Itaú BBA - Constraints for further fiscal expansion

Brazil Scenario Review

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Constraints for further fiscal expansion

November 6, 2013

The room for further fiscal and quasi-fiscal policy expansion has narrowed.

• The room for further fiscal and quasi-fiscal policy expansion has narrowed. Risks of a sovereign rating downgrade reduce the room to maneuver. As a result, we have increased the forecast for the primary budget surplus in 2014 to 1.3% from 1.1% of GDP. Our estimate for 2013 remains unchanged at 1.7% of GDP, given the recent fiscal data worsening. We expect slower growth in public investment and in administrative expenses in the coming years.

• The postponement of QE tapering in the U.S. and the outlook for a milder decline in primary surplus in 2014 remove some of the pressure on the exchange rate. We have maintained our forecast for the exchange rate by year-end at 2.35 reais per dollar. For the end of next year, our forecast is now 2.45 reais per dollar, from 2.55 previously.

• A relatively stronger currency helps to relieve inflationary pressures. We have cut our estimate for the IPCA consumer price index this year to 5.8% from 5.9%. Our forecast for 2014 has been revised downward to 5.9% from 6.0%.

• Our 3Q13 GDP forecast went through a slight upward revision, contributing to a rise in our estimates for GDP growth, to 2.4% from 2.3% in 2013, and to 1.9% from 1.7% in 2014. After the release of the minutes for the October monetary policy meeting, we revised our forecast for the benchmark interest rate. We expect the Selic rate at 10.00% p.a. by the end of this year and  10.25% p.a. next year.

Fiscal policy: Worse results in the short term, but less room for maneuvering should restrain new stimuli

The public sector posted a primary deficit of 9 billion reais in September, which equals 2.3% of GDP. The reading was much worse than market estimates (a surplus of 500 million reais), marking the weakest performance for the month in the historical series started in 2002. The September deficit was influenced by both atypical and permanent factors, particularly the pick-up in federal spending. Central government outlays expanded 12% yoy in real terms, the fastest pace since 2011. Over 12 months, the primary budget balance stands at 1.6% of GDP (August: 1.8%), the lowest since late 2009. The annual recurring surplus – which removes atypical revenues and expenses – was 1.1% of GDP in September (August: 1.3%), the lowest since 2010.

Central government budget figures point to a gradual recovery in tax revenues. Expenses, which had been on a downward trend, rebounded sharply in September. The six-month moving average of revenues managed by the Revenue Service posted the fastest year-over-year growth in a year (2% in real terms). Average six-month growth in central government spending had been declining, reaching about 4% in August. However, in September, outlays picked up again (influenced by expenses related to the Labor Ministry’s FAT fund, pensions and subsidies to the electricity sector, as well as by investments), bumping up the half-yearly expansion pace to around 6%, the highest in nearly a year.

Quasi-fiscal incentives, especially National Treasury loans to state-owned banks, are moderating in 2013. Federal government’s loans to BNDES, the state development bank, should reach 35 billion reais this year, extending the gradual and steady decline seen in recent years. In 2012, the Treasury loaned about 45 billion reais to BNDES, down from 55 billion reais in 2011. Although the overall quasi-fiscal stance is still expansionary, credit incentives as a percentage of GDP have been on a downward trend this year.

Some signs of stabilization in the growth of central government expenditures in previous months and a recent accommodation in loans to state-owned banks suggest that the room for new fiscal stimuli is vanishing. Notwithstanding the delay in QE tapering in the U.S., we understand that a scenario of lower international liquidity (in the medium term) and risks of a sovereign ratings downgrade for Brazil (in the short term) will drive fiscal (i.e., budget) and quasi-fiscal (i.e., off budget) government policies.

With less room for fiscal maneuvering and signs of a more parsimonious stance towards fiscal and quasi-fiscal policies, our estimates for the primary budget surplus in the medium and long run have been revised slightly upward. Our forecast for the consolidated primary balance in 2013 is unchanged at 1.7%. The federal tax revenue should expand 1.5% in real terms this year, while federal expenses should increase 5.4%. Our estimate for the primary balance of regional governments remains at 0.4% of GDP. For 2014, we now expect a less steep decline in the fiscal performance. The expected drop in the primary budget surplus next year is partly explained by lower atypical revenues in real terms, as compared to 2013. However, we have revised upward our estimate for the primary budget balance to 1.3% of GDP from 1.1%, due to a reduction of approximately 8 billion reais in our spending forecast compared with our previous scenario. Our estimate for real growth in federal tax revenues in 2014 was unchanged at 2.3%, with federal spending rising 4.2%. We maintained our forecast for the primary balance of states and municipalities at 0.2% of GDP.

