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Further Interest Rate Cuts in Brazil

May 9, 2012

Incomes are rising, public spending is growing and the currency is weaker. But the data point to a more moderate pickup in growth this year.

Global Economy
Can Less Fiscal Restraint Save Europe?
Hollande’s victory in France and Greece’s troubling election outcome suggest fiscal skepticism and renewed concerns on the growth front. Without a credible commitment to reforms and future fiscal control, however, markets will remain skeptical, and the euro zone will remain a risk – as Spain so vividly shows.

A More Proactive Short-Term Agenda
Incomes are rising, public spending is growing and the currency is weaker. But the data point to a more moderate pickup in growth this year. The new rules for savings accounts have cleared the path for the Central Bank to cut the Selic rate further.

Argentina’s Blues
Parallel FX markets are emerging due to controls on official FX market purchases. The business climate is deteriorating, especially after the YPF events.

A Different Monetary Policy Mindset
Mexico's Central Bank left the reference rate unchanged in April, but if were not for the deteriorating external scenario, the rate would have been cut.

Listening to the People
The Chilean government announced a tax reform in response to student protests. Over the medium term, increasing the quality of education is key.

After Conga
As uncertainty about mining fades, confidence rises – and the sol strengthens.

Popularity Puzzle
The government is successfully engineering a soft landing and moving ahead with economic reforms. But President Santos’ popularity is falling. We have revised our forecasts for year-end exchange rate to 1,750 pesos per dollar and interest rate to 5.25%.

Modest, Concentrated Losses
The arrival of El Nino augurs well for summer crops in the U.S.. With fears of a hard landing in China going down, demand for metals may pick up again. Regarding oil, geopolitical risk is now off from the radar screen but, amid still-tight supply conditions, price shocks cannot be ruled out.  

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Further Interest Rate Cuts in Brazil
A change in the rules that govern Brazil’s savings accounts (poupança) has enabled further Selic cuts. Based on the Central Bank’s view on activity and inflation, we believe that the Selic will reach a level of 7.75%. Apart from allowing more rate cuts, the change in the poupança is in keeping with an increasingly proactive economic policy in which more tools are used, and more intensively, by the government and Central Bank.

Our Brazil scenario changed in other ways, too. We lowered our 2012 GDP forecast, keeping 2013 intact. We also carefully reassessed the key factors behind the exchange rate. As a result, we now expect the Brazilian real to remain slightly weaker in 2012 and 2013 but stay strong in the longer term. These changes in our estimates also had an impact on our inflation forecasts.

This month we look at Europe’s hard choices as the region wrestles with recession and grows more skeptical of fiscal restraint as a solution to the crisis. Outside of Europe, the world has been consolidating trends.

In Latin America, we explain why recent steps in Peru will likely unblock mining investment. Chile, Colombia and Mexico continue to grow at a solid pace. In Argentina, YPF’s saga is the latest twist in an unfolding drama, now complete with a growing unofficial dollar market.

Global Economy
Can Less Fiscal Restraint Save Europe?
Hollande’s victory in France and Greece’s troubling election outcome suggest fiscal skepticism and renewed concerns on the growth front. Without a credible commitment to reforms and future fiscal control, however, markets will remain skeptical, and the euro zone will remain a risk – as Spain so vividly shows.

The world economy continues to consolidate trends. The U.S. is growing moderately, and the Fed maintains a wait-and-see disposition. China is slowing as expected, with no sign of a hard landing. The Japanese economy remains fragile, and the Bank of Japan continues to do what it can to support growth. Oil prices have stabilized, and geopolitical risk moved out of the headlines. Europe — especially after last election results in Greece and France, and Spain’s difficulties — is again the main concern.

The euro zone may no longer be on the brink as it was last year. Recent developments, however, illustrate the complex nature of a hard policy choice: to adjust fiscal policy, while avoiding a major recession.

The euro-zone economy probably shrank by 0.2% in the first quarter, and hasn’t been doing much better since. Manufacturing surveys point to an anemic April, adding to concerns about the growth outlook. We still forecast a 0.6% contraction in 2012, but could lower this number if the signs of weakness are confirmed by hard data.

