Itaú BBA - Rate hikes around the corner

Scenario Review - Chile

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Rate hikes around the corner

Outubro 5, 2015

Partial withdrawal of monetary stimulus amid a weaker economic recovery.

Please see the attached file for all graphs. 

• In a low-copper-price environment, we now expect Chile’s economy to expand by 2.0% this year (from 2.2% in our previous scenario) and record a modest recovery of 2.5% for 2016 (from 2.7% previously). In spite of weak growth, the weakening of the currency will keep inflation pressured for some time. We expect inflation to reach 4.8% by the end of the year, and to decelerate gradually to 3.5% by the close of next year.

• We see the exchange rate at 700 pesos to the dollar by the end of this year, broadly stable from the current levels. For the next year, some additional weakening is likely as the U.S. dollar continues to appreciate globally. Our 2016 year-end forecast is 715.

• A split central bank indicated in the last policy decision that it would withdraw part of the “sizable” monetary stimulus in the short term. We now expect the central bank to start a tightening cycle in October (with a 25-bp rate increase) and to deliver another 25-bp rate increase in November. Due to the negative surprises on activity, we expect no further hikes at least until the end of 2016.

• With the reform program advancing gradually, the government submitted the 2016 budget to congress. The Finance Minister indicated that the structural deficit will fall next year, but the government will not be able to meet the zero-structural-deficit target by 2018.

Bumpy economy

Activity indicators for the month of August surprised to the downside, led by weak mining and manufacturing. Most indicators declined at the margin, reaffirming that the expected activity recovery this year will be mild. As a result, the monthly GDP proxy (Imacec) contracted by 1.0% from July to August.

Mining output is being hampered by the low copper production, which hit its lowest mark since April 2013. Mining output in the quarter ending August with a contraction of 4.1% year over year, deteriorating from -0.1% year over year in 2Q15. Manufacturing decreased 1.4% year over year, ending two months of annual gains, negatively affected by metal-related manufacturing. Overall, the Industrial Production Index decreased 5.2% over twelve months and -1.8% in the quarter (from +0.1% in 2Q15), and will likely be the main drag on activity in 3Q15.

Private-consumption-related sectors are weakening. Retail sales rose 1.9% year over year (2.8% in July). Supermarket sales increased 0.2% year over year. Sequentially, retail sales also decelerated from 2Q15. Private consumption weakened in spite of a resilient labor market. The unemployment rate for the quarter ending in August came in at 6.5% – the unemployment rate has been stable in the narrow 6.5%-6.6% range recently. Employment growth accelerated to 2.3% year over year (1.8% in July).

Economic sentiment is still depressed, with no clear reversal sign in sight. Adimark’s consumer confidence remains entrenched in negative territory, reaching 33.9% in August (34.3% in July), the lowest confidence print since November 2008. Confidence is near historical minimums, failing to recover from the decline that started in 2014. Alternatively, Icare’s business confidence stood at 39.7 points in August (42.6 in the previous month), the lowest level since March 2009 and not much higher than the historical minimum reached in December 2008. Business confidence has now been in pessimistic territory for 17 consecutive months.

We now expect Chile’s economy to expand by 2.0% this year (2.2% previously) and 2.5% for 2016 (from 2.7%). With copper prices not expected to show a rebound, the economic recovery would come from some improvement in confidence as the government works on reducing uncertainty arising from its reform program. A still-expansionary monetary policy and a weaker currency may also help.

Low copper prices affect trade numbers

For the first time in 19 months, a trade deficit (although small) was recorded in August. The weaker trade-balance number is primarily due to disappointing mining exports. As a result, the rolling twelve-month trade balance came in at USD 7.6 billion in August, down from USD 7.9 billion as of 2Q15. Our own seasonal adjustment shows a larger deterioration in the trade balance at the margin, to USD 6.5 billion (3mma annualized) from USD 7.5 billion as of July. Even so, we still expect the current account to remain close to zero (-0.1% of GDP) for both this year and 2016.

We see the exchange rate at 700 pesos to the dollar by the end of this year, broadly stable from the current levels. For the next year, some additional weakening is likely, as the U.S. dollar continues to appreciate globally. Our 2016 year-end forecast is 715.

Another upside inflation surprise

Consumer prices gained 0.7% from July to August, surprising the market to the upside. The pass-through of the weaker currency to local prices has been reflected in an acceleration in tradable inflation, gaining 1.1% from July, while growth of non-tradable goods prices moderated to 0.2% from last month. On an annual basis, inflation came in at 5.0% (4.6% in July), a full percentage point above the upper bound of the central bank’s 2%-4% target range. Our diffusion index (the difference between the amount of items increasing above the center of the target and those below it, on a year-over-year basis) increased for the second consecutive month, with the majority of the added contribution derived from tradable goods.

We continue to expect inflation to reach 4.8% by the end of the year, and to decelerate to 3.5% by the end of the next, only returning to the target range in 2H16. Lower exchange-rate depreciation and a negative output gap would help to bring inflation down.

