Itaú BBA - Brazil: Unsteady State

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Brazil: Unsteady State

January 10, 2013

Intervention in the foreign-exchange market reveals that the economic policy goals and preferences may change, as could interest rates over the coming months.

Intervention in the foreign-exchange market reveals that the economic policy goals and preferences may change, as could interest rates over the coming months

We have revised the path for the exchange rate throughout 2013, but have not changed our year-end forecast of 2.15 reais per dollar. We continue to expect interest-rate cuts in March and April, with the benchmark SELIC rate at 6.25% by year-end. However, we acknowledge the increased likelihood that the exchange and SELIC rates will remain unchanged throughout 2013. The recent advance in inflation and government signals (as well as actual moves, in the case of foreign exchange) point in that direction.

A less-depreciated exchange-rate path caused us to lower our trade-balance estimate for 2013, to $18 billion from $20 billion. We raised our consumer price index (IPCA) estimate for 2013, to 5.6% from 5.5%, due to the withdrawal of the IPI tax break on automobiles. We maintained our GDP growth estimates at 0.9% in 2012 and 3.2% in 2013. Our forecast for a primary budget surplus in 2013 also remains unchanged, at 2.1% of GDP.

The exchange rate: a change in signals and actions

In December, policymakers changed again their signals regarding the desired path for the exchange rate. Given likely concerns about inflation, the government and the central bank acted against further depreciation, easing controls on foreign capital inflows (see Macro Vision: U-Turn) and resuming sales in the derivatives market (swaps). These moves prompted a 4% gain by the Brazilian real against the U.S. dollar, despite the largest outflow of foreign currency since 2008 ($6.8 billion). This behavior indicates that economic policy actions and the desired level for some variables are not in a steady state.

There is more uncertainty regarding the evolution of the exchange rate. On one hand, the fundamentals suggest a stronger rate than now (in the absence of additional domestic savings) and an additional weakening of the currency could put further pressure on inflation. On the other hand, there have been signals that a weaker exchange rate is considered part of the policymakers’ toolbox for increasing competitiveness and boosting growth.

Therefore, our scenario now forecasts the exchange rate holding at around 2.05 reais per dollar throughout the first half of 2013, before it tips into gradual depreciation to 2.15 by the end of 2013. We previously assumed that the rate would be 2.15 by the beginning of 2013.

We believe that the signals and actions related to the currency market have been intense, increasing the chances of a scenario in which the exchange rate stays around the current level for longer than we assume in our base-case scenario.

Regarding the balance of payments, the trade balance ended 2012 at $19.4 billion, consolidating a year of decline in the trade surplus, which fell from $29.8 billion in 2011. A drop of 4% in the terms of trade in 2012 stood out as one of the key drivers for the slowdown in the trade balance last year. For 2013, we have lowered our trade balance estimate to $18 billion from $20 billion, due to a stronger average exchange rate and a worse outlook for soybean prices than in our scenario.

We estimate that foreign direct investment ended 2012 at $63 billion. Despite the positive surprise of the November figure ($4.4 billion), a weaker preliminary reading for December FDI ($2 billion through December 14) suggests that our estimate is still valid. For 2013, we stand by our forecast of $64 billion in FDI. As for the current account deficit, we have adjusted our forecast for 2012 to 2.3% of GDP from 2.2%; for 2013, we have also adjusted our call slightly, to 2.4% of GDP from 2.2%, based on forecasts of a lower trade surplus and a wider deficit in services and income.

Rebound in economic activity remains moderate

The economy continues to grow, but at a moderate pace. After rising in October (the Itaú Unibanco monthly GDP index rose by 0.5%, and the central bank’s economic activity index, the IBC-Br, climbed by 0.4%), the data point to weakening economic activity in November and a pick up in December. There was a broad-based reduction in economic activity in November: a broad dataset showed that more indicators were going down than going up. For December, early signs show improvement, with broader-based growth.

Industrial production fell by 0.6% in November, and growth was probably slower in 4Q12 than in the previous quarter. The drop in investment stood out. Domestic absorption of machinery and equipment slid by 3.6% mom/sa in November, influenced by the fourth consecutive decline in the production of capital goods and by a contraction in imports of these items. Our estimates point to a 2.8% drop at the margin in gross fixed capital formation and a decline of 1.9% in the quarter ended in November. In other words, there is still no rebound in investment.

