Itaú BBA - The adjustment has started and it won’t be easy

Brazil Scenario Review

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The adjustment has started and it won’t be easy

enero 16, 2015

Adjustments in fiscal policy and regulated prices will be deeper.

• The government has started the process of making the needed adjustments, announcing measures to improve the fiscal picture and reduce lags in regulated prices. These measures are necessary and welcome. The adjustments are likely to be deeper than we anticipated, in light of the situation met by the government. With the slowdown in economic activity and still-pending risks of electricity and water shortages in the Southeast, the coming months will be challenging. 

• Activity indicators once again deteriorated at the margin, and we revised our growth forecast for 4Q14 downward to 0.3% from 0.5%. Worsening current indicators, low confidence levels and the need for deeper adjustments in fiscal policies and regulated prices led us to cut our GDP growth forecast for 2015 to 0.2% from 0.8%. In 2016, we expect a still-moderate rebound in growth to 1.6%.

• The outlook for low rainfall levels in the Southeast and Northeast in January intensified the risks of electricity rationing and further restrictions on the water supply. With low rainfall levels in December and January, even if rainfalls normalize from February onwards, reservoirs for hydropower dams will end the rainy season at lower levels than last year.

• We revised our estimate for inflation this year upward to 6.9% from 6.5%, due to greater pressure from regulated prices. We revised our forecast for the change in regulated prices to 9.8% from 7.5%, given increases in electricity tariffs and urban bus fares. For market-set prices, we have slightly reduced our forecast to 6.1% from 6.2%, in the face of signs pointing to weaker activity and a larger-than-expected increase in the unemployment rate.

Inflation should be under intense pressure early in the year, with the IPCA consumer price index rising 1.1% in January, and 7.0% yoy, driven by higher prices for electricity (following the introduction of the new tariff flag system), urban bus fares (hikes in the largest cities), food (seasonal pressure) and new automobiles (due to a recomposition of the tax on industrialized products – IPI). We reduced our forecast for the IPCA in 2016 to 5.7% from 6.0%, contemplating lower increases for market-set and regulated prices as well. 

• Meeting the target for the primary budget surplus this year will require greater efforts by the new economic team, as the starting point is more unfavorable. We reduced our estimate for the primary surplus in 2014 to -0.2% of GDP (0.2% previously) and maintained our forecast for 2015 at 1.2% of GDP.

• We expect the benchmark Selic interest rate to reach 12.50%, after a 50-bp hike in January and a final increase of 25 bps in March. In 2016, the Selic rate will probably remain at 12.50%, to ensure a downward path for inflation. We also anticipate gradual increases in the long-term interest rate known as TJLP.

• We changed our year-end forecasts for the exchange rate to 2.90 reais per U.S. dollar in 2015 and 3.00 in 2016. The trade balance posted a deficit in 2014. Falling commodity prices and lower sales of manufactured items hurt exports. In the next years, the outlook for still-low commodity prices requires more currency depreciation for the current account deficit to enter a more sustainable path in the long run.

It is adjustment time for the Brazilian economy

Adjustments in fiscal policy and regulated prices will be deeper. With the latest bout of fiscal deterioration and higher energy costs, these measures should be deeper than we assumed in our previous scenario review. These are needed and welcome measures, which reduce risks of deterioration in the fiscal situation. 

The economy is still frail. After a brief improvement following the Football World Cup, economic activity slowed down again, and we already see signs of weakening in the labor market. Consumer spending should continue to disappoint.

We will know in the next few months if the Southeast region will have the needed rainfall amounts to avoid electricity rationing and improve water supply. The rainy season usually starts in October, peaks in February, and lasts until April. Hence, reservoir levels in late April determine the system’s capacity to generate power and supply water until the next rainy season.

Deteriorating economic activity in the last quarter and greater uncertainties going forward

Recent data suggest that activity is decelerating at the margin. In November, industrial output posted its sharpest decline since June 2014, as manufacturing production reached its lowest level since 2009. Our diffusion index (based on a broad dataset that includes business and consumer confidence indicators, retail sales and credit demand, among other variables) suggests a drop in economic activity in December. Coincident indicators for the industrial sector also suggest a retreat in the final month of 2014. The number of vehicles produced (according to national automakers association Anfavea) fell in December, and this segment represents nearly 10% of the industrial sector.

