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Scenario Review - Chile

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Political Noise

May 8, 2015

President Michelle Bachelet announced that the government will start a constitutional reform process in September.

• President Michelle Bachelet announced that the government will start a constitutional reform process in September. She also made a surprise announcement of a significant cabinet reshuffle. Details on the constitutional change proposal remain vague, and the debate process has the potential to continue to suppress business confidence as uncertainty increases.

• The IMACEC (monthly proxy for GDP) grew by 3.7% (annualized) from 4Q14 to 1Q15, after the 3.3% growth recorded in 4Q14. While these growth rates suggest a recovery, an unfavorable carry-over for the second quarter and the recent string of natural disasters that have affected some regions of the country point to a weakening in 2Q15. We continue to expect the economy to expand by 2.8% this year and by 3.5% in 2016, up from 1.9% in 2014. 

• Inflation once again surprised to the upside in April. While the year-over-year measure continues to decline, it remains above the upper-bound of the target range. Inflation excluding food and energy and non-tradable inflation are displaying a similar pattern on an annual basis. We continue to expect inflation to end this year at 3.3%, but there are upside risks to this forecast.     

• The Central Bank of Chile unanimously held its reference interest rate at 3.0% in April. The minutes of the board meeting show that members see no room for additional easing, but are also unwilling to hike soon. Taking into account both the below-trend growth and the expected inflation’s convergence to the target, we believe that the central bank will hold the interest rate at 3.0% for the remainder of this year and in 2016. However, considering the upside inflation surprises, a tightening cycle starting this year cannot be ruled out.    

• The Chilean peso has appreciated in April, supported by a weak U.S. dollar globally and higher copper prices. However, we expect that the pressure for currency depreciation will return once it becomes clear that the Fed will start to hike rates in September. Our year-end exchange-rate forecasts stand at 645 pesos to the dollar for 2015 and 665 pesos to the dollar for 2016.

Mining Lifts Growth in 1Q15

Chile’s monthly GDP proxy (IMACEC) fell by 0.3% from February to March, after a 0.6% contraction the month before. Hence, although the growth rate for 1Q15 (3.7% qoq/saar) was the highest quarterly rate since 1Q14, the carry-over for 2Q15 is unfavorable. Growth during 1Q15 was led by a 17% qoq/saar gain in mining production. Other sectors – those more susceptible to demand than to supply factors – performed poorly: manufacturing production contracted by 5.8% qoq/saar, while retail sales grew by a modest 0.2%. From February to March, the three abovementioned indicators all contracted significantly (mining: -6.4%; manufacturing: -3.6%; retail: -1.3%).

Business confidence showed no improvement in April, coming in at 48.5 (vs. 48.6 in March). While the index is above last year’s average level of 45.2, it remains in pessimistic territory. The sector composition shows that business confidence in the mining and manufacturing sectors remained roughly stable (at 66.5 and 44.8, respectively), while the construction sector saw some improvement in confidence, reaching 37.7 (up from 35.5 last month). Meanwhile, confidence within the Commerce sector fell back into pessimistic territory, coming in at 48.3, down from 50.4 in March.

In spite of weak growth, the unemployment rate remains low. Chile’s unemployment rate stood at 6.1% at the end of 1Q15 (vs. 6.5% at the same time of last year). However, the breakdown of employment growth shows that labor market conditions are being affected by the economic slowdown. Employment in the private sector rose by only 0.4% year over year in 1Q15 (from 1.2% in 4Q14). Also, growth in employment under verbal contracts only (which tends to be less desirable than employment under written contracts) grew by 5.3% (up from 3.1% growth 4Q14), contributing 42% of the employment growth in the private sector during that period.

A recent string of natural disasters in Chile, which has included floods and volcanic eruptions, will add to the unfavorable carry-over, ensuring weak economic growth in 2Q15. Still, we continue to expect an expansion of 2.8% for this year. For 2016, we expect a further recovery, to 3.5% growth. In our view, the fiscal stimulus, along with the monetary stimulus already in place, will drive this modest recovery. Downside risks to these growth estimates include the persistently low business confidence and the effects of the recent natural disasters lasting longer than we currently expect.

Inflation once again surprises to the upside

Chile’s consumer price index came in at 0.6% month-over-month in April, above market expectations (0.3%). On an annual basis, inflation came down slightly to 4.1% (from 4.2% in March and a peak of 5.7% in October 2014), remaining above the upper-bound of the target. Energy prices continue to increase at the margin, due to the recovery of oil prices, so they are contracting by less on a year-over-year basis. Excluding both food and energy, inflation fell to 4.3% year-over-year (from 4.6% in March). Non-tradable inflation came down to 4.7% (from 5.1%). In all, inflation and its key underlying measures are falling, but far more slowly than would have been anticipated by the economic slowdown.   

