Itaú BBA - Fiscal Deterioration to Contain Inflation and Interest Rates

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Fiscal Deterioration to Contain Inflation and Interest Rates

April 5, 2013

We forecast a falling primary budget surplus and a widening current-account deficit

Our forecasts for the primary budget surplus point to a decline to 1.9% of GDP in 2013, and to 0.9% of GDP in 2014 (from 2.4% in 2012). Due to tax breaks, we expect lower inflation this year. We reduced our forecast for IPCA in 2013 to 5.6% (from 5.7%), after the government extended the tax break on vehicle production until the end of the year. Our forecast for 2014 remained at 6.0%. We continue to expect the economy to grow 3.0% this year and 3.5% in 2014.

Following the release of the minutes of March’s monetary-policy committee (Copom) meeting, in which the central bank signaled an interest-rate hike, we changed our scenario for the benchmark Selic rate. Now, we expect a maximum increase of 100 bps (from stability), at a pace of 25 bps per meeting starting in May. After this hiking cycle, we expect the Selic rate to remain at 8.25% p.a. until December 2014. The risk is a shorter tightening cycle than we anticipate, with the possibility of the Selic rate remaining at 7.25% if current inflation turns out to be more favorable than expected.

The current-account deficit has been widening, and foreign direct investment (FDI) is cooling down. There is funding to cover Brazil’s external deficit, but conditions are not as good as before. We raised our forecast for the current-account gap this year to 2.9% of GDP from 2.6%, partly due to the reduction in the trade-surplus forecast to $10 billion from $14 billion. We also revised downward our estimate for FDI, to $59 billion (2.4% of GDP) from $63 billion. For the exchange rate, our scenario still contemplates 2 reais per U.S. dollar until the end of 2014.

A more expansionary fiscal policy

In February, the public sector posted a negative primary balance of 3.0 billion reais, or 0.8% of GDP for the month. It was the worst reading since the beginning of the historical series (2002), reinforcing our view that the strong performance seen in January (i.e., primary surplus of 30.3 billion reais, or 8.1% of monthly GDP) was an outlier.

Due to the gradual economic recovery (and despite tax breaks), there are signs of stabilization in federal tax revenues, after consecutive slides in the second half of 2012. However, central government expenses have been rising quickly this year (around 7.5% on a year-over-year basis), helping to explain the recent decline in the fiscal surplus.

We estimate the recurring primary result (which excludes atypical or temporary budget transactions) at around 1.7% of GDP in the 12 months through February (the typical 12-month result is 2.16%). This is the lowest reading in our series for the recurring primary result since April 2011, suggesting a more expansionary stance in fiscal policy.

Recent economic policy decisions reinforce expectations of a reduction in the primary surplus in the next few years. The budget that was recently approved by the Congress includes a larger volume of deductions from the fiscal target than in previous years. According to the Budget Guidance Law (LDO in its Portuguese acronym) of 2013, the government may reduce the primary surplus target by up to 65 billion reais (1.4% of GDP), using any combination of spending on the Growth Acceleration Program (PAC) and tax breaks. Such increased flexibility to use deductions should ensure the full utilization of this fiscal room, especially given the high volume of tax breaks already planned for this year (which we estimate at about 60 billion reais in 2013) and a likely faster execution of the PAC (due to the final implementation of projects budgeted in previous years and the re-classification of PAC expenses, which extended the project pipeline late last year).

On top of that, new tax cuts are being announced or discussed. In March, the government cut taxes for food and cleaning items in the so-called “cesta básica”, probably giving up 5.5 billion reais in revenues this year (about 7.3 billion reais next year). The government also decided not to raise IPI tax rates for automobiles (the original plan had been to raise rates in April and July.) The maintenance of tax rates that were in place in March causes the government to give up about 2 billion reais in fiscal revenues in 2013. Soon there may be announcements of tax cuts for other products, such as medication and fuels.   

For the next few years, we anticipate a growing volume of tax breaks and a relatively fast expansion in federal spending (about 5% p.a., thus faster than estimates for potential GDP, which hover around 3%). We expect a falling primary budget result in the upcoming years, with the conventional primary reading receding from 2.4% of GDP in 2012 to 1.9% (recurring primary result: 1.5%) in 2013 and 0.9% (recurring primary result: 0.5% to 0.9%) in 2014.

The numbers we forecast for the budget are consistent with a small increase in public debt in 2013-2014, with the public sector’s net debt rising from 35.2% of GDP in 2012 to a little below 36%. The gross debt of the general government, excluding the impact of changes in international reserves held by the central bank, should move from 40% of GDP by the end of 2012 to around 41% by December 2014.

Inflation probably surpassed the upper limit of the target range in 1Q13, but will retreat in coming months

Inflation remained under pressure at the beginning of the year and probably accumulated 2% in Q1, from 1.2% in 1Q12. The year-over-year change in the IPCA likely reached 6.6%, outpacing the upper limit of the target range. The diffusion index continues to show that price increases are more widespread, while core inflation measures indicate that underlying inflation remains high.

