Itaú BBA - Activity continues to disappoint

Scenario Review - Chile

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Activity continues to disappoint

July 6, 2016

We now expect GDP growth of 1.5% this year, below the 2.1% rate from last year.

Please see the attached file for all graphs. 

• Activity has weakened beyond expectations. We now expect GDP growth of 1.5% this year (1.8% in our previous scenario), below the 2.1% rate from last year, and 2.0% for 2017 (2.3% previously). Activity is being hindered by less fiscal support, low commodity prices and weak confidence.

• The expectation of supportive monetary policy in the developed economies coupled with an improvement in copper prices has led to a stronger exchange rate recently, in spite of the vote on Brexit. Still, volatility is likely to remain in the short term. We see the peso at 685 to the dollar by the end of this year and at 695 by year-end 2017. 

• We expect a current account deficit of 1.7% of GDP this year. The lagged impact of the weaker exchange rate and low internal demand growth will likely lead to some narrowing of the deficit from last year. The current account deficit would widen to 2.2% of GDP next year as internal demand posts a mild recovery.

• Inflationary pressures are diminishing. We see year-end inflation of 3.5% (4.4% in 2015), as the negative output gap and less currency depreciation favor slower price increases. For 2017, we expect inflation to return to the central bank’s 3% target. 

• We expect the central bank to hold the policy rate at 3.5% throughout our forecast horizon. Amid declining inflation, anchored inflation expectations and weak growth, the resumption of the tightening cycle is unlikely.

• With low political capital, the reform agenda of the government remains challenging.

Labor market catching up with the weak economy

The available data for 2Q16 has reaffirmed a fragile economy. The 0.7% year-over-year rise in April’s GDP proxy (Imacec) was hampered by unfavorable calendar effects. However, the rebound in May (1.8%), which had three additional working days compared with May 2015, wasn’t enough to offset the weakness of the previous month and the index grew a modest 1.6% year over year in the quarter ended in May. Industrial production remains fragile (down by 2.0% year over year in May), as mining continues to fall (-5.7% year over year), penalized by lower ore-grade, while manufacturing is yet to show a significant recovery (although it grew by 2.1% year over year, when adjusted for calendar effects it continued to contract). Business confidence is at lows last seen at subprime crisis.

Meanwhile, the labor market is turning less supportive for consumption. The national unemployment rate increased to 6.8% in May (6.6% one year before), the highest level for this month since 2011. While the expansion of employment (1.3% year over year) is not weak, the breakdown of job creation suggests a loosening of the labor market, as self-employment grew 6.5% year over year and unpaid employment in family businesses expanded 7.8%. Meanwhile, waged employment growth decelerated to 0.4% year over year. Additionally, consumer confidence is at its lowest level since 2008. In this adverse environment, retail sales grew a modest 0.6% year over year. Even after accounting for seasonal and calendar effects, retail sales grew 1.6% year over year (6.0% previously). In the quarter ending in May, retail sales posted growth of 3.2% (4.0% in 1Q16).

We expect an additional weakening of the labor market ahead. The sluggish pace of economic growth in the coming quarters, the anticipated destruction of jobs in the construction sector – as the end of VAT tax credit on housing sales approaches – and a negative contribution from public employment (due to the fiscal tightening) will drive the unemployment rate higher. We expect the average unemployment rate at 7.1% this year (6.3% in 2015).

We now expect GDP growth of 1.5% this year (1.8% in our previous scenario), slowing from 2.1% in 2015. A mild recovery to 2.0% (2.3% previously) is anticipated. Activity is being hindered by less fiscal support, low commodity prices and weak confidence.

Mining exports hurt the trade balance

We see the peso at 685 to the dollar by the end of this year and at 695 by year-end 2017. The expectation of supportive monetary policy in developed economies, coupled with an improvement in copper prices, have led to a stronger exchange rate recently. Still, volatility is likely to remain in the short term as uncertainty from the Brexit result persist.

The trade balance surplus is shrinking as low commodity prices negatively impact mining exports. The 12-month rolling trade balance moderated to USD 3.0 billion as of May (USD 3.5 billion in 2015). In the quarter ending in May, exports declined 7.2% year over year (-19.3% in 4Q15), with an 11.3% contraction in the mining component. Imports are still declining (-4.7% in the quarter ending in May; -14.5% in 4Q15) but with less intensity.

We still expect a current account deficit of 1.7% of GDP (-2.0% last year). While the trade balance surplus would narrow to USD 1.6 billion this year (USD 3.5 billion last year), low copper prices are denting into profits of foreign mining companies operating in Chile, leading to a smaller income balance deficit. The mild recovery of internal demand would lead the current account deficit to increase to 2.2% of GDP for 2017.

Inflation set to re-enter the target range

The stabilizing exchange rate and low economic growth are leading to lower inflation. Headline inflation stood at 4.2% year over year in May (stable from April). Core inflation – prices excluding food and energy prices – slowed to 4.3% from 4.6% previously. Tradable inflation remains within the 2%-4% target range (at 3.9% year over year). However, due to indexation, non-tradable inflation remains high, at 4.7%. Our diffusion index also shows inflationary pressures are diminishing.

We expect inflation to reenter the target range by July and decelerate to 3.5% by year-end. The widening output gap, the more benign evolution of the exchange rate and well-anchored inflation expectations will likely continue to favor disinflation. Inflation is expected to reach the central bank’s 3.0% target by year-end 2017.

On hold now and ahead

As unanimously expected, the central bank left its policy rate unchanged, at 3.5% in June. The central bank has been on hold throughout 2016, following a short and discontinuous tightening cycle in 4Q15.

The central bank noted the weak activity data and the downward trend of inflation. The labor market is a growing concern for the central bank. Furthermore, the two-year horizon expectations remain well anchored at the 3% target.

We continue to expect the central bank to remain on hold at 3.5% throughout this year and the next. As consumer price inflation continues to decelerate towards the target range, aided by a less intense depreciation of the currency and a widening output gap, the central bank is unlikely to resume the tightening cycle.

Reforms remain challenging

In its final stage, the labor reform discussion is still bumpy. In late April, the constitutional court rejected the bill’s intent to grant exclusive collective bargaining rights to unions on the grounds of discrimination (against other negotiating groups). Lacking the votes to address the issue in congress, the administration opted for removing references to exclusive collective bargaining rights through a partial veto of the bill.

The veto has already been ratified by both chambers of congress and is to be signed into law shortly. However, as the final wording of the labor bill does not explicitly rule on negotiating parties besides unions, uncertainty remains over their negotiation capability. So, the opposition wants to once again take the bill to the constitutional court, as it still considers it to be discriminatory.

With limited political capital, the government faces a challenge in advancing the reform agenda. Amid elevated disapproval figures, the recent change of the interior minister (after barely one year in his post) reveals the friction within the governing coalition. The government has only just sent the bill that sets the guidelines for free higher education, has yet to start the discussion of the 2017 budget (estimated for early July) and still has to submit a pension reform bill (no set date). In the meantime, a much disputed constitutional reform process is advancing, with no certainty of the final outcome. Additionally, the political race ahead of November’s municipal elections and next year’s presidential elections are about to begin. Uncertainty over the timing and extension of reforms is a key factor behind low confidence.


 

João Pedro Bumachar
Vittorio Peretti
Miguel Ricaurte


 

Please see the attached file for all graphs.  


 

 



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