Itaú BBA - Growth Risks, Growth Boosters

Brazil Scenario Review

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Growth Risks, Growth Boosters

April 12, 2012

The economy is rising, but the risk of a weaker recovery remains.

The economy is rising, but the risk of a weaker recovery remains. Measures to help manufacturers and boost lending by state banks suggest that the government wants more. The Central Bank is signaling that the Selic will bottom at 9%, but current lower-than-expected inflation and activity could push it lower.

The first quarter raised concerns of a weak recovery. The government unveiled a package of measures to boost the economy, but we continue to forecast GDP growth of 3.5% in 2012, starting with a 0.5% seasonally-adjusted quarterly gain in the first quarter. The latest batch of data, in fact, suggests a slightly better near term.

We still expect the Central Bank to push the Selic rate to 9.0%, but chances of adding a 50-bp cut in May are rising. In light of easier inflation in the first quarter, and using new assumptions about diesel price adjustments, we lowered our 2012 IPCA forecast to 5.1% (from 5.5%). We also expect the 2012 trade surplus at $15 billion (from $11 billion), and the current account deficit at 2.7% of GDP (from 3.0%). We continue to expect the year-end exchange rate at 1.75 reais to the dollar. After re-estimating tax collection and factoring in a slower pickup in public investment, we now believe that the government will meet this year’s fiscal target of a primary surplus of 3.1% of GDP.

Growth: short and medium term

In the short-term, supermarket sales held steady in February after a strong pickup in January. That suggests that overall retail retreated only slightly after January’s fast gain: a small payback within a solid trend. In the three months to February, retail was probably rising at an annualized pace of between 10% and 15%.

Industrial production was back to growth in February, after a strong drop in January. In March, auto makers reported higher production and inventories, a sign of strength in manufacturing (but also a risk of weaker production ahead, if demand does not move faster).

With overall better data, our monthly GDP proxy now points to a 0.4% decline in February. The preliminary indication had been a much worse 1.1% drop.

Given the monetary and fiscal stimulus still under way, we continue to expect a strong pickup in coming quarters.

There are risks, however. Public investment is picking up more gradually, and the transmission of monetary policy to the economy (through expectations, credit etc) seems slower. Those may be temporary holdups: we see no reason to change our forecasts.

A package for manufacturers

Our forecasts also didn’t change when the government announced, in early April, a package of measures to “strengthen the economy” and help local manufacturers compete with imports. The package coalesces around a set of tax breaks, subsidized loans, and trade protection.

On tax breaks, firms in 15 sectors of the economy will no longer pay taxes on payrolls, paying in its place a new, lower sales tax [1]. An IPI tax break on durable goods will last longer than initially planned. A tax program for port investment was expanded. Firms in selected sectors will be able to defer payment of PIS-Cofins taxes.

In addition, the BNDES is taking a fresh line of 45 billion reais ($25bn) from the Treasury to boost its lending with even lower rates and longer maturities, although with a similar total volume of lending. A new trade-financing facility is also being created.

Brazil’s special tax regime for auto makers is due for renewal later this year. In its new version, the program will favor firms that invest more, spend more on research and development, or use more local inputs, among other criteria. The objective is to make the mechanism even more favorable to local production.

Finally, the list of sectors graced with a price advantage of up to 25% in government purchases was widened.

According to official estimates, the program’s total tax cost will be around 6 billion reais this year, and 9 billion in 2013. These will be partially offset by higher levies on imports, leading to net impact of around 3 billion in 2012, or 0.07% of GDP (this could change slightly depending on the outcome of talks now under way over taxes on beverages). It is a drop in the pool of federal revenues, which we estimate at 1.1 trillion reais this year. The package did not change our fiscal forecasts.


We reduced our 2012 IPCA forecast to 5.1% from 5.5% (6.5% in 2011). The revision reflects lower inflation so far this year, as well as new assumptions regarding an adjustment of diesel prices in the second half of the year. We now expect the price of diesel oil to rise by 7.5% (previously 20%). We continue to expect gasoline prices to rise by 8.5%, fully offset at the pump by a lower CIDE tax.

We expect modest rises in regulated prices this year: 3.3%, representing around 1pp of the drop in the IPCA from 2011.

For 2013, we slightly lowered our IPCA forecast to 5.6% (from 5.7%), reflecting lower inertia from 2012. Still, regulated prices will likely rise faster (5%) and, in the context of a still-tight labor market, strong demand in the second half of this year will keep service inflation around 8% in 2013.

