Itaú BBA - The Risks of Implementing the Fiscal Target

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The Risks of Implementing the Fiscal Target

March 14, 2014

The government’s announcement of the first budget review for 2014 revealed a more realistic fiscal target and budget assumptions.

• The government’s announcement of the first budget review for 2014 revealed a more realistic fiscal target and budget assumptions. Despite the government’s efforts to improve perceptions about the management of fiscal policy, there are risks associated with the implementation of the 2014 target, as illustrated by a relatively low primary balance and the acceleration in spending in January. Our forecast for the primary budget surplus remained at 1.3% of GDP this year.

• We maintain our GDP growth forecast at 1.4% this year, despite the stronger expansion in activity in 4Q13. Fundamentals continue to suggest moderate growth ahead, and weather conditions led to downward revisions in crop estimates. The Agricultural sector brings also renewed inflationary pressures for the year. The increase in agricultural prices lifted our forecasts for wholesale prices. For the consumer price index IPCA, our 2014 estimate remains at 6.2%, but upside risks have increased.

• The downward revisions in crop estimates and weaker data at the margin led us to revise our forecast for the trade surplus this year to USD 3 billion from USD 6 billion, also prompting a revision in the estimate for the current account deficit to 3.8% of GDP from 3.6%. Our year-end estimates for the exchange rate were maintained at 2.55 reais to the dollar in 2014 and also 2015.

• We maintain our year-end forecast for the Selic benchmark interest rate at 11.00%, assuming a 25 bp-hike at the April meeting. For 2015, we anticipate an increase to 12.00%.

Fiscal policy: risks associated with the implementation of the target for 2014

On February 20, the government published its first revision of the Annual Budget Law (LOA, in its Portuguese acronym). Overall, the new budget program sought to provide clearer signals for fiscal policy in 2014. The new assumptions are closer to market consensus (e.g.: GDP growth, primary surplus by regional governments), and the fiscal target is now more feasible.

The target for the public sector’s primary surplus in 2014 was reduced to 1.9% of GDP from 2.1%. In order to pursue this target, the government announced it would freeze BRL 44 billion in spending that was part of the 2014 budget. This amount equals a 3.7% reduction in the LOA, which is less than the historical average (4.1%) of spending freezes in previous years (in the series started in 2003).

Part of the adjustments (BRL 13.5 billion, or 0.7% of the LOA) is relate to a downward revision in mandatory spending forecasts. Of this amount, around BRL 6 billion pertains to cuts in indemnifications paid by the National Treasury to social security (RGPS), due to payroll tax breaks. The latter are intra-budget transactions with no effect on the primary balance.

The revised budget assumes a real growth in the central government spending that is somewhat in line with our forecast (4.0%) but lower than the 6.1% growth seen last year.

However, total revenues forecasted by the central government are approximately BRL 31 billion above our expectation. The difference arises from an estimate of faster GDP growth in 2014 (LOA: 2.5%; Itaú: 1.4%; Focus survey: 1.7%) as well as an implicit expectation in the official forecast for a higher ratio for the tax revenue-elasticity of GDP.

In our view, difficulties on the revenue side (e.g., slower activity and modest withdrawal of tax breaks) add up to the usual stickness of federal spending in the short term, creating risks for the implementation of the fiscal target in 2014. Considering these risks, we still expect the consolidated primary budget surplus to be at 1.3% of GDP this year.

Short-term data on budget execution illustrate the hardships that the government will likely face this year when it comes to fiscal policy. According to central bank figures, the public sector’s primary surplus stood at 19.9 billion reais in January, disappointing market expectations (22.5 billion reais).

The consolidated primary balance was equivalent to 4.8% of GDP in January, which is usually a favorable month for public accounts. The first monthly result of 2014 came in below the January average of 6.0% of GDP in the post-crisis period of 2009 to 2013. In the 12 months through January, the conventional consolidated primary surplus (without accounting or economic-cycle adjustments) reached 1.67% of GDP (81.0 billion reais), down from 1.90% of GDP (91.3 billion reais) in December. The public sector’s (conventional) primary surplus over 12 months is the lowest since 2009.

