Itaú BBA - Some Adjustments

Brazil Scenario Review

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Some Adjustments

December 12, 2014

For a decade, the Brazilian economy benefited from favorable external and domestic conditions, which we no longer can rely on.

• To avoid a downturn in the Brazilian economy, macroeconomic adjustments are needed, with limited room for maneuvering. The adjustments must address a less favorable external scenario, limited economic growth, high inflation (with the need for adjusting regulated prices) and the deterioration in the fiscal and external accounts. Our scenario assumes that the government will implement an adjustment strategy, in line with the announcement of the new cabinet and statements by authorities.

• The fiscal adjustment announced by the new economic team is vital for rebalancing public accounts. We forecast an increase in the primary budget surplus to 1.2% of GDP in 2015, and we have increased our 2016 estimate to 2.0% from 1.8%, in line with the targets set by the new economic team.

• We forecast a weaker real in the coming years given external and domestic factors. We revised our forecast for the exchange rate to 2.60 reais per U.S. dollar by the end of the year (2.50 previously) and to 2.80 by the end of 2015 (2.70 previously). 

• GDP growth of 0.1% in 3Q14 was not enough to compensate for two consecutive quarterly declines in the first half of the year. We estimate 0.2% GDP growth in 2014. We expect continuing weakness in household spending in 2015 due to the slowdown in the real wage bill, and some improvement in gross fixed capital formation and higher net exports. We project GDP growth of 0.8% (down from a previous estimate of 1.1%).

• We forecast a 6.5% advance in the consumer price index IPCA this year, up by 0.6 pp from last year (5.9%). In disaggregated terms, we estimate increases of 6.8% for market-set prices and 5.4% for regulated prices. For 2015, we expect a material change in the composition of inflation. Our estimate for the IPCA in 2015 remains at 6.5%, with advances of 6.2% for market-set prices and 7.5% for regulated prices. Among market-set prices, we project increases of 7.2% for services; and 5.4% for tradable goods. Despite the expectation of stable inflation around 6.5% by year-end, we expect the year-over-year change to accelerate in the beginning of 2015 to 7.0%, driven by expected increases in January for electricity tariffs (due to the new tariff flags system), urban bus fares (adjustment in São Paulo) and prices for new passenger cars (higher IPI tax rate). 

• We expect the Selic to reach 12.50%, after a 50-bp hike in January and a final increase of 25 bps in March. The goal is to ensure that inflation stays under control, given the depreciation in the exchange rate and the need to increase regulated prices. We also expect a hiking cycle for the long-term interest rate (TJLP).


The Brazilian economy is adjusting to a new cycle

For a decade, the Brazilian economy benefited from favorable external and domestic conditions, which we no longer can rely on.

Externally, the economy benefited from substantial gains in the terms of trade and from expansive monetary policies in advanced economies. Growth in commodity demand from China led to a sharp increase in Brazil’s terms of trade, largely due to higher prices for iron ore and soybeans. The structural change in the Chinese economy will likely reduce its investment rate in the next years and is already impacting iron ore prices, which fell almost 50% in 2014 yoy (please refer to MACRO VISION – China: the impact of a new growth model on Brazil.). As the U.S. labor market strengthens gradually, we expect the Federal Reserve to begin a monetary-tightening cycle in mid-2015, which is set to increase external borrowing costs for emerging nations such as Brazil. Finally, the recent slide in crude oil prices, if sustained, limits gains from exploration activities in the pre-salt oil fields.

Domestically, stagnation in household spending significantly limits the contribution of domestic demand to GDP growth.  Household spending, which expanded faster than GDP in nine out of the last 10 years, stalled due to a weak labor market and the repayment of debt by households. Since late 2013, the creation of government-registered jobs in the Brazilian economy decelerated, although the impact on the unemployment rate was milder because of the decline in the participation rate. With stagnation in employment and slowing real wages, average growth in the real wage bill decelerated to 2.4% in 2013-2014 from 5.9% in 2005-2012.

The needed fiscal adjustment to rebalance public accounts should also reduce the contribution of government spending to GDP growth. The slowdown in economic growth was partially offset by a less restrictive fiscal policy, but the impact on confidence had the effect of reducing investment. There is a growing perception that the cycle of fiscal expansion has come to an end and requires a change in course. While tax cuts and quasi-fiscal measures brought some temporary relief to specific economic sectors, these measures are not sustainable because of their impact on public debt.

The reduction in the current account deficit requires an adjustment in relative prices in favor of tradable goods, and that complicates the central bank’s mission: the exchange-rate depreciation would ease the adjustment in relative prices, but the fact that the IPCA is close to the upper limit of the target range creates a challenge for the monetary authority.