Domestic uncertainties are set to limit a rebound in confidence levels. Among the main economic activities, only entrepreneurs in the service sector expressed higher confidence in December, albeit at still-low levels, as is also the case in the other sectors. Confidence among industrial entrepreneurs fell again after two consecutive monthly increases. We believe that domestic uncertainties prevent a recovery in this indicator. Uncertainties involving the availability of and prices for electricity and water, as well as legal troubles involving investments by the government and state-owned companies, could cause projects to be postponed and revised, thus preventing a recovery in capital expenditures in the short term. Furthermore, growth in household spending will likely be curbed by the slowdown in the real wage bill and by low consumer confidence levels.

Meanwhile, a greater tightening in public expenditures also holds back expectations for growth in domestic demand. And notwithstanding some declines in recent months, inventories are still high and suggest further adjustments and impacts on output ahead.

We revised our forecasts for GDP growth downward to 0.2% (from 0.8%) in 2015 and to 1.6% (from 1.8%) in 2016. We observed deceleration in activity and thus cut our estimate for 4Q14 to 0.3% qoq/sa (from 0.5%). Hence, our forecast for 2014 as a whole now stands at 0.1% (0.2% previously).

With less-favorable fundamentals and statistical carryover, we reduced our estimate for GDP growth this year to 0.2%. We anticipate a moderate rebound in activity in 2016 to 1.6% (1.8% previously).

Upward trend in unemployment at the margin. The unemployment rate climbed to 5.2% in November from 4.7% in October, seasonally adjusted, driven by faster growth in the labor force than in employment. We continue to observe a reversal in the downward trend in the labor force. Looking ahead, deterioration in economic activity is set to keep job creation at low levels, triggering a faster increase in the unemployment rate this year. We thus revised our year-end forecast for the seasonally-adjusted unemployment rate upward to 6.0% from 5.7%.

The weakness in non-earmarked loans remained in November. The daily average of new non-earmarked loans increased 0.8% mom/sa in real terms. Total outstanding non-earmarked loans are still sliding in year-over-year terms, as the drop steepened to -1.7% from -1.5% in October in real terms. Year-over-year growth in earmarked credit decelerated to 13.3% from 13.9%. Hence, the year-over-year expansion in total outstanding loans slid to 4.9% in November from 5.3% in October, in real terms. Overall delinquency was stable, despite a drop in delinquency in non-earmarked loans to non-financial corporations, to 3.5% from 3.7%. Overall interest rates were stable, while spreads narrowed.

Deterioration in the balance of risks for electricity and water supply

Rainfall levels disappointed in December and ended below the historical average for that month. Rainfall levels weighted by hydropower-dam reservoirs stood at 90% of their historical average, so that Affluent Natural Energy (ANE) closed at 81.2% of its long-term average. The rainfall index in the Cantareira System, which is a key water supplier to the greater São Paulo metropolitan area, stood at 75% of its historical average.

Rainfall levels in January are set to be quite weak, and tend to worsen. Rainy formations have been restricted to the South region, at the most important moment for recovery in reservoir levels. Rainfall levels weighted by hydropower dams should be at just 70% of their historical average for the month (approximately 50% in the Southeast). Meanwhile, the expectation of rainfall in the basins which supply water to the São Paulo metro area is even worse.

The imbalance between regions worsens the problem for aggregate generation by hydropower dams. While rainfall levels are normal in the South and the ANE in the region is well above its long-term average, the worse-off regions (Southeast, Center-West and Northeast) are not getting enough rain. For instance, ANE normalization in the South would drive aggregate ANE (at 55% of its long-term average as of January 12) down to 45% of its long-term average, ceteris paribus. In our view, ANE normalization in the South will materialize regardless of rainfall volumes, due to the limited capacity of reservoirs in the region.

Higher electricity tariffs will likely contribute to reducing energy consumption. The government has recently signaled that the electricity sector costs will be passed on to the consumers’ electrical bill, which will likely lead to further price increases in 2015. Higher tariffs are likely to reduce the electricity consumption, partly offsetting the effects of low hydropower generation.

In a nutshell, the expectation of unfavorable rainfall levels in January materially increases the risks for electricity supply in 2015. Even assuming a return to normal rainfall levels starting in February, our base-case scenario assumes that, by April 30, aggregate reservoir levels will be lower than one year earlier.

If this unfavorable evolution continues and some kind of rationing action is needed, we expect the decline in electricity consumption to be less intense than in 2001, for the following reasons: 

- Interregional transmission lines and thermal power plants reduce the dependence on hydropower generation for a specific basin.

- Electricity consumption in 2015 is set to fall naturally due to modest economic growth, increases in regulated electricity tariffs and sustained high prices in the free market. This reduction in consumption should fully or partially replace the need for additional measures.

