Itaú BBA - Euphoria Amid the Crisis

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Euphoria Amid the Crisis

April 19, 2016

Now is not the time to sanction market euphoria.

Brazil is fully focused on politics. The lower house just voted favorably on continuing the impeachment process. But the reforms and adjustments needed to unlock the economy are not easy. The primary deficit could officially hit 1.6% of GDP this year, maybe even higher. In this case, Brazil’s gross public debt could reach 73% of GDP by year-end. Meanwhile, markets enjoy a euphoric interlude. Stimulus from global central banks has reversed the panic of earlier this year and boosted global markets. In Brazil, the markets seem to believe it will be easy to resolve future political and economic challenges. Better news on inflation and the shrinking balance of payment deficit help sustain this belief. What can we expect in the short term? How should the central bank act in such a situation?

Brazil faces a fork in the road. If there is not enough political consensus to adopt tough adjustments and reforms the economy would remain adrift, hoping not to run aground on a reef that could sink it. Deficits would remain high and debt would continue to grow, with uncertainty dampening growth recovery. Alternatively, if political consensus would allow for the approval of measures and reforms, confidence and growth recovery would follow. Each of these scenarios offers quite a different outlook for the currency, country risk, interest rates and growth. Boosted by external stimulus and political developments, markets currently want to believe in the more optimistic scenario, maybe minimizing structural difficulties (including implementation risks) in the years ahead.

Meanwhile, the economy continues to suffer its worst-ever recession, and unemployment is rising.

There are certainly bright spots in the economy.  Inflation is starting to ease, and the current account in the balance of payments is approaching balance.

Not long ago, many were worried inflation could rise continuously. Experienced analysts are haunted by memories of decades of hyperinflation in Brazil. In the past, fiscal challenges meant inflationary spiral. Based on this, inflation expectations kept rising. As a result, interest rates were also expected to rise.  A solution for the present was sought in the past.

But this was a solution of the past, not the present. Nowadays, inflation has little impact on public accounts because of formal and informal indexation. An obvious example is the fact that various expenditures are linked to the minimum wage which, under current rules, is linked to past inflation. A straightforward calculation suggests that for every 10% surprise in inflation, fiscal accounts would gain only around 0.4% of GDP.

And inflation will not escape so easily from control. The global context is one of very low inflation. Central banks in developed economies are more fearful of deflation than inflation. Today’s hyperinflation is Argentina`s, where it hovers around 30%-40%, not higher than that.

In fact, inflation in Brazil is currently retreating after reaching 10.7% last year. Inflation could fall to 7% this year or lower this year – monthly figures are already consistent with the average of recent years (5.5% in annualized terms between 2006 and 2014).

There is a simple reason for disinflation: the system has no strength. Brazil is facing its worst recession in history – and there is no room for raising prices. Last year, survival required passing through costs, as the significant increase in regulated costs (a 50%-60% spike in electricity prices) and currency depreciation (almost 100% on an accumulated basis). But this year, regulated prices are well behaved, and the currency remains stable (actually appreciating significantly over the short term).

Foreign exchange stability (or appreciation) is backed by the balance of payment results. A little over a year ago, the current account deficit stood at USD 105 billion. We estimate that next year (or by the end of this year) there will no longer be a current account deficit.

The remaining inflationary risk is the possibility of a sudden stop in capital flows and a major depreciation that follows. But with low interest rates worldwide, resilient direct investment and more than 20% of GDP in international reserves at the central bank’s disposal, this sort of outcome currently unlikely. Even so, Brazilian political reality means we cannot completely ignore the possibility of such an event.

In the absence of any extreme policies, inflation is likely to continue falling. We can already see inflation moving down, and high-frequency price surveys indicate it will continue to do so in the short term.

At some point – probably still this year – the central bank is likely to cut interest rates, reflecting better inflation dynamics. But the Central Bank is not in a position to cut interest rates right now (during the first half of 2016), as it wants first to guarantee the disinflation trend.

This is not also the time to validate excess optimism reflected in recent currency appreciation. Now is the time to put some sands in the wheels by buying dollars in the market (i.e, reducing the central bank’s current stock of FX swaps) while the market is willing to sell them.

Now is not the time to sanction market euphoria. This euphoria is based on a temporary relief in global markets combined with too recent optimism in Brazil. The central bank is right to lean against the wind.


Ilan Goldfajn is chief economist and partner at Itaú Unibanco.

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