The reality of recession has put growth back on the policy agenda. Mario Draghi proposed a “growth compact” in addition to the “fiscal compact” in place, echoing the view of many economists. In short, their view is that Europe must pace fiscal consolidation and financial deleveraging so as to avoid a deep recession that could derail the whole process.

Could a slower fiscal adjustment be good for Europe? The idea has appeared in newspaper articles and policy papers. Even the IMF produced a report suggesting that pacing down can be important, especially for countries already in recession (Balancing Fiscal Policy Risks, April 2012).

A more moderate pace, however, may raise doubts about fiscal commitment, adding to borrowing costs and eventually giving countries no option but to promise additional fiscal measures. It is a fate difficult to escape.

Over the last weeks, policymakers have swayed between those hard options: at times bent on doing less fiscal adjustment, at others offering more fiscal promises to ease market reactions.

A weaker fiscal hand has a better chance of success if countries can credibly commit to more growth-enhancing reforms and to future deficit control. Short-term indulgence must be balanced against long-term commitment. But this commitment may not be credible. Until it becomes so, the euro zone will remain a source of risk to global markets.

Spain’s Challenge
Spain, where GDP fell by 0.3% in each of the last two quarters, embodies those challenges and is now the main source of risk. In the year to March, the central government deficit stands at 1.09% of GDP – actually worse than last year. In autonomous regions, which have a history of fiscal slippages, 2012 budgets are still being negotiated. Poor performance and little clarity in the regions are leaving Spain no room for maneuver on the fiscal front.

The situation in the banking system is also delicate. The Bank of Spain estimates that banks held €184 billion in troubled assets in December 2011 (17% of GDP), and demanded that banks arrange €53.8 billion in new capital. Will it be enough?

The root of problem is in the real estate market, where losses keep rising and uncertainties have not abated. A prolonged recession and high unemployment could hit the residential mortgage market, by far the largest real estate segment in Spain, with €658 billion in loans as of December 2011.

So the answer is yes – banks will probably need more capital. Where will it come from?

Using government money would tie up banks and the sovereign even more, creating the risk of negative dynamics involving them – not to mention that Prime Minister Rajoy promised, during his campaign, not to bail out banks.

The EFSF/ESM funds could help but, unless rules change, these can lend only to sovereigns. The problem still lacks a clear answer.

Other parts of the euro zone also face difficulties. In Italy, the fiscal deficit stood at 1.9% of GDP in the year to April, compared with 2.6% in 2011. The labor reform has yet to be approved in parliament. The economy is in recession and we expect GDP to decline 2% in 2012. While Spain has already placed half of the bonds it plans to sell this year, Italy has only one quarter covered: May and June will be easier, but larger rollovers will be back from July on.

Finally, unpopular fiscal measures and reforms continue to shake politics. In France, the socialist Francois Hollande will replace the right-centrist Sarkozy at the Elysee. The Dutch cabinet resigned after the right-wing Freedom Party walked out of budget negotiations.

In Greece, the two main parties – the New Democracy and the Pasok – supporting prime minister Papademos failed to secure enough votes to form a government, holding only 149/300 of the seats in between them. Greece’s rising political forces are a diverse group of parties, mostly with extreme views either to the left or to the right. Not all favor membership in the European Union, and all have campaigned against fiscal austerity. Politics has dragged Greece back to the radar screen.

The U.S. economy grew at an annual rate of 2.2% in the first quarter, a result slightly softer than consensus expectations. Consumption grew by 2.9%, but that was partly due to the warmer winter. On the other hand, the savings rate dropped from 4.5% to 3.9%, suggesting that this pace of consumption is unlikely to be sustained, even if personal income reaccelerates in the coming quarters, as expected. Therefore, we maintain our 2.1% GDP growth forecast for 2012.

The Federal Open Market Committee strengthened its “on hold” stance at the April 25 meeting. Members raised their 2012 GDP growth forecast from 2.2%-2.7% to 2.4%-2.9%, but reduced growth prospects for the next couple of years. During the press conference, Bernanke reiterated that a shift in policy will come only in the event of significant change in the economic outlook.

