Itaú BBA - A New Wave of Uncertainty

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A New Wave of Uncertainty

June 13, 2012

The global economy took a turn for the worse since our latest LatAm Macro Monthly report.

Global Economy
At the Crossroad
European woes will largely define the global economic scenario ahead.

Brazil
Weaker than expected
Brazilian economic activity started 2012 on a weak note, and the recovery tends to be slower than expected. We revised down our GDP forecast for 2012 and 2013, and see more policy stimulus on the horizon.

Argentina
Domestic uncertainty amid external volatility
The Argentine government has recently tightened the foreign-exchange controls. Spreads increased in the “blue” foreign-exchange market, and banks started to lose U.S. dollar deposits. We now expect growth to fall to 1.0% this year and, if the euro-zone crisis deepens, the economy would contract in 2013.

Mexico
Positive surprises
We revised our growth forecasts upwards and became more constructive on long-term growth, as the probability of reforms seems higher. However if the euro-zone crisis deepens, Mexico’s economy would still suffer.

Chile
The Focus Shifts to the External Scenario
The central bank gets more concerned about the global risks. In a more adverse external scenario, Chile would be able to respond fast and strongly.

Peru
Economy in Good Shape
Activity is growing strongly, but is also vulnerable to the global scenario.

Colombia
Losing Steam
Industrial output and excessive leverage point to softer growth ahead.

Commodities
Macroeconomics dominate the perspective
Global outlook deterioration surpass other fundamentals, prompting a strong correction in May.


A New Wave of Uncertainty

The global economy took a turn for the worse since our latest LatAm Macro Monthly report.

Hope of relief came from the Spanish government’s agreement to a rescue plan for the country’s troubled banks. The deal in Madrid, however, does not necessarily mean progress in troublesome issues such as fiscal union, the mutualization of the region’s sovereign debt, and a more unified framework for European banks.

In the meantime, Greece could still exit the European monetary union.

“When you come to a fork in the road…Take it.” In this edition, we take Yogi Berra's famous advice and look at both paths that Europe might take from its current crossroad. At this point, Greece’s remaining or exiting the euro zone are both possible paths.

On the other side of the pond, hopes of a faster U.S. recovery are fading. China is slowing perhaps more than we expected.

In LatAm, we expect more depreciated currencies and weaker growth (to still-robust levels, in some cases). We raised our GDP forecasts for Chile and Mexico, as growth in these countries has been more robust than expected. Our estimates for Peru remain unchanged, as activity continues to expand at a strong pace.

However, Argentina is likely to undergo a more abrupt deceleration due to the impact of the current foreign-exchange controls on activity. We also lowered our GDP forecast for Colombia.

In Brazil, a slower-than-expected GDP in the first quarter, as well as weaker prospects for the second quarter, led us to decrease our growth forecast for 2012. Although demand continues to hold up well, production, particularly in manufacturing, has suffered. We forecast further government stimuli, through various instruments, and a recovery ahead.

Global Economy
At the Crossroad
European woes will largely define the global economic scenario ahead.

Recent concerns regarding the Greek elections and bank problems in Spain have brought a new wave of pessimism to the markets. The announced €100 billion to recapitalize Spanish banks is positive[1]. But will it provide some relief to markets? Initial reaction was muted and might continue to be so, at least until the Greek situation becomes clearer. Meanwhile, austerity support has lost some ground, as worries about low growth in the peripheral euro zone keep mounting.

The U.S. and China’s economies do not offer optimism to balance the European problems. After months of positive surprises, hopes of returning to the past’s higher growth have finally faded. The Chinese economy continues to decelerate. We reduced our 2012 forecast for China’s GDP growth to 7.8%, from 8.0%.

As uncertainty persists, financial conditions deteriorate, the euro-zone recession deepens and the fiscal adjustment becomes more difficult.

A large, well-coordinated plan to deal with sovereign and liquidity problems in the peripheral countries is unlikely to be implemented due to political constraints. Countries’ specific programs would still be available, but during moments of stress it is more likely that the European Central Bank would have to step in, providing banks with extensive liquidity (possibly against bad collateral) and intervening in sovereign-bond markets.

Even a decisive ECB intervention doesn’t guarantee the maintenance of all countries in the euro zone. Depending on the development of political events in Greece, the official group of creditors (the European Union, the ECB and the International Monetary Fund, known as the troika) could cut support to the country, which would eventually run out of euros.The ECB, in conjunction with policy-makers in the euro area, might decide to cut liquidity support to Greek banks, forcing the country out of the euro, while supporting (and effectively ringfencing) the rest of its members.

