Itaú BBA - The Government’s Grace Period Is Over

Scenario Review - Chile

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The Government’s Grace Period Is Over

September 9, 2014

Chile’s economy weakened further in 2Q14.

The economy weakened further in 2Q14 and the available indicators for 3Q14 do not suggest a rebound just yet. We have reduced our growth forecast for this year to 1.9%. Higher global growth and the stimulus measures will likely boost growth to 3.5% in 2015.

Inflation surprised on the upside in August, and we now foresee year-end inflation rates of 4.2% this year and 2.9% next year. Looking ahead, the sharper-than-expected weakening of the currency will probably be offset by the negative surprises on activity.

As interest rates fall in Chile, the Chilean peso weakened by more than we were expecting and underperformed most of the core emerging-market currencies in August. We now expect the Chilean peso at 615 to the dollar by the end of this year and at 635 by the end of 2015. 

The easing cycle continued in August, with a unanimous 25-bp rate cut. An easing bias remains in place. We expect the central bank to reduce the policy rate by 25 bps in both September and October, before the easing cycle ends. However, we cannot rule out the possibility that the recent surprise on consumer and wage inflation will lead to a delay in additional cuts. 

In response to the slowdown, the government announced a short-term fiscal stimulus package amounting to USD 500 million (approximately 0.2% of GDP) for 4Q14. 

President Michelle Bachelet’s approval rating fell to 49% in August, down five percentage points from the previous month and the lowest level recorded so far in her second presidential term, which commenced in March of this year.

Weak Internal Demand Reduces Growth

Chile’s economy weakened further in 2Q14. The shortage of investment is still the main drag on growth, but the slowdown in private consumption has exacerbated the slowdown. On a sequential basis, GDP growth slowed to 0.6% qoq/saar (after a 2.5% rise in the previous quarter). Gross fixed investment gained a weak 1.5% qoq/saar, while private consumption was almost flat with the previous quarter (+0.1% qoq/saar). As a result, internal demand excluding change in inventories also rose by 0.1% qoq/saar (-0.5% yoy).

The economy doesn’t seem to be recovering in 3Q14. Manufacturing production contracted by 0.1% from June to July, leading to a 5.8% qoq/saar decline. Although retail sales gained 1.4% compared with June, growth remained weak, at 0.7% qoq/saar. As a result, the IMACEC (monthly proxy for GDP) was up 0.5% from June to July, but this came after a 0.8% decline in the previous month, which translates to an increase of only 1.1% on a qoq/saar basis. Business confidence figures do not suggest a bright outlook, as the private sector was even more pessimistic in August than in July (in August, business confidence fell by 2.2% compared with the previous month and by 18.9% compared with one year before).

Due to the weak economy, the labor market continues to soften. The unemployment rate was 6.5% for the quarter ending in July, higher than the 5.7% recorded in the same period last year. Employment slowed to 1.0% in 3Q14 from 1.3% in 2Q14. While the overall unemployment rate is not high, the breakdown of employment growth continues to show that the job market is weak. Wage-employment growth was only 0.4%, while self-employment grew by 3.0% (compared with 5.9% last month and 7.4% at the end of 1Q14). 

We now expect 1.9% GDP growth for this year. For 2015, we expect growth to recover to 3.5%. In our previous scenario, we were expecting a 2.2% expansion this year and a 3.8% recovery in 2015. While the economy has been disappointing, we believe that the monetary stimulus measures already in place and the recovery of the global economy will likely boost growth ahead.

More Persistent Inflation

The consumer price index rose by 0.3% month over month in August (previously: 0.2%), above both our estimate and the market consensus estimate of 0.1%. 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 (up from 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% in July.

Wage inflation edged higher, to 7.3% year over year in July (vs. 6.6% in June). While the increase was influenced by the increase 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 is now at 4.2%. For 2015, our 2.9% forecast is unchanged. In our view, the sharper-than-expected weakening of the currency will probably be offset by the wider output gap.

Sticking With Gradualism

As expected, the Chilean central bank cut the policy rate by 25 bps, to 3.50%, in August. This follows last month’s unanimous decision to resume the easing cycle. In the press statement announcing the decision, the easing bias was left unchanged, with the board saying that it “will evaluate the possibility of introducing additional policy rate cuts according to the evolution of the internal and external macroeconomic conditions and its implications for the inflation outlook”.

