Itaú BBA - A further deterioration in the growth-inflation trade-off

Scenario Review - Chile

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A further deterioration in the growth-inflation trade-off

July 13, 2015

Amid higher-than-expected inflation and lower-than-expected growth, we continue to anticipate unchanged policy rates both this year and in 2016.

• The most recent activity data confirm that Chile’s economy slowed sharply in 2Q15. We have lowered our growth forecasts to 2.2% from 2.5% for this year and to 3.2% from 3.4% for 2016.

• On an annual basis, inflation accelerated to 4.4% in June, thereby breaching the high end of the target range; all core measures were up. We now expect inflation to reach 3.7% (we previously expected 3.3%) by the end of this year before slowing to 3.0% in 2016.

• Amid higher-than-expected inflation and lower-than-expected growth, we continue to anticipate unchanged policy rates both this year and in 2016.

• Weak internal demand, currency depreciation and lower oil prices continued to boost the trade balance during 2Q15. As we expect some recovery in internal demand, we foresee the current-account deficit widening somewhat throughout the year, to a still-comfortable 1.1% of GDP this year and to 1.8% in 2016 (from 0.5% in the four-quarter period ended in 1Q15).

• With uncertainty over the Greek and Chinese economies rising and U.S. data coming in strong, the Chilean peso has weakened sharply. Once the volatility in international markets subsides and copper prices recover, we expect the exchange rate to rebound somewhat, ending this year at 645 pesos to the dollar and 2016 at 650 pesos to the dollar.

• The Ministry of Finance updated its macro scenario for the year, implying a larger nominal balance than was contemplated in the 2015 budget law. We have revised our forecast for this year’s fiscal deficit to 3.1% of GDP, up from 2.5%, previously.


Denting the recovery

Economic activity has deteriorated sharply during the second quarter halting the recovery witnessed in the previous two quarters. The monthly GDP proxy (IMACEC) came in well below expectations, with the economy growing by only 0.8% year over year in May, down from 1.7% in April. In the three-month moving average through May, growth decelerated to 1.4% year over year from 1.9% in April and 2.4% in 1Q15. Corrected for seasonal factors, May activity was flat from April, as was the case the previous month. As a result, the economy contracted by 2.3% qoq/saar as of May. Manufacturing activity fell by 14.3% qoq/saar, while mining production was down 12.3%. Retail sales also fell on a quarter-over-quarter basis, in spite of a 0.6% month-over-month gain.

The labor market has been affected by the deterioration in economic activity, with the unemployment rate increasing to 6.6% in the quarter ending in May (vs. 6.1% in the previous three readings).Employment grew by 1.2% year over year (vs. 0.8% previously). However, a large part of the employment growth was in public sector jobs (which grew by 9.8% year over year), as private sector jobs increased by a modest 0.7%.

Business confidence remained pessimistic in June but moved towards the neutral threshold of 50%. Confidence stood at 47.7% in June, up from 46.5% the previous month (and 43.7% in June 2014). The Construction sub-index posted the largest confidence gain (to 39.9% from 34.3%). Mining confidence remained relatively stable, and this was still the only optimistic sub-index (at 65.2%, vs. 66.8% in May). Aggregate business confidence has now been in pessimistic territory for 15 consecutive months.

We have revised our growth forecasts to 2.2% from 2.5% for this year and to 3.2% from 3.4% for 2016.The recent activity figures show that the economic recovery has been bumpy. Lower copper prices and low confidence continue to be a drag on investment and activity in general. In fact, imports of capital goods – a good proxy for investment in machines and equipment – fell by 15.5% year over year in 2Q15 (a sharper contraction than the 9.7% registered the previous quarter). Meanwhile, the evolution of manufacturing activity shows that the weakening currency is failing to help activity.

A slower convergence to the target

Inflation came in at 0.5% in June, after the 0.2% recorded in May. The number not only surprised us and the market on the upside, but it was above every analyst’s forecast. Core measures and non-tradable inflation were also high on a month-over-month basis. Specific price increases (electricity, airfares, cigarettes and gasoline) explained 28 bps of the monthly inflation.

On an annual basis, inflation was 4.4% in June, above the 3.97% posted in May.Inflation excluding the food and energy components also picked up strongly, to 4.7%, from 4.2% in May. Tradable inflation showed a 4.0% yearly increase, above the 3.4% increase registered in May. Non-tradable goods prices grew by 5.0% year over year, up from 4.7% growth the previous month. In spite of the increase in all price indices, our diffusion index (the difference between the amount of price increases above the center of the target range and those below it, on a year-over-year basis) has remained stable.

Given the higher-than-expected inflation in June, we now expect inflation to reach 3.7% at the end of this year (vs. our previous estimate of 3.3%). Although the price increases in June were mostly linked to items that do not respond to internal demand growth, the persistently high levels of overall inflation and of its core measures are raising concerns about the amount of slack in the economy. For 2016, we continue to expect inflation to reach the center of the target range.

