Itaú BBA - Worsening prospects

Brazil Scenario Review

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Worsening prospects

March 13, 2015

We reduced our GDP forecast for 2015 to -0.5%. We raised our exchange rate forecast for 3.10 reais per U.S. dollar.

• The outlook for financing the current account deficit has deteriorated. Economic and political uncertainties generate the need for a faster adjustment in the balance of payments. We have thus changed our year-end exchange rate forecasts to 3.10 reais per U.S. dollar in 2015 and 3.40 reais per U.S. dollar in 2016.

• Positive January figures and continuing measures of fiscal restraint signal that fiscal policy is moving toward a significant recovery this year. However, the task of reaching the fiscal target has become more difficult because of political headwinds, which are hindering the implementation of some measures, and the declining economic activity. We have reduced our primary budget surplus forecasts to 0.9% of GDP from 1.2% for this year and to 1.8% of GDP from 2.0% for next year.

• Economic activity continues to worsen. The uncertainties in the domestic scenario are affecting consumer and business confidence, which are already at historically low levels. The consequences for the labor market are increasingly clear. We have thus lowered our GDP forecast for 2015 to -1.1% from -0.5%. We expect a moderate recovery next year, with GDP growing by 1.1%. 

• We have raised our 2015 inflation estimate to 8.0% from 7.4% to reflect our expectation of a larger adjustment in electricity tariffs and a weaker currency. We have raised our forecast for regulated prices to 13.1% from 11.7%, after factoring in a steeper hike in electricity tariffs (50%, up from 40% previously). Our forecast for market-set prices has increased to 6.5% from 6.1% as a result of a weaker currency. We continue to expect a slowdown in service inflation compared with last year.

• For 2016, our estimate for the consumer price index (IPCA) growth remains at 5.5%, with upside risks related to greater inflationary inertia and downside risks resulting from weak economic activity.

The tightening cycle is close to the end. We see the Selic rate at 13.00% by year-end, and falling toward 12% in 2016. However, if the local currency continues to weaken, the Central Bank may choose to extend the cycle until the exchange rate stabilizes.

A weaker currency and intense volatility

The foreign exchange market has experienced intense volatility in the past few months. The exchange rate strengthened to 2.57 reais per dollar in January, but two months later it had weakened to more than 3.10 reais per dollar. We expect this pattern of intense volatility in the currency market to persist over the next few months amid the political and economic uncertainty in part related with the potential impact of the Lava Jato corruption investigation.

We have revised our year-end exchange rate forecasts to 3.10 reais per U.S. dollar (from 2.90) in 2015 and to 3.40 reais per U.S. dollar (from 3.00) in 2016. In recent years, foreign investors have been willing to finance Brazil’s widening current account deficit. In the next few years, however, the availability of external savings is likely to decline. The revisions in our exchange-rate estimates reflect these rising headwinds that will make financing the current account more difficult, especially in a year when global liquidity will likely thin out, payments on gross external debt are heftier and the political scenario is more complex.

Furthermore, the central bank has signaled its intention of interrupting its interventions in the currency market. The slowdown in the rollover pace for FX swap contracts expiring in early April was a strong signal in that direction. Unlike what happened in the previous six months, when the central bank rolled over virtually the entire batch of swap contracts, this month the institution will roll over just 78% of the total batch. Hence, the swap stock will be constant after increasing for nine consecutive months.

In this context, a weaker currency will trigger a faster adjustment in the current account. We forecast current account deficits at $66 billion in 2015 and $59 billion in 2016 (vs. $91 billion in 2014), or 3.7% and 3.3% of GDP, respectively (vs. 4.2% in 2014). We also see the possibility of the currency overshooting during the year to beyond 3.10 reais per dollar.

According to our estimates, exchange rates matching our forecasts (3.10 reais per dollar in 2015, 3.40 in 2016 and then constant in real terms afterwards) would lead the current account deficit to 2.5%-3.0% of GDP by 2017. The biggest risk to this scenario is the need for an adjustment in the current account that is even faster (convergence before 2017) or deeper (below 2.5%-3% of GDP). In a less-likely scenario, if more financing becomes available in the next few years (in the event of a rebound in confidence in the economy), the equilibrium exchange rate could be more appreciated.

Results in the current account have been slightly more favorable in early 2015. The current account deficit totaled $10.7 billion in January and the seasonally-adjusted annualized three-month moving average deficit declined to $96 billion in January 2015 from close to $110 billion in the end of 2014. Although foreign direct investment (FDI) has not been enough to fully cover the current account deficit, other capital flows have kept the balance of payments in positive territory. Inflows to the local capital markets (both fixed income and equities) amounted to $9.9 billion in January, reversing the outflow trend seen in recent months. Yet these flows are typically more volatile and depend on global liquidity conditions.