In this scenario, there are incentives to execute the needed adjustments and thereby avoid the deterioration of the economy. In the past, the government had to change course when its original choices did not produce the expected results – as in concessions of airports and highways and in adjustments in electricity tariffs this year. The announcement of the new economic team and the communication of its strategy corroborate our expectation that the government will carry out the adjustments needed to avoid economic deterioration, but these are not likely to be sufficient to boost growth substantially in the coming years. Going forward, our focus and the market’s will be on the details of the adjustment and its execution.

Fiscal accounts: New economic team signals fiscal adjustment

The fiscal adjustment announced by the new economic team is necessary for rebalancing public accounts and stabilizing the public debt-to-GDP ratio. We forecast an increase in the primary budget surplus to 1.2% of GDP in 2015, and we have increased our forecast for 2016 to 2.0% from 1.8%, in line with the targets announced by the new economic team.

The adjustment will likely rely on an increase in the tax burden and on spending cuts, as well as contributions from the central government and regional governments. We expect increases in the CIDE fuel tax and in the IPI tax on industrialized products early next year, in addition to the creation/reinstatement of other taxes and contributions. On the spending side, we expect tighter controls on administrative expenses and expenditures related to allowances and unemployment aid, in addition to investment cuts and changes in rules for survivor pensions. For further details, please refer to “MACRO VISION – The feasible fiscal adjustment.”

Federal spending eased and the fiscal result topped our estimate in October. The primary budget surplus reached 3.7 billion reais in October, somewhat in line with market expectations, while topping our forecast for a primary deficit of 3.0 billion reais (our estimate prior to the release of the central government’s results). The biggest surprise in relation to our call was a sharp deceleration in discretionary expenses (investment and other administrative expenses), which we expected to begin only in November. Over 12 months, the conventional primary surplus slid to 0.56% of GDP from 0.61%, while our estimate for the recurring result (excluding atypical revenues and expenses) was revised downward, to -0.55% from -0.47%. An unfavorable base effect will take place for the conventional primary surplus in the next report due to large extraordinary revenues in November 2013 (nearly 35 billion reais from the tax amnesty program known as Refis and from the Libra oil field).

The public debt-to-GDP ratio continued to increase. The public sector’s net debt rose to 36.1% of GDP from 35.9% and is up by 2.5 pp of GDP this year. The general government’s gross debt climbed to 62.0% of GDP from 61.7% and is up by 5.3 pp this year. In November, currency depreciation will have a positive effect on net debt, because the public sector has more U.S.-dollar-denominated assets than liabilities. However, the currency depreciation effect is unfavorable for gross debt due to foreign debt, to internal debt tied to the exchange rate and to the stock of FX swap contracts. For instance, a 10% depreciation in the exchange rate causes a decline that equals 1.0 pp of GDP for net debt and an increase of 0.8 pp of GDP for gross debt, according to our calculations.

The primary surplus will welcome revenues from the 4G spectrum auction in December. The telecom carriers who won licenses for the 4G spectrum auction paid a large part of them in early December, in a move that should create a positive impact of nearly 3.0 billion reais in the primary surplus.

The positive surprise with the primary surplus in October and the materialization of revenues from the 4G auction reduce the downside to our forecast for the primary balance in 2014 (0.2% of GDP). Yet the downside was not eliminated, given the negative result year to date (-11.0 billion reais). Our forecast for the recurring primary balance by year-end stands at -0.4% of GDP.

The National Treasury will loan 30 billion reais to the state development bank BNDES in December, representing a quasi-fiscal incentive that is larger than we expected. Loans by the Treasury to state-owned banks will add up to 60 billion reais in 2014, following another injection of 30 billion reais in June. We expected only 30 billion reais in 2014, declining to 20 billion reais in 2015 and 2016. According to our estimates, the quasi-fiscal momentum through loans to state-owned banks (i.e., the change in the stock of Treasury assets to state-owned banks as a percentage of trend GDP) will be +0.7% of GDP this year. For 2015 and 2016, we expect negative impulse of 0.2%-0.3% of GDP each year.

External and domestic factors point to an adjustment in the exchange rate going forward

The exchange rate is under pressure from external factors and factors that are specific to Brazil. Internationally, the slide in commodity prices continues to have an impact, not only on the real, but also on the currencies of commodity exporters. The recovery in the U.S. economy has also strengthened the dollar against other currencies. In Brazil’s case in particular, deterioration in external accounts should weigh on the real throughout the next years.

