Itaú BBA - Consumption Following the Footsteps of Investment

Scenario Review - Chile

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Consumption Following the Footsteps of Investment

June 9, 2014

The economy once again grew at a below-trend pace in 1Q14.

• The IMACEC (monthly proxy for GDP) was flat from March to April, after a weak 1Q14. We have reduced our GDP growth forecast for 2014 to 2.8% (from 3.3%), while maintaining our 4.0% growth estimate for 2015.

• Inflation moderated on a sequential basis in May, but base effects drove it higher on a year-over-year basis (to 4.7%). Core measures are close to the upper bound of the target, while annual wage inflation continued to rise. We see inflation at 3.6% by the end of this year and at 2.9% by the end of 2015.

• Chile’s central bank left the interest rate unchanged at 4.0% in May. Although the easing bias was maintained by the committee, the minutes of the meeting emphasized its greater concern over inflation. We still expect the central bank to resume the easing cycle, but given the recent inflation dynamics, rate cuts are likely to come only in 4Q14. We expect the policy rate to end this year at 3.5%, but no moves in 2015 (previously, we saw the policy rate at 4.0% by the end of next year), amid a sider output gap.

• Loose monetary policy at home and higher U.S. Treasury yields will likely weaken the peso further. Although our forecast for the exchange rate is unchanged at 575 pesos to the dollar by the end of this year, we now expect the rate to reach 600 pesos to the dollar by the end of 2015.

• In the annual May 21 presidential speech, President Michelle Bachelet shed more light on her government’s reform program. The tax reform bill, which will be used to finance the majority of her initiatives, is currently being debated in the Senate. No change is expected to the revenue target, but the government is now more open to changing some of its proposals to increase collection.

Activity: poor on many fronts

The economy once again grew at a below-trend pace in 1Q14. Chile’s GDP increased by 2.6% year over year in 1Q14 (vs.+2.7% in 4Q13). Adjusting for calendar effects, GDP expanded by even less (2.0%). The demand-side breakdown showed that gross fixed investment continues to be the main drag on the economy, declining by 5.0% from one year before (-12.3% in 4Q13), while domestic demand components came in mixed: private consumption weakened to 3.7% year over year (from 4.9% in the previous quarter), while public consumption increased by 9.6% (vs. +3.1% in 4Q13). On a sequential basis, GDP growth was better but remained below-trend at 3.0% qoq/saar.

The IMACEC (monthly proxy for GDP) for April showed that Chile’s economy is still not recovering. On a seasonally adjusted basis, activity was flat from March after a 0.4% drop in the previous month. In April, retail sales declined by 1.0% month over month and by 1.2% qoq/saar, hinting that consumption contributed for the weak IMACEC. Meanwhile, imports of capital goods - a proxy for investment in machines and equipment - fell by 30% year over year in the same month.

We have lowered our 2014 GDP estimate to 2.8% (from 3.3%). Chile’s economy has been slowing more sharply than we previously expected as higher inflation and lower employment growth weigh on private consumption and higher mining costs, lower copper prices and uncertainty over tax measures reduce investment. Meanwhile, exports are rising on the back of stronger mining output, which is a consequence of the massive investment made in the sector over the past few years. Still, we expect a recovery ahead, supported by looser monetary policy. For 2015, we maintain our 4.0% GDP growth estimate.

Wages picked up, in spite of the weak economy

Although inflation fell sequentially in May, base effects drove it higher on an annual basis. The consumer price index increased by 0.3% between April and May, after a 0.6% increase. Inflation rose to 4.7% year over year (4.3% in April), further away from the target range. Excluding food and energy, inflation was 0.2% month over month and 3.8% year over year (0.8% and 3.5% previously).

Tradable inflation was once again strong in May. Tradable prices rose 0.5% from April and by 4.5% year over year (3.8% previously).

However price indexes less exposed to the exchange rate and to commodity prices also continue at an uncomfortable level.  While inflation for wages and non-tradable items fell sequentially, it continues very high on a year-over-year basis, especially considering the weakness of the economy. Nominal wages rose 6.3% year over year (6.2% previously) in April while non-tradable inflation was 5.1%.

We see inflation at 3.6% this year and 2.9% in 2015.  The evolution of the output gap will likely contribute to reduce inflationary pressures.

Rates on hold amid greater concern over inflation 

As expected by us and most market participants, Chile’s central bank left its policy rate unchanged at 4.0% for the second consecutive month in May. It is important to note that we and the market were expecting the central bank to resume the easing cycle at this meeting until the much higher-than-expected April CPI was released. Importantly, the board maintained its easing bias in the press statement announcing the decision, stating that it “will evaluate the possibility of introducing additional policy rate cuts according to the evolution of the internal and external macroeconomic conditions”. However, the central bank also made it clear in the statement that it remains vigilant regarding the recent inflation spike, thereby hinting that it might be a while before additional cuts are made.

