Itaú BBA - Facing the storm

Brazil Scenario Review

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Facing the storm

September 10, 2015

The scenario for Brazil has deteriorated, given the difficulties in the fiscal adjustment.

• The scenario for Brazil has deteriorated, given the difficulties in the fiscal adjustment. The country had its sovereign rating downgraded and lost the investment grade by Standard & Poor’s. Higher domestic uncertainty in an unfavorable international context reduced asset prices in Brazil, including the exchange rate, and raised inflation forecasts. In this scenario, the outlook points to lower growth and higher unemployment.

• The 2016 budget proposal submitted by the government with a primary deficit of -0.34% of GDP clearly signaled these fiscal difficulties. We forecast a primary deficit of 1.0% of GDP in 2016 (previously +0.2%), following a 0.3% deficit in 2015.

• The worsening of the economic environment has an important impact on the availability of external financing over the coming years, increasing the country risk and requiring an even faster adjustment in the external accounts. Therefore, we have increased our forecast for the exchange rate to 4.00 reais per dollar by the end of 2015 and to 4.25 reais per dollar by the end of 2016.

• The new round of currency depreciation adds pressure on prices in the economy. We raised our forecast for the IPCA inflation from 9.3% to 9.5% for 2015 and from 5.8% to 6.5% for 2016. An important risk to inflation ahead is the possibility that expectations lose their anchor.

• Higher inflation reduces room for interest rate cuts in 2016. We now expect the Selic rate to remain at 14.25% until the end of 2016.

• Economic activity continues to deteriorate. We expect a contraction of 2.8% of GDP in 2015 (previously: -2.3%). For 2016, increased uncertainty, the maintenance of the monetary rate at the current level for a longer period and worse statistical carry-over have led us to revise our growth forecast to -1.2% (previously: -1.0%). The unemployment rate will likely increase  further: we forecast 8.3% by the end of this year and 9.6% by the end of next year (previously: 8.0% and 9.3%, respectively).

Scenario worsens and Brazil loses investment-grade from Standard and Poor’s

Adjusting the economy has proved more challenging than we anticipated.

The government submitted a 2016 budget proposal to Congress with a primary deficit (0.34% of GDP) for the year. Gross debt is expected to continue on an upward trend, expanding from 66% of GDP this year to 71.9% of GDP in 2016.

The deterioration of the fiscal situation has increased the level of uncertainty in the economy. As a result, the country had its sovereign rating downgraded and lost the investment grade by Standard & Poor’s.

The CDS, a measure of country risk, as well as other financial assets, such as stock market and long interest rates, have been affected by the worsening scenario.

The increase in the country risk has impacted the exchange rate. The increased uncertainty in the domestic scenario has weakened the real, which has been underperforming its peers. The slowdown in China and the drop in commodity prices have been pressuring the exchange rates of emerging economies.

The increase in uncertainty and the devaluation of the real make the tradeoff between activity and inflation even more complex. The contraction in economic activity is expected to intensify, and the inflation forecast will likely rise. In this scenario, we expect the Selic rate to remain flat, at 14.25%, until the end of 2016.

End of fiscal adjustment?

The 2016 budget indicates that the fiscal effort will not continue next year. The primary balance target in 2016 was reduced from +0.7% to -0.34% (-0.50% from the central government, +0.16% from regional governments). The budget indicates an increase in federal spending of 5.5% in real terms next year. Almost all of this growth comes from mandatory spending (mainly social security), but discretionary spending (PAC investments and ministry spending) will not be cut to compensate for this expansion (as in 2015). The government indicated a nominal growth of 6.8% (slightly above the expected inflation for next year) for discretionary spending, an increase of BRL 16 billion (from BRL 234 billion to BRL 250 billion). Before the budget was released, we were expecting a reduction of BRL 14 billion. These expenses are the ones that normally accommodate deeper cuts in the short term.

In the absence of additional fiscal effort, we see a declining trend in the primary result. Without additional effort, the scenario becomes even more challenging. (See our report “Macro Vision: Fiscal adjustment: how much more to go?”.

