Itaú BBA - First Step in the Government Reform Program

Scenario Review - Chile

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First Step in the Government Reform Program

April 8, 2014

Investment led the deceleration in 4Q13.

•           The Chilean economy continues to grow slowly after a weak 4Q13. We reduced our growth forecasts to 3.3% for 2014 and 4.0% for 2015.

•           We expect inflation to be at 2.8% by the end of 2014. Despite our expectation of a wider output gap, we are maintaining our inflation forecast at 3.0% for 2015, given the significant likelihood of a tax increase on alcoholic beverages next year (as part of the country’s tax reform).

•           Higher mining output, a weaker exchange rate and more sluggish internal demand are likely to lead to a reduction in the current-account deficit (to 2.7% of GDP in 2014 and 1.7% in 2015, from 3.4% in 2013). Meanwhile our exchange-rate forecasts remain unchanged at 575 pesos to the dollar, by both year-end 2014 and 2015.

•           The central bank left the interest rate unchanged at 4.0% during the March monetary policy meeting and, while an easing bias remains, it is now more “moderate”, according to Governor Rodrigo Vergara. We see room for an additional 50-bp reduction in the policy rate this year, but expect the interest rate to remain unchanged in April.

•           President Michelle Bachelet submitted a tax reform proposal to congress. Overall, the reform is in line with Bachelet’s campaign promises. The reform aims to increase fiscal revenues by 3% of GDP, mainly through higher corporate taxes and removing the taxable profit fund (FUT).

Activity Continues to Grow at Below-Trend Pace 

Investment led the deceleration in 4Q13. Chile’s GDP increased 2.7% year over year in 4Q13, after recording an upwardly revised growth of 5.0% (from 4.7%) in the previous quarter. The economy consequently grew 4.1% in 2013, below the downwardly revised 5.4% expansion in 2012 (from 5.5%). According to the demand-side breakdown, 4Q13 growth slowdown was attributable to a sharp 12.3% year-over-year contraction in gross fixed investment, which was fueled by the 28.5% annual reduction in machinery and equipment investments. Although the remainder of the domestic demand components continued to slow, the decline was less steep: private consumption increased 4.9% year over year (from 5.4% in 3Q13) and public consumption increased 3.1% (vs. 5.6% in 3Q13). Internal demand excluding changes in inventories slowed to 0.2% year over year. Real exports fell 0.9% from a year earlier (11.3% in 3Q13), while activity was also weak on a sequential basis. GDP decreased 0.3% qoq/saar (after a 6.5% revised expansion in the previous quarter), led by a 36.1% qoq/saar reduction in gross fixed investment. Consumption growth, on the other hand, outpaced the previous quarter (5.7% qoq/saar vs. 3.2% in 3Q13), once again boosted by the robust growth in purchases of durable goods (15.2%).

Growth is likely to have remained below potential in 1Q14. Chile’s IMACEC came in at 2.9% year over year in February, following a 1.6% increase in January. On a seasonally-adjusted basis, the IMACEC gained 0.2% from January, after a 0.5% increase the previous month, bringing the quarterly growth to a weak 2.3% qoq/saar (-0.5% qoq/saar in 4Q13).

Consumption has been losing momentum in 1Q14, as the real wage bill becomes less supportive for households. Although the unemployment rate remains low (at 6.1% for the quarter that ended in February), waged employment growth is at a moderate 1.2% year over year, bringing the real wage bill growth down to 3.7% (from 4.0% in January and 4.8% in December). Retail sales grew 1.0% month over month in February, following a 1.7% drop in January. The quarter-over-quarter retail growth rate improved to 4.5% (annualized), but the improvement was due to favorable base effects that will fade next month (retail dropped 4.4% month over month in September 2013). Supermarket sales fell 0.7% qoq/saar.

