Brazilian president Jair Bolsonaro kicked off the new year with a frank admission: “Brazil is broke. There is nothing I can do.”

Latin America’s largest economy mitigated the initial economic hit of coronavirus last year with a massive stimulus package worth more than 8 per cent of gross domestic product, resulting in an output contraction of less than 5 per cent, considerably smaller than other countries in the region.

But that leaves Brazil with public debt of more than 90 per cent of GDP, the highest total debt of any major developing economy other than China, and investors are getting jittery about its outlook.

Rising unemployment, the uncontrolled spread of coronavirus and delays to vaccination programmes, as well as the government’s faltering reform agenda, are set to contribute to an underwhelming recovery this year. The IMF forecasts Brazil’s GDP will expand 3.6 per cent, leaving it still well below its pre-pandemic level.

Line chart of GDP, rebased (2019 = 100) showing Fiscal boost helped cushion Brazil from last year

And as Mr Bolsonaro recently argued, there is little scope to boost that with a fresh stimulus round. A spending cap introduced in 2016 limits government spending to the previous year’s expenses, adjusted for inflation. It has become a key signal to investors that the public finances are under control.

“There is a huge demand among society for more social spending and public investment. [But] We don’t have any room for this,” said Solange Srour, chief economist at Credit Suisse in Brazil. “Investors are asking about the sustainability of [Brazil’s] debt. They understand the fragility of our accounts . . . The biggest challenge this year is not to breach the spending cap.”

Halting the stimulus spending will be hardest felt by Brazil’s vast informal sector, which accounts for tens of millions of citizens who are not registered in official employment data but received monthly cash stipends last year as part of the pandemic relief effort. It is also likely to impact the country’s official unemployment level, which is now at 14.1m, up from 12.3m before the pandemic.

“There is no jobs recovery and no prospect of one. The only reason the unemployment rate has not gone up more is because people have not returned to the labour market so much. And the segments suffering the most are in the informal economy,” said Silvia Matos, a co-ordinator at the Brazilian Economy Institute. “The service sector is also still well below the pre-crisis period.”

Luciano Rostagno, chief strategist at Mizuho bank, said much will depend on whether the government can stem the second wave of coronavirus and efficiently roll out its immunisation programme.

“The spread of a second wave of Covid-19 and delays in vaccinations may trigger precautionary savings behaviour, shifting consumption further down,” he warned.

As a result, most economists agree there cannot be a complete cessation of crisis funding.

“Brazil’s outperformance last year had a lot to do with enormous fiscal stimulus. This is going to be withdrawn at a time when private demand isn’t ready to pick up the slack,” said William Jackson, chief emerging markets economist at Capital Economics.

Line chart of General government gross debt as % GDP showing Pandemic stimulus pushes up Brazil

One way around the dilemma would be for Congress to pass an emergency constitutional amendment cutting the government’s mandated spending obligations — mainly public sector salaries and pensions — which soak up almost 95 per cent of its budget.

However Congress, which returns from recess next week, is fiercely protective of public sector benefits, so passing such legislation would not be easy.

It would also be politically unpopular. The closer the country gets to federal elections next year, the less likely Mr Bolsonaro will be to spearhead economic reforms that could cause economic pain for swaths of his voters. The looming polls mean the president may be tempted to revert to stimulus spending to boost his popularity.

“With the surge in the pandemic, it is natural that the discussion over benefits will return. [But] The government’s concern goes further than the economy and touches on the president’s declining popularity,” said Sergio Vale, chief economist with MB Associados.

That leaves investors to contemplate their willingness to continue financing government spending.

Most Brazilian debt is in local currency, meaning the country can avoid the kind of foreign debt crises that have plagued neighbouring Argentina. But there is still the possibility of a domestic markets crisis if investors’ concerns grow.

The yield curve for Brazilian sovereign bonds steepened sharply in the latter half of last year, reflecting higher premiums demanded by investors to lend longer term.

Investors also want more economic reform — particularly an administrative reform to cut state costs, which finance minister Paulo Guedes last year estimated would save $57bn over the next decade, and efforts to simplify Brazil’s byzantine tax code.

“When the foreign investor looks at Brazil, he is concerned with the economic situation and the business environment,” said Paulo Feldmann, professor of economics at the University of São Paulo. “Transport is very expensive, energy is expensive, there is a high tax burden. This scares companies, especially when the economy is deteriorating and unemployment and inflation [are] rising.”

Ms Srour from Credit Suisse said the “most important thing is for [Mr] Bolsonaro to improve the articulation of policies in Congress”, pointing to the president’s acrimonious and unproductive relationship with the legislature.

“It should not be difficult for Brazil to grow 4 per cent this year, but we need to send a signal that the accounts will be kept in check and this depends a lot on the executive,” said Ms Srour. “[Mr] Bolsonaro needs to do more.”

Additional reporting by Carolina Pulice