We forecast a primary deficit of 1.0% of GDP in 2016 (previous forecast: +0.2%), following a 0.3% deficit in 2015. Higher spending will produce a primary result below the -0.34% target, as revenues tend to disappoint the expectations contained in the budget. The government based its revenue projections on a GDP growth forecast of +0.2% next year. The Focus survey shows consensus at -0.4%, while our forecast stands at -1.2%. Moreover, the breakdown of economic growth, with greater adjustment in consumption and the labor market, tends to generate an even more challenging scenario for revenues. Thus, our central government revenue forecast is about BRL 46 billion (0.7% of GDP) below the projection contained in the budget, and in our scenario we included extraordinary revenues (with asset sales and others) of BRL 30 billion (the budget includes extraordinary revenues of BRL 37.3 billion).

Public debt will likely post steeper growth. We forecast gross debt increasing from approximately 66% of GDP this year to 71.9% of GDP in 2016.

A weaker Real as early as this year

The Brazilian real depreciated significantly over the past month. Concerns about China's growth have taken over the global market and the risk-aversion environment has led to a depreciation of the real and other currencies against the dollar. In the domestic scenario, economic and political uncertainties added additional pressure. Within one month, the exchange rate weakened from 3.40 reais per dollar to close to 3.85.

We increased our forecast for the exchange rate to 4.00 reais per dollar by the end of 2015 (compared to 3.55) and to 4.25 by the end of 2016 (compared to 3.90). The worsening economic outlook will probably impact the availability of external financing in coming years. The revision in our exchange rate estimates mainly reflects those difficulties. We also expect that the global scenario of a strong dollar and the slowdown in China to impact the real and other currencies of emerging countries and/or commodity producers.

A weaker currency will likely lead to a faster adjustment in the current account. We forecast current account deficits at USD 71 billion in 2015 (compared to USD 76 billion) and at USD 45 billion in 2016 (compared to USD 54 billion). In percentage of GDP, these figures are equivalent to 4.0% and 3.0%, respectively. According to our estimates, exchange rates matching our forecasts (4.00 reais per dollar in 2015, 4.25 in 2016, and then constant in real terms afterwards) will likely lead to a current account deficit around 2.0% of GDP in 2017.

The trade balance keeps posting positive results. Year to date, the trade surplus reached USD 7.3 billion, far above the USD 240 million surplus posted in the same period of 2014. The drop in imports, due to the more depreciated exchange rate and weaker activity, was greater than the decline in exports, which remain penalized by the lower commodity prices. For the coming years, we incorporated the latest data indicating a larger trade balance (especially in fuel) and a more depreciated exchange rate and raised our trade surplus forecast from USD 5 billion to USD 8 billion in 2015 and from USD 13 billion to USD 22 billion in 2016.

The current account deficit continues to recede, but so do direct investment and portfolio flows. The current account deficit accumulated over twelve months decreased for the seventh consecutive month, reaching USD 89.4 billion in July, with a positive contribution from the trade balance. The services and income deficit is also receding. On the financing side, direct investment in the country and foreign portfolio investment have been cooling down month after month, and for the first time in six months, we have seen outflows from the local capital market.

New round of currency depreciation raises inflation forecasts

The IPCA index increased 0.22% in August, broadly in line with our estimate (0.20%) and the median of market expectations (0.23%). The largest upward contributions came from personal expenses, and health and personal care. On the other hand, drops in fresh fruits and vegetables and airfare prices brought significant relief to monthly inflation. As a result, the IPCA accumulated an increase of 7.06% year to date, with the year-over-year rate reaching 9.53%, compared to 9.56% until July and 6.51% in the same period last year.

For September, our preliminary forecast indicates an increase of 0.50%. The rise in inflation over the previous month will come, in large part, from the sharp increase expected in airfare – virtually reversing the reduction observed in August – and from a smaller drop in fresh fruits and vegetables prices.