What lies ahead? It mostly depends on a binary outcome: whether there is a Greece fall-out or not, which, in turn, depends mostly on political events. What are the odds? They are close. In this sense, there are two probable scenarios.

The “basic” scenario assumes that Greece remains in the euro zone, at least trough this crisis. In this scenario, the Greek government resulting from the elections agrees with the troika on some changes to the current austerity program, allowing the country to remain in the monetary union.

Over time, some degree of fiscal and financial integration could slowly and painfully be implemented, although this is not guaranteed. Neither are the reforms needed to boost growth and competitiveness (such as labor markets and pension reforms). If adopted, low growth would eventually replace the current recession in the region. In this case, the euro zone would survive this crisis with the same format.

In our basic scenario, we see the ECB reducing rates and the Federal Reserve still in a wait-and-see mode. With the Fed on the sidelines, the ECB cutting rates and prolonged uncertainty in the euro area, we are revising our euro forecast from 1.28 to 1.20 at the end of 2012.

In our “alternative” scenario, the current crisis precipitates Greece’s exit from the euro zone. Fear of contagion to other peripheral countries would prompt a more radical reaction from the ECB, which would make massive interventions in the sovereign-bond markets and provide liquidity to banks. Spain and Italy remain in the euro zone, but would need official assistance.

How would the euro-area crisis spread to the world economy? Assuming that contagion to other countries is controlled, so only Greece leaves the euro zone, we would probably see some financial stress and a mini credit crunch, but not a banking crisis. World growth would be reduced, some risk aversion would arise and commodity prices would fall, but none of those movements would be too dramatic.

Political Uncertainty in Greece and Banking Problems in Spain

Without being able to form a government after the May 6 vote, Greece is heading to another election on June 17. Tired of a prolonged recession, the population wants to remain in the euro but massively rejects the austerity package. Polls show that the vote will be polarized between Syriza, with its promise to stay in the euro while radically renegotiating the bail-out program, and the New Democracy (ND), which positions itself as the only credible alternative to avoid a euro exit. The two parties are technically tied in first place and the final result is still open.

If a coalition lead by the ND wins the election, renegotiation of the austerity package could occur. The ND participated in the negotiation of the current package and would probably reach a new agreement with the troika quickly. A euro exit would again be avoided.

A Syriza victory could lead to a very different environment. Alexis Tsipras, the party leader, promises to completely scrap the current program, something that the troika is very unlikely to accept. Talks would occur and Syriza could moderate its demands, allowing an agreement. But the chances of a breakdown during the negotiations are high. Without the troika’s support, Greece would eventually leave the euro.

Another alternative is that the election fails to yield a government again. Greece cannot remain without government for long, as the political impasse is further deteriorating economic conditions.

Reports indicate that measures of tax revenues are plummeting. More worryingly, in the week after the May 6 vote, local bankers said that depositors, who fear their savings will be converted into a new currency, withdrew around € 700 million from local banks on a daily basis. The situation appears to have normalized, but deposits have been steadily declining since mid-2009, at an average monthly pace of € 2 billion (see Figure 1). The biggest monthly decline was € 6.8 billion in October 2011. So far, a full bank run has been avoided, but the political mess could trigger one.

The uncertainty is already producing damage. Worries about deposit flight have reached Spain. It is unlikely that we are at that point yet, but the financial sector in the country remains fragile.

In May, the Spanish government required banks to increase their provisions against real estate assets by € 30 billion, on top of the € 54 billion announced in February. Most banks won’t be able to recapitalize themselves in the markets and will need official support. Bankia, the third-largest bank in the country, has already asked for € 19 billion.

Where will the money come from? With access to bond markets increasingly costly (see Figure 2), Spain had no alternative but to ask for € 100 billion from the EFSF/ESM framework. The aid increases public debt and raises important questions regarding debt seniority, but we believe it is a positive step in dealing with the problematic banking sector in the country.

The “Basic Scenario”: a Greek Exit Is Avoided, for Now

If ND wins the election or Syriza becomes more moderate, Greece would remain in the euro zone. This “basic” scenario is very similar to our muddling-through scenario, although the ECB would eventually have to step in more decisively.

The current financial stress is likely to reduce growth in the second half of this year. We already see signs of a slowdown, with the manufacturing surveys in May continuing to picture an anemic second quarter. However, first quarter GDP showed a stagnant economy when compared to previous quarter, above our expectation of a 0.2% decline. Therefore we maintain our 0.6% contraction forecast for 2012.

