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Minimal adjustments going forward

November 11, 2014

The need for macro adjustments will probably set the tone for economic policy in the coming months.

• Macroeconomic adjustments are needed for a vigorous recovery in economic growth.

• Our scenario assumes a set of minimal adjustments needed to avoid economic deterioration, but they will not be enough to enable a vigorous growth recovery. For 2014, we revised our GDP growth forecast to 0.2% from 0.1%. For 2015, we reduced our estimate to 1.1% from 1.3%, but we acknowledge downside risks related to possible energy rationing, lower commodity prices and the execution of the needed adjustments.

• We have revised our call for the conventional primary budget surplus in 2014 to 0.2% of GDP from 0.5%. For the recurring primary surplus, our estimate was revised downward, to -0.4% of GDP from -0.2%. In order to avoid economic deterioration, the government will likely need to make a fiscal adjustment to reverse the decline in the primary surplus. For 2015, we anticipate a meaningful fiscal adjustment, driving the official primary surplus to 1.2% of GDP, in a move that requires: i) changes in the tax rate applied to revenue sources such as the CIDE (tax on fuels) and the IPI (tax on industrialized products) and the introduction of new revenue tools; ii) tighter controls on unemployment aid and social security spending; iii) cuts in public investments; and iv) greater efforts by regional governments. 

• We expect a continuation of the stronger U.S. dollar and low commodity prices scenario, which has been pressuring the Brazilian real and other currencies since August. Hence, we revised our forecasts for the exchange rate to 2.50 reais per dollar in 2014 and to 2.70 in 2015.

• We anticipate a 6.5% increase for the consumer price index IPCA this year, in a reading that would be 0.6 pp higher than last year’s (5.9%). Breaking it down, we expect advances of 6.8% for market-set prices and 5.2% for regulated prices. Our IPCA forecast for 2015 was revised upward, to 6.5% from 6.4%, with increases of 6.3% for market-set prices and 7.2% for regulated prices. The revision in our 2015 estimate followed the incorporation of a weaker currency, partly offset by lower commodity prices and by the effects of a higher benchmark interest rate.

• In its October meeting, the central bank’s Monetary Policy Committee (Copom) surprised the market by lifting the benchmark Selic rate by 25 bps, to 11.25% per annum. We now foresee an additional 25-bp increase in December, taking the Selic to 11.50% by year-end. Looking ahead, we believe that the Selic rate will reach 12.00% at the beginning of 2015. The aim is to ensure that inflation remains under control in the face of exchange rate depreciation and the need for realigning administrative prices.

Macroeconomic adjustments are needed for a vigorous recovery in economic growth 

The need for macro adjustments will probably set the tone for economic policy in the coming months. We anticipate minimal adjustments in economic policy to avoid a downturn. External accounts, as measured by the current account deficit, remain at uncomfortable levels, despite weakness in domestic demand. If extended, deterioration in fiscal accounts, expressed by the steady decline in the primary surplus since 2012, will generate material risks for the economy. Inflationary pressure persists due to the adjustment in relative prices (exchange rate and regulated prices), requiring careful attention so as to avoid secondhand effects. A new monetary-tightening cycle seems to have started, based on the Copom meeting of October 29.

Our forecasts assume that the government will go ahead with the needed and sufficient adjustments to avoid economic deterioration. However, our forecasts do not envision adjustments and reforms that would enable a vigorous recovery in economic growth.

The scenario of minimal adjustments is a necessity. In the past, the government was forced to change course when its initial choices did not produce the desired results – as was the case with airport and highway concessions and electricity tariffs earlier this year. Now it is vital to ensure a fiscal adjustment that is enough to avert a downgrade of Brazil’s sovereign credit rating. It is also necessary to allow a realignment of relative prices, favoring regulated prices and tradable goods, while monetary policy remains alert to its commitments under the the inflation-targeting regime.

Deep economic adjustments are needed to resume vigorous growth, but they mean hefty costs in the short term. Policymakers face difficult trade-offs between opposing goals. For instance, a hike in indirect taxes on fuel consumption would contribute to the fiscal effort, but its impact on consumer price indexes could push inflation above the upper limit of the target range and, thus, narrow the room for an increase in fuel prices at refineries, which, in turn, would help Petrobras. Also, the more intense the depreciation of the real, the more difficult this trade-off becomes, because a weaker currency widens the gap between domestic and international fuel prices.

