Itaú BBA - Brazil: More Tax Cuts, More Stimuli

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Brazil: More Tax Cuts, More Stimuli

October 4, 2012

We have lowered our forecast for the primary budget surplus to 2.6% of GDP, and revised our forecast for the exchange rate to 2.0 reais per dollar.

We expect further declines in the primary budget surplus in coming years 

We have lowered our forecast for the primary budget surplus to 2.6% of GDP (from 2.8%) in 2012 and 2.2% (from 2.6%) in 2013, due to a sequence of low budget results recently and additional tax cuts expected for next year. The government has maintained the exchange rate  at weaker levels, and signs indicate that it will remain there for a while longer. We have therefore revised our forecast for the exchange rate to 2.0 reais per dollar (from 1.95) by year-end. For 2013, we have maintained our estimate at 1.90 reais per dollar. Our GDP growth estimates are at 1.7% for 2012 and 4.5% for 2013; for the consumer price index (IPCA), our estimates are at 5.5% for 2012 and 5.3% for 2013. In this context, our forecast for the benchmark Selic interest rate remains at 7.25% by the end of 2012 and 8.50% by the end of 2013.

Fiscal policy in the “new model”[1] 

The fiscal performance has been on a declining trend in recent months due to a cyclical slowdown in tax collection, the (still-limited) impact of tax cuts, and a consistent acceleration in public spending. In August, the annual primary budget surplus stood at 2.5% of GDP, down from 3.1% at the end of 2011.

Government revenues have underperformed expectations this year, leading us to reduce our 2012 primary balance forecast to 2.6% of GDP (116 billion reais) from 2.8% (123 billion reais). We maintained our federal expenditure growth forecast for this year at around 7% in real terms.

For 2013, we expect a looser fiscal stance, particularly within the federal government. We believe that the “new model” of economic policy will bring, alongside lower interest rates, new stimuli to gross fixed-capital formation, either through tax cuts or higher public investment. This strategy to reduce costs in the economy will bring about a decline in the primary surplus. With the recent fall in interest rates, the cost of public debt will go down in coming years even with a lower primary surplus, creating room for a more expansionary fiscal stance.

We assume total tax cuts worth 70 billion reais next year, out of which 30 billion reais have already been announced. We had previously estimated 30 billion reais in tax cuts. Larger tax stimuli should slow down the recovery in government revenues (following the rebound in economic activity) next year. Thus, we revised down our forecast for the 2013 primary surplus to 2.2% of GDP (110 billion reais) from 2.6% (128 billion reais).

The set of tax breaks already announced so far includes payroll-tax cuts in many sectors, lower taxes on electricity tariffs and on acquisition of capital goods. The additional tax reductions contemplated in our scenario could include more of such measures or new initiatives on the tax front (e.g., focusing on sales taxes such as PIS/Cofins and ICMS).

In recent weeks, important budget decisions were taken. Some of these measures should help limit the expansion in administrative expenses and government transfers in the short and medium term. Among those: setting a 5% annual nominal increase in wages of many categories of federal employees for the next three years; and keeping in the 2013 draft budget the current minimum wage rule, likely to prompt a nominal increase between 8% and 9% in 2013 (vs.14% granted in 2012). 

Still, we forecast a rapid expansion in federal expenditures next year: around 7% in real terms, boosted by investment spending (including outlays related to the Minha Casa, Minha Vida low-income housing subsidy program) and other discretionary expenses.

We believe fiscal policy will take a more expansionist tone next year, both on the spending and revenue side. This looser stance should contribute for a pickup in the economy in 2013. The greater the contribution of tax cuts and investment (or, alternatively, the smaller the stimuli through current spending), the greater the eventual contribution of this fiscal expansion to activity in the long run.

Exchange rate: A longer-lasting decoupling from fundamentals

The exchange rate is still moving very little and remains slightly above 2 reais per dollar, despite recent pressure for appreciation. The strong correlation between thereal and its peers – commodities currencies – is no longer being observed.