Despite upward pressure at the beginning of the year, we expect inflation to retreat during 2Q13, mainly driven by the food group. Food prices should start to reverse part of the increases seen previously, due to tax cuts for items in the “cesta básica” and to the pass-through of lower agricultural prices at the beginning of the year. As for producer prices, many items got cheaper in 1Q13, especially soybeans, corn, rice, coffee, beef, poultry and pork. Normalization of the supply of perishable food should also bring relief to inflation in the near future.

Lower IPI tax rates for automobiles, which had been scheduled to rise in early April and July, were maintained until year-end. Thus, tax cuts will reduce inflation this year, ceteris paribus. The impact on consumer inflation (IPCA) is -0.14 p.p. Hence, considering this tax change, we reduced our forecast for the IPCA to 5.6% from 5.7% in 2013. Our forecast for the IPCA in 2014 was maintained at 6.0%.

The key upside risk to our inflation scenario is recent price increases – which became more widespread – becoming more resilient. More favorable demand conditions and worsening inflation expectations may sanction a larger pass-through of higher costs, impacting mainly the prices of tradable goods. In this scenario, the diffusion index as well as the headline inflation index and core inflation measures may reach higher levels, hindering the decline in inflation. Another upside risk stems from service inflation, which remains resilient, despite some cool-down at the margin.

In contrast, the downside risk to our scenario is even more favorable food prices. The pass-through of tax cuts for items in the “cesta básica” may be greater than estimated. And the reversal of the unfavorable conditions of last year, which characterized the shock in agricultural supply, may be more intense. Finally, the government may announce more tax cuts, as well as postpone or dilute adjustments in regulated prices.

Caution in monetary policy

The central bank has recognized the deterioration in inflation. But it will act with caution, if at all, given the uncertainties that surround its evaluation of the current scenario.

In recent official communications (the minutes of the Copom meeting in March and the Inflation Report for 1Q13), the central bank recognizes the unfavorable dynamics for short-term inflation and the risk imposed on expectations, but indicates that it is not sure about whether this situation will endure.

According to the central bank, external and internal uncertainties surround the inflation scenario. External uncertainties are probably related to Europe (the political standstill in Italy, banking crisis in Cyprus), the fiscal adjustment in the U.S. and commodity prices, to name a few. Among internal uncertainties, we point out the pace and sustainability of the rebound in economic activity and the impact of different tax-cutting measures on short-term inflation dynamics.

Facing that, the Copom signals that monetary policy will be conducted with caution. In other words, the committee will wait until it is certain that a monetary policy action is needed.

Hence, the importance of incoming inflation data is high. In our scenario, monthly IPCA readings should retreat substantially in coming months, favored by falling grain prices in international markets, by seasonality in perishable food prices, and mostly, by tax breaks. More favorable inflation results in the short term tend to reduce the urgency of eventual monetary tightening.

In the government’s opinion, a premature or too intense monetary-policy tightening could abort the economic recovery, with undesired consequences on the labor market and on consumer spending.

The government’s view may be summarized as follows: Inflation surprised on the upside and may contaminate expectations, requiring an adjustment in interest rates. Tax breaks help to reduce current inflation. There are a lot of uncertainties in the scenario and there are reasons to believe that inflation will be low in coming months. A fine adjustment must be sought in order to contain inflation expectations, but not to the point of affecting growth. Therefore, a hike in interest rates, if it happens, would tend to be moderate and cautious.

We expect a hiking cycle of 100 bps at most, starting in the May meeting, at a pace of 25 bps per meeting. If there is greater-than-anticipated relief in short-term inflation, the increase in the interest rate may not materialize.

Mixed signs in economic activity

GDP growth was probably strong in 1Q13; our estimate of 1.2% qoq/sa was not changed with the latest information, although downside risks have increased. The data also reinforce the fact that temporary factors explain a significant share of this expansion. In addition to the robust increase in agricultural output (which has been contemplated in our scenario for a few months), which should be much milder in 2Q13, industrial activity also shows that the momentum seen in January was not a new trend. February figures were weak and the first data for March are mixed (strong vehicle production, but a decline in confidence index). The industrial sector should also post slower expansion in 2Q13.

Business confidence also supports this outlook. After stagnating in January and February, the business-confidence indicator fell 1.5% in March, going back to the level seen in September 2012. The slow rebound in business confidence indicates moderate growth in industrial activity and sluggish acceleration in investments. The global economy continues to recover at a moderate pace, and uncertainties still run high. Doubts about the rescue plan for the banking system in Cyprus and its consequences illustrate the fragility of the external scenario.