Rate hike in October

As widely expected, the central bank of Chile kept its policy rate unchanged at 3% in the September meeting, one month short from being an entire year on hold. However, the press release introduced a tightening bias, signaling that rate hikes are approaching. Specifically, the board indicated that the “sizable” monetary stimulus in place will likely be reduced in the “short term.” By qualifying the stimulus as “sizable,” the board indicated that it could hike rates amid weak growth figures: after all, monetary policy could remain expansionary even after some hikes.

The minutes from the monetary policy meeting show that the decision to hold the policy rate at 3.0% was split, for the first time since June 2014. While all board members saw the appeal of the rate-hike option, only one of them voted to raise the policy rate by 25 basis points, to ensure that inflation expectations are anchored and to prevent the need for a sharper and more costly (to activity and employment) hiking cycle later. Two other members believed that a rate hike could convey the wrong idea regarding the intensity and speed of the tightening cycle, compared to the cycle described in the 3Q15 Inflation Report (IPoM). The IPoM indicated that there would be a reduction of the monetary stimulus (with the policy rate rising 50 to 75 basis points) starting by the end of this year or the beginning of 2016. A fourth board member was not convinced that either option outweighed the other, in spite of which, he believed that the central bank’s communication had to adopt a clear bias for rate hikes in the short term.

We now expect two 25-bp rate hikes in 4Q15 (one in October and another in November) taking the policy rate to 3.50% by year-end. In our previous scenario we were expecting a cycle of 75-bps. Considering that activity continues to disappoint we see no further rate hikes in 2016. The modest tightening cycle will be aimed at keeping inflation expectations in check.

Reform agenda advancing gradually

The advisory committee formed last year by President Bachelet to study the current pension system and propose measures to address potential deficiencies has delivered its report. The current pension system consists of individual contributions managed by private-run pension managers, and a tax-funded basic retirement for the poorest citizens. The recommendation, with a majority vote within the committee, was to keep the structure of the current private pension scheme unchanged, while increasing the monthly contribution and increasing the retirement age for women (currently 60 years old) to the retirement age for men (65). In addition, the minimum guaranteed pension (aimed at low-income earners) should be increased through a higher state subsidy. The creation of a state-run pension fund to compete with the already existing private ones is proposed. Another key proposal is the enactment of a 4% payroll tax to increase pension contributions and to fund the minimum-guaranteed-pension scheme.

All in all, the committee estimated that the reform would require additional fiscal spending of close to USD 1 billion per year once the recommendations are fully implemented. Following the report’s presentation, the economic branch of ministers (which includes the heads of Finance, Labor and Economy) must draft the required legal changes to implement the recommendations. There is no deadline for this second stage of the process. We believe that this will not be a priority reform while government revenues remain weak.

Less room for fiscal policy

The 2016 budget submitted to congress at the end of September will see government expenditure growing 4.4% in real terms in 2016. Next year’s expansion is roughly half of the 8.8% growth estimated for the 2015 budget bill, but exceeds GDP growth forecasts for 2016. Public expenditure will be concentrated in the key areas of education (a crucial campaign promise), security (a major social concern) and health. Regarding the first of these areas, the government had committed to move toward free higher education in 2016, but a bill to rule on the matter will be submitted to congress only by the end of the year, at the earliest. So the budget law will contain a temporary mechanism to fund free education for students from the most vulnerable economic strata at selected tertiary education institutions. We anticipate a heated discussion in congress, with social groups (especially students and public workers) exerting pressure on the authorities to live up to their promises (free education and income adjustments, respectively).

Finance Minister Valdes indicated that getting the structural deficit to zero by 2018 is becoming very challenging. Under the current economic conditions, a reduction of the structural deficit by 0.25% of GDP each year is plausible, according to Minister Valdes. So, we estimate that it would reach 0.85% of GDP by 2018, down from the 1.6% of GDP structural deficit we expect for this year.

Reduced political capital

The findings from the latest CEP (a local think-tank) survey show no respite for President Bachelet, as the government approval rating dropped to 22% from 29% in the previous survey (April). This is the lowest approval rating recorded by CEP over the last four governments (the previous low was 23% during the Piñera administration.) The disapproval rating rose to 61%, from 56% in April, only topped by Piñera’s 62% record. The weak approval comes around four months after the president implemented a cabinet change; the government has attempted to raise dialogue on its reform agenda in a bid to ease concerns.

With a vote of 14 to 2, the International Court of Justice (ICJ) ruled that it can review Bolivia’s demand for access to the Pacific Ocean. The decision does not imply that the ICJ would side with Bolivia's demand, and it does not mean that the 1904 Peace Treaty – which established the borders between Chile, Bolivia and Peru – will be revised. It does, however, imply that the court, if it sides with Bolivia, could require Chile to negotiate some form of improved access to the sea. Both parties will now be invited to present their cases to the ICJ, but the entire process could take up to 3-5 years, according to various legal experts.


João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti


Please see the attached file for all graphs. 



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