Itaú BBA - Growth Without Energy

Brazil Scenario Review

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Growth Without Energy

February 14, 2014

We have lowered our forecast for GDP growth in 2014 to 1.4% from 1.9%, and to 2.0% from 2.2% in 2015.

• Brazil’s economic growth has lost momentum in recent months. Weakening investment and inventory adjustments suggest slower-than-expected economic expansion in 4Q13 and sluggish growth in 1Q14. Scarce rainfall and higher electricity prices are risks. The impact on growth expectations will depend on the evolution of weather conditions over the year. The situation in Argentina is another drag on the Brazilian economy. We have lowered our forecast for GDP growth in 2014 to 1.4% from 1.9%, and to 2.0% from 2.2% in 2015.

• An expected decline in exports to Argentina prompted us to lower our forecast for the 2014 trade balance to USD 6 billion from USD 7 billion, which in turn contributed to a revision in our forecast for the 2014 current account deficit, to 3.6% of GDP from 3.5%. Our year-end forecasts for the exchange rate remain at 2.55 reais to the dollar for both 2014 and 2015.

• We have raised our year-end 2014 estimate for the Selic benchmark interest rate to 11.00% from 10.75%, incorporating our projection of two 25-bp hikes in February and April. Our forecast for 2015 has been revised upward to 12.00% from 11.50%. Consequently, we have reduced our 2015 estimate for the consumer price index IPCA to 6.0% from 6.2%. Our IPCA forecast for 2014 remains unchanged, at 6.2%.

• Our estimate for the 2014 primary budget surplus is still at 1.3% of GDP, but the breakdown has changed. We now expect faster growth in expenses, smaller tax revenues and larger extraordinary revenues.

Drop in investment and industrial production leads to lower growth forecasts

Lower investment and inventory adjustments caused a widespread decline in industrial production in December. Fundamentals less favorable to investment – higher interest rates and low business confidence levels, for instance – affected the production of capital goods in December (-11.6% mom/sa). Inventory adjustments also weighed on several sectors in late 2013. Industrial output slid by 3.5% mom/sa in December, marking the sharpest drop since January 2009. Following this retreat in production, inventories became more balanced in many sectors, but there are still signs of imbalances in some segments. Furthermore, demand indicators related to capital goods continue to show weakness, and growth in consumer spending is likely to decelerate. Hence, despite signs of a strong rebound in January, industrial production is still slowing down.

Based on fundamentals and current data, we have lowered our forecast for GDP growth in 2014 to 1.4% from 1.9%. We have lowered our forecast for 4Q13 GDP growth to 0.4% from 0.6% to reflect the impact of the weak industrial production in December (our growth estimate for 2013 is unchanged, at 2.2%). This performance reduced the carryover into 2014. Even if we assume that there is a strong recovery in January, industrial activity in 1Q14 is likely to be weaker than initially anticipated. We have thus lowered our forecast for GDP growth in 1Q14 to 0% from 0.4%. These drivers have led to a reduction in our forecast for GDP growth in 2014, to 1.4% from 1.9%. We have changed our GDP forecast for 2015 to 2.0% from 2.2% due to our upward revision for the Selic rate.

Slowing economic activity in Argentina contributed to lower domestic growth. A deteriorating scenario in Argentina may lead to a 15-pp decline in the growth rate for Brazilian exports to Argentina, according to our calculations. Through the trade channel, a reduction of such magnitude would have an impact of -0.2 pp on Brazil’s GDP growth in 2014. In our view, the weakness in the Argentine economy, in particular the reduction in demand for manufactured products, will contribute to preventing industrial production from sustaining the expected improvement in the January figures. The slowdown in exports, particularly shipments of motor vehicles and auto parts, will likely contribute to weaker performance in the industrial sector in 1Q14. Also, the deceleration in Argentina may be even more intense than anticipated, and financial conditions in Brazil may also be affected.

The impact of higher electricity costs on the economic activity scenario for 2014 will depend on the evolution of weather conditions. The increase in electricity costs in the spot market will have little impact on economic activity this year if the rainfall picks up to close to its historical average in the next months, as we consider in our base case scenario. However, even in this scenario, it could have more intense effects over shorter periods of time (such as a month or a quarter). The hike in electricity costs in the spot market may lead to a reduction in output in some manufacturing sectors – either because production has become more expensive or because the return from trading contracted energy has exceeded the return obtained by producing goods.