Fiscal policy: We have revised our call for the official primary budget surplus in 2014 to 0.2% of GDP from 0.5%. For the recurring primary surplus, our estimate was lowered to -0.4% of GDP from -0.2%.

The public sector had a primary deficit of BRL 25.5 billion in September (our forecast and market consensus pointed to a deficit of BRL 12.5 billion). The disappointment was due to deficits of BRL 21 billion for the central government, BRL 3.1 billion for regional governments and BRL 1.4 billion for state-owned companies. In the first nine months of the year, the public sector accumulated a primary deficit of BRL 15.3 billion. The last-12-month official primary surplus slid to 0.6% of GDP from 0.9%. Our estimate for the recurring primary surplus (excluding atypical revenues and expenses) has been lowered to -0.5% of GDP from -0.1%.

Behind the biggest surprises in relation to our call were the significant pickup in discretionary spending (capital expenditures and other administrative expenses) and the large deficits posted by regional governments. The central government’s total revenue has been relatively stable in real terms during the year, while expenses are up 5.3%. Thus, the decline in the primary surplus is being driven by the impact on revenues of the slowdown in economic activity and tax cuts, as well as by the still-expansionary fiscal stance in terms of expenditures. According to the table below, central government expenses accumulated over the last 12 months are up by 0.7 pp of GDP in 2014. Other administrative and capital expenditures, which offer greater flexibility for adjustments in the short term, contributed an increase equivalent to 0.6 pp of GDP.

Net debt remains stable due to exchange-rate depreciation, but gross debt is still on the rise. The last-12-month public sector nominal deficit climbed to 4.9% of GDP in September from 4.0% in August, due to the slide in the primary surplus and to the increase in interest expenses, which went up to 5.5% of GDP from 5.0%. Interest expenses were affected by an unfavorable result of BRL 18.4 billion in FX swap transactions. The public sector’s net debt as a share of GDP remained stable (35.9%) because the favorable balance sheet valuation adjustment, coming on the heels of currency depreciation, offset the effect of the nominal deficit. This is a temporary effect, however, and given the low level of the primary surplus, net debt will soon begin an upward trend. The general government’s gross debt rose to 61.7% of GDP in September from 60.1% in August.

In light of these recent results, we have revised our forecast for the official primary budget surplus in 2014 to 0.2% of GDP from 0.5%. For the 2014 recurring primary surplus (excluding non-recurring revenues and expenses), our estimate has been lowered to ‑0.4% of GDP from -0.2%. These estimates assume a slowdown in discretionary expenditures in the final months of the year, some recovery in tax revenues, and about BRL 20 billion in non-recurring revenues in 4Q14.

For 2015, we anticipate a meaningful fiscal adjustment which would push the official primary surplus to 1.2% of GDP, a level which we regard as the minimum needed to prevent an economic downturn. This task requires: i) GDP growth of 1.1%; ii) changes in tax rates of revenue tools such as the CIDE (a tax on fuels), the IPI (a tax on manufactured items) and others; iii) tighter spending controls on unemployment aid and social security; iv) a cut in public investments; and v) stronger efforts by regional governments.

Persistent pressure on the real will likely lead to further depreciation

Responding to a strengthening move in the U.S. dollar, the real depreciated about 12% since late August, weakening to about 2.55 reais per dollar from 2.25. Recent months were marked by stronger economic figures and the prospect of interest-rate increases in the U.S. next year. Additionally, the drop in commodity prices put pressure on the currencies of exporters of these products, as was the case for Brazil.

In our view, the dollar will remain strong and prices of the major commodities in 2015 will remain on average below those observed in 2014. After incorporating these developments and recent currency moves, we have revised our exchange-rate forecast. We still foresee a more depreciated real in the coming years, but we now project even weaker levels than we did in our previous scenario. Our year-end estimates now stand at 2.50 reais per dollar for 2014 (vs. 2.40 previously) and 2.70 reais per dollar for 2015 (vs. 2.50 previously).

