Itaú BBA - More easing ahead

Scenario Review - Chile

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More easing ahead

August 7, 2017

Weak growth and a stable currency have led to subdued inflationary pressures.

Please see the attached file for all graphs.

• Chile’s sovereign credit rating was downgraded for the first time since the 1990s, as rising debt levels and an unfavorable growth outlook elevated credit concerns.

• With inflationary pressures likely to remain muted and activity still weak, we foresee further monetary easing, with the policy rate reaching 2.0% by the end of this year. 

• Polls show that former president Sebastian Piñera is consolidating a substantial lead in advance of the first-round presidential vote in November. However, it remains likely that a runoff vote in December will be required, and current polls still show diverging results in a potential second-round contest.

The inevitable arrival of the rating downgrade

In an unsurprising development, S&P lowered Chile’s long-term foreign currency rating to A+ from AA-, with a Stable outlook. In January of this year, S&P had lowered the outlook on its AA- rating to Negative and assigned 33% odds to a rating downgrade before the end of 2018. Chile’s disappointing growth performance in 1Q17 (0.1% yoy) likely fast-tracked the downgrade. The one-notch rating downgrade, which for some time had already been priced in by the market (as shown by Chile’s 5-year CDS spread of 65, which is close to the spreads of countries with A ratings), leaves Chile six notches above speculative grade. The agency highlighted that the prolonged period of subdued economic growth has hurt Chile’s fiscal revenues, added to the government’s fiscal burden and eroded the country’s macroeconomic fundamentals.

S&P went further, saying that it could assign a Negative outlook to its rating on Chile within the next couple of years if activity continues to disappoint (their current growth rate forecasts are 1.6% in 2017, 2.0% in 2018 and 2.4% in 2019) and leads to larger fiscal deficits and increased debt burden. Additionally, the same action could unfold if there is a loosening of Chile’s commitment to prudent fiscal and monetary policies. To achieve a Positive outlook, a sustained recovery in growth along with observance of prudent fiscal and monetary policies would be required.

Higher copper prices will help contain the fiscal deficit this year. The Chilean budget office reported a fiscal deficit of 0.2% of GDP for 1H17, as real spending grew by 5.7% (vs. 3.9% in the equivalent period of 2016). Government revenues increased by 3.6% in the period (vs. 7.1% in 1H16), with tax revenues from private mining rising by 33.6% and revenue from non-mining taxpayers climbing by 2.8%. Revenue from the state mining company Codelco rose by 4.8%. The finance ministry recently raised its estimate for the copper prices this year to USD 2.50/lb (from USD 2.20/lb), leading it to expect a fiscal deficit of 3.1% of GDP in 2017 (vs. the previous estimate of a 3.3% deficit and the 2.7% deficit posted in 2016).

The rating agencies’ main concern is not the overall level of gross public debt, but rather the rapid increase in this metric over the last decade (from 3.9% of GDP in 2007 to 21.5% as of 1Q17). Chile’s credit ratings include a Negative outlook from Fitch (A+) and a stable outlook from Moody’s (Aa3), but the latter recently raised concerns about the country’s higher debt levels. With public debt likely to keep rising, we cannot rule out the possibility that Moody’s implements a change in outlook and possibly a rating downgrade in the coming months.

Modest activity improvement in 2Q17

In spite of an improvement in the second quarter, activity remains weak. The industrial production index fell by 1.8% in 2Q17, following a 5.9% drop in 1Q17. Mining production continues to be a drag, as the rebound following the end of a strike in the sector has been weaker than expected, partly as a result of low-grade ore, maintenance programs, and temporary plant closures amid poor climate conditions. Meanwhile retail activity growth remained broadly stable in 2Q17, expanding 3.1% (3.2% in 1Q17), supported by durable goods sales (15.8% in the quarter, compared to 17.5% in 2016), while non-durable consumption remains feeble (0.6%, after 0.4% in the previous year).

According to the Imacec (monthly proxy for GDP), total activity grew by 1.0% in 2Q17 (vs. 0.1% in 1Q17). At the margin, activity rose by 3.0% qoq/saar (vs. +0.6% qoq/saar in 1Q17 and -1.5% in 4Q16), led by mining. Non-mining GDP lost momentum (1.6% qoq/saar vs. 3.1% in 1Q17), in spite of a 0.6% month-over-month gain in June. 

Going forward, the gradual loosening of the labor market will limit any consumption recovery. In the second quarter of the year, the unemployment rate reached 7.0%, inching up by 0.1 pp from one year before as public and non-salaried employment continued to prop up job growth. Effective labor (employment times hours worked) dropped by 1.6% year over year in 2Q17 (vs. +0.8% in 1Q17), more clearly reflecting the weakness of the labor market.

We expect activity to show some recovery ahead. Firming growth in China and rebounding copper prices are likely to support the economy, as are a loose monetary policy and low inflation. We expect a GDP growth rate of 1.6% this year, stable compared with 2016, with activity picking up to 2.5% next year.