Low rainfall volumes also worsen the balance of risks for water supply in the São Paulo metro area. This deterioration is driven by an increase in the number of basins with low water levels and by the unfavorable evolution of the Cantareira System reservoirs.

The water-supply problem is no longer limited to the Cantareira. Some São Paulo neighborhoods that were previously supplied by this system went on to be served by other basins, allowing for lower outflows from the city’s main reservoir. However, this move increased outflows from other basins, expanding the area under risk of water shortages.

Despite smaller outflows from the Cantareira, its reservoirs continued to decline throughout the beginning of the rainy season. Recent evolution is similar to the previous rainy period. The already-low levels of its reservoirs, even after two extractions of the so-called dead volume, make these risks more serious.

We revised our forecast for the IPCA this year upward to 6.9% from 6.5%, but reduced our estimate for 2016 to 5.7% from 6.0%

The IPCA consumer price index climbed 0.78% in December, and 6.41% in the full year, up by 0.50 p.p. from 2013 (5.91%). Market-set prices rose 0.89% during the month and 6.7% during the year (7.3% in 2013), while regulated prices advanced 0.43% in December and 5.3% during the year (1.5% in 2013). The largest upward contribution for inflation in 2014 came from foodstuffs, up by 8.0% (8.5% in 2013), creating an impact of 1.97 p.p. (2.03 p.p. in 2013). Among foodstuffs, meats climbed 22%, causing the largest individual impact on the IPCA (0.55 p.p.). After that, the largest contributions came from housing, 1.27 p.p. (0.50 p.p. in 2013); personal expenses, 0.88 p.p. (0.87 p.p. in 2013); healthcare and personal care, 0.78 p.p. (0.77 p.p. in 2013); and transportation, 0.71 p.p. (0.64 p.p. in 2013). Compared with 2013, housing was the main area behind the hike in inflation, due to the adjustment in electricity tariffs (17.1%), which reversed the previous year’s decline (-15.7%), but was not enough to correct the lag in the cost for this item.

Our preliminary forecast for the IPCA in January stands at 1.12% (0.55% in January 2013), accelerating the year-over-year change to 7.0%. The biggest pressure on inflation in January will come from electricity tariffs (due to the adoption of the tariff flag system), urban bus fares (due to hikes in the largest state capitals) and food. On the other hand, airfares are set to drop in January, following a sharp increase in December. Our forecast for the IPCA in 1Q15 is 2.5%, vs. 2.2% one year ago.

For 2015, we raised our estimate for the IPCA to 6.9% from 6.5%, due to greater pressure from regulated prices. We now anticipate a 9.8% hike in regulated prices (7.5% previously), due to revised estimates for electricity tariffs (to 30% from 17%) and urban bus fares (to 11% from 8%). Regarding electricity, we incorporated into the tariffs the effects of new losses in the sector due to the price adjustment for Itaipu electricity, the deficit in the Energy Development Account (CDE) in 2014, and the end of government transfers to CDE. Our estimate for urban bus fares was revised following the announcement of higher-than-anticipated increases in fares in São Paulo and Rio de Janeiro. Our scenario for gasoline still assumes a hike in the tax known as CIDE from zero to BRL 0.14/liter, triggering a 7% increase in prices at the pump. Meanwhile, we do not expect any drop in gasoline prices at local refineries, despite the large premium over international prices.

We slightly reduced our call for market-set prices to 6.1% from 6.2%, due to signs of weaker activity and a sharper increase expected for the unemployment rate. For that reason, we reduced our estimate for private services to 7.0% from 7.2% (8.3% in 2014). Deceleration in service inflation will be driven by greater accommodation in the labor market and in the real estate sector, and ensuing moderation in wage and rent costs. Regarding food, we still assume a favorable scenario for agricultural supply, particularly grains, amid the outlook for plentiful crops and a recovery in global inventory levels. Tame grain prices in 2014 and 2015 should provide some relief in animal protein and wheat byproducts. Meat prices, which climbed more than 20% last year, are set to behave more benignly, rising less than 10%.

For 2016, our forecast for the IPCA was lowered to 5.7% from 6.0%, as we now expect smaller increases for market-set and regulated prices. Our estimate for market-set prices was reduced to 5.8% from 6.0%, given the outlook for weaker economic activity. Our call for regulated prices was revised downward to 5.5% from 6.0%.