Recent data confirms a soft-landing scenario. GDP grew slightly less than expected in the first quarter, slowing from 8.9% to 8.1% yoy. On the other hand, March showed a recovery in industrial production, industrial profits and exports. Surveys show a pickup in industrial orders, both domestic and external. Credit growth is accelerating, and better financial conditions since last November continue to drive the economy. We expect faster quarterly growth in the second quarter, keeping year-on-year growth at 8.1%.

The official rhetoric continues to favor selective easing and gradual reforms, and the latest step was the widening of the yuan’s trading band. The reference FX continues to be set daily by the People’s Bank of China (we still expect 1% to 2% appreciation in 2012), but volatility of the spot rate will likely rise.

We continue to expect GDP growth of 8.0% in both 2012 and 2013, as well as further cuts in bank reserve requirements in the context of selective easing.

The Bank of Japan confirmed expectations and increased its asset purchase program. Apart from increasing the program from 65 to 70.2 trillion yen, the deadline for implementation was extended to June 2013 (previously the end of 2012), and bonds of longer maturity were included.

In the BoJ’s revised macro forecasts, inflation does not converge to the 1% goal even by the end of fiscal year 2013. At the same time, the data points to weak activity in the second quarter, and political pressure remains. This environment suggests more monetary stimulus ahead.

However, the BoJ also expressed concern regarding fiscal credibility. The remark was possibly directed at lawmakers now examining the bill hiking the consumption tax, submitted by the cabinet in the first days of April. Still on a cautious note, BoJ governor Shirakawa said after the meeting that the effects of recent stimuli must still be evaluated, suggesting lower chances of further easing in the short term.

Later on, however, political pressure and slow growth will likely lead the BoJ to further easing – but probably not before July.

The monetary policy outlook and the incoming data are consistent with our forecast for GDP growth at 1.7% in 2012 and 0.9% in 2013.

Commodities endured a month of deterioration in the market’s mood with only slight losses. Among the injured, metal prices suffered due to concerns regarding activity in China, and energy assets lost part of the support from geopolitical headlines. Looking ahead, we have left our forecasts unchanged, considering that the fundamentals remain the same: we expect a recovery in global activity in the medium run combined with a very tight supply-demand balance for the main commodities. We forecast average increases in commodity prices of 11.3% year-over-year in 2012 (they are already up 6.6%) and 5.7% in 2013.

Oil prices stabilized at a lower level than at the end of February, with geopolitical issues no longer making headlines. The very tight balance between supply and demand should keep prices at these levels and spikes cannot be ruled out.

The summer crop in the U.S. got off to an excellent start this month, with warmer weather and the prospect of favorable rains stimulating strong planting progress. With the end of La Niña and more abundant rain, there is a high probability of very good crops for corn and wheat in the U.S., which would help to restore inventories and give price relief. Soybean prices, however, should maintain an upward trend, propelled by the decline in planted area registered in the U.S. and the need to stimulate planting here in South America next year.

Industrial metal prices should maintain a very close relationship with economic activity in China. As the deceleration trend gives way to some recovery – which is what the data at the margin have been indicating – we can expect a consolidation or slight increase in metal prices by the end of the year.


Growth Risks, Growth Boosters
The economy is rising, but the risk of a weaker recovery remains. Measures to help manufacturers and boost lending by state banks suggest that the government wants more. The Central Bank is signaling that the Selic will bottom at 9%, but current lower-than-expected inflation and activity could push it lower.

We have revised our forecasts for interest rates, the exchange rate, growth and inflation. We now believe that the Selic will fall to 7.75%, instead of 8.5%. We now project the exchange rate at 1.85 reais per dollar by end-2012 and 1.87 by end-2013 (up from 1.75 for both years). We have reduced our forecast for GDP growth in 2012 to 3.1% (from 3.5%) but have kept our 2013 forecast at 5.1%. We have slightly raised our IPCA inflation forecasts to 5.2% (from 5.1%) for 2012 and to 5.7% (from 5.6%) for 2013.

