Itaú BBA - Brazil: Slow Recovery in Activity and an Extra Grain of Inflation

Brazil Scenario Review

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Brazil: Slow Recovery in Activity and an Extra Grain of Inflation

August 3, 2012

We raised our 2012 IPCA inflation forecast to 5.2%; We now forecast the dollar at 1.95 at year-end 2012.

An auto sales bonanza helped the economy in June, but a more widespread recovery is still to come. In the meantime, a spike in grain prices makes its way into consumer prices

We raised our 2012 IPCA inflation forecast to 5.2% (from 4.9%) because of the spike in grain prices, but trimmed 2013 to 5.3%. Our forecast for the 2012 trade surplus is unchanged at $18 billion, but we upped 2013 to $15 billion (from $10 billion). We still see the currency’s fundamental level at 1.90 reais to the dollar, but Central Bank intervention will likely prevent a quick convergence. We now forecast the dollar at 1.95 at year-end 2012, and maintain 1.90 for year-end 2013. Regarding the primary surplus, we lowered our forecast to 2.8% (from 2.9% of GDP) in 2012 and to 2.6% (from 2.8%) in 2013. We still expect the Central Bank to drive the Selic rate to 7% in two more rounds of 50-bp cuts. Our GDP growth forecasts remain at 1.9% for 2012 and 4.5% for 2013.

A tax break boosted auto sales and helped the economy in June. A wider set of indicators, however, still show weakness elsewhere, and the first numbers for July are not different.

Auto sales increased 30% in June from May with seasonal adjustment, a selling spree fueled by cheaper prices after a tax break. The surge in sales prevented a sharp decline in auto production, and cleared excess factory inventories. The sector is now ready to produce, should demand stay on as we expect it to.

Judging from the data so far, our monthly GDP index may have gained as much as 0.6%, a result consistent with our projection of 0.6% quarterly growth in the second quarter.

Bank lending improved again in June. New borrowing by consumers soared 5.5% (adjusting for seasonality and inflation). Loans to companies continued to expand, with concessions up by 1.6%, the fifth consecutive monthly gain.

Rates and spreads fell again for both consumers and businesses. Non-performing loans fell across most categories, suggesting that the cycle may be coming to an end. State-owned banks are gaining market share.

The better June, it appears, gave way to a tepid July. A survey from the Getúlio Vargas Foundation showed waning manufacturing confidence, while consumer confidence, although still high, fell for the third month in a row. Global uncertainty still weighs on investment. And, after a very strong June, auto sales fell in July, even though they remain at a strong level.

Looking ahead, the economy still has much stimulus to assist it. Interest rates continue to fall, public spending is rising, and many tax incentives remain in place. State-owned banks are lending more. The government has been considering more incentives, especially to prop up investment and reduce costs in the manufacturing sector. Some of those incentives take time to affect the economy, which is why we expect the economy to accelerate in the second half of the year.

We thus expect to see stronger and more widespread signs of recovery. Until that happens, risks will remain. For example, unemployment is at an all-time low and wages are still rising, but there are signs of moderation and formal hiring has slowed. If growth takes longer, job creation could slow further, weighing on the recovery.

For now, our GDP growth projections are unchanged. We forecast 1.9% for GDP growth in 2012 and 4.5% in 2013.

Fiscal Policy, Helping Demand

Fiscal policy is helping push demand. Federal spending has grown at a pace of 7.0% so far in 2012, an increase driven by transfers, subsidies and “administrative” costs. Investment is also accelerating, due to increased spending under the “Minha Casa, Minha Vida” home subsidy program. We still expect public spending to rise by 7.1% this year, twice as fast as last year.

Tax collection, on the other hand, is growing at a trend pace of 3.3% (adjusted for inflation): faster than the economy, but the lowest speed since 2008. While we still expect activity to raise revenues ahead, we lowered our hopes slightly and now forecast real revenue growth of 5.0% (5.3% previously). All told, our primary surplus forecast now stands at 2.8% of GDP (from 2.9). The 2011 surplus stood at 3.1%.

Structural Surplus and Medium-Term Fiscal Trends

Beyond its short-term impact, we must also have a structural view of fiscal policy.

This structural view must take into account the speed of the economy, as well as, in countries like Brazil, the cycle of commodity prices. When growth is good, the headline result will tend to look better, even if policymakers don’t hold back spending.