For 2015, we increased our forecast for the IPCA inflation from 9.3% to 9.5%, given the new round of FX depreciation. The forecast for market prices rose from 7.6% to 7.8%. Higher market prices will cause an impact of 6.0 pp in the full-year IPCA. In disaggregated terms, we now forecast a variation of 10.8% for food consumed at home, up from 10.5% previously (7.1% in 2014). The higher pressure on prices of this subgroup this year reflects the impact of various cost shocks (exchange rate, energy and fuel) as well as the effect of climate problems on the supply of some products, especially meats and fresh fruits and vegetables. For services, we slightly increased our forecast for this year from 7.8% to 8.0% (8.3% in 2014). For prices in the Industrial sector, we adjusted our projection from 5.5% to 5.7% (4.3% in 2014).

For regulated prices, we forecast an expansion of 15.2% this year, with an impact of 3.5 pp in the IPCA. We reduced our forecast for electricity from 51% to 48%, due to the reduction in the value of the red tariff flag, but increased our forecast for bottled gas from 7% to 14%, due to the readjustment in the refinery price. The greatest contribution among regulated prices will come from electricity (1.4 pp). For the other regulated prices with higher weight on inflation, we anticipate the following changes in 2015: gasoline (10%); health insurance (12%); urban ​​bus fares (14%); water and sewage tariffs (14%); medicines (7%); and fixed telephone services (-3%).

The revision in the scenario for the exchange rate also led us to raise the forecast for the IPCA inflation in 2016 from 5.8% to 6.5%. We believe that the effects of the more depreciated exchange rate, greater inflationary inertia and increased inflation expectations will outweigh the relief provided by weaker activity and higher unemployment. We increased our forecast for market prices next year from 5.7% to 6.5%. Nevertheless, the contribution of market prices to inflation will decrease to 4.9 pp, compared to 6.0 pp expected for 2015. In disaggregated terms, we adjusted our forecasts for industrial prices from 4.6% to 5.6%, for food consumed at home from 6.0% to 7.0%, and for services from 6.3% to 6.9%. Despite the increased resistance in service inflation this year, we maintain the view that the worsening in labor market conditions and in the Real Estate sector, with consequent moderation in wages and rents, will likely contribute to the drop in private services inflation next year. In the case of foodstuffs, our baseline scenario assumes more favorable weather conditions than in previous years, which will likely provide good grain harvests in major global producers such as the U.S., Brazil and Argentina. In addition to the supposedly more benign climate for crops, lower FX variation and more contained increases in energy and fuel costs will probably lead to a reduction in food inflation next year. In this context, we anticipate tamer increases in prices for meat, wheat products and fresh fruits and vegetables. For regulated prices, we increased the forecast from 6.3% to 6.5% next year. The contribution of regulated prices to inflation will drop from 3.5 pp in 2015 to 1.6 pp in 2016.

Despite the increase in the inflation forecast for 2016, we continue to expect a decline in inflation compared to this year. In addition to the weak economic activity, other factors contribute in this direction. Among these factors, we highlight the prospect of better weather conditions and the significant reduction in the upward adjustment of regulated prices, especially electricity, given that much of the relative price adjustment process (between regulated and market prices and between domestic and international prices) will have taken place this year. On the other hand, an upward risk for inflation next year is the possibility that, given the need for increased tax collection, new tax increases directly or indirectly impact some prices of goods and services (market and/or regulated).

The behavior of inflation expectations or, more precisely, the possibility of some loss of anchoring due to the strong FX depreciation, may represent an important risk factor for inflation next year and for longer periods. Finally, the recognition of liabilities in the Electricity sector, if translated into pass-through to residential electricity bills, also represents a risk for inflation in 2016.

For the IGP-M inflation, we increased our forecast this year from 7.7% to 8.3%, largely due to the more depreciated exchange rate. In disaggregated terms, we now expect an increase of 8.1% in the IPA-M, the component with the highest weight in the IGP-M (60%); 9.5% in the IPC-M, with a share of 30% in the IGP-M; and 7.2% in the INCC-M, with a 10% weight in the IGP-M. In 2016, we raised the forecast for the IGP-M from 6.3% to 7.2%, also due to the new scenario for the exchange rate.

