Brazil Review. U-Turn in Exchange Rate Policy. The Brazilian economy in December 2012

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1 Brazil Review Wednesday, January 02, 2013 U-Turn in Exchange Rate Policy The Brazilian economy in December 2012 The Brazilian economy proved to be harder to manage, with simultaneous concerns involving weak growth and inflation. The government adopted measures to fight both. The central bank started taking steps to avoid currency depreciation and curb inflation, which is on the rise again. The central bank also signaled its intent to maintain the current interest rate level for a sufficiently long period. The government launched a new package of fiscal incentives to stimulate growth, including allowing reserve requirements to be used to finance some credit lines and announced new airport concessions. Difficulties notwithstanding, external accounts remain sound, with strong direct investment inflows. In the political arena, the Supreme Court ended the important trial known as mensalão and the Public Ministry indicted 24 people in a new influence-peddling scandal in an operation known as Porto Seguro. The government seems concerned with inflation and is taking steps to avoid currency depreciation. Facing market pressure to weaken the exchange rate, the central bank reversed the direction of the exchange rate policy, implementing a number of measures to avoid currency depreciation. Authorities removed some capital controls that had been introduced previously and proceeded to sell U.S. dollars in the derivatives market. The central bank also signaled its intent to maintain the current level of interest rates for a sufficiently long period. Inflationary pressure and a heated labor market may be behind those measures. Short-term inflation is under more pressure... The mid-month consumer price index (IPCA-15) climbed by 0.69% in December (vs. 0.54% in November). The pickup was caused by greater pressure from personal expenses, housing, transportation and food costs. We expect the headline IPCA for 2012 to go up by 5.7% vs. 6.5% in For 2013, the end of the IPI tax break for automobiles led us to increase our forecast for the IPCA to 5.6% from 5.5%....partly because the labor market is still heated. The unemployment rate in November stood at 4.9%, which was below our estimate and market consensus (5.1%). In seasonally-adjusted real terms, the rate is at 5.3%. The real average income rose significantly, by 5.3% from November A heated labor market supports the good performance of consumer spending. In fact, in the 12 months through October, retail sales advanced by 14.5% in real terms. But the government is also concerned with growth, and is adopting new incentives. Weaker-than-expected GDP growth in the third quarter prompted the government to free up reserve requirements and implement new fiscal stimuli. A fraction of reserve requirements may now be used by banks with more than $6 billion in equity to finance some credit lines. Among the incentive measures announced in December are the (partial and temporary) extension of the IPI tax break for automobiles and other durable goods, a reduction in payroll taxes for retailers, and a reduction in income taxes on profit sharing. For now, the measures do not change our expectation for a moderate rebound in growth in 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 It s not all about current growth and inflation: the government makes progress on ICMS tax reform. The government has proposed to the states certain changes in the interstate ICMS system. According to the proposal, the ICMS tax rate should be gradually reduced to 4% from 12%- 7% (depending on the state) by Two funds would be created to compensate the states for financial losses. The states would also be compensated with lower interest rates on their debt to the federal government. The reform of the ICMS system (if successfully implemented) will reduce part of the inefficiency of the Brazilian tax system and help boost productivity in the years to come. New airport concessions are scheduled. The government announced that the Confins airport (in the state of Minas Gerais) and the