Itaú BBA - Reforms advance

Scenario Review - Chile

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Reforms advance

Fevereiro 11, 2015

the December indicators came in significantly better than expected.

• Activity ended 2014 on a positive note, surprising the market on the upside. We now estimate growth of 1.8% for 2014 (1.7% in our previous scenario), and continue to see a gradual recovery to 2.5% in 2015 and 3.5% in 2016.

• Due to lower copper prices, we now expect a weaker exchange rate than in our previous scenario. We see the peso ending this year at 645 to the dollar (from 635 in our previous scenario) and at 650 by the end of 2016 (640 previously). Our expectation for the current-account deficit rose to 1.9% of GDP in 2015 (1.2% in our previous scenario) and to 2.2% in 2016 (from 2.0%).

• Inflation surprised to the upside in January, when the market had been expecting a negative figure resulting from falling oil prices. Core inflation rose further and wage inflation is still accelerating. We expect inflation to recede, but now see it reaching 2.8% by the end of 2015 (instead of 2.3% previously). 

• The central bank kept the policy rate as expected in January and is not showing any willingness to cut. The recent inflation data will likely make board members even more cautious. We still do not expect policy-rate moves in our forecast horizon. 

• The Chilean government has effectively continued to pursue its political agenda. Bills aimed at reforming education, the political system, and other social changes have been approved by Congress, which contributed to reduce uncertainty over reforms. Other reforms will soon be debated.

Stronger activity in 4Q14, in a disappointing year

In a year characterized by a sharp slowdown in economic activity, the December indicators came in significantly better than expected. Chile’s Imacec (monthly proxy for GDP) gained 1.0% from November. The resulting quarter-over-quarter annualized growth rate was 4.0% in 4Q14 (accelerating from 2.3% in November, 1.6% in 3Q14 and -0.1% in 2Q14). Adjusted for calendar effects, the Imacec gained 3.1% year-over-year in December.

Manufacturing performed strongly in December, increasing 3.1% yoy and 5.1% qoq/saar in 4Q14. However, overall, manufacturing completed a disappointing year, declining by 0.9% in 2014 (vs. +0.2% in 2013). Mining contracted 0.9% yoy in December, accumulating growth of only 0.9% in 2014. As a result, the Industrial production index, which aggregates Mining, Manufacturing and Utilities, rose 0.9% yoy in December (-3.5% last month and 0.4% in 2014).

Retail sales also grew above expectations in December, at 1.9% yoy, hinting that consumption is doing better. In 4Q14, retail sales jumped 11.4% qoq/saar, but after many quarters of poor performance. Thus, during 2014, retail sales slowed considerably to 2.4% (vs. 9.8% in 2013).  

Confidence remained weak in January, although there was a recovery in business sentiment. The business confidence index improved to 45.1% (from 40.2% in December, but is still below the 50.4% seen in January 2014). Increased confidence occurred in all sectors, except for construction, where it fell to 26.3% (from 26.5% in the previous month). The mining sector’s confidence, which is somewhat volatile, saw the biggest improvement, reaching 62.9% (from 49% in December). However, lower copper prices could deteriorate sentiment within the business community ahead. Meanwhile, consumer confidence retreated in January. The overall perception index decreased to 41.9% (from 45.3% in December and 43.2% in 4Q14). The respondents’ evaluation of the country’s future economic situation led the deterioration.

The unemployment rate continues low, in spite of the weak economy. The unemployment rate in December stood at 6.0% (versus 5.7% in the same period of 2013). Employment grew 1.4% yoy (1.1% previously). As in the previous month, employment growth was supported by rising self-employment (3.1% yoy), while waged employment picked up more moderately, to 1.4% (1.1% previously). The breakdown of employment expansion suggests that the labor market is looser than the unemployment rate suggests.

As a result of December’s Imacec, GDP is expected to have grown 1.8% in 2014 (marginally above our previous 1.7% forecast, but down notably from 4.1% in 2013). In our view, the economy is unlikely to sustain the 4Q14 sequential pace, due to lower copper prices and subdued confidence. So we expect only a gradual recovery. We continue to expect a 2.5% expansion for 2015. For 2016, an additional recovery to 3.5% is expected.

Weaker exchange rate and higher current-account deficit, as copper prices fall

The Chilean peso has kept weakening against the U.S. dollar since the beginning of this year. Apart from the global movement of dollar strengthening, the weakening of the Chilean peso was driven by the decline in copper prices during the period. Considering the revisions we made in the outlook for copper prices, we now see the peso at 645 to the dollar by the end of this year (from 635 in our previous scenario) and at 650 by the end of 2016 (from 640).

The trade balance remains healthy. A USD 1.4 billion trade surplus was recorded in January. As a result, the rolling 12-month trade balance reached a surplus of USD 10.5 billion (USD 8.6 billion in 2014 and the highest level since the USD 11.0 billion in 2011).

As internal demand remains soft, the peso weaker and oil prices low, imports for the quarter ending in January fell 9.1% yoy. Energy imports, which averaged 20% of the total in 2014, declined 28.7% yoy in the same period. Excluding energy, imports were down by 4.0%.

Meanwhile, exports rose 8.7% yoy in the quarter ended in January, as mining exports increased 7.3%. The strong growth of mining exports in January is mostly explained by an unusually low base of comparison (arising from a nationwide port strike last year), as prices and domestic production of copper have been weak. Industrial exports (which performed well in 2014) increased 6.5% in the quarter, in spite of a weak result in January.

While a weaker exchange rate, subdued internal demand and low energy prices will likely keep the current-account deficit low this year, the deterioration of copper prices will likely lead to a wider deficit than we were previously expecting. We are now forecasting the deficit at 1.9% of GDP in 2015 (vs. 1.2% in our previous scenario and 1.5% estimated for 2014) and at 2.2% in 2016 (from 2.0% previously).

