Itaú BBA - Scope for extra monetary easing

Scenario Review - Chile

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Scope for extra monetary easing

November 16, 2016

Rate cuts next year would come amid a faster disinflationary process.

Please see the attached file for all graphs. 

• While the election of Donald Trump is negative for EM, Chile is in a favorable position to deal with the shock, as exports of copper (a commodity that is already benefiting from the expectation of fiscal stimulus in the U.S.) account for 12% of GDP and the balance-of-payment position is solid (external public sector assets, reserves plus sovereign funds, are around 30% of GDP and the current account deficit – 1.7% of GDP expected for this year - is low).

• For activity, higher copper prices will be offset by a still-low confidence level and higher interest rates abroad. We still expect 1.5% GDP growth this year, slowing from 2.3% in 2015. A mild recovery to 2.0% next year is still envisaged.

• The Chilean peso has performed better than expected, because of higher copper prices. Although we continue to expect depreciation from the current levels (due to a narrower interest rate differential with the U.S.), we now see the exchange rate at 675 pesos to the dollar by the end of this year and at 685 by the end of 2017.

• A better performing currency has sped up the disinflationary process. We now expect inflation to end the year at 3.0% from 4.4% in 2015 (3.3% previously), also supported by the negative output gap and well-anchored inflation expectations. For 2017, we expect inflation to end the year at 2.8% (3% previously).

• With a faster-than-expected disinflation process and weak activity, we now expect additional rate cuts. We see the central bank taking the policy rate to 2.5% (3% previously) next year from the current 3.5%.

• The results of the municipal election favored the right-leaning opposition, likely giving former President Piñera more confidence ahead of next year’s presidential election.

Activity bottoming out

Activity remained sluggish in 3Q16. The GDP proxy, Imacec, expanded 1.4% year over year in September (2.5% in August), bringing growth to 1.4% in 3Q16, broadly stable from the 1.5% in 2Q16.

But private consumption is showing some recovery. In 3Q16, retail sales posted 4.0% growth, up from 3.1% in 2Q16, while supermarket sales grew 2.7% year over year (1.2% in 2Q16). The quarter was marked by numerous price reductions and promotions related to stock turnover. Durable goods sales were up 6.3% from one year ago, and were broadly stable the previous quarter, while non-durable goods sales growth increased to 3.0% (1.6% in 2Q16).

Labor market weakness suggests frail support for private consumption ahead. The unemployment rate reached 6.8% in 3Q16 (6.4% one year before). This is the highest unemployment rate for a third quarter since 2011. Job growth is at the lowest rate since the quarter ending in April last year. Total job growth was 1.0% (1.1% in 2Q16). Also, waged employment declined 0.1% in 3Q16 from one year ago (+0.4% in 2Q16), the first contraction recorded since the financial crisis, while self-employment expanded 4.2% year over year (6.0% in 2Q16), indicating that the quality of job creation remains poor.

The improvement in industrial production numbers may be temporary. The industrial production index - which aggregates manufacturing, utilities and mining - grew a modest 0.2% in 3Q16, after declining 3.0% year over year in 2Q16, led by the pickup in mining. However, the comparison base for mining production will be higher in 4Q16, as in the last quarter of 2015 some sizable maintenance programs came to an end.

We expect GDP growth of 1.5% for the year (2.3% in 2015), but recent surprises put an upward bias to our call. For 2017, we expect a modest recovery to 2.0%. While higher copper prices are positive for Chile’s small and open economy, higher U.S. treasury yields and still-low confidence levels at home reduce the odds of a more meaningful activity improvement.

Another (dis)inflation surprise

Inflation moved to the lower half of the central bank’s 2%-4% range around the target, following a downside surprise in October. Consumer prices increased 0.2% from September to October (0.4% twelve months ago), below expectations. So, annual inflation moderated to 2.8%, from 3.1% in the previous month, the lowest inflation recorded since January 2014. The faster than expected disinflation underway is primarily due to the tradable component, linked to the more favorable evolution of the Chilean peso. Tradable inflation moderated to 1.9% (2.3% in August).

Core inflation measures range between 2.7% and 3.2%. In particular, the index that excludes food and energy prices moderated to 3.2% from 3.4% in September, and is the lowest since March 2014. The lower core inflation is derived mainly from the “goods component” (down to 1.6% from 2.3% previously), as core service inflation is still stable at 4.1% (the same as non-tradable inflation), just above the range around the target.

The consecutive downside surprises have led us to lower our yearend inflation forecast to 3.0% (from 3.3%). For next year, amid subdued inflationary pressures, we now see inflation at 2.8% by yearend, from 3% previously.