Galeão airport (in Rio de Janeiro) will be handed over to the private sector in auctions scheduled for September The expectation is that 11 billion reais will be invested in the two airports during the concession contracts. The government imposed stricter demands than it did in the first big auction for the sector, held in February The interested groups must include a company with experience in managing airports for at least 35 million passengers (up from 5 million in the previous auction) and must have at least 25% of the shares in the consortium (10% in the previous auction). External accounts remain sound. Foreign direct investment (FDI) inflows reached $4.6 billion, once again topping expectations. In the first 11 months of the year, FDI totaled $60 billion, nearing the all-time high of The current account deficit has been steady, at around 2.2% of GDP, with low profit and dividend remittances offsetting a declining trade surplus. In the political arena, the Supreme Court ended the mensalão trial... After four and a half months, the Supreme Court (STF, in its Portuguese acronym) ended the so-called mensalão trial. The STF understood that there was a scheme to purchase congressional votes during the first years of the Lula da Silva administration. The court found 25 of the 38 defendants guilty, set sentences (ranging from three to 40 years, in addition to fines) and ruled that the three condemned federal representatives must leave their posts. STF president Joaquim Barbosa ruled that defendants found guilty are to be jailed only after all defense petitions are exhausted....and the Public Ministry indicted people who were under investigation for influencepeddling in the Porto Seguro Operation. The Federal Prosecution Service (MPF) indicted 24 people investigated by the Federal Police in the Porto Seguro Operation. Among them are Rosemary Noronha, former cabinet chief for the presidency in São Paulo and close to former President Lula da Silva; Paulo Vieira, former director of the National Water Agency; and his brother Rubens Vieira, who was ousted from the National Civil Aviation Agency. Among the crimes listed by the MPF are influencepeddling and criminal conspiracy. Stock market rises, the Brazilian real strengthens. After two months of declines, the Bovespa benchmark index rose by 6.1% in reais (9.4% in dollars) in December. For the year as a whole, the index climbed by 7.4% in reais (-1.4% in dollars). The 5-year CDS spread ended the month at 108.4, down by 1.25% from the previous month. The real strengthened in December, finishing at 2.04 reais per U.S. dollar, influenced by foreign exchange measures adopted by the government. Page 2

3 What s next? The monthly minimum wage will rise to 678 reais, marking a 9% increase over the previous year, set by a pre-established formula. The central bank is unlikely to touch the benchmark Selic interest rate in the January monetary policy meeting, but we expect a move in March, if the country s economic recovery by then disappoints the government. So all eyes will be on the pace of economic bounce-back, inflation and the direction of exchange rate policy. Key macroeconomic data INFLATION (1) (2) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Accumulated 12M 3M Annualized 2011 CPI (IPCA) WPI (0.4) (0.2) (0.5) IGPM (0.2) (0.1) (0.1) CPI (IPCA) WPI (0.1) (0.3) (0.2) (0.2) IGPM 0.2 (0.1) (0.0) MONEY AND CREDIT (1) (4) 2011 M Bank credit M Bank credit INTEREST RATES (5) 2011 Overnight (Interbank rate in R$) Two-year interest rate (in R$) Two-year interest rate (in USD) Overnight (Interbank rate in R$) Two-year interest rate (in R$) Two-year interest rate (in USD) STOCK MARKET - IBOVESPA São Paulo Stock Exchange Market Index (6) 2011 Traded Volume (daily average in US$ mm.) Index Variation (end of month in US$) (4.4) (0.2) (2.7) (2.3) (5.4) (5.8) (20.7) 22.4 (9.1) (3.7) (2.2) Traded Volume (daily average in US$ mm.) Index Variation (end of month in US$) (8.1) (7.7) (17.5) (0.2) (3.6) (2.9) EXCHANGE RATE Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec (End of month) 2011 (a) BRL/USD (7) (b) % monthly change 0.4 (0.7) (2.0) (3.4) 0.4 (1.2) (0.3) (8.9) (c) BRL/EUR (7) (d) % monthly change (2.5) (0.3) (1.2) (5.3) 3.4 (0.3) 9.5 (9.2) 2012 (a) BRL/USD (7) (b) % monthly change (7.3) (1.7) (0.0) 1.4 (0.6) (0.3) (3.0) (c) BRL/EUR (7) (d) % monthly change (6.1) (0.1) 2.4 (1.4) (1.6) MAIN BRAZILIAN BONDS (%) 2011 CDS 5-yr (8) BR 40 Spread over US Treasury (9) CDS 5-yr (8) BR 40 Spread over US Treasury (9) End of month values. Percentage change over the previous period. 