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What a Difference the Exchange Rate Makes

July 4, 2013

During the process of portfolio reallocations, the drop in the Brazilian currency was sharper than for its peers.

•           A new global outlook and domestic uncertainties led to many changes in our scenario. A weaker exchange rate due to signs that a new monetary policy stance in the U.S. is around the corner implied many changes, such as: higher inflation, higher interest rates, a less expansive fiscal policy and slower growth. We revised our forecast for the exchange rate from 2.07 reais per U.S. dollar by the end of this year and from 2.10 by the end of next year to 2.18 for both periods.

•           We raised our forecast for the Selic benchmark interest rate to 9.75% from 8.75% year-end. We expect the adjustment to be implemented in 50 bps steps over three meetings, followed by a 25 bps hike. Hence, we lowered our estimates for GDP growth to 2.3% from 2.4% in 2013 and to 2.2% from 2.8% in 2014. We increased our forecast for the primary budget surplus to 1.7% of GDP from 1.5% in 2013 and to 1.1% of GDP from 0.9% in 2014. As the currency depreciated, we revised downward our forecast for the current account deficit in 2014 to 2.9% of GDP from 3.2%.

•           Our estimate for consumer prices (measured by the IPCA) in 2013 rose to 6.1% from 5.8%, due to the pass-through of currency depreciation. But we now expect slightly lower inflation in 2014 (our call was revised to 5.9% from 6.0%) due to monetary-tightening measures and slower increases in regulated prices.

•           Street demonstrations reduced the likelihood of a deeper adjustment in public accounts, at least in the short term. There were several demonstrations throughout June, which challenge a more cautious fiscal stance. Growth may also be affected. Government approval ratings are showing the impact of the protests, falling 27 percentage points over three weeks.

Market adjustments to the Fed’s signals and popular demonstrations change the macro scenario substantially

Bernanke signals that the withdrawal of stimuli is imminent; portfolio rebalance affects asset prices in Brazil. U.S. Federal Reserve Chairman Ben Bernanke signaled that the pace of asset purchases will likely taper off in coming months, causing significant depreciation in exchange rates, increases in CDS spreads and rising long-term bond yields across emerging countries, including Brazil. The increase in long-term bond yields in the U.S. led to capital reallocation, with money flowing out of emerging markets. The outflow from fixed income and equity markets in emerging nations has been heavy, and Brazil stands out when it comes to the volume of financial outflows. 

Brazilian real underperforms. During the process of portfolio reallocations, the drop in the Brazilian currency was sharper than for its peers. While the real weakened about 11% against the dollar since mid-May, currencies from Chile, Mexico, Australia and South Africa lost about 5% to 8%. Though market factors such as liquidity may also be behind the changes in behavior across these currencies, the underperformance of the Brazilian real may be associated with domestic factors, such as low growth and greater uncertainty about economic policy. These factors also suggest that the real may appreciate less when markets normalize.

Some correction is expected for asset prices; fundamentals will determine how much of the change will be permanent. While asset prices move toward a new equilibrium, some overshooting is to be expected. Macro fundamentals are important in such moments to determine the short-term shock as well as to determine the magnitude of appreciation when permanent changes become clear. Nations with better fundamentals tend to suffer less. Moreover, after the adjustment of market positions, countries with good fundamentals tend to be more attractive for new investments. Compared with other times of change in U.S. monetary policy, some fundamentals of the Brazilian economy are better, such as the high level of international reserves and the current level of public debt. But compared with some peers, we see deterioration at the margin, such as the fast decline in the primary budget surplus and higher inflation.

Despite higher volatility, there is no increase in global risk aversion. Greater confidence in a U.S. recovery is positive for global activity. The current scenario is different from moments of high volatility as in September 2008 or August 2011, when there was high risk aversion and a high probability of a sharp reduction in global activity (as was ultimately the case in 2008). Variables such as the VIX (measure of implied volatility in S&P 500 index options) and business and consumer confidence indicators in several countries have not been affected by increased volatility. In fact, as we see less downside risk to U.S. economic growth, global activity tends to sustain the expansion. Thus, the new scenario’s transmission channel to Brazil is more likely to be the financial asset channel, especially the exchange rate and its domestic effects.  

Street protests in many cities change the economic scenario in the short and medium term. More than one million people took the streets in many cities to protest last month. The list of complaints was diverse, including higher public transportation costs, spending on the upcoming soccer World Cup, corruption and the poor quality of healthcare. The intensity and duration of the demonstrations forced governments into action. In many cities, increases in bus and train fares were rolled back. Furthermore, the federal government announced measures to fight corruption and to improve public services, and started a debate about political reform.

