Itaú BBA - Officially Neutral

Scenario Review - Chile

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Officially Neutral

September 8, 2016

Despite weak growth, faster disinflation is needed to trigger rate cuts in 2017.

Please see the attached file for all graphs. 

We expect 1.5% GDP growth this year, slowing from 2.3% in 2015, with a modest recovery to 2.0% next year. Activity is being hindered by low commodity prices and weak confidence.

As the Fed resumes rate hikes, we see the peso weakening somewhat, to 685 to the dollar by the end of this year and 695 by the end of 2017. 

Still, as the evolution of the currency is now far more favorable than over the past few years, we expect inflation to continue on a downward trend, reaching 3.5% by the end of this year and the 3% target in 2017. Weak activity amid well-anchored inflation expectations also helps to reduce inflationary pressures.

The central bank finally dropped the tightening bias for monetary policy and will probably keep rates on hold until at least the end of 2017, in line with our scenario. But as inflation approaches the target center and the economy remains sluggish, we cannot rule out interest-rate cuts next year.

Ahead of the upcoming 2017 presidential election, as yet no potential candidate has amassed convincing support, reinforcing the perception of popular unease with the political class. The pension-reform discussion will play a key role in the election.

The economy slows further in 2Q16

GDP expanded 1.5% year over year in 2Q16, below the 2.2% recorded in 1Q16. The annual expansion of the seasonally adjusted series (which also corrects for calendar effects) was even lower, at 1.3%. At the margin, the GDP fell from 1Q16 (-1.4% saar).

The weak GDP happened despite an improvement in gross fixed investment and strong public-consumption expansion (7.0% year over year). Total consumption expanded 2.6% (2.9% in 1Q16), even though private consumption grew by 1.7%. Meanwhile, gross fixed investment posted a second consecutive quarter of expansion (+2.7%, after +1.1% in 1Q16), following a 1.5% contraction in 2015.

We expect 1.5% GDP growth this year, down from 2.3% recorded in 2015, with a modest recovery to 2.0% next year. With low copper prices and weak business confidence, a further improvement of investment is unlikely. Moreover, the labor market will probably provide less support for private consumption. The national unemployment rate reached 7.1% in the quarter ending in July, the highest unemployment rate for this period of the year since 2011. Meanwhile, employment growth was sustained by low-quality jobs, evidencing the weakness of the labor market. However, we note that the central bank recently revised GDP growth up to 2.3% (from 2.1%) for 2015 as well as for the first half of 2016, which helps limit downside risks to our growth forecast for this year.

Current-account deficit remains moderate

The current-account deficit remains moderate, in spite of lower copper exports. The trade deficit reached USD 5.1 billion (-2.1% of GDP) in 2Q16 (accumulated in four quarters), slightly above the USD 4.8 billion (-2.0% of GDP) in 2015. Mining exports (due to both lower prices and lower volumes) continue to be a drag on trade balance. Meanwhile, the income deficit inched up, but is still well below the deficits earlier in the decade, as the low copper prices weigh down on the profits of foreign mining companies operating in Chile. Weak growth and a weaker peso, compared with figures seen in the recent past, also acted to narrow the income deficit.

Despite weak growth prospects and low copper prices, foreign direct investment in Chile remains robust. Foreign direct investment was USD 19.7 billion in the rolling four-quarter period (8.4% of GDP), from USD 21.3 billion previously (USD 20.5 billion in 2015). As of the second quarter, net direct investment shrank to 3.0% of GDP, but still fully funds the current-account deficit.

We expect a current-account deficit of 1.7% of GDP this year. Weak internal demand will probably narrow the deficit from current levels. For 2017 we expect a larger deficit, of 2.2% of GDP, consistent with our expectation of a modest economic recovery.

As the Fed resumes rate hikes, we see the peso weakening somewhat, to 685 to the dollar by the end of this year and 695 by the end of 2017. 

