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Tougher fiscal challenges

August 8, 2017

Tax hike is not enough to meet the primary result targets.

Please open the attached pdf to read the full report and forecasts.

The tax hike is not enough to meet the primary budget target, which will still require extraordinary revenues and other compensatory measures to be accomplished.

We revised downward our forecast for unemployment in 2018, incorporating more informality in the job market. Our estimates for GDP growth are 0.3% in 2017 and 2.7% in 2018.

We revised our exchange rate estimates to 3.35 reais per U.S. dollar in 2017 (from 3.50) and 3.50 in 2018 (from 3.60), reflecting a more benign international scenario.

We increased our estimate for 2017 inflation to 3.4% from 3.3% due to the recent tax hike; our call for 2018 remains at 4.0%.

The Selic benchmark interest rate is expected to reach 7.25% by year-end.

Tax hike is not enough to meet the primary result targets

The government increased fuel taxes in order to reinforce its commitment to the fiscal adjustment. The hike will ensure additional revenues of about BRL 10 billion this year and BRL 25 billion next year, and it was a key signal regarding the government’s effort to meet the primary budget result targets.

However, the target of a deficit of  2.1% of GDP (BRL 142 billion) in 2017 remains under great threat, particularly because of uncertainties on the materialization of large extraordinary revenues. The government estimates around BRL 54 billion in additional revenues related to the tax-amnesty program REFIS and auctions of hydropower plants and oil fields, which are scheduled to take place in coming months (see table). Considering that cuts in discretionary expenses (BRL 45 billion currently) reached a limit and given the limited array of tax hikes that could boost revenues in 2017, disappointments and delays could jeopardize the target. 

Keeping in mind the expectation that extraordinary revenues might disappoint, we maintain our forecast for the primary deficit at 2.4% of GDP (BRL 155 billion) in 2017.  However, in the absence of negative surprises with these revenues, the country’s economic team should be able to hit the current target.

We revised our estimate for the 2018 primary deficit downward, to 1.8% of GDP (BRL 131 billion) from 2.1%, in line with the target.  The greatest risk to next year’s target is slower economic growth than we currently anticipate. However, we expect the government to present compensatory measures when it submits its budget bill to Congress in late August. These measures tend to focus on mandatory spending, such as personnel expenses and particular tax revenues like the reversal of payroll tax breaks.

The pension reform has yet to run through Congress. The proposal is waiting for greater political consensus before being voted on in two rounds on the main floor of the Lower House and later in the Federal Senate. Without reforms, the government is less likely to comply with the constitutional spending cap, particularly after 2019, and public debt is more likely to remain on an unsustainable path.

Activity: unemployment nearing its peak

The main economic indicators advanced in April and May, signaling a broader recovery in economic activity. Industrial production, broad retail sales and real service revenues expanded 1.9%, 0.5% and 1.1% cumulatively in these two months, respectively (seasonally-adjusted).

The decline in confidence indicators in June amid greater political turmoil was not reflected in gross activity figures. Industrial production remained stable after two consecutive increases, and we forecast an advance of 1.2% in retail sales. Demand in the auto sector, which could be more affected by consumer expectations, remained somewhat heated.

Nevertheless, the outlook for 2Q17 GDP is a small contraction. Our estimate is -0.2% qoq/sa, driven by a discrete drop in agriculture GDP and unfavorable statistical carryover from many GDP components after weak March figures. These two factors offset improved underlying growth throughout the quarter.

We anticipate a negative headline number in 2Q17, despite strong underlying growth. This is the opposite of what happened in 1Q17 (strong headline, but very concentrated on agriculture).

Our GDP growth estimates are 0.3% in 2017 and 2.7% in 2018, in line with a gradual recovery amid slower political progress on reforms. If reforms move forward (particularly the pension reform), the recovery could be stronger next year. On the other hand, a full breakdown of reforms could cause additional delays in the economic revival, with lower annual growth.