Despite the reaction, government approval ratings were hurt by the demonstrations. A survey by Datafolha Institute carried out on June 27 and 28 showed that the government’s approval rating (share of people who rated the government’s performance as great or good) sank to 30% from 57% at the beginning of the month. Approval ratings had already fallen by 8 pp between March and early June, especially due to higher inflation. The drop in approval ratings was greater than 20 pp in all regions in the nation and in all age, income and education brackets.

Economic activity and fiscal policy could be affected by the protests. Economic activity could be impacted in the short and medium term. Stores had to close earlier and mobility was impaired, hurting retail sales and new hires. In the medium run, investment may be affected by political uncertainties. Public accounts could also be impacted. The room for fiscal maneuvers to rein in spending has narrowed in the face of demands for better public services.

Brazilian real weakens and capital controls are withdrawn

 The expectation that monetary stimuli in the U.S. will be removed weakened the Brazilian currency. The exchange rate got close to 2.30 reais per dollar. While portfolios are being rebalanced with more U.S. assets and fewer emerging-market assets, volatility will remain high, pressuring the real. As markets normalize, accommodation is expected. We see the real at a weaker level than in the past. Risk spreads have increased and terms of trade are lower, reducing the nation’s capacity to finance widening current-account gaps. We now anticipate the currency will stay around 2.18 per dollar, vs. 2.07 previously. For 2014, our forecast assumes an appreciation in the real exchange rate, with the nominal level flat, at 2.18 per dollar (vs. 2.10 previously).

The central bank sold currency swap contracts, withdrew the IOF tax for derivatives and erased the reserve requirement on short-dollar positions. Responding to the drop in the Brazilian real, the central bank sold USD 24.4 billions in currency swaps, somewhat cushioning the slide. The IOF tax on increases in short-FX derivative positions, in effect since July 2011, was withdrawn on June 12. Additionally, the central bank slashed the reserve requirement for short-dollar spot positions for banks (the rate was 60% for positions above USD 3 billion, in effect for about two years). With these actions, all relevant capital controls imposed in 2011-2012 were completely removed.

The current account deficit narrowed in May to USD 6.4 billion. The improvement was driven by a positive trade balance. Over 12 months, the deficit stood at 3.2% of GDP. Foreign direct investment (FDI) declined to USD 3.9 billion in the month. Investments by non-residents in the local capital markets continued to advance, reaching USD 14 billion year to date, up from USD 4 billion one year earlier. For 2014, we incorporated into our forecast a weaker currency and slower economic growth, particularly less investment, and now see the deficit at 2.9% of GDP (vs. 3.2% previously). June posted a USD 2.4 billion trade balance, above expectations. This was the first month in 2013 without distortions caused by delayed accounting of fuel imports.  

As the exchange rate weakened, our inflation forecast went up

According to our estimate, consumer inflation measured by the IPCA reached 6.8% year over year in June, but we expect it to recede from now on, as the hike in food prices loses momentum. After climbing 6.7% between January and April, prices for food at home already show signs of cooling down at the margin, and they are expected to drop 0.3% in June after registering no change in May. The roll-back in increases in public transportation fares, as well as other regulated prices, should also bring relief to inflation in the short term, amounting to about 0.15 pp.

However, the slowdown in inflation in the second half should be milder than expected, due to currency depreciation. Inflation in tradable goods will likely go up in the next months. Though a weaker currency cannot prevent deceleration in food prices, the change in the exchange rate may cushion the move. After rising 14% yoy in April, food inflation should retreat to 9.8% at year-end, already including the effects of a weaker currency. Additional pressure stemming from currency depreciation will also likely impact some durable (electronics) and semi-durable consumer goods (clothing).

Our forecast for the IPCA in 2013 rose to 6.1% from 5.8%, as we incorporated a weaker currency. The exchange rate will more than offset the relief provided by the cancelation of increases in bus and train fares following popular demonstrations. Breaking down our forecast, market-set prices are expected to rise 7.6% (6.6% in 2012) and regulated prices should climb by only 1.3% (3.7% in 2012). Our previous forecast for the IPCA, at 5.8%, assumed increases of 7% for market-set prices and 2% for regulated prices.

