Itaú BBA - Brazil: On the Borderline

Brazil Scenario Review

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Brazil: On the Borderline

March 8, 2013

Even if interest rates rise, they will remain at historically low levels

The change in the central bank’s message has made for a less certain interest rate path. In our view, even if rate hikes take place, the Selic will rise to around 8.25%. Despite the signals of stronger growth in 1Q13, the economic rebound under way is moderate and in line with our forecasts for both GDP growth (3.0% in 2013 and 3.5% in 2014) and inflation (5.7% this year and 6.0% next year).

We revised our exchange rate estimate to 2 reais per U.S. dollar until the end of 2014 (from 2.10 for both the end of this year and the next), in line with the current economic fundamentals and the central bank inflation concerns. We widened our current account deficit estimate, given the recent above-expectation numbers, but maintained our trade balance forecast ($14 billion this year and $15 billion in 2014). We now project a current account gap of 2.6% of GDP this year and 2.5% in 2014 (from 2.5% and 2.4%, respectively). Our primary budget surplus estimate remains at 1.9% of GDP in 2013 and 0.9% of GDP in 2014, reflecting the continuity of the current fiscal policy.

Copom: tighter, but not for now

Brazil’s monetary policy committee kept the Selic rate at 7.25% p.a. The decision was unanimous and in line with market expectations and our view.

In the statement that accompanied the decision, the Copom removed the indication that the Selic rate should remain stable for a “sufficiently long” period, as it had reiterated in the previous statements. In our view, the change in the statement is in line with the latest speeches of Copom members, aiming to gain flexibility for an eventual rate hike.

The language used (“follow the evolution of the macroeconomic scenario”) indicates that the Copom considers the possibility of hiking the rate in coming months. However, it is not strong enough to signal a hike already in its next meeting, in April.

Our assessment is that the Copom’s strategy is to gain flexibility to observe current inflation, before deciding if it will indeed deliver the tightening cycle. If monthly inflation comes in line with our scenario, the decision will be a close call. On the other hand, if the government accelerates tax breaks and short-term inflation declines more, the Copom may opt to remain on hold.

Therefore, rate hikes in coming months are possible, but not certain. For now, we maintain our forecast that the Selic rate will remain at its current level until year-end. But we see the possibility of a short tightening cycle (around 100bps through 25-bp hikes), starting in May.

Inflation remains high despite lower electricity tariffs

Inflation remained high at the beginning of the year and the year-over-year results are expected to fluctuate between 6.2% and 6.6% until the end of 3Q13, when inflation should start to retreat. The drop in inflation has failed to meet expectations despite the reduction in electricity tariffs, which had a significant impact on the consumer price index (IPCA) in February. Although the current food-price pressure is expected to be partially reversed, the price increases have been broader. A heated labor market, the lagged effects of exchange-rate depreciation and higher inflation expectations are boosting inflation and its resilience.

Which inflation effect is most likely to prevail in the coming months, lower food prices or greater resilience and more widespread price increases? We expect some reversal of the perishable food prices, albeit smaller than the increases. In fact, the drop in February was already less steep than anticipated, suggesting the greater resilience of these prices.

Another driver that could benefit consumer inflation is the decline in agricultural commodity prices in international markets. For instance, the recent slide in soybean prices already reversed the substantial increase registered in the middle of last year. However, the impact tends to be stronger on producer prices (measured by IGPs) than on the IPCA, on which the effect is indirect.

Together, these effects create a lower (but still-high) inflation-reading scenario in the coming months, with the year-over-year result slightly topping the upper limit of the target range by mid-year. We therefore expect a downward path for inflation. We maintain our expectation that the IPCA will end 2013 up 5.7%. We also maintain our 6.0% forecast for 2014. A stronger exchange rate than in the previous scenario reduced the upside risks to our forecast for 2014, but did not change our basic scenario, which had a (upward) bias in the balance of risk for inflation.

There are both downside and upside short-term risks. On the one hand, food inflation – which has been more resilient in the short term – could present a sharper decline. New tax breaks may be announced and inflation may drop. On the other hand, a disappointing drop in food prices and higher industrial-product prices could pressure short-term inflation even further.

A still-moderate rebound 

The economy expanded 0.6% in 4Q12, close to our 0.7% expectation, which was included in our projection after the publication of 3Q12 GDP report. While the data reinforced a gradual rebound scenario, the good news was the return of investments to positive territory.

Over the past month, there have been increased signs that GDP growth in 1Q13 may be stronger. In addition to robust agriculture and livestock activity, the expansion in Industrial sector seems more vigorous. We adjusted our 1Q13 GDP growth forecast, to 1.2% from 0.8%, with continued upside risk, but wonder about the February figures. After a strong January, there is evidence of weakness in the middle of the quarter, which, depending on the intensity, could eliminate the upward risk for quarterly growth.

In our view, the strong economic growth in 1Q13 is related to short-term factors. Inventory increases in some segments, such as trucks, temporarily contributed to stronger industrial activity. While fundamentals continue to indicate a moderate economic acceleration, signs of broader-based economic activity growth remain scarce. Business confidence has virtually stalled over the past two months, and consumer confidence is falling. Once again, there is more uncertainty surrounding the evolution of the global economy, possibly affecting investment decisions. Thus, a stronger advance in one quarter should be followed by a cool-down in the next period. As a result, we lowered slightly our forecast for GDP growth in 2Q13 and 3Q13.

