Itaú BBA - Hanging on the Social Security Reform

Brazil Scenario Review

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Hanging on the Social Security Reform

mayo 12, 2017

We expect approval of the Social Security reform in Congress by the end of 3Q17.

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

• Weaker activity on the margin

• We expect approval of the Social Security reform in Congress by the end of 3Q17.

• We have revised our YE17 exchange rate forecast to 3.25 reais per U.S. dollar (from 3.35)

• Our estimates for the IPCA consumer price index remain at 3.9% for 2017 and 3.8% for 2018.

• Asymmetrical risks for interest rates

No consistent signs of a rebound in activity yet

After a string of data consistent with a pickup in activity between December and February, weak March figures cast doubt on the strength of a rebound.

Industrial production declined by 1.8% in March, after two months of stagnation. Activity in all four large economic categories declined during the month: durable consumer goods (-8.5%), other consumer goods (-1.8%), capital goods (-2.5%) and intermediate goods (-2.5%).

Formal job creation worsens again. In March, a net of 63,600 formal jobs were destroyed (according to the Ministry of Labor Caged registry). The seasonally adjusted three-month moving average for job creation fell to -55,000 from -36,000. New hires — which tend to react before net job creation — declined again after five consecutive increases.

The nationwide unemployment rate climbed to 13.2% in March from 13.1% in February (using our seasonal adjustment), marking the 28th consecutive increase. We expect the upward trend in unemployment to continue throughout 2017, despite the outlook for recovery in growth, as the cycle of contraction in economic activity has not yet been fully reflected in the labor market. We forecast unemployment rates at 13.8% in 4Q17 and 13.6% in 4Q18 (using our seasonal adjustment).

Despite the weak results in March, we maintain our estimate of 1.4% GDP growth in 1Q17[1]. The forecast is based on a strong contribution from agriculture, a favorable statistical carryover for industrial production (which will not continue in 2Q17) and stabilization in the service sector. Importantly, methodological changes in retail sales and real service revenues have little relevance in explaining what happened during the first quarter.

Weak growth in 2Q17. Our current growth estimate for 2Q17 is 0.2% qoq/sa, with the slowdown triggered by a reversion of the two main factors behind the gain in 1Q17: agricultural GDP will provide a small negative contribution and the statistical carryover from industrial production will be negative as well. Furthermore, coincident indicators suggest stagnant activity. Some activity figures for April may show atypical behavior due to the many national holidays and strikes organized by labor unions during the month.

However, consumption is showing signs of improvement. The recent retreat in inflation eased the erosion in households’ real income. Withdrawals from inactive accounts held under the FGTS employment protection program are improving consumers’ balance sheets and encouraging spending. These factors may be temporary, but they influence activity before interest rate cuts begin having an effect on aggregate demand.

Hence, we maintain our forecasts for GDP growth of 1.0% of GDP in 2017 and 4.0% in 2018, with the weakness in recent data offsetting the stronger pace in 1Q17. Nevertheless, we recognize that recent developments have increased the downside risk to the recovery.

Fiscal: Social Security reform advances in the Lower House

The Lower House special committee approved the assessment of rapporteur Arthur Maia (PPS-Bahia state) on the Social Security reform bill (PEC 287/16). The next step will be for the Lower House to vote on the bill, which will take place in two rounds and will probably be completed by the end of June. Analysis and approval by the Senate (the final steps before the presidential sanction) will likely be finished by the end of 3Q17, in our view.

The rapporteur’s assessment entailed changes to six aspects of the original proposal. First, the transition rule (the measure in the reform with the largest fiscal impact) now incorporates all workers and establishes initial minimum retirement ages of 55 for men and 53 for women, which would rise to 65 and 62 over the course of the ensuing 20 and 18 years, respectively. Second, the adjustments in the retirement rules for rural workers, teachers and police officers, social assistance (BPC/Loas) and survivor benefits are now very small compared with the current rules. Finally, the basis for calculating benefits is now a simple average of all contribution salaries, instead of the 80% of highest salaries.

