Itaú BBA - Sluggish growth persists

Scenario Review - Chile

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Sluggish growth persists

September 4, 2017

With weak activity and low inflation, the upcoming Inflation Report would point to more easing.

Please see the attached file for all graphs.

• Activity in the first half of the year confirmed that the Chilean economy is still slumbering. Investment remains a drag on activity as confidence levels stay low. We now expect growth of 1.3% this year (1.6% previously), with a pick-up to 2.5% next year, aided by higher copper prices, expansionary monetary policy and low inflation.

• Amid weak copper production, the current-account deficit increased in 2Q17, and we now forecast a 1.4% of GDP deficit for this year (1.2% previously). Meanwhile, plummeting foreign direct investment makes financing the current-account deficit more challenging.

• The central bank has been careful not to commit to further easing. However, with activity remaining weak and inflation staying at low levels, we expect the upcoming Inflation Report to point to more easing ahead. We expect the policy rate at 2% by year-end, from the current level of 2.5%.

Weak first half of the year

Activity improved in the second quarter of the year, yet the Chilean economy remains weak. Activity expanded 0.9% from one year ago, up from 0.1% in 1Q17, when activity was negatively affected by wildfires and an extended mining strike. Growth in 2Q17 was higher (at 1.3%) after correcting for the unfavorable calendar effect in the quarter, but is still sluggish. Overall, the economy expanded 0.5% year over year in 1H17, below the 2.1% pace for the corresponding period of 2016.

Domestic demand picked up from the previous quarter, but was weak when changes in inventories are excluded. Internal demand in 2Q17 was lifted by the 9.7% increase in durable consumption (mainly explained by robust new-car sales). A recent central bank business-perception report notes the pick-up in car sales likely comes from the need for replacement after several years of postponing that decision, so a slowdown in consumption of durable goods is likely. With other categories of private consumption still weak, total private consumption grew 2.6% (1.8% in 1Q17). On the other hand, public consumption weakened to 2.7%, from 4.9% in 1Q17, consistent with the fiscal consolidation. Meanwhile, the disappointing investment performance continued, with a fourth consecutive quarter of contraction (-4.1%, after shrinking 2.4% in 1Q17). As mining production is recovering more gradually than expected from the first-quarter strike at Escondida mine, net exports dragged growth down by 2.9 percentage points in 2Q17.

Activity improved sequentially, but this is mostly due to the end of the mining strike. While GDP expanded by 3.0% qoq/saar following a 0.5% expansion in the previous quarter, excluding the mining sector, the economy grew a mild 1.1% qoq/saar (3.8% in 1Q17).

Chile’s labor market continues to gradually loosen. In the second quarter of the year, the unemployment rate reached 7.0%, inching up by 0.1 percentage point in 12 months. Public and non-salaried employment continue to prop up job growth. Even so, once hours worked are considered, employment is contracting.

A modest recovery in the second half of the year is still likely. Activity will be favored by firming growth in Chile’s trade partners, higher copper prices and stronger copper production, the monetary stimulus applied by the central bank, and low inflation. However, uncertainties linked to the fate of reforms after the presidential elections will continue to weigh negatively on confidence and investment, curbing an activity improvement. We now expect GDP growth of 1.3% for 2017 (1.6% in our previous scenario, which is also the rate recorded in 2016), with a recovery to 2.5% next year.

Weak mining production deteriorates external accounts

The current-account deficit widened in 2Q17, as mining export volumes remain weak. The deficit came in at USD 1.5 billion in the second quarter, with a weaker trade balance of goods and services, as well as a larger income-balance deficit, leading the deterioration from 2Q16 (USD 1.0 billion deficit). The rolling-four-quarter current-account deficit rose to USD 5.6 billion (2.2% of GDP), from USD 3.6 billion in 2016 (1.4% of GDP). Our own seasonal adjustment shows the current-account deficit moderated at the margin, but to a still-wide level of 3.0% of GDP (from 3.4% in 1Q17).

