Itaú BBA - Recession deepens, reforms needed

Brazil Scenario Review

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Recession deepens, reforms needed

marzo 10, 2016

The ongoing fiscal/political problems would maintain the economy under pressure and block the approval of reforms and other measures.

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

We currently face two possibilities. Under the most likely scenario, the ongoing fiscal/political problems would maintain the economy under pressure and block the approval of reforms and other measures needed for a recovery. More meaningful changes would come only in the medium term. However, the longer the economic difficulties persist and deepen, the greater the likelihood of movements that could bring forward a scenario of adjustments and reforms.

We are projecting that GDP will shrink 4.0% in 2016. In 2017, we expect a 0.3% rise in GDP. Unemployment is likely to continue rising, to 13% at the end of the year and 13.4% in 2017.  

Fiscal challenges remain. The primary surplus rose in January, but this was because of temporary factors. We have adjusted our primary result forecast to -1.6% from -1.5% in 2016 and to -2.1% from -2.0% in 2017. 

The external accounts adjustment has been more intense than expected. We now see a current-account surplus as early as next year, reducing pressure on exchange rates. We have revised our exchange-rate forecast to 4.35 reais per dollar at the end of 2016 (previously 4.50) and to 4.50 reais per dollar at the end of 2017 (previously 4.75). 

We have slightly increased this year’s projection for market-price inflation (to 7.3% from 7.0%), but reduced the outlook for regulated-price inflation (to 6.2% from 7.0%). As a consequence, our headline-inflation forecasts for this year remain unchanged, at 7.0% for 2016 and 5.0% for 2017.  

Still-high inflation readings suggest that the BCB will hold the Selic benchmark rate at 14.25% for a while. However, inflation is expected to fall gradually, encouraging the BCB to start cutting interest rates in the second half of the year, to 12.75% in 2016 and 10.50% in 2017.

Two paths ahead 

The most likely scenario is one of continuing fiscal/political difficulties. In this case, adjustments and reforms would come only in the medium term. The recession has deepened. Despite the temporarily positive fiscal results in January, we have worsened our primary deficit forecast, after incorporating new expenditure projections. The current account results have been a welcome surprise, justifying our projections of a surplus being reached as early as 2017 and our revision for a more appreciated Brazilian real for this year and the next. Regarding inflation, we have maintained our IPCA projections, but some variables have changed: pressure on industrialized prices has been stronger than expected, but regulated-price inflation has slowed even further. Given the depth of the recession, we believe that a cycle of interest-rate cuts is likely to come in the second half of 2016. 

However, as difficulties grow, there is an increasing chance of changes that would anticipate a new scenario. In this scenario, adjustments and reforms could materialize sooner than expected. The better outlook would lower country risk, reduce financing costs for businesses, attract more capital inflows and support the appreciation of the Brazilian real. In turn, a stronger currency would help push down inflation, allowing for a more rapid – and significant – cut in interest rates. Fewer uncertainties and looser monetary policy would drive a faster economic recovery. For now, this is not our most likely scenario, but odds have increased.

Activity: expected decline, negative outlook

GDP shrank 3.8% in 2015. GDP shrank 1.4% QoQ in 2015Q4. Although slightly better than our projections (-1.8%), there is a persistent weakness, as the GDP fell for the fourth consecutive quarter. On the demand side, the main focus was the widespread reduction in domestic demand components. Gross fixed-capital formation declined 4.9%, in its tenth consecutive contraction. Family consumption fell 1.3%, its fourth consecutive loss. Public administration consumption recorded its biggest fall since 2008, shrinking 2.9%. Inventories made a positive contribution of 0.1 p.p. (based on our calculations), compared with our projection of -0.5 p.p. This suggests further output adjustments ahead. Foreign trade also contributed positively, as imports (-5.9%) fell faster than exports (-0.4%). On the supply side, the service sector has slowed even further; this was its fourth consecutive slowdown. Six out of seven service activities shrank. As a result, the carry over for 2016 GDP has been adjusted to -2.5%. In other words, if GDP remains stable at its current level, 2016 will see a 2.5% reduction in economic activity from 2015.

