, on. November 29 Brazil Currency Perspectives Research Ana Esteves + 351 21 381 19 ana.esteves@itaueuropa.pt María Insausti + 351 21 381 1149 maria.insausti@itaueuropa.pt Bruno Baptista + 351 21 381 1136 bruno.baptista@itaueuropa.pt Contents: 1. Scenario 2. Roadmap 3. Correlation Matrix 4. Macro Forecasts With emerging markets role in the global economy increasingly determinant and lower risk aversion in financial markets, local currencies are likely to be on the spotlight going forward. In particular, the BRL, the currency of Brazil, a country that remained rather resilient in the whole financial crisis, and which still has attractive real interest rates, has been outperforming most of its peers since the beginning of the year. Brazilian economic growth as it is, boosted by future events such as exploration of the pre-salt oil areas and forthcoming global sport events (World Cup and Olympics) suggests higher investment in the economy which could come in either forms of physical or financial capital. Foreign investors anticipating returns in several business areas, much influenced by the commodity related potential of Brazil and the need for infrastructure investment, are likely to continue to boost foreign direct investment. On the other hand, financial investors, attracted by high interest rates, should also remain prone to invest in local financial markets. Demand for Brazilian products abroad continues rising. What is more, exports growth has been fuelled by other emerging markets such as China, as their economy outperforms the developed world. If exporters sell more, they should need to convert increasing amounts of cash into local currency, pressuring demand for BRL. USD weakness could also be a positive for the Brazilian and other emerging market currencies. Low interest rates in US, for a longer period than the market anticipates, reserve diversification by central banks and higher risk premium for US on the back of high government debt are the key reasons that lead us to believe in a strong BRL in the coming future. Economic momentum gathering pace and domestic demand remaining strong could have a contrarian effect, especially in a longer time horizon. Domestic growth could fuel imports and exert a contrary pressure on the BRL. Foreign investors in Brazil could raise the amount of profits and dividends they send abroad and cash laden Brazilian companies could materialize their internationalization ambitions and increase the amounts invested abroad too, similarly to what Ambev has done. Moreover, long-term interest rate convergence should also weight negatively on the currency. The recently created sovereign wealth fund, could serve as a government instrument to stabilize the currency, i.e., depreciate the currency, as exporters complain about a strong BRL hurting the country s competitiveness. Moreover, foreign investment in Brazil's fixed income and equity markets is now subject to a 2% IOF tax payable upfront, that is, upon conversion into local currency. FDI remains exempted. According to FM Mantega, the objective is to reduce currency appreciation and prevent the development of a bubble in asset prices. Evidence from Brazil and other countries suggests that taxation of inflows is not effective as a tool to permanently alter the exchange rate. In March 28, when this same tax was adopted with the same objective (with a rate of 1.5% on FI flows only), the BRL weakened slightly, only to resume its appreciating trend a few days later. It eventually touched on 1.56 in August, and plummeted back in September in the wake of the Lehman collapse. The tax was discontinued in October. We view currency market intervention as a temporary shock on the currency, as fundamentals are all that matters in the long run. That said, we expect to stand at 1.7 at year-end, and we are projecting a stable exchange rate in real terms going forward, closing 21 at 1.73. All estimates by Itaú Unibanco Economic Team Please see page 7 of this report for important disclosures.