We anticipate a reversal of federal tax breaks and a slight increase in the tax burden starting in 2015. We also expect stricter control of central government expenses, particularly in 2015. This additional fiscal effort by the central government (which we expect to come from the part of public investment and personnel expenses) should be partly offset by a sharper structural decline in the primary budget balance of regional governments. The latter should follow the fiscal room (which we estimate around 0.2 to 0.3% of GDP) created by the change in the index that adjusts the regional government debt owed to the federal government (a bill was recently approved in the Lower House and now awaits approval in the Senate). In the add-up, we upwardly revised our estimate for the long-term primary budget balance to 1.7% of GDP from 1.5%. In this scenario, the public sector’s net debt should reach 39% of GDP in 2020 (previous forecast: 40%; 2012: 35%), with the general government’s gross debt probably around 60% by the end of the decade (previous forecast: 61%; 2012: 59%).

A less depreciated currency and a slower decline in the current-account deficit

We have maintained our forecast for the exchange rate by the end of 2013 and changed for 2014. We have maintained our forecast for the exchange rate by the end of 2013 at 2.35 reais per dollar. The Central Bank is expected to maintain its daily swap program until the end of the year, but is unlikely to fully roll over auctions that are due soon. The roll-over should be adjusted according to the behavior of the exchange rate. The scenario in 2014 should include some volatility, driven by monetary policy in the U.S. and by the election cycle in Brazil, which we expect to contribute to weaken the local currency. But we now expect this devaluation to be less intense than previously thought, as the decline of primary surplus should be smaller than we expected. We revised our forecast for the exchange rate by the end of 2014 to 2.45 reais per dollar from 2.55.

The current-account deficit narrowed in September to USD 2.6 billion. A larger trade surplus and hefty inflows of profits and dividends largely explain this slide. Foreign direct investment stood at USD 4.8 billion in September, remaining robust. The highlight in terms of flows was once again the local fixed-income market, where inflows hit another all-time high, at USD 7.2 billion. Adding this to USD 2.3 billion in inflows to the stock market, USD 9.6 billion entered the local market, the most since November 2009.

We have revised our estimates for the trade balance and for the current-account deficit in 2014. We broke down our forecasts for the trade balance, which unveiled a not-as-favorable scenario for next year, even with few changes in our assumptions. After incorporating into our disaggregated models the expectation of low prices for iron ore and soybeans and of an abundant corn crop in the U.S. (reducing demand for Brazilian corn), our forecast for the trade balance came out lower than estimated by aggregate models. This scenario is reinforced by the outlook of a less depreciated currency. All in all, we have revised our forecast for the trade surplus in 2014 to USD 7 billion from USD 12 billion. As for the balance for crude oil and its byproducts, we expect a deficit of USD 9.5 billion in 2014, meaning a net improvement of USD 7 billion, because of higher production and the absence of accounting distortions which characterized the first half of 2013. A lower trade surplus and a relatively stronger currency will slow down the pace of the adjustment in the current account gap, which should end 2014 at 3.1% of GDP (previously 2.7%).

Slight downward revision in our inflation forecasts for 2013 and 2014 

Our estimate for the IPCA in 2013 has been reduced slightly, to 5.8% from 5.9%. Inflation should pick up in 4Q13 (to 1.9% from 0.6% in 3Q13), but less than we forecasted. Seasonal factors, such as pressure on food, clothing and some travel services, and the lagged effect of currency depreciation in previous months put pressure on inflation late in the year. But pressure from the exchange rate, for instance, will be less intense. Recent appreciation in the Brazilian real reduces the magnitude of the exchange-rate pass-through to prices in the short term. Additionally, we pushed forward the increase in fuel prices to mid-December, transferring part of the effect on inflation to early next year (our scenario contemplates a 6% hike in gasoline and diesel prices at refineries by mid-December, with an impact of 0.16 p.p. on the IPCA distributed over December 2013 and January 2014). There is an ongoing discussion about a pricing methodology for fuels, which could move the price hike up to late November.

Our estimate for the IPCA in 2014 has also been revised downward, to 5.9% from 6.0%. A higher real interest rate and a less-depreciated currency have helped to reduce the inflation forecast. But unemployment rate at a lower level than initially expected cushions that impact.

Slower increases in market-set prices and sharper lifts in regulated prices in 2014. Market-set prices should rise 6.3%, with some relief in food and service prices. We anticipate a smaller change in the food group (slightly above 6%), following two years of increases that were much higher than headline inflation. Service prices should slow down somewhat due to the expectation of accommodation in the labor market, including a smaller hike in the minimum monthly wage. Regulated prices should advance 4.5%, as the effect of discounts on electricity tariffs will not be repeated.

