Itaú BBA - A Grain of Inflation - August 2012

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A Grain of Inflation - August 2012

August 2, 2012

The prices of some agricultural commodities have risen. The spike in grain prices became a common theme across Latin American countries.

Global Economy
Markets Act, Policymakers React: The Euro Crisis Duet Continues
Market pressure in Europe is on the rise again and requires a new round of reactions from policymakers. With Spain at the center of the crisis, and risk of contagion to Italy, the stakes are high

Slow Recovery in Activity and an Extra Grain of Inflation
An auto sales bonanza helped the economy in June, but a more widespread recovery is still to come. In the meantime, a spike in grain prices makes its way into consumer prices

No Growth, More Intervention
We now expect no growth in 2012. Meanwhile economic intervention has increased, with the central bank starting to direct commercial bank credit

Slower, but Still Strong
Mexico’s economy continues to grow at a solid pace, though less rapidly than in the first quarter

A Strong Economy in the First Half
Chile’s economy expanded strongly in the first half of this year. Slower global growth will likely cause a moderate deceleration in coming quarters  

New Minister, Renewed Hopes?
In a bid to move Conga forward, a new cabinet chief has been appointed

A Surprising Rate Cut
As the deceleration became more widespread, the central bank decided to move quicker

Commodities: Supply shock, for a change
Commodity prices are rebounding, propelled by the drought in the U.S.

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A Grain of Inflation
The loud cheering for Mario Draghi as he again committed to keeping the euro afloat reminds us of how dependent the markets are on central banks. However, as we argue in this month’s report, both they and their governments continue to be led by markets, instead of leading them. The global scenario remains difficult: little growth, lingering risks.

In the meantime, the prices of some agricultural commodities have risen as a result of poor supply conditions. The spike in grain prices became a common theme across Latin American countries.

In many of them, including Brazil, higher producer prices are beginning to trickle down to consumers, driving inflation expectations up. Weak local and export sales, however, are favoring supply and mitigating the impact. Inflation, it must be said, remains a moderate source of concern.

Growth probably attracts more attention in the region. We lowered our 2012 GDP forecasts for Colombia and Argentina. Chile, Mexico, and Peru are also slowing, but at a slower pace. In Brazil, our GDP growth forecasts remain unchanged, but the pickup needed to deliver them remains a source of uncertainty.

In Peru, the government and protesters remain at loggerheads over mining projects. Last month, violent clashes between the police and protester triggered an overhaul of President Humala’s cabinet.

Global Economy
Markets Act, Policymakers React: The Euro Crisis Duet Continues
Market pressure in Europe is on the rise again and requires a new round of reactions from policymakers. With Spain at the center of the crisis, and risk of contagion to Italy, the stakes are high

In Europe, policymakers prepare new responses to crisis. The head of the European Central Bank (ECB), Mario Draghi, promised to act. Spain will likely ask for further external support. Meanwhile, growth rates in Europe, U.S. and China show signal of stabilization, albeit at a weak pace. We still expect another rate cut from the ECB, more quantitative easing from the U.S. Fed and further easing in China.

Financial markets in Europe show signs of stress again. The latest European Summit didn’t set a clear roadmap for more integration, nor did it do enough to break the link between sovereign and banks. Disappointed investors continued to push Spanish yields to record highs (see graph).

Will European leaders react? Yes. We haven’t experienced a lack of measures in this crisis. But policymakers are the followers: first financial markets act and create intense pressures; then leaders react.

Moreover the perspective of policy responses doesn’t bring relief. Some progress was made in the last two years. But the reactions so far were limited and often postponed key decisions. And with Spain at the center of the crisis, and with risk of contagion to Italy, the stakes are high.

The next move will likely be further financial assistance to Spain. First, the bailout funds ESM and EFSF could start buying Spanish bonds.  But these funds have limited firepower and create issues of seniority for other investors. Spain might then need a full Troika program.

The ECB will continue to play a major role. Ultimately it is the only institution with an unlimited balance sheet. On August 2, Draghi said that the ECB could buy sovereign bonds of a country that asks for assistance from the bailout funds.    

Meanwhile, global activity shows some signs of stabilization. However, growth rates were low or negative in the second quarter. Risks remain to the downside, and we foresee only a slight recovery in the second half of the year. As a consequence, we continue to expect more easing from the world’s main central banks in the next few months.