Fiscal accounts: Adjustment is on track, but faces greater challenges

Off to a good start in January. The consolidated primary budget surplus totaled 21.1 billion reais in January, beating market expectations and our own forecast of 15 billion reais. In order to adjust for positive seasonality in January, we assessed how much January surpluses represented as a proportion of the surpluses registered in previous years, on average, and compared these figures with how much the latest monthly numbers represent as a proportion of the 2015 target. The central government’s primary surplus in January 2015 equals about 20% of the target set for the year, in line with the average since 2009 but below the numbers for 2012 and 2013. For the regional governments, the latest result amounts to 95% of the target for the year, compared to an average of 18% since 2009.

Federal spending declined by 4.8% yoy in real terms in January, which is consistent with the drops in expenditures expected for the year. For comparison purposes, federal expenses increased by 5.2% in 2014 and by 6.4% in 2013. Capital expenditures stood out in the January numbers, falling by 35.4%. In nominal terms, investment execution reached 7.7 billion reais in the latest report, compared with an average of 9.0 billion reais in January in the previous four years.

The latest fiscal measures reinforce the outlook for falling expenditure. The government issued a decree limiting discretionary expenditures (both expenditures under the growth-acceleration program known as PAC and discretionary administrative expenses) by 75 billion reais between January and April, in accordance with the recently announced goal of reducing discretionary expenditures in 2015 to the same nominal level observed in 2013.

The January figures and additional measures reflect the finance ministry’s efforts to reverse the trend of fiscal deterioration and are likely to produce a significant increase in the primary surplus this year. In our view, expenditure will continue to fall during the year, while revenues will recover thanks to higher taxes (starting in February).

However, the political difficulty of implementing some fiscal measures and declining economic activity will likely weigh on the fiscal performance. The government issued a temporary decree (MP 669) to increase pension contributions as a proportion of gross revenues for sectors that previously benefitted from cuts in payroll taxes. Government calculations indicate that this measure would have a positive impact on revenues amounting to 5 billion reais (0.1% of GDP) this year and 12 billion reais (0.2% of GDP) next year, and this impact would come on top of higher taxes on fuels, a higher IOF tax on consumer loans and a higher IPI tax on automobile purchases. However, Congress annulled the temporary decree and the government is working on replacing it with a project of law. This will reduce the positive impact on revenues this year even if Congress ultimately approves the law, as the measure will take longer to become effective. The prospects of Congress approving further fiscal restraints (such as temporary decrees restricting bonuses paid to low-wage workers and unemployment benefits) have become less favorable. According to our calculations, the measures that still require congressional approval are equivalent to approximately 0.26% of GDP in terms of this year’s primary surplus.

We have reduced our primary budget surplus forecasts to 0.9% of GDP (from 1.2%) for this year and to 1.8% of GDP (from 2.0%) for next year. Compared with our previous scenario, these forecasts assume (1) a more intense impact on tax revenues from the decline in economic activity (about 3 billion reais), (2) smaller savings from cuts in benefits to low-wage workers and the unemployed (10 billion reais, instead of 16 billion), (3) lower revenue gains from higher tax rates on pension contributions (2 billion reais, instead of 5 billion) and (4) less extraordinary revenues (10 billion reais instead of 15 billion reais). The downward revision in our forecast for 2016 is due to a less-favorable comparison base in 2015.

Economic activity remains on a downward trend

The latest data show a deterioration in economic activity in recent months. Our diffusion index (based on a broad dataset) pointed to widespread economic weakness in February and will likely end the month at its lowest level since last year’s World Cup (during which the number of working days declined considerably) and close to the level reached during the worst of the 2008 financial crisis. Furthermore, industrial production remains sluggish, despite an increase in January, and coincident indicators that have already been released (such as industrial capacity utilization and auto production) point to another slide in February. In the retail segment, auto sales also fell in February (with a notable decline in sales of trucks and buses, signaling a drop in capital expenditures during the quarter), while vehicle inventories are still large at manufacturers and dealerships.

Business and consumer confidence declined in February. Business confidence levels fell in February in all the major economic sectors (manufacturing, services, construction and retail), as did consumer confidence readings. Except for the industrial sector, confidence levels in all categories hit the lowest points in their respective historical series for a second consecutive month. Hence, the uncertainty in the domestic scenario is increasingly being reflected in economic agents’ expectations.