2. WPI (Wholesale Price Index) and IGPM (General Price Index, Market) from the Vargas Foundation; CPI (IPCA) (Consumer Price Index) from IBGE. The last figure for the CPI refers to the 30-day period ending on the 15th of this last month; previous figures refer to the full monthly period. Figures for the IGPM [a weighted average of Vargas Foundation s consumer price index (30%), WPI (60%), and national construction price index (10%)], always refer to the 30-day period ending on the 20th of each month. 3. Based on the average of the last three months, accumulated for 12 months. 4. M3 = currency outside banks plus demand deposits plus savings deposits plus CDs plus money market funds plus repurchase operations with federal securities. Bank credit = financial institutions' total credit to public and private sectors seasonally adjusted by Itaú-BBA 5. Annual yields, in percentage terms, gross of witholding tax on nominal income on nonbank operations. End of period values, except for the overnight rate, which is the cumulative value for the month. The USD rate is a swap rate and is deliverable in BRL. 6. Daily average: total monthly volume/business days. Index variation: ratio of % monthly change of Ibovespa in reais to % monthly change of R$/USD exchange rate. 7. Average of the offer rate of the last business day of the month. 8. CDS = premium in basis points, calculated over Libor, paid as a protection against Brazil's default over a 5y period. 9. Spread over US Treasury bond of equivalent duration, in basis points. BR 40 is callable on or anytime after 2015/08/17. Page 3

4 Key macroeconomic data (continued) GDP (1) Q4 Year Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Index (1995 = 100) % quarterly change 2.7 (0.3) ECONOMIC ACTIVITY Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2011 Industrial Production (2) Capacity Utilization (3) Industrial Production (2) Capacity Utilization (3) Retail Sales (4) Consumer Confidence Index (5) Business Confidence Index (6) Retail Sales (4) Consumer Confidence Index (5) Business Confidence Index (6) EMPLOYMENT Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec (%) 2011 Unemployment Rate (7) Employment/Household Survey (8) Employment/Business Registry(9) Unemployment Rate (7) Employment/Household Survey (8) Employment/Business Registry(9) PUBLIC SECTOR BUDGET (10) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec (% of GDP) 2011 Overall Balance (11) (0.5) (2.0) (2.0) (1.6) (2.2) (2.1) (2.0) (2.4) (2.4) (2.3) (2.4) (2.6) Ex-interest Balance Gross Public Debt (12) Net Public Debt (13) Overall Balance (11) 1.9 (0.4) (1.3) (1.1) (1.8) (2.1) (2.3) (2.6) (2.7) (2.5) (2.8) Ex-interest Balance Gross Public Debt (12) Net Public Debt (13) BALANCE OF PAYMENTS Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec (US$ billion) 2011 Trade Balance Exports Imports Current Account (5.6) (3.5) (5.7) (3.6) (4.2) (3.5) (3.6) (4.8) (2.2) (3.2) (6.6) (6.0) Foreign Direct Investment (14) Other Capital Inflows (15) Brazilian Capital Outflows (16) (6.1) (7.8) (4.9) (1.5) (6.2) (0.4) (4.1) (4.3) (1.1) (2.2) Intl Reserves / Liquidity (17) Total External Debt (15) Trade Balance (1.3) (0.2) Exports Imports Current Account (7.0) (1.7) (3.3) (5.4) (3.5) (4.4) (3.7) (2.6) (2.6) (5.4) (6.3) Foreign Direct Investment (14) Other Capital Inflows (15) 4.4 (1.1) Brazilian Capital Outflows (16) (2.8) (0.4) 4.2 (0.2) (3.0) (4.3) (3.6) (5.4) (3.8) (2.8) (3.1) Intl Reserves / Liquidity (17) Total External Debt (15) Year Average Year Average Last 12 M (3.0) 1.9 Last 12 M (52.5) (30.3) (51.9) (27.5) 1. Seasonally adjusted IBGE data. 2. Seasonally adjusted IBGE index for Brazil, average 2002= Seasonally adjusted FGV data for Brazil. 