Vehicle production fell 12% in February. Vehicles represent 10% of all industrial output and are likely to contribute toward a monthly fall in production, after January’s positive surprise. The level of capacity utilization fell to its lowest level since 2001, supporting this outlook.  

Confidence stabilizes at historical lows. Confidence decreased in February, offsetting the result in the previous month. Among all major economic sectors, only the retail sector reported an increase in confidence. Industrial confidence retreated 2.0%, approaching historical lows. In general, business and consumer confidence remain low, though apparently stable. Our diffusion index – based on a wide dataset, including business and consumer confidence, retail sales and credit demand – continues to suggest some stability in the second half of the year.

Coincident indicators suggest another GDP contraction in the first quarter of 2016. We believe that this trend may continue in the second quarter before somewhat stabilizing in the second half. Fundamentals suggest that a rise in external demand is unlikely to offset shrinking domestic demand.

Based on this scenario, we are maintaining our projections of a 4.0% drop in 2016 GDP and a slight 0.3% increase in 2017. 

Job market deterioration is likely to persist. Once again, the net job creation (CAGED) was negative in January. We calculate that 90 thousand jobs were lost (our seasonal adjustment). The formal labor market continues to face its most difficult period since 1995.

The lower participation rate prevented a rise in the unemployment rate in the six metro regions included in the Monthly Job Survey (PME-IBGE). The “PNAD continua” survey, a nationwide assessment, however, reported a slight rise in participation. Weak GDP growth this year tends to lead to further deterioration in the labor market. We expect the national employment rate, which probably ended 2015 at 10.0%, to reach 13.0% at the end of 2016 and 13.4% in 2017. 

Fiscal: challenges remain

January’s consolidated public-sector primary surplus of BRL 27.9 billion benefited from temporary factors. January is a seasonally favorable month and saw BRL 11 billion in one-off revenues from hydro-plant auctions and a continued and significant surplus from regional governments (BRL 8 billion). There was also a methodological discrepancy between Treasury and central bank calculations involving BRL 5 billion in interest-rate equalization expenditures (the Treasury calculates its figures every six months, in January and July, while the central bank calculates its figures monthly). The central bank announced that this difference, which refers to the second half of 2015, will gradually fall to zero in July, when a new discrepancy cycle begins for expenditure in the first half of 2016. We believe that the three factors that boosted January’s primary surplus are unlikely to reappear in coming months, therefore the January figures have not changed our expectations of a challenging outlook for 2016. 

We have adjusted our primary result forecast to -1.6% from -1.5% in 2016, and to -2.1% from -2.0% in 2017. This review reflects the inclusion of additional spending on health and priority projects that were announced. Rising mandatory expenditure and falling revenues continue to put pressure on fiscal results. We expect the primary result to represent -1.4% of GDP for the central government and -0.2% for regional governments in 2016.

Public debt and nominal deficit maintained their upward trend in January. The government’s overall gross debt increased to 67.0% in January (from 66.2% of GDP in December), while net public sector debt decreased to 35.6% of GDP (36.0% in December). The nominal deficit rose from 10.3% to 10.8% of GDP (and remained stable at 8.8% of GDP, excluding expenses such as currency swaps). Interest-rate expenses remain under pressure, reflecting the larger debt and higher average rates in 2016, compared with last year. We forecast that gross debt will reach 73% in 2016 and 79% in 2017, with net debt rising to 42% in 2016 and 48% in 2017. We expect a nominal deficit of 9.5% of GDP in 2016, with interest expenditures (excluding swap results) representing 7.8% of GDP.

Current-account surplus in 2017

The trade balance recorded a USD 4.0 billion surplus YTD in February, the best result for this period since 2008. Imports continue to fall, but exports started to rise. We have been emphasizing that, historically, exports take longer to react to currency depreciation than imports. However, the competitiveness arising from the BRL depreciation in recent years is starting to have a clearer effect on several sectors’ exports, particularly in manufactured goods, which rose 31% MoM/sa in February. 

