial flows to the U.S., putting pressure on emerging and developed market currencies, including the Brazilian real,” Francisco Nobre, economist at independent brokerage XP, tells The Brazilian Report.

• “Additionally, other central banks in developed countries began cutting interest rates, appreciating the dollar further, and therefore adding pressure on the real,” he adds.

Outlook. Markets have increased their inflation expectations for five weeks straight. According to a weekly survey by the Central Bank, the median forecast has gone from 3.76 to 3.9 percent. Investors have kept their median forecast for the year-end dollar exchange rate at BRL 5.05.

• This is a different view from the first survey of the year — when analysts expected a stronger Brazilian currency, with the U.S. dollar closing the year below the psychological threshold of BRL 5 — more precisely, BRL 4.95. 

• At that time, they expected the Fed to cut interest rates in January and were still excited about the tax reform, which cleared Congress in December.

 Why it matters. A rising U.S. dollar can fuel Brazilian inflation, influencing the decisions of the Central Bank’s Monetary Policy Committee while causing investors to flee the country. The persistence of an exchange rate above BRL 5.30 could increase inflation projections by 0.4 to 0.6 percentage points in the 12 months ahead.

Bottom line. Economists at Itaú Unibanco, Brazil’s largest private bank, believe there is room for the dollar price to grow further this year, depending mainly on the divergence of monetary policy between the Fed and other central banks and the evolution of geopolitical tensions.

Reserves. IMF data shows that the dollar and other traditional currencies (such as the euro, pound sterling, and yen) have lost space in central banks’ international reserves. The U.S. dollar accounted for 71 percent of reserves in 1999, a rate that dropped to 58.4 percent in 2023. But this will probably change this year.

• “American exceptionalism.” That is how Itaú’s economists describe the current scenario, “which tends to last, especially in a context in which Eurozone countries have low growth prospects, and China loses dynamism and generates excess capacity in several sectors.”

GDP. For Rafaela Vitória, chief economist at Inter, a bank, the exchange rate being at its highest since January 2023 “raises an alert for the government that the risks in the current scenario could impact economic growth, affecting investment and even family consumption.” She tells The Brazilian Report that “we may see some correction in the direction of fiscal policy.”

Quick catch-up

The Federal Accounts Court will analyze the Lula administration’s 2023 books on Wednesday and recommend to Congress whether or not to approve them. During Lula’s previous two terms, his books were always approved with caveats. 

• Fernando Henrique Cardoso was the only president whose administration got approval without caveats: in 1996, 1997, and 1999. Dilma Rousseff was the only one to have her books rejected: in 2014 and 2015.

Rio Grande do Sul companies that want access to credit lines put forward by the National Development Bank (BNDES) will have to meet job creation goals. Firms will have ten months to reach the same number of employees they had prior to the floods that hit the state.

Average gasoline prices at the pump have climbed 5 percent this year already, according to the National Oil Agency, despite Petrobras not increasing the price of fuel sold in its refineries for seven months.

The federal government plans to launch a BRL 100 billion plan to improve energy efficiency in public buildings. The goal is to reduce the cost of electricity bills.

The Education Ministry announced BRL 5.5 billion investments in universities and student hospitals. A strike by professors and administrative staff who asked for better pay has hampered activities in federal universities.

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