Given the activity deceleration in the current quarter and recession in the second half of the year, we are changing our call on the ECB from no cut to a 50-bp cut in the main rate (25 bps in July and another 25 bps in August).

The “Alternative Scenario”: a Greek Exit Materializes

The big risk associated with Greece leaving the monetary union is contagion. Given the high degree of uncertainty in this scenario, the recession would be larger in the euro zone, with some spillovers to the global economy.

The European Union has been raising its firewalls, but they are still not enough. Once the ESM (expected for July) is implemented, the EFSF/ESM framework will have € 500 billion of free lending capacity. If Italy and Spain lose market access, this wouldn’t cover all the funding needs in the periphery in the next few years. Moreover, both funds have a limited mandate and can face funding difficulties during a crisis.

Despite their commitment to the monetary union, leaders do not agree yet on crucial measures such as allowing the ESM to lend directly to banks, Eurobonds, euro-wide deposit insurance and a bank resolution mechanism. Moreover, these measures could take time to be implemented.

To avoid contagion, the ECB would need to engage in a full-scale quantitative easing with large purchases of sovereign bonds and possibly some private-sector securities. Liquidity provisions for banks would also need to increase massively, in particular if deposit flights from the periphery accelerate.

Spain and Italy would need official assistance. The IMF and bilateral loans could supplement the current lack of funds in the EFSF/EMS framework. Banks across Europe might need to be recapitalized with resources from euro-wide funds.

We ran an estimate of the impact of this on the euro area’s GDP (Figure 3). In the exercise, we assume that Greece exits the euro in the third quarter of this year. The largest impact would occur in that quarter, with GDP declining 3.6% qoq. Overall, GDP would decline by 2.7% in 2012 and 2.5% in 2013 – compared with, respectively, -0.6% and +0.4% in our baseline scenario (with no Greek exit in 2012 or 2013). The cumulative GDP loss three quarters after the shock would reach -5.8%. The corresponding figure after the Lehman collapse was -4.7%.

The “Stress” Scenario: a Euro-Zone Breakdown

The risk of a bigger breakdown remains. This outcome is not likely to occur – but neither is it impossible. It could be triggered by the ECB’s refusal to step in if a generalized bank run occurs, or by political backlash in core economies.

For example, if a large capital flight occurs in the periphery, the ECB liquidity provision to banks in the region would increase significantly, which would then cause a surge in the already large exposure of the Bundesbank (currently estimated at € 600 billion) to the Target2 system.

This is an inherent feature of the monetary union and shouldn’t be a concern as long as there is no euro breakup. However, public opinion in Germany might see it differently and the political system in the country might be compelled to limit its exposures. If they do, that would be the end of euro.

In this stress scenario, there is a complete breakdown of the euro followed by a banking crisis in some countries of the region. In that case, according to our estimates, the cumulative loss of GDP could reach 14% (-6.9% in third quarter, -5% in 2012 and -9.1% in 2013).

U.S.

U.S. economic data has been consistent with our 2.1% GDP growth forecast in 2012, but has reduced the odds of a stronger-than-expected recovery. The 1Q12 GDP growth was revised from 2.2% to 1.8% qoq/saar. Tighter financial conditions due to higher global uncertainties should be offset by the lower oil prices and long-term interest rates.

Regarding the so-called 2013 fiscal cliff (the need to renew fiscal measures at the end of this year), the CBO estimates a fiscal drag of 4% of GDP in the fiscal year 2013, if current legislation remains unchanged. We currently forecast a below-consensus 1.5% GDP growth in 2013, assuming that legislators will postpone 2/3 of that fiscal drag. If the legislators fail to smooth out the fiscal adjustment during the lame-duck session, the risks of a recession are much higher.

There are signs that the Fed is closer to promoting more stimulus. The latest data point to economic growth below its own forecasts, and financial conditions deteriorated. Although remaining on the sidelines is still our base case for the Fed, if economic activity decelerates further or the perceived downside risks to its scenario increase, we expect it to implement additional easing measures.

The U.S. economy would be negatively affected by a Greek exit from the euro zone, but wouldn’t head towards a new recession. We forecast GDP growth of 1.5% in 2012 and 0.8% in 2013 in our “alternative scenario”.