Itaú Europa Brazil Currency Perspectives November 29 1- Scenario Brazil s economy has recovered faster and stronger than many expected since the beginning of the global financial crisis. The job market has demonstrated remarkable resilience and is already showing consistent signs of recovery. Conditions in credit markets, particularly in the household segment, have improved, as spreads narrowed, average repayment terms increased and, more recently, average credit concessions jumped. Credit quality ceased to deteriorate with NPL/total loans stabilizing at 4.4% since July according to Central Bank s data. Together, those factors should ensure a flat GDP growth in 29 compensating the recession experienced in the first half of the year. Thereafter, we expect the Brazilian economy to outpace the world s average GDP growth by expanding 5.5% in 21 and 4.6% in 211. On a medium term perspective, planned investment in infrastructures for the World Cup and the Olympics and for the pre-salt oil exploration area should add to positive economic momentum. Even in this scenario, we believe that inflation will remain contained in 29 and 21. There are, however, risks that inflation drifts higher in 211. We expect IPCA to stand at 4.3% and 4.1% in 29 and 21, respectively, remaining comfortably lower than the BCB s mid-target at 4.5%, with low risks of upside surprises. In 211, however, consumer inflation should start to reflect current expectations of activity pick-up. The robust growth in demand should become the main driver of inflation pressures in 211. The outlook for faster growth, and inflation upturn starting in 2H1, should persuade the Central Bank to start a tightening cycle already in 21. We expect a total hike of 15bps, pushing the Selic to 1.25% by year-end 21. By acting in a preemptive manner, monetary authorities would avert the need for a larger tightening further down the road. Foreign investors should remain interested in the country, bolstering demand for BRL. Both portfolio inflows and FDI should continue to rise, as suggested by the strong IPO pipeline on tap for the next few months and by our expectation of FDI increasing up to 85 bn USD by 212. As a result, we expect the BRL to stand at 1.7/USD at year-end. After that, we are projecting a stable exchange rate in real terms, closing 21 at 1.73/USD. As the local economic growth outpaces the global average, and the BRL remains strong, we estimate an 24.5 bn USD trade surplus in 29, but expect a 2.2 bn USD trade deficit in 21. The currentaccount deficit is on track to reach 1.2% of GDP this year, and in 21, the current account gap should rise to 3.1% of GDP. This deficit should be comfortably financed, either via stronger FDI inflows (we expect a 2.4% increase in 21), and portfolio inflows. In a longer-term perspective, we expect Brazilian real interest rates to converge to those of peers. For example, Mexico (Baa1/BBB+/BBB+) and Peru (Ba1/BBB-/BBB-), which are rated similar to Brazil (Baa3/BBB-/BBB-), have benchmark rates of 4.5% and 1.25%, respectively, and zero or even negative real rates. At year-end 28, benchmark rates were 6.5% in Peru, 8.25% in Mexico and 1% in Brazil, while 28 inflation was 6.5% in Peru and Mexico and 5.9% in Brazil. Do the math and see that the tendency for Brazilian rates should be downwards. That said, although our expectation is for a strong BRL but with limited upside potential from current levels, in the short-term risks are clearly skewed to the upside. - 2 -
Itaú Europa Brazil Currency Perspectives November 29 2- Road Map What could appreciate the BRL? Commodity Prices: Higher commodity prices have been associated with BRL appreciation and USD depreciation: BRL appreciation against the USD. 3.5 3. 2.5 2. 1.5 1.25 1. and Commodity Prices 1/ 12/ 11/1 1/2 9/3 8/4 7/5 6/6 5/7 4/8 3/9 5 1 15 2 25 3 35 4 45 5 13 12 11 1 9 8 7 6 USD and Commodity Prices 1/ 12/ 11/1 1/2 9/3 8/4 7/5 6/6 5/7 4/8 3/9 15 2 25 3 35 4 45 5 CRB (right reverse order) DXY CRB (right reverse order) Source: Bloomberg, BIE. Commodity Prices: Brazil is mostly a commodity exporter and exports should be positively influenced by high commodity prices. Brazil Export Products 34% 66% Commodity Non commodity Source: Bloomberg, BIE, Itaú Unibanco. Exports: The higher the export volume the higher the demand for BRL, Brazil s export profile has been improving targeting fast growing countries. Main destinations for Brazilian Exports (12-month accumulated / total) 4. 3.5 3. 2.5 2. 1.5 vs Monthly Exports 1/ 12/ 11/1 1/2 9/3 8/4 7/5 6/6 5/7 4/8 3/9 25 2 15 1 5 3% 25% 2% 15% 1% 5% % 12% 11% 8% 5% 4% 3% Monthly Exports (right) Dec-89 Dec-9 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec- Dec-1 Dec-2 Dec-3 Dec-4 Dec-5 Dec-6 Dec-7 USA Germany Netherlands Argentina Japan China Dec-8 Source: Bloomberg, BIE, Itaú Unibanco. Mn USD. - 3 -
