Itaú BBA - Fresh efforts to push through adjustments and reforms

Brazil Scenario Review

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Fresh efforts to push through adjustments and reforms

mayo 5, 2016

The chances of fresh efforts being made to push through fiscal reform and adjustments are increasing.

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

• We have revised our exchange-rate forecast down to BRL 3.75 per dollar at the end of 2016 (previously BRL 4.00) and BRL 3.95 per dollar at the end of 2017 (previously BRL 4.25), reflecting both a more benign external scenario and an improved outlook for adjustments on the domestic front.  

• The renewed efforts for adjustments also tend to have a positive effect on confidence, but it will not be enough to avert a marked drop in activity this year. We are maintaining our forecast of a 4.0% decline in GDP this year. In 2017, this new environment should provide moderate growth of 1.0% (previously 0.3%).

• We have maintained our IPCA (Extended National Consumer Prices Index) inflation forecast for this year at 6.9%. The projected rise in market prices has increased slightly, to 7.1% from 7.0%; however, our forecast for regulated prices has dropped to 6.5% from 6.7%. Our inflation forecast for 2017 remains at 5.0%. 

• We expect fresh efforts to push through reforms and adjustments in the months ahead. We have maintained our forecast for a primary result in 2016 of -1.7% GDP; however we have improved our 2017 forecast to -1.0% of GDP, compared with the previous forecast of -2.1%.

• The balance of risks for inflation is expected to improve. We therefore believe that the Copom will embark on an easing cycle over the second half of the year.

Markets post gains in response to external factors and hopes for fiscal adjustment

In April, domestic asset prices improved significantly.

This can be attributed in part to changes in both internal and external fundamentals. Activity in China once again surprised positively, commodity prices rose and the Fed opted for a more cautious approach. In Brazil, the chances of fresh efforts being made to push through fiscal reform and adjustments are increasing, leading us to revise our forecast for the primary result next year.

Some of the market gains made by domestic assets reflect the constructive view of these new fiscal efforts. However, some risks (both domestic and global) remain.

There are two main consequences for the scenario that follows these fiscal changes: first, the BRL has made further gains, resulting in a more benign balance of risks for inflation. In this context, the markets have also started to factor lower interest rates and inflation into prices.

The second consequence is that improving financial conditions may have a positive impact on economic activity. We have therefore revised our forecast for next year’s growth upward.

The rising value of the BRL and the possibility of economic recovery are likely to have an impact on external accounts. Even so, the current-account adjustment is set to continue, albeit at a slower pace. As demand for currency protection slackens, the CB has been able to quickly reduce its inventory of swaps.

Elsewhere, the trend for inflation is becoming clearer. The slowdown in service-price inflation is becoming increasingly apparent. Industrial prices remain under pressure from the currency devaluation at the end of last year, but there are clear signs (particularly from wholesale prices) of a reversal in this trend.

We have maintained our IPCA forecast for this year unchanged, however the index composition is different. We have raised our forecast for service inflation following changes to the IPCA calculation methodology (affecting items “domestic employee” and “home repair services”), but have reduced our forecast for industrial inflation as the BRL has made gains.

Finally, we believe that the IPCA’s downward trend is consistent with a decision to cut interest rates in the second half of the year. The Central Bank’s recent statement corroborates this interpretation.

BRL boosted by reduced external volatility and outlook for adjustments in Brazil

The international scenario continues to support global currencies, and the dollar lost ground again in April. The likely delay in U.S. interest-rate hikes and higher commodity prices have supported emerging-country currencies, including the BRL.

The likelihood of fresh efforts to push through reforms and adjustments has also increased over the past month. The improved outlook has reduced country risk and increased capital inflows, driving up the BRL.

The exchange rate fell from BRL 3.60 per dollar at the end of the March to less than BRL 3.50, despite central-bank interventions on the currency market. Over the past month, the central bank purchased USD 31.7 billion in reverse swap contracts, reducing its short position in FX swaps to USD 69 billion from USD 102 billion.

