Itaú BBA - Risk Control by the ECB, Steadier Growth - Sep 2012

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Risk Control by the ECB, Steadier Growth - Sep 2012

September 6, 2012

The ECB has reduced risks for the moment; There is evidence of a recovery in economic activity in Brazil; Activity is growing again in Argentina.

Global Economy
Lower Risk, Activity Stabilizing
The ECB has reduced risks for the moment. Global activity is stabilizing and we foresee a slight improvement in the last quarter of the year

Signs of Recovery, Though Not Widespread
There is evidence of a recovery in economic activity, but inflation is more widespread than growth

The Economy is Bottoming Out
Activity is growing again but domestic uncertainties will continue to play against a solid rebound

Still Strong
Mexico's economy continues expanding at a solid pace, helped by both internal and external demand. While we still expect the economy to slow down, we have raised our growth forecasts for this year and the next

Waiting for Inflation
Inflation and the core measures remain below the center of the target. A fast growing economy and higher commodity prices will likely change the inflation’s path  

High Growth at Risk
The expansion was still robust in the second quarter. Reduced appetite for mining investment likely

Currency War and Peace Talks
Fight the strong peso, but negotiate with the FARC

Higher Food and Energy Prices
Drought in the U.S. and better sentiment in global markets are driving food and energy prices higher

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Risk Control by the ECB, Steadier Growth

The European Central Bank (ECB) is ready to act, easing concerns about tail risk in the euro zone. The crisis is not over, but the threats look less pressing, at least for now. In Europe and the U.S., growth appears to be firmer, even if not really robust. A notably poor U.S. grain harvest continues to drive up global food and energy prices.

In Brazil, the economy is slowly improving, but most of the good news still comes from a rebound in auto sales and production. At the same time, inflation is rising, mostly as a result of higher food prices, but price hikes are spreading across the economy.

Mexico maintains a solid pace, helped by both internal and external demand. We still expect a slowdown, but raised growth forecasts for 2012-13.

Argentina is recovering from a strong contraction in the second quarter and will likely do better in 2013, thanks to better grain prices and a bigger harvest. Policy uncertainty, however, remains, and President Kirchner’s popularity is hitting new lows.

Chile is demonstrating good growth and low inflation so far this year, but both will be tested soon. Weak exports will likely slow down the economy, and higher grain prices may cause a wave of inflation in coming months.

Colombia seems to be stabilizing after a surprisingly weak second quarter, and it still has some room for rate cuts. Talks with the FARCs are raising hopes for peace, which in turn could boost the country’s medium-term outlook.

After a good second quarter, Peru is dealing with weak global demand and greater risk over mining investments now that the Conga project has been suspended.

Global Economy
Lower Risk, Activity Stabilizing
The ECB has reduced risks for the moment. Global activity is stabilizing and we foresee a slight improvement in the last quarter of the year

As the European Central (ECB) Bank prepares large interventions, investors attribute a smaller probability to tail events in Europe. This is not the final word in the euro crisis, but the power of the ECB balance sheet provides a relief.

With risks receding for the moment, we turn our attention to global activity.

The economy is weak but stabilizing. Business surveys are close to stable (see graph). U.S. data released in August was mostly better than expected, with the housing sector leading the way. In China, indicators show tentative signs of stabilization, albeit at lower growth rates. The euro area is in recession. But the third quarter shouldn’t be worse than the second.

Looking ahead, we expect a very gradual recovery. We see growth in the third quarter similar to the second, followed by a slight pick-up in the next quarter.

And risks remain to the downside. Financial tensions in Europe can intensify again. The fiscal cliff might derail U.S. growth next year. And the slowdown in China could be harder than we anticipate.

As a consequence, we continue to expect more easing from the world’s main central banks in the next few months.


Perceptions of tail risks in the euro zone have declined since the beginning of August, when the ECB first outlined a revamped framework - now called Outright Monetary Transactions - to intervene in the sovereign-debt markets. In particular, yields of short-maturity bonds fell sharply (see the graph for the case of Spain).