An uncomfortable trade-off

The minutes from the June monetary policy meeting, at which the board unanimously decided to hold the rate at 3.0%, retained an overall neutral tone.Once again, the central bank saw leaving the policy rate unchanged as the only relevant option.

The last monetary policy meeting was held before the most recent data releases on activity and inflation. Given the weaker-than-expected economic growth and slower-than-expected convergence to the inflation target, we continue to expect rates to remain on hold both this year and next. Hence, our call differs from the guidance provided by the central bank in its latest monetary policy report, for rate hikes starting in the first half of 2016.

A solid trade surplus in 2Q15

As the trade balance continues to post strong surpluses, we expect that the current-account deficit remained low in 2Q15.A USD 783 million trade surplus was recorded in June, up from the USD 570 million surplus registered one year earlier. As a result, the 12-month rolling trade balance came in at USD 8.4 billion in 2Q15, almost flat with the result for 1Q15. However, according to our own seasonal adjustment, the trade surplus improved from 1Q15 (USD 8.4 billion, annualized) to 2Q15 (USD 9.4 billion), as a contraction in imports (23.1% qoq/saar) more than offset a decline in exports (15.6% qoq/saar).

The recovery of Chile’s trade balance is being driven by weak internal demand, the more depreciated peso and lower oil prices, factors that are more than offsetting lower copper prices.Mining exports contracted by 8.6% year over year in 2Q15. Energy imports fell by 37.1% in the same period, while non-energy imports were down 8.8%.

We forecast current account deficits of 1.1% of GDP for 2015 and 1.8% of GDP for 2016, compared with the 0.5% deficit recorded for the four-quarter period ended in 1Q15. Later in the year, given the likelihood of modest recoveries in domestic demand, we anticipate some moderation in trade surpluses. Still, Chile’s current-account deficit will likely remain very low, especially compared with other countries in the region.

With uncertainty about the Greek and Chinese economies rising and U.S. data coming in strong, the Chilean peso has weakened sharply. Once the volatility in international markets subsides and copper prices recover, we expect the exchange rate to rebound somewhat, ending this year at 645 pesos to the dollar and ending 2016 at 650 pesos to the dollar.

Strong political headwinds and a weaker fiscal position

President Bachelet made additional changes to her cabinet in June. Nicolás Eyzaguirre, who was previously the Minister of Education, was made Minister Secretary-General of the Presidency. He will be in charge of negotiating with Congress on behalf of the administration. The new Minister of Education is Adriana Delpiano, who had been the executive director of Education 2020, an NGO with the goal of making policy recommendations to improve the educational system in Chile.

While overall these changes were favorably received, some sectors expressed caution regarding the likely effectiveness of the newly appointed ministers.While Mr. Eyzaguirre’s reputation as a negotiator precedes him, the complicated debates over various educational reform bills wore down his relationship with Congress, according to some. Ms. Delpiano’s appointment was seen as positive by Jaime Gajardo, the head of the teacher’s union, who believes that Delpiano understands what the main educational issues are. Her arrival could help unlock the negotiations over the public education service bill currently being debated in Congress, against which the teachers’ union has been on strike for over a month. However, she will face much more complex negotiations when the administration discusses the topic of free higher education. All in all, we continue to see no significant changes in the government’s agenda and believe that the recent changes in the cabinet were primarily aimed at improving communication and dialogue with various political and social actors.

In his midterm report to the Senate, the Minister of Finance presented a less optimistic economic scenario for 2015, compared with the outlook issued last year as part of the budget.The growth projection for this year was downgraded to 2.5% from 3.6%, the average copper price estimate was lowered to USD 2.75/lb from USD 3.12/lb, the average exchange rate forecast was revised to 630 pesos to the dollar from 585 pesos to the dollar and the year-end inflation forecast was increased to 3.5% from 2.8%. These revisions affected the government’s revenue and expenditure estimates, yielding a larger nominal projected deficit of 3.0% of GDP, compared with the 1.9% deficit envisioned in the budget law.

In light of the revisions to our growth forecast and the updated fiscal outlook presented by the administration, we have updated our deficit estimate for this year to 3.1% of GDP, up from 2.5% previously.

In spite of the cabinet changes that were implemented, approval ratings for both the government and the president reached historical minimums in June, according to the think-tank Adimark.Michelle Bachelet’s approval rating fell to 27% from 29% the previous month, while the government’s approval rating stood at 22%, the lowest rate recorded since this question was added to the survey in 2009. Meanwhile, Bachelet’s disapproval rating rose to 68% (from 66% previously). The approval rating for Bachelet’s oversight of the economy inched up to 32% from 30% previously, following the cabinet changes in this area. However, support for key reforms took a dip, with approval of the education reform falling to 33% in June from 45% in May – likely affected by the ongoing strike by public-school teachers – and approval of the labor reform reaching 34% (vs. 42% previously).


João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti


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