Itaú BBA - Weaker Growth, Lower Interest Rates

Scenario Review - Chile

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Weaker Growth, Lower Interest Rates

Agosto 11, 2014

The IMACEC (monthly proxy for GDP) contracted by 0.8% from May to June

• Activity disappointed in June, leading to a weak 2Q14. We have lowered our GDP growth forecast for 2014 to 2.2% (from 2.8% in our previous scenario), while we now expect a softer 3.8% rebound in 2015 (from 4.0%).

• Inflation remains high, but it is moderating sequentially. The consumer price index rose by 0.2% from June to July, but it was up by 4.5% year over year, above the upper bound of the target. We expect inflation to end this year at 4.0%. In 2015, our inflation forecast stands at 2.9%.

• Chile’s central bank resumed the easing cycle in July, cutting the policy rate by 25 bps, to 3.75%. Importantly, the board maintained the easing bias. Considering the revisions in our growth forecasts, we now expect the central bank to bring the policy rate to 3.0% (3.5% in our previous scenario) with three additional consecutive 25-bp rate cuts. For 2015, we expect no rate moves.   

• Weak growth in Chile and strong growth in the U.S. weakened the peso against the dollar. Considering our new forecast for the policy rate in Chile, we now expect the exchange rate to end this year at 585 pesos to the dollar and at 615 by the end of 2015 (575 and 600, respectively, in our previous scenario).  

• The Chilean central government recorded a fiscal surplus of 0.1% of GDP in the first half of 2014. The budget office still expects a deficit of 2.0% of GDP in 2014. With our reduced growth forecast for 2014, we now expect the nominal balance to post a 2.4% of GDP deficit this year.

• Members of the finance committee in the Chilean senate came to an agreement on a new corporate tax framework, which is to include two tax-system options for corporates, instead of simply eliminating the FUT (Taxable Profit Fund).  

Activity Largely Disappoints in June

The IMACEC (monthly proxy for GDP) contracted by 0.8% from May to June, leading to a small contraction during 2Q14 (0.13% qoq/saar). As a result, annual growth was only 1.8% year over year in 2Q14 and 2.2% in 1H14. Both consumption and industrial related indicators largely surprised on the downside in June. Manufacturing declined by 0.7% year over year and by 3.7% qoq/saar. The industrial production index , which aggregates Mining, Manufacturing and Utilities, grew by a weak 0.9% year over year, with Mining contributing 0.7 percentage points to the annual gain. On the consumption front, Retail sales slowed to 2.3% year over year in June and declined by 1.1% qoq/saar in 2Q14.

The labor market continues to be weak despite of a low unemployment rate. In 2Q14, unemployment affected 6.5% of the economically active population, which is 30 bps above the rate recorded one year ago. However, the breakdown of job creation reveals that employment growth is largely due to self-employment (5.9% year over year). Waged employment grew by a weak 0.4% (0.2% in May). All in all, the labor market is still not supporting a recovery in consumption.

Due to the recent weaker-than-expected economic data, we have lowered our economic growth expectation to 2.2% for 2014 (from 2.8% in our previous scenario). For 2015, our expectation now stands at 3.8%, from 4.0%. We note that our forecast for 2014 implies a pickup in activity during the second half. In our view, a looser monetary policy and an upturn in the global economy will likely support the recovery of the economy.

Inflation: lower sequentially but still high on an annual basis

The consumer price index came in at 0.2% month over month in July (0.1% in June), matching market expectations. Inflation excluding food and energy was 0% month over month. Prices for non-tradable items increased by 0.3%, while tradable inflation was 0.2%.

While inflation has been more moderate on a sequential basis, annual inflation rose further. Headline inflation climbed to 4.5% year over year, from 4.3% in June, remaining above the upper bound of the target. Excluding food and energy, inflation rose slightly, to 3.7% from 3.6%. Non-tradable inflation was flat, at a high 4.9%, while tradable inflation increased to 4.2% (from 3.9% in June).

Wage inflation, which has also been closely tracked by the central bank, has exhibited a similar behavior. While it is edging lower sequentially (0.1% in June), it is high and rose on a year-over-year basis (now at 6.6%).

We expect inflation to end this year at 4.0%. For 2015, our expectation stands at 2.9%. In our view, the negative output gap will likely bring inflation down, more than offsetting the impact of exchange-rate depreciation.    

The Central Bank Resumes the Easing Cycle

Chile’s central bank cut its policy rate by 25 bps, to 3.75% in July, following a three month pause amid positive inflation surprises. Importantly, the board maintained the easing bias in the accompanying press statement, indicating that it “will evaluate the possibility of introducing additional policy rate cuts according to the evolution of the internal and external macroeconomic conditions and its implications for the inflation outlook.”  

