Itaú BBA - Lower Growth and Less Room to Maneuver

Brazil Scenario Review

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Lower Growth and Less Room to Maneuver

August 9, 2013

GDP expansion in 2013 should be lower, despite the expectation of faster growth in 2Q13.

•           Lower confidence levels among businesses and consumers point to lower economic growth. Economic constraints weigh on performance at the moment. Room for countercyclical policies is limited. We lowered our estimate for GDP growth in 2013 to 2.1% from 2.3%. For 2014, we cut our forecast to 1.7% from 2.2% due to the carry-over of slower growth in 2H13 and to the outlook for higher unemployment.

•           We changed our forecasts for the exchange rate to 2.30 reais per U.S. dollar by year-end and 2.40 by the end of 2014 from 2.18 in both cases. We reduced our estimate for the trade balance this year to zero from USD 6 billion.

•           Lower current inflation led us to cut our forecast for the consumer price index (IPCA) this year to 5.9% from 6.1%. For 2014, we see more uncertainty surrounding the inflation scenario. Due to lower economic growth and lower commodity prices, we reduced our inflation forecast to 5.8% from 5.9%.

•           We maintain our expectation that the Selic benchmark interest rate will reach 9.75% by year-end. Our forecasts for the primary budget surplus remain at 1.7% of GDP this year and at 1.1% of GDP next year.

Confidence declines and affects growth outlook 

GDP expansion in 2013 should be lower, despite the expectation of faster growth in 2Q13. We increased our estimate for GDP growth in 2Q13 to 1.0% from 0.8%. Industrial production ended the quarter up by 1.1% qoq/sa. According to our calculations, agricultural and livestock activity advanced more than 2% in the period. Despite the better picture for the economy in 2Q13, we lowered our estimate for GDP growth in 2013 to 2.1% from 2.3%. We expect a flat GDP in 3Q13 and a modest pickup in 4Q13.

Lower confidence among businesses and consumers and deterioration in financial conditions point to economic weakness in 2H13. Consumer confidence sank 4.1% mom/sa in July, after a series of weak readings (12 drops in 14 months). Confidence among industrial entrepreneurs fell 4.0%, while confidence in the service sector declined 6.4%. Volatility in asset prices, street demonstrations, persistently high inflation and uncertainties surrounding fiscal policy contributed to hurt confidence. Additionally, losses in the stock market point to a worse outlook for earnings. Hence, investment is becoming less attractive, while funding sources are becoming more restrictive. Risk premium increased while long-term yields climbed. In this environment, we expect a decline in capital expenditures throughout 2H13. Consumer spending, particularly on durable goods, should also slow down.

Carry-over and labor market conditions cause a further reduction in growth forecasts for 2014. The expectation of lower growth in 3Q13 (to zero from 0.5%) reduced by 0.3 p.p. the estimated statistical carry-over from this year’s GDP to 2014. Additionally, we expect the unemployment rate to increase due to lower growth in 2H13. As a result, the real wage bill and consumer spending should slow down. We cut our forecast for economic growth in 2014 to 1.7% from 2.2%.

In the credit market, new non-earmarked loans retreated in June, but earmarked loans continued to expand. Adjusting for the number of working days and seasonality, new non-earmarked loans dropped 5.5% during the month, in real terms. The downward trend in the growth of the stock of non-earmarked credit continues for both the consumer and corporate segments. Private banks have been losing market share, and state-owned institutions now account for more than half of all outstanding loans, in a situation last seen in 2000. Overall delinquency over 90 days past due fell 0.21 p.p. during the month, to 3.38%. For households, delinquency dropped for non-earmarked and earmarked loans as well. For companies, the drop was only observed among non-earmarked loans. Uncertainties surrounding the macro scenario and the sluggish economic recovery may hinder the rebound in new loans and prevent substantial declines in delinquency.