We revised our forecast for the exchange rate in 2014 and 2015 after incorporating the latest events. We foresee the year-end exchange rate at 2.60 reais per dollar in 2014 (2.50 previously) and at 2.80 in 2015 (2.70 previously).

The trade balance posted a deficit of 2.3 billion dollars in November. Price declines for the main commodities exported by Brazil and poor competitiveness in the manufacturing sector continue to be the main reasons for the weak performance of exports this year. Imports also slid, in line with currency depreciation and weaker economic activity, but not enough to ensure a positive trade balance. With a negative result in November, the trade balance has a deficit of $4.2 billion year to date, compared to a deficit of $103 million in the year-earlier period. Importantly, in the three final months of 2013, the trade balance benefitted from pro forma exports of oil-drilling rigs worth $5 billion, and that situation won’t likely be repeated this year.

In the face of weaker figures recently, we revised our forecasts for the trade balance in 2014 and 2015. The latest results indicate that the trade balance is unlikely to end the year with a positive reading, so we revised our forecast to a deficit of $2.5 billion from zero previously. The last year in which the Brazilian trade balance had a deficit was 2000. For 2015, a weaker currency and the recovery in the global economy should contribute to an improvement in the trade balance. The fuel balance, which has a deficit right now, is set to improve on an increase in domestic output and falling oil prices. However, given the slide in iron ore prices, among other factors, we revised our forecast for the trade balance in 2015 downward, to $6 billion from $7.2 billion.

The current account deficit over 12 months remained at 3.7% of GDP in October. The current account deficit during the month stood at $8.1 billion, pressured by a negative contribution from the trade balance. We expect the deficit over 12 months to increase when the favorable results of the two final months of last year (explained by very positive trade balances) drop from the 12-month comparison. After incorporating the changes in the trade balance, we revised our forecasts for the current account deficit to $86.5 billion from $84 billion in 2014 and to $77.1 billion from $75.7 billion in 2015.

Copom accelerates the pace of rate hikes but signals a short cycle

The Brazilian Central Bank’s Monetary Policy Committee (Copom) increased the benchmark Selic interest rate by 50 bps, to 11.75% p.a. in its December meeting, in a unanimous decision that was expected by us and many in the market. 

However, the statement was surprising to some because it signaled a shorter interest-rate hiking cycle going forward, at a pace of 50 bps at most per meeting. According to the statement that announced the move, the Copom decided to intensify the adjustment in the Selic rate “at this moment,” an expression that is usually employed to signal changes in monetary policy in the short term. Additionally, the Copom referred to the “cumulative and lagging effects of monetary policy” and “other factors” (likely a reference to the recent decline in commodity prices and the fiscal adjustment) to justify that the “additional monetary policy effort tends to be implemented parsimoniously.”

In the minutes of the meeting, the Copom maintained the references to parsimony. The minutes reiterated that monetary policy should remain “especially vigilant”, but also that, considering the cumulative and lagged effects of monetary policy, the additional monetary-policy effort tends to be implemented with “parsimony”. In this sense, the Central Bank could decide for another increase of 50 bps and finish with a 25 bp-hike, or could reduce the pace and opt for two increases of 25 bps. We regard the first option as more likely.

We expect another 50-bp increase in the January meeting. In fact, inflation is still high, and the recent depreciation in the exchange rate tends to exert pressure on prices, even in an environment of weak growth and falling commodity prices.

Hence, we understand that the latest decision and the prospective economic scenario are compatible with our forecast for an additional 50-bp increase in the Selic in January and a final adjustment of 25 bps in March, taking the rate to 12.50%. 

We also foresee an adjustment in the long-term interest rate known as TJLP. As part of the adjustment in economic policy, we expect the National Monetary Council (CMN) to lift the TJLP. We anticipate gradual increases in the next years, taking the TJLP to 8% from 5% currently.

Weak GDP in 3Q14 as household spending contracts

Brazil’s GDP expanded 0.1% qoq/sa during 3Q14. Despite positive growth, economic activity remained weak during the quarter, as the increase did not offset drops in 2Q14 and 3Q14. For the second time in three quarters, household spending fell. In our view, the weakness in household spending reflects the ongoing slowdown in the real wage bill since early in the year. Gross fixed capital formation advanced after four quarters of declines, but it remains significantly below its year-earlier level. The largest positive contribution came from public administration’s consumption, which climbed 1.3% during the quarter.