Our own measure of Brazil’s structural primary surplus adjusts not only for growth and commodity prices, it also excludes the significant volume of non-recurring revenues seen in recent years. Once all is considered, we note that the structural surplus has been lower than the actual surplus since 2007 (see graph).

The lower Selic should help reduce interest payment and the debt-to-GDP ratio, driving the government to settle for smaller primary surpluses in the future. The extra room will likely be used to boost spending (hopefully in investment) and ease taxes, especially on manufacturing.

On that note, we trimmed our 2013 primary surplus forecast to 2.6% of GDP (from 2.8%), incorporating more tax breaks in our scenario. Since revenues will likely profit from a better economy in 2013, we estimate that the structural surplus will fall to 1.3% of GDP. A more expansionary fiscal policy is to be expected in the coming years. For a discussion of structural fiscal trends in Brazil, see our research note “Brazil’s Structural Fiscal Balance”, published last April.

External Sector and the Exchange Rate: Adjusting Forecasts

The recent surge in grain prices should strengthen the currency, moving it closer to our previous forecast of 1.90. That said, the real has been away from that level for a while and it is reasonable to expect it to take longer to return, given that the government is firmly intervening to reduce volatility.

That is why we now forecast the currency at 1.95 to the U.S. dollar at year-end 2012, and to converge back to 1.90 at the end of 2013.

Equity and fixed-income inflows were back in June after May’s strong outflows. The rollover rate of medium- and long-term debt soared to around 200%. Foreign direct investment was strong again: $5.8 billion in the month, with preliminary data pointing to a number close to $7 billion in July. The current-account deficit rose slightly to 2.2% of GDP (from 2.1%), precisely our forecast for 2012 (previously 2.3%). For 2013, we also trimmed our estimate to 2.4% of GDP (from 2.6%).

After a weak result in June, the trade surplus rose to $ 2.9 billion in July. The impact of higher grains prices on the trade balance has been neutral: corn exports are up, but so are wheat imports, and iron-ore prices are weaker. We thus stick to our $18-billion forecast. In 2013, however, soybean prices around 40% higher will likely drive up the trade balance. We now forecast $15 billion (from $10 billion).

Inflation: Food Prices to Push the IPCA Upward This Year

Higher global grain prices – corn, wheat and soybean – are pushing producer prices up in Brazil, and will soon hit consumer prices too. The IGP-M index –60% of which is made up of producer prices – rose by 1.34% in July from June. It’s a high reading and a sharp pickup. After this result, we raised our forecast for the 2012 IGP-M to 7.5%, from 6.2%. One month ago, it was 5.4%.

Moving into consumer inflation, the pressure on corn and soybean will likely raise the cost of pasture, making meat more expensive. Higher wheat prices will burden all of its by-products, especially bread, flour, and pasta. We thus raised our 2012 forecast for the IPCA index to 5.2% (from 4.9%).

Some mitigating factors held back the forecast revision. The livestock cycle (more slaughtering of females) has favored beef supply, and so have weaker demand and falling exports. The government has also been considering tax cuts in food staples, including meat products. In addition, given the magnitude of the shock, it is reasonable to expect that the pass-through to consumer prices will extend into early next year.

For 2013, we trimmed our IPCA forecast to 5.3% (from 5.4%). This is because food inflation will likely ease back to a pace of around 5%-6%, after gaining around 9% in 2012. Regulated prices should accelerate to around 4% (from an expected 3% this year), and market-set prices should be relatively stable, rising a bit less than 6%.

Among market-set prices, food prices should give back some of the gains caused by rising grain prices this year. On the other hand, we do not expect prices of consumer durables (vehicles, household appliances and furniture) to fall as they did this year as result of tax cuts.

Monetary Policy

Growth remains moderate and inflation continues under control even after the pressure from food prices. Thus, we expect the Central Bank to keep cutting interest rates. The wording of the latest monetary policy meeting was similar to that of previous meetings, which suggest that the committee is comfortable with the pace of 50-bp cuts.

We still expect the benchmark Selic rate to fall to 7% (from 8% today) in two rounds. In 2013, as growth picks up and inflation pressure returns, we expect the bank to reduce monetary stimulus, raising the Selic back to 8.50%.

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