The meeting´s corresponding minutes revealed that the lower-than-expected growth coupled with more moderate inflation readings encouraged board members to unanimously resume the easing cycle. Still, most board members continued to express some degree of concern with the current level of inflation and, in particular, with wage dynamics, thereby curbing expectation for a more aggressive easing cycle. One board member added that the decision to lower rates should not be communicated as the beginning of an easing cycle, although further adjustments were possible depending on available data. Two other board members also highlighted that the board should take a cautious approach in the next monetary policy decisions. On the other hand, one board member noted that a 50-bp rate cut should have been considered as an option, at least as relevant as keeping the policy rate unchanged, even though a 25-bp rate cut seemed the best option.

As Chile’s economy continues to be frail, we expect the central bank to continue the easing cycle, with the policy rate ending this year at 3.0% (previously 3.5%), with a 25-bp rate cut in each of the next three meetings. We note that the latest monetary policy decision took place before the disappointing readings for activity in June. In addition, this data suggests that the forecast range in the most recent Monetary Policy Report is too optimistic, which calls for more aggressive easing than the one implied in the baseline scenario of the central bank (policy rate at 3.75% or 3.50%).  

More Depreciation Ahead

Weak growth in Chile and the positive surprises in the U.S. economy have weakened the peso against the dollar. As yields in Chile fall, the Chilean peso continues to underperform most emerging market currencies.

Due to our new forecast for the policy rate in Chile, we now expect a greater exchange-rate depreciation relative to our previous scenario. We expect the peso to end this year at 585 to the dollar (previously 575) and at 615 by the end of 2015 (previously 600).

The trade balance continues to improve because of the slowdown in domestic demand and the weaker exchange rate. The trade balance posted a surplus of USD 0.4 billion in July, leading to an increase in the 12-month rolling surplus to USD 6.0 billion (from USD 5.4 billion last month and USD 2.1 billion in 2013), the highest value since July of 2012.

Our new forecasts for activity and the exchange rate are consistent with a narrower current account deficit than we were previously forecasting. We have increased our trade balance estimate to USD 6.2 billion for 2014 (from USD 6.0 billion) and to USD 6.7 billion in 2015 (from USD 6.7 billion). We see the current account deficit at 2.1% of GDP this year (2.3% previously) and at 2.0% in 2015 (previously 2.1%).

A Higher Public Deficit

The Chilean central government recorded a fiscal surplus of 0.1% of GDP in the first half of 2014, according the budget office (Dipres). In the first half of 2013, the fiscal surplus was 0.6% of GDP. Additionally, Dipres said that it continues to forecast a deficit of 2.0% of GDP in 2014 (0.6% deficit in 2013), when not considering the implementation of the tax reform (-1.7% otherwise). In the first six months of the year, central government income contracted by 0.2% over the same period of 2013 (in real terms), as revenues from Codelco and private mining companies fell by 1.8% and 18.9%, respectively. Central government expenditures incurred real growth of 5.3%, led by the 6.1% annual increase in current expenditure.

Meanwhile, central government assets totaled 12.1% of GDP, according to the budget office, rising slightly from 11.5% at year-end of 2013. Sovereign Wealth Funds, at USD 23.75 billion, account for 73.4% of total assets.

Given our reduced growth forecast for 2014 (compared with the 3.2% of the budget office), we now expect the central government’s nominal balance to reach a deficit of 2.4% of GDP this year. 

Tax Reform: A New Agreement

Members of the Finance Committee in the Chilean senate came to an agreement on a new corporate tax system. The revised tax package gives companies two options when deciding on their tax system. Corporates can now select between a higher tax rate (27%), where the shareholder would gain some tax credit for reinvesting profits, or a lower tax rate (25%) with no tax credit for reinvested earnings. Companies with high payout ratios will likely choose the latter option, while companies with low payout ratios would probably choose the former. In both cases, corporate income taxes will rise gradually. The agreement followed a long debate that included widespread criticism from the business community, which was concerned about the unfavorable effects on investment and growth from eliminating the incentives to reinvest earnings.

The government aims to have the tax reform approved in congress by mid-September. If that happens, then the additional tax collection can be included in the budget discussion for 2015. In order to achieve this, the reform needs to be voted on in the senate during the week of August 18, before returning to the lower house for the changes to be approved once again. Finance Minister Alberto Arenas indicated that the changes to the original bill will still preserve the goal of raising USD 8.2 billion (around 3% of GDP), which is to help finance an ambitious education and health-care reform.

João Pedro Bumachar
Vittorio Peretti

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