Itaú BBA - Easing Cycle to Continue

Scenario Review - Chile

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Easing Cycle to Continue

November 1, 2013

The Chilean peso has weakened, led by the earlier-than-expected start of the easing cycle.

•    Consumption decelerated in September and several fundamentals point to below-trend growth. We maintain our GDP forecasts at 4.2% and 4.4% for 2013 and 2014 respectively. 

•   Annual inflation fell to 2.0% in September, while core measures remain below the lower bound of the central bank target. We expect the weaker currency to offset the negative contribution from the looser output gap, leading to higher inflation. We keep our CPI forecasts at 2.2% and 2.6% for this and the next, respectively.   

    The central bank cut the interest rate by 25 bps in October (to 4.75%). The timing was surprising, considering the most recent consumption figures – we had been expecting the easing cycle to start in November. We think that below-trend growth and inflation below the target leaves room for another cut by 25 bps in November and 50 bps more in cuts during 1Q14.

   The Chilean peso has weakened, led by the earlier-than-expected start of the easing cycle. We still expect that lower domestic interest rates and worse terms of trade will lead to a weaker currency next year. We maintain our forecast at 500 pesos to the dollar at year-end 2013 and 525 for year-end 2014.  

    Presidential and parliamentary elections will be held on November 17, while a potential runoff will be held on December 15. According to recent polls, Michelle Bachelet (from Nueva Mayoria, the opposition coalition) and Evelyn Matthei (from Alianzapor Chile, the government coalition) will likely compete in the runoff. 

Strong GDP in August, But More-Recent Activity Indicators Suggest a Slowdown

Growth was strong in August. The IMACEC (monthly proxy for GDP) grew 4.1% year over year in August, above both our expectations and the Bloomberg consensus (3.7% and 3.9% respectively). On a sequential basis, activity was up 0.7% from July, bringing the quarter-over-quarter growth rate to 6.1% (annualized), following a weak 1.8% increase during 2Q13 and 3.3% during 1Q13.

The Labor market is still tight. Chile’s unemployment rate stood at 5.7% in September, declining from 6.5% one year before, as employment grew at a faster pace (2.0% year over year) than the labor force (1.1%). Waged employment was up by 2.1% year over year in September (2.7% in August), while the growth rate for self-employment fell to 2.2% (from 3.4% in the previous month).

However, consumption slowed in September, while manufacturing and building-permit growth remained in negative territory. Retail and supermarket sales rose 7.0% and 1.3% year over year, respectively (after increasing 12.0% and 9.3% in August), while manufacturing production and building permits fell by 1.0% and 11.2%, respectively.

In addition, several factors are still pointing to below-trend growth ahead. Although business and consumer confidence improved somewhat in September, this was due to temporary factors. Also, lower copper prices will continue reducing investment growth. Finally, fiscal policy will be less expansionary. On the other hand, lower policy rates will likely contribute to smoothing the impact of these factors on the economy.

We maintain our GDP forecasts. We still expect Chile’s GDP to grow 4.2% this year and 4.4% in 2014.

Inflation Returns to the Lower Bound of the Target 

Headline CPI fell to 2.0% year over year in September, reaching the lower bound of the target range, while the key core measures are still below the range. Excluding food and energy, inflation increased to 1.4% (from 1.2%).

We expect inflation to remain below target throughout this year and the next. In our view, lower private demand growth will contribute to keep non-tradable inflation in check (currently at 3.5%). However, a weaker currency will lead to a higher tradable inflation. In the short term, we can’t rule out that recent frosts lead to temporarily higher prices for non-processed food. We maintain our forecasts at 2.2% and 2.6% for year-end 2013 and year-end 2014, respectively.  

The Central Bank Starts the Easing Cycle 

The central bank reduced the interest rate by 25 bps in October, surprising both us and the market consensus. The decision does not represent a major departure from our previous scenario (we were expecting that the first rate cut of the cycle would take place in November), and it is justified by below-trend economic growth and a below-target inflation rate. However, its timing was puzzling, especially considering that the decision took place after the release of the strong August retail sales number, and the central bank’s tone had been suggesting that the board was uncomfortable providing stimulus to an economy in which consumption continues to expand at an unsustainable pace.

In the press statement that accompanied the decision, the board cited some new elements supporting the cut. The Fed’s decision to postpone the tapering (and its impact on the U.S. dollar); the fact that “many” leading indicators are pointing to a further slowdown of internal demand; and lower short-term inflation expectations. Furthermore, the central bank cited a “consolidation” of a less-favorable external scenario in the medium term (lower global economic growth, worse terms of trade, tighter external financial conditions and the end of the global cycle of mining investment). In our view, a tighter domestic fiscal policy aided the decision.

We expect another rate cut in November, so the policy rate would end this year at 4.5%. In the short term, we expect the central bank to deliver the same amount of monetary stimulus signaled in its most recent monetary policy report (50 bps). In 2014, we expect growth to continue below potential and inflation below the target, leaving room for two additional 25-bp cuts in the first quarter of 2014. 

Weaker Currency After the Central Bank Decision

The Chilean peso has weakened since the rate cut. Despite the postponement of the tapering by the Fed, the peso has weakened 2.6% since the central bank reduced rates.

We forecast the peso at 500 and 525 by year-end 2013 and 2014. In our scenario, we expect that lower interest rates and worse terms of trade will lead to a weaker currency. Therefore, we maintain our forecasts at 500 and 525 to the dollar at year-end 2013 and 2014, respectively.

Higher Public Deficit Led by Lower Mining Tax Revenues 

We adjusted our forecasts of fiscal balance from -0.3% of GDP to -0.9% in 2014. The government announced recently that fiscal spending will grow 3.9% in 2014, after increasing an estimated 5.9% this year. However, the government estimates a 22.8% reduction in private-mining tax revenues, due to rising costs in the sector. In addition, the government also mentioned that in 2014 the transitory increase of the mining tax will end, which will also contribute to lower revenues.

Presidential Elections to Be Held Soon

Presidential and parliamentary elections will be held on November 17. Nine candidates will run in the elections. If there is no candidate with more than 50% of the votes, the president will be elected in a runoff (December 15). According to the latest available polls, there will be a runoff between Michelle Bachelet (socialist, from the opposition coalition) and Evelyn Matthei (from the government coalition).

Michelle Bachelet, if elected, pledged to raise corporate taxes to finance educational reform and to change the constitution through the “current legislative mechanisms.” She would aim to raise revenues by 3% of GDP, mainly by gradually increasing the corporate tax rate from 20% to 25% in 2018. The extra resources would be used to finance educational reform (which would cost about 2% of GDP) and to reach a zero structural fiscal balance by the end of her term. Although Ms. Bachelet will likely fail to get the number of seats in congress necessary for a constitutional change, she explicitly said that her government would not seek changes through a constituent assembly.

João Pedro Bumachar
Rodrigo Aravena

Forecasts: Chile

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