Itaú BBA - A slowing economy faces risks of power and water rationings

Brazil Scenario Review

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A slowing economy faces risks of power and water rationings

February 13, 2015

December data showed a deceleration in economic activity and a deterioration in the fiscal accounts.

• The deterioration in economic activity, already seen in the December figures, is likely to continue in the coming months. Planned investment and production in the oil industry will likely be cut; the labor market is losing momentum, weakening household spending; and domestic uncertainties are hurting business confidence. We have thus lowered our 2014 GDP forecast to 0% from 0.1% and our 2015 GDP forecast to -0.5% from 0.2%. 

• The risk of power rationing and water supply cuts is high. In our view, a scenario combining power rationing and a lower water supply until the next rainy season would reduce GDP growth by a further 0.6 p.p. 

• We have raised our forecast for inflation this year to 7.4% from 7.1%, to reflect the higher pressure from regulated prices, particularly electricity tariffs. We revised our estimate for regulated prices to 11.7% from 10.4% after adjusting our estimate for the hike in electricity tariffs to 40% from 30%. Our 2015 inflation forecast for market-set prices remains at 6.1%, consonant with our scenario of weaker activity and a higher unemployment rate. We expect a slowdown in inflation readings for services and food consumed at home. For 2016, we have lowered our forecast for IPCA inflation to 5.5% from 5.7%, after revising our call for market-set prices to take account of a background of weaker economic activity and lower commodity prices. In an alternative scenario marked by power and water rationings, our 2016 IPCA estimate would slide to 5.3%.

• The Brazilian Central Bank faces a challenging scenario in the short term, with the prospect of inflation breaching the ceiling of the target range this year. On the longer-term horizon, the weakness in economic activity is likely to steer inflation toward the target. We believe that the central bank is near the end of its tightening cycle.

• With a more unfavorable starting point (a primary budget deficit of 0.6% of GDP in 2014) and the prospect of a decline in economic activity this year, reaching the fiscal target becomes an even bigger challenge. We maintain our 2015 forecast of a primary surplus of 1.2% of GDP, but we acknowledge downside risks, both in the political implementation of the fiscal adjustment and in the possibility of additional economic weakness in the event of power and water rationings.

• The current account deficit widened to 4.2% of GDP in 2014, under pressure from the trade deficit, requiring a weaker real. In the coming years, a weaker currency and slower domestic activity point to a gradual adjustment in external accounts.


Brazil’s economy is already slowing. It will soon become clear whether the country will also face power and water rationing

December data showed a deceleration in economic activity and a deterioration in the fiscal accounts. The monthly figures included negative surprises for industrial production, retail sales and formal jobs creation (signaling that the economy is losing momentum) as well as for the fiscal accounts (indicating that the fiscal adjustment is likely to be deeper than we anticipated, because the starting point is worse).

The decline in oil prices and difficulties in the oil and construction industries foretell a slowdown in economic activity in 2015.

Investment cuts and the lower output growth projected for the oil industry will hurt economic activity. The difficulties being experienced by some construction companies will likely affect the execution pace of their infrastructure projects in the short term.

We have thus revised our 2015 GDP forecast for Brazil to ‑0.5% from 0.2%.

The rainy season has been disappointing; the risk of water and power rationings has never been so high. The rainy season generally starts in Brazil’s Southeast region in October, peaks in February and lasts until April. Hence, the reservoir levels in late April determine the system’s capacity to generate electricity and supply water until the next rainy season. Given the scarce rainfall recorded through the end of January, the probability of rationing has increased significantly.

In our view, a scenario combining power rationing and a lower water supply until the next rainy season would reduce Brazil’s GDP growth by a further 0.6 p.p.[1]

Weak rainfall in January heightens risks for electricity and water supply

Rainfall levels in January matched pessimistic expectations, coming in significantly below their historical averages. The volume of rainfall at electricity reservoirs was 64% of the historical average, pushing affluent natural energy (ANE) to 50.4% of its long-term average (MLT). The rainfall index for the Cantareira system, a key supplier of water to the São Paulo metro region, reached 55% of its historical average.

Rainfall levels are expected to be close to their historical averages in February. Heavy rains are expected until February 11, especially in the Southeast, followed by reduced humidity in the region due to another atmospheric blockage. All in all, rainfall levels in the month are set to be slightly above historical averages for hydropower dams as well as for the basins that make up the Cantareira and Alto Tietê systems.