Economic constraints limit policy reaction to the slowdown. High and persistent inflation levels limit room for changes in monetary policy toward avoiding lower economic growth. Inflation has been close to the upper limit of the target range and inflation expectations have moved in the same direction. In this environment, even with a weaker economy, room for countercyclical monetary policy is restrained. The same goes for fiscal policy. The recurrent primary budget balance has been low. As the economy weakens, tax revenues will be lower. Hence, deterioration in the fiscal result limits the use of public spending as a channel to cushion the economic slowdown. An action in this direction could further hurt confidence and pressure risk premium, causing negative effects on economic activity in the short and, especially, in the long run.

Weaker currency

Short-term factors put pressure on the Brazilian real, but long-term variables also point to a weaker currency. The exchange rate depreciated again last month, outpacing 2.30 reais per dollar. The currency reacted mostly to higher yields in U.S. bonds. We re-assessed our assumptions for terms of trade, incorporating the drop in iron-ore prices and higher crude oil prices, among other factors, which negatively impact this indicator. Furthermore, the outlook for lower availability of external savings over the long term reinforces a scenario of a weaker exchange rate. We now forecast the exchange rate at 2.30 reais per dollar by year-end and 2.40 by the end of 2014, from 2.18 previously in both cases.

More favorable figures in the balance of payments in June. With a higher trade balance and a lower service-account deficit, the current-account deficit stood at USD 4 billion in June. The seasonally adjusted annualized three-month moving average for the deficit fell to USD 76 billion as of the end of June, from more than USD 90 billion in March. On the funding side, there was another positive surprise, as USD 7.2 billion entered the country as direct investments and the same amount was invested in the local fixed-income market, in response to the withdrawal of the IOF tax.

However, the deficit should widen again in July due to a negative surprise with the trade balance. The trade deficit reached USD 1.9 billion in July, driven mostly by crude-oil imports, amounting to USD 3.1 billion. Fuels continue to hurt Brazil’s trade balance, and the deficit involving fuels adds up to USD 16.7 billion year-to-date. Excluding fuels, the accumulated deficit of USD 5 billion in the trade balance would turn into a surplus of USD 11.7 billion. Therefore, we revised our estimate for the trade balance in 2013 down to zero from USD 6 billion.

As a result, our forecast for the current account deficit increased to USD 78 billion, or 3.5% of GDP (from 3.3%). In spite of the negative impact of terms of trade on trade balance, a weaker currency and slower economic activity should act positively on the current account balance next year. We forecast the gap at 2.9% of GDP in 2014.

Lower current inflation, but relevant risks in the future

Inflation decelerated in recent months, with lower-than-expected readings. After climbing 0.26% in June (6.7% yoy), the IPCA was flat in July, and the yoy rate declined to 6.3%, due to deflation in fresh fruits and vegetables (which have been reversing part of the sharp increases seen early this year) and public-transportation fares, as governments rolled back increases in bus and train fares in several state capitals. The decline of fresh fruits and vegetables prices may be extended until September, but the effect of cuts in public-transportation fares was one-off and ended in July.

We anticipate a gradual pickup of inflation to 0.3% in August and 0.5% in September, then to a monthly average of 0.6% in 4Q13. Higher inflation in the final quarter of the year will be driven by seasonal factors and by the impact of a weaker exchange rate.

We reduced our forecast for the IPCA this year to 5.9% from 6.1%. Favorable surprises with inflation at the margin (particularly a sharper deceleration in the food group) were behind this revision. This move is explained by a steeper price decline in fresh fruits and vegetables and more favorable behavior of grain prices (especially corn and soybeans). The revision in our forecast for regulated prices also contributed to a downward revision of inflation this year.

The inflation scenario for the next year is surrounded by uncertainties. On one hand, a still-heated labor market, increasing inflation expectations and high inflation may lead to greater pass-through of the currency devaluation than our models contemplate. The biggest risk is a pickup in inflation at the end of the year consolidating expectations at a higher level, or making the process of forming expectations more reliant on past inflation and less dependent on agents’ assessments about future economic conditions and the inflation target. On the other hand, lower growth and a cooling labor market may reduce service inflation.

For 2014, we have reduced our IPCA forecast slightly to 5.8% from 5.9%. Although there is a lot of uncertainty surrounding the effects of several variables on inflation next year, a slower economy and lower commodity prices should cause a slight retreat of inflation in 2014, even in a scenario of weaker currency. Still, greater inflationary inertia, inflation expectations above the target and greater risk of exchange rate pass-through are factors curbing the decline of inflation amid slower economic growth.

