By Marcela Ayres

BRASILIA (Reuters) – Investors are increasingly worried about Brazil’s growing public debt under President Luiz Inacio Lula da Silva, compounded by a government debt profile highly sensitive to interest rates.

Latin America’s largest economy relies heavily on floating-rate bonds, which became particularly necessary for the Treasury to use amid market stress last year, leading to the worst debt composition in 20 years.

As the central bank tightens monetary policy to combat inflation, the sensitivity of Brazil’s debt to interest rates is set to increase, overshadowing any gains in primary budget balance.

Brazil holds more debt in floating-rate bonds, known as LFTs, than any major country. The issuance of these instruments hit an all-time high last year, raising their proportion in total debt significantly. Interest rate hikes threaten to elevate servicing costs on nearly half of Brazil’s extensive debt.

Former Treasury Secretary Paulo Valle highlighted that rising interest rates mean immediate costs with LFTs, presenting heightened risks to debt assessment by rating agencies.

With economic pressures and uncertainties weakening the currency, the central bank has indicated intentions to raise the Selic benchmark rate by another 200 basis points, bringing it to 14.25% by March.

Demand for LFTs surged last year amid market volatility and fiscal concerns, further worsened by Lula’s initial spending control proposals that let down market expectations.

By November, LFTs accounted for 46.1% of the total debt, marking a record increase. This rise is projected to continue, hitting the highest level since 2004 by year-end.

Gross debt has escalated to 77.8% of GDP, significantly elevating debt servicing demands. Despite efforts to reduce the primary deficit in 2024, nominal deficits may reach 8% of GDP, the highest among major emerging economies.

Itau projects that even if the government meets its primary deficit goals, nominal deficits could deepen further by 2026.

With 2024 debt management strategies underway, there’s hope to gradually shift from floating-rate to fixed-rate and inflation-indexed securities, although reliance on floating-rate debt is expected to persist given fiscal challenges and global uncertainties.

Economists are forecasting the Selic rate to exceed 15% as inflation deviates from the 3% target. Market analysts suggest it could rise past 16% by November.

Carlos Kawall, a partner at Oriz Asset Management and former Treasury Secretary, argues that the current fiscal framework is insufficient for stabilizing debt growth, blaming political reluctance to pursue necessary fiscal adjustments for the rise in LFTs and overall debt accumulation. “Debt management is a passenger in the government’s misguided fiscal policy strategy,” Kawall stated. “You can’t fix the consequences without addressing the cause.”