The capital goods import data suggests that investment is recovering, but not nearly enough to offset the contraction in 4Q13. Exports improved during 1Q14, driven by a weaker peso and higher mining output. Exports increased 17.8% year over year in March and 4.5% in 1Q14 (-8.2% in 4Q13), led by a 25.3% rise in external mining sales (3.8% increase in 1Q14). Manufacturing exports also performed well, coming in at 10.2% in March and 4.1% in 1Q14.

Northern Chile suffered an 8.3 magnitude earthquake on April 1. A number of cities were severely affected, including Arica, Iquique and Antofagasta. Subsequent tsunamis also damaged some ports. According to the available information, several sectors of the economy were hurt. Schools throughout most of the Chilean coast cancelled classes, while port and ground transportation activities were suspended. The hardest hit zones account for nearly 12% of the country’s GDP (13% of the population). While the earthquake is likely to cause a temporary drag on activity in April, the positive growth impact of the reconstruction efforts should help boost activity in subsequent months.

We now expect GDP to increase 3.3% and 4.0% in 2014 and 2015, respectively (from 3.6% and 4.2% in our previous scenario). We note that our scenario still implies stronger sequential growth rates beginning in 2Q14, helped by monetary stimulus. 

Weaker Currency Causes Temporary Rise in Inflation

Headline Inflation and core measures increased in March. The CPI rose to 3.5% (from 3.2% in February), above the center of the central bank´s 2.0%-4.0% target range. The CPI (excluding food and energy) increased to 2.7% (from 2.5%). Tradable inflation increased from 2.4% in February to 2.9% (due to a weaker Chilean peso), while non-tradable inflation stood flat at 4.3% (above the upper bound of the target), likely as a result of an ongoing low unemployment rate.

We see inflation at 2.8% in 2014 and 3.0% in 2015. Initially, the wider output gap that we now forecast would lead to a reduction in our inflation forecast for 2015; however, there is a high probability that a tax hike on alcoholic beverages and sugary drinks will be implemented in 2015 (as a result of the tax package detailed below), which may lift inflation by as much as 30-bps.     

Public Expenditures Pick Up Early in the Year

Fiscal spending grew 6.1% year over year in February, following a 12.2% increase in January. The higher fiscal expenditure growth is mainly attributable to current spending. On the other hand, fiscal revenues posted an average contraction of 4.7% year over year in the first two months of the year due mostly to the drop in copper revenue (which declined 39.3% year over year).

We now expect a fiscal deficit of 1.3% of GDP this year, up from 1.0% in our previous scenario and a deficit of 0.6% of GDP last year. While we expect fiscal expenditure to moderate over the next few months (relative to the first two months of the year), slower activity growth and lower copper revenue is likely to generate a higher fiscal deficit than a year before.    

A More "Moderate" Easing Bias

As expected, the central bank reduced the interest rate to 4.0% in March. In the press statement that accompanied the decision, the central bank kept an easing bias, citing in the last paragraph that “it will evaluate the possibility of introducing additional interest-rate cuts, according to the evolution of internal and external macro variables and its implications for the inflation outlook”. Thus, an easing bias remains, but with different wording (in the statement announcing the previous decision, the board stated that it “estimates that over the next months an additional monetary stimulus could be needed to ensure that forecasted inflation stays at 3% in the monetary policy horizon”). Governor Vergara later stated that the easing bias is now more “moderate”, meaning that the central bank is more cautious regarding further rate cuts. According to the minutes of the meeting, the board is somewhat more concerned about the potential second-round effects of a weaker exchange rate on prices.

In the March Monetary Policy Report, the central bank reduced its GDP estimate and confirmed the easing bias. The bank reduced the GDP estimate for this year by 75 bps (to a range between 3.0% and 4.0%), due to worse investment growth expectations, adding that risks to the GDP forecast are tilted downward. In this context, the central bank reaffirmed the easing bias, mentioning that the report “uses a working methodological assumption where the policy rate will follow a path comparable to that inferred from financial asset prices”. While, initially, this means another 25-bp rate cut, Governor Vergara mentioned during a speech at ICARE (a private corporate association) that the central bank expects an additional reduction in the reference interest rate of 25 to 50 bps.