Available data suggest that the economy resumed growth in December. The withdrawal of the IPI tax break for autos starting in January prompted higher sales in December (5.8% mom/sa). Electricity usage and confidence among industrial entrepreneurs also advanced. But weakness in November and the pick up in December are in line with our scenario. Therefore, we have maintained our GDP growth forecast for 4Q12 at 0.7% qoq/sa. Our GDP growth forecasts for 2012 and 2013 remain at 0.9% and 3.2%, respectively.

There is one risk for GDP growth in 4Q12 which is unusual. For statistical reasons, a slightly positive surprise in the year-over-year growth rate may cause a leap in growth compared with 3Q12. The inclusion or exclusion of an outlier in 4Q08 produces a significant change in the seasonal adjustment for GDP (for instance, if the economy grows 1.6% yoy the outlier is included in the seasonal-adjustment model, but if GDP grows 1.8% the outlier stays out of the model). These seasonal-adjustment changes would drive 4Q12 growth to a level of 1.2% qoq/sa in the event of a small upward deviation from our yoy growth forecast (1.6%). Thus, the natural perception would be of a much stronger rebound in economic activity than contemplated in the 0.7% forecast. However, this figure would possibly be revised downward later, thus leaving unchanged the scenario of a moderate recovery in economic activity.

In the credit market, new bank loans were relatively stable in November, amid signs of a retreat in consumer delinquencies. New consumer loans rose by 1.2% mom/sa in real terms, recovering from the drop in the previous month (-1.9%). New corporate loans fell by 2.3% during the month, in a second consecutive decline (-2.1% in October). The three-month moving averages for new consumer loans as well as corporate loans are virtually stable. Total outstanding loans are still expanding (1.5%), particularly earmarked credit transactions.

The consumer delinquency rate for loans over 90 days past due fell by a seasonally-adjusted 0.1 pp, to 7.8%, marking the first slide since March. The corporate delinquency rate was stable at 4.1%. Interest rates and spreads went down again for consumers and companies. The prospect of a retreat in delinquencies is favorable to credit expansion ahead.

In December, the central bank authorized the use of a share of reserve requirements on deposits to finance purchases of machinery, equipment, trucks, buses and other items. The decision formalized the expansion of resources available to the Investment Support Program (or PSI, in its Portuguese acronym) to 100 billion reais, out of which 85 billion reais will come from state development bank BNDES and 15 billion from freed reserve requirements. The measures seek to boost investment.

Labor market data remain positive, with the unemployment rate remaining at a historically low level that is below our estimated equilibrium rate. Thus, real average income and the real wage bill have remained on a steady upward path, a trend which we expect to continue in 2013, though at a somewhat slower pace.

Expansionary fiscal bias creates downside risks to the primary budget surplus in 2013

The public sector posted a primary budget deficit of 5.5 billion reais (1.4% of GDP) in November, the worse reading for the month in the series calculated by the central bank (since 2002). The fiscal target for 2012 was threatened, even after deductions for expenditures within the Growth Acceleration Program (PAC). A strong result, around 25 billion reais (close to 7% of monthly GDP), would be needed in December to meet the adjusted target for the year.

The signs are that this strong result will materialize through extraordinary revenues (such as new dividend payments by state-owned banks, following new capital injections by the Treasury, in addition to money withdrawn from the Sovereign Wealth Fund). The volume of atypical inflows in the last days of 2012 is estimated at about 21 billion reais (0.5% of GDP), ensuring an accounting primary budget surplus close to 2.5% of GDP (vs. 3.1% in 2011). The recurring result, which excludes only atypical budget transactions, should be around 1.8% of GDP (vs. 2.7% in 2011).

New tax cuts for 2013 were announced in December. The break on payroll taxes was extended to construction and retail companies, in addition to other fiscal benefits granted to the construction sector. A gradual return of the IPI (tax on industrial products) was announced for automobiles and other durable goods, as well as a reduction in personal income taxes on profit-sharing. The government also included in the budget bill exemptions from new tax rates that will be implemented by the new legislation for PIS/Cofins.

In order to ensure the legal viability of recent and future tax breaks, the government submitted to Congress a bill to change the Fiscal Responsibility Act (2000) and allow tax benefits to be granted based on “excess” revenues forecasted for the year. Previously, the law dictated that tax exemptions could only take place through spending cuts or increases in other revenues.

Overall, there will be an additional volume of 18 billion reais (0.4% of GDP) in revenue losses in 2013, totaling about 50 billion reais (1.0% of GDP) for the year (we had already contemplated this assumption in our scenario). Our calculations indicate that there is no more room for new tax breaks. From now on, further tax reductions should be accompanied by lower spending (possibly on investments, where there is more room for adjustment) or by a lower fiscal target (for instance, with more room for PAC-related deductions).