Inflation in the target range 

In August, inflation convincingly returned to the central bank’s 2%-4% target range. Consumer prices were flat from July to August as falling energy prices offset the seasonal fruit and vegetable gains. As a result, annual inflation moderated to 3.4%, from 4.0% previously. Core inflation – which excludes food and energy prices – was 3.9% (4.2% previously), the lowest reading since July 2014. Tradable inflation slowed to 2.6% (3.7% in July), as the supply-side shocks from the previous weakening of the exchange rate dissipate, while non-tradable inflation is still high at 4.3%, from 4.5% the previous month. Our diffusion index showed a notable decline, with pressures from the tradable component becoming less widespread, while the non-tradable component was broadly stable.

We expect the negative output gap, a more favorable evolution of the exchange rate (compared with the previous two years) and well-anchored inflation expectations to support year-end inflation of 3.5% (4.4% in 2015). For next year, we expect inflation to stabilize at the 3% target.

A looser monetary-policy stance

The central bank removed the tightening bias from its communication. The minutes of the August monetary-policy meeting show that the board is anticipating faster convergence of inflation than that envisioned in the 2Q16 Inflation Report (IPoM), largely due to the behavior of the exchange rate. In this context, the board of the central bank unanimously voted for the eighth consecutive month to leave the policy rate at 3.50%. The scenario also convinced most board members to drop the tightening bias in the communication, adopting a neutral stance.

Moreover, one board member deemed it necessary to include a rate cut as a valid alternative. This member disagreed with the staff’s recommendation to consider only the option to keep the rate unchanged, as he saw the need for additional monetary stimulus. The other board members were more cautious, with two of them preferring to wait until the publication of the 3Q16 IPoM before dropping the bias. One member believed that a more-detailed explanation of the bias-change could minimize the risk that the market incorporated rate cuts into the baseline scenario, something he believed would be incorrect in the current circumstances.

The 3Q16 IPoM confirmed that its baseline scenario now considers the policy rate to remain at current levels (3.5%) throughout the 2-year policy horizon. The previous baseline scenario had seen some gradual tightening ahead. The central bank lowered the medium-term GDP growth outlook to 3.2% (3.5% as of 3Q15) given lower capital investment expenditure. This is in line with a lower neutral real rate, of around 1.0% - 1.5%, and a nominal neutral rate of 4.0% - 4.5%

We expect the central bank to remain on hold for at least the remainder of this year and the next. With inflation returning to the range around the target, weak growth and well-anchored inflation expectations, rate hikes are unlikely. Actually, in our view, rate cuts in 2017 are more likely than hikes, considering that the real policy rate is not far below its historical average. However, given the long period of above-target inflation, the board is unlikely to consider this option before inflation has stabilized around the 3% target.

Dissatisfaction with the political class is rising

Public opinion surveys provide no respite to President Bachelet and her government. Meanwhile, the opposition is failing to take advantage of the downturn, showing that discontent with the political class is widespread. Survey results from CEP, a local think tank, show the government’s approval rating dropped to 15% from 24% in the previous survey (November 2015). This is the lowest presidential approval rating recorded by CEP since the return to democracy (the Piñera administration had the previous record, with a minimum approval rating of 23%). The disapproval rating rose to 66% (from 58%), higher than Piñera’s 62% record. The survey results were echoed by other higher-frequency polls.

There is no frontrunner with substantial support for the 2017 presidential election. A vast majority of respondents (62%) did not have a preferred candidate, while former President Sebastián Piñera led the rest of the candidate pack with only 14%. Recently, former President Ricardo Lagos confirmed his candidacy for the presidency, but will face a notable challenge, as he currently has single-digit support. The lack of clear frontrunner from either political coalition is unusual with just over a year to go until the election.

Pension reform can play an important role in the outcome of next year’s election. Recent protests have drawn attention to the shortcomings of the private pension system. In response, Michelle Bachelet has pledged to enhance the public role in pensions, aiming at increasing competition and reducing financial fees. However, some protesters have demanded a complete overhaul of the pension model, eliminating the private system. Such a drastic change is not in the government’s plans. Rather, President Bachelet proposed including an additional 5% contribution to be paid by employers, which would go into a solidarity fund used to prop up the lowest pensions.


João Pedro Bumachar
Vittorio Peretti
Miguel Ricaurte


Please see the attached file for all graphs.  


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