Weakening Fiscal Performance in the 1Q14

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1 Brazil Wednesday, April 30, 2014 Weakening Fiscal Performance in the 1Q14 Highlights The public sector s primary budget surplus was slightly better than expected in March (actual: 3.6 billion real; consensus: 3.1) on higher non-tax revenues. Year-to-date, the fiscal performance lags behind last year s result (1Q14: 2.1% of GDP; 1Q13: 2.8%); Central government s real expenditures kept moving fast in the first quarter (+7.4% YoY), apace from late 2013 and outpacing (estimates of) trend GDP, around 2 3%; An expansionary fiscal stance remains in place. Our estimates of adjusted primary fiscal results point to a core balance below 1% of GDP. We estimate that the primary surplus required to stabilize the public debt in the long run is % of GDP; We continue to see headwinds for the government to achieve this year s consolidated primary balance target (1.9% of GDP). We forecast a primary surplus of 1.3% of GDP. Public Sector Primary Surplus: Weakening Performance in the 1Q14 According to a Central Bank report, the public sector posted a primary fiscal surplus of 3.6 billion real in March, topping our forecast (a null surplus) and market consensus (3.1 billion real). The surprise vis-à-vis our forecast is due to: (i) 2.4 billion real in revenues from the Telecommunications Surveillance Fund (Fistel); (ii) tax refunds 1.6 billion real less than we had penciled in; (iii) better than expected primary result from regional governments. March s headline is equivalent to 0.9% of the month s GDP, similar to last year s figure but below the post-lehman 1 average for the month ( : 2.3% of GDP). The central government posted a ( below the line 2 ) primary surplus of 3.2 billion real in March (0.8% of the month s GDP), below the average for the month (1.3%), but above last year s figure for the month (0.3%). States and municipalities added 482 million real (0.1% of GDP; : 1.0%; 2013: 0.6%). Government-owned companies posted a small deficit (-64 million real). Year-to-date, the public sector primary surplus stands at 2.1% of GDP, below the average (3.2%) and the 1Q13 result (2.8%). So far, the weakening fiscal effort this year stems from the federal government (1Q14: 2.0% of GDP; 1Q13: 3.1%). On the other hand, states and municipalities showed higher figures than 1 Choosing the post-lehman as a basis of comparison for the monthly fiscal performance reflects the search for a parameter that better signals consistency of the result with a narrower primary surplus target seen in recent years. Thus, we usually compare the monthly fiscal print to a less challenging benchmark, as compared to the elevated primary surplus recorded in the years of The below the line ( abaixo da linha ) primary fiscal balance follows the Brazilian Central Bank (BCB) methodology, which obtains its final number through monthly net debt changes for each public sector entity. This approach is somewhat different from the one used by the National Treasury Secretariat (STN, in Portuguese acronym), the above the line criteria ( acima da linha ). The latter follows the analysis of revenues and expenditures to calculate the central government primary fiscal surplus (before the interest payments). Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

2 last year (1Q14: 1.1%; 1Q13: 0.9%), on higher transfers from the federal government (some of those had been delayed late last year). The trailing 12-month consolidated, conventional primary fiscal surplus (i.e., not adjusted for economic cycles or non-recurring transactions) inched down to 1.75% of GDP in March from 1.76% in February. The recurring primary surplus (stripping out atypical revenues and expenses) remained stable at 0.9% of GDP in the twelve months to March (Graph 1). This is one of the lowest levels since the series started in % Graph 1: Public Sector's Primary Fiscal Balance (12m) 3.5% 3.0% 2.5% 2.0% 1.75% 1.5% 1.0% % GDP Conventional Primary Surplus Recurring Primary Surplus 0.5% Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar % Source: Brazilian Central Bank, Itaú March s fiscal data points to a decline in regional governments fiscal performance, after a significant budget improvement over the first two months of this year. The 12-month primary surplus of states and municipalities fell to 0.38% of GDP in March, from 0.42% in February. Even though it is necessary to gather more information to see a trend, today s numbers seem to confirm our expectations that the increase in federal transfers to states and municipalities would imply in higher expenditures, and not a higher primary balance. Central Government: Higher Non-Tax Receipts; Fast-Rising Expenditures According to Treasury data, the central government posted a primary surplus of 3.2 billons real in March, topping our forecast (+0.7 billion real) and market consensus (+1.1 billion real). The federal primary surplus is equivalent to 0.8% of the month s GDP, a weaker print than the average federal deficit of 1.2% of GDP recorded for the same period in the Post-Lehman years ( ). In March 2013, the federal surplus was 0.1% of GDP. Page 2