The purchasing managers’ index was unchanged, at 46.4 in July. The breakdown shows weakness in the manufacturing component, which declined 1.1 points to 44. Services offset this decline with an increase from 47.1 in June to 47.6 in July. Overall the levels point to recession in the region.

The decline in the euro, which depreciated 8% in relation to the U.S dollar this year, boosts exports. But high uncertainty, fiscal consolidation and financial sector deleveraging are strong drags on the economy. 

Given the weak economic outlook, we expect the ECB to cut rates by an additional 25 basis point. Our baseline is for the cut to occur in September, when the ECB releases its new economic forecasts.

The initial enthusiasm with the European Summit at the end of June didn’t last. The subsequent lack of details raised doubts about the decisions.

Will national governments be liable for their banks, even with direct loans from the ESM? Germany insists that it will, invalidating the summit promise to break the link between sovereign and banks. How long will it take to set a single regulator? Six months, as initially promised, or at least one year, as suggested afterwards? Through what decision process will the ESM intervene in the sovereign bond markets? Can an individual country block it?

European leaders don’t plan to answer these questions soon. The finance ministers meet only on September 15. Specific proposals for fiscal and financial integration are expected only in December.

In addition, the ESM was not implemented in July as initially planned. The German constitutional court is judging whether the fund is compatible with the country’s law. A decision strictly about a temporary injunction won’t be available until September 12.


European politicians finalized a €100 billion ($121 billion) aid to the banks in Spain. The Spanish government is fully liable for the financial assistance. Sovereign and banks remain deeply interlinked.

The country revised its fiscal deficit targets to 6.3% (5.3% before the revision) of GDP in 2012, 4.5% (3%) in 2013 and 2.8% (2.1%) in 2014. The government also announced tax increases and spending cuts to save an additional €65 billion (6% of GDP) from 2H12 to the end of 2014.

The dynamic of the Spanish sovereign debt remains a source of risk. The new fiscal measures help. But the bank’s bailout adds to the debt level, deficits remain high, and the prolonged recession makes adjustments harder. In our simulations, the debt-to-GDP ratio continues to rise, from 69% in 2011 to 95% in the next five years. Only then do we see some decline.

Moreover the regions have lost access to financing. The federal government has put several programs in place to help them. The latest facility will provide up to €18 billion. Of that, €6 billion will come from the national lottery, but the treasury needs to specify where it will obtain the remaining €12 billion.

Adding debt rollovers, deficit financing and funding to the regions, we estimate that the Spanish treasury need to issue up to €50 billion in bonds by the end of the year. At the moment, markets are not willing to finance that amount. 

We still expect Spain to ask for further external assistance, first in the form of ESM/EFSF interventions in the sovereign debt markets. The problem is that the ECB intervention remains temporary, while the bailout funds have limited firepower and create issues of seniority for other investors.

Eventually, Spain might end up needing a full Troika program. In that case, a package could exceed €200 billion for the next two years.


Greece resumed negotiations with its official creditors. Germany and the IMF demand full compliance with the fiscal and reforms targets. The Greek government appears to agree with additional measures for 2013 and 2014, but it wants no further austerity this year.

Greece’s economy remains in a deep recession and cannot meet the package conditions.The official creditor position has increased again the possibility of a Greek exit in the near term.


GDP growth decelerated to a 1.5% annualized seasonally-adjusted pace in the second quarter, from 2.0% in the first quarter. Consumption also decelerated in the period (see graph). After two very strong quarters, vehicle sales were also weaker.

Fundamentals to private demand remain relatively healthy with low interest rates and ample availability of credit. But we expect GDP growth slightly below a 2.0% annualized pace in the second half of the year, as business reduce inventory accumulation and the public sector remains a drag to demand.

We maintained our growth forecast of 2.1% in 2012. For 2013, when fiscal policy will become more restrictive, we still expect a slowdown to 1.5%.

The U.S. Fed has been conveying a message that after extending the operation “twist” until year-end, it was inclined to wait and see whether the economy would accelerate. But we are getting closer to the thresholds for more monetary stimulus.

The timing for additional monetary easing is probably September, as the Fed downgrades its economic outlook, which remains more optimistic than our scenario. Our base case is that it will come in the form of a balance-sheet expansion.


China’s GDP rose 7.6% in the second quarter over a year ago, slowing from the 8.1% in the first quarter. However, following the sharp deceleration seen in April and May, June data showed signs of stabilization.