Household spending continues to expand, though there are also signs that it is cooling down. Consumers are still optimistic, but confidence has been sliding for a few months. The labor market remains positive, supporting growth in consumption. However, a lower increase in the minimum wage, slower job creation and higher inflation slow down the pace of real income gains. The extension of lower IPI tax rates for automobiles until the end of the year should prevent a drop in sales in 2H13. The impact on GDP may be positive, albeit small. It reduces downside risks for economic growth this year.

Investments probably ended 1Q13 with strong growth. Production of transportation capital goods, particularly trucks, advanced briskly, influencing gross fixed-capital formation in the quarter. But the effect tends to be temporary. The sluggish improvement in confidence and uncertainties surrounding the external scenario and the domestic rebound tend to slow down growth in capital expenditures.

Another element reinforcing the outlook of gradual growth following a strong 1Q13 is the diffusion of economic activity data. A broad set of data – including income, credit, employment, production and sales figures – suggest that growth will slow down after the 1Q13.

Though data point to lower expansion in the next few quarters than in 1Q13, the same data suggest that the pace of growth should be more intense than in the second half of 2012. For instance, industrial inventories are well-adjusted, and the credit market shows signs of improvement.

In real terms, the daily average for total new loans climbed 15.1% yoy in February, a similar pace to the two previous months, but faster than the pace registered in the second half of 2012 (4.3%). Delinquency in consumer loans more than 90 days past due slipped from 5.5% in January to 5.4% in February, marking a fifth consecutive month of declines. Meanwhile, delinquency in corporate loans more than 90 days past due was flat at 2.3%. Signs point to stability in interest rates and spreads.

During the past month, we incorporated in our scenario an increase of 100 bps in the benchmark interest rate. Tighter monetary conditions would indicate slower growth, especially in 2014. Even considering some obstruction in the monetary-policy transmission channel, such tightening would reduce GDP growth by 0.1 p.p. this year and by 0.4 p.p. in 2014. However, we expect other economic policy tools (quasi-fiscal tools, for instance) to be used to avoid a cool-down in economic activity, particularly in 2014.

In short, the economy is recovering, but evidence provided by several indicators shows that the pace during 2013 should be not as strong as in the first quarter and not as weak as in 2012. We maintain our forecasts for GDP growth at 3.0% in 2013 and 3.5% in 2014.

Higher current-account gap and lower FDI

The current-account gap has been widening, while foreign direct investment is cooling down somewhat. Still, Brazil’s external position remains favorable, with enough flows to finance the current deficit. There is still appetite for Brazilian assets. However, for a country that needs external savings to ensure an increase in the investment rate in the next few years, changes in the dynamics of the balance of payments, if permanent, may have significant implications for the domestic scenario (exchange-rate pressure, reserve losses and less growth).

In February, the current-account deficit amounted to $6.6 billion, deteriorating $8.3 billion from one year earlier, mostly because of two components: the trade balance, which was negative by $1.3 billion during the month, driven by fuel imports; and profit and dividend remittances, which are rebounding as economic activity picks up.

FDI stood at $3.8 billion in February, and added up to $7.5 billion in the first two months of the year, marking a decline from $9 billion one year earlier. Portfolio flows remain very positive, with investments in stocks and fixed income totaling $6.7 billion in the first two months of 2013.

We expect this change in the balance of payments to endure and the current account deficit to reach $71 billion, or 2.9% of GDP (previously: 2.6% of GDP) in 2013. Two main drivers are behind this change: i) the trade-balance slowdown; and ii) the increase of profit and dividend remittances.

We lowered our forecast for the trade surplus in 2013 to $10 billion from $14 billion, due mostly to disappointing exports of manufactured items compared with our previous forecasts. Despite fast growth in Latin America (the main destination for these products, or 41% of total), trade barriers and other factors have prevented sales of Brazilian products from matching this expansion.

Many logistical problems involving highways and waterways, along with threats of labor strikes, led soybean shipments in 1Q13 to add up to only 4.5 million metric tons, compared with 9.1 million in 1Q12. However, exports of soybeans and its byproducts are not compromised for the year as a whole. The record-high crop will be a positive driver for the trade balance in 2013.

We also raised our forecast for profit and dividend remittances, to $31 billion from $25 billion, as we incorporated actual data and reassessed future flows.

As for foreign direct investment, we reduced our estimate to $59 billion (or 2.4% of GDP) from $63 billion. Hence, FDI will no longer fund the current-account gap and reserve accumulation will drop to $9 billion in 2013 from $18.9 billion in 2012. But considering $380 billion in accumulated reserves and negative net foreign debt, Brazil’s international investment position remains benign.

Though the external position is still favorable, there is some deterioration in the country’s CDS spreads. In contrast to some of its peers, Brazil’s risk perception rose in recent weeks, in a move that does not seem solely a result of uncertainties in the international environment. Albeit modest, the deterioration may be related to domestic factors, such as weaker results for public accounts. Worse external flows may raise risk perception at the margin.

As for the exchange rate, there was no change in our scenario, and the forecast remains at 2 reais per U.S. dollar by the end of 2013 and in 2014.

Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú


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