Given this picture of tight fluctuation and actions to keep the real on a weaker level, we changed our forecast for the exchange rate in December 2012 to 2.00 reais per dollar (from 1.95). Greater global liquidity, lower market volatility, the drop in Brazilian risk premium and rising commodity prices are compatible with a stronger currency in the medium term. Therefore, we are keeping our forecast for the exchange rate by the end of 2013 at 1.90 reais per dollar.

In the balance of payments, there were no significant surprises. In August, the current account deficit reached $2.6 billion, marked by a high trade surplus and subdued profit and dividend remittances. On the financing side, foreign direct investment (FDI) was $5 billion, down from $8.4 billion in July. Over 12 months this flow represents 2.8% of GDP, ensuring comfortable financing of the current account gap, now at 2.1% of GDP.

Among the other flows, the highlight was the inflow of $1.3 billion to the local stock market, which had been getting low flows in recent months. We maintained our forecast for the current account deficit at 2.2% of GDP in 2012, climbing to 2.5% in 2013, due to a narrower trade balance ($13 billion, vs. $18 billion in 2012) and more profit and dividend remittances. In our view, FDI will remain at high levels, ending 2012 at $61 billion and rising to $64 billion in 2013.

Growth picks up in the third quarter

Economic activity data published in recent weeks reinforced our forecast of 1.2% qoq/sa GDP growth in the third quarter. August data suggest high growth in our monthly GDP proxy, following moderation in July. At the margin, we see growth a bit more broadly based.

There are positive signs arising from the improvement in confidence among industrial entrepreneurs. The index accumulated an increase of more than 2% in August and September. The acceleration in the component of forecasted production stood out, indicating sharper increases in industrial output ahead. Improved confidence is a positive sign for expansion of current activity and for a more consistent rebound in investment in the coming quarters. Consumer confidence is up again, reinforcing the outlook of sustained sharp growth in consumption.

Though fundamentals improved and there is some evidence of broader-based growth, uncertainty remains high. We see more downside risks than upside risks to growth in the fourth quarter. The contribution from the auto sector tends to be smaller. Thus, investments must accelerate in order for GDP expansion to remain high, even with slower growth in consumer spending.

Bank credit cooled down again in August, marking a second month of declines. New loans to consumers dropped by 2.0% (adjusted for inflation and seasonality), following a 4.0% drop in the previous month, but concentrated on bank-overdraft facilities and personal loans. Similarly, new corporate loans fell by 3.0% during the month, after a 2.8% drop in July. Rising confidence indicators, a heated labor market, rising credit demand and greater confidence among players in a rebound in domestic activity justify the expectation of a resumption of credit expansion in the next few months.

Interest rates and spreads remain on a downward path for companies as well as consumers, albeit at a lower speed than in March and June. Delinquency rates remained unchanged in almost all categories, showing stability at a high level (the performance of new credit crops suggests a decrease in delinquency in the future). State-owned banks keep gaining market share.

Acting to increase liquidity in the financial system and boost the economy, the Central Bank lowered reserve requirements in September (for further details, please refer to “Brazil – Lower Reserve Requirements Free Resources for the Economy”). Purchases of loan portfolios and debt securities known as letras financeiras from smaller banks stand as options to meet the requirement for that share. Motorcycles became a new alternative, replacing automobile-financing portfolios. According to the Central Bank’s calculations, together these measures should free 30 billion reais for the economy in the next few months (leaving total reserve requirements at 350 billion reais).

This information is compatible with our expectations for GDP growth. We maintain our estimates at 1.7% in 2012 and 4.5% in 2013. Thus, our scenario still contemplates a pickup in economic activity in 4Q12 and 1Q13. Our scenario of further tax cuts, particularly in 2013, reinforces the expectation of higher growth in coming quarters.

