Itaú BBA - A better fiscal reading, for now

Brazil Scenario Review

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A better fiscal reading, for now

enero 12, 2018

We revised our estimate for the primary budget deficit in 2017 to 1.9% of GDP from 2.3%.

Please open the attached pdf to read the full report and forecasts.

We revised our estimate for the primary budget deficit in 2017 to 1.9% of GDP from 2.3%, but the structural fiscal rebalancing still depends on reforms.

• The activity recovery continues: our growth forecasts are 3.0% in 2018 and 3.7% in 2019.

• The Brazilian currency tends to depreciate somewhat: we forecast BRL 3.50 per USD by YE18 and 3.60 by YE19.

• The inflation scenario remains benign: we estimate 3.8% this year and 4.0% in 2019.

• We expect a 25-bp cut in the benchmark Selic interest rate in February and another 25-bp cut in March, ending the monetary easing cycle at 6.5% p.a.

Better primary result in 2017 does not change the challenging fiscal picture

We revised our estimate for the primary budget result in 2017 to -1.9% of GDP (or BRL -120 billion) from -2.3% of GDP (or BRL -150 billion), vs. a target of BRL -163 billion (or -2.5% of GDP). The revision was driven by surprises in extraordinary revenues, particularly under tax amnesty program Refis, as well as in results from states and municipal governments. Notwithstanding the reversal of BRL 25 billion in spending freezes announced throughout 2017, the public sector should post a better primary result than both the target and our previous estimate. 

However, the revision does not mean a permanent improvement in fiscal readings. Large extraordinary revenues in 2017 will not be repeated in 2018, while results from states and municipalities will probably remain relatively stable compared with a year earlier, given the challenging fiscal situation faced by many Brazilian states.

For 2018, we maintain our expectation of a deficit of 2.1% of GDP (BRL 150 billion), compared with the target of BRL -161 billion (or -2.3% of GDP).  Compliance with this year’s target depends on approximately BRL 15 billion (0.2% of GDP) in government measures, which could come from BRL 31 billion (0.45% of GDP) in adjustment proposals that were sent to Congress but were not yet approved, or from a discretionary spending freeze. As spending is fixed exactly at the constitutional spending ceiling, results above these BRL 15 billion in revenues – such as better economic growth than assumed in the budget law (our 3.0% call vs. the government’s 2.5%) or faster progress in the agenda of asset sales – would imply a better reading than the primary deficit target. 

For 2019, we expect a primary deficit of 1.0% of GDP (BRL 80 billion). Compliance with the spending cap for the year requires an adjustment of approximately BRL 30 billion, which, in our view, will be executed through additional reductions in discretionary spending and the reversal of the payroll tax exemption.

Despite the very wide primary deficit and the continuous increase in public debt (see chart above), reflecting the very delicate fiscal situation, uncertainty over approval of the pension reform persists. Congressional debates on the reform are scheduled to resume in late February, after the legislative summer break, but there are doubts as to whether there will be political consensus for approval. Without the reform, the government is less likely to comply with the constitutional spending cap after 2019, jeopardizing the gradual return to primary budget surpluses that would be compatible with public debt stabilization. Maintenance of the currently unsustainable path of public debt means increasing uncertainty over the consistency of the economic recovery and the sustainability of historically low interest rates. 

Activity: Gradual recovery continues

We reduced our forecast for GDP growth in 4Q17 to 0.0% qoq/sa, down from 0.2% (2.1% yoy). The adjustment incorporates somewhat disappointing data for October. This forecast is below what fundamentals and confidence surveys suggest (back to 2013-2014 levels – see chart) due to two factors: i) agricultural GDP is still providing a negative contribution, after a strong reading in 1Q17; and ii) persistent weakness in some service components. Nevertheless, our forecast for 2017 GDP growth stands at 1.0%.

We forecast 3.0% GDP growth for 2018 and 3.7% for 2019, but the balance of risks is tilted to the downside. These forecasts assume that the reform agenda will continue going forward. If an interruption or even reversal of this process is anticipated, the recovery in activity will be in jeopardy, particularly if the tapering of global monetary stimulus becomes more intense. 

The gradual recovery in the labor market continues. In November, 12,300 formal jobs were eliminated in net terms (according to the Ministry of Labor’s CAGED registry). However, the seasonally adjusted quarterly moving average rose to 21,000 from 13,000 and has been improving gradually since 2Q16. Importantly, seasonality is also likely to cause net destruction of formal jobs in December, a result that would not affect our assessment of labor market dynamics.