Rainfall near historical levels would be insufficient; risks are set to rise. Our assessment framework for power rationing risks[2] suggests that, even if rainfall levels normalize between February and April, aggregate reservoir levels would end the rainy season below 40% of capacity. Likewise, near-average rainfalls would not be enough to prevent a further reduction in water outflow from the Cantareira and Alto Tietê basins, decreasing the water supply to São Paulo City and other municipalities. There is also evidence of water supply problems in other parts of the Southeast, including the Rio de Janeiro metro area.

Activity decelerates in December

The December data point to weak economic activity in that month and we have revised our forecast for 2014 GDP growth to zero. Industrial production fell sharply, by 2.8% mom/sa, hitting its lowest level since 2009. Broad retail sales also plunged, with a 3.7% drop mom/sa. Accordingly, the formal jobs creation disappointed, with 555,000 jobs being eliminated in December. The January indicators continue to show weakness. Production in the auto industry (which accounts for 10% of all industrial activity in Brazil) dropped for a fourth consecutive month, while employment shrank and sales declined for a second straight month. Figures compiled by Serasa Experian point to slow activity in the service sector in January.

Business confidence indicators hit all-time lows. The confidence index for industrial managers improved in January, but in all the other major sectors (services, construction and retail) confidence not only declined but also hit all-time lows. Risks related to potential power and water rationing increase uncertainty and will likely depress business confidence in the coming months, causing investments to be postponed.

Consumer confidence also fell sharply in January, by 6.7%, reaching its lowest level since the beginning of the series in 2005. With low confidence and a slowing real wage bill, household spending is set to remain weak, as in the past few quarters.

Additionally, we expect cuts in investment and production plans in the oil industry. We have lowered our 2015 forecast for oil output growth to 4.5% from 8.8% and have reduced our estimate of capital expenditures in this sector by 10%.

We have lowered our forecast for 2015 GDP to ‑0.5% from 0.2%. Recent data and fundamentals are all consonant with a scenario of deteriorating economic activity over the coming months. We expect modest 1.0% growth in 2016, largely due to the unfavorable statistical carryover produced by subsequent declines in GDP throughout 2015.

We now expect the seasonally adjusted unemployment rate to rise to 6.3% by year-end (vs. our previous estimate of 6.0%). Despite the recent decline in the unemployment rate to 5.0% in December (according to our seasonal adjustment) from 5.2% in November, we anticipate increases in the unemployment rate in the next few months. The labor force has been expanding in recent months, and the deterioration in economic activity will likely keep the labor market weak.

New loans remained sluggish in December. The daily average of new non-earmarked loans rose by 1.3% mom/sa in real terms in December. On the other hand, the daily average of new earmarked loans dropped by 4.2%. Growth in total outstanding loans decelerated in year-over-year terms, to 4.6% in December from 4.8% in November. The decline in outstanding non-earmarked loans moderated to 1.7% from 1.8% in November. In the same comparison, outstanding earmarked loans decelerated to 12.3% from 13.2%. Overall delinquency fell by 0.1 p.p, to 2.9%. Interest rates and spreads narrowed for both non-earmarked and earmarked loans.

The potential impact of the water crisis: An additional 0.6-p.p reduction in our GDP forecast

Given the high risk of restrictions on electricity and water use, we estimate an additional impact of -0.6 p.p on GDP in 2015 in a scenario that combines 5% electricity rationing and an additional 25% reduction in the water supply to part of São Paulo state until the next rainy season.

The size of the needed electricity cut will depend on how far reservoir levels fall below the rationing threshold. A 5% cut in electricity consumption for six months would be enough to prevent reservoirs from reaching their minimum operational levels until the beginning of the next rainy season if aggregate reservoir levels hit 36% by late April. A 10% cut over the same period would be enough if reservoir levels stand at 30% by late April.

Tariff increases and the expected decline in economic activity will probably curb electricity consumption. The government’s intention of passing sector-related costs through to tariffs will likely lead to new tariff hikes in 2015. We forecast an average increase of 40% for the year. Higher tariffs and declining economic activity will likely ease the burden on any eventual program to limit electricity usage.

