Assessing Brazil's Fiscal Illusion and Its Implications for Emerging Market Debt

Brazil’s fiscal strategy under President Luiz Inácio Lula da Silva has sparked intense debate, particularly regarding its ambitious 2026 budget surplus target. The government aims to achieve a primary surplus of 0.25% of GDP in 2026, a first under Lula’s third term, as part of a broader plan to normalize fiscal policy and reduce public debt [1]. However, the credibility of this target is increasingly questioned, as the administration relies on unconventional measures—such as tapping forgotten bank accounts and implementing selective tax exemptions—to meet its goals. These tactics, while technically legal, have been criticized for creating a “fiscal illusion” that masks structural weaknesses in Brazil’s public finances [3].

The International Monetary Fund (IMF) has acknowledged Brazil’s progress in structural reforms but emphasized that fiscal credibility hinges on a stronger medium-term anchor and concrete steps to reduce public debt, which is projected to peak at 84.2% of GDP by 2028 [5]. The government’s recent decision to delay the 1.0% primary surplus target from 2026 to 2028 further undermines confidence, signaling a lack of fiscal discipline [3]. Such shifts, combined with a strategy that avoids spending cuts and relies on optimistic revenue assumptions, risk deterring private investment and slowing growth [1].

Investor sentiment reflects this duality. While Brazil’s 10-year sovereign bond yields reached 15.267% in 2025—a reflection of persistent fiscal risks—there has been a partial recovery in demand for inflation-linked NTN-B bonds, which offer real yields of around 4.2% [2]. This apparent “oasis” for investors [3] is, however, built on shaky ground. The fiscal illusion is evident in the high yields that mask underlying challenges: rising public debt, inflation above the 5.5% target, and a current account deficit widening to 4% of GDP [4]. For example, incentivized debentures now account for 40% of NTN-B issuance, skewing yield curves and distorting capital flows [4].

The implications for emerging market debt are profound. Brazil’s fiscal credibility—or lack thereof—acts as a bellwether for investor trust in the region. A weakening fiscal framework could trigger capital outflows, exacerbate currency depreciation (the real traded at R$5.76 per dollar in 2025 [3]), and increase borrowing costs. Morningstar DBRS notes that Brazil’s GDP growth is projected to slow to 2.0% in 2025 and 2026, further straining fiscal sustainability [4]. Meanwhile, the U.S. imposition of a 50% tariff on Brazilian steel and aluminum, though not permanent, adds to trade uncertainties [1].

For investors, the paradox of Brazil’s high-yield debt lies in its dual nature: a potential for capital appreciation if reforms succeed, versus the risk of a fiscal crisis if credibility erodes. The World Bank has recommended reforms to rural land tax and personal income tax to improve fiscal balance [2], but political resistance and structural inertia remain significant hurdles.

In conclusion, Brazil’s fiscal illusion—where optimistic targets and high yields obscure deeper vulnerabilities—poses a critical test for emerging market debt. While the government’s 2026 surplus goal may attract short-term capital, long-term sustainability requires a shift from creative accounting to structural reforms. Investors must weigh the allure of high returns against the risks of a fiscal credibility crisis that could ripple across the global emerging market landscape.

Source:
[1] Government's 2026 Budget Plan Tests Fiscal Credibility [https://valorinternational.globo.com/economy/news/2025/08/18/governments-2026-budget-plan-tests-fiscal-credibility.ghtml]
[2] Brazil's High-Yield Dilemma: Navigating Debt, Inflation ... [https://www.ainvest.com/news/brazil-high-yield-dilemma-navigating-debt-inflation-sovereign-opportunities-2025-2507/]
[3] Brazil's Weakening Fiscal Framework and its Impact on Businesses [https://www.globalpolicywatch.com/2024/07/brazils-weakening-fiscal-framework-and-its-impact-on-businesses/]
[4] Morningstar DBRS Confirms Brazil at BB, Stable Trend [https://dbrs.morningstar.com/research/459538/morningstar-dbrs-confirms-brazil-at-bb-stable-trend]
[5] IMF Executive Board Concludes 2025 Article IV Consultation with Brazil [https://www.imf.org/en/News/Articles/2025/07/16/pr-25252-brazil-imf-executive-board-concludes-2025-article-iv-consultation]