Itaú BBA - Growth despite unfavorable global winds

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Growth despite unfavorable global winds

April 12, 2013

Countries with good fundamentals will perform well over the decade, despite global adjustments

Dear reader,

Once a year, we present our long-term scenario, a task that has gained importance in a world of unusual risks and conditions following the global financial crisis. In this report, we address the questions: How will Latin American countries fare in the upcoming years? Is it possible to outline a trend?

There are global headwinds, as developed nations will take years to rebalance their economies. Our outlook for Latin America is relatively optimistic, but performance will vary greatly from country to country. Those with good fundamentals should perform well, despite the external scenario. Chile, Peru and Colombia have the potential to stand out. Mexico has been adopting reforms and could grow faster. In Argentina, we expect macroeconomic adjustments to curb growth.

Brazil will face challenges. Slower workforce expansion, driven by demographics, is likely to make the country more reliant on investment and productivity gains to maintain its growth pace.

We hope you enjoy your reading.


Ilan Goldfajn

For the complete report with graphs and tables, please see the attached pdf file.

Slow Return to Normalcy
We believe that developed nations will rebalance their economies by the end of the decade

Prices Will Remain High
Growth in emerging nations and rising production costs could lift prices between 2012 and 2020

Latin America
Time for Differentiation
During this decade, growth will continue strong in Chile, Colombia and Peru. In Argentina, macro adjustments will limit growth, while in Mexico reforms will likely lead to higher growth rates than in the past

    Argentina: The time for macro adjustments will come

    Chile: Stable terms of trade will not deter strong growth

    Colombia: Strong investment to keep high growth

    Mexico: Reforms will raise productivity and growth

    Peru: Why so Fast?

Challenges Ahead
Due to less-favorable demographics, sustainable growth will depend on a rebound in investments and on an increase in efficiency in the economy

LatAm: growth despite unfavorable global winds 

Countries with good fundamentals will perform well over the decade, despite global adjustments

We present our long-term scenario once every year. This task, already challenging under normal conditions, has gained importance in a world where the conditions and risks have been unusual, after the global financial crisis. In this context, what can be expected for Latin American countries over the coming years? Is it possible to outline a trend?

Uncertainty is great, but we are noticing a slow return to normality. Developed countries need to rebalance their economies. Major central banks have been maintaining interest rates near zero and expanding their assets in an effort to restore growth. Normalization of monetary policy will likely be carried out during the second half of the decade. The adjustment of the public sector's accounts are likely to take a long time: despite the efforts already being made, which will intensify in the coming years, we believe that a new round of fiscal adjustments will be required at the end of the decade. In the euro zone, advances in the monetary and fiscal union are needed. Additionally, the peripheral countries need to continue gaining competitiveness.

Emerging countries’ good performance will probably continue, but the global settings will likely lead to slightly lower growth. In China, signs of the incipient replacement of an economic model geared for export and investments with one based on domestic consumption are already evident.

Commodity prices will remain high, due to emerging economies’ growth and rising production costs, but grow at a slower pace than in the past decade. Restrictions on production growth and demand expansion favor real hikes in grain prices over the decade. Alternative energy sources will gain importance.

The good performance of commodities creates favorable conditions for Latin American countries, but their performance will likely be unequal. Chile, Peru and Colombia stand out as potential highlights, thanks to the strong fundamentals of their economies. Mexico, with the ongoing adoption of reforms, may achieve higher growth rates. In Argentina, on the other hand, macroeconomic adjustments will probably limit growth in the coming years.

In Brazil, there are challenges ahead. The slower expansion of the labor force will cause growth to depend more on investment and productivity. In order to cope with rising investment, the country will need increased domestic savings or higher current-account deficits. We expect less-favorable demographic conditions, adding pressure to social security accounts and thus leading to a smaller primary surplus and a possible increase in public debt ahead. Finally, inflation will likely hover around the upper bound of the target range.