According to our calculations, a 5% reduction in electricity consumption would have a negative impact of 0.5 p.p on GDP in 2015. Our estimate is based on a model that considers the effect of increases in electricity tariffs (already incorporated into our base-case scenario) and an eventual reduction in the supply of electricity, which are combined in an energy availability index. The causal impact of shocks to this index are estimated using aggregate reservoir levels as an instrumental variable.[3]

Additional savings in water outflow from the Cantareira and Alto do Tietê basins would have a negative impact of 0.1 p.p on GDP in 2015. This estimate is based on the share of GDP generated by the regions supplied by these two basins, on the industries that are most exposed to water volumes (and their significance for the affected cities) and on assumptions regarding the exposure of each sector to a sudden cut in water supply. The assessment assumes additional savings of 25% in water outflow from both basins.

We raised our forecast for 2015 IPCA inflation to 7.4% from 7.1%, to reflect higher regulated prices, but we lowered our 2016 estimate to 5.5% from 5.7%

The consumer price index, or IPCA, climbed by 1.24% in January, in line with our call and the median of market expectations, under intense pressure from regulated prices. The largest increases were in residential electricity tariffs (following the implementation of the tariff flag system), public transportation prices (reflecting fare adjustments in several state capitals) and prices for some food items (fresh fruits and vegetables, beans and meals away from home). The year-over-year growth in the IPCA accelerated to 7.14%.

Our preliminary estimate for February points to a monthly increase of 1.10% (vs. 0.69% in February 2014), with the year-over-year rate picking up to 7.6%. The greatest upward price pressure in the month will likely come from transportation (as gasoline prices go up following the increase in the PIS/Cofins tax rates) and education (due to the annual adjustment in school tuition fees, which is mostly incorporated into the February survey by IBGE). On the other hand, food inflation is likely to slow down compared with January.

For 2015, our IPCA estimate has increased to 7.4% from 7.1%, due to greater pressure from regulated prices, particularly for electricity. We now expect regulated prices to climb by 11.7% (vs. our previous estimate of 10.4%) due to a revision in our estimate for the hike in electricity tariffs (to 40% from 30%). This revision took into consideration the forecast by Brazil’s energy regulator, ANEEL, for a deficit of 21.8 billion reais in the Energy Development Account (CDE) in 2015. A significant share of the yearly adjustment in electricity bills is expected to be carried out in the first quarter. ANEEL signaled that there would be an extraordinary tariff review in March, which will pass through to tariffs the cost of energy generated by Itaipu and the CDE deficit. Also in the first quarter, we will observe the impact of the increase in the  red-flag tariff (to 5.50 reais for each 100 kWh consumed in the month, from 3.00 reais). Regarding other regulated prices with large weights in inflation, we expect increases of 10.5% for gasoline prices (due to hikes in the Cide and PIS/Cofins taxes), 11.6% for urban bus fares, 9.4% for healthcare premiums, 8.7% for water and sewage tariffs and 5% for medication prices. Meanwhile, tariffs for landline phone services will probably decline by 4%, due to lower rates on calls from landline phones to mobile phones.

Our inflation forecast for market-set prices remains at 6.1%, which seems consistent with a scenario of weaker economic activity and higher unemployment. We expect a slowdown in inflation for market-set prices relative to last year (6.7%) to be driven by smaller price increases for food consumed at home and for services. We expect price increases of 6.0% for food consumed at home (vs. 7.1% in 2014) and 7.3% for services (vs. 8.3% in 2014). Regarding food, we anticipate a favorable scenario for agricultural supply, especially for grains, amid high crop yields and a recovery in global inventory levels. Tame grain prices last year and this year will likely hold down price increases for animal protein and wheat byproducts. For meat prices, which climbed by 22% last year, we expect a more benign behavior, with an increase below 10%. Even so, a longer drought in the Southeast could exert pressure on some food prices throughout the year. We assume temporary risks for prices for fresh fruits and vegetables if there are limitations to water supply. For private services, we still expect a slowdown driven by accommodation in the labor market and in the real estate sector, leading to moderation in wage and rental costs.

For 2016, we have lowered our IPCA forecast to 5.5% from 5.7%, following a revision in our call for market-set prices. Our 2016 inflation estimate for market-set prices is now at 5.5% (vs. 5.8% previously), assuming both weaker economic activity and lower commodity prices. Our 2016 inflation forecast for regulated prices remains at 5.5%.

