Itaú BBA - Fuel for Inflation

Brazil Scenario Review

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Fuel for Inflation

September 11, 2013

We incorporated in our scenario an adjustment in fuel prices before the end of 2013.

•           A weaker exchange rate and high international oil prices have substantially widened the gap between domestic fuel prices and prices in international markets. We thus incorporated in our scenario an adjustment in fuel prices before the end of 2013. This change affected our 2013 forecast for the consumer price index, IPCA, which was raised to 6.2% from 6.1%. Our estimate for the 2014 IPCA was maintained at 6.0%. We had already raised our inflation forecasts somewhat over the last month due to the weaker exchange rate.

•           We have maintained our exchange rate forecasts at 2.45 reais to the dollar for year-end 2013 and 2.55 for year-end 2014 (we had already revised those figures over the last month). Taking into account the more depreciated exchange rate, our estimate for the current account deficit in 2014 has been lowered to 2.7% of GDP from 2.9%.

•           We forecast 2.3% GDP growth in 2013, having revised our estimates after the release of the 2Q12 figures at the end of last month. Our GDP estimate for 2014 remains at 1.7%. We have maintained our forecasts for the Selic benchmark interest rate, which we expect to be 9.75% p.a. at the end of both this year and next year. Our estimates for the primary budget surplus remain at 1.7% of GDP for 2013 and 1.1% of GDP for 2014.

Increase in fuel prices raises our inflation forecast

We are now incorporating an assumption of a 6% hike in gasoline and diesel prices at refineries, with slightly smaller increases at the pump, in 4Q13. In our scenario, gasoline prices will rise by 4% at the pump, while diesel prices will rise by 5%. We assume that this adjustment in fuel prices will take place in 4Q13, causing an increase of 0.15 pp in the IPCA. Gasoline prices were raised by 6.6% at the beginning of this year, and diesel prices have been raised twice for a total increase of 10.7%. For 2014, our scenario already assumed price hikes at refineries of 7% for gasoline and 10% for diesel, in line with the pattern observed over the last two years. These adjustments would not fully erase the difference between domestic prices and international prices, which currently stands at around 30%.

Due to the expected adjustments in fuel prices, we have increased our full-year 2013 inflation estimate. Our forecast for the 2013 IPCA has been raised to 6.2% from 6.1%. We had already raised our forecast for the 2013 IPCA to 6.1% from 5.9% over the last month due to the weaker currency. Our inflation estimate for 2014 has been maintained at 6.0% (we had already revised from 5.8% throughout the last month).

The economic slowdown combined with lower food prices should slightly reduce inflation in 2014, even with a weaker exchange rate. Lower service and food prices (which account for about 50% of the IPCA) may provide some relief from inflation next year, potentially more than offsetting the expected acceleration in regulated prices to 4.7% from 1.7%. Greater inflationary inertia, inflation expectations above the midpoint of the target range and a greater risk of pass-through from the exchange rate will likely limit any slowdown in inflation amid lower economic growth.

Latest inflation numbers are still tame, with lower food prices. After being little changed in July, at 0.03%, the IPCA rose by 0.24% in August, while the year-over-year reading retreated to 6.1%. The component of food at home posted deflation for a third consecutive month (‑1.4% in the June-August period), driven by price cuts for several items, particularly root vegetables and legumes. Price increases for milk and dairy stood out on the opposite side.

In the next few months, we expect to see a gradual acceleration in IPCA inflation, to 0.4% in September and to a monthly average of 0.75% for 4Q13. The likely hike in inflation late in the year would be driven by seasonal factors, the impact of a weaker exchange rate, a less favorable scenario for grain prices and the likely increase in fuel prices. In the short term, there is downside risk for food inflation, as the drop at the margin has been more resilient than anticipated.

Worsening weather conditions in the U.S. represent an upside risk for inflation. In recent weeks this factor has led to a significant correction in prices for major grains, particularly soybeans. The increase has already been transmitted to domestic producer prices and may exert additional pressure on consumer prices in the coming months. Still, the recent hike in grain prices is not likely to fully erase the decline observed since the beginning of the year. The recent change only suggests that the scenario for agricultural commodity prices will not be as favorable to inflation as previously anticipated.

Higher international grain prices are likely to put more intense pressure on producer prices. In addition to the higher grain prices, the expected hikes in fuel prices have also been incorporated into our forecast for general price indexes (IGPs). We now estimate that the IGP-M will rise by 5.5% this year and by 6.0% in 2014.

