Itaú BBA - Tighter fiscal policy, looser monetary policy stance

Scenario Review - Chile

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Tighter fiscal policy, looser monetary policy stance

March 10, 2016

Low copper prices limit the room for fiscal policy and weigh growth down.

Please see the attached file for all graphs. 

• The economy started the year on a weak foot. We reduced our growth forecasts for this year and next to 1.8% and 2.3%, respectively (from 2.0% and 2.5% in our previous scenario).

• The Chilean peso strengthened recently, but we expect some depreciation from the current levels. We expect the exchange rate to be 730 pesos to the dollar by the end of 2016 and to remain at that level in 2017.

• We see inflation decelerating to 3.5% by year-end 2016, and reaching 3.0% in 2017. Weak growth, less exchange-rate depreciation this year (compared to 2015) and well-anchored inflation expectations will contribute to the moderation of inflation.

• The government revised the assumption for long-term copper prices and announced cuts to this year’s budget to comply with the structural-deficit target.

• Given the deterioration of activity and our expectation of a decline in inflation, we no longer expect rate hikes, so the policy rate would end 2016 and 2017 at 3.50% (from 4.0% for both years in our previous scenario).

Activity hits a soft spot in 1Q16

High-frequency indicators are consistent with a weak 1Q16 for GDP growth. The main drag is coming from the mining sector, but manufacturing is also showing weakness. Meanwhile, data related to private consumption is still holding up well.

In January, the monthly GDP proxy (Imacec) grew 0.3% year over year. In the quarter ending in January, activity expanded 1.2% year over year, below the 1.6% recorded in 4Q15. Lower copper production led the 12.6% year-over-year mining contraction in January (-0.6% in 2015). Also, weak mining output explains the fall in metal-products-related manufacturing, which pushed the 4.6% contraction in industrial production from last year (-0.6% in 2015). On the other hand, retail sales accelerated to 3.4% year over year (+2.5% in 2015).

Sequentially, the Imacec was flat between December and January, bringing quarter-over-quarter growth to a modest 1.6% (annualized).

The unemployment rate in January remained at historically low levels, but the breakdown of employment growth indicates some loosening of the labor market. The acceleration in self-employment supported job creation, as waged employment growth moderated. Construction activity in anticipation of higher taxes on real estate transactions is still helping employment growth, but should subside later in the year. Additionally, there was a pick-up in part-time work. We expect the unemployment rate to reach 7.1% this year, up from the 6.3% recorded in 2015. So the uptick in retail sales growth is likely temporary.

We now expect the economy to expand by 1.8% in 2016 (from 2.0% in our previous scenario). For 2017, we expect 2.3% (from 2.5% previously). Low copper prices and weak internal demand will likely maintain economic growth at a low level.

The peso temporarily appreciates

Chile’s trade balance is improving at the margin, helped by low oil prices. While the 12-month trade surplus stood unchanged between January and February (at USD 3.9 billion), we estimate that the seasonally adjusted surplus reached USD 4.7 billion (annualized), from USD 3.9 billion the previous month. Exports contracted 5% qoq/saar in February, while imports declined 20%, as energy imports collapsed.

We still expect the exchange rate at 730 pesos to the dollar by the end of 2016 and 2017. Helped by higher copper prices, the Chilean peso strengthened recently. However, we expect that additional rate hikes in the U.S. this year will lead to depreciation from the current levels. Higher oil prices later in the year will also help to weaken the currency.

Inflation yet to decelerate

Consumer price inflation in February was still high at 4.7% year over year, but is stabilizing. Our diffusion index remains broadly stable, indicating that the increase in prices, while elevated, is not becoming more widespread. The pass-through of past depreciation of the currency and indexation mechanisms in the economy, as well as the effect of the tax reform on some prices, are behind the high inflation.

We continue to expect year-end inflation at 3.5% this year, reaching the center of the target only in 2017. The milder depreciation of the currency compared with last year, weak internal demand and well-anchored inflation expectations would favor the deceleration of price increases. However, we note that non-tradable inflation remains high and wage inflation picked up in January, indicating that bringing inflation down could be more challenging than previously expected.

A challenging scenario for copper revenues

The government cut its budgeted expenditures for this year by 1% (approximately USD 540 million or 0.25% of GDP). The move seeks to reaffirm fiscal responsibility by ensuring that the structural balance this year does not differ significantly from the 1.3% of GDP originally estimated in the budget. In fact, the announcement came after a request was made for the expert committee to update its forecast for the long-term copper price, a key input in the government’s fiscal estimates. The committee then lowered the long-term copper-price forecast from USD 2.98/lb to USD 2.57/lb, and the average price in 2016 to USD 2.15/lb (previously USD 2.50/lb). The authorities also indicated that the current consensus estimate of a 2.0% real growth rate for this year was more likely than the 2.75% assumed in the 2016 budget law.

The government now estimates a structural deficit of 1.4%-1.6% this year (only slightly higher than the 1.3% previously estimated). The latest adjustments imply that real government expenditures would grow 4.2% this year, below the original 2016 budget’s 4.4% estimate (7.4% in 2015). The bulk of the adjustment in spending will affect current expenditures, excluding key areas in education and health. While the announced expenditure cut shows the administration’s commitment to Chile’s reputation as a responsible fiscal manager, more is needed to achieve the target of bringing the structural deficit to zero in the medium term.

We expect a nominal fiscal balance of 3.3% of GDP this year, widening from the 2.2% recorded last year (when fiscal accounts were benefited by a one-off effect from an amnesty bill aimed at regularizing Chilean investment abroad).

No additional rate hikes

In February, the central bank left the policy rate unchanged at 3.5% for a second consecutive month. The tightening cycle that began in October has been discontinuous and short so far (with total hikes of 50-basis points). The board considered the options of hiking the policy rate and of leaving it unchanged, but opted for the latter, given the increased uncertainty in the global economy and the associated downside risks to domestic activity.

The board saw the evolution of inflation as consistent with the baseline scenario in the 4Q15 IPoM, while activity disappointed. The concern with activity’s weakness was generalized, with one board member extensively discussing the deterioration of qualitative indicators of the labor market.

We no longer expect rate hikes this year or next (previously, we expected two additional 25-basis-point increases). Given the deterioration of activity and our expectation of a decline in inflation, the central bank is unlikely to raise rates further.

Labor and abortion bills in the spotlight

Back from the summer break, congress will discuss the much-debated labor reform. Unable to gather support to approve the bill that seeks to strengthen collective-bargaining rights in Chile, the administration postponed the discussion to March in order to find common ground within the governing coalition. The statements by political leaders show that gaps remain between market-friendly parties that favor including some sort of worker-replacement mechanism during strikes in the bill, and the opposing rest. With no preliminary agreement, an open discussion will take place in the senate, likely resulting in a version of the bill that differs from the one approved in the lower chamber. The reconciliation of the two bills will further delay the approval of this key government bill.

The abortion legalization bill is also facing an uphill battle in congress. Support for the bill that approves abortion in the cases of rape, child unviability and life-threatening situations is not guaranteed by the Christian Democrats (the most right-wing member of the governing coalition). While the expectation is for the bill to be approved, the discussion is likely to be a rocky one.

Adimark’s February political-evaluation survey shows the approval rating for President Bachelet remained broadly stable at 27% (28% in the previous month). Meanwhile the government’s approval rating dropped five percentage points to 20%, representing the widest gap from the President’s approval rating since the beginning of this presidential term.

Please see the attached file for all graphs. 


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