The new framework has two major advantages over past interventions.

First, purchases have no ex-ante quantitative limit. For us, this signal that the central bank is willing to promote large interventions to keep yields at levels it considers appropriate. The ECB will publish monthly the duration and volumes of its purchase per country to help guide investors.

Second, the central bank will accept the same (pari passu) treatment as private or other creditors with respect to bonds purchased by the new program. This should address investors’ concerns about the ECB senior status.

Interventions will be limited to bonds with short maturities, a classic target of monetary policy. This should be enough to keep yields on longer maturities under control as well (see the fall in the yields of 10-year bonds in Spain in the chart above.)

It is true that the central bank will only purchase bonds from sovereigns that first ask for direct assistance from the bailout funds (EFSF/ESM). Countries also need to comply with the strict conditions imposed by the aid from the funds.

But we expect Spain to ask for aid from the EFSF/ESM in the next couple of months. The treasury continues to face funding pressures. Regions lost access to funding and rely on the central government. Banks have their own package, but investors worry about deposit flight; deposits dropped another €74 billion in July.

Overall, the measures from the ECB should support bond prices in the periphery and provide some relief. 

However, the euro crisis is not over. ECB support is only available for countries that adjust their fiscal budget and reform their economies. Despite some progress, these adjustments remain a challenge and Europe still needs to advance on financial and fiscal integration.

In addition, some risks could materialize in the short term.

In early October, official creditors will decide if and how they can continue to support Greece. We expect an agreement, as the Greek government remains cooperative, but the economic situation is extremely difficult and the possibility of a euro exit this year cannot be discarded.

On September 12, the German constitutional court will rule whether the ESM respects the country’s basic law. A negative ruling would seriously jeopardize the region’s firewalls.

Finally, the European Commission will prepare a first proposal for a banking union, to be discussed at the Eurogroup meeting on September 14. The meeting could disappoint if little progress is made.

In terms of activity, the GDP in the euro area declined 0.2% seasonally adjusted in the second quarter, after being unchanged in the first three months of the year. The breakdown by country shows a strong recession in the periphery, with GDP dipping 0.7% in Italy, 0.4% in Spain and 1.2% in Portugal. The French economy stagnated for the third consecutive quarter. Finally, growth in Germany decelerated to 0.3%, from 0.5% in the previous quarter.

Monthly data indicates that activity is not deteriorating further. The composite purchasing managers’ index was 46.4 in July and 46.5 in August, almost identical to the average of 46.4 observed in the three months up to June.

Overall, we remain comfortable with our scenario, in which GDP contracts another 0.25% this quarter and then slightly improves in the end of 2012 and beginning of 2013.

The recovery is very gradual. We have revised our forecast upward from a fall of 0.6% to a decline of 0.4% in 2012 because of the second-quarter GDP, which was better than we had anticipated. But for 2013, we continue to expect only a 0.4% expansion.


Economic indicators have surprised to the upside. Stronger retail sales, trade balance and payroll gains have led us to revise our 3Q12 GDP forecast up, from 1.5% to 1.9% (qoq/saar). For the same reason, we adjusted our expectation for 2012 slightly, from 2.1% to 2.2%.

The housing market is another source of positive news. Prices are slowly trending up as the inventory-sales ratio returns to pre-bubble levels. New-home sales and housing starts are also recovering. Finally, the National Association of Home Builder index reached new highs, signaling more increases in production ahead (see graph.)

However, economic growth remains modest. Our GDP forecast for the third quarter is only marginally better than the annualized rate of 1.7% in the second. 

We expect some fiscal drag to materialize in the last quarter of this year and the first half of 2013. Moreover, downside risks prevail, mainly due to the fiscal cliff and the euro crisis. Given these potential headings, we are keeping our GDP-growth forecast for 2013 at 1.5%, despite the recent improvement in activity.

We also don’t think the U.S. Fed is convinced about the recovery. The minutes from August showed an FOMC close to more stimuli. It is very likely that the central bank will extend the low Fed Fund Rate guidance from late 2014 to at least mid-2015 in its September meeting.

