Brazilian markets sharply rebounded in the wake of Jair Bolsonaro's emergence as the likely victor in the country's upcoming presidential run-off election. But without a hard and fast plan for the country's growing debt pile and persistent deficit, the reaction could be short lived, experts warn.

Bolsonaro, who turned in a better-than-forecast result in Brazil's first-round election and has since taken a commanding lead in the polls, is widely seen as the more market-friendly candidate as compared to Fernando Haddad, the Workers' Party candidate he will face in the run-off vote. A recent poll gave Bolsonaro a 14-point advantage in the Oct. 28 election, 57% to 43%.

In the weeks since the right-wing candidate won the first round election, Brazil's currency has gained nearly 4% against the U.S. dollar, while the spread on 5-year credit default swaps — an indicator of perceived risk — has dropped 14% to about 211 basis points.

Markets could continue on an upward trend should Bolsonaro take the presidency, José Faria Júnior, director at Wagner Investimento told S&P Global Market Intelligence. CDS spreads could fall to about 180 basis points, he said, while the Brazilian currency could strengthen to 3.45 to US$1, compared to its current 3.73 level.

To be sure, the improvement would be coming off of a relatively low base. Brazil is still recovering from its worst recession in modern history, during which it saw a series of credit rating downgrades that left it in sub-investment grade territory.

The country is running a fiscal deficit equal to 7.00% of GDP. Its public debt pile amounts to 77.3% of GDP and generates an annual interest rate bill of 418.5 billion reais. Oxford Economics recently called Brazil's public debt "the country's most acute economic problem," driven in large part by an overextended pension system that experts say must be addressed quickly.

"Brazil faces a big fiscal problem and reforms need to be made," said Marcel Balassiano, an economist with the Getulio Vargas Foundation, a think tank. "One candidate is favorable to tackle these problems, we do not know what the other intends to do. The signs are completely contradictory."

Under Bolsonaro's economic plan, which includes privatizing many state-owned firms and using the proceeds to pay down debt, Brazil's public debt-to-GDP ratio would tick down to 75% by 2022, according to a recent report from Oxford Economics. Haddad, meanwhile, has pledged to bolster employment and salaries and push banks to dramatically lower interest rates, but he hasn't expressed a need for pension reform. That, according to Oxford Economics, would balloon Brazil's public debt to nearly 100% of GDP and reduce economic growth.

Still, neither candidate has provided great detail on their respective economic plans. What's more, both would likely face difficulty in gaining the congressional and public support to push their economic agendas through unmodified.

Ultimately, the implementation of reforms will eventually "determine whether some short-term relief could mark the beginning of a re-rating of Brazilian assets, or merely a 'dead cat bounce' scenario," Irina Topa Serry, a senior emerging markets economist at AXA Investment Managers, wrote in a report.

"You could initially have a significant rally, but then doubts [over] delivering actual economic policy proposals will come back and there is gonna be a lot of volatility again next year because that is when you have to deliver on these things" Gustavo Rangel, chief economist for Latin America at ING, said.

Fiscal crisis not imminent

But while a failure to enact meaningful structural reform could erode Brazil's economic situation, experts stress that the country isn't likely to fall into to kind of fiscal crisis that has plagued other emerging market countries like Argentina and Turkey.

"It's very different," Rangel said, pointing out that Brazil does not have the external vulnerabilities that Argentina has. "Essentially, it's all in the hands of Brazil, contrary to Argentina, where it is all in the hand of foreigners or foreign institutions," he said.

About 96% of Brazil's public debt is denominated in local currency, while only about 12% of its real sovereign bonds were held by non-resident investors as of year-end 2017. The country also benefits from being a net external creditor, a solid stockpile of international reserves, and a central bank with a track record of being able to keep inflation in check.

"Moving forward, if we were to see cracks coming in into some of those strengths, that could [put negative] pressure on the rating," said Lisa Schineller, lead sovereign analyst on Brazil at S&P Global Ratings. "A reversal in the fiscal commitment could potentially trigger some weakness in other pieces and start a more negative dynamic, but [that is] not our base scenario," she added.

As of Oct. 24, US$1 was equivalent to 3.73 Brazilian reais.

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.

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