We estimate that the modified proposal will have an impact on the federal government’s primary balance of 1.4 p.p. of GDP in 2025, or 70% of the projected impact of 2.0 p.p. of GDP laid out in the government’s original proposal. In terms of government spending, the proposal allows for savings of 1.1 pp of GDP by bringing the rules for accessing social security benefits more into line with Brazil’s current fiscal and demographic reality. Revenues could increase by 0.3 p.p. of GDP, mainly because people will remain in the labor force longer, contributing to the sustainability of the pension system. Compared with the original proposal, the dilution of the transition rule subtracted 0.4 p.p. of GDP (or 20% of the total), changes in other benefits subtracted another 0.3 p.p. of GDP (or 15%) and the change in the calculation base of benefits added 0.1 p.p. of GDP (or 5%).

Notwithstanding these dilutions, an approval of the Social Security reform bill would be a key step toward the stabilization of public debt in the medium term. Without such a reform, or if the reform ultimately approved is watered down further, there would be a high probability of eventual non-compliance with the spending cap and the path of public debt would remain unsustainable. We forecast primary surpluses only in 2020, but in our view, the rebound in growth and falling interest rates driven by reforms would significantly slow the breakneck pace of public debt growth. We expect public debt to remain stable at around 80% of GDP starting in 2018.

We forecast a primary deficit of 2.2% of GDP (142 billion reais) in 2017, in line with the fiscal target. However, the target is ambitious and will require significant cutbacks in discretionary expenses, reversals of tax breaks (such as those applied to payroll taxes) and inflows of extraordinary revenues (such as the repatriation of money held by residents overseas). In order to ease spending cuts during the year, the government is still pursuing additional revenues related to judicial claims (precatórios) and electricity and transportation concessions.

For 2018, we estimate a primary deficit of 1.7% of GDP (122 billion reais), slightly below the target of 1.8% of GDP (131 billion reais). This forecast implies faster GDP growth than the government anticipates (we estimate 4.0%, while the government forecasts 2.5%), compliance with the spending cap (approved in 2016) and 15 billion reais (0.2% of GDP) in extraordinary revenues, in line with a gradual reversal in Brazil’s fiscal imbalance.

Milder currency depreciation ahead, in a benign external scenario

Despite the recent decline in commodity prices, the external scenario remains favorable for emerging market currencies. The risk-on mode has been dominant and is providing support to many currencies, including the Brazilian real. Domestically, political uncertainties about the Social Security reform have triggered volatility, but not to the point of causing intense currency depreciation. The exchange rate has continued to hover around 3.10-3.20 reais per dollar over the past month.

We have revised our exchange rate forecasts to 3.25 reais per dollar at YE17 (from 3.35) and 3.35 reais per dollar at YE18 (from 3.45). The real did not sharply depreciate in response to the correction in commodity prices, pointing to a higher appetite for risky assets. The international scenario is likely to remain benign over the next few months, which is why we revised our forecasts. Nevertheless, we continue to expect a slightly weaker currency (vs. current levels) due to the narrowing interest rate differential (driven by a decline in interest rates in Brazil and/or higher interest rates in the U.S.) during the year.

The trade balance has continued to show strong surpluses in early 2017. Despite some signs of recovery (especially in year-over-year terms), imports remain at low levels. Along with higher prices for the main commodities exported by Brazil and larger shipments, this situation has ensured all-time-high trade surpluses in the first months of the year. Nevertheless, a slightly stronger currency (on average, in real terms), a rebound in domestic demand and commodity prices settling below current levels will likely produce somewhat weaker trade results in the coming months.

The all-time-high trade surplus in the first months of the year helped to maintain the current account deficit at low levels. Over the past 12 months, the current account deficit narrowed to USD 20.6 billion, or 1.1% of GDP.

We have increased our trade surplus forecasts due to the strong readings of early 2017. We now project surpluses[2] of USD 60 billion in 2017 (USD 52 billion previously) and USD 40 billion in 2018 (USD 37 billion previously). For the current account, we expect deficits of USD 25 billion in 2017 (USD 30 billion previously) and USD 50 billion in 2018 (USD 52 billion previously).

Unchanged inflation forecasts: 3.9% in 2017 and 3.8% in 2018

Our estimate for the IPCA consumer price index in 2017 remains at 3.9%. We expect the year-over-year increases to recede to 3.8% in May, 3.7% in June and 3.5% in September. Importantly, disinflation may prompt a welcome debate about the reduction of the inflation target. The National Monetary Council (CMN) will meet in June to reconsider the inflation target of 4.5% for 2018 and set the target for the following year.