We have revised our exchange-rate forecast down to BRL 3.75 per dollar at the end of 2016 (previously BRL 4.00) and BRL 3.95 per dollar at the end of 2017 (previously BRL 4.25). This forecast reflects both a more benign external scenario and the likelihood of fresh efforts to push through domestic adjustments.

The current-account deficit continues to shrink, but at a slower pace. The seasonally adjusted annualized three-month moving average is close to a USD 19 billion deficit. The improvement reflects both a weaker exchange rate and slower activity. The main positive contribution comes from the trade balance. On the financing side, direct investment in Brazil has been resilient and fully covers the entire current account deficit. However, flows into the local capital markets (fixed income and stocks) continue to shrink and already show outflows over the past 12 months.

We have changed our external account estimates for the next two years. We continue to forecast an improvement. On one hand, revised commodity prices should provide a further boost to the trade balance. On the other hand, the stronger BRL in our scenario suggests a slightly worse result. The outcome is a USD 52 billion trade surplus in 2016 (previously USD 50 billion) and USD 55 billion in 2017. We forecast a USD 15 billion current account deficit in 2016 (previously USD 13 billion) and USD 7 billion deficit in 2017 (from a previously zero balance).

Activity: still falling, but the outlook for next year is improving

Consumption remains low. Supermarket sales dropped 1.2% in March compared with the preceding month, indicating a drop in core retail sales. Real service-sector revenues shrank 1.2% at the margin in February, with a particularly sharp 1.6% decline in services for families. With the persistent increase in unemployment and drop in the real wage bill, family consumption is likely to remain weak for the next few months.

Leading indicators suggest smaller GDP reductions in the next half. Our diffusion index – which shows the number of rising indicators, based on a wide dataset, including business and consumer confidence, retail sales and credit demand – should end March at around 46% (3-month moving average). If confirmed, this will be the first time since the end of 2014 that the index has climbed above the neutral level (44%). This is a leading index for economic activity and, as such, is consistent with our outlook of relative stability in the second half of this year.

Industry continues to slash inventories. In April, the number of companies reporting excess inventories was 9.6 percentage points ahead of those reporting insufficient inventories. This is lower than the figure reported in March and the eighth consecutive drop. We believe that inventories will continue to fall over the coming months. As a result, industrial confidence may begin to show a moderate improvement. Additionally, if we can confirm that inventories are normalizing, we expect industry to ramp up use of installed capacity (which currently stands around 8 percentage points below the level recorded at the beginning of 2014). However, confidence in other economic sectors is unlikely to shine quite as brightly, particularly for family-oriented services and the retail sector.

Short-term contraction. Recent data suggest that GDP fell during the first and second quarters of the year. With leading indicators presenting improvements at the margin, we expect to see relative stability from the third quarter onward. Even if there is an increasing likelihood of adjustments and reforms, this will probably be insufficient to avoid a pronounced drop in economic activity in 2016. We are maintaining our forecast that GDP will shrink 4.0% this year. In 2017, we believe that this outlook, allied with the ongoing adjustments in the industrial sector, should result in GDP growth of 1.0% (previously 0.3%); however, industrial activity will remain well below the peak levels seen at the start of 2014.

Job market deterioration. In March, a net 118 thousand formal jobs were destroyed (Caged). The 3-month moving average presents destruction of 135,000 jobs, almost double the number lost at the worst point of the financial crisis (-76,000). Job destruction was widespread, affecting 7 out of 8 sectors of economic activity.

Unemployment rising. Despite the significant reduction in formal jobs, the increase in the national unemployment rate fell below expectations once again. In March, unemployment rose to 10.9%, compared with our forecast of 11.1%. At the margin, unemployment rose from 10.0% to 10.2% (our seasonal adjustment). We believe that this is occurring because more workers are now self-employed. This has averted an even larger increase in unemployment in recent months and will tend to increase the lag with which unemployment reacts to activity. We have therefore revised our unemployment forecast to 12.5% at the end of 2016 (previously 13.0%). This trend toward a marked increase in unemployment is likely to continue in 2017, with unemployment rising to 13.0% (previously 13.4%).

