Itaú BBA - "A Year of Diminished Expectations", by Ilan Goldfajn

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"A Year of Diminished Expectations", by Ilan Goldfajn

December 26, 2013

Little is expected from 2014. That’s not so bad. The advantage is that positive news will have more impact than negative news

Little is expected from 2014. That’s not so bad. The advantage is that positive news will have more impact than negative news. The discouraging outlook is partly due to the performance in 2013, which was disappointing. Next year, growth in Brazil is likely to be slightly above 2%, while inflation is expected to be a tad below 6%. Next year brings an unusual combination of global and domestic issues that deserves our attention. After several years of low growth, we expect a global recovery. We already know that the Fed will begin to withdraw its exceptional monetary stimulus at the beginning of 2014. In Brazil, in addition to the challenge of reducing inflation, there is the question of anemic growth, whether or not the concession auctions will attract investors. The fiscal performance next year will also indicate whether a downgrade of Brazil's country risk rating is likely, and whether the real will register another year of depreciation.

Next year could be the year of global recovery. The idea that the world is unable to overcome stagnation was gaining strength. Some economists were already speaking of a "japanization" of the U.S economy, in a secular stagnation process. They also spoke of previous growth supported by bubbles, and that the economy is currently facing structural problems that hinder growth, not to mention the zero lower bound for interest rates. The recovery of the U.S. (and global) economy in the coming year will bring back the tranquility that comes with better employment numbers, even if growth is below previous exceptional numbers of the 2000s.

A U.S. recovery, if confirmed, will allow for the normalization of monetary policy by the Fed, which got an earlier-than-expected start at the end of 2013. This normalization process consists of the removal of the exceptional stimulus introduced by the Fed to deal with the consequences of the 2008/2009 financial crisis. The Fed announced that it will inject only USD 75 billion per month next year. Until December, the Fed had been injecting a monthly sum of USD 85 billion in the economy, through the purchase of various market securities, which tends to exert pressure to maintain long-term interest rates at low levels. As we move further away from the financial crisis, the normal behavior would be to inject fewer resources into the economy to avoid the formation of bubbles (artificial price increases in risky assets).

But injecting fewer resources does not mean that U.S. interest rates should rise. The Fed has indicated that it will maintain rates at low levels for an extended period, in order to avoid aborting the still-fragile recovery. In contrast, the event of a strong economic recovery would trigger expectations of rate hikes in the U.S. and the consequent impact in the rest of the world. 

The normalization of U.S. monetary policy has led to a strengthening of the dollar. The rise in bond rates (the ten year Treasury rates, for example) causes capital flows to return to the US and generates dollar purchases, thereby raising the currency price.

Part of the BRL depreciation reflects the global strength of the dollar. However, another part reflects local factors such as the fiscal situation, the balance of payments and the possible downgrade of Brazil’s risk rating.

The threat of a downgrade is a result of the ongoing decline in the primary surplus, but also the (quasi)fiscal expansion via capitalization of public banks and, more broadly, poor GDP growth performance. The primary surplus has been gradually declining, to a value of below 2% in 2013 (we estimate 1.8%) and likely to fall below 1.5% next year. One factor is that states and municipalities are expected to spend their savings during an election year; the other factor is that the federal government has to deal with the revenue impact of the tax cuts in recent years (to stimulate the economy), while public spending continues to grow strongly. If this trend continues, an agency's downgrade may occur without the loss of investment grade, but could be enough to scare investors who depend on the country’s investment grade status to invest. Fiscal policy must change course, and the stimulus via public banks seems to be moving in that direction. However, tail risk materializing, such as the Supreme Court acceptance of the hefty compensation (billions of dollars) for alleged losses during economic disinflation plans of the 80's and early 90's, may lead to severe downgrades.

As for monetary policy, the BCB’s recent communication signaled that the cycle of SELIC hikes is coming to an end. Nevertheless, if the fiscal and inflationary issues are not properly addressed in the coming year, there may be upward pressure on the country’s market interest rates, which depend on Brazil’s risk rating.

As the normalization of worldwide monetary policy runs its course, corporations’ cost of capital is likely to increase and generate investment challenges in Brazil. In this sense, the infrastructure concession program is crucial. As with most programs, it will be smaller than originally planned, but will play a key role in addressing one of the main bottlenecks of the Brazilian economy. The efforts undertaken in 2014 will have to be sustained in the coming years.

Inflation should also be on the spotlight. The government's goal is to get inflation to (gradually) decline toward the target, thereby avoiding the risk of inflationary shock that could trigger an inflationary spiral in the other direction. However, several repressed regulated prices (such as gasoline, diesel and electricity) must be readjusted in an environment in which market prices inflation continues under pressure. In 2013, market-price inflation remained at around 7%-8%, while regulated-price inflation fell to below 1.5%. A rebalance is now required.

Brazil must reinvent itself. The country needs to grow through higher investment, productivity and efficiency. And aim for progress in education as a guidance for the future. We hope that 2014 is a step in that direction. For now, the expectation remains low. But a positive surprise would be certainly welcome.

Ilan Goldfajn is Chief Economist and Partner at Itaú Unibanco.

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