Itaú BBA - One Final Cut to Come

Scenario Review - Chile

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One Final Cut to Come

September 30, 2014

We expect a modest 0.5% year-over-year increase in August’s IMACEC (monthly proxy for GDP).

• Activity indicators for August remained weak and we expect a 0.5% year-over-year increase in the IMACEC (monthly proxy for GDP) for that month. We expect GDP growth of only 1.9% in 2014. In 2015, we maintain the view of a growth rebound to 3.5% as the global economy recovers and monetary stimulus bears dividends.

• In spite of weak growth, inflation remains high. We foresee year-end inflation rates of 4.2% this year and 2.9% next year. 

• Chile’s central bank decided to continue its easing cycle by lowering the interest rate by 25 bps, to 3.25%, in September, while also keeping an easing bias. However, the minutes of the meeting hint that the end of the cycle is very near. We expect the central bank to reduce the policy rate by 25 bps in October, ending the easing cycle. 

• The peso depreciated recently and we expect further weakening. We see the Chilean peso reaching 615 to the dollar by year-end of 2014 and 635 to the dollar by the end of 2015. The expected increase in the U.S. Treasury yields will drive the additional depreciation. 

• External accounts continue to improve as the exchange rate depreciates and internal demand softens. We expect a trade surplus of USD 6.2 billion for 2014 with a current-account deficit of 1.9% of GDP.

• President Michelle Bachelet signed the tax reform into law, which will likely help to reduce uncertainty in the economy. However, the government still faces a number of challenges as it seeks to advance legislation for the education and labor reforms. 

Activity Set to Grind to a Halt in 3Q14

We expect a modest 0.5% year-over-year increase in August’s IMACEC (monthly proxy for GDP). Activity indicators for August suggest that 3Q14 may be even weaker than 2Q14 on a year-over-year basis. Manufacturing production declined by 4.9% year over year (-4.1% in July), with a month-over-month gain of only 0.1% (-5.5% qoq/saar). Subsequently, the Industrial Production Index, which aggregates Mining, Manufacturing and Utilities, contracted by 1.8% year over year (-2.6% last month). The consumption side is showing slightly more positive signs. Retail sales increased by 1.7% year over year (up from the 1.5% recorded in the previous month) after gaining 0.5% from July. However, this resulted in only a small 0.3% qoq/saar expansion.

Consistent with the weaker economy, the labor market is softening further. The unemployment rate stood at 6.7% for the quarter ending in August, compared with 5.7% during the same period last year. The labor force increased by 1.7% year over year, while employment slowed to 0.7% (1.0% in the previous month). Growth in self-employment, which has previously been strong, slowed to 0.7% year over year (3.0% in the previous month), while growth of waged employment increased by only 0.6%, still a weak number, though faster than the 0.4% recorded last month.

Confidence indicators turned even more pessimistic in August. Consumer confidence has declined by 24% since the end of 2013, while the extremely weak confidence levels in the construction industry have pulled business confidence down by 19% over the same period.

We continue to expect 1.9% GDP growth for this year. However, as confidence deteriorates further and activity shows no signs of rebounding, the risk for this forecast is tilted to the downside. For 2015, we expect growth to recover to 3.5%. We expect that higher global growth and the effects of expansionary macro policies will lift the economy ahead.

Annual Inflation Unrelenting for Now

Chile’s consumer price index surprised in August by gaining 0.3% month over month. Annual inflation came in at 4.5% year over year (the same rate recorded in the previous month). Excluding food and energy - the core measure closely tracked by the central bank – inflation reached the 4.0% upper bound of the target range (3.7% in July). Tradable inflation moderated to 4.0% from 4.2%, while non-tradable inflation remains particularly high at 5.2%, increasing from 4.9%. Overall, August’s inflation numbers show that the activity-inflation trade-off in Chile is deteriorating.

Wage inflation edged higher, to 7.3% year over year in July (vs. 6.6% in June). While the increase was influenced by the raise in the minimum wage (which in 2013 affected wage inflation in August instead of July), wage gains continue to be uncomfortably high.

Our inflation forecast for this year remains at 4.2%, while for 2015, our 2.9% forecast is also unchanged. In our view, the sharper-than-expected weakening of the currency will probably be offset by the wider output gap.

Board Opts for Flexibility as Easing Cycle Draws to a Close

As expected, the Chilean central bank cut the policy rate by 25 bps to 3.25% in September. In the press statement announcing the decision, the board kept an easing bias, but expressed it with different wording. The board now says that it “will evaluate the possibility of introducing a further monetary stimulus according to the evolution of the internal and external macroeconomic conditions and its implications on the inflation outlook.” So the board is no longer talking about the possibility of “additional rate cuts” (plural), hinting that the easing cycle is about to end.

Consistent with the message of the statement, the minutes of the meeting revealed that board members agreed on signaling that the end of the easing cycle is near. The board also considered a 50-bp rate cut as a “relevant” option. However, board members did not sound enthusiastic about increasing the pace of rate cuts. The minutes explained that the option of a 50-bp rate cut, if implemented, would also need to be accompanied by a change in the bias from “easing” to “neutral.” This would be necessary because the economic scenario had not changed significantly from that in the September monetary policy report, which had incorporated a policy path ending at 3.0% (or at most 2.75%). But the board felt that reducing the policy rate more than expected while removing the easing bias could confuse markets. In addition, board members did not sound comfortable with giving a strong signal that the easing cycle is over, when, as yet, there are no clear signs of an economic rebound.

We expect one further 25-bp rate cut to 3.0% in October, with the rate remaining at 3.0% throughout 2015. However, the tone of the minutes (in particular, the unwillingness to move the bias to “neutral” now and the view that high inflation is transitory) suggests to us that the board would resume the easing cycle if the recovery expected (by the market and by the central bank) fails to materialize.

Improving External Accounts in an Environment of a Weakening Peso

As the central bank hinted that the easing cycle is about to end, the peso depreciated less than the other floating currencies of the region in September. Still, we continue to expect an additional weakening of the peso against the dollar, as the U.S. Treasury yields rise. We see the peso trading at 615 to the dollar by the end of this year and at 635 by the end of the next.

Weak internal demand and the weaker peso continue to aid the improvement in external accounts. A USD 356 million trade surplus was recorded in August, taking the 12-month rolling trade balance to USD 6.7 billion (USD 6.0 billion in the previous month, USD 2.1 billion in 2013). Imports declined by 14.9% year over year (-8.8% for the quarter ending in August), while exports fell by 5.2% year over year (-1.8% in three months) as mining exports worsened, while industrial exports continue to provide support for overall exports. We continue to expect a current account deficit of 1.9% of GDP (3.4% in 2013). In 2015, we expect to see a further improvement of the deficit, to 1.7% of GDP.

First Key Reform Completed

President Michelle Bachelet signed the tax reform, which is the base for all other reforms promised in her re-election campaign, into law. The tax reform aims to increase government revenue by three percentage points of GDP by 2018. The resources will be used mostly to fund a major education reform, in a bid to reduce inequality in the country.


João Pedro Bumachar
Vittorio Peretti

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