Monetary policy: doubts on the extent of rate cuts

In recent policy minutes and in its latest inflation report, the Central Bank clearly signaled its intention of ending the current easing cycle with the Selic at 9% (our call since last October). The rate is now at 9.75%.

However, inflation has been surprisingly weak. In December, the CB projected first-quarter inflation at around 1.8% (already factoring in the new IPCA weights). Later, in March, that projection was lowered to around 1.5%. The actual number was even lower: 1.2%. Core measures have also been lower than expected.

Even before the March results were known, the CB’s “reference scenario” had inflation at 4.4% in 2012. It is plausible that the Central Bank’s perception of the inflation outlook improved after the results came out.

At the same time, growth was still weak in January and February, and global uncertainty is rising again.

The CB’s perception of lower inflation and growth still below the desired level may prompt it to cut beyond the 9% consensus – let’s say, to 8.5%. However, the signaling in official communication and in speeches by Copom members still points to 9%.

For now, we maintain our view that the CB will ease the Selic by 0.75 bps to 9% in April, and leave it there for the rest of the year. Upcoming inflation and activity readings could, however, tilt the scale in favor of one further cut in May.

In our scenario, the Selic remains at 9.0% until the beginning of 2013, when inflation concerns cause the CB to tighten again: first, with macroprudential measures, and then with rate hikes, taking the Selic to10.5% in the course of next year.

Larger trade surplus, smaller current account deficit

Brazil posted a $1.8 billion current account deficit in February, much smaller than in January ($7.1 bn). The trade balance was back to positive territory after an unusual deficit in January. Remittances of profits and dividends slowed down significantly to $528m, making the income account post its weakest outflow since 2001.

In March, the trade surplus rose to $2.0 billion, reflecting weaker imports at $18.9bn.

What lies ahead? Although we still expect the exchange rate at 1.75 reais to the dollar by year-end 2012, the currency will likely stay, on average, weaker through the year. Factoring in a slightly weaker currency, and reassessing the impact of commodities prices and activity on exports and imports, we now expect a trade surplus of $15 billion in 2012 (US$ 11bn previously).

Adding the prospect of weaker outflows in the income account, we lowered our current account deficit estimates in 2012 to 2.7% of the GDP (from 3.0%).

Fiscal policy

On the fiscal side, we upgraded our primary fiscal balance estimates for both 2012 and 2013. We now project that the public sector will fully meet the target of 3.1% of GDP. We previously expected a surplus of 2.8% of GDP (to reach the target, the government would have to resort to deductibles in investment spending under the PAC program).

A cyclical slowdown in federal revenues should last until the middle of the second quarter. However, a re-estimation of our tax collection models (which had been underestimating actual data) point to larger tax receipts for the same level of economic activity, probably as a result of higher formalization, surveillance and efficiency. As we noted above, the recently announced tax breaks for local manufacturers did not change our revenue forecasts.

We thus raised our federal revenue estimates by 15 billion reais for 2012, (including better-than-expected results so far this year) and 21 billion reais for 2013.

On spending, the slow pickup in federal investment suggests delays in projects, owing especially to legal and bureaucratic obstacles. We lowered our forecast for federal investment in 2012 to 68 billion reais (72 billion previously), and raised our 2013 forecast by 5 billion (to 95 billion).

Even it targets for 2012 and 2013 are met, fiscal policy is turning more expansionary after the 2011 moderation. For example, we forecast real federal spending growth of 7.0% this year and 7.5% next year. Data for January and February are in line with that scenario.

Finally, our 2012-13 estimates are consistent with a decline in the structural primary fiscal balance, which we estimate at 2.4% of GDP in 2011, 2.3% in 2012, and 1.7% in 2013. This means that fiscal results will depend on favorable activity and high asset prices - especially in 2013.

FUNPRESP: a window on reforms?

The FUNPRESP, a new pension regime for civil servants, was finally approved in Congress last month, raising hopes that longer-term structural reforms could return to the country’s radar screen after a long leave of absence.

Much of the reform agenda still revolves around fiscal issues. For example, Brazil could adopt a structural fiscal target, as Chile, Colombia, Mexico and other countries have done, or are working to achieve.

Reforming the tax system and reducing the tax burden are old challenges, and increasingly urgent. The need to improve basic education is just as evident.

Those are but a few items in a long and promising agenda. We can group the reforms around three broad objectives: to increase the ability of the public sector to invest, to encourage private investment, and to foster productivity. We hope to return to these issues in the future.

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