A weaker currency and a new strategy by the central bank

The exchange rate reached 2.45 reais to the dollar, and the central bank has switched its strategy. After a period of steady depreciation, the Brazilian real last month reached its weakest level since March 2009. On August 22, the central bank announced a new intervention strategy, in which daily auctions will take place until the end of the year, at the earliest. On weekdays from Monday through Thursday, $500 million in currency swaps will be auctioned. On Fridays, $1 billion in repo credit lines will be offered. Furthermore, the central bank may promote extraordinary auctions if needed.

These decisions by the central bank calmed the foreign exchange market. As of now, the central bank is short $49 billion in currency swaps. Considering only the planned auctions, this short position will reach $82 billion, or approximately 23% of international reserves, by the end of 2013. The bank’s new program calmed investors, and the exchange rate ended the month at 2.39 reais to the dollar. Before these decisions by the central bank, we had revised our exchange rate forecasts to 2.45 from 2.30 reais to the dollar for year-end 2013 and to 2.55 from 2.40 for year-end 2014 (see our Macro Vision “Brazil: more depreciated exchange rate and higher inflation”). Our forecasts already incorporated the possibility of new interventions such as this strategy implemented by the central bank.

We believe that the exchange rate in real terms will bounce back in the long run. Our calculations suggest that an exchange rate of around 2.30 reais to the dollar is enough to reduce the current account deficit to 1.5% of GDP, a ratio that we regard as fundable in the long term. Our scenario assumes such an adjustment in the balance of payments over the coming years as well as a gradual normalization of the exchange rate toward its equilibrium level starting in 2015.

The current account deficit deepened in July. Brazil’s current account deficit totaled $9 billion in July, or 3.4% of GDP over the trailing 12 months. The main reason for the deterioration in the monthly reading was the $1.9 billion trade deficit. But the biggest surprise was a wider-than-expected gap in the service account.

Currency depreciation should narrow the current account deficit through adjustments in the trade, service and income accounts. At first, imports will be discouraged due to the weak currency. Then, exports will likely react positively as prices for items made in Brazil become more competitive abroad. Services contracted by consumers (such as travelling) and companies (such as equipment rentals) will become more expensive in Brazil, and profit and dividend remittances will be less attractive. We now estimate a trade surplus of $12 billion in 2014 (up from $10 billion previously), with the current account deficit at 2.7% of GDP (down from 2.9% previously).

We have revised upward our 2013 estimate for foreign direct investment (FDI). FDI figures have been robust month after month, adding up to $35.2 billion this year to date. Even considering a slowdown in the second half, we increased our FDI estimate to 2.7% of GDP in 2013 (from 2.5% previously).

Stronger GDP in 2Q13 likely to be followed by a weaker quarter

The stronger reading for GDP in 2Q13 increases growth for the full year but does not change the picture of weakening activity. GDP grew by 1.5% qoq/sa in 2Q13, topping expectations. Sharp growth in agricultural, manufacturing and investment took the spotlight. This stronger result contributed to an upward revision in our estimate for GDP growth this year, to 2.3% from 2.1% (see our Macro Vision “Signs of Weakness in 3Q13 and the Outlook for GDP Growth”), but did not change the outlook for a slowdown in the economy in the second half of 2013. Industrial production slid by 2.0% in July and will likely end the quarter in negative territory. In this scenario, we expect the GDP to decline by 0.5% qoq/sa in the current quarter. Our forecast for GDP growth in 2014 remains at 1.7%.

Lower confidence indicators reinforce a scenario of weak activity. Consumer confidence indicators and indicators measuring confidence in the service sector rebounded from declines in July, though not fully in the case of the service sector. Confidence among industrial entrepreneurs dropped further last month. Overall, confidence indicators are at lower levels, reinforcing the outlook for weakening economic activity. Investment is likely to be more affected by the slide in confidence. Indeed, both production and capital goods imports retreated in July.

Mixed signals from the labor market, but the trend points to a gradual increase in the unemployment rate. Formal job creation (according to the Labor Ministry’s Caged registry) slowed to 17K in July from 47K in June in seasonally adjusted terms, dragging the three-month moving average to its lowest level in about four years. Despite weakness in formal job creation, the unemployment rate fell slightly, to 5.6% in July from 5.7% in June, in the seasonally adjusted series. However, given the slow pace of formal hiring, the unemployment rate should still increase gradually in the coming months. Consumer surveys support this conclusion.

The employment component of consumer surveys does not show a material recovery. The advance in consumer confidence, up 4.4% in August, was not driven by an improvement in consumers’ assessments of labor market conditions. There was only a small drop in the share of households that assess the labor market situation as difficult, and the survey still points to an employment rate above 6% in the coming months.