Admittedly, the better economic data and easier financial conditions reduced the probability of another round of quantitative easing in the next meeting. But the probability of expansion remains above 50%, given the wording of the last minutes. In any case, even if the Fed stay on hold now, we continue to expect a balance-sheet expansion this year by the FOMC as it downgrades its economic outlook, which remains more optimistic than ours.

China, Japan

Activity data continues to show tentative signs of stabilization. In July, industrial production increased 9.2% from a year earlier; a tad lower than the 9.5% in June. Looking at demand indicators, nominal retail-sales expansion slowed to 13.1% over a year ago (13.7% in June). But we estimate that real retail sales expanded at 11.3%, indicating that real consumption is growing steadily. Moreover, disaggregated fixed-asset investment data showed a pick-up in infrastructure investment.

On the negative side, trade data keeps showing significant downward pressure from foreign demand. In addition, investment in the real estate sector is subdued, with the government signaling that the restrictive measures in this sector are unlikely to be relaxed.

The government continues to signal more stimuli, although moderated, especially on the fiscal side. As we move towards year-end, we expect that measures will support a mild pick-up in activity.

Hence we continue to expect a slight recovery in activity, as embedded in our forecast of 7.8% GDP growth in 2012 and 8.0% in 2013.

Although it is decelerating, the Japanese economy grew more than we expected in the first half of the year. The GDP expanded 1.3% seasonally adjusted in the first quarter, revised from 1.2% in the first estimate. Growth then decelerated sharply to 0.3% in the second quarter, but it was still better than our 0.1% forecast.

We see another slowdown in the third quarter, when we expect the economy to stagnate. However, the rate of deceleration is declining and we expect a small recovery in the fourth quarter.

Finally, we revised our GDP-growth forecast for 2012 to 2.2% from 2.4%. For 2013, we keep our call of 0.9%.


Commodity prices rose again in August, propelled by oil and grain. Metals were the exception, as pessimism about Chinese demand continues to weigh on prices.

The movements were broadly in line with our expectations. Hence we adjusted our forecasts just slightly for the Itaú Commodities Index in 2012 and 2013, to 25.7% and -9.7%, respectively, from 27.4% and -10.6% in our August report.

We foresee that higher food and energy prices will raise consumer prices in the coming months. While higher gasoline prices at the pump directly lower disposable personal income and increase cost levels, the effects of higher grain prices on the economy are harder to estimate.

Emerging countries, where foods have higher weights in consumer-price indexes, suffer the most. Nonetheless, in developed economies, especially the U.S., higher grain prices will also be transmitted across the food chain.

Signs of Recovery, Though Not Widespread
There is evidence of a recovery in economic activity, but inflation is more widespread than growth

We lowered our GDP growth forecast for 2012 to 1.7% from 1.9% and kept our estimate for 2013 at 4.5%. We raised our forecast for the consumer price index (IPCA) in 2012 to 5.5% from 5.2%, due to price increases that were more widespread than we’d expected. For 2013, we maintained our estimate at 5.3%. Our forecast for the trade surplus in 2012 remains at $18 billion, but for 2013 we lowered our call to $13 billion from $15 billion. We continue to expect the exchange rate to strengthen to 1.95 reais per dollar by year-end 2012 and to 1.90 at the end of next year. For the primary surplus, our estimates remain at 2.8% of GDP in 2012 and 2.6% in 2013. Since the last monetary policy committee meeting, we have expected the Central Bank to end the current easing cycle with the benchmark SELIC interest rate at 7.25% p.a. (from 7% previously). We have slightly adjusted our long-term scenario for the Brazilian economy.

Economic activity picked up in June. Itaú Unibanco monthly GDP indicator grew 0.8% mom/sa, the sharpest gain since June 2011. The significant increase (6.1% mom/sa) in broad retail sales drove this result (which was partially expected due to the strong positive effect from the IPI tax cut on vehicle sales). Core retail sales (ex-vehicles and building material) - strong and above expectations - also helped. Rising incomes and bullish consumers have supported the expansion in consumer spending, even in segments that were not granted temporary stimuli.