Inflation surprises to the upside in January

Consumer prices grew 0.1% month over month in January, well above market expectations, which were for an oil-led deflation. In fact, energy prices fell by 5.5% from December 2014, but underlying inflation measures remain uncomfortably high. Inflation excluding food and energy grew by 0.7% from December, while non-tradable inflation came in at 0.5%. So on a year-over-year basis, headline inflation fell only slightly, to 4.5% (from 4.6% in December), while non-tradable inflation rose to 5.4% (from 5.3%) and core inflation climbed to 4.8% (from 4.3%). These numbers add to the high wage inflation registered in December (7.2% yoy, from 7.0% in November).

We have adjusted our inflation forecast for this year, to 2.8% from 2.3% in our previous scenario. This revision responds to the recent inflation surprise, as well as our expectation of a weaker Chilean peso than in our previous scenario. Still, we highlight that we continue to expect a substantial drop of annual inflation from the current levels, due to spare capacity in the economy, lower oil prices and the spill-over of lower energy prices to the other items of the consumer basket (through indexation and costs) in a context of well-anchored inflation expectations. Finally, we note that our scenario assumes a further recovery of oil prices by the end of the year (to USD 70 per Brent barrel), so if oil doesn’t rebound, inflation would be lower.   

No intention to cut

According to the minutes of the January monetary policy decision, the decision to maintain the interest rate at 3.0% was unanimous, and the only “relevant option” considered. The board saw the December drop in inflation mostly as a result of fuel prices and was concerned about the dynamics of both core and wage inflation. In addition, some members questioned the persistence of oil prices at the current levels and whether monetary policy should react to supply-side factors. Besides, the possibility of a sudden tightening of external financial conditions and the uncertainty about the size of the output gap (given that the unemployment rate remains low) also make “forecasting inflation particularly complex.”

The board acknowledged that the main news since the December meeting had come from abroad, with current oil and copper prices lying well below the estimates for 2015 used in the 4Q14 Monetary Policy Report. However, it was suggested that it is premature to evaluate the medium-term economic implications of lower commodity prices, given the uncertainty over the outlook for such prices. Hence, the central bank continues to work with the scenario for growth and inflation outlined in the report.

On inflation, it was recognized that lower gasoline prices contributed to a faster-than-expected retreat in consumer prices in December. However, the central bank noted that core inflation had been somewhat more resilient than expected, due to the depreciation of the peso and to inertia. Also, some board members said the acceleration of nominal wages should be carefully monitored because of the impact it could have on inflation ahead.

We continue to expect the central bank to keep the monetary policy unchanged both this year and the next. In our view, the central bank is clearly comfortable with the current amount of monetary stimulus in the economy and it will likely avoid adding liquidity amid interest rate increases in the U.S. In addition, since the latest meeting, underlying inflation measures have deteriorated further, which will probably turn members even more cautious. Finally, the recent increase in breakeven inflation reduced market real-interest rates, so it can be argued that monetary conditions are looser now than when the board last met.   

Keeping the reform agenda on track

After submitting its labor reform bill to Congress in January, the administration’s political agenda has been active. The administration continues to send bills that it promised in its campaign program to Congress. These have been varied, encompassing the economic, political, and social fronts. Following suit, the governing coalition majority in congress managed to get key reforms approved prior to the summer break.

Congress approved a more proportionally representative political system, putting an end to the 25 year-old “bi-nominal” or “two-coalition” system. The new system will come into effect for the 2017 electoral process, potentially changing the political landscape of Parliament for the next presidential period (2018-2022). The precise effect on the composition of both houses remains to be seen. However, the new system could favor the participation of marginal parties or political agendas. We share the view of some market participants that a more fragmented Congress may arise under the new framework, adding to uncertainty over the political process in Chile’s near future. Other reforms include a newly approved civil-union law, opening the way to legal same-sex relationships and an abortion-legalization law, which is currently under discussion.

The first part of the highly discussed educational agenda was also approved by Congress. This first bill will eliminate co-payment and profit-making at publicly funded schools. It also restricts student selection processes in public schools, setting maximum quotas to be chosen on performance in establishments identified as offering special educational programs. These norms will gradually be applied between 2016 and 2018 to allow for the administrative and budgetary changes required. Some impact on inflation (through educational fees) and public finances is expected. In the next stage, the government will submit projects aiming at free higher public education and the centralization of municipally managed schools.

A new framework to promote foreign investment was submitted to Congress on the last day of January. It will replace the current framework which dates back to 1974 and is due to expire at the end of the year. The old “DL600” was set up to create tax certainty for FDI during a time when Chile’s image was more volatile. The framework allowed the authorities to sign bilateral agreements guaranteeing unchanged tax schemes for the duration of a project. The current administration believes that Chile’s reputation for the rule of the law is in itself attractive and does not warrant exceptional conditions to draw foreign investment. The project follows the recommendations of a presidential commission and includes tax benefits for the preliminary stages of investment, standard treatment afterwards, and fair access to financial markets within the legal framework in place. The project also creates an investment-promotion body whose objective is to sponsor projects and identify sectors with systematic investment deficiencies. A preliminary assessment of the project indicates a limited impact on FDI, which has, over time, relied less on the incentives related to the DL600.

Government approval showed some recovery in January, increasing 4%. The fall in fuel prices and the announcements of socially popular programs have contributed in this direction. Also, political scandals close to key politicians in the opposition have improved the relative perception of the government. Still, support for the government remains below 50%. A cabinet reshuffle could occur after the summer break, in an attempt to improve the perception of the administration.


João Pedro Bumachar
Miguel Ricaurte

Vittorio Peretti

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