Itaú BBA - More challenges, lower targets

Brazil Scenario Review

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More challenges, lower targets

August 10, 2015

The scenario has proved more complex. We now forecast a longer recession and a weaker exchange rate.

• The scenario has proved more complex, further hindering the fiscal adjustment. The government reduced its fiscal targets. We forecast a primary result of 0.0% of GDP this year (target: 0.15%), 0.2% for 2016 (target: 0.7%), 0.6% for 2017 (target: 1.3%) and 0.8% for 2018 (target: 2.0%). In the absence of additional cyclical and structural measures, the gross public debt could reach 70% of GDP. The country may loose its investment grade status. 

• We reduced our GDP growth forecast for 2015 and 2016, indicating a longer recession. We now expect GDP to contract 2.3% in 2015 (-2.2% previously) and 1.0% in 2016 (-0.2% previously). We maintained our unemployment rate forecast at 8.0% by the end of this year but expect an increase to 9.3% in 2016 (previously, 9.0%).

• This scenario demand a deeper and faster correction of the current account deficit. We increased our exchange rate forecast to 3.55 reais per dollar by the end of 2015 (prior: 3.20) and 3.90 reais per dollar by the end of 2016 (prior: 3.50). 

• The currency depreciation puts greater pressure on prices. We raised our IPCA inflation forecast to 9.3% from 9.1% for 2015 and to 5.8% from 5.3% for 2016.

• The Brazilian Central Bank signaled the end of the tightening cycle in July, and the intention to maintain the Selic rate at current levels for an extended period. The riskier economic and political environment and its impact on the exchange rate limit room for interest rate cuts next year. We expect the central bank to keep the Selic rate at 14.25% for the remainder of 2015 and start reducing it only by the third quarter of 2016 (we previously expected a cut in the second quarter), bringing the rate to 12.25% by the end of the year (previously, 11.25%).

The harsh reality

The scenario worsened in July, further hindering the fiscal adjustment. The recession is spreading, political uncertainties have increased and investigations of the Lava Jato operation have deepened. This scenario further hurts tax revenues, both through the drop in activity and the difficulty of implementing additional measures.

In this environment, the government has been forced to significantly reduce its fiscal targets and admit execution difficulties going forward, which increases the chance that the country might lose its investment grade status.

The fiscal difficulties affect the balance of other economic variables. Financing conditions are likely to become less favorable, requiring an additional depreciation of the exchange rate. The weaker real puts greater pressure on inflation in 2016, limiting room for interest rate cuts next year. The recession will probably last longer, which in turn makes the fiscal scenario more difficult.

We believe that Brazil will continue to implement the adjustments necessary to rebalance the economy, but the path has been proving to be longer and harsher. Some of these efforts bring favorable results, such as the gradual decline of the current account deficit and the improvement of long-term inflation expectations. But the difficulty on the fiscal side requires additional effort in other areas. The road is steeper and rougher than most had anticipated, and the threat of losing investment grade status hangs overhead like a black cloud.

Fiscal accounts - Lower targets should lead to a faster increase in public debt

Despite the efforts, cyclical and structural problems have led to disappointing results in the first half of the year. The central government posted a primary deficit of BRL 1.9 billion in the first half of the year (the lowest reading of the series, started in 1997) due to the drop in tax collection, the recognition of past spending and insufficient cuts in current expenditure. Regional governments posted a high surplus during the first half (BRL 19.3 billion), but the result tends to deteriorate during the second half, toward the 2015 target for states and municipalities (BRL 2.9 billion, or 0.05% of GDP). (See BRAZIL – Central government posts primary deficit in 1H15 and public debt remains on the rise)

The government reduced its fiscal targets and has been signaling a smaller adjustment ahead. In July, the government announced a significant reduction in fiscal targets. It indicated that there is limited room for tax increases, making it difficult to reach the surplus targets, especially given the rigidity of public spending. In addition, the National Treasury intends to loosen loan authorizations to regional governments in the second half.

Fiscal difficulties add to the uncertainty over the economy, leading to an extension of the economic recession (see the section in this report on economic activity, below), hindering tax collection and the public accounts results, in a vicious circle.

