Itaú BBA - The Reforms Begin

Brazil Scenario Review

< Volver

The Reforms Begin

octubre 10, 2016

Approval of fiscal reforms is critical to pave the way for a monetary easing cycle and for a sustainable economic recovery.

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

In October, the Lower House will vote on the constitutional amendment of the spending cap. The government will then send a Social Security reform bill to Congress. We have maintained our forecast for a primary balance of -2.6% of GDP in 2016 and -2.2% of GDP in 2017 – however, short-term results may be revised depending on the outcome of the offshore-capital registration program.

Leading indicators suggest positive GDP change in the fourth quarter. Despite August’s drop in industrial output, we should continue to see a rise in output over the next several months, consistent with a cyclical inventory adjustment. Looking ahead, we expect to see monetary policy easing and fiscal reforms driving more-robust economic growth. We are maintaining our forecast of a 3.2% drop in 2016 GDP and a 2.0% increase in 2017. Turning to the labor market, we continue to forecast unemployment of 12.5% by the end of this year and 12.2% in December 2017 – we expect unemployment to reach a cyclical peak in the second quarter of next year.

We have left our exchange-rate forecast at 3.25 reais per dollar for the end of 2016 and 3.50 reais per dollar for the end of 2017. External accounts adjustment is losing traction, but the balance of payments remains comfortable at this exchange rate.

We have reduced our IPCA inflation forecast for this year, to 7.0% from 7.2%, based on more favorable results at the margin. Lower food prices in September reinforce our assessment of moderate increases through to the end of the year. We continue to forecast that inflation will drop to 4.8% in 2017, with market prices rising 4.7% and regulated prices increasing 5.0%.

The economic outlook appears to have matured to the point where monetary easing can begin. Central bank inflation forecasts are consistent with this scenario. We have maintained our scenario of a total 0.75 pp cut in the benchmark Selic rate this year, beginning with a 0.25 pp reduction in October. We are forecasting that the cycle will continue in 2017 until the Selic falls to 10.00%.

Voting on reforms likely to begin in October

From October onward, a number of uncertainty factors surrounding the domestic economy is likely to dissipate. During the month, voting on the fiscal reforms will begin. Additionally, the central bank will probably start a cycle of interest-rate cuts. Finally, inflation is likely to show clear signs of decelerating.

The Lower House is set to vote on the constitutional-amendment bill that sets a cap on public spending increases this month. This bill, alongside Social Security reforms, has the potential to reverse the past 20-year upward trend in government spending. It is critically important in order to guarantee a sustainable public-debt curve.

If the bill is approved, the central bank is likely to start what, in our view, will be a long cycle of interest-rate cuts. We believe that the main short-term inflation risk is the possibility of a sharp BRL depreciation caused by a credibility shock in the domestic economy. Approval for the fiscal adjustments would significantly mitigate this risk, allowing the central bank to take a more flexible approach to monetary policy.

The start of the cycle of interest-rate cuts is compatible with the drop in inflation. Food prices, which had been putting pressure on inflation until recently, are likely to contribute toward further inflation slowdown from this month.

Low interest rates are a necessary condition for a future recovery in activity. We are already seeing signs – albeit volatile and incipient ones – of a recovery, but the fundamentals suggest a return to growth from the last quarter of this year.

We believe that the BRL at current levels is compatible with long-term balance-of-payments equilibrium (if the reforms are approved). However, in the short term, we may see a temporary appreciation of the BRL from currency flows linked to the repatriation of offshore funds. We believe that a possible appreciation of the BRL resulting from stronger currency flows than expected would not be sustainable for long.

In sum: throughout the month, we expect to see less uncertainty and the beginning of a new cycle for various macroeconomic variables. However, approval for the reforms is critical if this improvement is to be sustainable.

Beginning the reforms: the Lower House will vote on the spending cap in October

In October, the Lower House will vote on the constitutional amendment of the spending cap. If approved by the Lower House after two rounds of voting, the bill restricting overall growth of primary federal expenditure to the previous year’s inflation will move to the Senate, where it will be voted on before the end of the year. 

If the reform is approved, it will represent a structural change in Brazilian policymaking. Public spending has increased in real terms almost every year for the past 20 years (see graph). Under the cap, if any expenditure rises in real terms, it will have to be offset with a real-term reduction of other expenditures. By creating the conditions for a more benign trend in public spending, the reform would gradually reverse the structural fiscal imbalance.

The government has signaled that it will send a Social Security reform bill to Congress within the next few months to ensure that the spending cap remains feasible in the years ahead. Social Security expenditure represents 45% of the federal government’s total spending (8.5% of GDP) and will increase in real terms over the next several years because of population is aging. A Social Security reform setting a minimum retirement age of 65, as the government has signaled, would bring the federal budget into line with Brazil’s new demographic situation. It would also reduce the need for significant cuts to the rest of the budget and support the spending-cap compliance for a longer period.

We believe that, if approved, these measures will be an important step toward stabilizing public debt in the medium term. Even with the reforms, primary results are likely to remain in negative territory for several more years. However, the reforms will create conditions for a return to growth and a reduction in interest rates, supporting efforts to stabilize the debt in the future – more specifically, we believe that public debt will peak at around 80% of GDP in 2020.