The public sector’s recurring primary surplus (excluding atypical revenues and expenses) over 12 months slid to 0.8% of GDP last month (from 1.0% in December), marking one of the lowest readings in the historical series. The retreat of the fiscal effort is taking place at the federal level and at the regional level as well.

As for federal spending, there was a considerable pickup in January, with real growth of 12.0% yoy, vs. an average of 5.7% in the last two months of 2013. The six-month moving average for federal spending is still on a sharp upward pace, hitting 8.3%,  the fastest in three years (and much higher than potential GDP growth, estimated between 2.0% and 3.0%). In our view, an accommodation in spending throughout the year will be strictly necessary to achieve a result that is at least close to the fiscal target set for 2014.

Stronger GDP growth in late 2013 did not change forecasts for 2014, but downside risks receded

Brazil’s GDP expanded faster than expected in 4Q13, by 0.7% qoq/sa (forecast: 0.3%), ending the year at 2.3%. A milder decline in industrial activity and a stronger gain in the Service sector stood out on the supply side. From a demand standpoint, investment surprised expectations by growing 0.3%, while several indicators pointed to a sharp drop. The stronger result improves the statistical carryover into this year, but it does not change the outlook for growth.

Indicators still point to slower growth in 1Q14. Despite positive activity indicators in January, with important gains for industrial output and retail sales, the outlook is for a still weak GDP during the first three months of the year. The better indicators in January only partially offset the poor data from December. The activity level is still low. We thus maintain our expectation for stable GDP in 1Q14.

Fundamentals continue to indicate low growth this year. The fundamentals that point to low growth this year have not changed over the past month. Real interest rates are still on the rise, and business confidence has ebbed again, particularly among industrial entrepreneurs, with a slide of 1.0% in February. The fiscal picture also suggests a slowdown in expense-driven momentum. Although our scenario considers spending growing above-GDP, it should be slower than in previous years. The real wage bill is still advancing more slowly, limiting gains in consumer spending. Externally, data at the margin show a steep decline in exports to Argentina, and the impact on Brazilian growth this year may be more intense than anticipated. 

Weather conditions worsen the outlook for agricultural and livestock GDP. Dry weather early in the year and excessive rainfall in the Center-West region over the recent weeks has reduced our estimates for some crops. We have slashed our growth forecast for agricultural and livestock GDP in 2014 to 0.4% from 2.6% (7.0% in 2013).

We maintain our forecasts for GDP growth at 1.4% in 2014 and 2.0% in 2015. Despite the improvement in the statistical carryover due to stronger growth in 4Q13, we maintain our forecasts for GDP growth based on the unchanged fundamentals, signs of weakness in 1Q14 and deterioration in crop conditions this year. However, we now see fewer downside risks to our call.

In the labor market, unemployment may remain low for longer, despite a moderate hiring pace. On one hand, recent data show moderation in new government-registered jobs (according to the Labor Ministry’s CAGED registry). On the other hand, employment indicators in the monthly employment survey (PME, published by census bureau IBGE) improved somewhat, but they still reveal weakness and a declining number of working people year over year. Yet, as in earlier months, the unemployment rate remains low, even dropping slightly at the margin. The labor force has remained at low levels. In our view, the return of young people to the labor market may be slower than anticipated and, in this case, the unemployment rate tends to rise at a more gradual pace. 

Swings in credit figures in recent months. After a month of strong growth in December (6.6%), the daily average of new non-earmarked loans fell 5% mom/sa in January, in real terms. The overall delinquency rate was stable, at 3%, while interest rates and spreads sustained an upward trend. State-owned banks continued to widen their market share, advancing to 51.6% in January from 51.2% in December. In real terms, growth in outstanding total loans of state-owned banks accelerated slightly, to 16.4% from 15.8%, but the pace is slower than what we saw through November 2013. The other banks continue to recover growth at a gradual pace, with the change in balance improving to 1.7% from 1.3% in real terms.