The trade balance posted a deficit of USD 1.2 billion in October. Price drops for the main commodities exported by Brazil as well as weak economic growth in major trading partners put pressure on exports, which are down 4.2% year-to-date. After incorporating the latest figures, we have reduced our call for the trade surplus in 2014 to zero from USD 2.5 billion. We anticipate some improvement in 2015 due to a weaker currency and a partial recovery in the global economy, which we expect to lead to a surplus of USD 7.2 billion.

The last-12-month current account deficit reached 3.7% of GDP in September. For the month, the deficit totaled USD 7.9 billion, with negative contributions from the trade balance as well as the services account. We have revised our current account deficit forecasts to USD 84 billion (from USD 82 billion previously) in 2014 and to USD 76 billion (from USD 77 billion previously) in 2015. In terms of financing, foreign direct investment (FDI) has remained robust this year, despite some moderation in the past month (to USD 4.2 billion). Based on the latest figures, we have raised our estimate for FDI in 2014 to USD 62 billion (from USD 60 billion before).

Copom resumes the tightening cycle: the size of adjustment depends on the exchange rate

The central bank resumed increasing interest rates, a movement that we expect not to be interrupted through this year. We believe that the Selic rate will reach 12.00% at the beginning of next year. The aim is to ensure that inflation remains under control in the face of exchange rate depreciation and the necessity of administrative prices realignment.

The Brazilian Central Bank’s Monetary Policy Committee (Copom) surprised the markets and increased the benchmark interest rate (Selic) by 25 basis points to 11.25% p.a. It was a split decision, with five members voting for an increase and three voting to maintain the Selic rate at 11.00%.

In the post-meeting statement and in the meeting minutes, the Copom stated that the intensification of relative price adjustments has worsened the balance of risks. For the Copom, inflation remains high, partly due to the occurrence of two important relative price adjustments now underway in the economy – the realignment of domestic prices relative to international prices and the realignment of regulated prices. Since its last meeting in September, the committee notes that there has been an “intensification” of these adjustments, leading to deterioration of the balance of risks for inflation. In our view, this is the reason that the Copom has resumed the tightening cycle.

We believe that the Copom’s mention of the risks of intensification of relative price adjustments refers primarily to the recent depreciation of the exchange rate. The exchange rate considered by the Copom for inflation forecasts rose from 2.25 reais to the dollar in the September minutes to 2.50 reais to the dollar in the October minutes.

The inflation outlook also depends on the fiscal policy. In the minutes, the committee affirmed that it identifies “evidence of fiscal stimulus in the composition of aggregate demand this year”, but asserts that “the public sector balance tends to move into a neutral zone” on the relevant monetary policy horizon. The Copom emphasizes that its central scenario for inflation takes this trend into account.

The Copom stated that the decision aims to ensure “a lower cost” of disinflation. Thus, the Copom signals that it is acting preemptively: a prompt – and possibly smaller – adjustment in interest rates would prevent a larger increase in the future in order to keep inflation within its target range.

Three members of the Copom voted to maintain interest rates “at this moment,” arguing that there is uncertainty regarding the maintenance and persistence of relative price adjustments. This suggests there was no disagreement in the committee on the need to increase interest rates under the current conditions, but that part of the committee preferred to be more certain that the exchange rate depreciation that already occurred is persistent, before deciding to increase interest rates.

Looking forward, we now expect the rate hikes to continue at the current pace, bringing the Selic rate to 12% in 1Q15. Our base-case scenario forecasts the exchange rate at 2.50 reais to the dollar at the end of this year. Under these circumstances, the Copom will likely continue to increase the Selic rate at the current pace, bringing the Selic rate to 12% per year. However, the Copom warned that it is “especially vigilant,” which, in our view, indicates that it may increase the hiking pace if the exchange rate continues to depreciate significantly over the coming weeks.

Activity remains weak; we forecast GDP growth of 0.2% in 2014

Recent data have shown a recovery that is still insufficient after the contractions registered in the two first quarters of the year. After sharp declines in several economic activity indexes in June, economic activity resumed positive growth rates at the margin in July and August, and possibly in September as well. Our diffusion index (based on a broad dataset that includes business and consumer confidence levels, retail sales, credit demand and other factors) showed increases in approximately 60% of its components in July, and a similar reading in August (56%). We expect a similar level in September.