The minutes of the decision revealed that the divisions within the board are now deeper, even though it voted unanimously for the 25-bp reduction in the policy rate. In the meeting, the board considered three “relevant” options (in contrast to the usual two options): i) keeping the reference rate unchanged, ii) reducing it by 25 bps; and iii) reducing it by 50 bps. Four board members saw some appeal in a 50-bp rate cut and none advocated keeping the policy rate unchanged.

However, in its 3Q14 inflation report, released after the meeting, the central bank signaled that it is unwilling to deliver a more aggressive monetary easing than the one already expected by the market. In the report, the central bank assumes that the policy rate will follow a path similar to the one expected by market participants. Thus, the board is hinting at two additional 25-bp rate cuts. In fact, the central bank thinks that it has already done a considerable amount to help the economy. Speaking to the Senate, Governor Vergara emphasized that the current easing already implemented (150 bps since October 2013) has taken long-term market interest rates, including mortgage rates, to levels below those recorded during the global financial crisis of 2008-09. This was important, he argued, because these long-term rates affect investment. Furthermore, the board believes that some of the slowdown cannot be countered with monetary policy. In fact, in the monetary policy report the central bank also reduced its estimate of Chile’s potential growth. The bank now sees the economy evolving at rates of between 4.0% and 4.5% in the medium term, down from 5.0% previously. According to the central bank, this revision was due to lower productivity growth and a lower investment rate. 

We expect the central bank to reduce the policy rate by 25 bps at both its September and October meetings, before ending the easing cycle. However, we acknowledge that the recent consumer price index and wage figures may lead the central bank to introduce a pause in the cycle.

The Underperformance of the Peso Continued in August

As interest rates in Chile have fallen, the Chilean peso has weakened by more than we were expecting, and it underperformed most of the core emerging-market currencies in August. We now foresee exchange rates of 615 pesos to the dollar at the end of this year (up from 585 in our previous scenario) and 635 at the end of 2015 (up from 615 in our previous scenario). In our view, the additional depreciation from the current levels will be purely a consequence of the increase in U.S. Treasury yields, as we do not expect the interest rate yield curve in Chile to fall further.

During 2Q14, the current-account balance posted a surplus of USD 28 million. While small, this is the first surplus for this period of the year since 2011. The four-quarter rolling deficit declined to 2.4% of GDP, from 3.1% in 1Q14. Apart from the weaker internal demand, the real exchange-rate depreciation was the main reason for the lower deficit. Due to our new growth and exchange-rate forecasts, we now expect a current-account deficit of 1.9% of GDP this year (down from 2.1% of GDP previously). For 2015, we expect a deficit of 1.7% of GDP (down from 2.0% in our previous scenario).

Fiscal Stimulus in Place

In response to the slowdown, President Michelle Bachelet announced a short-term fiscal stimulus package amounting to USD 500 million (approximately 0.2% of GDP) for 4Q14. Finance Minister Alberto Arenas declared that the aim of the package is to decisively boost public investment, as it will increase total government spending by roughly 12% from what was initially budgeted in 4Q14. The minister expects the tax reform to raise around 0.3% of GDP in 2014, of which 0.1% of GDP (or USD 250 million) would be allocated to fund this bill. The financial stimulus package will target several areas for investment, including infrastructure, small and medium-size businesses (SMEs) and the energy sector, most of which are expected to be labor-intensive operations.

Bachelet’s Grace Period Seems to Be Over

According to Adimark, President Bachelet’s approval rating fell to 49% in August, down five percentage points from the previous month and the lowest level recorded so far in her second presidential term, which commenced in March of this year. Meanwhile, the president’s disapproval rating rose by five percentage points, to 41% – also the highest level since she took office. The government’s approval rating also fell by five percentage points, to 43%. The management areas which recorded the biggest drops in approval were international relations, the economy, employment, education and public transportation. Public approval of a number of government reforms has also suffered, as support for the tax reform fell by 11 percentage points, to just 39%, and approval for the education reform was down 6 percentage points, to 46%.


 

João Pedro Bumachar
Vittorio Peretti

 



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