We expect less pressure on producer prices. A more-benign scenario for commodity prices also led us to lower our forecast for the general price index IGP-M to 4.6% from 5.0% in 2013 and to 5.5% from 6.0% in 2014.

Inflation risks persist and the Copom should continue to hike rates

Despite short-term relief in inflation and expectations of slower growth, we believe that inflationary risks persist. The effects of exchange-rate depreciation on prices are yet to show up, the unemployment rate remains low and inflation expectations are consolidating above the mid-point of the target. Thus, room for countercyclical maneuvering in monetary policy is compromised.

In the latest minutes and in other public communications, members of the monetary policy committee (Copom) re-affirmed their concerns with inflationary risks. The main reason for worry is currency depreciation and its impact on future inflation. Additional weakening in the Brazilian real in the past few days reinforces this concern.

Therefore, we believe the Copom will choose to continue its tightening cycle, sustaining the same tightening pace in order to reduce risks for inflation in 2014. We maintain our forecast of two more 50-bp hikes in the next meetings and a final 25-bp increase in November, driving the Selic to 9.75% p.a.

Limited room for additional fiscal stimuli

Extraordinary revenues contributed to a positive surprise with the primary budget balance in June. Boosted by a strong performance of regional governments, the consolidated primary budget surplus reached 5.4 billion reais (consensus: 3 billion) in June, or 1.3% of monthly GDP. Federal expenses (particularly administrative expenses) accelerated. However, thanks to non-tax revenues accrued by the central government (e.g., dividends, concessions and revenues received by public entities) and extraordinary intakes by regional governments (especially revenues received by São Paulo state in an amnesty program for renegotiation of tax debts), the result came out better than expected.

Despite a positive surprise, the primary budget balance in June stood below the average for the month in 2009-2012 (1.6% of GDP). The consolidated result over 12 months was stable, at 2.0% of GDP, with the recurring annual balance (adjusting for some atypical revenues) remaining at 1.5%. In both cases, the result is lower than the target of 2.3% of GDP set for 2013.

The government announced a revision in the budget, but revenues and contributions from regional governments forecasted in the budget still seem too high. On July 22, the federal government published its third bi-monthly budget revision for the year, blocking 10 billion reais in expenses planned in the budget law. This new package of spending cuts by the central government, following 28 billion reais retained in the budget review done in May, signals greater concerns by authorities regarding the impact of the recent fiscal expansion on inflation. However, despite the adjustment, the 2013 budget still relies on a high level of planned expenses (based on optimistic estimates for non-tax revenues). Furthermore, the estimated contribution from regional entities for this year’s surplus also assumes a very tough adjustment on state and municipal budgets.

We foresee a still-slow recovery of tax revenues this year. This expectation is valid for both the federal and regional governments. Tax breaks that are already in place (or approved) and a sluggish rebound in economic activity outline a scenario of low growth in revenues. A mighty effort to limit spending is needed (through new budget cuts or future restraints), in addition to a significant increase in other revenues, in order to achieve the primary balance target of 2.3% of GDP in 2013, as the government desires.

We expect the economic cycle to be even less favorable to fiscal policy in coming quarters. Given our downward revision for economic growth in 2013 and 2014, we reduced our estimate for tax revenues by 4 billion reais (0.1% of GDP) in 2013 and by 11 billion reais (0.2% of GDP) in 2014.

Public investment should expand more slowly to compensate lower tax revenues. Given that there is less room for sharper fiscal expansion (i.e., reduction in the reported primary budget surplus), as well as economic, political and operational difficulties to implement a hefty adjustment in accounts such as administrative spending and transfers in the short term, we forecast a lower volume of federal investment in 2013 and 2014. This implies less growth in central-government expenses than contemplated in our previous scenario. We now expect average spending to increase about 4% in real terms in 2013 and 2014 (previously: 5%). We maintain our estimates for the consolidated primary budget surplus at 1.7% of GDP this year and at 1.1% of GDP next year.

Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú

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