We lowered our forecasts for the unemployment rate in 2012 and 2013, although our growth outlook was maintained. Job creation data show a slowdown, but it is not intense enough to prevent a decline in the unemployment rate. Growth composition – with manufacturing underperforming the service sector – continues to explain to a large extent the persistently low unemployment rate within an environment of moderate GDP growth. We now forecast an average unemployment rate of 5.5% in 2012 (down from 5.7%) and 5.2% in 2013 (down from 5.6%).

Inflation: Uncertainty about 2013 remains high

We forecast consumer inflation (IPCA) at 5.5% this year and at 5.3% in 2013. Current data indicate that inflation should accelerate in the coming months (monthly average of 0.55% until year-end), with pressure from the food group taking the spotlight. This upward movement in food prices will largely occur through the transmission of the shock in international grain prices to some food items, such as meats and wheat byproducts. With forecasted inflation at 5.5% this year, market-set prices should rise by 6.3%, while regulated prices should go up by 3.1%.

The electricity package pushes inflation estimates downward (please see details in Macro Vision “Impact of the Electricity Package on Inflation”). Assuming that the average tariff for residential consumers will drop by 16.2% at beginning of 2013, as announced by the government, the direct impact on the IPCA would be -0.53 pp, given the weight of electricity on the official inflation index (3.3%). However, our inflation calculations for 2013 already considered a share of the announced reduction in electricity tariffs. The difference of the factors above compared with our scenario amounts to -0.10 pp on the IPCA next year.

In our scenario, we contemplate further tax cuts, which should impact inflation. The effect on prices is uncertain, as it depends on the type of cut. We incorporated in our forecasts an additional impact of -0.10 pp on the IPCA in 2013 due to the greater volume of tax cuts we expect for next year. This impact may come, for instance, from tax cuts on food items that form the so-called cesta básica. Tax cuts may also be used to prevent inflation from rising, as is the case of gasoline prices – the reduction in PIS/Cofins could prevent a pass-through to prices at the pump (our scenario already contemplated this premise for 2012, but it could also happen in 2013).

The additional impact from the electricity package (-0.1%) and more tax cuts (-0.1%) on inflation in 2013 was offset by our expectation of lower unemployment. Despite our inflation forecast being unchanged at 5.3%, its composition has changed. We now expect smaller price increases for food and regulated items, and a sharper increase in service prices.

Recent IPCA reports have shown high core inflation and high diffusion indexes, indicating some robustness in inflation, while expectations (as measured by the Focus survey) have remained at levels above the mid-point of the target. We maintain our opinion that there is still a lot of uncertainty for the inflation scenario next year, with factors that could mitigate it as well as push it up.

Central Bank: Neutral balance of risks

In its Inflation Report (IR) for the third quarter, the Central Bank described the domestic balance of risks for inflation in the relevant monetary policy horizon as “neutral”. In the June IR, this balance had been characterized as “favorable.”

For the Central Bank, the external scenario manifests “inflationary bias in the short term”; being “impacted by supply shocks arising from external weather events, whose effects may be leveraged by recent non-conventional monetary policy actions.” However, the Central Bank stresses that the external influence is disinflationary in the medium term by contemplating low global growth for a prolonged period.

Given this scenario, the Central Bank maintained the signal of the last monetary policy committee (Copom) meeting: “if the prospective scenario requires an additional adjustment in monetary conditions, this movement should be conducted with maximum parsimony.”

For the long term, the Central Bank indicates that it is comfortable with maintaining real interest rates close to current levels. First, through the disinflationary evaluation of the external scenario over time. Second, by reinforcing the view that the neutral interest rate has been falling.

We understand that recent signals by the Central Bank reinforce the perception that the easing cycle in interest rates is finished or close to it. We maintain our forecast that the Central Bank will reduce the Selic rate by 25 bps to 7.25% in October, remaining at that level until mid-2013.

[1]For reference, we recommend reading “The New Model”, by Ilan Goldfajn, published in O Globo newspaper on September 4, 2012.



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