Itaú BBA - All Engines Forward

Brazil Scenario Review

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All Engines Forward

March 15, 2012

While conditions favor future growth, a slow recovery has compounded official concerns regarding the rising currency.

While conditions favor future growth, a slow recovery has compounded official concerns regarding the rising currency. The response has been faster rate cuts, a higher fence on inflows, and pledges of additional growth-promoting measures

We continue to expect the Central Bank to lower the Selic rate to 9.0% with a 75-bp move in April. We have also raised our 2012 inflation forecast to 5.5%, reflecting new pressures from grain and fuel prices. With inventory adjustments still weighing on production, we now expect a first-quarter GDP growth of 0.5% qoq/sa (0.8% previously), but maintained our year-end growth estimate at 3.5%.

For 2013, we lowered our GDP growth forecast to 5.1% (from 5.4%) as a result of a reassessment of the impact of stimuli. We also adjusted our 2013 IPCA inflation forecast to 5.7% (from 5.6%). We still expect the Selic back at 10.5%, with the tightening preceded by macroprudential measures. We expect the current account deficit to reach 3% of GDP and the exchange rate to close the year at around 1.75. We raised our forecast for the 2012 primary fiscal surplus to 2.8% (from 2.5%).


The Brazilian economy is slowly stretching out after lying low throughout most of 2011. The IBGE’s latest nationwide retail data (December) shows a steady pickup in demand, a trend also seen in the January results from ABRAS, the supermarket association.

Consumer lending rose by 1.3% in January (new loans adjusted for seasonality, inflation, and business days), a strong result following a sharp drop in December. Lending is rising modestly, consumer confidence is sustaining a high level, and wages are growing. Finally, our forecast for global growth has risen (by 0.4 pp in the last two months), reducing growth risks.

In other words, although demand is not exploding, it seems to be improving.

Manufacturing, on the other hand, continues to shrink. The IBGE’s industrial production index sank 2.1% mom/sa in January, a surprisingly weak result led by a drop in iron ore output as well as a sharp contraction in autos and auto parts. The weakness, however, runs deeper than these two sectors.

In fact, more than half of the IBGE’s industrial subsectors reported a drop in January. Weak production, it seems, continues to reflect the inventory adjustments following the frustrating sales in the second half of last year. In light of the available data, we now expect a first-quarter GDP growth of 0.5% qoq/sa, down from a previous forecast of 0.8%.

The weakness in production stems not from lack of demand but, primarily, from the ongoing adjustment in inventories. In fact, lower inventories will likely make way for a bolder recovery ahead, if demand stays on track, as seems likely. With more stimulus at home and a better global backdrop, we have maintained our 2012 growth forecast at 3.5% despite a weaker first quarter. For 2013, we reassessed the impact of growth stimuli, and reduced our GDP growth forecast to 5.1%, from 5.4%.

A slower start of the year naturally raises the risk of a lower final reading for 2012, but the trend, in our view, remains broadly intact.

Capital Inflows and the Balance of Payments

Easy monetary conditions in advanced economies have helped drive up capital inflows. The real appreciated for a while, raising fears that it could gain strength very quickly. The Central Bank and the Finance Ministry have sought to discourage "speculative" inflows by extending the reach of the IOF tax to increasingly longer-term foreign debt inflows, as well as threatening to “do more” in order to keep the real at an "adequate level." In its latest move, the government restricted longer-term export financing, closing a door on possibly disguised (untaxed) capital inflows.

We believe that a tighter fiscal policy is the best weapon against surges in capital inflows. It makes room for sustainable interest rate cuts and could enable broader tax cuts, thereby improving industrial competitiveness over time.

Brazil posted a US$7.1bn current account deficit in January, including a $1.3bn trade deficit mostly caused by the disruption of mining exports due to heavy rains. Funding, however, was broad and diversified. Fixed income and equity flows reached $4.8bn, the highest level since October 2010. Foreign direct investment stood at $5.4bn. Medium- and long-term loans added another $1.9bn.