China

Recent data show that the deceleration in activity in China was more pronounced in the last months. Industrial production grew by 9.3% yoy in April and 9.6% yoy in May, after averaging 11.6% in the first quarter. Also, demand indicators such as fixed asset investment and retail sales have shown slower rates of growth. We now expect GDP growth in the second quarter to be 7.7% yoy, down from 8.1% in the first.

Authorities recognized that the economy has shown signs of further slowing, and signaled that policies will focus more on growth, but that the reaction will be limited. The general “proactive fiscal policy and a prudent monetary policy” stance was maintained, as well as the broad restrictions on the real estate sector. The trade-offs of “properly handling the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” were still highlighted.

Inflation is well-controlled in the short-run (3.0% yoy in May), which favors the balance for more stimulative policies. However, China still has to deal with some of the side-effects of the 2008/09 large-scale stimuli. Those include troubled loans to local-government investment vehicles, the need to cool down the real-estate sector (after the sharp increase in prices in 2009/10) and the increase in macroeconomic imbalances (such as the increase of the investment share of GDP from around 42% in 2007 to around 48% in 2011). These needed adjustments and the desire not to create new distortions in the economic structure make the case for limited and targeted stimuli.

On the monetary side, there was a reduction in reserve requirements, announced after the release of April activity data, and last week the benchmark interest rates were decreased. Now the 1-year lending rate stands at 6.31% (6.56% previously). Also, greater flexibility was introduced in the rates that banks can actually offer their clients. Going forward, we can expect the Central Bank to further reduce the reserve requirement ratio and increase lending guidance for banks, particularly to those sectors the government wants to promote in its long-term strategy. 

On the fiscal side, there was the announcement of targeted measures such as the front-loading of some infrastructure investments, increased investment in sectors focused on the current 5-Year Plan, and subsidies to promote energy-efficient auto and home-appliance consumption.

The expected size of the new stimuli should only partially offset the recent slowdown in activity, so we are decreasing our forecast for 2012 GDP growth from 8.0% to 7.8%.

In our “alternative scenario”, the impact of lower world growth on China will be partially compensated by more intense countercyclical measures. We forecast growth of 7.3% in 2012 and 7.4% in 2013 if Greece leaves the euro zone.

Japan

First-quarter GDP came in at 1.2% qoq/sa, higher than our scenario. We still expect a relevant slowdown in the second quarter, but to reflect mainly the surprise in the first quarter we are increasing the forecast for GDP growth in 2012 from 1.7% to 2.2%.

In our “alternative scenario”, the Japanese economy would maintain positive growth in 2012 (1.1%), but output would fall in 2013 (-0.4%).


[1]See the Q&A section at the end of this text with a summary of our view on the program.

Brazil
Weaker than expected
Brazilian economic activity started 2012 on a weak note, and the recovery tends to be slower than expected. We revised down our GDP forecast for 2012 and 2013, and see more policy stimulus on the horizon.

The Brazilian economic recovery has been slower than expected. We revised our 2012 GDP growth forecast to 2% (from 3.1%) following the poor 1Q12 figures and the deterioration of the external scenario. While the government stimulus is expected to eventually lead to better GDP numbers, the improvement is likely to be less than previously expected; we therefore reduced our 2013 GDP growth forecast to 4.5% (from 5.1%).

We marginally revised the IPCA inflation for 2012 to 5.0% (from 5.2%), mainly as a result of the tax cut in the Auto sector. We also reduced our IPCA forecast for 2013 (to 5.4% from 5.7%), due a revision in regulated prices inflation.

Less growth and controlled inflation open room for further economic stimulus. We now believe that the Selic rate will fall to 7.50% (instead of 7.75%) and we anticipate a lower primary surplus for 2012 of 2.9% (vs. 3.1%). Furthermore, we expect an even more proactive short-term agenda in addition to lower interest rates, higher fiscal expenditures (hopefully on infrastructure) and further tax cuts in target sectors. Macro-prudential measures and quasi-fiscal expansion are also part of the government toolkit.

Emerging market currencies are, in general, depreciating. The Brazilian real has underperformed its peers, losing some 20% since March. The movement has been driven by both the deteriorating global environment and government interventions. We expect a more depreciated exchange rate, at 1.90 reais per dollar by the end of 2012 and in 2013 (vs. 1.85 and 1.87, respectively).

A Disappointing Start

Economic growth seems to be losing steam in many regions, including in the BRIC and Latin American economies. Commodity prices are falling and risk aversion is on the rise. In this context, Brazilian economic activity started 2012 on a weak note. GDP grew only 0.2% qoq/sa in the first quarter, below our 0.6% expectation. Part of the weak GDP figures is a result of inventory adjustment, and Agriculture’s higher-than-expected drop, while domestic demand is still robust. But the overall recovery is clearly more gradual than previously expected.