Foreign direct investment in Chile is moderating, and net direct investment failed to fully fund the current-account deficit. Foreign direct investment recorded an outflow of USD 0.3 billion, the worst quarterly direct investment in Chile on record (USD 2.7 billion inflow in 2Q16). On the other hand, 2Q17 foreign portfolio investment in Chile picked up to USD 3.8 billion (USD 0.5 billion one year ago), consistent with the benign external financial conditions for emerging markets. Over the last four quarters, foreign direct investment in Chile fell to USD 7.9 billion, from USD 12.2 billion in 2016 (USD 20.5 billion in 2015). Hence, net direct investment declined to USD 0.4 billion (USD 5.1 billion in 2016).

We expect the current-account deficit to narrow in the remainder of the year as internal demand stays weak, the effects of mining strike continue to fade and copper prices remain high. However, given the 2Q17 surprise, we now see a current-account deficit of 1.4% of GDP (1.2% previously), in line with that recorded in 2016. A stable deficit in 2018 will likely materialize. As for foreign direct investment, an activity recovery and the recovery in copper prices mean the low flows seen recently are likely temporary.

The Chilean peso has performed strongly in recent months, appreciating 3.8% in August and reaching the strongest level since July 2015. The sharp rise in copper to above USD 3 per pound, a 22% year-to-date rise, is a key driver of this appreciation. Our expectation of a slowing Chinese economy in 2H17 and the monetary normalization in the U.S. will likely lead to lower copper prices and a weaker peso. Additional easing by the Chilean central bank would reinforce this movement. Therefore, we still see the Chilean peso ending the year at 675 per dollar, with further weakening to 685 by the close of 2018.

Inflation stays low

Tradable inflation continues to keep consumer prices at low levels. Non-tradable inflation picked up, but to still-comfortable levels. Inflation was stable at 1.7% year over year in July, lower than the central bank’s 2%-4% target range and at levels previously seen only in 2013. The favorable evolution of the exchange rate continues to reduce tradable inflation, which is now nearing a null annual variation. Meanwhile, following the sharp drop in June, non-tradable inflation rose back to the average level recorded in 1H17 (3.4%). Once food and energy prices are excluded, inflation came in at 2.0% (from 1.8% previously), while other core inflation measures were stable at 2.0%. Excluding food and energy, service inflation rose to 3.4% (from 3.1%). Our diffusion index, unchanged from June, continues to show that price pressure is limited. There were also stable contributions to the diffusion index from tradable and non-tradable products.

Low growth, inertia and the favorable performance of the Chilean peso combined with well-anchored inflation expectations will likely contain inflationary pressures. We expect inflation to remain low for the remainder of the year (2.4% year-end) and to remain below the target in 2018 (2.8% year-end).

Caution ahead of Inflation Report

At its August monetary policy meeting, the board of the central bank favored keeping the policy rate at 2.5%, and retained a neutral bias. The board was divided once more regarding the need for additional easing. Pablo García continued to opt for a rate cut as he sees enough evidence of low inflation to warrant some additional easing. Meanwhile, two of the five board members are comfortable with keeping the policy rate stable, as they do not see data pointing at a meaningful change to the 2Q17 baseline scenario. Two other board members acknowledge that a more thorough evaluation of how the risk scenario has evolved since the last Inflation Report (IPoM) will be key to understanding whether further cuts should be implemented to ensure inflation’s convergence to the target.

The central bank’s revision of the baseline scenario on September 6, combined with its evaluation of risk scenarios entailing a weaker activity recovery and lower inflation, will be the driving factors as to whether additional easing will be implemented ahead. The central bank has indicated that headline inflation has evolved below the baseline scenario of the second-quarter IPoM. Meanwhile, inflation expectations have not shown significant shifts. Regarding activity, a downward revision in the forecast scenario has been signaled.

We continue to expect further rate cuts to materialize before year-end. The minutes of the July and August meeting show that several members are not opposed to the idea of more easing. We see the policy rate being lowered to 2.0% by year-end (through two 25-bp rate cuts), where it would stay for most of next year. However, considering the division within the board regarding the need for further easing, we acknowledge the risk that the board keeps the path for the policy rate unchanged.