Breaking down our 2017 index forecast, we anticipate increases of 3.4% in market-set prices and 5.2% in regulated prices. Among market-set prices, we forecast a 2.0% price increase for food consumed at home. After rising by 9.4% last year, prices for this subgroup climbed by 2.5% over the 12 months ended in April. The positive outlook for large crops in Brazil and other major producing countries has been triggering declines in wholesale agricultural prices since September 2016 and thus favorably affecting retail food prices this year, and this pattern will likely continue. Wholesale agricultural prices (measured by the Getúlio Vargas Foundation’s IGP-DI) have already shown 6.3% deflation in the last 12 months (13.1% in the past eight months). Sharp disinflation in food prices this year, driven by a positive supply shock, could lower the IPCA reading by 1.2 p.p. – half of the projected retreat in inflation for this period. For industrial prices, we expect a 2.1% rise this year (4.8% in 2016). For services inflation, our call stands at 5.0% (6.5% in 2016). Adverse conditions in the labor and real estate markets, a dissipation of the inertial effect of past inflation and smaller adjustments in the minimum wage have moderated wage and rent costs and in that way will contribute to lower service inflation in 2017. For regulated prices, we forecast increases of: -3% for landline phone tariffs; -1% for gasoline; 4% for medication; 7% for bottled cooking gas; 7% for electricity; 8% for urban bus fares; 8% for water and sewage tariffs; and 11% for health insurance premiums. As for electricity, we assume that the red mode in the tariff flag system will prevail throughout the dry season, moving to the yellow mode by the end of the year, when the rainy season begins.

Our 2018 inflation forecast remains at 3.8%. Breaking down our estimate, we expect market-set prices to rise by 3.5% and regulated prices to climb by 4.7%. The main factors behind our below-target forecast are the negative output gap, less inertia from 2017 inflation and anchored expectations. Inflation settling below the target-range midpoint starting in 2Q17 will likely fuel a debate about a reduction of the inflation target in the coming years. We think that a lower target would be credible, reinforcing the objective of bringing inflation down to levels commensurate with those of peer nations.

The main risks for inflation are still political. The emergence of unforeseen difficulties in advancing reforms and necessary adjustments could trigger apprehension among investors and affect risk premiums and the exchange rate, and could necessitate alternative fiscal measures, such as tax hikes. All eyes will be on the debate over the Social Security reform, the key question being whether the bill will be passed in the form approved by the Lower House’s special committee. As for the external environment, high levels of uncertainty may still increase risk premiums and, consequently, weaken the currency. Special attention must be paid to the possibility of faster interest rate hikes in the U.S. than the market is currently anticipating.

Slack in the economy may contribute to a sharper decline in inflation. The negative output gap (the difference between potential and effective GDP) may prompt faster disinflation in market-set prices, particularly in segments that are more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months have shown evidence of widespread disinflation, which has been affecting these segments in particular. Likewise, progress in fiscal reforms may improve the outlook for inflation – through the exchange rate and inflation expectations channel or through the impact of better fiscal momentum on the economy.

A lower inflation target would reinforce the outlook for lower inflation and anchored expectations. The median of inflation estimates for the year, as measured by the central bank’s Focus survey, declined in the past month to 4.0% from 4.1%. The median expectation for 2018 slipped to 4.4% from 4.5%. Median estimates for 2019 and 2020 remained at 4.25%, probably already reflecting the possibility of a lower inflation target for 2019.

Asymmetrical risk for acceleration in interest rate cuts in May

The minutes from the central bank’s April monetary policy committee (Copom) meeting brought back asymmetric signaling on future policy moves. One particular passage indicated that the committee considered a more aggressive move than the 100-bp cut that was delivered. But the Copom ended up opting for “moderate” acceleration given the forward-looking nature of policymaking and the degree of uncertainty around the scenario.

We think that the Copom will deliver another 100-bp cut at its next policy meeting on May 30-31, but the cut could be steeper than that. A favorable vote on the Social Security reform in Congress in May would substantially reduce uncertainty and increase the chances of a faster pace of interest rate cuts.

We still expect a Selic rate of 8.25% at both YE17 and YE18. Renewed frustration with activity data in a deeply disinflationary environment could lead to a steeper cutting cycle, especially if the pension and labor reforms are approved.


 


[1] Learn more about our 1Q17 GDP forecast here.

[2] As per MDIC



 

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



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