We expect the central bank to maintain the interest rate at 4.0% at the monetary policy meeting in April.  However, according to our growth outlook, there is still room for further interest rate reductions; we therefore expect the central bank to resume an easing cycle within the next few months. We continue to expect a 50-bp interest-rate cut this year, ending the easing cycle once the interest rate reaches 3.5%, and the beginning of a tightening cycle only in late 2015.

A Lower Current Account Deficit

The current account deficit stood at USD 2.4 billion in 4Q13, down from USD 2.7 billion one year before. As a result, the four-quarter rolling deficit declined slightly, to 3.4% of GDP from 3.5% in 3Q13. Although foreign capital flows to Chile continued to be strong, foreign direct investment (FDI) fell substantially from last year (in 2013, FDI was USD 20.2 billion, down from USD 28.5 billion in 2012). Still, net direct investment (that is, FDI excluding Chilean direct investment abroad) increased to USD 9.3 billion in 2013 (from USD 6.2 billion in 2012). Foreign portfolio investment was very strong in the second half of 2013 in spite of higher U.S. yields, bringing total foreign portfolio flows in 2013 to USD 15.7 billion, higher than Chilean portfolio investment abroad (USD 10.7 billion).

We reduced our current account deficit estimate to 2.7% and 1.7% of GDP in 2014 and 2015, respectively (from 3.0% and 1.8%). Higher mining output, the weaker Chilean peso and sluggish internal demand growth are likely to cause a narrowing of the current-account deficit this year, from 3.4% of GDP in 2013. Our new GDP forecasts are consistent with a faster deficit reduction than we were previously expecting. In fact, the trade balance improved substantially in March, taking the 12-month rolling surplus to USD 4.2 billion, from USD 2.1 billion in 2013.

Lower domestic interest rates and higher U.S. treasury yields are likely to lead to a weaker Chilean peso. Our exchange-rate forecasts remain unchanged at 575 to the dollar by the end of both this year and the next.

President Bachelet Submits a Tax Reform Proposal, With No Major Surprises

President Bachelet submitted the tax reform bill to congress on March 31. The contents of the proposal were broadly in line with the elements laid out during Ms. Bachelet’s campaign. The reform seeks to increase fiscal revenue by 3% of GDP in order to finance the education reform and reduce the structural public deficit to zero by 2018; Chile reported a structural deficit equivalent to 0.7% of GDP last year, and a 1.0% deficit is expected this year. The government estimates that about 2.5% of GDP revenues would come from changes in the tax structure, while 0.5% of GDP would come from closing tax loopholes.

According to the proposal, the implementation of the tax reform will be gradual. The bill confirmed the government’s intention of reaching a corporate income tax rate of 25% (from 20% currently) by the end of the current term. The corporate tax would reach 21% this year. The gradual approach would lead to extra tax revenues of only 0.29% of GDP this year, reaching the 3.0% target only in 2017. Furthermore, tax hikes on specific goods, including beer (to 20.5% from 15%), sugary non-alcoholic drinks (to 18% from 13%), wine (from 15% to 24%) and pisco (27% to 37.5%) were announced, but it is still unclear when the hikes will be carried out. The government also plans to raise the stamp tax, from 0.4% to 0.8% in 2016 (which has a relevant impact on inflation). Finally, there was confirmation that the FUT (taxable profit fund) will be withdrawn in 2017, and that the top personal income tax rate will be reduced from 40% to 35%.

The tax-reform debate in congress may not be smooth, although the Nueva Mayoria (government coalition) has enough support to approve the reform in the congress. The reform only requires a simple majority of 50%, while the ruling coalition has 55% of the seats. However, coalition members diverge on some key aspects of the tax reform. The government intends to approve the reform within the next two months, before the first presidential speech to congress (scheduled for May 21), although the critical deadline is before the end of September, when the 2015 budget is scheduled to be submitted to congress.

João Pedro Bumachar
Rodrigo Aravena
Vittorio Peretti

Forecasts: Chile


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