The strength in June activity boosted 2Q12 GDP, which went up by 0.4% qoq/sa. The IPI tax cut for the auto sector prevented the economy from posting a low rate of growth, as was the case in previous quarters.

We see some positive signs in early 3Q12, though activity is still partially reliant on the effects of tax cuts in some segments. Anecdotal evidence reinforces this scenario (please refer to our “Brazil Orange Book: Encouraging Signs, Still Cautious,” published on August 21).

The outlook for retail sales and industrial production is encouraging. With inventories adjusted in several industrial sectors, there is now room for production to react to incentives to demand. Uncertainty over the international scenario has abated somewhat, though it remains high. The lower probability of tail risk tends to be positive for investments.

Regarding credit, there was a cool-down in July, interrupting an upward trend. New consumer loans fell by 3.8% (adjusted for inflation and seasonality), partially reflecting the absence of new stimuli, as the IPI tax cut for vehicle purchases boosted the credit market in June and produced a reversal in July. New corporate loans dropped by 2.7% in July, ending a sequence of five consecutive increases.

Following months of sharp declines, interest rates and spreads retreated just marginally for companies as well as consumers. Delinquency rates remained stable in nearly all categories, albeit at a high level (the performance of new loans suggests lower delinquency in the future). State-owned banks continue to widen their market share.

We forecast that GDP will grow by 1.2% in 3Q12, accelerating to 1.3% in 4Q12. We believe that growth in economic activity will be more widespread in the final quarter of the year, a period when incentives (lower real interest rates, higher fiscal spending, weaker exchange rate, etc.) will likely have a greater impact on the economy.

Although lower than early last month, downside risk to growth remains high. The international scenario continues to be an important source of risk. It still may lead to investment delays, which means lower growth at the end of the year. Another risk is that delayed signs of a steady rebound in the economy cause more intense contagion in the labor market. However, upbeat data on formal jobs (Caged) in July provided some relief in the short term.

We lowered our 2012 GDP growth forecast to 1.7% from 1.9% based on two factors: i) growth in 2Q12 was slightly below our call; and ii) the pickup in 4Q12 will probably be a bit less intense than we expected before. For 2013, we have maintained our growth forecast at 4.5%.

Recent fiscal performance and its effect on demand

The primary budget surplus for the public sector declined in recent months due to a cyclical slowdown in revenues and a pickup in public spending. 

In the six months through July, central government revenues expanded by 0.7% yoy in real terms. It was the lowest rate since late 2009, reflecting the impact of slower activity on tax revenues, in addition to a drop in dividends paid by state-owned companies.

Meanwhile, federal expenditures climbed at a 7.2% clip, boosted by higher transfers (for example, pensions, unemployment insurance, and social programs) following the sharp increase in the monthly minimum wage this year. Investments also advanced due to higher outlays (i.e., subsidies) related to the Minha Casa, Minha Vida housing program.   

Our calculations for the structural primary surplus until 1Q12 point to a slightly tighter fiscal stance early in the year: we estimate 2.3% of GDP in the 12 months through March adjusted for activity and financial cycles (conventional balance: 3.2%). In 2011, the structural primary surplus stood at 2.2% of GDP.

This slight fiscal tightening reflects an apparent structural increase in the tax burden, cushioned by a more expansionist stance on the spending side.  Such ambiguity is in contrast with the tighter stance in both budget vectors throughout 2011.

Considering evidence that fiscal policy may not have reflected the intensity of the deterioration in the economic cycle in recent quarters, it is difficult to see clearly the impact of the fiscal stance on demand. There are many reasons for this.

First, the fact that the fiscal stance acts in opposite directions on the revenue and spending sides suggests ambiguity in the final result for demand, given the difference in the multipliers for revenues and expenses.