One last push for the reform agenda

Public opinion surveys show solid first-round support for former-president Sebastian Piñera in the lead-up to the November 19 presidential election. The Cadem survey (July 28 to August 18 weekly average) puts support for Piñera at 42%, once adjusted for likely participation. Meanwhile, Alejandro Guillier (whose candidacy is supported by the majority of parties in the ruling coalition) stays in second spot with a broadly stable 21%, and Beatriz Sanchez from Frente Amplio has dipped slightly to 19%. The first-round momentum is clearly with the former president (with the last weekly Cadem survey putting Piñera at 43% and the August CEP survey showing a lead of around 20 points); however, securing the election in the first-round vote is not the base case. The likely runoff vote will be held on December 17, and the existing simulations still point at uncertainty over the outcome of the presidential race is still high. Clarity on the political agenda after the presidential elections is key for a meaningful and sustained rebound of confidence and investment in Chile.

As President Bachelet’s second term in office draws to a close, the urge to pass reforms has intensified. The administration has managed to pass a landmark abortion bill, after receiving the green light from the Constitutional Court following an appeal by conservative lawmakers. Moreover, the highlight came when President Bachelet sent a bill to Congress that aims to increase Chilean pensions by raising contributions and creating a new collective savings system. The reform will see employers contributing 5% of employees’ gross salaries on top of the current 10% contribution to individual accounts managed by private pension-fund administrators. Of the total, 3 percentage points will be directed to individual savings accounts, while the remaining 2 percentage points would go to a collective savings system. A separate, complementary, bill has been submitted to create an independent “collective savings council” to manage the new savings. The government would like Congress to approve the bill before the presidential and congressional elections in November.

A lively discussion has risen following the presentation of the bill, considering the potential impact it could have on employment. A productivity report from the Ministries of Finance and Labor estimated that if contributions were increased by the full 5 pp immediately, formal employment might fall between 2,200 and 394,000 (that is, a maximum effect of 7% of salaried employment). The government has stressed that a gradual implementation of the reform bill would mitigate this impact. The leading presidential candidates have entered the discussion with a variety of proposals, ranging from a 4pp increase in the contribution to individual accounts (Piñera) to a pay-as-you-go system (Sánchez).

Regardless of nearing its end, the Bachelet administration is not short of its own internal challenges. Key members of the economic team in President Bachelet’s cabinet - the Minister and Vice-Minister of Finance and the Minister of Economy - resigned from their posts. The move follows discrepancies in opinion over the rejection of an iron and copper mining project in the center-north region of Coquimbo on environmental concerns. Mr. Valdés will be replaced by Nicolás Eyzaguirre, until now the Minister Secretary of the Presidency. Meanwhile, Jorge Rodriguez Grossi, until now President of state-owned Banco Estado, will replace Felipe Céspedes at the Ministry of Economy. Finally, Mr. Eyzaguirre will be replaced by Gabriel De la Fuente as Minister Secretary of the Presidency, until now the undersecretary of the same Ministry.

Beyond reputational damage, we expect no material change in terms of policy. We see Mr. Eyzaguirre maintaining a responsible management of public finances. Yet, we note that fluid relationship between Mr. Eyzaguirre and the President could smoothen the discussion of key economic bills such as the upcoming budget, the pension reform bill and the educational reform.

Credit ratings deteriorate

Following S&P’s sovereign-rating downgrade (from ‘AA-’ to ‘A+’ with a Stable outlook), Fitch also lowered Chile’s long-term foreign-currency rating to ‘A’ from ‘A+’, with a Stable outlook. Meanwhile, Moody’s changed its outlook from Stable to Negative but retained the ‘Aa+’ rating. The moves are not unexpected as Chile’s fiscal standing deteriorates. The market has for some time priced Chile alongside countries with single ‘A’ ratings (as shown by Chile’s five-year CDS spread of around 60), in line with the S&P and Fitch ratings. Moody’s holds the highest sovereign-debt rating for Chile, and is one and two notches above S&P and Fitch’s respective ratings.

Low growth and the rapid increase in government debt are key drivers in the rating amendment. The lengthy period of economic weakness and lower copper prices has contributed to a sustained deterioration in the sovereign balance sheet. Meanwhile, government debt to GDP has risen considerably from the low levels of a decade ago. In reaffirming the sovereign rating for Chile, Moody's still sees the country preserving important strengths (governability and good policy framework) that put Chile in line with other ‘Aa’ peers and well above the region.

With public debt likely to keep rising, we cannot rule out that Moody’s lowers Chile’s rating to single ‘A’ sometime before the end of next year.


 

João Pedro Bumachar

Vittorio Peretti

Miguel Ricaurte


 

Please see the attached file for all graphs.



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