3 Year-to-date, the central government primary surplus stands at 1.1% of GDP, below the average (2.1%) and the 1Q13 budget result (1.8%). Real federal revenues grew 9.3% from a year ago, led by non-tax income (+64% YoY in March; 1Q14: +32% YoY). Non-tax takings were boosted by dividends from state-owned banks, which added 3.0 billion real to federal coffers last month. Year-to-date, the dividends sum up to 5.9 billion real, more than the 767 million paid over the same period in There was also a relevant contribution from proceeds related to an inspection fee by Fistel (adding 2.4 billion real). Real tax revenues upped 4.1% YoY, accumulating a 2.0% growth over 1Q14. This suggests a cyclical loss of steam, as the tax collection trend has been following closely the GDP growth rate (Graph 2). 11% 9% 8% 6% 5% 3% 2% 0% -2% Graph 2: Federal Tax Collection and Real Activity %yoy, 6m, IPCA-adjusted Itaú Monthly GDP (PIBIU) Core tax receipts 21% 18% 15% 12% 9% 6% 2.0% 3% 2.1% 0% -3% -3% -6% %yoy, 6m, IPCA-adjusted -5% -9% Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: Brazilian Revenue Service, Itaú Core tax collection, which accounts for 85% of total central government revenues, continues to underperform the official government forecast for the full-year (around 4% in real terms). We believe that the (moderate) pace of activity in coming months and (the lack of adjustment in) the tax policy will prompt a slow growth in tax collection ahead. Altogether, suggests there is a risk that revenues will come below the official projection. We project an increase of % in real federal tax receipts this year. (For further details on March s tax collection, refer to our April 29 LatAm Talking Points) Transfers to regional governments (including shared revenues and other disbursements) increased 5.2% YoY in real terms (1Q14: +11%). The data indicates a natural slowdown in federal transfers after a sharp increase at the beginning of the year (offsetting retentions made at the end of last year). The slower federal transfer growth is one more reason to estimate a lower tax effort of local governments in the coming months. Page 3

4 Federal expenses maintained a fast pace in March: +6.1% YoY. In the first quarter, expenditures grew at a real clip of 7.4% YoY, keeping the strong trend as of late 2013 (Graph 3). We see no signs of spending adjustments in the meantime, as the growth rate in central government outlays continues to outdo potential GDP growth estimates (2 3%). Graph 3: Central Government Expenses (% annual, 3m, IPCA-Adjusted) 9.0% 8.0% 7.6% 7.0% 6.8% 7.3% 7.4% 7.0% 5.8% 6.0% 5.1% 4.9% 5.4% 5.0% 4.1% 4.0% 3.0% 2.6% 2.0% 1.1% 1.3% 1.0% 0.0% Source: National Treasury, Itau Among the main expenditure drivers, we highlight the strong expansion in government costs 3 (+26% YoY in March; +34% in 1Q14) and investments (+11% YoY in March; +15% in 1Q14). These are spending lines with more flexibility for adjustments in the short run. Adjusting for inflation, subsidies also grew strongly: 81% YoY in March (1Q14:+54% YTD). Payroll are also picking up: +4% YoY in March (1Q14: +6% YTD). On the opposite direction, transfers to families (i.e., including mandatory expenditures such as pensions, entitlements) are decelerating fast. Real transfers to families 4 fell 2.5% YoY in March and 3% YoY in 1Q14. Anecdotal news suggest that some mandatory social security disbursements are being delayed, which could be an evidence that this slowdown in transfers could be temporary. Graph 4 illustrates the main contributions to the expenditure increase of 0.9p.p. to 19.2% GDP in Government costs ( custeio ) (+0.4p.p. to 4.0% of GDP), investments excluding Minha Casa Minha Vida (+0.2p.p. to 1.2% of GDP), and payroll (+0.2p.p. to 4.3% of GDP) are the main factors behind this federal spending increase. 3 Excludes Bolsa Família expenditures from administrative costs ( custeio ) 4 Includes expenses such as unemployment insurance, pensions and entitlements. Page 4