Second, there is evidence that part of the fiscal tightening through revenues could reflect just a breakdown of GDP growth that is more deeply influenced by activities that pay more taxes (for further details, please refer to our report “How Tight Was the Fiscal Stance in 1Q12,” published on August 27). As a result, the increase in the structural surplus would not reveal heavier taxation in the economy, limiting the impact of a higher tax burden on activity. 

Third, there are specific fiscal incentives that, despite having a limited influence on the total budget result, had important effects on short-term activity. This is the case of the IPI tax cut for vehicles, which prompted a relatively small revenue sacrifice of 0.05% of GDP. According to literature1, temporary cuts on indirect taxes tend to create significant consumption anticipation, affecting GDP in a material way in a specific period.

We maintain our forecast for the primary budget surplus in 2012 at 2.8% of GDP – equivalent to a structural surplus of 2.6%. Our estimate considers stronger intakes during 4Q12, reflecting an expected pickup in economic activity in the second half of the year. If activity disappoints, the fiscal result will probably be lower than we forecast.

For 2013, we continue to forecast a primary surplus of 2.6% of GDP and a structural surplus of 2.0%. This forecast assumes about 30 billion reais in lost tax revenues (including payroll and electricity tax cuts, and maintenance of the current levels of Cide and IPI for durable goods, automobiles, and others).

We believe this decline in the primary surplus will be a trend for the next few years, with the drop in interest rates helping debt dynamics and leading to an option for more tax cuts and public investments. 

Trade balance: sharp drop in iron-ore prices lowers the surplus expected for 2013

The price of iron ore, which accounts for about 15% of Brazilian exports, fell by more than 30% in the past two months. The price reached $90 per metric ton, reflecting in part less optimism about Chinese growth. Though we believe a high marginal production cost in China will prompt prices to resume equilibrium of about $120 by the end of 2013, the move in the price curve led us to lower our forecast for the trade balance in 2013 to $13 billion from $15 billion. As most contracts are set on a quarterly basis, there is a lag between the market price and the price paid to Brazilian exporters. Thus, for this year, we maintain our forecast for the trade surplus at $18 billion.

Following the downward revision in the forecast for the trade balance, we slightly adjusted our estimate for the current account deficit in 2013 to 2.5% of GDP from 2.4%. In July, the current account gap reached $3.8 billion, influenced by the seasonality of interest payments and international travelling. For 2012, our forecast was maintained at 2.2% of GDP.

Foreign direct investment (FDI) topped even the most optimistic expectations and hit $8.4 billion. Though possibly tied to some specific deals, this figure was the third highest ever, prompting us to boost our 2012 forecast to $61 billion, or 2.6% of GDP, from $58 billion. For 2013, we maintain our forecast of an even higher FDI of $64 billion, with the rebound in the global and domestic economies contributing to the move.

Our forecast for the exchange rate by year-end remained at 1.95 reais. Fundamentals do point to this level, considering the speed of adjustment compared with the current level. However, there is more upside potential to this call. In the last three months, the Brazilian real moved very little, staying mostly within the range of 2.00 to 2.10 per dollar. Interventions in the currency market (in the spot market, through swap contracts or even verbal interventions) have helped keep the rate at this level in the short term. Given the current scenario, apparently there is no desire for a stronger real than the bottom-end of the recent range. For 2013, we maintain our call that fundamentals will drive the exchange rate back to 1.90 per dollar.

More widespread inflation

We raised our forecast for the IPCA this year to 5.5% from 5.2%. Current data show more pressure on inflation, with more widespread price increases. Core inflation as well as diffusion indexes accelerated at the margin. Service inflation remains high, and even some durable goods segments lifted prices again, after the effect of the IPI tax cut waned. This scenario reflects a heated labor market, high inflation expectations and currency devaluation.

The food segment has contributed to the advance in inflation in recent months. An important share of this increase is driven by fresh fruits and vegetables. But this effect is short-lived and may prompt a relief in inflation ahead. However, the impact of the recent increase in international grain prices on consumer inflation is yet to come. The effects will likely be felt in the next few months.

