Itaú BBA - The Easing Cycle Will Likely Continue

Scenario Review - Chile

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The Easing Cycle Will Likely Continue

May 7, 2014

The Chilean economy grew at a below-potential rate in 1Q14.

•           Chile’s economy grew at a below-potential rate in 1Q14. Several indicators suggest that private consumption is worsening, while there has been a slight improvement in net exports. We expect a 3.3% expansion this year and a rebound to 4.0% growth in 2015.

•           As the government has made clear that the tax reform will increase taxes on non-alcoholic drinks and tobacco this year (and not in 2015, as we had previously assumed), we have subsequently adjusted our CPI estimate to 3.3% (from 2.8%) for 2014, while reducing our 2015 estimate to 2.8% (from 3.0%).

•           The central bank left the interest rate unchanged at 4.0% in April, but maintained an easing bias in the press release announcing the decision. We expect the central bank to resume the easing cycle in May, but we also acknowledge the risk that the central bank might take more time to restart the cycle.

•           Lower interest rates in Chile and higher U.S. Treasury yields will likely lead to a further depreciation of the peso. We see the currency at 575 pesos to the dollar at both the end of this year and the end of next.

Activity remains weak, while growth composition is changing

The Chilean economy grew at a below-potential rate in 1Q14. On a seasonally adjusted basis, the IMACEC (a monthly proxy for GDP) contracted by 0.2% compared with February, after a 0.2% increase in the previous month. Consequently, the economy grew by 2.5% qoq/saar in 1Q14, after declining by 0.5% in 4Q13.

The most recent economic data suggest that the growth composition is changing. During 1Q14, retail sales declined by 3.9% qoq/saar, while supermarket sales grew by a modest 1.9%. The slowdown follows a reduction in the real wage bill growth rate (to 3.8% year over year in February) and a worsening in consumer confidence. The increase in the unemployment rate (to 6.5% in 1Q14 from 6.2% one year before) is also consistent with a less-supportive labor market. While consumption is doing worse, exports are recovering, led by mining, which together with lower imports is boosting the contribution of net exports to growth.

We maintain our below-trend GDP growth estimates for this year and the next. In our scenario, GDP grows by 3.3% this year, helped by the lagging effects of the monetary policy easing and the weaker exchange rate. For 2015, we expect 4.0% GDP growth.

A temporary increase in inflation

Annual inflation increased to 3.5% in March (from 3.2% in February), led by temporary effects from the weaker currency. Tradable inflation rose to 2.9% in March from 2.4% in February, while non- tradable inflation was flat with the previous month, at 4.3%.

The core inflation measures have also been on the rise, but they remain below the center of the central bank’s target. Specifically, the CPI excluding food and energy rose by 2.7% in March (from 2.5% in February).

The proposed tax hikes for sales of alcoholic drinks and tobacco will be implemented once the reform is approved in the congress, which is likely to be before September 2014. In our previous scenario, we expected these tax hikes to be implemented only in 2015. Thus, we have raised our expected CPI for 2014 to 3.3% (from 2.8%), but we have also reduced our forecast for next year to 2.8% (from 3.0%). Despite the acceleration in the annual inflation rate, we don’t foresee second-round effects over the next few months, mainly due to a negative output gap as well as the persistence of anchored inflation expectations at the target center.    

Only a pause in the easing cycle

As expected, Chile’s central bank left the policy rate unchanged at 4.0% in April. The decision to hold the rate steady followed two 25-bp rate cuts over the previous two months. Importantly, the central bank kept its easing bias, with the exact same wording as in the previous decision: “the board will evaluate the possibility of introducing additional policy rate cuts, according to the evolution of internal and external macroeconomic variables and their implication for the inflation outlook”.

In our view, the decision to leave the interest rate unchanged is just a pause in the easing cycle. The evolution of the output gap leaves enough space for the central bank to introduce further monetary stimulus. Recently, board member Pablo Garcia gave a speech in which he said that the central bank does not face a dilemma (alluding to the mix of higher inflation and below-trend growth), arguing that the recent increase in CPI was due to temporary factors. He asserted that the main drivers of inflation beyond the short term are inflation expectations and the output gap.

We expect the central bank to resume the easing cycle in May. Nevertheless, we acknowledge that the board might wait slightly longer than that before reducing the policy rate again. In any case, in our scenario the easing cycle will be concluded before the end of 3Q14, with the policy rate at 3.5%. We see a tightening cycle beginning in late 2015, but only if the economy gives solid signals that a recovery is underway.

A narrower current-account deficit

The 12-month rolling trade balance increased to USD 4.2 billion in March from USD 2.1 billion last month. In March, there was a notable 17.8% year-over-year increase in exports (led by 25.3% growth in mining sales), leading to annual export growth of 4.5% in 1Q14. On the other hand, imports fell by 1.4% year over year in March (-10.2% in 1Q14), reflecting the weakening in domestic demand and the weaker Chilean peso.

We see the exchange rate at 575 Chilean pesos to the dollar both at the end of this year and at the end of next. Lower interest rates in Chile and higher U.S. Treasury yields will likely lead to a further depreciation of the peso.  

We continue to expect a reduction in the current account deficit this year, to 2.7% of GDP (from 3.4% in 2012). In our scenario, the weaker currency, higher export volumes (as result of the mining investments made over the past few years) and weak domestic demand will all contribute to narrowing the deficit, despite the lower copper prices. We foresee a further reduction in the deficit next year, to 1.7% of GDP.

Tax reform is still at the center of the debate

The first section of the tax reform legislation passed the Finance committee in the House of Representatives and will be debated by the full House this month. This first section includes the gradual increase in the corporate tax rate (to 25% in 2017, from the current 20%) and the elimination of the FUT system. There were also modifications made to the second section, whereby the government accepted lower increases in alcoholic drink taxes (after several negotiations in the Congress), to be offset by a higher tax on tobacco sales. The next two sections will consider modifications to the VAT credit for construction companies and an increase in the stamp tax.

Although the reform bill is underway, there is still a high level of uncertainty regarding several measures of the reform. One such uncertainty is over the specific timing of the stamp tax implementation (which has a significant impact on inflation), although it is known that the government would prefer to implement it gradually over two years, ending in 2016. The government is aiming to have the bill approved by the House of Representatives before the first official government speech (scheduled for May 21) and by the Senate before September 31, when the 2015 budget has to be submitted to the congress.

João Pedro Bumachar
Rodrigo Aravena
Vittorio Peretti

Forecasts: Chile



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