The effects of upward surprises in economic activity have offset the impact of the disappointments. Hence, our GDP growth forecast remains at 3.0% in 2013 and 3.5% in 2014.

The unemployment rate remains low despite the low growth; however, there are signs of moderation in the labor market, with a substantial deceleration in the pace of formal employment expansion. In the last two quarters, there has been a notable decoupling between the IBGE’s (census bureau) monthly-employment household survey data, which affects the unemployment rate, and formal employment data (Caged). Hiring has picked up in the former and continues to slow down in the latter. Which reflects the true conditions of the labor market? The surveys complement each other. However, economic conditions explain the deceleration in formal employment, but not the working population acceleration shown in the IBGE survey.

Both surveys show a tight labor market and sharp real-wage increases. We believe that the favorable conditions will be maintained over the next few quarters. With the economy gaining momentum (albeit at a moderate pace), the number of new formal employment tends to accelerate and the unemployment rate tends to remain low.

The January credit report showed significant changes in statistics for the sector, providing greater detail and a wealth of information (please refer to “BRAZIL – Credit: Change in Methodology Shows Lower Spread and Delinquency Levels”).

New bank loans continued to expand at a moderate pace in January. In real terms and adjusted for the number of working days, the total volume of new loans rose 7.8% yoy, topping the average for the second half of last year (3.3%).

Influenced by weak seasonality, total outstanding loans remained unchanged on a monthly basis. The year-over-year growth in total outstanding loans was also stable in January, at 16.4%.

Delinquency in consumer loans (more than 90 days past due) fell from 5.6% in December to 5.5% in January, marking the fourth consecutive month of declines. Consumer delinquency for earmarked and non-earmarked loans retreated, while delinquency in corporate loans (more than 90 days past due) was stable at 2.2%. Interrupting the recent downtrend, interest rates and spreads increased for both companies and consumers.

A stronger exchange rate 

In the foreign exchange market, the heightened concerns about inflation resilience expressed in speeches by authorities led to a currency appreciation. After the central bank’s sale of U.S. dollars in the derivatives market in late January, the exchange rate remained below 2 reais throughout February, reaching 1.95 per U.S. dollar. At this level, the central bank purchased dollars (also through derivatives) to partially curb the strengthening movement.

The speeches by authorities and the currency market interventions suggest that a stable exchange rate of around 2 reais per dollar (closer to macroeconomic fundamentals) is the current desired level. We therefore revised our expected exchange-rate path, with the dollar stable at 2 reais throughout 2013 and 2014 (vs. 2.10 previously).

Trade balance deficit reaches $5.3 billion in the first two months of 2013

The trade balance in February was negative by $1.3 billion, with still-incipient soybean exports and strong fuel imports. Adding January’s $4 billion deficit, the balance for the first two months of the year is negative by $5.3 billion. Still, we maintain a more optimistic view on the balance for the rest of the year (we forecast a $14 billion surplus), boosted by the record-high soybean crop and higher international iron ore prices.

The current account deficit reached $11.4 billion in January, disappointing expectations. The above-expectation figures for service and income accounts are not expected to be offset in the next few months, leading us to revise our accumulated deficit forecast for 2013, to 2.6% from 2.5% of GDP. For 2014, an increase in the profit and dividend-remittance forecast also led us to raise our estimate, to 2.5% of GDP.

Foreign direct investment reached $3.7 billion, less than in previous months. The flow over the last 12 months reached 2.8% of GDP, enough to comfortably finance the current account deficit. Furthermore, the flow to the stock market stood out, sustaining the high December levels (above $3 billion) after registering very small or negative flows throughout 2012.

Fiscal policy: January’s strong primary budget surplus unlikely to be repeated

The public sector reported a high primary budget surplus in January: 30.3 billion reais, or 8.1% of GDP for the month, marking the second best result for the month in the historical series starting in 2002. The consolidated primary balance over the last 12 months equals 2.46% of GDP (2.38% in December), the strongest reading since August. Our series for the recurring primary surplus (which excludes atypical or temporary revenue and expenditures from the conventional result) shows a balance of 1.99% of GDP (1.82% in December).

The fiscal performance in January is due to a strong increase (20% yoy in real terms) in revenue from corporate profit taxes. Overall, revenue from the IRPJ (income tax for corporations) and CSLL (tax on net earnings) accounted for about half of the growth in federal government revenue. Given the gradual rebound in activity, the higher tax revenue in early 2013 probably does not reflect a pickup in corporate profits. We expect the situation to be counterbalanced in the coming months, negatively affecting both tax revenue and the primary budget result.

We continue to expect a reduction in the fiscal effort throughout 2013 and 2014, due to tax breaks and a relatively-high sustained growth rate for federal government expenses of 5% in real terms (vs. an estimated trend GDP of 3%). We maintain our forecast for the consolidated primary budget surplus at 1.9% of GDP in 2013 and 0.9% of GDP in 2014. These figures are consistent with an expansionist stance on fiscal policy.

Our scenario also contemplates a greater expansion in federal investments, which could reach close to 2% of GDP by the end of next year (vs. 1.4% in 2012), considering the room created by the moderate adjustments in monthly minimum wage (limiting transfer outlays) and the likely control of personnel expenses.

Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú



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