Itaú BBA - Time to Adjust

Brazil Scenario Review

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Time to Adjust

July 4, 2012

The economy is still adjusting to a less benign environment

We trimmed our 2012 GDP estimate to 1.9%, from 2.0%, and our inflation forecast to 4.9%, from 5.0%. We continue to expect the currency at 1.90 real to the dollar at yearend 2012 and 2013. Although the forecasts revisions were small, the risk of lower growth is still present, and the Central Bank will likely seek to mitigate it. Our scenario now takes the Selic rate to 7.0% (from 7.5%) in three rounds of half a percentage point.

Brazil has received much praise in recent years. Growth has been faster than in the old days of macro instability, and income is now more fairly distributed. The economy recovered fast after the Lehmann collapse, posting growth of 7.5% in 2010. In a world of low growth and high risk, the country still offers a balanced macro picture and many consumers. Its new oil promise is bolstering an already large investment pipeline related to Brazil’s infrastructure backlog – not to mention the mega sports events of 2014 and 2016.

All of that is true. But the economy may have moved too fast in 2010 – especially considering it is part of a risky world where demand is, and will remain, weak. Having slowed down considerably in the second half of 2011, Brazil still seems to be adjusting on many fronts as it digests excessively optimistic plans. It appears that manufacturers still hold too much inventories, retailers too much capacity, homebuilders too many projects, and so on.

This is part of the reason why, although demand is gradually picking up, investment still struggles. Another reason is, of course, that the world continues to be a source of risk and weak growth.

In spite of this longer-than-expected adjustment and the risks still present, we expect a recovery in the second half of the year.

Economic activity: small changes, large risks

Recent data shows activity recovering at a moderate pace. Sectors touched by government stimulus, such the auto industry, picked a good speed in June. Elsewhere, demand is rising too. However, industrial production has not seen a broad reaction so far (it fell again in May), partly reflecting a prolonged inventory adjustment.

A business survey from FGV, a think tank, found uncertainty regarding future demand to be a key factor holding back capital spending in the private sector. The government is trying to mend that. The latest step was a new program of public spending, mainly on capital goods for transport and agriculture. If the government manages to deploy it quickly, fiscal spending will rise in the short term and GDP growth will likely pickup temporarily.

In the short term, after May’s weak industrial production we expect GDP to grow by 0.6% in the second quarter compared to the previous three months (from 0.8%). We slightly lowered our 2012 GDP growth forecast to 1.9% (from 2.0%), and kept 2013 at 4.5%.

It is a small revision to forecasts, but risks now appear to be higher. The world economy is still a threat. Even if a major disruption doesn’t happen, prolonged uncertainty may hold private investment down in coming quarters.

Another risk is that low growth finally hit the labor market. Until now, low unemployment and rising incomes have been a key factor supporting consumer demand. In May, however, formal job creation fell to 64 thousand, according to the Labor Ministry’s CAGED report (our seasonal adjustment). This is the first relevant indication of weakness: will the labor market cave in before the rest of the economy strengthens? The next few months will provide an answer.

In the meantime, credit conditions have improved. Having moved sideways until March, bank lending rose moderately. In May, new corporate lending rose by 2.6% after adjusting for seasonality and inflation. New consumer loans fell by 0.7%, although conditions are improving. State-owned banks continue to gain market share. Lending rates fell again to both consumers and businesses, and the rate of non-performing loans stabilized. The exception is the share of consumer loans more than 90 days past due, which is still rising.

Fiscal policy

Revenues continue to slow, and spending is picking up. Taxes on domestic spending, corporate profits and labor continue to prop up federal revenues, while the settling of tax debt still brings in good cash. Those intakes help smooth the trend, but tax collection should continue to slow. It is now up 3.8% from last year, the slowest pace since the fourth quarter of 2009.

Spending is picking up, as expected. The central government is disbursing 8% more than a year ago (after adjusting for inflation), the fastest pace since late 2010, and close to the rate we project for the year. Growth has been faster in transfers (due to the new minimum wage), subsidies (especially for agriculture), administrative, health & education costs, and investment.

With administrative hurdles still holding down infrastructure spending, the pickup in public investment has happened mostly in the Minha Casa Minha Vida home subsidy program. This is, unfortunately, a line of investment with less impact on productivity.

What else? The finance ministry recently unveiled an 8 billion reais program of government purchases, part of which brings forward spending that would happen later in the year. Also, the much-needed increase in gasoline and diesel prices at refineries was offset, at the consumer end, by a reduction in the CIDE tax – that’s some five billion reais in lost tax revenues.

We already factored in an expansionary fiscal policy this year. As a result, we maintain our forecast for the 2012 primary surplus at 2.9% of GDP. This implies that the government will use “deductibles”, an allowance to reduce the target. But weaker-than-expected activity in the second half could hurt revenues and prompt more fiscal stimulus, and eventually lead to an even smaller surplus.

Balance of payments: better in June

The month of May saw a $2.4 billion outflow from equity markets, and lower rollover of medium and long term loans. On net, financial outflows reached a high $6.3 billion as global and domestic uncertainty upset investors. Foreign direct investment, however, held strong with a $3.7 billion inflow that kept the 12-month total at a solid 2.7% of GDP. The trade balance also stood out, helped by a record-setting 7 billion tons of soybean shipments.

June data shows a reversal, with financial inflows of $1.3 billion in the month. Equity flows are back, even if modestly, with $340 million until June 20, according to the Central Bank. In that month, the trade surplus was weak, $807 million. Despite the currency weakening, the global demand deceleration seemed to have a bigger impact, which led the country to the worst June since 2002.

Inflation, behaving well

Numbers so farshow a drop in consumer inflation in June. Lower prices of autos are a major factor, but other prices are going up less fast too. Core inflation is quiet, and services prices are going up less, suggesting that weak activity is, to some extent, slowing inflation. The 2012 outlook now looks easier, although much results from tax breaks on autos and home appliances. After the June surprise, we slightly lowered our forecast for the 2012 IPCA to 4.9% (from 5.0%).

No doubt, June’s lower-than-expected IPCA, and a weak global economy (risking turning even weaker) point to easy inflation ahead. But a strong labor market, a constant flow of growth-promoting initiatives and bigger increases in regulated prices still suggest higher inflation next year. The recent increase in agricultural commodity prices, if persistent, represents an upward risk to inflation. We have kept our 2013 IPCA forecast at 5.4%.

Monetary policy: less growth, less inflation, lower rates

While our growth and inflation forecasts fell only slightly, current conditions suggest those numbers are more likely to go down than up in the future. The Central Bank is also alert to the risk of weaker growth ahead, and may seek to prevent it by cutting rates more. Easy inflation is making that option even more attractive.

We thus lowered our forecast for the Selic rate and now expect it to reach 7.0% this year in three rounds of 50 basis points (previously 7.5%). In 2013, we expect the Selic to go up by 150 basis points, beginning in the third quarter. Before that, we expect the government to use other instruments (para-fiscal, macro-prudential, etc.) to moderate growth, when necessary.

Brazil: Macro Forecasts

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