Compared with our forecast, the first-quarter GDP numbers’ positive surprises in the Industrial sector and negative surprises in the Service sector balanced each other out. The sharp fall in Agricultural activity was, then, decisive for the lower headline figure. We forecasted a drop in this sector, but not as intense as reported. On the demand side, excluding the change in inventories, the divergence with our forecast was half that of the supply side; thus, a significant part of the lower growth reflected the decline in inventories.

Investment came in weaker in the first quarter. Fixed investment declined 1.8% qoq/sa, mostly attributable to a specific factor comprising capital goods for the Transportation sector: the change in truck- and bus-engine technology as part of the program to reduce pollutants (the Brazilian version of the Euro 5 standard, adopted in Europe). Indeed, the production of capital goods for the Transportation segment fell about 20% qoq/sa in 1Q12, while the output of other capital goods expanded approximately 0.8%. We expect investment to recover at a moderate pace in the short term, given the spare capacity in the Industrial sector.

Consumption and government spending increased 1.0% and 1.5% qoq/sa, respectively. Demand growth therefore outpaced GDP: excluding changes in inventories, domestic absorption increased 0.8% qoq/sa (see Figure 1). This might suggest a stronger acceleration in 2Q12. However, industrial production disappointed again in April, marking the second consecutive monthly decline (-0.2% in April and -0.5% in March). Meanwhile, available indicators suggest a still-high level of inventories in some sectors through May, and the global economy is deteriorating further. Thus, a stronger GDP acceleration may take longer to materialize.

Bank lending rose in April, after being stable during the first quarter of the year; new consumer loans rose 3.0% mom sa in real terms, while new corporate loans rose 0.4%. Interest rates for both consumers and businesses fell for the second month in a row, while delinquency rates showed signs of stabilization.

The weaker 1Q12 GDP and the drop in industrial production in April (indicating a longer period of inventory adjustment) led us to revise our GDP growth forecast for the year down to 2.0% from 3.1% (see Macro Vision “We revised our growth forecast down to 2.0% in 2012: Q&A about GDP”, published on June 5, 2012.) For the rest of the year, we expect a 0.8% qoq/sa GDP increase in 2Q12, picking up to 1.0% in 3Q12 and 1.4% in 4Q12.

Therefore, our growth scenario for the year still contemplates an important acceleration in economic activity in the second half, although at a more gradual pace than previously anticipated. Several stimuli were, and continue to be, implemented. The impact of these stimuli is expected to accumulate throughout the second half of the year. Real interest rates have already retreated more than 400 bps since mid-2011 to under 3.0%. Public-sector expenses have already shown acceleration, as have transfers, reflecting the significant increase in the monthly minimum wage. The lower IPI tax on vehicle sales is expected to bring forward some consumption, helping to stimulate growth in the coming quarters.

The most significant risks in our scenario are deterioration of the international scenario and the rapid contamination of the labor market due to an extended period of low economic growth. In the first case, exports, investments and consumption of durable goods would be affected, worsening the economic-growth outlook. In the second case, further layoffs as a result of the delay in recovery would remove a key growth support (expansion of the real wage bill and consumer spending).

Lower Growth and Tax Cuts Reduce Inflation Risks

 Weak growth, both domestic and abroad, reduces the odds of a higher inflation scenario ahead. We believe that the impact of lower commodity prices will be partially offset by a weaker currency. Despite the slower-than-expected domestic recovery, the labor market remains robust. Strong wage-bill growth and a low unemployment rate should buffer the impact of our lower-domestic-output scenario on inflation.

In sum, inflation fundamentals are changing, but in opposite directions. Our inflation revisions are basically driven by the recent government macroeconomic measures (tax incentives and regulated prices).

Our consumer price index (IPCA) forecast for the year retreated to 5% from 5.2%, due to the impact of the cut in the so-called IPI tax on automobiles (around -0.2 pp) announced late last month. This measure is supposed to be temporary and is set to expire on August 31; however, we believe that it will be extended, at least until the end of 2013.

For 2013, we expect lower regulated-price inflation (4% rather than 5%), given signals that the government intends to cut taxes on electricity and telecommunication fees. The impact of this revision on our 2013 IPCA is ‑0.25 pp; we have therefore reduced our inflation forecast for 2013 to 5.4% from 5.7%.