In light of this scenario, we forecast a primary surplus of 0.0% of GDP this year (target: 0.15%), 0.2% for 2016 (target: 0.7%), 0.6% for 2017 (target: 1.3%) and 0.8% for 2018 (target: 2.0%). Even this trajectory remains challenging and requires ongoing fiscal adjustment, with a focus on extraordinary revenues – such as sales of public-sector assets and the regularization of undeclared assets abroad – and on cuts in discretionary spending and public investment. We estimate that an additional effort of 2.0% of GDP may be necessary to generate our primary surplus forecasts by 2018. In the absence of additional measures, the tendency is a drop in the primary surplus, mainly due to the increase in social security spending (see Macro Vision – Fiscal Adjustment: how much more to go?). Our forecasts consider a moderate recovery in economic activity for 2017 and 2018.

Gross public debt may reach 70% of GDP by the end of next year. The low primary surplus, the steeper and longer recession and higher interest rates over the coming years (see section on monetary policy below) indicate a more rapid increase in public debt.  We now estimate that the gross debt will reach 65.0% of GDP this year, 70.0% next year, 72.5% in 2017 and 74.0% in 2018. The chart below compares the public debt projection under this new trajectory compared with what would have been observed using the previous targets and the current targets, always using the macroeconomic parameters (GDP, interest rates) of our current scenario.

Recession extends to 2016

Indicators suggest that the recession will continue through the second half. Our diffusion index – based on a broad set of data, including consumer and business confidence, retail sales and demand for credit – remains at a level that is compatible with contraction of economic activity over the coming months. In June, the twelve-month moving average will probably reach its lowest level since 2009. In the past three months, the diffusion is even lower, consistent with a drop in GDP of about 6% annualized.

Household consumption, one of the main drivers of growth in recent years, is losing strength. Retail sales, which expanded at an average rate of 7.0% per year over the past eleven years, are expected to decline about 3% in 2015. The weakening observed throughout 2015 also affects growth next year, as the starting point is lower (statistical carry-over).

Business and consumer confidence remain at record-low levels, and industrial production will likely continue to decline. In July, business and consumer confidence indicators in the Service, Trade and Construction sectors receded again, reaching new record lows. Confidence in the Industrial sector posted a slight increase (1.5%) but remains at low levels. Inventories in the Industrial sector are at their highest level since 2009, suggesting that the drop in output has not been enough to offset the weaker demand. We expect a continued decline in industrial production in the coming months.

Credit remains weak in June. The daily average of non-earmarked new loans fell by 3.3% in real terms, mom/sa. In the opposite direction, earmarked new loans grew by 5.1%. Total credit outstanding continued to slow down: real annual growth fell from 1.6% to 0.9%. In the same comparison, non-earmarked outstanding loans continued to recede (-3.6%), and earmarked credit moderated from 7.4% to 6.1%. The system's delinquency rate remained virtually flat. The system's interest rate and spread increased.

The risk of losing investment grade status and the high level of interest rates for a longer period (see section on monetary policy below) are pressuring borrowing costs and will likely affect investment. We expect gross fixed capital formation to post its third consecutive annual drop in 2016, something that has not occurred since 1996, the beginning of the time series used by the IBGE's Quarterly National Accounts.

Faced with these daunting conditions and additional risks, we reduced our GDP growth forecast for 2015 and 2016 to an extended recession scenario. We now forecast a contraction of 2.3% of GDP for 2015 (-2.2% previously) and a contraction of 1% of GDP for 2016 (-0.2% previously). The implementation of adjustments is proving harder than we anticipated, increasing uncertainty over the economy and hindering the economic recovery. Costs still at high levels restrict an expansion of supply in the economy.

Weaker activity will probably lead to a further increase in unemployment in 2016. Unemployment increased from 6.3% in May to 6.4% in June (our seasonal adjustment). The other labor market indicators suggest that the labor market continues to weaken. In the formal market (CAGED), net job destruction reached 146,000 jobs in the average of the past three months ended in June (seasonally adjusted). The result was widespread across sectors and regions of the country. FGV's July survey showed the proportion of people reporting difficulty in finding employment increasing for the seventh consecutive time. In this environment, we expect an increase in the participation rate (ratio between the economically active population and the working-age population) over the coming months, due to the decrease in real household income and contextual uncertainties. Thus, we have maintained our forecast for the unemployment rate at 8.0% by the end of this year, and we have increased it to 9.3% for 2016 (previously 9.0%).

