Itaú BBA - Less fiscal support, more monetary stimulus

Scenario Review - Chile

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Less fiscal support, more monetary stimulus

October 10, 2016

We now expect two 25-basis points rate cuts in 1Q16 amid faster disinflation and weak growth.

Please see the attached file for all graphs. 

Chile’s reputation for fiscal responsibility has been reinforced, as the finance ministry proposed a tighter budget for 2017. Real expenditure will increase by 2.7% from this year, in real terms, below the estimated 4.2% for this year, which is in line with the goal of reducing the structural deficit by 0.25% of GDP per year.

A notable recovery in activity remains beyond our baseline scenario. We expect 1.5% GDP growth this year, slowing from 2.3% in 2015, with a modest recovery to 2.0% next year. Low commodity prices and low confidence are preventing higher growth rates.

We now expect inflation to end the year at 3.3% (3.5% previously) from 4.4% in 2015, supported by the negative output gap, a stable exchange rate and well-anchored inflation expectations. For 2017, we expect inflation to stabilize at the 3% target.

Given low growth and better behaved inflation, we now expect the central bank to cut rates early next year, taking the policy rate to 3.0% by yearend 2017 (no rate cuts expected previously). Moreover, given the fragility of activity, the possibility of further cuts is non-negligible.

Low copper prices will shrink the income-balance deficit and offset a smaller trade surplus, bringing the current-account deficit to 1.7% of GDP this year (-2.0% in 2015). A widening to 2.2% of GDP next year is expected on the back of the modest economic pickup.

We continue to see the Chilean peso ending this year at 685 to the dollar and 695 by the end of 2017, weakening from current levels as the interest-rate differential narrows once the Fed resumes rate hikes.

Budget tightens

The administration presented the 2017 budget plan to Congress at the end of September. According to the bill, public expenditure will see a real growth rate of 2.7% next year, the lowest expansion in 14 years (4.2% estimated for this year). The tighter budget goes in line with the administration’s commitment to decreasing the structural-balance deficit by 0.25 percentage points from this year (to 1.5% of GDP). The growth rate is lower than market forecasts of a real 3.0% increase in public expenditure; this is a positive development, as it goes in the direction of preserving Chile’s fiscal position at a time when pressure to bolster growth through public expenditure is high. In nominal terms, the budget would come to USD 60 billion (25% of GDP), with a deficit that is close to 3.3% of GDP (3.1% in 2016) and total financing needs of USD 10.5 billion next year (including debt rollover).

Expenditure growth will mainly favor Education, Health and Public Security. The bill also seeks to improve pensions for the lowest income earners. Additionally, investment expenditure for next year would amount to 6.1% of GDP (5.6% this year). In total, public investment would grow 10.8% next year, considering expenditure made by the national petroleum company, the Santiago subway company and copper producer Codelco. Regarding the latter, President Bachelet indicated that the government will continue the capitalization program, provided operational efficiency gains are achieved. No precise figure was given in this regard, but reports indicated that capital injections this year are below the USD 800 million originally committed.

All in all, we see government expenditure being less supportive of growth next year. Because of smaller real growth of government expenditure, the structural-balance deficit would be smaller (1.5% of GDP vs. the 1.7% estimated for this year).

Subdued activity

High-frequency indicators point at weak activity in 3Q16. Activity indicators came in mixed in August, with industrial production posting some recovery, albeit aided by a favorable calendar effect and a low base of comparison, while private consumption continues to weaken. The industrial production index – which aggregates Manufacturing, Utilities and Mining – increased 2.8% in August (-1.9% in July), and 2.1% when corrected for seasonal and calendar effects. The pick-up in the month was favored by a low comparison base, as numerous mines underwent maintenance in the corresponding period in 2015. So, we do not see the recovery as a reflection of a trend improvement. Meanwhile, retail sales increased 0.2% year over year (4.6% in July) and 1.8% (3.0% in July) once adjusted for seasonal and calendar effects. In the quarter ending in August, retail sales posted growth of 1.9% (3.1% in 2Q16).