February’s weak trade surplus ($1.7bn) reinforced our view that the surplus will narrow to $11bn this year (from $29.8bn in 2011). This below-consensus forecast rests on falling terms of trade and faster domestic growth relative to global growth. We still expect a current account deficit of 3% of the GDP in 2012. Our currency forecast remains at 1.75 reais to the dollar at year-end 2012 and 2013.


Unrelated to the rising currency, inflation continues to fall, as expected. In February, the IPCA index rose 5.85% relative to February 2011, the fifth consecutive decline since reaching a 7.31% peak last September. Monthly inflation is also falling.

However, later on, we expect the recent spike in grain prices (particularly soy) and a likely readjustment in fuel prices to add more pressure than was built into our forecasts.

On fuel, we now assume an 8% rise in gasoline prices at refineries in the second half of the year. We also assume that the CIDE tax on pump prices will fall from 8% to zero, leaving consumers (and consumer inflation) untouched.

Furthermore, we project a 20% adjustment in diesel prices, with no compensation at the pump. Although diesel oil is negligible for consumer prices, it feeds very broadly into the economy and has a significant (but hard to measure) indirect effect. We assume a total impact of 0.3pp on consumer inflation in 2012, and expect it to hit again in 2013 through regulated prices subject to annual revision, such as urban transport.

In addition to fuel price adjustments, inflation expectations continue to rise and the pressure on the labor market is not fading. We have therefore raised our IPCA forecast to 5.5% (from 5.2%) in 2012, and revised it slightly to 5.7% in 2013 (from 5.6%).

Fiscal Results

January’s fiscal results were the strongest since 2008, with surprises in both revenue (higher) and spending (lower). From a broader perspective, however, revenues are slowing and spending is likely to rise as investment picks up and the minimum wage continues to feed into transfers.

That said, we now expect federal payroll spending to be at 190 billion reais ($105bn), down from 195 billion. The government will probably stave off pay raises for civil servants again in 2012. With that, real spending should rise by 7.5% (instead of 8.2%).

It also appears that the government will secure more non-recurring revenues (for example, from concessions). We expect an extra 6 billion reais in “non-tax” revenue, bringing the total to 135 billion. All things considered, we have revised our forecast for the 2012 primary surplus to 2.8% of GDP (from 2.5%), slightly below the 2012 target (3.1%) and the 2011 result (also 3.1%).

Monetary Policy

In short, although the economy is rising through slow steps, monetary and fiscal policies suggest faster growth ahead.

It was against this background that the Central Bank cut 75 bps from the Selic rate on March 7, pushing it to 9.75% (below the symbolic 10% threshold for the second time in recent history, the first was in 2009). Most economists, including ourselves, expected the CB to maintain the 50-bp pace of previous meetings.

Given the rising inflation expectations, the Central Bank probably based its decision on the pressured currency and a less favorable assessment of the growth outlook.

The monetary policy committee stated in the March policy minutes: the committee sees high probability that the Selic rate will fall to a level “slightly above historical lows” – a reference, to the 8.75% level it reached in 2009. Admitting that growth will continue to rise only gradually and that the pressure on the currency is unlikely to go away any time soon, we still expect the Central Bank to steer the Selic to 9.0%, with one more 75-bp round. Previously, we expected the same 9%, but through more moderate 50-bp moves.

In an alternative scenario, the Copom would extend rate cuts to 8.5% if the pickup in growth proves to be slower than the committee expects. However, that level would be very close to the limit established by regulations on saving accounts, which offers a government-guaranteed, tax-free yield currently at around 7.5%. In order to leave the Central Bank’s options open, the government may seek to rush a reform of the saving account system through Congress. The topic is, understandably, back in the newspapers.

What about 2013? Even our slightly-lowered GDP forecast is consistent with a good pace of growth - and more inflation - next year. We slightly raised our 2013 IPCA forecast to 5.7% (from 5.6%) to reflect, among other things, the lingering impact of higher diesel prices.

We still expect the Selic rate to rise in 2013 by 150 bps, reaching 10.5% by year-end. We also expect rate hikes to be preceded by macroprudential measures.

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