Electric power - Favorable development

The electric power balance has improved in Brazil over the past four months. We estimate that the seasonally adjusted reservoirs advanced from 18% to 35% of capacity between March and July.

This improvement is a combination of three factors. First, the El Niño phenomenon is affecting the volume of rainfall in the South and parts of the Southeast, causing rainfall above the historical level in the average of the last three months. Second, electricity consumption is weak as a result of the modest activity performance and the increase in regulated market tariffs. Finally, the generating capacity of wind-power plants has strongly increased over the year.

Reservoirs are likely to reach the end of the year at higher levels than last year. Thus, we will probably start 2016 with lower rationing risks and the possibility of change in the tariff flag, despite the inefficiencies of hydroelectric plants and delays in generation growth.

However, there is still the risk that generator losses are spilled over to tariffs. Companies are managing to avoid payments to the CCEE (electric energy trading chamber) by means of injunctions, which is forcing the regulator to redefine the regulatory framework in order to reduce uncertainty in the sector. A possible pass-through to tariffs may offset part of the decline associated with the lower use of thermal plants next year.

Tighter financing conditions, weaker exchange rate

The revision of fiscal targets, the political uncertainties and the risk that Brazil loses its investment grade status added pressure to the currency market. In less than a month, the real depreciated from 3.10 per dollar in late June to more than 3.50 per dollar.

The difficulties of this scenario require a steeper and faster correction in the current account deficit. We revised our exchange rate forecast to 3.55 reais per dollar by the end of 2015 (compared with 3.20 before) and 3.90 reais per dollar by the end of 2016 (compared with 3.50).

Recent data indicate a faster adjustment in the current account but also tighter financing conditions. In the first half of the year, the current account deficit declined 23.4% yoy (USD 38.3 billion vs. USD 50 billion). The trade surplus, combined with the reductions in international travel and transportation deficits and the decline in profit and dividend remittances, explain the improvement. On the financing side, both direct investment into the country and foreign portfolio investments continue to decline. Direct investment fell from 4.1% of GDP in early 2015 to 3.8% of GDP at the end of the first half of 2015. Portfolio flows, in turn, dropped from 1.4% of GDP to 1.3%.

We now forecast a faster adjustment in the external accounts. We believe that the more depreciated exchange rate combined with slower activity will likely help to further contain the import of goods and services, resulting in a higher trade surplus and a lower current account deficit. Lower oil prices also help the process. We raised our forecast for a trade surplus of USD 5 billion in 2015 (compared with USD 4 billion) and USD 13 billion in 2016 (compared with USD 8 billion). For the current account, we reduced our forecast to a deficit of USD 76 billion (from USD 79 billion) and USD 54 billion for 2016 (compared with USD 69 billion).

A more depreciated exchange rate puts pressure on inflation

The Extended National Consumer Price Index (IPCA) increased 0.62% in July, slightly above our estimate and the median of market expectations (0.60). The largest upward contributions during the month came from housing - partly due to a sharp increase in the electricity - and food and beverages group. Hence, the IPCA went up 6.83% year to date, already surpassing the upper limit of the inflation target for 2015. Year over year, the IPCA rose by 9.56%, compared with 6.50% in the same period last year.

For August, our preliminary forecast indicates an increase of 0.27%. The slowdown in inflation over the previous month will come from lower increases in electricity, food consumed at home and water and sewage tariffs, in addition to the expected drop in airfare, after a slight rise in July.

For 2015, we raised our IPCA inflation forecast from 9.1% to 9.3%, given the revision in our exchange rate outlook. The forecast for market prices increased from 7.4% to 7.6%. The impact to the rise in market prices will be 5.9 pp in the IPCA for the full year. We now forecast a variation of 10.5% for food-at-home inflation, up from 10% previously (7.1% in 2014). The higher pressure on prices of this subgroup this year reflects the impact of different shocks on production costs (exchange rate, energy and fuel), as well as the effect of climate problems on the supply of some products, especially meats and fresh fruits and vegetables. For services, we slightly increased our projection for this year from 7.7% to 7.8% (8.3% in 2014). In this regard, we stand by our view that the worsening labor-market conditions and the real estate sector – which has been proving true – with the consequent moderation in wages and rents, will likely contribute to the drop in private services inflation this year, and more intensely for 2016. For industrial-sector prices, we adjusted our forecast from 5.4% to 5.5% this year (4.3% in 2014).