Slow Return to Normalcy
We believe that developed nations will rebalance their economies by the end of the decade

Nearly five years after the subprime crisis erupted in September 2008, the situation in the global economy shows slow progress. Government response prevented a repetition of the 1929 crisis, but created new imbalances that have to be faced in the coming years.

The adoption of expansionist monetary policies for an extended period tends to distort resource allocation and increase inflationary risks. If maintained, the current fiscal stimuli could lead sovereign debt onto an unsustainable path. But a premature withdrawal of incentives could lead to a new crisis.

The road ahead is full of uncertainty, but we have seen significant progress and the major countries’ willingness to implement the necessary adjustments, despite their political cost.

As growth becomes more robust, interest rates are expected to gradually return to equilibrium levels and excess liquidity injected by the main central banks should be mopped up. Fiscal adjustments are being made, but this process will probably take many years. In the euro zone, peripheral countries have started to cut costs and increase competitiveness. Meanwhile, China is adopting measures to boost consumer spending.

In our view, after a long period of uncertainties and adjustments, the global economy will again enjoy balanced, albeit moderate, growth.

Outlook for moderate growth in major economies

The performance of the global economy disappointed expectations in recent years, growing somewhat below 3% in 2011 and 2012. The situation is likely to improve from 2013 onward, but moderately. The high growth rates seen before the 2008 crisis, of about 5% p.a., are a thing of the past. The global economy will probably grow at an annual pace of about 3.5% through the decade.

In our view, U.S. and European economies will recover in the second half of the decade, with potential GDP growth at 2% in the U.S. and close to 1% in the euro zone. Several factors are behind this difference: growth in the capital stock, workforce expansion and productivity gains are faster in the U.S. than in Europe.

In Japan, growth between 2016 and 2020 will resemble Europe’s, despite a faster increase in the capital stock in the Asian nation. The main drag to growth is the unfavorable demographic dynamics in Japan, leading to a decline in the workforce.

In China, the need to rebalance the economy (toward consumption rising faster than investments) will reduce potential GDP to an average of 6.9% between 2016 and 2020.

Interest rates in the G7: Normalization will likely take place throughout the second half of the decade

In response to the 2008 crisis, the major central banks adopted expansionist policies. Benchmark interest rates fell to near zero in several countries and many central banks expanded their balance sheets through direct asset purchases.

This monetary expansion was not enough to offset the negative effects of balance-sheet adjustments that followed the crisis, first in the private sector and then in the public sector.

We believe that economic growth will pick up in the next few years as fiscal tightening is relaxed, closing the output gap and leading central banks to normalize interest rates.

The U.S. Federal Reserve should start to normalize monetary policy in the end of 2015, when the unemployment rate is expected to drop below 6.5%. When the monetary-tightening cycle ends, Fed funds will probably be balanced at 4%, below pre-crisis levels, due to the decline in potential growth and lower leverage in the financial sector (wider banking spreads).

The European Central Bank should start to lift rates in early 2017. But the rate for overnight interbank loans could converge from the current 0.1% to 0.75% by 2016, as excessive liquidity is mopped up from the system. The benchmark rate will likely be balanced at levels that will be somewhat lower than in the U.S. We estimate 3.00% by 2020.

In Japan, we expect interest rates to remain near zero for a long time, but still not enough to support inflation close to the 2% target.

Fiscal effort will improve budgets by 2015, but a new round of adjustments will be needed by the end of the decade.

G7 nations made significant fiscal adjustments in the past two years. This effort should become more intense in 2013 and 2014, leading to more-balanced fiscal dynamics starting in 2015. Meanwhile, fiscal adjustments will prevent the global economy from reaching higher growth rates during those years.

Narrowing nominal deficits in the U.S., Europe and Japan will improve the dynamics of debt-to-GDP ratios in the second half of the decade, but fiscal challenges will endure. In our basic scenario, debt-to-GDP ratios will stabilize at high levels, with a pessimistic bias, because this scenario assumes no deviations in full employment. Furthermore, nominal deficits will again be pressured toward the end of the decade by the normalization of interest rates and by population ageing, so that more fiscal adjustments will be needed.