The government brought a new outlook to monetary policy early this month when it changed an important regulation covering Brazil’s financial market. From now on, returns on regulated savings accounts – the poupança – will track the Selic rate, at a 30% discount, whenever the Selic falls below 8.5%. By eliminating poupança’s 6% floor, the government removed the risk that investors could migrate from Treasury bonds to savings accounts if the Selic falls below a borderline level of around 8.5%. The new poupança rules have cleared the way for more rate cuts.

Given the Central Bank’s views on inflation and activity, we believe that it will push the Selic down to 7.75%, going beyond our previous forecast of 8.5%. The path towards 7.75% should be through two 50-bp moves in May and July, and a final 25 bp-cut in August.

A New Agenda?
Apart from allowing more rate cuts, the change in the poupança is in keeping with an increasingly proactive economic policy in which more tools are used, and more intensively, by the government and Central Bank.

Reforming the poupança was desirable but politically tricky, and many doubted that the government would actually face up to the task. By taking it on, President Rousseff signaled her wish to test new lows for the interest rate. Indeed, the Central Bank will probably reduce it more than previously expected.

On a separate front, the Central Bank has been more active in the FX market. While fundamental trends do suggest a slightly weaker currency in the short-to-medium run (as we discuss below), the Central Bank’s dollar purchases have pushed the exchange rate to values above what we believe to be the equilibrium level.

A proactive approach was also on display earlier this year, when the Finance Ministry selectively reduced the taxes paid by manufacturers while offering some protection against imports.

In short, the government is making broader use of the tools at its disposal, actively seeking to lower borrowing rates, stop currency appreciation, protect local producers and increase public investment. A new agenda seems to be unfolding, but its contours are still not entirely clear.

Activity: Same Dynamics, Less Intense
The first months of 2012 suggest a more moderate pace of activity ahead. On the one hand, the global economy is growing more slowly and credit conditions are still improving gradually. On the other, the labor market remains tight, government outlays are accelerating and confidence, especially that of consumers, is rising.

We have thus reduced our forecast for GDP growth in 2012 to 3.1% (from 3.5%). Even with lower growth this year, we do expect a pick-up in the second half of the year: lower interest rates, more public spending (as we discuss below) and a weaker currency will all continue to support growth, each with its own lag. Lags are sometimes long and hard to detect, but that does not mean they are not there.

There are still some factors holding back the economy. Auto sales are still weak, even after contracting in the first quarter; as a result, auto inventories will likely continue to restrain manufacturing for a few months. Surrounded by uncertainty, the global economy expands moderately. Confidence among manufacturers is rising only slowly, despite the incentives. That will tend to weigh on investment.

Bank lending was stable in the first quarter of the year. New consumer loans were up 1.7% year over year (after adjusting for seasonality, inflation, and business days), but business loans were down 0.7%.

Other factors suggest that a recovery is well under way. Total real wages are now up more than 7% from one year ago, a solid gain that reflects the new minimum wage and the low rate of unemployment. Strong income is boosting supermarket sales. Consumer confidence hit a record high in April and will likely prop up demand for consumer goods ahead.

The pick-up may be slow, but it is already in evidence in important areas of the economy and will likely continue to spread. Remember, a solid set of growth boosters is at work. The second half still looks to be the best part of 2012. In fact, we are keeping our 2013 GDP growth forecast at 5.1%.

FX: Revised Forecasts
We reassessed the levels of some exchange rate fundamentals and considered the short-term impact of Central Bank’s dollar purchases and of lower interest rates. As a result, we have revised our year-end forecast to 1.85 reais per dollar in 2012 and 1.87 in 2013 (up from 1.75 for both years).

In recent years, the prices of Brazilian exports have consistently risen faster than prices of imports, an improvement in the terms of trade that explains much of the currency’s appreciation over the years. However, the terms of trade have lately given some ground, falling by around 6% from their peak in late 2011. In addition, Brazil’s risk premium is now slightly higher than the level of early 2011. Both factors suggest a weaker short- to medium-term equilibrium exchange rate.