The IGP-M general price index climbed 0.62% in December and 3.7% in 2014 (5.5% in 2013). The IPA-M producer price index – which has the largest weight in the IGP-M – rose just 2.1% (5.1% in 2013), as industrial prices advanced 1.6% and agricultural prices went up 3.6%. The largest downward contributions to the IPA came from iron ore and soybeans. Iron ore prices tumbled 38% and provided relief equivalent to 1.4 p.p. to the IGP-M in 2014, while soybean grains (down by 13%) and soy meal (down by 9%) shaved 0.6 p.p. off the index. On the other hand, the largest upward pressures on the IPA came from beef and coffee. The IPC-M consumer price index advanced 6.8% (5.5% in 2013), while the INCC-M construction cost index climbed 6.7% (8.1% in 2013).

Our forecast for the IGP-M this year remains at 5.3%. Breaking down by sub-index, we estimate increases of 4.5% for the IPA-M, 7.0% for the IPC-M and 6.5% for the INCC-M.

Copom: The extent of the fight against inflation

In December, the Central Bank’s Monetary Policy Committee (Copom) accelerated the pace of increases in the Selic to 50 bps, taking the benchmark interest rate to 11.75% p.a. 

In its 4Q14 Inflation Report, the Copom stated its intention to do “whatever it takes for inflation to enter a long declining period that will drive it to its 4.5% target in 2016.” The sentence was repeated by Central Bank Governor Alexandre Tombini when commenting on the IPCA reading for 2014.

Notwithstanding the Copom’s statement that it will do “whatever it takes” for inflation to reach 4.5% in 2016 (which, if taken literally, would require a more substantial adjustment in the Selic rate), we do not believe that the committee’s base case assumes a more intense or prolonged hiking cycle than we forecast at this moment. We expect an adjustment in interest rates that puts inflation on a downward path starting in 2016. In fact, estimates in the Inflation Report already show a downward path, nearing 4.5% in 2016. Additionally, the Copom revised its growth scenario downward for 2015.

The economic situation in early 2015 also suggests that the tightening cycle in interest rates will not last much longer. Fiscal adjustment measures announced by the government and weaker-than-expected activity figures — which led us to revise GDP growth forecasts for 2014 and 2015 — reinforce our call that the hiking cycle will probably not last much longer

Thus, we expect the benchmark Selic rate to reach 12.50%, after a 50-bp hike in January and a final increase of 25 bps in March. In 2016, the Selic will probably remain at 12.50% to ensure a downward path for inflation. 

Fiscal accounts: Reaching the target will require greater efforts

According to our calculations, the primary budget result ended 2014 with a deficit equal to -0.2% of GDP, intensifying the fiscal challenge for the coming years. The consolidated public sector posted a primary deficit of BRL 8.1 billion in November, disappointing market forecasts and our own. Between January and November 2014, the primary deficit totaled BRL 19.6 billion. Considering a primary surplus of BRL 7.1 billion in December (in line with that month’s positive seasonality), we forecast a primary balance of BRL -12.4 billion for the year, or -0.2% of GDP (our previous estimate was a surplus equal to 0.2% of GDP). The nominal deficit over 12 months reached 5.8% of GDP in November, almost twice that of 2013. The public sector’s net debt was stable at 36.2% between October and November, but gross debt continued to increase, rising to 63.0% of GDP from 62.4%.

We regard the starting point for the fiscal adjustment that begins in 2015 as more unfavorable. We do not see evidence that recent disappointing figures result from a widespread “clean-up” in delayed expenses. In November, the biggest surprises in relation to our call came from discretionary expenses (other administrative expenses and capital) and from the wide primary deficit posted by regional governments. Additionally, there were no expenses related to the CDE in November. The component that could be associated with some sort of clean-up of past moves was an expenditure related to precatório bonds (whose execution was delayed early this year). This bill totaled BRL 6.1 billion, while we had estimated BRL 4.1 billion.

The fiscal adjustment has already started, as several measures were announced. The government changed rules for granting labor benefits (unemployment aid and wage bonuses) and pension benefits (pension in case of death, aid for people with ill health), in order to correct distortions in these programs. The government also set a decree cutting some discretionary administrative expenses by 33% (in relation to the proposed budget for 2015), and there are also signs of fiscal adjustment among state governments. Top government officials announced that electricity subsidies will no longer be paid by the Treasury, a measure that should save about 9 billion reais (0.2% of GDP) per year. Furthermore, the hiking cycle has started for the long-term interest rate (TJLP) used as guidance in loans granted by state development bank BNDES, reducing the public sector’s net interest expenses. On the revenue side, IPI tax rates on passenger cars and furniture returned to past levels.