In the credit market, indicators showed a recovery in December. In the final month of 2013, the daily average of new non-earmarked loans rose by 4.6% mom/sa in real terms, with gains of 7.8% in consumer loans and 3.3% in corporate loans. Overall delinquency declined again, reaching 3%, although delinquency in non-earmarked consumer loans increased slightly, to 6.7% from 6.6%. Both interest rates and spreads slid. Total outstanding loans kept widening as a share of GDP, reaching 56.5%. The market share of state-owned banks also continued to increase, to 51.2% from 50.9%. However, annual growth in the balances of state-owned banks has been decelerating since July.

Reservoirs: Unfavorable weather points to higher usage of thermal power plants in 2014

Hot and dry weather in early 2014 has reduced generation by hydropower plants and increased electricity usage. Hydroelectric reservoirs started 2014 at 42.8% of capacity[1], higher than in early 2013 (30.5%) but lower than the average of the past 10 years (52.6%). Hence, the system had a wider safety margin than last year. Some thermal power plants with higher operational costs had been turned off during the second half of 2013 as reservoir levels got closer to seasonal norms. From January to mid-February, however, temperatures were much higher than the seasonal pattern and rainfall was far below normal (50% of the historical average), affecting the energy balance through two channels: i) less generation by hydroelectric plants and ii) higher electricity consumption. This year to date, hydropower generation is considerably below potential: natural affluent energy (NAE) was 70.4% of its long-term average (LTA, or the amount of energy generated under historical hydrological conditions) in January and stands at only 41.2% of LTA so far in February. In addition, unseasonably warm temperatures drove average electricity consumption to a 10.6% yoy increase in January, up from approximately 3% yoy in 4Q13.

Reservoirs have fallen to lower levels than in 2013. With low hydropower generation and higher demand, reservoir levels are falling, counter to the normal seasonal pattern of accumulation throughout the rainy period (December through May). Hence, thermal power plants with high operational costs are once again being used, and the debate over possible rationing is heating up again.

Thermal power usage is up again and will likely remain high. As noted above, low reservoir levels have pushed thermal plant usage back up. Capacity has increased from last year, so that the system’s capacity to offset low hydro generation is higher, but the capacity comes at a hefty cost. Specialists expect normalization of weather conditions in late February. Rainfall following the historical pattern starting in March would reduce the risk of rationing. However, even with possible normalization of weather conditions ahead, the dry weather early in the year will likely dampen hydropower generation until April. Hence, reservoir levels will probably rise slowly over nearly the entire rainy season, leading to reservoirs ending the period at low levels. An intense usage of thermal plants (higher than in 2013) will therefore likely be needed throughout the year.

Higher usage of thermal plants comes with higher costs. A more intensive usage of thermal power plants (for instance, average generation 3 GW above its 2013 level) would raise the cost paid to power distributors (by approximately 20 billion reais, in this example), which may be offset by government subsidies or tariff hikes. The government budget for 2014 already sets aside 9 billion reais for the Energy Development Account (CDE), but this amount will likely not be enough to cover the additional costs. The government’s current message is that it intends to minimize tariff hikes by entirely or partly covering the extra costs. We will thus incorporate into our scenario additional fiscal costs to subsidize the CDE.

Favorable external factors hold back depreciation in the real

We maintain our forecasts for a year-end exchange rate of 2.55 reais to the dollar in both 2014 and 2015. This year, the real weakened less than most of its peer emerging-market currencies, thanks to Brazil’s more restrictive monetary policy, its USD auctions in the futures market and external fundamentals, especially negative net external debt. These favorable factors – Brazil’s large reserves and its foreign debt profile (low and predominantly private debt, with long-term maturities and fixed rates) – should curb the contagion from the turmoil in other emerging markets. Another factor supporting our unchanged year-end forecasts for the exchange rate is our view that recent turmoil in emerging economies will be temporary. 

For 2013, the current account deficit was 3.7% of GDP. The December reading was marked by a continuation of the gradual decline in the service deficit (USD 4.2 billion) and large remittances of profits, interest and dividends (USD 7.5 billion). In the capital account, foreign direct investment totaled USD 6.5 billion in December and USD 64 billion (2.9% of GDP) in 2013, in line with USD 65 billion in the previous year. However, the breakdown of inflows in 2013 was less benign than in 2012, as only 65% of inflows involved equity capital transactions, compared with 81% in 2012.

The economic slowdown and sharp currency depreciation in Argentina will likely have negative consequences for Brazil’s trade balance. Argentina is the main destination for manufactured products made in Brazil, particularly motor vehicles and auto parts. Although exchange rate depreciation may be partly offset by customs controls, Argentina’s importance as a trade partner and the magnitude of the expected slowdown there (we estimate a contraction of 3% in GDP) mean that this move will almost certainly affect Brazil’s trade balance. We estimate the loss at USD 1 billion, so that the expected surplus for 2014 is now USD 6 billion (down from USD 7 billion previously). We have changed our forecast for the 2014 current account deficit to 3.6% of GDP from 3.5% due to a lower trade balance and GDP growth expectations.