Moreover, the Chinese government continues to signal more stimuli. It already implemented two interest rate cuts, reduced reserve requirements and promoted targeted fiscal policies. We expect similar actions this semester.

The policy easing should provide a mild boost to activity from the third quarter onwards. Our scenario already assumes this. Hence, we continue to forecast GDP growth of 7.8% in 2012.


Commodity prices bounced back in July from their depressed levels in June. Agricultural prices posted the strongest gains. Adverse climate conditions in the U.S. sharply reduced production forecasts and pushed grain prices up (see graph).

Brent is back above $100 per barrel. The $90 price seen in June does not appear compatible with the current balance between supply and demand.

Finally, the downward trend in metal prices was interrupted.  Prices oscillated within a tight range over the past few weeks. A more pronounced recovery needs a clear signal that demand will improve in the second half of the year.

Slow Recovery in Activity and an Extra Grain of Inflation
An auto sales bonanza helped the economy in June, but a more widespread recovery is still to come. In the meantime, a spike in grain prices makes its way into consumer prices

We raised our 2012 IPCA inflation forecast to 5.2% (from 4.9%) because of the spike in grain prices, but trimmed 2013 to 5.3%. Our forecast for the 2012 trade surplus is unchanged at $18 billion, but we upped 2013 to $15 billion (from $10 billion). We still see the currency’s fundamental level at 1.90 reais to the dollar, but Central Bank intervention will likely prevent a quick convergence. We now forecast the dollar at 1.95 at year-end 2012, and maintain 1.90 for year-end 2013. We still expect the Central Bank to drive the Selic rate to 7% in two more rounds of 50-bp cuts. Our GDP growth forecasts remain at 1.9% for 2012 and 4.5% for 2013.

A tax break boosted auto sales and helped the economy in June. A wider set of indicators, however, still show weakness elsewhere, and the first numbers for July are not different.

Auto sales increased 30% in June from May with seasonal adjustment, a selling spree fueled by cheaper prices after a tax break. The surge in sales prevented a sharp decline in auto production, and cleared excess factory inventories. The sector is now ready to produce, should demand stay on as we expect it to.

Judging from the data so far, our monthly GDP index may have gained as much as 0.6%, a result consistent with our projection of 0.6% quarterly growth in the second quarter.

Bank lending improved again in June. New borrowing by consumers soared 5.5% (adjusting for seasonality and inflation). Loans to companies continued to expand, with concessions up by 1.6%, the fifth consecutive monthly gain.

Rates and spreads fell again for both consumers and businesses. Non-performing loans fell across most categories, suggesting that the cycle may be coming to an end. State-owned banks are gaining market share.

The better June, it appears, gave way to a tepid July. A survey from the Getúlio Vargas Foundation showed waning manufacturing confidence, while consumer confidence, although still high, fell for the third month in a row. Global uncertainty still weighs on investment. And, after a very strong June, auto sales fell in July, even though they remain at a strong level.

Looking ahead, the economy still has much stimulus to assist it. Interest rates continue to fall, public spending is rising, and many tax incentives remain in place. State-owned banks are lending more. The government has been considering more incentives, especially to prop up investment and reduce costs in the manufacturing sector. Some of those incentives take time to affect the economy, which is why we expect the economy to accelerate in the second half of the year.

We thus expect to see stronger and more widespread signs of recovery. Until that happens, risks will remain. For example, unemployment is at an all-time low and wages are still rising, but there are signs of moderation and formal hiring has slowed. If growth takes longer, job creation could slow further, weighing on the recovery.

For now, our GDP growth projections are unchanged. We forecast 1.9% for GDP growth in 2012 and 4.5% in 2013.

Fiscal Policy, Helping Demand

Fiscal policy is helping push demand. Federal spending has grown at a pace of 7.0% so far in 2012, an increase driven by transfers, subsidies and “administrative” costs. Investment is also accelerating, due to increased spending under the “Minha Casa, Minha Vida” home subsidy program. We still expect public spending to rise by 7.1% this year, twice as fast as last year.

Tax collection, on the other hand, is growing at a trend pace of 3.3% (adjusted for inflation): faster than the economy, but the lowest speed since 2008. While we still expect activity to raise revenues ahead, we lowered our hopes slightly and now forecast real revenue growth of 5.0% (5.3% previously). All told, our primary surplus forecast now stands at 2.8% of GDP (from 2.9). The 2011 surplus stood at 3.1%.

Structural Surplus and Medium-Term Fiscal Trends

Beyond its short-term impact, we must also have a structural view of fiscal policy.