The minutes of the meeting indicated that the likelihood of additional cuts will depend on inflation data. The committee members sounded concerned not only with the level of inflation, but also how broad-based it is. Considering the increase in service and wage inflation, the committee doesn’t think that the inflationary pressures are coming only from the exchange rate. On activity, the committee has been seeing (at least until this latest decision) a slowdown in line with the forecasts in its most recent monetary policy report, which highlights the fact that it is more concerned about inflation than about economic growth. Although the economy is growing at a below-potential rate, the committee members acknowledged that the size of the output gap is uncertain, especially considering that the unemployment rate remains very low.  

As Chile’s economy continues to be sluggish, we expect the central bank to further ease the policy rate ahead. We continue to expect the interest rate to end this year at 3.5%. However, considering the recent inflation dynamics, we don’t expect rate cuts soon. In our view, the central bank will resume the easing cycle only in 4Q14, once the board has seen clear evidence that the inflation outlook is no longer a major risk. Based on our reduced growth forecast, we now expect the central bank to maintain the reference rate at 3.5% throughout 2015 (previously, we expected rate hikes by the end of 2015).

Weak internal demand helps narrow current account deficit

Improved trade balance numbers led to a decline in Chile’s current account deficit, to USD 0.8 billion in 1Q14 from USD 1.9 billion one year before. Consequently, the four-quarter rolling deficit declined to 3.1% of GDP from 3.4% in 4Q13. Although foreign capital flows to Chile continued to be strong, rolling four-quarter foreign direct investment (FDI) fell to USD 17.4 billion in 1Q14 (from USD 20.3 billion in 2013 and USD 28.5 billion in 2012). Net direct investment (FDI excluding Chilean direct investment abroad) for the last four quarters was USD 9.0 billion (down from USD 9.3 billion in 2013), still sufficient to fully finance the current account deficit. Foreign portfolio investment weakened in the first quarter of 2014, bringing total portfolio flows for the last four quarters down to USD 10.3 billion (USD 15.7 billion in 2013), although this is still higher than Chilean portfolio investment abroad (USD 5.3 billion).

The trade balance continued to strengthen in 2Q14. The 12-month rolling trade surplus increased to USD 5.3 billion in May (from USD 2.1 billion in 2013), its highest value since August 2012.

Although our forecast for the exchange rate is unchanged at 575 pesos to the dollar by the end of this year, we now expect the rate to reach 600 pesos to the dollar by the end of 2015. Loose monetary policy at home and higher U.S. Treasury yields will likely weaken the peso further.

We have reduced our expected current account deficit for 2014 to 2.5% of GDP (from 2.7%), as internal demand is more sluggish than we previously thought. In 2015, a weaker peso, higher mining output and moderate internal demand growth will likely help to reduce the deficit further (to 1.7% of GDP).

A Wider Budget Deficit

Amid slower growth, the government now foresees a 2014 nominal deficit of between 1.7% and 1.8% of GDP (up from its original forecast of 0.9% and the 0.6% posted in 2013). The Ministry of Finance reduced its economic growth forecast for 2014 to 3.4% from 4.9%. Finance minister Alberto Arenas said that the government’s forecast for the deficit also takes into account an average copper price of USD 3.05 per pound (down from USD 3.25) as demand in China has continued to slow. In order to make up for the shortfall in revenues, the minister has spoken about using resources from sovereign wealth funds, issuing new debt or to utilize money collected from Codelco that is being held for military spending.

President Bachelet spells out her political plans 

In the annual May 21 presidential speech, Michelle Bachelet spelled out what her government is planning to achieve in its term in office. Apart from the widely discussed tax reform (which has started to be debated in the Senate), the president’s speech also touched on a USD 650 million energy program that would focus on strengthening the State´s role in the planning and regulation of the industry, while increasing private competition; the commitment to form a state pension fund (to compete with private pension funds); and the education reform (an initial reform bill proposing an end to state subsidies for for-profit schools has already been submitted to Congress). She also discussed a proposal to nationalize water rights. This proposal, which had already been raised in Bachelet’s first government, would seek to establish priority uses for water and limit the use of water rights acquired under certain circumstances. The president also indicated that a capitalization proposal for the state-owned copper company Codelco would be submitted to Congress in the second half of the year. Codelco’s former CEO, Thomas Keller, has previously said that the company’s investment program will require more than USD 20 billion to increase output by about 10% over this decade, adding that without these investments, output is likely to fall by more than half as open-pit ore-bodies start to become commercially exhausted and are replaced by underground mines.

João Pedro Bumachar
Vittorio Peretti



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