Current-account figures also display favorable results. This improvement results from both currency depreciation and shrinking activity. The current account deficit 3-month moving average (annualized and seasonally adjusted) stood at USD 15 billion in January 2016, and is rapidly approaching zero. In the capital account, direct investment in Brazil has shown some resilience and continues to more than offset the entire current-account deficit. However, typically more volatile flows (like foreign investment in fixed income and equities) continue to contract.

We improved our forecasts for external accounts for 2016 and 2017. We have increased our trade surplus forecast for 2016 to USD 50 billion from USD 42 billion and to USD 60 billion from USD 56 billion for 2017. We are expecting a lower current-account deficit in 2016 (USD 10 billion instead of USD 21 billion) and a current-account surplus in 2017 (USD 5 billion compared with a zero balance).

We have revised our exchange-rate forecast to BRL 4.35 per dollar at the end of 2016 (previously BRL 4.50) and BRL 4.50 per dollar at the end of 2017 (previously BRL 4.75). There is no need for further BRL depreciation in real terms (relative to last year) to adjust the balance of payments. The risk of further depreciation over the next few years reflects current economic and political uncertainties. Domestically, the news flow remains negative. This month Brazil was downgraded by Standard and Poor’s (from BB+ to BB) and Moody’s (from Baa3 to Ba2). Both agencies retained their negative outlook and explained that the downgrades were driven by increasing political and economic challenges. 

Inflation on a downward trend 

The IPCA index climbed 0.90% in February, below our forecast (0.95%) and the median of market estimates (0.98%). The 12-month rate retreated to 10.36%, from 10.71% in January. Food and education provided the largest upward contributions. Prices for private services rose less than we anticipated and represented the biggest deviation from our forecast. Our preliminary forecast for the IPCA in March stands at 0.48%, with the year-over-year change slipping to 9.4%.

We project a 2.7% increase for the IPCA in the first-quarter (compared with 3.8% in 2015), with the 12-month rate dropping to 9.4% (10.7% at end 2015). During this period, the main upward contributions will come from food (particularly fresh fruits and vegetables affected by El Niño), increasing public transport costs in several state capitals, tax hikes and school-fee increases. On the other side, electricity bills, which suffered a substantial 36% increase in the first quarter of 2015, will fall 3% as dependence on thermal power plants is reduced. This means the rise in regulated prices should slow to 1,8% during the first quarter, compared with 8.5% over the same period in 2015, reducing inflation by 1.6 p.p. for this period. For the rest of the year, we forecast a 1.3% increase for the IPCA in the second-quarter (2.3% in 2015), followed by 1.0% in the third quarter (1.4% in 2015) and 1.8% in the fourth quarter (2.8% in 2015).

We increased our market-price inflation forecast to 7.3% from 7.0%, following higher-than-expected increases on industrial prices. We have increased our industrial prices forecast for 2016 to 6.3% (6.2% in 2015) from 5.5%. Indeed, the rise in industrial prices has proven to be stronger than previously estimated, possibly because of cost transfers and tax increases. Looking at other components, we reduced slightly our forecast for service inflation to 7.3% from 7.4% (compared with 8.1% in 2015), with food at home increasing 8.5% (12.9% in 2015). Despite service inflation showing greater resistance last year, we continue to forecast worsening conditions on the job market and in the real estate sector, which are facing a particularly difficult time. This is likely to have a moderating effect on wage and rent costs and push down service inflation in the months ahead. We already notice a slightly lower increase in major service-sector price components, such as residential rents, condominium costs, personal services and even school fees, which rose less than expected at the start of the year. 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 of last year, should diminish in the second half of 2016 and relieve inflationary pressure on these 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 occurred in the last two months of the year. Alongside predictions of better weather for crops, expectations of a smaller increase in the exchange rate and more manageable fuel and energy costs should help to hold back food-price increases throughout the year.