Fiscal results continue their downward trend as long as the reforms remain unapproved by Congress. In August, the 12-month cumulative primary deficit reached 2.8% of GDP (see graph). The deficit will remain above the fiscal targets of -2.6% of GDP until the end of the year because of the extraordinary payment of 0.9% of GDP in delayed expenditure that was carried over in December 2015. With a high nominal deficit (9.6% of GDP for the 12 months to August), gross debt remains high. It reached 70.1% of GDP in August, compared with 66% of GDP at the end of 2015 and 57% of GDP in 2014.

We have maintained our forecast for a primary result representing -2.6% of GDP in 2016 (BRL -164 billion) and -2.2% of GDP in 2017 (BRL -143 billion), in line with government targets. In 2016, we expect extraordinary revenues of BRL 20 billion (0.3% of GDP) from the so-called capital repatriation program. In 2017, we expect extraordinary revenues of BRL 37 billion (0.6% of GDP) from the sale of assets and concessions, in line with the government’s proposed budget.

Fundamentals continue to support growth

The upward trend in industrial output is likely to continue despite August’s contraction. Industrial output fell 3.8% mom/sa in August. The result was widespread, with contractions in three out of four main economic categories. Broken down by activities, vehicle manufacturing and the food industry stood out (their contribution to the aggregate result was about -2 pp).

Despite this, the fundamentals continue to suggest that output will increase as we move ahead.

Growth diffusion continues to indicate fourth-quarter growth. 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 – has been highly volatile in recent months, which is a typical reaction when the economy reaches an inflection point. However, the trend is upward. In August, diffusion is likely to reach around 54% (three-month moving average). This indicator continues to suggest that GDP will rise in the fourth quarter of this year.

Confidence rises, inventories fall. In September, confidence continued its upward trend, reflected in the main sectors of economic activity and among consumers. Over the past three months, confidence indicators have risen at least 5%. In industry, the level of installed capacity utilization rose 0.9 pp in September, showing a recovery compared with the August result (-0.5 pp) and achieving the highest level since December last year. Additionally, sector inventories have fallen sharply. Both results suggest that industrial output will increase in September, following the trend toward an industrial recovery.

We have maintained our GDP forecasts for 2016 and 2017. We expect GDP to start rising again in the fourth quarter. Leading indicators suggest that GDP will also rise in the first quarter of next year, in line with our scenario. Looking ahead, we expect to see monetary policy easing and fiscal reforms driving more robust economic growth. We are therefore maintaining our forecast for a 3.2% drop in 2016 GDP and GDP growth of 2.0% for 2017.

Decline in the formal labor market. In August, a net 33 thousand formal jobs were destroyed (CAGED). Without accounting for seasonal effects, the contraction affected 103,000 jobs, and the three-month moving average remained practically stable (down from -104,000 to -103,000). Destruction was widespread, affecting all activities. Industry, however, which saw the loss of 15,000 jobs in August (three-month moving average), continues to see a slowdown in job destruction.

Persistently high unemployment. In August, the national unemployment rate rose to 11.8%. Without accounting for seasonal effects, the rate of unemployment rose from 11.4% to 11.7% (our adjustment), the 21st consecutive increase. The labor-market reaction lags behind economic activity, which means that unemployment is likely to remain high through the second quarter of next year. We have maintained our unemployment forecast of 12.5% for year-end 2016 and 12.2% for December 2017.

Exchange-rate stability amid the uncertainty


The exchange rate traded around 3.25 reais per dollar through most of September. Elsewhere, the Fed signaled that the process of raising rates will occur gradually, boosting stocks and currencies around the world. Domestically, the Brazilian Central Bank reduced its reverse-swap offerings (from 10,000 contracts/day to 5,000 contracts/day) during the month, easing pressure on the currency.

We have maintained our exchange-rate forecast of 3.25 reais per dollar at the end of 2016 and 3.50 reais per dollar at the end of 2017. These forecasts are in line with growing current-account deficits over the next several years, albeit at sustainable levels.

Approval for the fiscal reforms and gradual U.S. rate hikes are needed to avoid BRL depreciation. However, there is uncertainty regarding the volume of dollars that will be repatriated and the possible effect on the exchange rate. The BRL could appreciate more than we have forecast if a significant volume of funds is repatriated.

External accounts are stabilising, after having improved for several months. Improved activity and, to a lesser extent, currency appreciation have contributed to more-modest results in recent months, but this will not hurt the sustainability of the external accounts. On the financing side, there were strong direct-investment flows into Brazil during September after the weak inflows of July (caused by a specific banking-sector transaction). However, portfolio flows (fixed income and stocks) remain negative for the year.

We have maintained our external account estimates for the next two years. We are forecasting a USD 47 billion trade surplus in 2016 and USD 42 billion surplus in 2017. For the current account, we are forecasting a USD 21 billion deficit in 2016 and a USD 33 billion deficit in 2017.