Wage inflation also remains high. Nominal wages gained 0.8% from February to March (vs. a 0.2% gain the previous month), resulting in wage growth of 7.1% over the 12 months through March (the same rate recorded in the first two months of this year). Indexation mechanisms coupled with a still-low unemployment rate are keeping wage inflation at an uncomfortably high level. In real terms, wages grew by 2.8% year over year. Thus, the real wage bill increased by 5.5% year over year in March, above the 4.5% growth registered in February and the fastest growth rate since October 2013.

We still expect inflation to reach 3.3% by the end of 2015 and 3.0% in 2016, but we see upside risks to these forecasts. Below-potential growth and lower exchange-rate depreciation will likely bring inflation down from the year-end 2014 level of 4.6%.

No hikes in the short term

The Central Bank of Chile unanimously held its policy rate at 3.0% at its April meeting – the sixth consecutive meeting at which the board has left rate changes on hold. The minutes from the meeting revealed that the board considered holding the policy rate the only relevant policy option. In fact, board members saw no room for further rate reductions, while rate hikes have been ruled out in the near term. This is consistent with the tightening bias expressed since the publication of the most recent Inflation Report: a gradual “normalization” of monetary policy starting around the end of this year or the beginning of 2016.

The board welcomed the lower-than-expected March inflation data. Still, some of the board members noted that volatile prices were mostly behind the surprise. In addition, these board members said that the evolution of core inflation, while in line with expectations, continues to raise doubts over the size of the pass-through and the amount of slack in the economy.

Activity – until the time of the meeting - is viewed to have evolved as anticipated. In one board member’s opinion, preliminary data indicated negative growth for investment in the first half of the year, with demand ultimately remaining weak. Another member noted that the baseline scenario assumed an improvement in confidence levels, yet confidence remains in pessimistic territory.

Taking into account both the below-trend growth and the expectation of inflation’s convergence to the target, we believe that the central bank will hold the interest rate at 3.0% for the remainder of this year and in 2016. However, we acknowledge that if inflation continues to be more sticky than the central bank and the market expects, interest rate hikes are likely and could materialize sooner than the timing communicated by the board.

Stronger peso as copper prices pick up

The trade surplus widened further. A USD 1.15 billion trade surplus was recorded in April, following the USD 1.0 billion surplus posted the previous month. As a result, the 12‑month rolling trade balance came in at a strong USD 9.1 billion, above the USD 7.8 billion posted for 2014. The significant trade surplus was supported by weak internal demand and low global oil prices, with total imports (FOB) declining by 17.1% year over year. Intermediate goods imports, led by energy goods, declined by 22.8%. Also, consumer goods import growth fell back into negative territory, while capital goods imports moderated their contraction. The slowdown in imports was partly offset by weaker export performance, with total exports declining by 10.2% year over year in April.

However, some deterioration of the trade balance is expected. While the latest trade data confirmed that the external accounts are still healthy, we expect that the lower copper prices, the recovery of oil prices and of domestic demand will result in a widening of the current account deficit to 1.9% of GDP in 2015 (from 1.2% in 2014).

The Chilean peso appreciated in April, supported by a weaker U.S. dollar globally and higher copper prices. The debate among the central bank board members over the timing of an interest rate hike could also be supporting the currency. However, we expect that the pressure for currency weakening will return once it becomes clear that the Fed will start to raise rates in September. Our year-end exchange-rate forecasts stand at 645 pesos to the dollar for 2015 and 665 pesos to the dollar for 2016.

Political uncertainty grows

President Michelle Bachelet announced that in September the government will start a constitutional reform process, one of her key campaign promises. While formal details have yet to be revealed, President Bachelet indicated that she will seek to foster an inclusive process. The current constitution was enacted under the military government and has only been subject to partial reforms over the last 30 years. We expect that uncertainty over the form and scope of the constitutional reform and its impact on the economy will continue to affect confidence ahead.

In a surprising move, President Bachelet also announced that she had asked for the resignation of all her ministers, and that she will finalize changes to her cabinet shortly. A cabinet renewal had been on the table for some months, given the weak economy, a contentious reform agenda and, most recently, corruption scandals. The government and the president’s popularity are now at historically low levels – close to 30%, according to various surveys. We do not expect President Bachelet to change her policy direction, meaning that she will likely continue to push forward with her education reform (free university education is the next step) and labor reform initiatives.

The president also announced anticorruption measures following several scandals that have shaken the political landscape and affected the president’s approval ratings. President Bachelet called the measures “severe” but necessary to eliminate the influence of financing on political parties and campaigns. One measure seeks to ensure that political financing is completely transparent by setting up a state fund to finance political parties and closely regulate campaign spending. Under the new framework, companies would be prohibited from making financial contributions to politicians, while anonymous political campaign donations would also be ruled out.


 

João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti



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