We have reduced our forecast for regulated-price inflation to 6.2% from 7.0%, due to lower electricity- and gasoline-price increases. Our electricity price projections have been revised down from no change to a 3% drop, after the government announced its decision to remove electricity-bill surcharges (green flag) starting in April as dependence on thermal energy plants, which are more expensive to run, diminishes. Our previous forecast was based on a yellow-flag scenario, which involves an additional BRL 1.50 charge for each 100 kWh (kilowatt hour) consumed. Less pressure from components that drove 2015 costs up will help reduce electricity prices this year, after last year’s 51% increase, particularly: the Itaipu plant 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 as dependence on thermal plants falls. We have also reviewed our gasoline-price projection, forecasting a 1% increase instead of 4.5%, as our scenario no longer suggests that refinery prices will increase this year. We are working on the assumption of no increase in the Contribution for Intervention in the Economic Domain (Contribuição de Intervenção no Domínio Econômico – Cide) that applies to gasoline, which remains an inflationary risk factor. Each BRL 0.10 that the Cide rises (per liter of gasoline) has an impact of approximately 0.20 p.p. on official inflation figures. On the other hand, we have revised our price projections upwards to 10% from 8% for medicines, to 14% from 12% for health plans, and to 10% from 9.5% for urban bus fares.

In sum, we maintain our forecast that inflation will retreat to 7% in 2016.

Fiscal issues pose a major risk for inflation. Worsening public accounts could cause an even more intense and prolonged realignment of relative prices than initially stated in our inflation projections. Inflation could be passed on via further exchange-rate depreciation due to a rise in risk premiums, further tax hikes and/or increases in regulated prices, or a worsening outlook for inflation expectations.

However, weaker economic activity could contribute toward a larger inflation retreat during 2016. We believe that the significant economic slowdown 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 repercussions of tax increases and adverse weather conditions) lose force or could even be reversed, this would magnify the trend.

We forecast 5% IPCA inflation for 2017. Next year’s drop in inflation will reflect the dissipation of relative price increases (regulated prices and exchange rates), less inflationary inertia and the impact of continued weakness in economic activity, with no clear signs of a recovery.

Monetary policy: stable interest rates, for now

The scenario for monetary policy remains challenging, leading the Brazilian Central Bank (BCB) to hold interest rates at 14.25%.

On the one hand, inflation remains above the upper limit of the target range.

On the other hand, the recession continues. Fundamentals point towards further contraction in aggregate demand. Confidence indicators have stabilized, but remain depressed. The unemployment rate is likely to continue rising this year and next.

Interest rates are expected to remain stable in the short term. In its official statements (Copom minutes and recent comments from directors), the BCB has been signaling that the Selic rate will remain stable, for now.   

However, as the scenario evolves, we believe that the Copom will start an easing cycle. Weak demand and the end of effects from relative price adjustment (regulated prices and exchange rates) leave room for a gradual decline in inflation.

The external scenario also points toward an easier monetary policy in Brazil. The expansionary trend in global monetary policy, particularly in advanced economies, reinforces the likelihood of exchange-rate stability in Brazil and supports the outlook for interest-rate cuts in the second half of 2016.

In our baseline scenario, we expect the Selic benchmark rate to fall to 12.75% by the end of the year, with three 0.50 p.p. cuts starting in August. The easing cycle is expected to continue in 2017, with interest rates falling to 10.50%. 

What happens if the scenario of adjustments (and reforms) is brought forward?  

Adjustments and reforms should tackle fiscal problems and help boost confidence in the Brazilian economy.  

However, even in this scenario, the country would still live with short-term primary deficits, albeit on a downward trend. Public debt would still increase, but at lower rates.

Changes in the medium- and long-term fiscal outlook would reduce risk and uncertainty in Brazil, leading to a faster economic recovery through various channels: among other factors, greater predictability should support a rise in spending and investment, while lower country risk would reduce the cost of corporate financing.

There would be pressure for currency appreciation, which would probably be accompanied by reductions in the stock of BCB’s currency swaps, to avoid risking the recent balance-of-payments improvement. The current level of the BRL is sufficient to drive a sustainable improvement in external accounts. The economy would present small current-account deficits but no financing problems.

Inflation would fall more rapidly, which would allow faster and more aggressive interest-rate cuts. Inflation would fall due to the impact from exchange rates and better anchored expectations as the fiscal situation improves. In this case, it would be plausible for the Selic benchmark rate to return to single-figure territory in 2017.

Fewer uncertainties and looser monetary policy would bring about a faster economic recovery over the next few years.

For now, this is not our most likely scenario, but odds have increased.


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


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