As for short-term factors, the Central Bank stepped up the pace of its purchases in the spot and forward markets in the last couple of months, helping to push the exchange rateto 1.92 in early May from 1.71 in early March. Although the long-term impact of such FX intervention is limited at best, it can work in the short term, especially if fundamentals are pushing in the same direction, as we believe they are. Also, domestic real interest rates have fallen faster and more deeply than expected at the end of last year. Lower interest rates and higher Central Bank intervention have caused the currency to weaken even more than our revised equilibrium estimate would suggest.

Balance of Payments
A weaker currency will likely make the current account deficit rise more moderately ahead. We have lowered our deficit forecasts to 2.3% of GDP in 2012 (from 2.7%) and 2.6% of GDP in 2013 (from 2.9%). The deficit now stands at 2.0% of GDP.

One of the factors behind the smaller deficits is a stronger trade surplus due to the weaker FX. We now expect a 2012 trade surplus of $18 billion (up from $15 billion). For 2013, we now expect a surplus of $10 billion (up from $5 billion).

In March, foreign direct investment reached a solid $5.9 billion, reinforcing our forecast of strong inflows this year. We stand by our call of FDI amounting to 2.6% of GDP in 2012 (compared with 2.7% in 2011).

Fiscal Trends
The March fiscal results showed the public sector on the way to meeting this year’s primary target of 140 billion reais (3.1% of GDP), as in 2011. In the first quarter of the year, the primary surplus hit 4.5% of GDP – higher than last year’s 4.1%. Despite the slightly better primary surplus at the start of the year, fiscal policy will contribute to boost growth this year, thanks to higher spending.

In March, federal spending was up 11% year over year in inflation-adjusted terms, with sturdy gains in discretionary spending (34%), including investment (70%) and administration (22%). Transfers were up 9%, reflecting the highest real minimum wage hike in six years.

Except for payrolls, which are still muted, federal spending is rising across the board, exhibiting a real annualized growth rate of around 5% over the past six months

We maintain our view that the government’s fiscal targets will be met in full in 2012 and 2013. If revenues pick up as the economy recovers later this year, the government will be able to keep real spending rising at the fast pace of around 7% in both 2012 and 2013. Government transfers will play a leading role in 2012, as will investment for the entire two-year period. In all, fiscal policy continues to look expansionary.

We have slightly raised our 2012 IPCA forecast to 5.2% (from 5.1%), reflecting the impact of a weaker currency (which will cause an even stronger impact on wholesale prices), partly offset by lower GDP growth. We have also raised our 2013 inflation forecast slightly, to 5.7% from 5.6%.

This expected increase of inflation from 2012 to 2013 reflects the likelihood of a faster rise in regulated prices, which we expect to go up by 5.0% (from 3.1%). We still expect market-set prices to rise by around 6% and services inflation to stay close to 8%, echoing a strong labor market.

Inflation risks tilt to the upside. Fueled by strong growth boosters, a faster-than-expected recovery of the economy could increase inflationary pressures ahead.

From a broader perspective, Brazil’s long cycle of currency appreciation seems to have run its course, and the exchange rate could be stabilizing. What does that mean for inflation?

When a currency is appreciating, inflation in tradables – imports and import-competing goods – is lower than in non-tradables (services). The gap between the two categories can be significant. In Brazil, for example, with market-set prices up 84% over the last ten years, tradables rose by 77% and non-tradables rose by 90%.

This gap always narrows when the FX rate stabilizes. This narrowing may occur through import prices rising faster, which causes higher inflation. Or it may occur as prices for locally-produced goods rise more slowly, keeping inflation contained. If the currency is weakening, the greatest part of the adjustment may come through higher tradable good prices, creating more inflation pressure.

Monetary Policy in 2013: Some Tightening on the Horizon
With the Selic rate at 7.75% and inflation at around 5.5%, real interest rates will soon hit a level below 2.5%, the lowest in decades. If past performance is any guide (i.e. no sudden structural break), it is possible that future inflation pressure will necessitate measures to slow down the economy.

We believe that this pullback will start with other instruments (such as macroprudential and quasi-fiscal measures), and then proceed to rate hikes. We expect the Selic to be raised back to 9.5% from 7.75% in three 50-bp steps starting in April 2013 plus a final 25-bp hike.

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