As a result, the monthly GDP proxy grew 2.5% year over year, while growth in the quarter ending in August decelerated to 1.3% (1.5% in 2Q16). At the margin, the index expanded 1.3% qoq/saar in August.

Consumption is weakening as the labor market loosens. The unemployment rate sits at 6.9% in the quarter ending in August, above the 6.5% recorded in the same period of 2015, and is the highest unemployment rate for the equivalent quarter since 2011. Employment growth continues to be concentrated in lower quality jobs. Job growth was 1.1% (the same gain as in 2Q16), below the expansion of the labor force (1.6%), as has been the case since 1Q16. Meanwhile, self-employment expanded 5.5% year over year (6.0% in 2Q16), while waged employment was almost flat from one year ago (+0.2% year over year after 0.4% in 2Q16).

We expect GDP growth of 1.5% this year, down from the 2.3% recorded in 2015. Low business and consumer confidence, subdued copper prices and tightening fiscal policy will likely keep growth low. A modest recovery to 2.0% is still expected for next year.

Sharper disinflation underway

Inflation moved closer to the center of the central bank’s target range, following a downside surprise in September. Consumer prices increased 0.2% from August to September (0.5% twelve months ago), below expectations. So annual inflation moderated to 3.1%, from 3.4% in the previous month.

Annual inflation recorded the lowest gain since January 2014, and apart from non-tradable inflation, all key inflation measures are within the 2%-4% target range. Tradable inflation moderated to 2.3% (2.6% in July), while core inflation - prices excluding food and energy prices - came in at 3.4%, below the 3.9% the previous month and the lowest reading since March 2014. The lower core inflation is derived mainly from the tradable side, as core service inflation fell by less, to 4.1% from 4.3% previously. Our diffusion index showed a notable decline, with a diminished contribution from the tradable component.

The downside surprise led us to lower our yearend inflation forecast to 3.3% (from 3.5% previously). For next year, we still see inflation at 3% by yearend supported by the negative output gap and a stable exchange rate.

Rate cuts ahead

As unanimously expected, the central bank left the policy rate unchanged at 3.5% (stable since December last year) and retained its neutral stance. In the inflation report (IPoM) published shortly before the meeting, the central bank indicated that the policy rate would remain unchanged at the current level in the policy horizon. In the report, the central bank mentions the neutral rate is around 4.0 to 4.5% (nominal), implying that there is stimulus in place, but not a sizable one.

While the central bank will likely stay on hold for the remainder of this year, we now see some monetary stimulus in 2017. We expect the central bank to cut rates by 50 basis points during 1Q17 (in two 25-bp moves). Weak activity and better behaved inflation will likely convince board members to engage into an easing cycle. We cannot rule out cuts beyond our new scenario given the fragility of activity.

Trade surplus stabilizing

The trade surplus showed some improvement in the quarter. A trade balance deficit of USD 73 million was registered in 3Q16, smaller than the USD 993 million recorded one year ago. The 12-month rolling trade surplus is at USD 3.7 billion, inching up from the USD 3.5 billion in 2015, with an improvement in the non-mining balance offsetting a smaller mining balance. According to our seasonally-adjusted series, at the margin the trade balance reached USD 4.1 billion (annualized) in 3Q16, broadly stable from the USD 3.9 billion in 2Q16. So, the weak economy, low oil prices and the weaker currency are compensating the weak mining exports.

We expect a current-account deficit of 1.7% of GDP this year, narrowing from the 2.0% deficit in 2015. A widening to 2.2% of GDP next year is expected, supported by a modest expected economic recovery.

We continue to see the Chilean peso ending this year at 685 to the dollar, weakening from current levels as the interest-rate differential narrows once the Fed starts to raise rates again. Further weakening to 695 to the dollar by the end of 2017 is anticipated.


 

João Pedro Bumachar
Vittorio Peretti
Miguel Ricaurte


 

Please see the attached file for all graphs.  

 



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