Gradual economic recovery is slowing down the destruction of formal jobs. In net terms, 9,800 formal jobs were created in June (according to the Labor Ministry’s CAGED registry). The seasonally-adjusted quarterly moving average improved to -16,000 from -41,000 and has been on a gradual positive trend since 2Q16 (see chart). However, historically, stabilization of the unemployment rate without increased informality has required net creation of around 40,000 formal jobs. 

According to the national household survey (PNAD Contínua – IBGE), Brazil’s nationwide unemployment rate stood at 13.0% in the quarter ended in June vs. 13.3% in the quarter ended in May. Using our seasonal adjustment, unemployment dropped to 12.9% from 13.0% and has remained relatively stable throughout 2017. The decline in the unemployment rate despite net job destruction in the formal segment was driven by gains in informal jobs in the private sector and self-employment. 

In sum, unemployment has been prevented from going up by a change in the composition of the labor market toward greater informality (i.e. more people working outside the formal economy).

Hence, in our outlook for the labor market, we revised our expectations for the unemployment rate. In this new scenario, the peak is anticipated to occur in 1Q18 (previously 3Q18), and the peak level was reduced to 13.4% from 14.3% (seasonally adjusted), receding to 13.2% by YE18. Forecasts are based on models that take into account the sensitivities of different types of occupation to economic activity (see Macro Vision: Unemployment approaching a peak in Brazil). 

Benign international scenario for risky assets

The Brazilian currency appreciated in a more benign international environment for risky assets. The exchange rate appreciated to around 3.10 reais per dollar from 3.30 during the past month. Stronger economic figures from China, higher commodity prices, weaker U.S. inflation and signals by the European Central Bank that the withdrawal of stimuli will not be announced anytime soon supported emerging market currencies, including the BRL. 

Domestically, the approval of the labor reform in Congress also helped to boost currency gains. Brazil’s 5-year CDS narrowed to about 200 bps from 240 bps in early July, reflecting the external and domestic scenarios. Dollar inflows to Brazil also increased with several initial public offerings (IPOs). 

We revised our year-end forecasts for the exchange rate to 3.35 in 2017 (from 3.50) and 3.50 in 2018 (from 3.60). Our new estimates incorporate a benign scenario for risky assets in the coming months, higher commodity prices (on average) and a weaker dollar against several currencies. Internally, however, uncertainties surrounding adjustments and reforms are set to continue, pressuring risk premiums.

The current account posted a USD 715 million surplus in 1H17, supported by the good performance of the trade balance. Over 12 months, the current account deficit stands at 0.8% of GDP (USD 14.3 billion), the lowest since 2008. In terms of financing, direct investment in the country remains robust, hovering between USD 80 billion and USD 85 billion since the beginning of the year, covering the current account deficit multiple times. Volatile capital flows (i.e., portfolio flows) have been negative over 12 months. 

We revised our forecasts for external accounts in 2017 and 2018. On one hand, the revision of price estimates for some key exported commodities (such as iron ore and soybeans) and the latest results point to larger trade surpluses. On the other hand, new forecasts for the exchange rate suggest weaker readings going forward. The outcome is an estimated trade surplus[1] of USD 62 billion in 2017 (from USD 60 billion) and USD 50 billion in 2018 (from USD 47 billion). Our forecasts for the current account deficit are USD 15 billion in 2017 (from USD 19 billion) and USD 34 billion in 2018 (from USD 37 billion).

We expect inflation to reach 3.4% in 2017 and 4.0% in 2018

We revised our 2017 forecast upward slightly for the headline consumer price index IPCA, to 3.4% from 3.3% (6.3% in 2016). The larger-than-expected impact of the hike in fuel taxes more than offset the downward effect of revised exchange rate forecasts and more favorable inflation at the margin. According to our estimates, year-over-year inflation in 2017 will bottom at 2.6% in July and pick up to 3.1% in September.