Inflation improves at the margin

We have trimmed our IPCA inflation forecast for this year, to 7.0% from 7.2%, based on more favorable results at the margin. We are forecasting a 7.4% increase in market prices (compared with 8.5% in 2015). Looking at the components in the market-prices, we estimate an increase of 11.4% for food at home (12.9% in 2015); 5.2% for industrial prices (6.2% in 2015); and 7.0% for services (8.1% in 2015). We are forecasting a 5.8% increase in regulated prices (compared with 18.1% in 2015).

Lower food prices last month reinforce our assessment of moderate increases through to the end of the year. We estimate a 2.4% increase in food prices at home in the second half of the year, after rising 5.4% over the same period last year and 8.8% in the first half of this year. For this period, we are forecasting a drop in prices for fresh fruit and vegetables, beans and milk. On the other hand, we are forecasting a price correction for beef within the next few months, reflecting typical seasonal pressures.

The fiscal issue remains a major risk to the inflation scenario. Future attempts to increase government revenues could lead to fresh tax increases and/or larger increases in regulated prices. However, progress on fiscal reforms could improve the outlook for inflation, either through exchange rates and inflation expectations, or through switching from the current expansionary policies to neutral or even contractionary fiscal policies.

The high level of idle capacity in the economy is also likely to drive down inflation further as we move ahead. Although subject to uncertainty and errors in measurement, the negative output gap could lead to faster market-price disinflation over the next few months, particularly for industrial products and services.

We continue to forecast that inflation will fall to 4.8% in 2017. Next year’s drop in inflation will reflect the dissipating effects from relative price increases (regulated prices and exchange rates), less inflationary inertia, a brighter outlook for inflation, more favorable weather conditions and the high level of idle capacity still seen throughout the economy. If the reversal of some food-price increases is larger than expected, this could represent a risk of lower inflation for 2017.  

On a disaggregated basis, we are forecasting a 4.7% rise in market prices and a 5.0% increase in regulated prices for 2017. Among market prices, we are forecasting a 4.0% increase for food at home, as the exchange rate is expected to settle and weather conditions are likely to be favorable as the effects of El Niño taper off. In this scenario, a considerable portion of the price increases for certain products (such as milk and beans) is likely to be reversed during the coming year. In the other segments, we are forecasting a 5.5% increase in service prices and a 4.0% increase in industrial prices. For regulated prices, we have reduced our projected increase for gasoline prices from a 4% increase to zero, but we have increased our forecasted increase for electricity prices from 4% to 7%. As far as gasoline is concerned, it is our belief that the risks of a tax increase and a drop in refinery prices appear to be evenly balanced.

An improvement in inflation expectations reinforces the scenario of falling inflation. According to the Focus survey, inflation expectations for 2016 and 2017 retreated somewhat during the month. Median expectations for 2018 and further ahead are at the center of the target (4.5%), reflecting the increasing conviction of economists that the central bank will take steps to ensure the IPCA will converge to the target over longer horizons. Forecasts for 2017 remain slightly above 5%, based on strong inflationary inertia inherited from previous years and uncertainties clouding the fiscal issue, but this figure could still fall further as we move ahead.

Monetary policy – laying the groundwork for interest rate caps

The economic outlook appears to have matured to the point where monetary easing can begin. Economic activity remains in recession. Current inflation has been showing a much clearer downward trend, reflecting weaker demand, the completion of relative price shifts and the end of the food-price shock. Short-term inflation expectations continue to converge, while longer-term expectations are already at the target.

Central bank forecasts are consistent with a cycle of interest-rate cuts beginning shortly. In two of the four scenarios presented in the most recent Inflation Report, inflation forecasts are at the 4.5% target for 2017 and, in three scenarios, forecasts are at or below the target for 2018. Given these forecasts, we can conclude that a central bank operating under an inflation-target regime is on the verge of monetary-policy easing.

According to the CB, the start of the cycle will depend on three conditions: that short-term price shocks abate, progress on fiscal reforms/adjustments and that service price disinflation proceeds at an “adequate” speed. The food-price shock is already dissipating, and although there is still uncertainty, progress is being made on fiscal adjustment. Service price disinflation is happening, albeit slowly, which is usual for this sector in Brazil.

The most likely scenario is a cycle starting with a cautious 0.25 pp rate cut in October. The three conditions for beginning the cycle of interest rate cuts have materialized, but there are still uncertainties over congressional approval of fiscal reforms and (from the CB’s standpoint) service disinflation. We believe that as these uncertainties dissipate, the CB will choose to implement larger cuts of 0.50 pp.

The October interest-rate cut is not entirely guaranteed, as the authorities continue to monitor the progress of the fiscal adjustment. Voting on the constitutional-amendment proposing a cap on public-spending growth is likely to take place during the first few weeks of October. A reversal could jeopardise the monetary easing timetable.

We have maintained our scenario calling for the total 0.75 pp cut in the benchmark Selic rate this year, beginning with a 0.25 pp move in October. We are forecasting that the cycle will continue in 2017 at a rate of 0.50 pp per meeting, until the Selic falls to 10.00%.


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


< Volver