Itaú BBA - A More Proactive Short-Term Agenda

Brazil Scenario Review

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A More Proactive Short-Term Agenda

May 9, 2012

Incomes are rising, public spending is growing and the currency is weaker. But the data point to a more moderate pickup in growth this year.

Incomes are rising, public spending is growing and the currency is weaker. But the data point to a more moderate pickup in growth this year. The new rules for savings accounts have cleared the path for the Central Bank to cut the Selic rate further.

We have revised our forecasts for interest rates, the exchange rate, growth and inflation. We now believe that the Selic will fall to 7.75%, instead of 8.5%. We now project the exchange rate at 1.85 reais per dollar by end-2012 and 1.87 by end-2013 (up from 1.75 for both years). We have reduced our forecast for GDP growth in 2012 to 3.1% (from 3.5%) but have kept our 2013 forecast at 5.1%. We have slightly raised our IPCA inflation forecasts to 5.2% (from 5.1%) for 2012 and to 5.7% (from 5.6%) for 2013.

The government brought a new outlook to monetary policy early this month when it changed an important regulation covering Brazil’s financial market. From now on, returns on regulated savings accounts – the poupança – will track the Selic rate, at a 30% discount, whenever the Selic falls below 8.5%. By eliminating poupança’s 6% floor, the government removed the risk that investors could migrate from Treasury bonds to savings accounts if the Selic falls below a borderline level of around 8.5%. The new poupança rules have cleared the way for more rate cuts.

Given the Central Bank’s views on inflation and activity, we believe that it will push the Selic down to 7.75%, going beyond our previous forecast of 8.5%. The path towards 7.75% should be through two 50-bp moves in May and July, and a final 25 bp-cut in August.

A New Agenda?

Apart from allowing more rate cuts, the change in the poupança is in keeping with an increasingly proactive economic policy in which more tools are used, and more intensively, by the government and Central Bank.

Reforming the poupança was desirable but politically tricky, and many doubted that the government would actually face up to the task. By taking it on, President Rousseff signaled her wish to test new lows for the interest rate. Indeed, the Central Bank will probably reduce it more than previously expected.

On a separate front, the Central Bank has been more active in the FX market. While fundamental trends do suggest a slightly weaker currency in the short-to-medium run (as we discuss below), the Central Bank’s dollar purchases have pushed the exchange rate to values above what we believe to be the equilibrium level.

A proactive approach was also on display earlier this year, when the Finance Ministry selectively reduced the taxes paid by manufacturers while offering some protection against imports.

In short, the government is making broader use of the tools at its disposal, actively seeking to lower borrowing rates, stop currency appreciation, protect local producers and increase public investment. A new agenda seems to be unfolding, but its contours are still not entirely clear.

Activity: Same Dynamics, Less Intense

The first months of 2012 suggest a more moderate pace of activity ahead. On the one hand, the global economy is growing more slowly and credit conditions are still improving gradually. On the other, the labor market remains tight, government outlays are accelerating and confidence, especially that of consumers, is rising.

We have thus reduced our forecast for GDP growth in 2012 to 3.1% (from 3.5%). Even with lower growth this year, we do expect a pick-up in the second half of the year: lower interest rates, more public spending (as we discuss below) and a weaker currency will all continue to support growth, each with its own lag. Lags are sometimes long and hard to detect, but that does not mean they are not there.

There are still some factors holding back the economy. Auto sales are still weak, even after contracting in the first quarter; as a result, auto inventories will likely continue to restrain manufacturing for a few months. Surrounded by uncertainty, the global economy expands moderately. Confidence among manufacturers is rising only slowly, despite the incentives. That will tend to weigh on investment.

Bank lending was stable in the first quarter of the year. New consumer loans were up 1.7% year over year (after adjusting for seasonality, inflation, and business days), but business loans were down 0.7%.

Other factors suggest that a recovery is well under way. Total real wages are now up more than 7% from one year ago, a solid gain that reflects the new minimum wage and the low rate of unemployment. Strong income is boosting supermarket sales. Consumer confidence hit a record high in April and will likely prop up demand for consumer goods ahead.

The pick-up may be slow, but it is already in evidence in important areas of the economy and will likely continue to spread. Remember, a solid set of growth boosters is at work. The second half still looks to be the best part of 2012. In fact, we are keeping our 2013 GDP growth forecast at 5.1%.

FX: Revised Forecasts

We reassessed the levels of some exchange rate fundamentals and considered the short-term impact of Central Bank’s dollar purchases and of lower interest rates. As a result, we have revised our year-end forecast to 1.85 reais per dollar in 2012 and 1.87 in 2013 (up from 1.75 for both years).