Industrial production declined by 0.2% in September, after two consecutive increases since the end of the World Cup. Industrial output remained 0.4% below its May level (before the tournament), and went down by 0.2% qoq/sa in 3Q14.

The rebound in the service sector is also disappointing. Broad retail sales (including autos and construction material) fell by 0.4% mom/sa in August. Core retail sales climbed by 1.1%, but only offset the previous month’s 1.0% slide. Both broad and core sales remain at low levels and will likely have negative growth in 3Q14

In the short run, the fundamentals pose hurdles to a stronger rebound in economic activity. Consumer and business confidence remain at low levels, despite a small improvement in confidence among industrial, service and retail entrepreneurs in October. Job creation has been sluggish in recent months, while industrial inventories remain high, suggesting that there will be further adjustments in supply over the next few months. On the demand side, the expansion in the real wage bill is cooling off and is likely to curb growth in consumer spending.

We have revised our GDP growth forecast for 2014 to 0.2% from 0.1%. For 3Q14, taking coincident indicators into account, we have revised our call to 0.2% qoq/sa. For 4Q14, we now estimate a 0.3% gain, despite a better statistical carryover.

Our GDP growth forecast for 2015 has been revised to 1.1% from 1.3%. Growth will largely be driven by the resumption of normal investment levels, as well as a significant contribution from external demand. However, we see downside risks related to the possibility of deterioration in hydrologic conditions and a consequent implementation of power rationing, along with additional declines in commodity prices and the overall difficulty of executing the agenda of needed adjustments in economic policy.

Unemployment fell again in September. Extending the recent trend, the slide in the unemployment rate was caused by a sharp decline in the labor force, which offset a drop in employment. The average labor participation ratio (labor force/working-age population) in May-September was 55.8%. Although this is a much lower reading than in 2013 (57.1%), the shrinking of the labor force does appear to be slowing down. Given the recent downward path in employment, we foresee a moderate hike in the unemployment rate if the labor force starts growing again. We are thus leaving our 2014 year‑end forecast for the seasonally-adjusted unemployment rate at 5.4% (4.6% for the unadjusted series).

October was marked by extremely low rainfall levels in Brazil, so power generation by hydropower dams was seasonally weak. The weather conditions that were preventing rainfall in the central parts of the country have now changed, and the rainy season will probably start in November. Still, we foresee intense usage of thermal power plants for a prolonged period and a risk of rationing in 2015.

Non-earmarked loans are still weak. In September, the daily average of new non-earmarked loans fell by 2.1% mom/sa in real terms. The drop in outstanding non-earmarked loans steepened in real year-over-year terms to 1.9% (from -1.5% in August). Outstanding earmarked loans rebounded, with real growth picking up to 13.0% from 11.7%. The recovery was driven by earmarked loans granted to non-financial corporations, which grew by 9.4% in September, up from 6.6% growth in August, using the same metrics. Growth in earmarked loans granted to households continued to slow down (to 18.1% from 19.0%). The overall delinquency ratio slipped to 3.0% from 3.1%, as delinquency in earmarked loans granted to households declined to 1.6% from 1.8%. Delinquency rates for earmarked credit to non-financial corporations and non-earmarked loans remained stable.

We expect increases of around 6.5% for the IPCA in 2014 and 2015

The consumer price index IPCA climbed 0.42% in October, after rising 0.57% in the previous month. The latest reading was slightly below our call (0.45%) and the lowest of market expectations (0.44%). Market-set prices in the IPCA rose 0.43%, while regulated prices were up 0.38%. The largest upward contributions came from foodstuffs, housing and transportation. The IPCA is up 5.05% year-to-date (vs. 4.38% one year earlier), while the year-over-year change decelerated to 6.59% (6.75% in September). The adjustment in fuel prices (3% for gasoline and 5% for diesel at refineries) will likely have an impact of 0.08 p.p. on the IPCA distributed across November and December.