5 Graph 4: Central Government Spending (% GDP) Personnel 4.3% 4.1% % GDP, Up to March Subsidies 0.4% 0.3% Administrative Costs 4.0% 3.6% Other Capital Expenditures 1.2% 1.0% YTD'14 YTD'13 Housing Investment (MCMV) 0.5% 0.5% Government Transfers Total Spending 8.7% 8.7% 19.2% 18.3% Source: National Treasury, Itaú We forecast a significant slowdown in real spending for the remainder of the year, reaching an average annual rate of 2 3% over the next nine months. This number compares to the 7 8% so far this year. Implementing such an expenditure deceleration is a challenging task, which imparts an upside risk to our federal expenditure projection for this year. We forecast a real spending growth of 4% in 2014, compared to 6.5% in Nominal Deficit and Public Debt The public sector s nominal deficit in twelve months (a fiscal measure that includes interest expenses) was 3.2% of GDP in March (February: 3.3%). The recurring nominal fiscal gap (i.e., adjusting for atypical primary revenues and spending) also inched down 0.1p.p. to 4.1% of GDP. The public sector s interest expenses fell to 5.0% of GDP in the same period, from 5.1% in February. For this year, we continue to forecast a lower primary surplus and a continued increase in the Treasury s financing costs. These factors should add pressure on the nominal deficit, which we expect to widen to somewhere above 4.0% of GDP until the end of The public sector s net debt upped to 34.2% of GDP in March from 33.7% in February, reflecting the unfavorable effect of the BRL appreciation on the public debt (i.e., through the decrease in the BRL value of the central bank international reserves, computed as a public sector asset). The exchange rate appreciation over the period (3.0%, using the PTAX rate) contributed to an increase of 0.5 p.p. in the net public debt last month. The gross debt of the general government (excluding government owned-companies and the BCB) edged down to 57.5% of GDP in March from 57.6% in the previous month. The gross debt adjusted to exclude central bank international reserves increased to 40.2% of GDP in Page 5

6 March from 39.6% in February. Year-to-date, the gross debt ex-reserves grew by 1.6p.p (the headline gross debt increased to 0.7p.p.). Assessing The Fiscal Stance and the Outlook for the Year We still see an expansionary fiscal stance in place, as the 12-month recurring primary surplus (stripping out atypical revenues and expenditures) remains below its equilibrium level. We estimate that the threshold to stabilize the net public debt stands at 2.0% (or a bit higher). Primary results below equilibrium signal fiscal stimuli still in place, implying the necessity of budget adjustments sometime in the future to avoid a continued debt accumulation. Our estimates of the structural primary surplus (i.e., adjusting the conventional primary surplus to economic cycles) run around % of GDP at the end of 2014, confirming the presence of fiscal stimuli. Another way of observing this point is to look to the core tax collection ( receitas administradas ), which has been growing in line with potential GDP (2 3%) while public spending growth remains well ahead of that level. We believe that a moderate activity growth will continue to weigh on government revenues ahead. In turn, that should lead to a slower pace of public spending in coming months. Still, given the difficulties to implement a tight budget adjustment this year, the slowdown in federal expenses should not suffice to bridge this year s fiscal gap. As an upshot, we project the public sector will miss this year s primary surplus target of 1.9%. So far, as the table below shows, fiscal results are consistent with our forecast year-end primary surplus forecast of 1.3% of GDP (2013: 1.9%). % GDP Q14 (12m) 2014e (Budget) 2014e (Itaú) Dif. (Itaú - Gov.) Primary Surplus - Public Sector 2.4% 1.9% 1.7% 1.9% 1.3% -0.6% Primary Surplus - Central Government 1.7% 1.6% 1.4% 1.6% 1.1% -0.5% Net Revenues 20.0% 20.4% 20.3% 20.8% 20.4% -0.4% Total Expenditures 18.3% 18.8% 18.9% 19.2% 19.3% 0.1% Primary Surplus - Regional Governments 0.5% 0.3% 0.4% 0.3% 0.2% -0.1% Primary Surplus - Other Government Entities 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% Recurring Primary Surplus - Public Sector 1.8% 1.0% 0.9% - 0.7% - Mauricio Oreng Luiz Felipe Priolli Page 6

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