In recent years, the prices of Brazilian exports have consistently risen faster than prices of imports, an improvement in the terms of trade that explains much of the currency’s appreciation over the years. However, the terms of trade have lately given some ground, falling by around 6% from their peak in late 2011. In addition, Brazil’s risk premium is now slightly higher than the level of early 2011. Both factors suggest a weaker short- to medium-term equilibrium exchange rate.

As for short-term factors, the Central Bank stepped up the pace of its purchases in the spot and forward markets in the last couple of months, helping to push the exchange rateto 1.92 in early May from 1.71 in early March. Although the long-term impact of such FX intervention is limited at best, it can work in the short term, especially if fundamentals are pushing in the same direction, as we believe they are. Also, domestic real interest rates have fallen faster and more deeply than expected at the end of last year. Lower interest rates and higher Central Bank intervention have caused the currency to weaken even more than our revised equilibrium estimate would suggest.

Balance of Payments

A weaker currency will likely make the current account deficit rise more moderately ahead. We have lowered our deficit forecasts to 2.3% of GDP in 2012 (from 2.7%) and 2.6% of GDP in 2013 (from 2.9%). The deficit now stands at 2.0% of GDP.

One of the factors behind the smaller deficits is a stronger trade surplus due to the weaker FX. We now expect a 2012 trade surplus of $18 billion (up from $15 billion). For 2013, we now expect a surplus of $10 billion (up from $5 billion).

In March, foreign direct investment reached a solid $5.9 billion, reinforcing our forecast of strong inflows this year. We stand by our call of FDI amounting to 2.6% of GDP in 2012 (compared with 2.7% in 2011).

Fiscal Trends

The March fiscal results showed the public sector on the way to meeting this year’s primary target of 140 billion reais (3.1% of GDP), as in 2011. In the first quarter of the year, the primary surplus hit 4.5% of GDP – higher than last year’s 4.1%. Despite the slightly better primary surplus at the start of the year, fiscal policy will contribute to boost growth this year, thanks to higher spending.

In March, federal spending was up 11% year over year in inflation-adjusted terms, with sturdy gains in discretionary spending (34%), including investment (70%) and administration (22%). Transfers were up 9%, reflecting the highest real minimum wage hike in six years.

Except for payrolls, which are still muted, federal spending is rising across the board, exhibiting a real annualized growth rate of around 5% over the past six months

We maintain our view that the government’s fiscal targets will be met in full in 2012 and 2013. If revenues pick up as the economy recovers later this year, the government will be able to keep real spending rising at the fast pace of around 7% in both 2012 and 2013. Government transfers will play a leading role in 2012, as will investment for the entire two-year period. In all, fiscal policy continues to look expansionary.


We have slightly raised our 2012 IPCA forecast to 5.2% (from 5.1%), reflecting the impact of a weaker currency (which will cause an even stronger impact on wholesale prices), partly offset by lower GDP growth. We have also raised our 2013 inflation forecast slightly, to 5.7% from 5.6%.

This expected increase of inflation from 2012 to 2013 reflects the likelihood of a faster rise in regulated prices, which we expect to go up by 5.0% (from 3.1%). We still expect market-set prices to rise by around 6% and services inflation to stay close to 8%, echoing a strong labor market.

Inflation risks tilt to the upside. Fueled by strong growth boosters, a faster-than-expected recovery of the economy could increase inflationary pressures ahead.

From a broader perspective, Brazil’s long cycle of currency appreciation seems to have run its course, and the exchange rate could be stabilizing. What does that mean for inflation?

When a currency is appreciating, inflation in tradables – imports and import-competing goods – is lower than in non-tradables (services). The gap between the two categories can be significant. In Brazil, for example, with market-set prices up 84% over the last ten years, tradables rose by 77% and non-tradables rose by 90%.

This gap always narrows when the FX rate stabilizes. This narrowing may occur through import prices rising faster, which causes higher inflation. Or it may occur as prices for locally-produced goods rise more slowly, keeping inflation contained. If the currency is weakening, the greatest part of the adjustment may come through higher tradable good prices, creating more inflation pressure.

Monetary Policy in 2013: Some Tightening on the Horizon

With the Selic rate at 7.75% and inflation at around 5.5%, real interest rates will soon hit a level below 2.5%, the lowest in decades. If past performance is any guide (i.e. no sudden structural break), it is possible that future inflation pressure will necessitate measures to slow down the economy.

We believe that this pullback will start with other instruments (such as macroprudential and quasi-fiscal measures), and then proceed to rate hikes. We expect the Selic to be raised back to 9.5% from 7.75% in three 50-bp steps starting in April 2013 plus a final 25-bp hike.

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