According to the national household survey (PNAD Contínua - IBGE), Brazil’s nationwide unemployment rate fell to 12.0% in the quarter ended in November from 12.2% in the quarter ended in October. Using our seasonal adjustment, unemployment slid 0.1 pp, to 12.5%. Two details in the report caught our attention:

• Informal jobs are still the big driver of the unemployment decline on a quarterly basis, but their contribution is now smaller than in 3Q17. 

Formal jobs in the private sector weakened again, contrasting with CAGED figures. The chart below shows that such decoupling tends to reverse toward CAGED data.

We expect the seasonally-adjusted unemployment rate to decline to 11.8% by YE18 and to 10.9% by YE19, compared with 12.5% in the quarter ended in November. In our view, the decline in unemployment will be increasingly driven by formal jobs rather than informal positions.

Thus, unemployment is set to remain higher than its neutral level (which we estimate at 10%, but this may drop further due to the labor reform; see Macro Vision – Labor Reform: Potential Impacts), at least until the end of 2019. Therefore, we do not anticipate inflationary pressures arising from the labor market during this period.

A weaker currency in the coming years

The exchange rate ended 2017 near BRL 3.30 per USD. The external environment was favorable for risky assets during the past year, but domestically, political uncertainties remained high, particularly those related to reform approvals. This week, Standard & Poor's downgraded Brazil's sovereign credit rating from BB to BB- and changed the outlook to stable (from negative). The agency highlighted the difficulties related to the fiscal reform agenda and the perspective of higher political uncertainties throughout 2018.

Our forecasts for the exchange rate are unchanged, at BRL 3.50 by YE18 and BRL 3.60 by YE19. The increase in interest rates in the U.S. (albeit gradual) and the corollary tightening in financial conditions will reduce global risk appetite, supporting a weaker exchange rate in the coming years. Domestic uncertainties over adjustments and reforms tend to persist, pressuring risk premia. This path for the exchange rate is compatible with a slightly wider current account deficit, but not to the point of compromising external sustainability.  

There are upside and downside risks to our call. Domestically, the biggest risk is the progress of the reform agenda. If the agenda advances more quickly or more extensively than we anticipate, there may be a swift appreciation of the Brazilian real. On the other hand, a reversal may trigger a depreciating trend. Overseas, the evolution of U.S. inflation tends to determine the number of interest rate hikes (we anticipate three in 2018). Sharp inflation acceleration may require a fourth rate hike, pressuring emerging market currencies, including the real. However, if inflation expectations remain subdued, the Federal Reserve may lift rates only twice in 2018.

In 2017, the trade balance posted a USD 67 billion[1] surplus, an all-time high in the historical series. Good exports performance, supported by higher commodity prices and strong crops, as well as imports at low levels (despite the year-over-year increase), were behind the largest trade surplus on record.

However, the domestic demand recovery and lower commodity prices (on average) will likely produce weaker readings in the next years. December figures already point in that direction.  Our forecasts for the trade surplus are USD 55 billion in 2018 and USD 50 billion in 2019.

We maintain our expectation of a gradual increase in the current account deficit in 2018 and 2019, but not to the point of compromising Brazil’s external sustainability. Our estimates for the deficit are now USD 31 billion in 2018 (vs. USD 34 billion previously, in a revision triggered by the new timetable for interest expenses published by the central bank) and USD 45 billion in 2019.

We estimate inflation at 3.8% this year and 4.0% in 2019

Consumer price index IPCA climbed 0.44% in December, ending the year with a 2.95% increase, down substantially from 6.29% in 2016 and also below the lower-bound of the inflation target range (3.0%). Market-set prices rose 1.3% in 2017 (6.6% in 2016), contributing 1.0 pp to the inflation reading (5.0 pp in 2016). Regulated prices advanced 8.0% (5.5% in 2016), contributing 1.9 pp to annual inflation (1.3 pp in 2016). 

For 2018, our call for the IPCA is unchanged, at 3.8%. Breaking down the estimate, we anticipate advances of 3.5% in market-set prices and 4.8% in regulated prices. Our below-target forecast for inflation this year is driven by: lower inertia from past inflation, anchored expectations and a still-negative output gap. Among market-set prices, we expect prices for food consumed at home to rise 4.5% after falling 4.9% in 2017. In addition to a low comparison base, our scenario assumes weather conditions that are less favorable than those seen last year, as well as a weaker exchange rate. For industrial prices, we anticipate about 2.6% increase, after an unusually low reading of 1.0% in 2017. We expect service inflation to recede again, to 3.6% from 4.5%, largely due to lower inflationary inertia. As for regulated prices, we anticipate moderated price increases for gasoline, bottled cooking gas and electricity, more than offsetting the sharper hike expected for urban bus fares.