We expect the IPCA to finish the year up 6.5%, with increases of 0.6% in November and 0.8% in December. Last year, the IPCA rose 5.9%, as market-set prices climbed by 7.3% and regulated prices by just 1.5%. Our call for market-set prices (which represent 77% of the IPCA) now stands at 6.8% this year, providing a contribution of 5.3 pp to the overall IPCA. Our forecasts for its main components are 6.8% for food consumed at home (7.6% in 2013) and 8.3% for services (8.7% in 2013). Our estimate for regulated prices (23% of the IPCA) is an increase of 5.2%, with the main upward impacts coming from electricity tariffs and healthcare premiums. Regulated prices are set to contribute 1.2 pp to the IPCA in 2014, way up from 0.4 pp last year. The additional pressure on inflation this year reflects a 17% hike in electricity tariffs, compared with a drop of 15.7% in 2013.

Our IPCA forecast for 2015 has been raised slightly, to 6.5% from 6.4%. The increase takes into account a weaker exchange rate, partly offset by lower commodity prices and a higher benchmark interest rate. Although our estimates for inflation in 2014 and 2015 are the same, we foresee a different composition next year, with a smaller rise in market-set prices and a larger increase in regulated prices. Regulated prices are estimated to climb by 7.2%, driven by electricity tariffs, gasoline, urban bus fares and healthcare premiums. Tariff changes for public transportation and electricity may put more pressure on inflation early next year. Urban bus fares, which are behind the curve in some state capitals, are usually adjusted in the first months of the year. Regarding electricity tariffs, the system known as bandeiras tarifárias – which will adjust electricity tariffs according to the conditions for power generation – will go into effect in January. If the current red-flag situation continues in all regions of Brazil, the forecasted impact on the IPCA in January will be 0.25 pp. Our scenario for gasoline now assumes a smaller adjustment at refineries, given the reduction in the lag in relation to external prices, which is set to pave the way for a partial change in the CIDE tax on fuels. As for water and sewage tariffs, we believe that the bonus program to encourage water savings adopted by the São Paulo utility Sabesp will be extended into next year, in the face of a severe drought in the state and the need to restore reservoir levels. We have thus reduced our estimate for the sub-item comprising water and sewage tariffs to 7% from 12%. Our estimate for market-set prices stands at 6.3% in 2015, with smaller price increases for food consumed at home and for services. Regarding food, we expect a still-favorable scenario for agricultural supply, especially for grains, given the prospect of good crops and the recovery in global inventory levels. Tame grain prices this year and next year should also provide some price relief for animal protein and wheat byproducts. Prices for private services are set to slow down due to the accommodation in the labor and real estate markets, with a likely moderation in wage and rent costs.

The general price index IGP-M rose by 0.28% in October, after increasing by 0.20% in the previous month. The producer price index, IPA — the component with the biggest weight in the IGP-M – went up 0.23%, as industrial prices showed no change and agricultural prices climbed by 0.90%. The IGP-M is up by 2.05% year-to-date, while the year-over-year change slowed to 2.96% from 3.54% in September. Our preliminary estimate for the IGP-M in November is now around 0.9%.

We revised upward our call for the IGP-M in 2014 to 3.8% from 3.5%, considering the pressure on producer prices at the margin. Still, the reading would be much lower than last year’s 5.5%. The expected increase in producer prices in the next two months will reflect recent currency depreciation and price increases for some agricultural products. The producer price index is expected to go up by 2.4% (5.1% in 2013), according to our estimates, as industrial prices rise by 2.1% and agricultural prices increase by 3%. The main downward contributions to the producer price index are set to come from iron ore and the soybean complex (grain and meal). We estimate a 34% drop in iron ore prices, providing 1.3 pp of relief to the IGP-M for the year. We expect soybean prices to decline by 17%, providing a contribution of -0.6 pp to the IGP-M. The strongest upward pressure on the producer price index is likely to come from beef and coffee prices. As for the other components, the consumer price index (IPC-M) is set to climb by 6.6% in 2014 (vs. 5.5% in 2013), and the construction cost index (INCC-M) will likely rise by 6.8% (vs. 8.1% in 2013). For 2015, we anticipate a 5.7% increase in the IGP-M.



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