External accounts remain solid

In spite of recovering mining exports, improved consumer-goods and capital imports in the second quarter of the year led to a smaller trade balance. The rolling 12-month trade surplus as of June came in at USD 3.9 billion, inching down from the USD 4.3 billion surplus of 1Q17 (and the USD 5.3 billion surplus of 2016). Nevertheless, the trade balance remains at a comfortable level, and the recovery in mining exports is expected to continue (as production rebounds following the end of the strike). Our seasonally adjusted series shows that, at the margin, the trade balance picked up to a USD 1.7 billion (annualized) surplus in 2Q17, from the USD 1.1 billion annualized surplus recorded in 1Q17.

The trade balance will continue to be favored by higher copper prices. We expect current-account deficits of 1.2% of GDP in 2017 (broadly stable compared with last year) and 1.4% in 2018.

Lower inflation

Consumer prices for the month of June came in well below market expectations. A 0.4% monthly drop in prices pushed annual inflation below the lower bound of the central bank’s target range, to 1.7% (from 2.6% previously), which is the lowest annual inflation rate since October 2013. Our diffusion index continues to reflect diminishing price pressure, with the declining contribution coming from tradable products, while the non-tradable contribution is stable at low levels.

Tradable inflation dropped to 0.6% year over year (from 1.7% in May), pulling down headline inflation. Meanwhile, non-tradable inflation slowed to 3.1% from 3.6%, supported by lower housing prices. Once food and energy prices are excluded, inflation dropped to 1.8% (from 2.5% in May). Other core inflation measures fell by around 0.5 pp, to 2.0%. Excluding food and energy, services inflation declined to 3.1% (from 3.6%).

The latest data has led us to revise our year-end inflation forecast to 2.4% from 2.8%. Low growth and a stable currency combined with well-anchored inflation expectations are containing inflation pressures. Given this inertia, we now see the inflation rate ending 2018 at 2.8% (down from our previous estimate of 3%).

More easing on the cards

The minutes from the July monetary policy meeting show that the board has some appetite for further easing. A divided central bank board – the first such split since December 2016 – saw four of the five board members favoring keeping the policy rate at 2.5% and one member, Pablo Garcia, seeing enough evidence from slowing inflation to warrant additional easing. The July discussion confirmed that another rate cut is gaining support as the next move.

Some of the board’s four-member majority were not completely against the idea of further easing. One member believed that the June inflation numbers were particularly important in the risk assessment for the inflation trajectory. Another member believed that there were downside risks to inflation, which, if they materialized, could support more easing. The other two members were more categorical in their opinion that the inflation surprise was a one-off and would have no impact on the path of inflation convergence to the target.

Pablo Garcia argued that the data since the 2Q17 inflation report (IPoM) points to a lower inflation outlook. In Mr. Garcia’s view, sustaining the prognosis from the previous IPoM (on hold at 2.5%, neutral bias) is increasingly difficult as the risks of a delay in inflation convergence are growing.

In our opinion, the minutes of the July meeting have laid the groundwork for additional easing. We believe that muted inflationary pressure, along with weak activity, justify further easing to ensure that inflation remains on a trajectory toward the 3% target. Thus, we now foresee the central bank taking the policy rate to 2.0% by year-end (down from our previous projection of 2.5%), but it is likely that the next move will come only after the 3Q17 IPoM. 

Voting intentions consolidating

Less than four months ahead of the general election (to be held on November 19), Sebastian Piñera is extending his lead over his nearest rivals for the Chilean presidency. Early in July, the former president emerged victorious (over Felipe Kast and Manuel José Ossandón) in the primary elections for the Chile Vamos coalition. The average of recent polls (Cadem-Plaza Pública, Adimark and Cerc-Mori) shows Piñera (with 35% support) leading his nearest competitors by more than 10 percentage points. Alejandro Guillier (whose candidacy is supported by the majority of parties in the ruling coalition) is the nearest challenger (at 20%), but is facing stiff competition from Beatriz Sanchez (with 17%, representing Frente Amplio). 

However, second-round simulations are in short supply and have so far yielded divergent results. The latest Cadem poll suggests that Piñera’s most formidable competitor in a runoff would be Sanchez (48% vs. 42%), and gives him a 10-pp advantage over Guillier. Meanwhile, the Cerc-Mori simulation shows a statistical tie between Guillier and Piñera. In the other potential, but less likely, scenario, Piñera would likely beat Beatriz Sanchez by around 10 pp. 

In our view, a clearer political outlook is a prerequisite for a meaningful and sustained rebound in confidence and investment in Chile. Hence, we believe that there is unlikely to be a meaningful improvement in sentiment before the election. 


 

João Pedro Bumachar

Vittorio Peretti

Miguel Ricaurte


 

Please see the attached file for all graphs.



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