This structural view must take into account the speed of the economy, as well as, in countries like Brazil, the cycle of commodity prices. When growth is good, the headline result will tend to look better, even if policymakers don’t hold back spending.

Our own measure of Brazil’s structural primary surplus adjusts not only for growth and commodity prices, it also excludes the significant volume of non-recurring revenues seen in recent years. Once all is considered, we note that the structural surplus has been lower than the actual surplus since 2007 (see graph).

The lower Selic should help reduce interest payment and the debt-to-GDP ratio, driving the government to settle for smaller primary surpluses in the future. The extra room will likely be used to boost spending (hopefully in investment) and ease taxes, especially on manufacturing.

On that note, we trimmed our 2013 primary surplus forecast to 2.6% of GDP (from 2.8%), incorporating more tax breaks in our scenario. Since revenues will likely profit from a better economy in 2013, we estimate that the structural surplus will fall to 1.3% of GDP. A more expansionary fiscal policy is to be expected in the coming years. For a discussion of structural fiscal trends in Brazil, see our research note “Brazil’s Structural Fiscal Balance”, published last April.

External Sector and the Exchange Rate: Adjusting Forecasts

The recent surge in grain prices should strengthen the currency, moving it closer to our previous forecast of 1.90. That said, the real has been away from that level for a while and it is reasonable to expect it to take longer to return, given that the government is firmly intervening to reduce volatility.

That is why we now forecast the currency at 1.95 to the U.S. dollar at year-end 2012, and to converge back to 1.90 at the end of 2013.

Equity and fixed-income inflows were back in June after May’s strong outflows. The rollover rate of medium- and long-term debt soared to around 200%. Foreign direct investment was strong again: $5.8 billion in the month, with preliminary data pointing to a number close to $7 billion in July. The current-account deficit rose slightly to 2.2% of GDP (from 2.1%), precisely our forecast for 2012 (previously 2.3%). For 2013, we also trimmed our estimate to 2.4% of GDP (from 2.6%).

After a weak result in June, the trade surplus rose to $ 2.9 billion in July. The impact of higher grains prices on the trade balance has been neutral: corn exports are up, but so are wheat imports, and iron-ore prices are weaker. We thus stick to our $18-billion forecast. In 2013, however, soybean prices around 40% higher will likely drive up the trade balance. We now forecast $15 billion (from $10 billion).

Inflation: Food Prices to Push the IPCA Upward This Year

Higher global grain prices – corn, wheat and soybean – are pushing producer prices up in Brazil, and will soon hit consumer prices too. The IGP-M index –60% of which is made up of producer prices – rose by 1.34% in July from June. It’s a high reading and a sharp pickup. After this result, we raised our forecast for the 2012 IGP-M to 7.5%, from 6.2%. One month ago, it was 5.4%.

Moving into consumer inflation, the pressure on corn and soybean will likely raise the cost of pasture, making meat more expensive. Higher wheat prices will burden all of its by-products, especially bread, flour, and pasta. We thus raised our 2012 forecast for the IPCA index to 5.2% (from 4.9%).

Some mitigating factors held back the forecast revision. The livestock cycle (more slaughtering of females) has favored beef supply, and so have weaker demand and falling exports. The government has also been considering tax cuts in food staples, including meat products. In addition, given the magnitude of the shock, it is reasonable to expect that the pass-through to consumer prices will extend into early next year.

For 2013, we trimmed our IPCA forecast to 5.3% (from 5.4%). This is because food inflation will likely ease back to a pace of around 5%-6%, after gaining around 9% in 2012. Regulated prices should accelerate to around 4% (from an expected 3% this year), and market-set prices should be relatively stable, rising a bit less than 6%.

Among market-set prices, food prices should give back some of the gains caused by rising grain prices this year. On the other hand, we do not expect prices of consumer durables (vehicles, household appliances and furniture) to fall as they did this year as result of tax cuts.

Monetary Policy

Growth remains moderate and inflation continues under control even after the pressure from food prices. Thus, we expect the Central Bank to keep cutting interest rates. The wording of the latest monetary policy meeting was similar to that of previous meetings, which suggest that the committee is comfortable with the pace of 50-bp cuts.

We still expect the benchmark Selic rate to fall to 7% (from 8% today) in two rounds. In 2013, as growth picks up and inflation pressure returns, we expect the bank to reduce monetary stimulus, raising the Selic back to 8.50%.

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