The retreat in inflation early in the year is likely to be temporary

Brazil’s consumer price index, the IPCA, climbed by 0.55% in January, below our estimate (0.60%) and that of the market consensus (median of 0.61%). The result was also lower than one year earlier (0.86%), slowing the year-over-year change to 5.59% from 5.91% as of the end of 2013.

In our view, a significant portion of the slowdown in inflation in January is related to temporary factors, such as cuts in airfares and lower prices for some fresh fruits and vegetables. Airfares fell by 15.9% in January, as opposed to a 5.1% gain one year earlier. Likewise, the food component comprising tubercles, roots and legumes slid by 0.9% in January 2014 after having risen by nearly 20% in January 2013. We would highlight lower prices for tomatoes (-10.6%) and potatoes (-4.5%), in contrast to the sharp increases early last year (26% and 21%, respectively).


Our assessment that the early-year drop in inflation has been driven by temporary factors has led us to keep our 2014 forecast for the IPCA at 6.2%. Our preliminary forecast for February now stands at 0.67%, slightly higher than February 2013 (0.60%). For 1Q14, we expect IPCA inflation of 1.83%, compared with 1.94% in 1Q13. On one hand, there will be no repetition of the cut in electricity tariffs of early last year (which lowered the IPCA by 0.60 pp). On the other hand, the price behavior of food should partly offset this effect, with food prices rising by 2.1% in 1Q14, according to our estimates, compared with 4.6% in 1Q13. Transportation costs should also provide some inflation relief in 1Q14, given that fuel prices, which were adjusted early last year, are unlikely to rise now. In the education component, preliminary information points to slightly larger increases in tuitions than last year at this time, particularly in college-level courses (the sub-item with the greatest weight in the IPCA). Slower economic growth this year so far has not affected our inflation forecasts for the full year of 2014 because the unemployment rate has not shown significant changes.

We have maintained our 2014 forecast for market-set prices and slightly raised our estimate for regulated prices. We still forecast 6.7% inflation for market-set prices (vs. 7.3% in 2013), with smaller increases in food and service prices. We expect a 6% hike in food consumed at home (vs. 7.6% in 2013) and an 8.2% increase in service costs (vs. 8.7% in 2013). These segments account for two-thirds of the weight of market-set prices and slightly more than half of the IPCA weight. Regarding regulated prices, we adjusted our estimate to 4.7% from 4.5% (vs. 1.5% in 2013), incorporating a 9% increase in urban bus fares in Rio de Janeiro.

Our IPCA forecast for 2015 has been revised downward to 6.0% from 6.2%, due to an upward revision in our estimate for the benchmark Selic rate and downward revision in our GDP forecasts.

Our forecast for the general price index IGP-M still points to a 5.8% increase this year, vs. 5.5% last year. We estimate that producer prices (IPA-M) will climb by 5.5% in 2014, with industrial prices rising by 6% and agricultural prices rising by 4%. Despite the pressure arising from a weaker exchange rate, the hike in the IPA should be cushioned by the expected decline in prices for soybeans (grain and meal) and iron ore. As for the other components in the IGP-M, we expect gains of 6% in the IPC-M and 7.7% in the INCC-M.

Fiscal accounts: we maintain our forecast for the primary budget surplus in 2014, but with a different breakdown

The primary balance for the consolidated public sector was 10.4 billion reais for December 2013, or 2.5% of monthly GDP. This reading was in line with the 2.4% average for the month of December in the post-crisis period (2009-2012). The conventional consolidated primary balance (not adjusted for accounting or economic cycles) for 2013 was 1.9% of GDP (91 billion reais), down from 2.4% of GDP (105 billion reais) for 2012.

Although the central government met its fiscal target for 2013 (73 billion reais, or 1.5% of GDP), the fiscal performance of the public sector last year was the worst since the beginning of the historical series (2002). There was deterioration in every sector of government. Overall, the data point to an expansionary fiscal stance. The recurring consolidated primary surplus (which excludes atypical revenues and expenses[2]) over 12 months was 1.0% of GDP in 2013, also one of the lowest results in the historical series (2012: 1.8%).

Despite the effect of tax breaks, which caused federal tax revenues to slide by 0.3 pp from 2012 (to 20.9% of GDP), the hike in total federal spending (to 18.8% of GDP from 18.3%) was the main driver of the decline in the fiscal surplus. The increase in central government expenses came largely from transfers and administrative expenses, showing that incentives for aggregate investment are still low. Capital expenditures by the central government (including spending on the low-income housing subsidy program known as Minha Casa Minha Vida) receded to 1.3% of GDP in 2013 from 1.4% in 2012.