In our view, measures that were already announced and those yet to come – as well as significant spending control throughout the year – make it possible to attain the target for the primary budget surplus in 2015, of 1.2% of GDP. On the revenue side, in addition to the increase in the IPI tax, we also expect the CIDE tax to be hiked and the creation/reinstatement of other taxes or reversal of other tax cuts. On the expense side, in addition to measures already disclosed, we estimate a reduction in capital expenditures of approximately BRL 25 billion (0.5% of GDP), as well as a tighter control on discretionary administrative expenses. Finally, we foresee an improvement in the primary balance of regional governments, from near-zero in 2014 to a surplus of 0.2% of GDP in 2015. Hence, we maintain our forecast that the primary budget surplus will climb to 1.2% of GDP in 2015, emphasizing that the efforts to attain this target are greater than we previously anticipated, as the starting point is more unfavorable (primary deficit in 2014).

A trade deficit in 2014, but some recovery ahead

We changed our year-end forecasts for the exchange rate to 2.90 reais per U.S. dollar in 2015 (from 2.80) and 3.00 reais in 2016 (from 2.90). In addition to responding to external factors set to affect the local currency throughout 2015 (higher interest rates in the U.S. and lower commodity prices, as we have been pointing out for many months), the exchange rate will also contribute to an adjustment in external accounts. In order for the current account deficit to be reduced amid less favorable terms of trade, a weaker exchange rate discourages imports and makes Brazilian exports more attractive to buyers overseas and to its domestic producers.

Late last year, the Central Bank announced the extension of the FX swap program, which will be carried out at least until the end of March. The monetary authority announced daily offers of USD 100 million in FX swap contracts. In addition to reducing the program’s duration (renewal for three months, while previous renewals lasted six months), the Central Bank also reduced the amount offered daily from USD 200 million until December 31, 2014. The authority’s short position in these FX derivatives is now close to USD 110 billion (approximately 30% of its international reserves).

In 2014, the trade balance posted its first annual deficit since 2000. Exports fell sharply to USD 225 billion from USD 240 billion in the previous two years, dragged down by commodities and manufactured items. The slide in international commodity prices caused exports of basic goods to drop 3.1% from 2013, with the main negative contribution coming from iron ore, whose prices tumbled nearly 50% during the year. The decline in exports of manufactured products was even steeper (at -13.7%), due to the slide in shipments of passenger cars, which have Argentina as their main destination, as well as oil-drilling rigs, which added only  USD 2 billion to exports in 2014 (down from USD 7.7 billion in 2013). Imports totaled USD 229 billion and declined in all categories, but not enough to ensure a trade surplus in 2014. Hence, Brazil’s trade flow thinned significantly to USD 454 billion, from USD 482 billion.

The current account deficit over 12 months advanced to 4% of GDP in November from 3.8% in October. That month, the current account deficit stood at USD 9.3 billion, once again pressured by the trade deficit, which was the main negative highlight last year. In November, the deficit in the service account decreased due to the reduction in the international travel and equipment rentals deficits. For 2015, we anticipate stability in this account, as more spending on equipment rentals is offset by currency depreciation (which is set to curb the deficit related to international travelling) and by the reduction in the trade flow (set to curb the transportation deficit). In terms of funding, foreign direct investment (FDI) remains around 2.9% of GDP, but there were net outflows to the local capital markets (fixed income and stocks) in November, after eleven consecutive months of inflows. Due to the outlook for higher interest rates in the U.S., we expect smaller inflows to the local fixed income market this year.

We anticipate a recovery in the trade balance in 2015 and 2016. On one hand, a weaker currency and faster global growth will contribute to strengthen the trade balance. Due to still-moderate economic activity, we expect some restraint in imports, particularly purchases of capital goods and intermediary goods (normally used as industrial input). Additionally, the deficit in the oil and fuels account will shrink due to higher production of crude oil, higher refining capacity and falling international prices (which benefit Brazil in the short term, as the country is a net importer of these items). On the other hand, we foresee continuing frailty in major trading partners and price drops for some key commodities, such as iron ore, soybeans and sugar. These forces should produce trade surpluses of USD 6 billion in 2015 and USD 13 billion in 2016.

Our estimates for the current account deficit were maintained at USD 77 billion in 2015 and USD 71 billion in 2016. We continue to expect an improvement in external accounts, driven by a recovery in the trade balance in the next few years.

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