In 4Q14, we see moderate improvement in economic indicators, but fundamentals are not aligned for stronger growth. Our diffusion index (based on a broad dataset that includes business and consumer confidence, retail sales and credit demand) points to only moderate improvement in economic indicators for 4Q14. Along with a favorable statistical carryover, however, this situation does indicate some slightly faster growth in the period. Going forward, though, economic fundamentals will likely curb growth. Consumer confidence reached its lowest reading since 2008, leading us to expect continuing weakness in household spending in the next months. We also highlight poor business confidence in the main economic activities (manufacturing, services, construction and retail). Finally, industrial inventories are still high, and final demand by consumers points to needed adjustments in output, as indicated by the stability in industrial production in October, according to the latest Monthly Industrial Survey by census bureau IBGE.

We maintain our forecast of 0.2% GDP growth in 2014. In order to reach this figure, we expect activity to pick up slightly in the final months of the year, as suggested by some leading indicators (including vehicle sales reported by the national auto manufacturers’ association, Anfavea, and daily energy consumption figures from the Electric System National Operator).

We revised our growth forecast for 2015 downward, to 0.8% (1.1% previously). In our view, deceleration in the real wage bill will be permanent and continue, curbing growth in consumer spending next year. The implementation of macro adjustments contributes to an improvement in business expectations and favors the resumption of normalized investment levels. Given that gross fixed capital formation should contribute -1.3% to GDP growth in 2014, its stabilization would have a material effect on growth in 2015. In the external sector, weaker currency and weaker demand will likely lead to a better contribution from net exports.

Despite poor job creation, the unemployment rate declined in October. The Labor Ministry´s CAGED registry showed that 30 thousand jobs were eliminated in October, the worst result for the month since the historical series started in 1999. The working population, according to data in the Monthly Employment Survey (PME - IBGE) has been showing sluggishness in recent months. Surveys of consumers also suggest that it has become more difficult to find a job recently. However, the seasonally-adjusted unemployment rate fell to 4.7% in October from 4.8% in September, according to the PME. The low unemployment rate is largely explained by the decline in the labor force. However, in recent months, the labor force has stabilized. Hence we believe weak economic activity ahead may increase unemployment moderately. We expect the seasonally-adjusted unemployment rate to reach 5.1% by the end of 2014.

Above-average rainfall in November offset part of the rainfall deficit from the previous month, but improvement in potential hydropower generation was modest. Reservoir levels ended the month at just 19.5% capacity, the lowest aggregate level seen in recent years.

Rainfall levels in December are expected to be in line with historical patterns. Along with intense usage of thermal power plants, rainfall should prompt some recovery in reservoirs during the month.

Even with favorable conditions in November (and a favorable outlook for December), risks remain. If rainfall levels are close to the historical average during the entire rainy season (November 2014 through April 2015), we expect reservoir levels to be slightly higher than last year, still representing supply restrictions as seen in 2014 (intense usage of thermal power plants and its effect on costs, inflation and external accounts). Below-average rainfall levels, in line with the past three years, may force the adoption of additional measures to reduce power consumption, with negative effects on the economy.

Non-earmarked loans remain weak. The daily average of new non-earmarked loans fell 2.4% mom/sa in real terms. The balance of non-earmarked loans continues to decline in real year over year terms, but at a lower rate in October (-1.5%) than in September (-1.9%). On the other hand, annual real growth in outstanding earmarked loans accelerated to 14.0% from 13.1%, so that the real year-over-year expansion in total outstanding loans accelerated to 5.3% in October from 4.7% in September. Overall delinquency remained at 3.0%, despite the reduction in delinquency in non-earmarked loans to 4.8% from 5.0%. Overall interest rates and spreads increased.

We expect the IPCA to increase around 6.5% in 2014 and 2015

The consumer price index IPCA climbed 0.51% in November after rising 0.42% in the previous month. There is a visible deceleration in market-set prices. The latest result was slightly lower than our estimate and the median of market expectations (both at 0.54%). Market-set prices in the IPCA advanced 0.45%, while regulated prices increased 0.72%. The largest upward contributions came from foodstuffs, housing and transportation. The IPCA is now up by 5.58% year to date (4.95% one year earlier), while the year-over-year change fell slightly, to 6.56% from 6.59% in October. Our preliminary forecast for December points to 0.84%, leading to a 6.47% advance for the full year (5.91% in 2013).