For regulated prices, we forecast a 15.0% increase this year, with an impact of 3.4 pp on the IPCA. The largest contribution among regulated prices will come from electricity (1.5 pp), with an expected 51% increase. For the other regulated prices with greater weight on inflation, we anticipate the following changes for 2015: gasoline (10%); health insurance (12%); urban ​​bus fares (13%); water and sewage tariffs (13%); medicine (6%); and fixed telephone services (-3%).

The more depreciated exchange rate led us to raise our IPCA inflation forecast also for 2016, from 5.3% to 5.8%. This effect will more than offset the relief provided by the expectation of weaker activity and higher unemployment. We increased the projection for market prices next year from 5.0% to 5.7%. We adjusted our forecasts from 3.5% to 4.6% for industrial prices, from 5.0% to 6.0% for food consumed at home, and from 6.0% to 6.3% for services. In our view, the slowdown in services inflation tends to be steeper than expected this year, given the prospect of a worsening labor market. In the case of food, we continue to work with more favorable weather conditions than in previous years, which will likely mean better grain harvests for major global producers such as the U.S., Brazil and Argentina. For regulated prices, we maintained our forecast for a 6.3% increase in 2016, representing an impact of 1.5 pp in the IPCA, well below the 3.4 pp forecasted for 2015. Electricity will account for about two-thirds of the reduction in the contribution of regulated prices to inflation.

Despite the revision, we still anticipate a significant degree of disinflation in 2016. In addition to weak activity, other factors point in this direction. But there are risks. Among the factors contributing to disinflation, we highlight the prospect of better weather conditions and the significant reduction in regulated price increases, particularly electricity, as much of the adjustment in relative prices (between regulated and market prices, and between domestic and international prices) will have already occurred by then. On the other hand, an upward risk for inflation next year is the possibility that, given the need for increased tax collection, new tax increases directly or indirectly impact some prices of goods and services (market and/or regulated). Another risk is the recognition of liabilities in the Electricity sector, if they spill over to electricity bills – although the more favorable hydrological conditions could bring relief if they lead to changes in tariff flags throughout the year.

For 2017, we expect the downward trend for inflation to continue, with the IPCA reaching 4.8% in the year.

For the IGP-M, we raised our forecast for this year from 7.3% to 7.7% due to the more depreciated exchange rate, more than offsetting the downward revision in commodity prices. In disaggregated terms, we are now forecasting increases of 7.3% for the IPA-M, 9.3% for the IPC-M, and 7% for the INCC-M. For 2016, we raised the forecast for the IGP-M from 5.5% to 6.3%, also due to the new scenario for the exchange rate and commodity prices.

Monetary policy - Reduced room for interest rate cuts in 2016

In July, the Brazilian Central Bank (BCB) signaled the end of the tightening cycle, which has been in effect for over two years now (with a brief pause in mid-2014). In its post-meeting statement, the BCB said that the maintenance of the Selic rate at the current level of 14.25% for a "sufficiently long period" is "necessary" for the convergence of inflation with the target. The signal was confirmed in the minutes of the meeting.

In fact, the balance of risks for inflation over the medium and long term was improving. The economic recession, the weakening of the labor market and the recent decline in medium- and long-term inflation expectations were helping to improve the inflation outlook for 2016 onwards.

We still expect a significant deflation in 2016, but it will likely be weaker than in our previous forecast. Political and economic difficulties will probably cause further damage to the balance of risks. As a consequence, the room for monetary easing in 2016, in our view, has shrunk.

We expect the BCB to keep the Selic at 14.25% for the remainder of 2015.

 In 2016, we now expect the central bank to start an easing cycle only in the third quarter (we previously projected a cut in the second quarter), bringing the Selic rate to 12.25% by year-end (previously, 11.25%).

But there are risks to this outlook. The more complex scenario may lead to a weaker-than-expected exchange rate (overshooting), which could in turn cause the BCB to reconsider its plan to end the tightening cycle.


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