In an alternative scenario marked by power and water rationing in 2015, the decline in inflation for market-set prices in 2016 would probably be steeper. In such a situation, the negative effect on demand would affect the increase in market-set prices next year. In that case, our 2016 IPCA forecast would slide to 5.3%.

The general price index, IGP-M, climbed by 0.76% in January as the year-over-year change reached 4.0%. The producer price index, IPA-M – which is the component with the greatest weight in the IGP-M, at 60% – continues to post moderate readings, rising by 0.56% for the month and by 2.3% yoy, driven by increases of 1.35% for agricultural prices (5.9% yoy) and 0.26% for industrial prices (1.1% yoy). The consumer price index, IPC-M – responsible for 30% of the IGP-M – rose by 1.35% in January and by 7.3% yoy. The greatest upward pressure on the IPC-M came from electricity tariffs, public transportation fares, prices for fresh fruits and vegetables and school tuition fees. The construction price index, INCC-M – 10% of the IGP-M – rose by 0.7% for the month and by 6.7% yoy.

Our 2015 forecast for the IGP-M remains at 5.3%. Breaking it down by component, we expect increases of 4.3% for the IPA-M, 7.4% for the IPC-M and 6.8% for the INCC-M. We estimate that the IGP-M will climb by 5.5% next year.

Copom: Challenging short-term outlook, disinflation on the horizon

The Brazilian Central Bank (BCB) faces a challenging scenario in the short term, with the prospect of inflation breaching the ceiling of the target range this year. On a longer horizon, the weakness in economic activity is likely to steer inflation toward the target. The central bank is near the end of its tightening cycle.

Inflation is likely to exceed the upper bound of the target range this year, which will keep the Copom in “especially vigilant” mode. Given the regulated prices increases and recent currency depreciation, inflation in 2015 will probably be significantly above the ceiling of the target range. In this environment, Copom members have said, the committee will be “especially vigilant to ensure that short-term pressures do not spread to longer horizons”.

Depressed economic activity reduces the risk of secondary effects from inflationary shocks. When economic activity is depressed, the effects of increases in regulated prices and of currency depreciation on other prices tend to be smaller. In recent statements, BCB president Alexandre Tombini has emphasized that, despite the increase in current inflation, long-run inflation expectations have started to decline.

The outlook for 2016 onward is more favorable. Sluggish activity has contributed to reduce the capacity utilization in the economy and to weakening the labor market – both of which open room for disinflation in services prices. The regulated prices increases in 2015 will also reduce the pressure ahead. Therefore, despite high inflation in 2015, the outlook for 2016 has become more disinflationary.

The migration of fiscal policy to a more restrictive stance also contributes to reducing future inflation. Efforts to reach the fiscal target this year will put fiscal policy on the restraining side, reducing the burden on monetary policy. In the minutes from its latest meeting, the Copom stated that “the balance of the public sector tends to shift to the neutral zone” but “does not rule out migration to the fiscal restraint area”.

In this scenario, we believe that the Copom is near the end of its monetary-tightening cycle. In fact, it was noted in the minutes that the “scenario of inflation convergence to 4.5% in 2016 has been strengthening”, with the committee adding that “the advances seen so far in the fight against inflation (...) are still insufficient”. In the face of a challenging scenario of negative GDP growth and the need for a major fiscal adjustment, we believe that the quest for the center of the inflation target range will be postponed to 2017-18.

We maintain our expectation of a final 0.25-p.p hike in the Selic rate in March, with the benchmark rate remaining at 12.50% until the end of 2016. With the recent stronger depreciation of the Brazilian real, the probability of a 0.50-p.p rate increase at the next Copom meeting has increased. 

Fiscal accounts: Starting from way back – fiscal adjustment begins at -0.6% of GDP

The fiscal results once again surprised on the downside in December. The public sector posted a primary deficit of 12.9 billion reais in a month that is seasonally positive for fiscal performance. The biggest disappointments were the decline in revenues (due to weak economic activity) and the large deficits posted by regional governments.

There is no evidence that the negative surprise was caused by payments of delayed expenses. The balance even benefited from 5 billion reais in extraordinary revenues related to licenses for telecom services (4G) and 1.4 billion reais related to the Refis tax-amnesty program. Similarly, the November shortfall was related to discretionary spending on investments and administration, which also do not evince payment of delayed obligations.