Ushering in a new leadership

As unanimously expected by the market, the central bank left its monetary policy rate unchanged at 3.5% at the October meeting. The press release retained a neutral tone (for the third consecutive month), hinting that the central bank will probably wait until the December inflation report (IPoM) before changing the policy stance.

Inflation was the most significant development in the month. Following the September data release, Governor Vergara acknowledged that inflation is returning to the target faster than forecasted in the September IPoM, which would likely lead to a revision of the outlook for consumer prices in December. The press release announcing the latest policy decision highlighted surveys that show inflation expectations near the 3% target in the forecast horizon. We note these same surveys, as well as asset prices, now see monetary loosening (in the form of two 25 basis points rate cuts) in 2017. The central bank sees activity in line with the September IPoM and the labor market recording a gradual adjustment.

Following the meeting, President Michelle Bachelet announced that Mario Marcel will replace Rodrigo Vergara as the head of the central bank starting in December. Mr. Marcel, a board member since October 2015, when Enrique Mashall retired, was Director of the Budget Office (2000-2006) and has been a consultant on fiscal and regional governance matters prior to joining the central bank, having worked at the OECD and the IADB. Rodrigo Vergara joined the board for a 10-year period in December 2009 and was appointed president for a five-year stint that began in December 2011. So, Mr Vergara still has 3 years (out of a 10-year term) as board member. While he could choose to remain on the board, a resignation after his term as president ends would not come as a surprise.

We do not expect a drastic change in monetary policy. The remaining three board members remain unchanged and, if Rodrigo Vergara chooses to resign, the existing agreement between the two main political coalitions means that his potential replacement would come from a similar policy leaning. So the balance of forces will not change overnight. (See table below)

Given the revised inflation outlook, we now expect additional rate cuts next year. We expect the central bank to stay on hold for the remainder of the year as it waits to set up the scenario for an easing cycle in its 4Q16 Inflation Report (if financial conditions for emerging markets do not deteriorate much further). We expect four 25-bps rate cuts starting in 1Q17, taking the policy rate to 2.5% (3.0% previously).

A currency favored by copper

In spite of weak mining exports, the trade surplus has been resilient. The 12-month rolling trade surplus sits at USD 3.9 billion as of October, inching up from USD 3.5 billion in 2015, as the shrinking non-mining deficit balance offsets a declining mining surplus. According to our seasonally-adjusted series, at the margin, the trade balance reached USD 3.6 billion (annualized) in the quarter, broadly stable from the USD 3.6 billion in 2Q16. So, the sluggish economy, low oil prices and the weaker currency are compensating the feeble mining exports.

A broadly stable trade balance surplus alongside a smaller income-balance deficit (due to diminishing profits for foreign mining companies operating in Chile), will lead to a narrowing of the current-account deficit. We expect a current-account deficit of 1.7% of GDP this year, narrowing from the 2.0% deficit in 2015. Due to higher copper prices next year (relatively to our previous forecast), we now see a current account balance deficit of 1.9% of GDP in 2017 (smaller than our previous estimate of 2.2%).

The Chilean peso has been resilient, despite recent EM volatility amid a sharp recovery in copper prices. Therefore, we now expect the currency to end this year at 675 to the dollar (685 previously) and at 685 by the end of 2017 (695 previously). We still see a weakening from current levels, with higher interest rates in the U.S. and lower interest rates in Chile.

Governing coalition hit at the polls

The municipal election showed gains for the center-right opposition, but the low turnout was perhaps the most striking outcome. The Chile Vamos opposition beat the ruling Nueva Mayoría coalition, wining 38.35% of the vote versus the government’s 37.05%. The ruling coalition lost a substantial share of representation, losing 26 mayors compared to 2012. Discontent with the political class was demonstrated with a record low 35% turnout (43% in the 2012 municipal elections). Corruption scandals in the central government as well as voter registration complications likely affected vote enthusiasm.

The results will give former President Piñera confidence ahead of next year’s presidential election. However, the still tight nature of the municipal results and the low turnout limit the predictability heading into November 2017. Piñera, still undeclared as a candidate, will potentially come up against former President Ricardo Lagos. However, Lagos faces an uphill battle from within the center-left coalition, lagging outsider Alejandro Guillier in some polls and facing conflicts with the Cristian Democrats. In the end, an election between Piñera and Lagos will likely be seen as market friendly and may help improve confidence levels.


João Pedro Bumachar
Vittorio Peretti
Miguel Ricaurte


Please see the attached file for all graphs. 


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