Our estimates for the structural primary budget surplus also suggest that there is little room for new stimulus measures, in case the fiscal targets in the budget law are not changed. We estimate that the fiscal result, adjusted for the economic cycle, asset prices and non-recurring transactions, was around 1.0% of GDP in 2Q12 and 3Q12, compared with about 2.0% throughout 2011. This implies that the fiscal policy stance became more expansionary starting in 2Q12, which would be consistent with a primary surplus below the adjusted target throughout the cycles.

We maintain our forecast for a primary surplus of 2.1% of GDP for 2013, which is consistent with a structural result of 1.0% of GDP. On one hand, we are lowering our estimate for the primary surplus of regional governments (to 0.5% of GDP from 0.7%), incorporating faster execution of investments by some states, thanks to the replacement of the index that adjusts their debt with the federal government (which could free up 15 to 30 billion reais to the states). On the other hand, we are forecasting a larger volume of extraordinary revenues which, as in 2012, could be used to meet the adjusted target in 2013.

We note that there are downside risks for government intake, whether due to a slower rebound in activity or to a bigger-than-expected impact from revenue losses. Therefore, there are downside risks to the fiscal result this year.

The end of the IPI tax break for autos leads to small adjustment in the inflation forecast for 2013

We have slightly increased our forecast for the IPCA in 2013, to 5.6% from 5.5%, due to the end of the IPI tax break for autos. The IPI tax will come back gradually, with the rate for vehicles with 1.0 engines rising to 2% in January, 3.5% in April and 7% in July. Our previous scenario assumed a partial resumption of the tax, but only over the second half of the year. Downward-pushing drivers for inflation in 2013 will come from food prices (contained grain prices) and housing prices (discount on electricity tariff). The main upward-pushing driver will come from transportation prices, with expected pressure from public transportation, vehicle ownership and fuel.

Following a pick up in December, the IPCA is likely to remain under pressure in January. Starting in February, the effect of the decline in electricity costs (-0.5 pp impact on the IPCA) should create some relief. Upward pressure throughout 1Q13 (from adjustments in urban bus fares, gasoline, new cars, cigarettes and school tuitions) will likely prevent a deeper cool-down in inflation. We also expect sharper increases in food and clothing prices compared with early 2012. On the one hand, monthly inflation should show some improvement throughout 1Q13; on the other hand, inflation over 12 months will likely remain on the rise, reaching about 6.3% by the end of the period.

For the general price index known as IGP-M, we have maintained our 2013 forecast of 4.8%, vs. 7.8% in 2012. Significant relief on the IGP should come from lower producer prices, particularly agricultural prices. Better behavior on the part of the exchange rate and grain prices, amid favorable weather conditions, should enable a smaller change in the IPA agricultural price index, following a hike of 18.8% in 2012.

An upside risk to our inflation scenario is a full dispatch of energy from thermal plants for a longer period than expected (a year instead of two months). Regarding this assumption, energy prices would decline less than considered in our scenario, which would add between 0.1 pp and 0.2 pp to our IPCA forecast in 2013.

We continue to expect a drop in the benchmark interest rate, but the odds of stability have increased

Even with weak results for 3Q12 GDP, members of the monetary policy committee (Copom), in official speeches and in the December Inflation Report, reiterated their signal of “stability in monetary conditions for a sufficiently-prolonged period”. The current inflation pressure and heated labor market are helping to support the assertive and conservative stance by the Copom.

In fact, there are more risks to our scenario of a reduction in the benchmark rate in 2013. The government has signaled some comfort with the pace of rebound in economic activity (despite its expansionary reaction on the fiscal and credit sides following the publication of the 3Q12 GDP figure) and there were no significant surprises in the growth figures. The news was more inflation pressure, as well as a shift in activity in the foreign exchange market towards showing greater concern with the inflation picture. Externally, the risks of a greater negative effect from fiscal policy on U.S. growth have receded.

These elements suggest lower downside risks to domestic economic activity, higher inflation in the short term and less reaction from economic policy.

However, we understand that the Brazilian economy is still recovering at only a moderate pace. Even in our base-case scenario, in which there is a rebound, growth would still be fragile and any negative surprise may push expansion in 2013 to below 3.0%. Furthermore, though inflationary pressures are currently higher, we expect some relief in the monthly readings starting in February. As it was the case with the exchange rate, the signals and the desired level of interest rates may change, and the Copom may choose to lower the SELIC rate again. Our forecast is for two 50-bp cuts, in March and April, driving the SELIC to 6.25%, and then a stable rate until at least the end of 2013.

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