Inflation forecasts for 2016 and 2017 remain stable 

We have maintained our IPCA inflation projection for this year at 6.9%. Despite reviewing our exchange-rate scenario (we are now working on the basis that a dollar will buy BRL 3.75 at the end of the year, compared with BRL 4.00 in our previous scenario), there has been additional pressure from food at home and services, which are having the opposite effect. The projected rise in market prices has adjusted slightly, to 7.1% from 7.0% (8.5% in 2015); however, our forecast for regulated prices has dropped to 6.5% from 6.7% (18.1% in 2015). Most (around 2/3) of this year’s inflation slowdown will be driven by regulated prices, particularly relief from electricity and gasoline prices.

We are forecasting a 1.5% second-quarter increase for the IPCA (compared with 2.3% over the same period in 2015), with the 12-month rate dropping to 8.6%. In the first quarter, the IPCA rose 2.6%, with a 12-month rate of 9.4%. For the remaining periods, we are forecasting a 1.0% variation in the third quarter (1.4% in 2015); and 1.7% in the fourth quarter (2.8% in 2015).

We have slightly raised our inflation forecast for market prices to 7.1%, from 7.0%. Despite the currency appreciation, we have increased our inflation forecast for food at home from 8.2% to 8.8% (compared with 12.9% in 2015), given the growing pressure that food prices have been under since the start of the year. However, our basic scenario for foodstuffs includes better weather conditions than we have seen in recent years. The effects of El Niño, which have been pressuring fresh fruits and vegetables prices since November last year, are likely to diminish from May onward and relieve inflationary pressure on food products by the end of the year. It is important to note that in 2015, almost two-thirds of the 25% increase in fresh fruits and vegetables prices occurred in the last two months of the year. Alongside the outlook for better crop weather, a stronger currency and more manageable fuel and energy costs should help to hold back food-price increases throughout the year. We have reduced our forecast increase in industrial prices to 5.6% from 6.0% (6.2% in 2015), after reviewing the exchange-rate scenario and forecasting a moderate drop in ethanol prices. We have slightly increased the forecast annual increase in private-sector service prices to 7.3% from 7.1% (8.1% in 2015). This increase occurred following a change in the methodology used to calculate two items (“domestic employee” and “home repair services”), which used income information from the Monthly Employment Survey (Pesquisa Mensal de Emprego – PME) and is now defunct. The monthly calculation will now use 1/12 of the annual variation in the (national or regional) minimum salary. If it were not for this change, we would have reduced our forecast increase in service prices this year to 6.8%, given the recent results that came in below expectations. Despite the effects of this change in methodology, we continue to forecast worsening conditions on the job market and in the real estate sector, which are facing a particularly somber time; this should have a moderating effect on wages and rent costs and continue to contain service inflation in the months ahead. 

We have reduced our projected increase in regulated prices to 6.5% from 6.7%. This year, forecast electricity prices have dropped from -3% to -5% following the gains made by the BRL (which have an impact on energy costs at the Itaipu plant) and slightly below-expectation results at the margin. Electricity bills rose 51% last year. This year’s expected price reduction is due to a number of components that had put significant pressure on industry costs in 2015, which are experiencing some relief. They include: the Itaipu tariff reduction; a smaller deficit in the Energy Development Account (Conta de Desenvolvimento Energético – CDE), an industry charge; and the end to electricity bill surcharges – brought in with the tariff flags – as Brazil reduces its dependence on thermal plants. We are continuing to forecast a gasoline price increase of around 1% driven by a number of state tax increases, following the 20% price hike in 2015. We are not considering an increase in the Contribution for Intervention in the Economic Domain (Cide). For other regulated price components that weigh relatively heavily on inflation, we are forecasting increases of 20% for water and sewage, 12% for private health plans, 13% for urban bus, 4% for bottled gas and 0% for land-line telephone. Overall, most of the slowdown in regulated price inflation, from 18.1% last year to a forecast 6.5% this year, will come from electricity and gasoline. 