The exchange rate tends to impact inflation relatively quickly, usually a few months after the currency weakens. Thus, the weaker real should affect the IPCA in 2013 already. However, there is some uncertainty regarding the intensity of the pass-through. On one hand, there is evidence of less pass-through to inflation during the inflation-targeting regime. On the other hand, inflation expectations above the target may lead to a more intense pass-through of currency depreciation. Furthermore, the fact that the real was already depreciated before the movement started could lead to a greater pass-through.

For 2014, we slightly reduced our IPCA estimate to 5.9% from 6.0%, given a tighter monetary policy and our revised expectation for regulated prices to 4.0% from 4.5%. Our estimate for market-set prices remains at 6.5%. On one hand, there is inflationary inertia and a weaker currency exerting more pressure on inflation in 2014, but lower growth, higher interest rates and more-restrained regulated prices will contribute to bring down the IPCA next year. The greatest risk to our forecast is a pickup in the IPCA this year, leading to a more intense deterioration in expectations than our scenario considers, impacting inflation in 2014.

A weaker exchange rate also led us to revise upward our call for the general price index IGP-M to 5.0% from 4.2% this year. The currency pass-through to producer prices (producer prices have the largest weight in the general price index) is much larger than to consumer prices.

Despite a cool-down in consumer price indexes in coming months, underlying inflation remains high. Core inflation measures remain under pressure at the margin, as well as service inflation. On average, core measures are expected to rise 6.5% yoy in June, while service inflation could go up 8.6% yoy.

A weaker exchange rate requires higher interest rates

The new global and domestic scenarios include increased inflationary risks. The drop in inflation throughout 2013 – due to declining food inflation and the effect of tax breaks – was milder than expected. The weaker currency makes disinflation even more complex.

The central bank has reaffirmed its assertive stance in the fight against inflation, but it did not signal any urgency in speeding up the pace of interest-rate hikes. The Inflation Report for June stated that the balance of risks for inflation is “unfavorable” and that “monetary policy should remain especially vigilant.” However, the assessment of the scenario by the monetary policy committee (Copom) did not change much, even in the face of greater market volatility in June. The committee also stressed evidence that the transmission of exchange-rate changes to inflation has decreased in the last decade. In our view, this is an indication that the Copom is not in a hurry to speed up the pace of monetary tightening.

Greater inflationary pressure will likely prompt a sharper hike in interest rates; our forecast for the benchmark Selic rate was revised upward, to 9.75% from 8.75% by year-end. Higher interest rates will help keep the exchange rate close to our estimate (2.18 reais per dollar). Additionally, a more conservative stance by monetary authorities could prevent further deterioration of inflation expectations and help to slowdown demand, which could restrain the rise of inflation in 2014.

We expect the pace of interest-rate hikes to be maintained at 50 bps in the next Copom meeting. The pace of interest-rate increases depends on the exchange rate. With the exchange rate at current levels and considering the signals from the Inflation Report, we think the Copom will decide to maintain the hiking pace at 50 bps. If the currency weakens quickly, we do not rule out the possibility of a sharper hike in the short term (75 bps).

We expect 50 bps increases in the following two meetings as well. The cycle would end with a final 25 bps jump in November. We expect the Selic rate to remain at 9.75% until the end of 2014.

Exchange rate and interest rates affect GDP outlook

More uncertainty in the scenario, more volatility, a weaker currency and higher interest rates cause negative impact on the outlook for growth. We cut our GDP growth estimates to 2.3% from 2.4% in 2013 and to 2.2% from 2.8% in 2014. The new scenario with a weaker exchange rate, somewhat higher inflation and tighter monetary conditions should depress growth in coming quarters. The effect of this scenario would be more intense in 2014. In the short term, street demonstrations in several cities around the nation could impact activity indicators. Retail sales and employment may be weaker because of them. Consumer and business confidence indicators may also be affected. 

Current indicators still point to higher growth in 2Q13. Industrial production probably increased in 2Q13. Despite sharp volatility in monthly data, there is a trend of moderate growth in manufacturing. Retail sales are also expanding, albeit at a pace that is more moderate than in previous years. We maintain our estimate for GDP growth in 2Q13 at 0.8% qoq/sa. If this expectation is confirmed, 2Q13’s statistical carryover for GDP in 2013 will be 2.0%. In other words, even without any growth in the second half, the expansion posted this year would be 2.0%.