In the credit market, new loans declined in July. The daily average of new non-earmarked loans fell by 4.4% in seasonally adjusted real terms. The decline was more intense in the corporate segment, which saw a slide of 7.7%, while the consumer segment posted a drop of 1.2%. The outlook is for stability in new loans, in line with the level seen since the beginning of the year. Delinquency retreated for loans more than 90 days past due, but the decline was observed only for earmarked corporate loans, while delinquency in other categories remained stable. State-owned banks continue to widen their share of the credit market.

Exchange rate depreciation is likely to change the composition of growth, with lagging and temporary effects on economic growth. Exchange rate depreciation should accelerate the pace of activity, but this effect is likely to take a while to show up and tends to be temporary. A change in GDP composition is likely to be the most evident effect of the move in the exchange rate, as private demand (consumption and investment) is overtaken by an increase in net exports.

Monetary policy strategy is maintained

The monetary policy committee (Copom) maintained the pace of interest rate hikes at its August meeting. The benchmark Selic rate was increased by 50 bps, to 9.00% per annum.

The uncertainties surrounding the economic scenario and the volatility in financial markets apparently have not changed the Copom’s plans. Since the last Copom meeting, many developments have suggested a possible need to change the pace of interest rate increases in both directions, but the central bank’s statement ruled out this possibility.

At first, signs of slowing economic activity and a decline in current inflation created a perception that the Copom might interrupt its rate-hiking cycle earlier than expected. But the inflation risk stemming from the pass-through of the exchange rate depreciation to consumer prices led Copom members to make clear, in their statements, their intention to continue with monetary tightening.

More recently, sharp currency depreciation and rising inflation expectations have led interest-rate futures markets to price in a faster pace of increases in the Selic rate. And once again the central bank communicated – this time through a written statement – its intention to maintain the current pace of interest rate hikes, citing its concern over the possibility of an even steeper slowdown in activity.

These developments have reinforced our forecast that the Selic rate will end 2013 at 9.75% per annum. We expect an additional 50-bp hike at the next Copom meeting and a final 25-bp rise in November.

A larger pass-through from the exchange rate, however, may require higher interest rates. The confirmation by the Copom that it would continue its tightening cycle in 50-bp increments signals that the central bank will attempt to refrain from using interest rates to react to a rapid depreciation in the exchange rate. However, if the pass-through is more intense than we anticipate, we would not rule out an extension of the tightening to above 10% per annum.

Exchange rate cushions the impact of a lower primary balance on the net public debt

Poor results from regional governments are behind the negative surprise in the primary budget surplus in July. The consolidated primary budget surplus stood at 2.3 billion reais, disappointing expectations because of sub-par results from regional governments. The latter posted a primary deficit of 1.5 billion reais. The public sector’s primary balance for July was equivalent to 0.6% of GDP (according to the central bank’s preliminary estimates for the month), below the average of 1.7% of GDP for the same month over the 2009-2012 period.

Over the past 12 months, the consolidated primary budget result dropped by about 0.1 pp, to 1.9% of GDP. According to this criterion, the central government was responsible for 1.5% of GDP, while regional governments added about 0.4%. The recurring surplus, which adjusts for atypical revenues and expenses, remained around 1.5% of GDP for the same period.

We maintain our forecasts for budget results in 2013 and 2014. We still forecast a primary budget surplus of 1.7% of GDP this year (2012: 2.4%). We expect the central government to contribute with 1.3% (2012: 1.9%) and regional governments to add 0.4% (2012: 0.5%). According to our calculations, the real growth in net federal revenues (net of transfers to regional entities) should be around 1.5%, while central government spending should expand by nearly 4%, adjusted for inflation.

We see downside risks to our primary balance forecast this year. Increased spending on rigid lines (healthcare, education, government transfers), a (potentially) greater-than-expected impact of tax breaks on revenues, the effect of non-budgeted subsidies for the electricity sector and the expected GDP slowdown in 3Q13, all imply downside risks to our 2013 forecast. Those risks could be partially mitigated by revenues from a tax debt amnesty program for corporates (Refis). For 2014, we still estimate a primary balance drop to 1.1% of GDP, influenced by lower fiscal efforts by regional governments (-0.3 pp), new federal tax breaks (most of those already on the pipeline), and a sustained (4%) real growth in central government expenditures.

Exchange rate depreciation prevents a rising debt. With the dollar appreciation (which increases the value of international reserves, booked as an asset owned by the government), the public sector’s net debt fell by 0.4 pp in July, to 34.1% of GDP, the lowest level in the series. Across 2013, the weakness in the exchange rate helped reduce the debt-to-GDP ratio by about 1.7 pp from 35.2% in December 2012. The exchange rate more than offset the less favorable recent dynamics of the main components of the public debt: a declining primary surplus, rising interest rates and slowing economic activity. Our base-case scenario implies that net debt will remain stable at 34%-35% of GDP until the end of 2014.

Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú

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