Despite the improving outlook for the inflation scenario from stronger BRL exchange rates, we continue to believe that the fiscal issue remains a significant risk factor. Worsening public accounts could cause a more intense and prolonged realignment of relative prices than initially stated in our inflation forecasts. Inflation could be passed on via further exchange-rate depreciation, a rise in risk premiums, further tax hikes and/or increases in regulated prices, or worsening inflation expectations.

Weaker economic activity could help push down inflation in 2016. We believe that the significant economic slowdown we have already seen could lead to faster market price disinflation in the second half of the year. As some price increases from the start of the year (based on the temporary or short-lived repercussions of tax increases and adverse weather conditions) lose force or are even reversed, this would magnify the trend.

We have held our IPCA inflation projection stable for 2017 at 5%. Next year’s drop in inflation will reflect the dissipation or moderation of relative price increases (regulated prices and exchange rates), less inflationary inertia and the impact of continued weakness in economic activity.

Fiscal: fresh efforts to push through adjustments and reforms ahead

Fiscal results continue to deteriorate. The consolidated public sector registered a primary deficit of BRL 10.6 billion in March, with the accumulated twelve-month result of -2.1% of GDP in February widening to -2.3% of GDP in March. This negative trend reinforces the need for structural reforms that would reverse the continued rise in mandatory spending and create room to reduce discretionary expenditure.

However, we believe that there will be fresh efforts to push through reforms. As we see greater signs of a political consensus, the reforms needed to help correct the fiscal imbalance, particularly Social Security reform, spending caps and decoupling revenues from expenditure in the federal budget, could be submitted to Congress.

We have raised our forecast for the 2017 primary result from -2.1% to -1.0% of GDP. We have evaluated a range of measures that would help to reverse the worsening trend in primary results and add to the impact from a recovery in economic activity. As a baseline for this adjustment, we expect a BRL 48 billion cut in spending (0.7% of GDP) from 2016, based on a reduction on investment, administrative and personnel spending and, on the revenue side, BRL 18 billion (0.3% of GDP) based on a complete reversal of the payroll-tax exemption and BRL 50 billion (0.80% GDP) raised from new concessions, offsetting a net BRL 63 billion (1.0% of GDP) drop in extraordinary revenues compared with 2016.

We are projecting that gross debt will reach 72% in 2016 and 76% in 2017, with net debt rising to 44% in 2016 and 49% in 2017. We expect a nominal deficit of 8.6% of GDP in 2016, with interest costs representing 6.9% of GDP and 0.9% of GDP based on FX swap gains.

Monetary Policy – Interest rates remain stable a while longer

There are increasingly clear signs of a slowdown in inflation. The monthly IPCA has been presenting a favorable composition, with core measures indicating an improvement in the underlying trend for inflation. Inflation expectations, according to the Focus survey, are also beginning to retreat.

The Central Bank (CB) believes there is no room for a short-term cut in interest rates. In a recent statement, the CB acknowledged “improvements in the policy to control inflation,” however, it emphasized that “the high inflation level in twelve months and the distance between inflation expectations and the inflation targeting regime objectives do not allow monetary policy easing.”

The balance of risks for inflation is expected to improve. We forecast that twelve-month inflation and the outlook for inflation will continue to decline as a result of the prolonged recession, the end of the relative price adjustment process and the likelihood of a more stable exchange rate.

We therefore believe that as this scenario evolves, the Copom will begin a cycle of interest-rate cuts in the second half of the year, starting in July. 


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


< Volver