Itaú BBA - U-Turn in Exchange Rate Policy

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U-Turn in Exchange Rate Policy

January 2, 2013

The Brazilian economy proved to be harder to manage, with simultaneous concerns involving weak growth and inflation.

The Brazilian economy in December 2012

The Brazilian economy proved to be harder to manage, with simultaneous concerns involving weak growth and inflation. The government adopted measures to fight both. The central bank started taking steps to avoid currency depreciation and curb inflation, which is on the rise again. The central bank also signaled its intent to maintain the current interest rate level for a “sufficiently long” period. The government launched a new package of fiscal incentives to stimulate growth, including allowing reserve requirements to be used to finance some credit lines and announced new airport concessions. Difficulties notwithstanding, external accounts remain sound, with strong direct investment inflows. In the political arena, the Supreme Court ended the important trial known as “mensalão” and the Public Ministry indicted 24 people in a new influence-peddling scandal in an operation known as “Porto Seguro”.

The government seems concerned with inflation and is taking steps to avoid currency depreciation.

Facing market pressure to weaken the exchange rate, the central bank reversed the direction of the exchange rate policy, implementing a number of measures to avoid currency depreciation. Authorities removed some capital controls that had been introduced previously and proceeded to sell U.S. dollars in the derivatives market. The central bank also signaled its intent to maintain the current level of interest rates for a sufficiently long period. Inflationary pressure and a heated labor market may be behind those measures.

Short-term inflation is under more pressure...

The mid-month consumer price index (IPCA-15) climbed by 0.69% in December (vs. 0.54% in November). The pickup was caused by greater pressure from personal expenses, housing, transportation and food costs. We expect the headline IPCA for 2012 to go up by 5.7% vs. 6.5% in 2011. For 2013, the end of the IPI tax break for automobiles led us to increase our forecast for the IPCA to 5.6% from 5.5%.

...partly because the labor market is still heated.

The unemployment rate in November stood at 4.9%, which was below our estimate and market consensus (5.1%). In seasonally-adjusted real terms, the rate is at 5.3%. The real average income rose significantly, by 5.3% from November 2011. A heated labor market supports the good performance of consumer spending. In fact, in the 12 months through October, retail sales advanced by 14.5% in real terms.

But the government is also concerned with growth, and is adopting new incentives.

Weaker-than-expected GDP growth in the third quarter prompted the government to free up reserve requirements and implement new fiscal stimuli. A fraction of reserve requirements may now be used by banks with more than $6 billion in equity to finance some credit lines. Among the incentive measures announced in December are the (partial and temporary) extension of the IPI tax break for automobiles and other durable goods, a reduction in payroll taxes for retailers, and a reduction in income taxes on profit sharing. For now, the measures do not change our expectation for a moderate rebound in growth in 2013.

It’s not all about current growth and inflation: the government makes progress on ICMS tax reform.

The government has proposed to the states certain changes in the interstate ICMS system. According to the proposal, the ICMS tax rate should be gradually reduced to 4% from 12%-7% (depending on the state) by 2028. Two funds would be created to compensate the states for financial losses. The states would also be compensated with lower interest rates on their debt to the federal government. The reform of the ICMS system (if successfully implemented) will reduce part of the inefficiency of the Brazilian tax system and help boost productivity in the years to come.

New airport concessions are scheduled.

The government announced that the Confins airport (in the state of Minas Gerais) and the Galeão airport (in Rio de Janeiro) will be handed over to the private sector in auctions scheduled for September 2013. The expectation is that 11 billion reais will be invested in the two airports during the concession contracts. The government imposed stricter demands than it did in the first big auction for the sector, held in February 2012. The interested groups must include a company with experience in managing airports for at least 35 million passengers (up from 5 million in the previous auction) and must have at least 25% of the shares in the consortium (10% in the previous auction).

External accounts remain sound.

Foreign direct investment (FDI) inflows reached $4.6 billion, once again topping expectations. In the first 11 months of the year, FDI totaled $60 billion, nearing the all-time high of 2011. The current account deficit has been steady, at around 2.2% of GDP, with low profit and dividend remittances offsetting a declining trade surplus.

In the political arena, the Supreme Court ended the “mensalão” trial...

After four and a half months, the Supreme Court (STF, in its Portuguese acronym) ended the so-called “mensalão” trial. The STF understood that there was a scheme to purchase congressional votes during the first years of the Lula da Silva administration. The court found 25 of the 38 defendants guilty, set sentences (ranging from three to 40 years, in addition to fines) and ruled that the three condemned federal representatives must leave their posts. STF president Joaquim Barbosa ruled that defendants found guilty are to be jailed only after all defense petitions are exhausted.

...and the Public Ministry indicted people who were under investigation for influence-peddling in the Porto Seguro Operation.

The Federal Prosecution Service (MPF) indicted 24 people investigated by the Federal Police in the Porto Seguro Operation. Among them are Rosemary Noronha, former cabinet chief for the presidency in São Paulo and close to former President Lula da Silva; Paulo Vieira, former director of the National Water Agency; and his brother Rubens Vieira, who was ousted from the National Civil Aviation Agency. Among the crimes listed by the MPF are influence-peddling and criminal conspiracy.

Stock market rises, the Brazilian real strengthens.

After two months of declines, the Bovespa benchmark index rose by 6.1% in reais (9.4% in dollars) in December. For the year as a whole, the index climbed by 7.4% in reais (-1.4% in dollars). The 5-year CDS spread ended the month at 108.4, down by 1.25% from the previous month. The real strengthened in December, finishing at 2.04 reais per U.S. dollar, influenced by foreign exchange measures adopted by the government.

What’s next?

The monthly minimum wage will rise to 678 reais, marking a 9% increase over the previous year, set by a pre-established formula. The central bank is unlikely to touch the benchmark Selic interest rate in the January monetary policy meeting, but we expect a move in March, if the country’s economic recovery by then disappoints the government. So all eyes will be on the pace of economic bounce-back, inflation and the direction of exchange rate policy.

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