Itaú Europa Brazil Currency Perspectives November 29 FDI: The higher foreign direct investment the higher the demand for BRL. FDI is supportive for the currency compensating possible negative effects coming from current account deficits. 4. 3.5 3. 2.5 2. 1.5 vs FDI 1/ 12/ 11/1 1/2 9/3 8/4 7/5 6/6 5/7 4/8 3/9 15 1 5-5 -1-15 Monthly FDI (right) Source: Bloomberg, BIE. Mn USD. Financial Flows: The higher financial investment the higher the demand for BRL. Nevertheless, the volatility of financial flows could be a negative influence over foreign exchange stability. 4. 3.5 3. 2.5 2. 1.5 vs Financial Investment 1/ 12/ 11/1 1/2 9/3 8/4 7/5 6/6 5/7 4/8 3/9 1 8 6 4 2-2 -4-6 -8-1 1% 8% 6% 4% 2% % -2% -4% -6% FX Flows 2 21 22 23 24 25 26 27 28 29 YTD Financial Investment Financial Commercial Source: Bloomberg, BIE. Mn USD. Weakness of the USD: In the short term, with a looser monetary policy in place, and in the longer term, with government reserve diversification and high government deficits, the USD could remain under pressure against most of the currencies. 8.% 7.% 6.% 5.% 4.% 3.% Currency Composition of Official Foreign Exchange Reserves (COFER) 4.% 35.% 3.% 25.% 2.% 15.% 1.% Change Between 26 and 21E 2.% 1.%.% USD EUR GBP JPY CHF Other 25 29 5.%.% -5.% -1.% USA UK Japan Canada France Germany Italy Budget balance/gdp Net debt/gdp Source: Bloomberg, BIE. - 4 -
Itaú Europa Brazil Currency Perspectives November 29 What could depreciate the BRL? Imports: With economic growth on track and a strong currency, domestic demand could pressure imports up. Also companies operating in Brazil could be induced to repatriate profits and dividends. We expect a current account deficit going forward. 2.% 1.%.% -1.% -2.% -3.% -4.% External Accounts 26 27 28 29E 21E 6 4 2-2 -4-6 -8 Current account % GDP Trade balance Current account Source: Bloomberg, BIE, Itaú Unibanco. Bn USD. Brazilian Companies Investing Abroad: Similarly to the move made by Ambev, other Brazilian companies could aim at internationalization, pressuring the currency down. 1 5-5 -1-15 -2-25 -3 Brazilian Direct Investment Abroad 198 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 Source: Bloomberg, BIE. Negative data means money outflow from Brazil into foreign countries. Mn USD. Real Interest Rates Convergence: As economies develop and market efficiency improves, the cost of capital tends to decrease. Mexico and Peru are other examples, despite not having such a long history as developed countries. 1 8 6 4 2-2 -4-6 Real Rates Convergence 1/9 2/91 3/92 4/93 5/94 6/95 7/96 8/97 9/98 1/99 11/ 11/1 11/2 11/3 11/4 11/5 11/6 11/7 11/8 US UK EU Source: Bloomberg, BIE. %. - 5 -
Itaú Europa Brazil Currency Perspectives November 29 3- Correlation Matrix 4- Macroeconomic Forecasts 26 27 28 29E 21E World Economy World GDP growth USA Euro Area Japan China External Sector & Exchange Rate BRL / USD eop BRL / USD year avg Exports USD bn Imports USD bn Trade balance USD bn Total Trade Flows (exp + imp) % GDP Current Account USD bn Current Account % GDP Foreign Direct Investment USD bn Foreign Direct Investment % GDP International reserves, cash USD bn International reserves % GDP Economic Activity Nominal GDP BRL bn Nominal GDP USD bn Real GDP growth Inflationn IPCA IGP M Interestt Rate Selic eop Selic year avg Real interest rate (Selic/IPCA) - eop Public Finances Primary budget surplus % GDP 2 Nominal budget surplus % GDP 2 Net Debt % GDP 2 5.1% 2.8% 2.9% 2.% 11.6% 2.15 2.18 138 91 46 21.% 14 1.3% 19 1.7% 86 7.9% 2,369.8 1,88.9 4.% 3.1% 3.8% 1% 15.1% 9.8% 3.4% -3.4% 46.1% 5.2% 2.% 2.7% 2.4% 11.9% 1.79 1.95 1611 1211 4 21.4% 2.1% 35 2.6% 18 13.7% 2,565.1 1,313.9 5.7% 4.5% 7.8% 11.25% 12.% 6.5% 3.5% -2.7% 43.9% 3.%.4%.7% -.7% 9.% 2.39 1.83 198 173 25 23.6% -28-1.8% 45 2.9% 194 12.3% 2,889.7 1,575.2 5.1% 5.9% 9.8% 1% 12.5% 7.4% 3.7% -2.% 38.8% -1.2% -2.6% -3.7% -5.2% 8.% 1.7 1.99 144 119 25 17.4% -19-1.2% 33 2.2% 247 16.3% 3,15.5 1,511.8.% 4.3% -.8% 8.75% 9.9% 4.3% 1.6% -3.6% 42.9% 3.4% 2.1% 1.% 1.3% 8.5% 1.73 1.72 144 146-2 15.1% -6-3.1% 47 2.4% 28 14.5% 3,312.4 1,928.1 5.5% 4.1% 4.1% 1.25% 9.7% 5.9% 2.4% -2.8% 41.9% Source: Itau Unibanco. - 6 -
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