Monetary policy: No rate cuts in 2016

BCB signals Selic rate on hold for an extended period. Current inflation remains high and the forecasts for 2016 are above the mid-point target. Still, the prolonged recession and the lagged effects of the accumulated monetary adjustment led the central bank to maintain the Selic rate at 14.25% and signal stable interest rates "for an extended period."

There is upside potential for the Selic rate in the short term. If the exchange rate continues to depreciate, it may generate the "significant deviations of the inflation forecasts from the target" mentioned in the last minutes, requiring additional monetary adjustment.

We believed that there was room for interest rate cuts in 2016. In our previous scenario, we expected an easing cycle starting in the third quarter of next year.

But the new outlook of higher inflation and increased uncertainty prevents interest rate cuts in 2016. Despite the prolonged economic recession and the end of regulated price adjustments, we increased our 2016 inflation forecast from 5.8% to 6.5%, the upper limit of the central bank's tolerance range.

We now expect the Selic rate to remain at 14.25% until the end of 2016.

Increased uncertainty will likely impact economic activity

GDP fell by 1.9% in the second quarter qoq/sa, below our expectation (-1.8%). On the supply side, there was the second consecutive contraction in services and the sharpest decline in industrials (-4.3%) since 2009. On the demand side, the highlight was larger drops than we anticipated in household consumption and investment. According to our calculations, inventories declined, but less than anticipated. Thus, new adjustments in production will probably occur throughout the year. Not only was the aggregate result worse than anticipated, but also the future outlook worsened.

We revised our 3Q15 GDP forecast from -0.4% to -0.8%. Industrial production fell by 1.5% in July mom/sa. Our proxy for gross fixed capital formation remained at low levels and indicates further decline in investment in the third quarter. For August, we forecast another drop in industrial production, consistent with the decrease of 7.8% in vehicle production (Anfavea). The coincident indicators also point to weakness in retail sales: the trade activity index (Serasa) contracted in July and August.  Finally, our diffusion index (based on a broad set of data, including business and consumer confidence, retail sales and demand for credit) remains at a level compatible with GDP contraction (around 3.0% per year).

Confidence continues to deteriorate. The indicators of industry, service, retail, construction and consumer confidence reached record lows ​​in August. The downward trend in confidence continues to suggest lower household consumption and lower production ahead.

We revised our scenario for GDP in 2015 and 2016. The latest data negatively surprised and suggest a greater drop in economic activity in the second half than we anticipated. We changed our GDP contraction forecast in 2015 to -2.8% (previously: -2.3%). For 2016, the increased uncertainty (and the consequent deterioration in market conditions), the maintenance of interest rates at the current level and a more negative statistical carry-over motivated our revision to -1.2% (previously: -1.0%).

The unemployment rate will likely post sharper increases in the coming months. In seasonally adjusted terms (our seasonal adjustment), the rate increased from 6.7% in June to 7.2% in July. The proportion of people reporting that it is difficult to find employment continues to suggest an increase in the unemployment rate. In addition, the formal employment data (CAGED) showed destruction of 158 thousand jobs in July. The three-month moving average (seasonally adjusted) in July stood at -145 thousand, a steeper pace than in 2009, when it reached -76 thousand.

The participation rate (ratio between the economically active population and the working age population) increased in July. The contraction in real household income will probably contribute to the continuation of this upward trend.

Thus, we raised our forecast for the unemployment rate by the end of this year to 8.3% (previously: 8.0%). For 2016, we changed our forecast to 9.6% (previously: 9.3%).

Credit remains weak in July. The daily average of new non-earmarked loans fell 1.8%, mom/sa in real terms, while new earmarked loans declined 4%. Total outstanding loans continued to slow down: real annual growth fell from 0.8% to 0.3%. In the same metric, non-earmarked outstanding loans continued to recede (-3.9%) and earmarked credit moderated to 5.2% from 6.2%. Overall delinquency rose 0.1 pp, to 3.0%. Overall interest rates and spreads increased.


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