Our 2019 forecast for the IPCA remains around 4.0%, with market-set prices advancing 3.9% and regulated prices climbing 4.2%. 

The main risk factors for the inflation scenario are still tied to domestic politics and the evolution of the international scenario. Increasing political uncertainty has hindered progress in reforms and adjustments required for the economic rebound – particularly the pension reform – and at some point it may worsen risk premia and impact the exchange rate. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as tax hikes and/or reversal of tax breaks. As for the external situation, despite still-favorable signs at the margin (with sustained risk appetite for emerging market assets), there are policy risks in developed economies that could eventually cause deterioration in risk premia, impacting the local currency and domestic inflation.

Substantial slack in the economy may contribute to a sharper decline in inflation in 2018. The negative output gap and, consequently, unemployment above its equilibrium level for a longer period, notwithstanding some recent improvement, may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items. 

More favorable inflation inertia also presents downside risk to 2018 inflation. The sharp slide in agricultural and retail food prices last year, thanks to a favorable supply shock, contributed to an increase in the IPCA (2.9%) below the floor of the tolerance range (3.0%) and to even-lower readings for other inflation indicators, particularly the INPC (2.1%) and the IGP-M  (-0.5%). The INPC, whose basket is focused on a tighter income bracket of households earning up to five monthly minimum wages, is used to calculate adjustments in the minimum wage and is also a benchmark for most wage adjustments in the private sector. Hence, lower year-over-year readings for the INPC than for the IPCA, which should be observed at least until mid-year, may cause even more favorable inertial effects for inflation in 2018. Some favorable effects should also arise from low readings for the IGP-M, used to adjust certain regulated prices and home rental contracts.

Inflation expectations remain anchored, with breathing room in relation to the 2018 target. The median of market expectations for inflation, as per the central bank’s Focus survey, slid to 3.95% from 4.02% in 2018. The median estimates for 2019 and 2020 remained at 4.25% and 4.00%, respectively, anchored on the targets set for these years.

Monetary policy: Fine-tuning the end of the cycle

In December, the central bank’s Monetary Policy Committee (Copom) delivered the widely expected outcome, a 50-bp rate cut, taking the Selic to 7.0% p.a., an unprecedented low. The committee signaled, quite clearly, that unless the economy surprises in a major way, it will reduce the Selic by 25 bps, to 6.75% in its next policy meeting, on February 6-7. In the Copom’s view, the main downside risks to inflation are second-round effects of the shock to food prices (no longer present) and inertial effects arising from low levels of current inflation. Upside risks include disappointments with the reform agenda and a possible reversal of the external scenario, both pressuring inflation through the exchange rate channel. Furthermore, in its Quarterly Inflation Report, the Copom published forecasts until 4Q20. Estimates for 2018 – the dominant horizon for monetary policy – are below the target in each of the four presented scenarios. The market’s scenario (with market estimates for the interest and exchange rates) points to 4.2%, thus below the 4.5% target.

While the December IPCA climbed 0.44% in December, topping the highest of market expectations, the 12-month inflation rate ended 2017 at 2.95%, below the lower bound of the inflation target range (3%). As required by the inflation targeting regime in Brazil, the president of the central bank, Ilan Goldfajn, released an open letter to the Finance Minister, Henrique Meirelles, describing in details the reasons for the infringement. Fairly enough, a great emphasis was placed on food inflation, which has dropped from 16.79% at its peak in August 2016 to -4.85% at the end of 2017 and has experienced the sharpest 12-month drop of the series starting in 1989. That exceptional behavior stemmed mostly from food supply shocks which, as repeatedly argued by the central bank, should only require a response by monetary policy if they produce secondary effects on other prices.

Looking forward, Governor Goldfajn argues that the trajectory of inflation is already pointing in the direction of the target in 2018, as suggested by the rise of 0.49 p.p. of 12-month inflation at the end of 2017 relative to the bottom reached in august of the same year. He also emphasizes that the projections of the central bank (conditional on the Focus Survey path for the Selic rate and exchange rate) indicate the inflation rate will reach 3.2% by the end of the first quarter of 2018, above the 3% lower limit of the tolerance band. This creates an important guidepost: if inflation is significantly below the floor of the tolerance band in March, the central bank may add further to the monetary stimulus. For the moment, we stick to our call that the central bank will cut the Selic rate by 25bps in February and again in March, but we concede that this final cut has become less likely after the higher-than-expected IPCA reading.


[1] As per the Ministry of Trade (MDIC)


Please open the attached pdf to read the full report and forecasts.

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