4. Seasonally adjusted IBGE nationwide index for inflation-adjusted retail sales, 2003= FGV survey data on nationwide consumer expectations for their current and future economic conditions. Seasonally adjusted, September 2005 = FGV survey data on nationwide manufacturing industry expectations for their current and future conditions. Seasonally adjusted. 7. IBGE original household data for the six major Brazilian metropolitan regions, labor force with ten years of age or more, 30-day search period, seasonally adjusted by Itaú BBA. 8. IBGE household data (PME) on employed population for the six major Brazilian metropolitan regions, average 2003=100, seasonally adjusted by Itaú BBA 9. Business registry data (CAGED) from the Labor Ministry, average 2003=100, including all employees with labor cards in the country, seasonally adjusted by Itau BBA. 10. Accumulated flows in the year to date, except for net public debt which is an end-of-period stock. Includes federal, state and municipal governments, with respective non-financial enterprises (plus the Central Bank) and excludes Petrobras. 11. Net public sector borrowing requirements. 12. General Goverment gross debt. Does not include Central Bank, public enterprises and Social Security administration. 13. Gross debts less credits of the general government, plus net debts of Central Bank and public enterprises. 14. Includes intercompany loans. 15. Includes stocks, bonds, loans, suppliers' credits, asset transfers, and others 16. Includes direct investment and others 17. Includes, in addition to cash, stocks of repurchase lines and loans abroad Page 4

5 Macro Research at Itaú Ilan Goldfajn Chief Economist Adriano Lopes Artur Passos Aurelio Bicalho Caio Megale Carlos Eduardo Lopes Elson Teles Felipe Salles Fernando Barbosa Gabriela Fernandes Giovanna Siniscalchi Guilherme Martins João Pedro Bumachar Juan Carlos Barboza Luiz G. Cherman Luka Barbosa Mariano Ortiz Villafañe Mauricio Oreng Roberto Prado Click here to visit our digital research library. Relevant information 1. This report has been prepared and issued by the Macro Research Department of Banco Itaú Unibanco S.A. ( Itaú Unibanco ). This report is not a product of the Equity Research Department of Itaú Unibanco or Itaú Corretora de Valores S.A. and should not be construed as a research report ( relatório de análise ) for the purposes of the article 1 of the CVM Instruction NR. 483, dated July 06, This report aims at providing macroeconomics information, and does not constitute, and should not be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell any financial instrument, or to participate in any particular trading strategy in any jurisdiction. The information herein is believed to be reliable as of the date on which this report was issued and has been obtained from public sources believed to be reliable. Itaú Unibanco Group does not make any express or implied representation or warranty as to the completeness, reliability or accuracy of such information, nor does this report intend to be a complete statement or summary of the markets or developments referred to herein. [Opinions, estimates, and projections expressed herein constitute the current judgment of the analyst responsible for the substance of this report as of the date on which it was issued and are, therefore, subject to change without notice. Itaú Unibanco Group has no obligation to update, modify or amend this report and inform the reader accordingly. 3. The analyst responsible for the production of this report, whose name is highlighted in bold, hereby certifies that the views expressed herein accurately and exclusively reflect his or her personal views and opinions and were prepared independently and autonomously, including from Itaú Unibanco, Itaú Corretora de Valores S.A. and other group companies. 4. This report may not be reproduced or redistributed to any other person, in whole or in part, for any purpose, without the prior written consent of Itaú Unibanco. Additional information on the financial instruments discussed in this report is available upon request. Itaú Unibanco and/or any other group companies is not, and will not be liable for any investment decisions (or otherwise) based on the information provided herein. Page 5