Itaú BBA - Smaller primary budget surplus, higher interest rates

Brazil Review

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Smaller primary budget surplus, higher interest rates

mayo 2, 2013

The government signaled that fiscal policy will expand further. Foreign direct investment inflows are no longer enough to finance the current account deficit.

The Brazilian economy in April 2013

The government signaled that fiscal policy will expand further. Foreign direct investment inflows are no longer enough to finance the current account deficit. Facing higher inflationary pressures, the Central Bank lifted the benchmark interest rate. The most resilient source of inflation is the heated labor market, despite low output growth. Congress clashed with the Supreme Court over certain legal powers. Sovereign CDS spreads declined after three months of increases. The focus in May will be on the GDP report for 1Q13.

The government signals additional fiscal expansion...

The government presented its proposal for the Budget Guidelines Law (PLDO), which will be a template for fiscal policy in 2014. According to the proposal, the federal government will no longer be required to compensate below-target results by states and municipalities. In practice, this measure makes way for fiscal expansion in coming years. In an interview with the newspaper Valor Econômico, Treasury Secretary Arno Augustin said, “We are making it clear from the start that, for 2013 and 2014 — and probably this will be the government’s policy for 2015 and 2016 — the primary budget surplus will always be a variable for the economy and no longer for public debt itself."

... while the current account deficit widens.

The current account deficit widened to 2.9% of GDP in the 12 months through March. Hence, the current account gap exceeded foreign direct investment (FDI). The latest result was driven by the current account, with low trade balances and hefty outflows from the service and income accounts, as well as by moderation in direct investment. This combination is already reflected in reserve accumulation, which slowed to $13 billion over 12 months, down from $82 billion in August 2012.

Inflation remains under pressure...

In April, the mid-month consumer price index IPCA-15 climbed 0.51% during the month and 6.5% year over year, nailing the upper-limit of the target range. Food and service inflation were higher than expected. The diffusion index (share of items with positive price changes) stood at 68.2%, signaling that price increases are still widespread. We expect a slowdown in coming months, with less pressure stemming from some food items (e.g. tomatoes). However, inflation dynamics will still require attention. We forecast a 5.6% increase in the headline IPCA in 2013.

... driving the Central Bank to lift interest rates.

The Central Bank’s Monetary Policy Committee (Copom) lifted the benchmark interest rate by 25 bps to 7.50% p.a. The decision was not unanimous, as two members voted to keep the Selic at 7.25% p.a. The move was in line with our recent call, but came sooner than we expected one month ago. In the statement that followed the decision, the Copom recognized the recent deterioration in inflation but stressed that uncertainties, particularly in the external scenario, warranted caution. In our view, the decision and the statement are consistent with our expectation of a tightening cycle of 100 bps in the Selic rate.

The most resilient source of inflation is the labor market...

The seasonally-adjusted unemployment rate stood at 5.3% in March. Real wages and the wage bill declined, but the trend still points upward, given low unemployment. Job creation in education, healthcare and public administration continues to stand out, and services provided to companies also maintained a good hiring pace. Meanwhile, the slide continued in the number of people working in construction and household services.

... which remains tight despite moderate GDP growth.

This seemingly-paradoxical result is driven by labor supply (slower population growth) as well as labor demand (economic growth is led by the labor-intensive service sector). Leading indicators point to a gradual recovery in GDP throughout the year (0.7% on average). However, extraordinary factors, such as a larger-than-expected agricultural harvest, should enable stronger GDP growth in 1Q13 (1.2%).

Congress clashes with the Supreme Court.

Congress tried to pass a constitutional amendment by which certain rulings from the Supreme Court would have to meet with the approval of the house. The bill faces opposition and is unlikely to be approved. Among the initiatives that actually advanced, we highlight the unification of ICMS tax rates across states (the base text was approved by a senate commission) and a bill requiring the government to execute congressional amendments to the budget (currently the executive branch has veto power over them).

Sovereign CDS spreads decline after three months of increases.

The Ibovespa stock index continued to retreat, falling 0.8% in April in local currency (-0.2% in dollars). The 5-year CDS spread slipped after three months of increases, ending the month at 110 bps, vs. 137 bps in the previous month. The exchange rate rose 0.6%, finishing the month at 2.00 reais per U.S. dollar.

What’s next?

The 1Q13 GDP report will be published on May 29. We expect a seasonally adjusted gain of 1.2% over the previous quarter. On that same day, the Central Bank will decide if and by how much to hike the benchmark Selic rate.


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