Fiscal consolidation in Europe remains challenging. Spain and Ireland still have to increase their primary budget results by 7.2% and 7.8% of GDP, respectively, between 2012 and 2020, to ensure that public debt-to-GDP ratios start to fall. The highlight among the major economies is France, where the expected adjustment in the primary budget balance is 4.7% of GDP. Most of the adjustment in the euro zone will probably happen by 2015, but fiscal consolidation will need to continue in most countries in the second half of the decade.

Even with the fiscal effort, public debt will remain high in peripheral nations. In 2015, debt in Italy and Spain will probably be equivalent to 120% and 100% of GDP, respectively. The ECB lowered the risk of debt roll-overs with the Outright Monetary Transactions mechanism, but moderate shocks on growth and on fiscal results still threaten debt sustainability. For instance, if nominal GDP growth between 2013 and 2020 turns out to be 1 p.p. lower than our forecast, the debt of Spain, Ireland and Portugal becomes unsustainable.

Balance of payments adjustments are likely to continue

Current-account imbalances in some major economies were a reason for concern in the last decade. Deep deficits in the U.S., a sign of excessive housing investments, were matched by huge surpluses in China and the Middle East. The euro zone seemed more balanced, but the strong German surplus masked deficits in peripheral nations.

The matter is still relevant. How will the global balance of payments behave in the next decade as output gaps are closed? What are the actual real exchange-rate levels associated with these paths for the current account?

The current account of the euro zone as a whole went from balanced to a small surplus in 2012. But the most important adjustment is not seen in the headline result, but in the breakdown by country. Not only Germany is gaining market share; the current accounts and trade balances of peripheral countries are also improving (see chart).

Trade gains by peripheral nations are taking place with trade partners in and outside the euro zone. Back in 2008, the trade balances within the euro zone for Spain, Portugal and Greece stood at -1.4%, -7.3% and -5.9% of GDP, respectively. Meanwhile, Germany ended 2008 with a surplus equal to 3.4% of GDP. Since then, the German balance slipped to 1.6% of GDP in 2012, while the trade balances in Spain, Portugal and Greece climbed to 2.5%, -2.1% and -0.8%.  France and Italy stand out negatively, with deteriorating balances in recent years; they probably ended 2012 at -3.9% and -0.7%, respectively.

Part of the adjustment in the periphery is attributed to the recession, which reduces imports. But higher unemployment also reduces wages and unit labor costs in these nations (see chart). The final outcome is a gain in competitiveness that is equivalent to a devaluation in the real exchange rate for peripheral countries vs. major countries.

The adjustment started in Ireland, where the market is more flexible, but is also taking place in Spain, Portugal and Greece. According to our estimates, 20% to 40% of the adjustment in the trade balances of peripheral nations occurred through the reduction in unit labor costs in these countries between 2009 and 2012.

In China, there are incipient signs that the internal rebalancing of the economy has begun. In 2012, consumption growth topped investment growth for the second consecutive year, in a move that should become a trend in the decade.

The rebalancing of the Chinese economy requires a decline in the domestic savings rate. Demographic dynamics (leading to an increase in the dependency rate) and the expansion of social security nets will probably lead to a decline in household savings rates. The reduction of profits as a share of GDP (higher share in household income) and financial reforms (seeking to widen access to credit by small and medium enterprises and to reduce the share of funding done through profit retention) lower the need for corporate savings. Meanwhile, the government signals policy incentives toward a proportional increase in consumption.

The external adjustment has largely been made: the current-account surplus dropped from 10% in 2007 to 2.5% in 2012, and the process should continue until 2020, when the surplus will likely fall to about 0.9%.

In the U.S., the current-account gap will reach about 4% of GDP in the second half of the decade, pressured by higher interest rates. Dollar devaluation against emerging currencies will prevent further deterioration in the current account. We foresee a strong dollar against the yen and the euro throughout the decade.

For the complete report with graphs and tables, please see the attached pdf file.

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