Itaú BBA - Why is Brazil Set to Grow 4% in 2018?

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Why is Brazil Set to Grow 4% in 2018?

September 26, 2016

We forecast GDP growth of 2.0% in 2017 and 4.0% in 2018. However, this scenario fundamentally depends on fiscal reforms.

Please open the attached pdf to read the full report .

After two years of deep recession, economic activity is beginning to stabilize. The pace of recovery will be gradual. For the time being, the rebound is being driven by a cycle of inventory adjustment. Demand must recover to sustain the improvement ahead. Investment will be the main driver for the rebound due to corporate deleveraging, lower interest rates, and more favorable commodity prices. The recovery will gain impetus later ahead, with consumption reflecting better labor market conditions and lower interest rates. We forecast GDP growth of 2.0% in 2017 and 4.0% in 2018. However, this scenario fundamentally depends on fiscal reforms.

After the inventory cycle, the recovery will be investment-driven...

The downturn in investment during the current recession was the main reason for the GDP contraction, having fallen 26% since its peak in the third quarter of 2013. Gross fixed capital formation posted ten consecutive quarters of negative growth, only recently returning to positive territory in the second quarter of 2016. Indicators show some stability at the margin, and there are signs of an initial recovery in investment (Chart 1).

Econometric exercises suggest that investment is determined by a combination of factors, both external (commodity prices) and domestic (interest rates and corporate leveraging). Table 1 shows the estimated equation incorporating these factors. High corporate leverage was the main driver behind the drop in investment during the current recession. Our estimates indicates that for each 1 p.p. in additional leverage, companies reduce investment to potential GDP ratio by 0.6 p.p. Leverage contributed around -8 p.p. of the 24% contraction in investment between 2014 and 2015. High interest rates and falling commodity prices also had a negative effect on investment during this period, of -6 and -5 p.p. respectively. 

Fundamentals suggest an upturn in investment ahead. First, interest rates will fall. We expect the central bank to start an easing cycle in 2016, which has already been anticipated by market interest rates. In our view, monetary easing will continue into 2017, boosting demand growth in 2018 (Chart 2). Second, we expect the current commodity-price stability to continue over the next few years, also supporting investment growth (Chart 3).

Finally, leverage is on a downward trend as interest rates fall and margins rise. The reduction in corporate net debt can be attributed to the recent exchange rate appreciation and the expected interest rate cut. Margins will in turn be driven, not by revenue, but by lower production costs. These factors have prompted a reduction in corporate leverage. The leverage reduction between the final quarter of 2015 and the second quarter of 2016 can be attributed to exchange rate appreciation and lower costs. Looking ahead, lower interest rates and declining costs will allow companies to deleverage even further (Chart 4).

Companies’ production costs are likely to fall given the significant amount of slack in the production-factor market. The unemployment rate is near its historical peak and is likely to remain above equilibrium for the next two years (Chart 5). This means less pressure on unit labor cost (ULC), which leads to higher corporate margins (Chart 6). Adjusted for capacity utilization, ULC rose by 20% during the boom period; however, this trend was reversed in 2015. Since then, the indicator has returned to 2010 levels (Chart 7).  

Rental is another sign of easing pressure on costs. The FipeZap Index, which monitors commercial property rentals, registered an inflation-adjusted reduction of around 35% between the beginning of 2013 and July 2015.  On a cumulative 12-month basis, the index fell by 17.7% in real terms in July and 19.6% in the city of São Paulo (Chart 8).

The fundamentals (interest rates, corporate leverage and commodity prices) basically indicate an upturn in investment ahead. In our view, investment will rebound despite wide slack in the economy; we believe there is a link between the two variables. However, econometric exercises suggest that the level of capacity utilization does not precede investment growth; in fact, the opposite appears to be the case (Table 2). 

...but the recovery will gain strength further ahead, as consumption rebounds.

Consumption dropped by 9% during the recession, returning to 2011 levels (Chart 9). This can be attributed to high interest rates and a deteriorating labor market (Charts 2 and 5). Both fundamentals suggest a recovery in consumption further down the line. The labor market recovery will take longer to materialize as employment lags behind the economic cycle. This means that the recovery will only gain strength once consumption begins to rise again in 2018 (Chart 10).

We Forecast 2.0% GDP Growth in 2017 and 4.0% in 2018

Based on a macroeconomic model that includes the expected dynamics of fundamentals, we are forecasting 2.0% GDP growth for 2017 and 4.0% for 2018 (Chart 10). The Brazilian economy will recover gradually. Growth will initially stabilize as a result of the inventory build-up cycle – a process that is already under way. The second stage of the recovery will be an upturn in investment as companies deleverage, interest rates fall, and commodity prices take a more favorable path. However, the speed at which investment reacts will depend on the level of company leverage and labor-market weakness. GDP growth in 2017 will be further limited by the fact that companies remain highly leveraged. Looking ahead, the recovery will gain strength as consumption rebounds due to an improved labor market and lower interest rates. However, this scenario is fundamentally dependent on the approval of the proposed fiscal reforms.

What is more, the recovery is cyclical and does not represent a potential rise in GDP for the Brazilian economy.  The recovery will start at a low level of GDP. Our scenario assumes that GDP will only return to its pre-recession level after 2018 (Chart 11), and in 2020 in per-capita terms.

Table 3 shows a breakdown of demand-side GDP growth forecast over the next years.


Please open the attached pdf to read the full report .

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