We have lowered our 2015 GDP forecast to -1.1% from -0.5%. The latest data show that economic activity is deteriorating faster than we previously expected. Given the widespread economic and political uncertainty, tariff shocks (e.g., electricity), ongoing monetary and fiscal adjustments and a challenging external scenario, it seems unlikely that this situation will be reversed anytime soon. We have thus reduced our 2015 GDP forecast to -1.1% from -0.5%. Economic activity is likely to remain weak throughout the year, though the slide in 1Q15 may be particularly steep (our forecast: -0.6%). For 2016, we expect domestic uncertainties to ebb and ongoing adjustments to show positive effects. We anticipate moderate GDP growth next year, up 1.1% compared with 2015.

Unemployment continues to rise. The unemployment rate posted another increase in January, to 5.3% (according to our seasonal adjustment), up from 5.1% in December. The rising unemployment in recent months is due to slower job creation, given that the labor force and the working-age population are expanding at a similar pace. Data on new government-registered jobs (tracked by the labor ministry’s CAGED registry) illustrate the current situation in the labor market, as nearly 50,000 jobs were destroyed in January (according to our seasonal adjustment). We have thus raised our year-end unemployment rate forecast to 6.6% from 6.3% (seasonally-adjusted).

New loans showed strong growth in January. The daily average of new non-earmarked loans rose by 5.6% mom/sa in real terms in January, driven by short-term products, which carry higher interest rates. New earmarked loans also increased robustly, by 10.9%. Year-over-year real growth in total outstanding loans slowed to 3.6% in January from 4.6% in December. In the same monthly comparison, non-earmarked outstanding loans continued to decline (-1.9% yoy), while growth in earmarked outstanding loans decelerated to 10.4% yoy from 12.3% yoy. Overall delinquency ticked up 0.1 pp, to 2.9%. Interest rates and average spreads increased.

Electricity: More rainfall in February, and expectations of lower consumption

Rainfall volumes weighted by reservoirs stood at 101% of their historical average level in February. The evolution was better than in January, but insufficient to fully offset the hydrologic deficit accrued early in the rainy season. Rainfall levels were slightly more favorable in the Southeast/Center-West basin, at 105% of the historical average. 

Reservoirs rose to 23.2% capacity, but the risk of a shortage is still high. Our risk-assessment framework suggests that even with a normalization of rainfall levels in March and April, aggregate reservoir levels would end the rainy season below 35% capacity (vs. 42.6% in April 2014). 

Lower consumption may prevent power rationing. Electricity consumption may decline due to rising electricity tariffs, slower economic growth and campaigns to encourage less power usage. A reduction in energy consumption starting in April/May could be an alternative to a soft (4% - 5%) rationing. 

Water: Rainfall, construction work and lower consumption reduce risks and virtually rule out a supply collapse

Water levels in the reservoirs that form the Cantareira System rose by 5.1 pp in February, to 11.4% of useful volume (including withdrawals from the so-called dead volume), thanks to heavy rainfall (162% of the historical average) and further reductions in water withdrawals from the system. Lower water withdrawals from basins may affect economic activity, but the big news is that recent developments significantly reduce the risk of a supply collapse.

The Alto Tietê System benefits from rainfall and construction work. Rainfall in the basin amounted to 158% of the historical average in February, leading reservoir levels to rise by 10.8 pp, to 18.3% during the month. The completion of construction work that will increase the capacity for water transfers from the Billings Dam, expected for the middle of the year, will create some extra room in the balance between water-system inflows and outflows, allowing the reservoir to recover.

Raising our 2015 IPCA forecast to 8.0% from 7.4% to reflect the likelihood of higher electricity tariff increases and a weaker currency

Brazil’s consumer price index (IPCA) climbed by 1.22% in February, topping our forecast (1.10%) and the highest market estimates (1.16%, with the median at 1.08%). The largest upward contributions came from fuel prices, school tuition fees, electricity tariffs, urban bus fares and prices for new automobiles. The IPCA is now up 2.48% this year to date, and the year-over-year rise has accelerated to 7.70% (from 7.14% in January and 5.68% one year earlier).

Our preliminary inflation forecast for March is 1.30%, with the year-over-year change accelerating to 8.1%. The biggest upward pressure during the month will come from electricity bills, reflecting the effects of the extraordinary tariff review and the increase in the value of the so-called “red flag”. The hike in electricity bills we estimate for the March IPCA is 23% (impact of 0.75 pp), or 62% yoy. Food costs are expected to rise somewhat faster in March than in February, while apparel prices will likely again show increases after two months of deflation. On the other hand, monthly inflation readings for the transportation and education categories will likely decelerate sharply as the upward pressures from fuel prices and school tuition fees seen last month virtually vanish.