In 2014, the public sector posted a primary budget deficit of 32.5 billion reais, or -0.6% of GDP, the worst reading since 1997. Our estimate for the recurring result – which excludes atypical revenues and expenses – stood at -1.2% of GDP by year-end. The nominal deficit reached 6.7% of GDP, while the recurring nominal deficit hit 7.3% of GDP. The public sector’s net debt rose to 36.7% of GDP in December from 36.2% in November. In 2014, net debt as a percentage of GDP increased by 3.1 p.p. The general government’s gross debt rose to 63.4% of GDP in December from 63.0% in November, thereby widening by 6.6 p.p over the full year of 2014.

The slide in the primary balance was caused by an expansive fiscal stance in terms of revenues and expenses, in addition to the slowdown in economic activity. The fiscal stance is already changing (restrictive fiscal measures were announced recently), but poor economic activity will continue to hurt cyclical revenues this year.

As the starting point is now more unfavorable and economic activity is expected to decline, additional measures will be needed to meet the target for the primary surplus. Increasing the primary surplus to 66 billion reais this year (the target for the consolidated public sector) will require a total adjustment of nearly 100 billion reais. That will require more tax increases, with a positive impact of 25 billion reais this year, according to our calculations. For spending, we expect a 4.6% drop in real terms, through already-announced cuts in labor benefits, cuts in aid to the Energy Development Account (CDE) and a significant adjustment in discretionary expenses (investment and administrative spending). Our forecast also assumes that regional governments will succeed in attaining their overall fiscal target (11 billion reais), which would imply an adjustment of nearly 20 billion reais (0.4% of GDP) for the group compared with 2014.

We thus maintain our forecast of a primary surplus of 1.2% of GDP this year, but we acknowledge that there are downside risks. There are political hurdles to the implementation of the fiscal adjustment. In the alternative scenario with power and water rationings, the weak economic activity would render the fiscal adjustment an even bigger challenge and require additional measures.

A weaker currency and a gradual adjustment in the external accounts

The internal and external environments are both contributing to currency weakness. Internationally, lower commodity prices and a possible increase in interest rates in the U.S. are poised to affect the exchange rate during the year. Domestically, the large current account deficit also plays a role.

Our year-end forecasts for the exchange rate stand at 2.90 reais per U.S. dollar in 2015 and 3.00 reais per U.S. dollar in 2016. The rapid recent depreciation is indeed consonant to fundamentals, albeit it has happened faster than we expected.

The current account deficit widened to 4.2% of GDP in 2014 from 3.6% in 2013, driven by a negative contribution from the trade balance, which flipped to a deficit of $3.9 billion in 2014 from a surplus of $2.4 billion in 2013. The service and income deficit also widened last year, but at a slower pace than in the previous year. In the financial account, foreign direct investment (FDI) remained high, at 2.9% of GDP, but was not high enough to fully cover the current account deficit, thus intensifying the need for other modalities of external funding, such as portfolio flows, which are typically more volatile and subject to global liquidity conditions.

We anticipate a recovery in the trade balance in 2015 and 2016. On the one hand, a depreciated currency and weaker economic activity hold back imports, particularly of capital and intermediary goods, which are generally used in manufacturing. On the other hand, lower crude oil production and refining capacity, along with lower iron ore prices, tend to reduce the value of Brazilian exports. These drivers will likely produce trade surpluses in 2015 and 2016, despite a simultaneous decline in trade flows. We thus maintain our forecasts of trade surpluses of $6 billion in 2015 and $13 billion in 2016.

In the event of water and power rationing, the trade surplus will probably be larger ($7.5 billion in 2015 and $14 billion in 2016). With sharper declines in GDP and capital expenditures, imports will likely slow further due to even weaker performance in the industrial sector, which is the main buyer of intermediary and capital goods (which together account for nearly 70% of Brazil’s imports).

For the other items in the current account, we have revised our forecasts by assuming a decline in GDP in 2015 and lower growth in 2016. The service and income account will probably post a smaller deficit than we initially estimated, so that the current account deficit will shrink to 3.8% of GDP in 2015 (vs. our previous estimate of 3.9%) and 3.5% of GDP in 2016 (vs. our previous estimate of 3.6%).


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