Government approval ratings slide in February. Of three surveys published in February, two showed declines and one pointed to stability in government approval ratings compared with surveys published in November and December. Ibope showed a drop to 39% from 43%; in the CNT/MDA survey, the share of voters who approve of the administration fell to 36% from 39%; Datafolha pointed to stability, at 41%. The magnitude of the declines, however, must be read carefully, as there is positive seasonality in the final months of the year. Anyhow, February figures interrupted a sequence of improvement in approval ratings observed in the second half of 2013, following sharp declines in the face of street protests in June, when approval ratings hit 30%.

Normalization of rainfall does not change the risks or the need to use thermal power plants

The normalization of rainfall has improved hydro power generation at the margin, but dispatch by thermal power plants will probably remain high, and the risk of power rationing persists. Hydro power generation improved as rainfall levels have normalized since mid-February. Affluent Natural Energy (ANE) hit 40% of its long-term average at the peak of the drought in February, but it topped 60% on March 9. However, the evolution seen recently is not enough. Reservoir levels, despite some improvement, are still very low. To bring power-rationing risks back to normal levels, ANE must continue to improve. Meanwhile, usage of thermal power plants is heavy and will likely remain so in the next months.

Intense use of thermal power plants entails costs. Heavy usage of thermal power plants (e.g., average generation of 3 GW more than in 2013) involves costs of approximately 20 billion reais for distributors, which must be offset through government subsidies or tariff increases. The official budget for 2014 includes 13 billion reais (after recently adding 4 billion)  for the Energy Development Account (CDE), but this amount will not be enough to cover additional costs. Since February, our scenario incorporates additional fiscal costs with subsidies to the CDE. The recent evolution of the nation’s energy balance reinforces this need.

Despite the improvement in currency-sensitive components, the outlook for commodities points to a wider current account gap

The Brazilian real strengthened over the past month, reflecting the decline in U.S. Treasury yields. But as we expect this drop to be temporary and anticipate a rebound in U.S. interest rates, we still believe the Brazilian currency is set to depreciate as the year goes along. Furthermore, domestic risk factors are still on the radar, reinforcing the outlook for a volatile year for the exchange rate. Hence, we maintain our year-end forecasts for the exchange rate at 2.55 reais per U.S. dollar in 2014 and 2015.

The current account deficit in January reached USD 11.6 billion. The main reason behind the widening gap was the negative trade balance of USD 4.1 billion, driven by higher imports for all large sectors. Still, the service deficit declined 8% from one year earlier, in line with economic fundamentals.

In February, imports ex-fuels slid 8.3% mom/sa, resuming the downward trend from the second half of 2013, which was briefly interrupted in January. Declines in the service deficit and in imports ex-fuels indicate that the accumulated depreciation in the real exchange rate and slower activity are affecting the main components of the current account.

However, specific factors hurt the trade balance this year. Our new forecasts for commodity prices and exported volumes — particularly the drop in iron ore prices and in the corn crop — led to a poor outlook for the trade balance in 2014. Additionally, the February deficit, at USD 2.1 billion, was much wider than one year earlier, putting more pressure on the balance for 2014. We thus revised our forecast for the trade balance in 2014 to USD 3 billion from USD 6 billion, driving the current account deficit estimate to 3.8% of GDP (previous call: 3.6%).

Inflation will be under greater pressure in the short term

The consumer price index (IPCA) climbed 0.69% in February, above our estimate and the median of market expectations. The result was higher than one year earlier (0.60%), lifting the year-over-year change to 5.68% from 5.59% in January. Price advances for food consumed at home lost steam early in the year, and the year-over-year rate receded to 4.5% in February. Our preliminary estimate for the IPCA in March stands at 0.70%, which would be higher than in the same month of 2013 (0.47%). For 1Q14, our estimate stands at 1.95%, close to one year earlier (1.94%) but with a lower contribution from the food group and a larger contribution from the housing group, driven by electricity tariffs (which fell in early 2013).

We maintain our forecast for the IPCA in 2014 unchanged, at 6.2%, but we see greater risks. The sharp increase in agricultural prices recently may put additional pressure on consumer price indexes in the coming months. And despite the slowdown in the labor market, unemployment remains low and is lower than previously anticipated, reducing the expected relief in inflation in the medium term. We still estimate a 6.7% increase in market-set prices (vs. 7.3% in 2013), with modest advances in food and service costs. We anticipate gains of 6% for food consumed at home and 8.2% for service prices. However, recent pressure on agricultural producer prices represents upside potential to our forecast for the food group. As for regulated prices, our estimate was slightly adjusted to 4.8% from 4.7%, as we incorporated recent data related to vehicle sales. For now, we still estimate a 6% jump in electricity tariffs, but the adjustment may be larger if part of the increase in the generation cost (arising from more intense usage of thermal power plants) is passed through to the final consumer.