Policy Response to Reaccelerate Growth

In the current low-growth environment, the government is expected to continue to use a diversified arsenal of tools to lift GDP. This means, among other things, a lower Selic rate and primary surplus in 2012.

On the monetary side, the Central Bank will likely reduce the benchmark Selic rate further. We now call for 7.50% in 2012 (from 7.75%), to be achieved through two consecutive 50-bp cuts at the upcoming Copom meetings. For 2013, we still expect the Selic rate to return to 9.00%. The Central Bank may also use other complementary tools, such as the so-called macroprudential measures, in both the easing (2012) and tightening (2013) cycles ahead.

Policymakers are also expected to use quasi-fiscal tools (i.e., non-budgetary entities such as public banks and state-owned companies) as well as conventional fiscal measures (i.e., taxes and spending). We project increased federal-bank lending and higher capex in state-owned firms ahead. We also look for a quicker execution of budgeted public investments and more extensive tax incentives. The latter are likely to impact revenue in both 2012 and 2013, as we believe that most tax exemptions will be long lasting (if not permanent). The search for extraordinary revenue in 2012 may also prove more cumbersome than we previously thought, owing to a more challenging macro environment.

As an upshot, our public-sector, primary-fiscal-balance estimate for 2012 now stands at 129 billion reais (2.9% of GDP), compared with 141 billion reais (3.1% of GDP) previously. For 2013, we now project 142 billion reais (2.8% of GDP), down from 156 billion reais (3.1% of GDP). Based on the renewed commitment to boosting federal capital outlays, we have raised our expenditures forecast by 2 billion reais (to 814 billion reais) this year; for next year, we raised our spending estimate by 6 billion reais (to 922 billion reais). Federal expenses are expected to grow at a real annual pace of 7.0%-7.5% through 2013.

Despite the likely (at least partial) use of the PAC-related fiscal-target deductibles, we believe that the government will maintain its efforts to improve the quality of public spending, keeping a tight grip on payroll expenses and a lid on administrative cost growth.

A More Depreciated Exchange Rate

Our new estimates incorporate the increased uncertainty of our base-case scenario (volatility, risk premium) and the decline in commodity prices (see Figure 2). The Itaú Commodity Index - Exports, which is based on Brazilian exports, fell about 6% in May. As a result, we now forecast a weaker real in 2012 and 2013, at 1.90 at the end of both years, from 1.85 in 2012 and 1.87 in 2013. In the longer run, though, we maintain our call of a return to a more appreciated exchange rate.

In May, the BCB switched sides on FX intervention. After purchasing dollars in the spot and forward markets for months in a row and helping to push the exchange rate to above 2.00 in May (from 1.71 in early March), the monetary authority began to auction currency swaps in an attempt to avoid further depreciation of the real. From May to mid-June, the BCB had already sold over $7.9 billion of the derivative.

FDI Remains Robust, but the Future Presents Challenges

FDI inflows reached a solid $4.7 billion in April. Year to date, the flows add up to $19.6 billion. However, given that some of our biggest funders (43% of the FDI stock up to 2010 came from the euro zone) are in recession, future flows may be less intense than expected. For this reason, we have reduced our FDI forecast from $64 billion in 2012 (or 2.6% of GDP) to $58 billion (or 2.5%). As for the current account and trade balance, the scenario remains unchanged (2.3% gap and $18 billion surplus in 2012, respectively), so that the balance-of-payment adjustment would come from foreign reserves.

Brazil in a “Grexit” Scenario

In our “alternative” scenario, Greece leaves the euro zone. The probability of this scenario is difficult to measure, since it largely depends on political events. However, in our opinion, it is almost as high as the probability of the baseline scenario described above.

If the international scenario heads toward a Greek exit from the euro zone, world growth would diminish and volatility would rise, at least temporarily. Exports and commodity prices would fall sharply, while investment and consumption would decrease. In this case, the expected pickup in Brazilian economic activity during the second half of the year would not happen.

Consequently, Brazilian GDP growth would be even lower.

In this scenario, we would expect the BRL to reach 2.17 reais per dollar in 2012, and the Central Bank to intervene more aggressively. In 2013, the real would return to 2.12. Inflation pressures would to fade as a consequence of lower growth and lower commodity prices. IPCA inflation could be as low as 4.6% in 2012 and 4.0% in 2013 under these circumstances.

The policy reaction would be more intense. The Central Bank would likely cut the Selic rate to 6.75%, and the government would reduce the primary balance further.

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