For the full year, we have raised our IPCA inflation forecast to 8.0% from 7.4%, incorporating our expectation of a bigger increase in electricity tariffs and a weaker currency. We now estimate a 13.1% hike in regulated prices (previously: 11.7%), following an updated forecast for the increase in electricity tariffs (now 50%, vs. 40% previously). This revision incorporates the extraordinary tariff adjustment and the increase in the value of the so-called “red flag” – effective in early March – as well as estimates by energy regulator ANEEL of the ordinary adjustments to be applied on the anniversary date of each concession (10%, on average). An eventual extension of loans granted by banks last year to cover expenses in the electricity sector may result in some relief in the ordinary adjustment estimated by ANEEL. As for other regulated prices with a large weight in inflation, we expect increases of 10% for gasoline prices (higher PIS/Cofins and CIDE tax rates), 12.5% for urban bus fares, 9.4% for health insurance premiums, 9.3% for water and sewage tariffs, 4.8% for medication prices and a 4.2% reduction in tariffs for landline phone service (reflecting lower rates for calls from landlines to mobile phones).

We have increased our 2015 inflation forecast for market-set prices to 6.5% from 6.1%, due to our expectation of a weaker currency. Sluggish economic activity and rising unemployment may lead to a smaller currency pass-through to market-set prices than our models initially suggested. The slight deceleration in inflation for market-set prices compared with last year (6.7%) will be driven by smaller price increases for food consumed at home and services, according to our estimates. We have raised our inflation estimate for food consumed at home to 6.5% from 6.0% (vs. 7.1% in 2014) and for private services to 7.5% from 7.3% (vs. 8.3% in 2014). Regarding food prices, we still expect a favorable scenario for agricultural supply, particularly for grains, with the prospect of good crops and a recovery in global inventory levels. Tame grain prices last year and this year will likely ease price increases for wheat byproducts and animal proteins. Meat prices, up 22% last year, are likely to show a more benign level of inflation this year, rising by less than 10%. Milk prices are also expected to be more constrained, thanks to a recovery in supply from the major global producers, likely helping to mitigate inflationary pressure in the food group. Regarding services, we maintain our assessment that a slowdown in inflation will be driven by worsening conditions in the labor market and the real estate sector, which will likely moderate wage and rental costs.

Our IPCA inflation forecast for 2016 remains at 5.5%. Estimates for market-set and regulated prices point to increases of approximately 5.5% in both categories next year. A weaker exchange rate is a risk factor for inflation in 2016, as it could have a lagging impact on some regulated prices, particularly for fuels and electricity. On the other hand, slowing activity — in the labor market in particular — may pull inflation down to lower-than-expected levels next year.

The general price index (IGP-M) rose by just 0.27% in February, and the year-over-year change reached 3.9%. Growth in the producer price index (IPA-M) — the component with the largest weight (60%) in the IGP-M — remains well behaved, at -0.1% for the month and 2.0% yoy (6.5% for agricultural prices and 0.4% for industrial prices). The consumer price index (IPC-M) — which makes up 30% of the IGP-M — rose by 1.14% in February, as the year-over-year change accelerated to 7.7%. The biggest upward pressure on the IPC-M came from regulated prices, chiefly urban bus fares, gasoline prices and electricity tariffs. The construction cost index (INCC-M) — making up 10% of the IGP-M — went up 0.5% during the month and 6.8% yoy.

For the full year, we have raised our IGP-M inflation estimate to 6.0% from 5.3% on the back of expectations of a weaker currency. Breaking our forecast down by component, we now expect increases of 5.0% for the IPA-M, 8.2% for the IPC-M and 7.0% for the INCC-M. Our forecast for the headline index in 2016 has been revised upward to 5.8% from 5.5%.

Tightening cycle close to the end, provided the exchange rate stabilizes

The Brazilian Central Bank is in a tough spot, facing rising inflation and declining activity.

On the one hand, there are ongoing adjustments in relative prices. Both the hike in regulated prices and the currency depreciation make the balance of risks for inflation less favorable. In fact, the recent depreciation trend of the Brazilian real (down 20% YTD) puts additional pressure on current inflation, which is already high due to the increases in public tariffs.

In this context, the monetary policy response tends to be stronger in order to prevent short-term pressure on inflation from perpetuating itself and spilling over into inflation expectations. This is why the Central Bank continues to raise the benchmark interest rate.

On the other hand, weak economic activity indicates further weakness and the need for smaller future adjustments in market-set prices (particularly for services). The Central Bank has emphasized a scenario of inflation convergence toward the target in 2016, notwithstanding the higher inflation this year.

Overall, the more conservative monetary policy stance this year, the fiscal adjustment announced by the government and the front-loaded increase in regulated prices in 2015 tend to open room for lower inflation in 2016. We therefore do not expect a prolonged interest-rate hiking cycle.

We see the SELIC rate at 13.00% by year-end, and falling toward 12% in 2016.

However, if the local currency continues to weaken, the Central Bank may choose to extend the cycle until the exchange rate stabilizes.

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