The hike in agricultural prices should keep producer prices (IPA) under pressure this month, pushing general price indexes above 1% in March. This move in agricultural prices largely reflects adverse weather conditions, marked by atypically dry weather and excessive heat in important producing regions. Poor weather has been reducing estimates for several crops, particularly coffee, sugarcane, corn and soybeans, temporarily affecting the supply of some fresh products, as well as damaging pastures and increasing beef production costs. As price increases for some products seem to be more permanent, we also expect an impact on general price indexes for the year as a whole.

For the general price index IGP-M, our forecast for 2014 was revised upward, to 6.4% from 5.8%, due to pressure on agricultural items. Producer prices (IPA-M) are set to rise by 6.4%, with industrial prices climbing 6% and agricultural prices advancing 7.3%. The forecast for the IPA is not higher because we still expect price declines for soybeans (grain and meal) and iron ore, which weigh heavily in the index. For the other IGP-M components, we estimate gains of 6% for the IPC-M and 7.6% for the INCC-M.

Copom: A new pace, for the time being

In February, the central bank’s monetary policy committee (Copom) raised the benchmark Selic rate by 25 bps, to 10.75% p.a., slowing down the pace of monetary tightening. The decision to reduce the pace of rate hikes (from 50 bps in previous meetings) was unanimous and in line with our expectation. Lower volatility in international markets was probably an important factor behind the decision to reduce the pace of rate increases. Additionally, economic activity continues to show signs of weakness, with declining business and consumer confidence levels and still-high industrial inventories. The announcement of the fiscal target for 2014 and lower-than-expected January inflation likely weighed on Copom’s decision as well.

Copom signals continuity. The post-meeting statement was similar to the one released after the previous meeting, the only difference being the withdrawal of the expression “at this moment” signaling, in our view, that the tightening cycle tends to continue. In the minutes of the meeting, which were released the following week, the Copom reaffirmed this message, stating that it “considers it appropriate to continue the ongoing adjustment pace of monetary conditions.”

However, there are already indications that the Copom may end the cycle in the not-so-distant future. There was one important change in the description of the domestic scenario in relation to the minutes of the previous meeting. The committee stated that demand (absorption) and supply (output) growth rates “are gradually converging,” likely indicating that the adjustment in monetary policy already induces economic rebalancing. Apart from that, the outlook is for a “relatively stable expansion of domestic activity this year.”

Lower forecasts for inflation in 2015, commodities under less pressure and a reminder that the effects of monetary policy actions are cumulative. Inflation forecasts in the minutes suggest improvement ahead. Compared with the minutes of the previous meeting, estimates for 2015 declined in the reference scenario (with constant interest rates and exchange rates) and remained unchanged in the market’s scenario. Importantly, however, inflation forecasts for 2014 and 2015 remain above the target center in both scenarios. Externally, the committee continues to see moderation in the dynamics of commodity prices (“even considering localized pressures”), which removes a material source of inflationary pressure. Maybe the most important sign in the document was the inclusion of a comment arguing that the effects of monetary policy actions “are cumulative and materialize after a lag.” We read this comment by the Copom as an indication that the cycle won’t likely be extended much further.

The basic scenario assumes at least one more rate hike this year. In 2015, an additional adjustment will be necessary.  Recent communication from the Copom is consistent with our scenario of an additional 25-bp increase in interest rates in April, with the Selic rate being maintained at 11% until year-end. But if current inflation picks up again — particularly due to the recent hike in wholesale food prices — or if the exchange rate weakens quickly in response to improved figures for the U.S. economy, monetary authorities may choose to extend the cycle with one or more 25-bp increases. In 2015, we believe the Copom will see the need for an additional adjustment, taking the Selic rate to 12% p.a.

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