Outlook for investments worsens in the face of currency devaluation and higher interest rates. Strong growth in investments in 1Q13 was largely explained by the increase in earmarked credit. However, this factor will likely contribute less to the expansion in gross fixed capital formation from now on. Indicators related to approvals and eligibility for these credit facilities are already cooling down. Hence, low business confidence levels, currency depreciation, higher real interest rates and higher risk premiums are apt to weigh negatively on investment decisions. Exchange rate depreciation increases capital costs by making imported machinery and equipment more expensive. This situation slows down investment. Investments are also bound to decelerate due to a longer tightening cycle in interest rates. Also, in the current environment of higher volatility in financial asset prices, uncertainties increase, possibly impacting machinery and equipment purchases. Street protests may also discourage investment.

Formal job creation slowed down significantly in May. New government-registered jobs (according to Caged data) stood at 8,000 in May, seasonally-adjusted, the weakest reading since May 2009. But we expect some recovery in the following months. The current pace of economic growth is compatible with about 70,000 formal jobs being created each month. Furthermore, other labor market indicators, such as household assessments of employment and the outlook for hiring in the manufacturing sector, suggest a more positive picture in the labor market. However, the expected recovery may not materialize in June, as street demonstrations may have affected hiring activity.

Though we anticipate improvement in formal job creation data following weak numbers in May, the prospective scenario for the labor market is less positive. Previously, we saw the possibility of further decline in the unemployment rate in 2014, but we now believe the rate tends to be stable or rise slightly. At 5.4% nowadays, the unemployment rate may increase somewhat, to 5.5%-6.0%, assuming the scenario of lower growth in 2013 and 2014.    

New loans were up in May despite a downward trend. After a month of low growth, new loans recovered somewhat in May, though driven by earmarked credit. On average, new loans increased 11.6% yoy, in real terms. However, the slowdown in the balance for non-earmarked credit started in the middle of last year is still on the way, for consumer as well as corporate loans.  Slower expansion in activity, uncertainties surrounding the macro scenario and the substitution of earmarked credit could contribute to a more sluggish pace. Total delinquency in loans more than 90 days past due remained constant, with a marginal increase in delinquency in earmarked consumer loans and a drop in delinquency in earmarked corporate loans.

Different drivers for fiscal policy

In May, the public sector posted a primary budget surplus amounting to BRL 7.5 billion, or 1.8% of monthly GDP. Using this metric, the result tops the average of 0.9% of GDP for May between 2009 and 2012. This relatively favorable performance was driven by temporary revenues (court-mandated deposits, revenues based on public offerings in the stock market, concessions and dividends). Spending also slowed down to 2.7% yoy in real terms, vs. 8.4% in April.

Fiscal figures still point to a weak trend in core tax receipts (“receitas administradas”). The increase of 1% yoy in real terms reflects tax breaks and the slow rebound in activity. This loss of momentum in intakes is already causing slower expansion in spending, as the average real growth in federal expenses in the past six months reached 2.7% in May.

Uncertainties still surround fiscal accounts. On one hand, the adverse external scenario (currency depreciation and inflationary risk) and less optimistic view of Brazil’s fundamentals (peaking with a negative outlook for Brazil’s credit rating by S&P) impose the need to reverse (or at least smooth out) the trend of fiscal expansion that was being outlined for the short, medium and long term. These factors limit the government’s room to maneuver with further use of fiscal tools (i.e., taxes and spending) to boost the economy. On the other hand, recent street demonstrations all over the country increase pressure on politicians to increase spending on social programs, especially for transportation, education and healthcare.

 We increased our forecasts for the primary budget surplus in 2013 and 2014. This revision considers the ambiguous political context of budget decisions. We anticipate a lower volume of tax breaks in 2013 and 2014, given signs that the government will seek a primary budget result around 2.3% of GDP (in the 12 months through May, the consolidated primary result was 2.0% of GDP). And due to a number of factors (such as extraordinary revenues in some states, delays in negotiations over the index to adjust debts by regional governments with the central government, and possibly, more strictness in granting authorizations for credit transactions by regional entities), we expect slightly better readings from regional governments. Though there is little adjustment (if any) on the spending side, the abovementioned factors led us to revise our estimate for the primary budget surplus in 2013 to 1.7% of GDP from 1.5%. For 2014, our estimate was revised to 1.1% of GDP from 0.9%.

We cut our estimate for the public sector’s net debt. Considering a slightly larger primary balance and a weaker exchange rate, we revised downward our estimate for the public sector’s net debt by year-end to 35.6% of GDP from 36.1% (2012: 35.2%). A smoother rise in public debt this year, thanks to a weaker real, may be an additional factor helping to prevent large adjustments in government expenses for 2013 and 2014.

Forecast: Brazil

Source: IMF, IBGE, BCB, Haver and Itaú


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