For 2013, we maintain our forecast for the IPCA at 5.3%. There is much uncertainty regarding the inflation scenario for next year. There are important factors which may push the IPCA in opposite directions. First, we assume a decline in agricultural commodity prices throughout 2013, but the magnitude of the decline is hard to estimate, and deviations in relation to expectations may have a significant impact on inflation. Meanwhile, tax cuts mean both downward and upward risks for inflation.

On one hand, tax cuts on electricity promise some reduction in the IPCA. Though we assume a decline in prices for residential electricity usage, the impact of eliminating taxes and the anticipation of concession renewals on inflation is still uncertain. On the other hand, tax cuts for automobiles and household appliances may not be extended, lifting inflation in 2013 (or even in 2012; our scenario assumes that tax rates will be kept at current levels). New prices for fuel, without tax compensations, also represent a risk factor for future inflation.

For the general price index (IGP-M), we increased our forecast for 2012 to 7.9% from 7.5%. The new estimate takes into account data deterioration at the margin. Furthermore, we incorporated the assumption of a new change in fuel prices at refineries (8% for gasoline and diesel, without impact for consumers, as we expect tax cuts) at some point before year-end. The main contribution to the IGP-M this year will come from the Agriculture and Livestock index IPA (3.5 pp), with an expected 20% increase. This pressure is largely tied to higher international grain prices, particularly soybeans and corn. On the other hand, the decline in iron-ore prices will provide some relief to general prices indexes in 2012. For 2013, the outlook for price declines for some agricultural commodities, amid more favorable weather conditions, should ensure a better result for general price indexes. Thus, we maintain our forecast for the IGP-M at 4.5% next year.

Monetary Policy: close to the end of the easing cycle

In its August meeting, the Central Bank’s monetary policy committee (Copom) lowered the benchmark Selic interest rate by 50 bps, to 7.50% p.a., and signaled that the easing cycle is coming to an end. According to the statement, an eventual additional adjustment would be conducted with “maximum parsimony.” In other words, a 25-bp cut instead of 50 bps as in the most recent moves. 

In order to justify the nearing end of the cycle, the Central Bank mentioned "the cumulative and lag effects of the policy implemented up to this moment, which in part are reflected in the ongoing recovery of economic activity.”

We believe that the Central Bank will still opt for a new interest rate cut in October. The international scenario remains complex and the sustainability of the domestic recovery is still uncertain. A new cut in interest rates would reinforce the recovery trend, lowering the risk of a slowdown ahead.

We expect a new cut in rates in October, but now by 25 bps (vs. our prior expectation of 50 bps), driving the Selic rate to 7.25%, a level that should last until mid-2013. An extension of the easing cycle (to less than 7.25%) would only take place if the economic rebound forecasted by the Copom does not materialize.

Long-term scenario: small changes

Once a year, we publish a long-term economic scenario (please refer to “Macro LatAm 2020”). Six months after its publication, we present some marginal revisions to our scenario.

The basic message remains the same: growth in Brazil will increasingly depend on the expansion of the capital stock and on productivity gains. There is no shortage of investment opportunities: in addition to countless projects in the private sector, there are also large sporting events in 2014 and 2016, government plans to improve infrastructure, and the exploration of pre-salt crude oil. But to do that, the country needs to increase its savings rate. Savings increments will come in part from the public sector, but that will not be enough. Tapping external savings will be necessary, which means current account deficits. It also means a still relatively appreciated real exchange rate in the long run.

The main revisions (in addition to the ones already incorporated during recent months in the short-term scenario) are somewhat lower equilibrium interest rates and GDP growth.

We revised our equilibrium interest rate. The drop in long-term rates corroborates this view. Real equilibrium interest rates should reach 3% as early as 2014 (previously we contemplated rates at 3.5% only in 2016). Our new basic scenario assumes a single-digit interest rate through the entire forecast horizon.

Regarding GDP, we forecast growth of between 3.4% and 4% until the end of the decade.

[1] Spillimbergo, A. Symansky, S. and Schindler, M. “Fiscal multipliers”. IMF Staff Position Note, n. 09/11, 2009.


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