Breaking down the index, we expect market-set prices to rise by 2.5% and regulated prices to advance 6.2%. Among market-set prices, we anticipate zero change in costs for food consumed at home, after a 9.4% increase last year. The outlook for plentiful crops — amid favorable weather last year in Brazil and for other big global producers — has caused declines in producer prices since September 2016, with a favorable impact on retail food prices. In 1H17, costs for food consumed at home in the IPCA fell 1.1%. We expect industrial prices to rise just 1.0% (4.8% in 2016). Service prices are estimated to advance 4.8% this year (6.5% in 2016). Adverse conditions in the labor market and in the Real Estate sector, a lower inertial effect from past inflation and a smaller adjustment in the minimum wage prompted moderation in wage and rent costs. These factors will continue to contribute to a drop in service inflation throughout 2017. As for regulated prices, we have the following forecasts for the main components: 3% for gasoline, 4% for medication, 7% for urban bus fares, 8% for electricity tariffs, and 13.5% for health insurance premiums.

Our 2018 inflation estimate remains at 4.0%. Breaking down the index, we expect market-set prices to rise 3.6% and regulated prices to climb 5.3%. Our below-target inflation estimate for next year will be driven chiefly by a negative output gap, along with less inertia from 2017 inflation and anchored inflation expectations. 

The main risk factors for the inflation scenario are still tied to domestic politics. Rising political uncertainty has hindered progress in reforms and needed economic adjustments, and it may have an additional impact on risk premiums and the exchange rate. However, so far the net short-term effects of growing uncertainty on inflation have been neutral. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as new tax hikes and/or reversal of tax breaks. As for the external situation, despite more favorable scenario at the margin, there are still policy risks in central economies which could eventually lift risk premiums and weaken the local currency.

Substantial slack in the economy may contribute to a sharper decline in inflation. The negative output gap (difference between potential and effective GDP) and the corollary high level of unemployment for a longer period may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months have clearly indicated a broader disinflation process, which has been hitting exactly these segments. As for food consumed at home, given the benign supply shock and the recent path of wholesale agricultural prices, we cannot rule out an even more favorable behavior than we currently anticipate in 2017.

Inflation expectations remain anchored significantly below the target in 2017 and 2018. The median of market expectations for inflation, as per the Central Bank’s Focus survey, receded to 3.4% from 3.5% in 2017 and to 4.2% from 4.3% in 2018, while the median estimate for 2019 remained at 4.25%, and the call for 2020 slid to 4.0% from 4.25%.

Monetary policy: cruise speed, for now 

In its July meeting, the Central Bank’s Monetary Policy Committee (Copom) delivered the expected outcome: a 100-bp rate cut, leading the Selic rate to 9.25% p.a. This marks the return of the Selic rate to single digit territory for the first time since November 2013. The statement released after the meeting suggests that policymakers minimize the impact of the uncertainty shock on short-term economic developments, be it on the inflation or activity fronts, while noting that structural interest rates may be affected by the outlook for fiscal and credit reforms. The external scenario is still deemed to be favorable, as the gradual global recovery has yet to pressure financial conditions in advanced economies, supporting risk appetite in emerging economies.

The minutes from the July meeting suggest that the debate within the committee, regarding the next policy meeting, remains limited to the range of 75-100 bps. The committee assessed that the batch of economic data released since its last policy meeting in May remains consistent with stabilization of the economy in the near term, followed by a gradual recovery. The committee pointed out that inflation dynamics were still favorable, the disinflation process has become widespread (noting components more sensitive to the economic cycle and monetary policy) and that sharp disinflation in food and industrial prices may have secondary effects on inflation. 

The text also confirmed the signal, offered in the statement, that the base case for now is a 100-bp cut in September, provided current economic conditions, namely stabilization of economic activity amid wide slack, especially in the labor market, don’t change. Barring a shock, the macroeconomic scene is unlikely to change much by early September; we thus reckon that the Copom will repeat the 100-bp pace. After that, taking into account the stage of the cycle, the committee is likely to slow down the pace of easing to 50 bps per meeting, with the Selic rate ending the year at 7.25%.


[1] As per the Ministry of Trade (MDIC).


Please open the attached pdf to read the full report and forecasts.

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