The IPCA is likely to end the year up by around 6.5%, with market-set prices rising 6.8% and regulated prices advancing 5.4%. Last year, the IPCA was up by 5.9%, as market-set prices rose 7.3% and regulated prices increased only 1.5%. Market-set prices represent 77% of the IPCA and should provide a contribution of 5.2 pp to the headline index. Among its main components, we anticipate cost increases of 7.3% for food consumed at home (7.6% in 2013) and 8.3% for services (8.7% in 2013). Regulated prices (representing 23% of the IPCA) will contribute 1.3 pp to the IPCA, up sharply from 0.4 pp in 2013. This bigger contribution comes largely from increases in electricity tariffs (reflecting the 17% hike in electricity tariffs after a 15.7% drop in 2013).

In 2015, we expect the IPCA to increase 6.5%, as market-set prices cool down and regulated prices pick up. Our estimate for market-set prices was revised slightly, to 6.2% from 6.3%. The revision follows the incorporation of the effects of weaker economic activity and lower commodity prices on inflation, more than offsetting the exchange rate depreciation. Going forward, our forecast for market-set prices already assumes a reversal in tax cuts for automobiles, household appliances and furniture.

We revised our estimate for regulated prices upward, to 7.5% from 7.2%, largely due to an increase in our forecast for the change in electricity tariffs, to 17% from 14%. Gasoline, urban bus fares and health insurance premiums will also provide a material impact. Adjustments in public transportation and electricity tariffs may put more pressure on inflation early next year. Urban bus fares, which are lagging in some state capitals, are usually adjusted in the first months of the year. We assume a 10% increase in bus fares in the city of São Paulo in January. As for electricity, the adoption of the so-called bandeiras tarifárias system – which will likely anticipate part of the increase in tariffs expected for the full year – will go in effect in January. If the current red-flag situation remains for all regions of the country, the forecasted impact on the IPCA in January stands at 0.25 pp. Our scenario for gasoline now assumes a larger adjustment in the CIDE tax, to 0.14 real per liter (0.07 previously), prompting a full-year increase of about 7% for gasoline prices at the pump. Meanwhile, we no longer expect any adjustment in fuel prices at refineries, thanks to the reversal of the lag in domestic prices, due to the new reality of crude oil prices in international markets.

Our forecast for a 6.2% increase in market-set prices in 2015 assumes smaller cost increases for food consumed at home and services. Regarding food, we envision a favorable scenario in terms of agricultural supply, particularly for grains, given the outlook for good crops and a recovery in global inventory levels. Well-behaved grain prices this year and next should provide some relief in the animal protein segment and in wheat byproducts. For private services, we stand by our assessment that the slowdown will be driven by accommodation in the labor market and in the real estate sector, leading to moderation in wages and rentals. We are already observing a slowdown in service inflation at the margin, in line with weaker economic activity. Among market-set prices, we project service prices to increase by 7.2% and tradable goods by 5.4%.

Although we forecast stable inflation around 6.5% in 2015, we expect a sharp pickup in the year-over-year change early in the year, to about 7.0%. The main upward drivers will be electricity tariffs (under the bandeiras tarifárias system), urban bus fares (adjustment in São Paulo) and new passenger cars (higher IPI tax). In our view, the three abovementioned drivers will cause an impact of around 0.45 pp on inflation in January, lifting the IPCA in the month to 1.0% (0.55% in January 2014) and the year-over-year change to 7.0%.

The general price index IGP-M climbed 0.98% in November after rising just 0.28% the previous month. The producer price index IPA – the component with the largest weight in the IGP-M – advanced 1.26%, as industrial prices increased 0.6% and agricultural prices rose 3.0%. The pressure on the IPA reflected recent currency depreciation and hikes in some agricultural items (grains and cattle), which impacted soybean meal and beef prices. Hence, the IGP-M is up by 3.05% year to date, and the year-over-year change accelerated to 3.66% from 2.96% in October. Our preliminary estimate for the IGP-M in December stands at around 0.7%.

We estimate a 3.8% advance in the IGP-M in 2014, down from 5.5% last year. The producer price index IPA-M should increase 2.3% (5.1% in 2013), as industrial prices rise 1.8% and agricultural prices climb 3.5%. The largest contributions in the IPA will come from iron ore and soybeans. Iron ore is expected to fall 37% and provide a relief of 1.4 pp to the headline

IGP-M for the year. The estimated contribution from soybeans stands at -0.6 pp, as prices are expected to fall 16%. The largest upward pressures are set to come from cattle and coffee. For the other components, we estimate increases of 6.7% for the consumer price index IPC-M (5.5% in 2013) and 6.8% for the construction cost index INCC-M (8.1% in 2013).

We revised our forecast for the IGP-M in 2015 downward, to 5.3% from 5.7%, as we incorporated lower prices for iron ore and crude oil, which more than offset the effect of a weaker currency.

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