In 2014, the fiscal situation will be complicated by a tougher scenario in terms of revenues, reflecting the likelihood of slower growth in economic activity this year and the adverse base-effect created by high extraordinary revenues in 2013. Regarding spending, several constraints on an adjustment in federal expenses in the very short term (for instance, tied expenses) are also likely to weigh on fiscal performance this year.

We are leaving our forecast for the 2014 consolidated primary budget surplus unchanged at 1.3% of GDP (central government: 1.1%), but we expect a slightly different breakdown relative to our previous scenario. We have lowered our estimate for 2014 federal tax revenues by 0.2% of GDP, to 21.0%, due to our expectation of slower economic activity in 2014. We have lifted our forecast for federal expenses by around 0.2 pp, to 19.3%, to include larger subsidies for the electricity sector (through injections in the Energy Development Account, or CDE, totaling 15 billion reais) and larger administrative outlays. Our scenario also considers the possibility that part of the costs related to the higher utilization of electricity from thermal plants will be deferred through public credit instruments (i.e., quasi-fiscal subsidies).

On the other hand, we have also incorporated into our forecast for 2014 a higher volume of non-tax revenues (atypical revenues included), which we now forecast at 3.4% of GDP (up from 3.1% previously). We maintain our forecast for the primary balance of regional governments of 0.2% of GDP (2013: 0.3%). These numbers are consistent with a recurring primary balance coming in slightly below its 2013 reading (1.0% of GDP). Despite our expectation of a worsening fiscal effort in 2014, we think the government will signal greater caution in fiscal policy, as there will be less room to implement fiscal stimulus measures (given the scarce international liquidity and the threat of a sovereign-rating downgrade).

The government may announce a considerable adjustment when the budget-freezing decree known as contingenciamento is published (probably in the next few days). The spending freeze could amount to 40 billion reals, or 3.9% of total expenses set out by the budget law for 2014. (In 2013, the contingenciamento amounted to 28 billion reals, or 2.9% of expenditures written in the budget law for that year). However, problems during the year could lead to a re-estimation (and unfreezing) of spending in late 2014.

Copom: external scenario suggests a longer monetary policy cycle, while domestic scenario suggests a slower tightening pace

The external scenario may require a more conservative Brazilian monetary policy. The recovery in the U.S. economy and negative sentiment toward emerging economies have put pressure on the exchange rate, demanding more conservative monetary policy, particularly in countries where inflation is relatively high, as in Brazil. This situation may drive Brazil’s monetary policy committee (Copom) to hike the benchmark rate by another 50 bps at this month’s meeting.

On the domestic front, however, recent data indicate less pressure on inflation and lower growth. The IPCA reading in January and the result for industrial production in December indicate that there is less pressure on inflation and that growth remains weak. In recent weeks, the central bank’s Focus survey showed a decline in average market forecasts for GDP and IPCA in 2014. These trends favor a reduction in the pace of interest rate increases.

This difference between the external and domestic scenarios had been spotted by the Copom already. In the minutes of its last meeting, the Copom noted that it sees both more strength and more volatility in the external scenario, as well as a domestic situation that is more favorable in terms of inflation. This more favorable domestic situation will likely be read by the Copom as being a consequence of the monetary tightening cycle started in April 2013, which is relieving the inflationary pressures in the economy.

We maintain our forecast for a 25-bp increase in February, but we now expect the rate-hiking cycle to be extended through April. As the volatility in external markets has receded in recent weeks, we believe that domestic factors will prevail in the decisions by Copom members. Accordingly, we maintain our call that the Copom will slow the pace of rate increases to 25 bps at its February meeting. But we now believe that the Copom will also opt for an additional increase in April, in response to the more complex external environment. Therefore, we have revised our forecast for the year-end Selic rate to 11.00% from 10.75%.

However, if the external scenario deteriorates further before the end of the month, putting pressure on the exchange rate, the Copom may decide to keep the tightening pace at 50 bps at its next meeting.

We now expect higher interest rates in 2015: 12.00%. In order to ensure that inflation remains around current levels, we believe that the Copom will hike rates again in 2015. We anticipate a hiking cycle of 100 bps in the first half of the year pushing the Selic rate to 12.00%. In our previous forecast, we expected a smaller increase in 2015 that would drive the Selic to 11.50%.

Forecast: Brazil


Source: IMF, IBGE, BCB, Haver and Itaú


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