For the IGP-M, we have revised the forecast for 2013 upward and the estimate for 2014 downward. We have raised our forecast for the IGP-M in 2013 to 5.5% from 5.3%, as current data point to somewhat higher inflation at the wholesale level. Producer prices (IPA-M) should climb 5.1%, as manufacturing prices rise 7.8% and agricultural prices slide 1.4%. For the other components, we forecast increases of 5.4% for the IPC-M and 8.2% for the INCC-M. Our estimate for 2014 has been lowered to 5.5% from 6.0%, due mostly to a less depreciated exchange rate in our scenario.

Milder decline in the third quarter increases GDP estimates for 2013 and 2014

GDP contraction in 3Q13 was probably milder than we expected. We have revised upward our call for 3Q13 GDP to -0.3% qoq/sa from -0.5%. Retail sales were stronger in July and August, boosting activity in retail and service sectors. Temporary factors (such as earmarked credit for furniture and appliance purchases) boosted household spending in 3Q13, limiting the slide in economic activity. One remaining uncertainty surrounding the 3Q13 GDP report is the methodology change in National Accounts to incorporate data in the Monthly Service Survey (PMS). This change may impact quarterly and annual GDP readings.

Revised 3Q13 GDP raises growth estimates for 2013 and 2014. Given a smaller slide in 3Q13 and maintaining our 4Q13 forecast at a gain of 0.6%, we have increased our estimate for GDP growth in 2013 to 2.4% from 2.3%. A smoother decline in 3Q13 GDP increases the carry-over for 2014. Hence, even maintaining expected quarterly growth paths throughout 2014, our GDP forecast increased to 1.9% from 1.7%.

Fundamentals still point to moderate economic growth ahead. We have maintained our estimates for quarterly growth in 2014 at a moderate pace. Confidence among industrial entrepreneurs dropped again in October, by 0.2%. This index has fallen 8.3% since March. Lower confidence reinforces a scenario of slowing investment. Still-high manufacturing inventories are also a sign of slow economic growth ahead. Furthermore, we have adjusted our scenario for somewhat higher interest rates and for slower growth in government spending. These are additional sources of growth moderation in 2014.

Labor-force growth slows down; unemployment should advance less than expected. The working population has expanded at a slower pace, indicating a cool-down in the labor market. Employment among youths aged 18 to 24, for instance, has declined more sharply in recent months. But the unemployment rate remains low because of the behavior of the labor force, which decreased in recent months, preventing an increase in unemployment. Thus, with the unemployment rate already at a lower level, we now expect it to reach a lower level than we previously estimated, even considering normal behavior for the labor force throughout next year. We expect the average unemployment rate to be closer to 6.1% than to 6.5% (previous forecast).

Non-earmarked new loans are stable. The daily average of non-earmarked new loans was virtually stable in September in real terms (0.1% mom/sa). Low growth was partly caused by the beginning of a labor strike by bank tellers. Overall delinquency remained at 3.25%, with a marginal decline in non-earmarked delinquency and marginal increase in earmarked delinquency. As for the total credit stock, annual growth in non-earmarked credit, which had been slowing down for more than a year, rebounded to 2.7% in September from 2.5% in August, in real terms. The market share of state-owned banks was stable, interrupting an upward trend seen since October 2011.

Copom: Extending the cycle, but not that much

The benchmark interest rate should continue to rise. The minutes of the latest meeting by the Monetary Policy Committee (Copom) maintained the tone of previous documents and official statements. It was a sign that the tightening cycle should be extended for a while longer to help to reverse inflationary resilience that is still observed. Forecasts published in the minutes indicate the IPCA remaining above the target until 2015, reinforcing the need for additional adjustment in monetary conditions.

However, the Copom signals preliminary factors that could help the prospective scenario for inflation. On the domestic front, we believe that the Copom expressed more confidence that fiscal policy will move toward a neutral zone, by stating that it understands the fiscal momentum as “the change in the structural surplus in relation to what was observed in the earlier period.”

Recent strengthening in the exchange rate also helps to reduce inflationary risk. The minutes highlighted a cool-down “in the volatility (...) of currency markets,” referring to the substantial appreciation of the Brazilian real in the weeks before the meeting, which will be an important driver for future inflation dynamics. In our view, successful interventions by the central bank in the currency market provide more confidence to the Copom that the recent stability in the Brazilian real will be more permanent.

Hence, interest rates should not increase much beyond the current 9.50% level. We believe that already-implemented monetary tightening and the recent evolution of inflation drivers (especially exchange-rate dynamics) make the Copom more comfortable in relation to the prospective scenario. Hence, the tightening cycle should not be extended much beyond current Selic levels.

We forecast another 50-bp increase in the next Copom meeting in November and a final 25–bp hike in January, taking the Selic rate to 10.25%.


Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú


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