Scenario Review - Brazil June 9, 2017 A setback for reforms and a more challenging scenario A more turbulent political scene tends to delay reforms in Congress, making fiscal rebalancing more difficult and, consequently, affecting confidence levels and asset prices. We now anticipate a weaker exchange rate, at 3.50 reais per U.S. dollar in 2017 and 3.60 in 2018. We revised our forecast for the IPCA consumer price index downward for 2017 to 3.7% from 3.9%, but raised our call for 2018 to 4.1%, from 3.8%, due to exchange-rate depreciation. We maintained our estimate for the benchmark interest rate by YE17 at 8.0%. We expect the pace of rate cuts to slow down to 75 bps in the July meeting. A complex scenario, more uncertainties surrounding reforms and a milder decline in interest rates outline a challenging situation and should weigh on economic activity. We thus reduced our estimates for GDP growth to 0.3% this year and 2.7% in 2018. The international environment and mitigating factors such as international reserves, Treasury funds held by the central bank and falling inflation have cushioned the reaction of asset prices to the deterioration of reform prospects. For now, a situation of financial stress seems to be at bay. However, financial stability is a necessary not sufficient condition for a consistent recovery in economic activity. The cost of uncertainty is stagnation. Delayed reforms make fiscal rebalancing more difficult and uncertainties intensify With the significant intensification in political uncertainties, Congress will likely delay processing the pension reform. The proposal needs greater political consensus before being voted on in two rounds on the main floor of the Lower House, so it can then proceed to the Senate. Now, these votes may only take place in the second half of the year. Doubts about the approval of reforms heighten uncertainties about the outlook for public-debt stabilization. The delay affects confidence levels and pressures local asset prices, consequently undermining the outlook for a rebound in economic growth and further declines in interest rates (in response to greater fiscal equilibrium), and fueling more growth in public debt. Without reforms, the government is less likely to meet the constitutional spending cap over time and public debt would remain in an upward trend (see chart). Without reforms, the adjustment in public accounts in the long run would materialize in the form of higher inflation or alternative measures with a negative impact on the economy. For instance, the fiscal imbalance in Greece produced a 32% contraction in the economy from 2008 and effectively caused the removal of social rights. Among feasible remedies, an increase in the tax burden of more than 4 pp would be very likely, in order to finance growing deficits in the pension system and the public sector as a whole, significantly decreasing the chances of a sustainable economic recovery. Importantly, this would not be an increase in the tax burden in order to bankroll more capital expenditures (lifting growth capacity in the economy). It would simply amount to resources being transferred from one generation to another, without impact on potential growth. 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.
Unsustainable increase in public debt: Reforms are urgent 80% 75% 70% 65% 60% 55% 50% 45% % GDP Source: BCB, Itaú General government gross debt 70% 77% 75% 2006 2008 2010 2012 2014 2016 2018 Amid greater uncertainty, meeting fiscal targets will be even more difficult, delaying the gradual reversal of the country s fiscal imbalance. Our estimate for the primary deficit in 2017 is 2.4% of GDP (157 billion reais), missing the current target of 2.2% of GDP (142 billion reais). The expectation of slower economic growth in 2017 means that tax revenues will be shorter by 15 billion reais (0.2% of GDP), causing fiscal needs to meet the target to rise by 90 billion reais (1.4% of GDP). In this context, despite significant efforts in terms of spending freezes and extraordinary revenues (such as repatriation of funds held by residents overseas, concessions and several tax regularization programs), we regard the current primarydeficit target as ambitious. However, given the economic team s strong commitment to the target, we do not rule out additional spending cuts and higher revenues (with tax hikes, for instance), to compensate for the disappointing tax revenues. Our estimate for the primary deficit in 2018 is 2.1% of GDP (147 billion reais), also above the target of 1.8% of GDP (131 billion reais). Weaker economic growth and difficulties in terms of cutting discretionary expenses further, raising taxes amid political uncertainty, and a third consecutive year of large extraordinary revenues tend to produce a more gradual convergence to primary-budget surpluses that are compatible with stability in public debt. Greater risks pressuring the BRL Political uncertainties pressured the Brazilian currency during the month. Although the external environment remains favorable to emerging-market currencies, political events intensified the uncertainties about the approval of reforms and increased risk premiums. Brazil s CDS spread jumped to more than 265 bps from 200 bps in a single day, but later stabilized around 240 bps. The exchange rate behaved similarly, sinking to about 3.40 reais per dollar from 3.10 in a day, but it is again trading around 3.25, thanks to the central bank s interventions in the FX market. During the past month, the monetary authority sold USD 10 billion in FX swap contracts, to foster calm and make sure that the market continues to function well. We revised our exchange-rate forecasts to 3.50 reais per dollar by YE17 (from 3.25) and 3.60 by YE18 (vs. 3.35). Uncertainties about adjustments and reforms have intensified in the past month. A bleaker outlook tends to lift risk premiums, weakening the Brazilian currency. Higher risk premiums and a weaker BRL 4.20 4.00 3.80 3.60 3.40 3.20 3.00 180 Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Bloomberg, Itaú BRL CDS (RHS) 530 480 430 380 330 280 230 All-time-high trade surpluses in the first months of the year help to keep the current-account deficit at low levels. The current-account deficit over 12 months narrowed to USD 20 billion or 1.1% of GDP. A weaker exchange rate and slower activity led us to revise our forecasts for the current account in the coming years. We now forecast a USD 60 billion trade surplus 1 in 2017 and USD 50 billion in 2018 (vs. USD 40 1 As per MDIC Page 2
billion previously). For the current account, we forecast a USD 23 billion deficit in 2017 (vs. USD 25 billion) and USD 37 billion deficit (vs. US$ 50 billion) in 2018. We revised our inflation forecast downward for 2017 and upward for 2018 For 2017, our forecast for the IPCA consumer price index has been revised downward to 3.7% from 3.9%. Well-behaved inflation at the margin more than offset the effect of our revised estimate for the exchange rate. We expect year-over-year inflation to recede to 3.2% in June, bottoming at 2.9% in August and rebounding to 3.2% in September. Importantly, disinflation may pave the way for a welcome debate about reducing the inflation target. The National Monetary Council (CMN) will meet in June to confirm the inflation target of 4.5% for 2018 and set the target for the following year. Below-target inflation 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% yoy IPCA Market-set prices (76%) Regulated prices (24%) Source: IBGE, Itaú 10.7% 6.3% Forecast 3.7% 4.1% 0% Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Breaking down the IPCA, we anticipate increases of 3.2% in market-set prices and 5.2% in regulated prices. Among market-set prices, we forecast a 2.0% increase for food prices consumed at home, after a 9.4% jump last year. The outlook for large crops in Brazil and other large global producers has been prompting declines in wholesale agricultural prices since September 2016 and affecting retail food prices favorably during the year. Wholesale agricultural prices (measured by Getulio Vargas Foundation s IGP-M) show 8.7% deflation in the last 12 months (13.5% in the past nine months). Sharp disinflation in food prices this year is set to provide relief of 1.2 pp to the IPCA reading almost half of the estimated retreat in inflation during this period. For industrial prices, we expect a 1.7% increase this year (4.8% in 2016). For services, our call stands at 4.8% (6.5% in 2016). Adverse conditions in the labor and real estate markets, dissipation of the inertia effect of past inflation, and a smaller adjustment in the minimum wage have moderated wage and rent costs. In that sense, they will contribute to lower service inflation in 2017. As for regulated prices, we forecast - 3% for landline phone service; -3% for gasoline; 5% for medication; 7% for electricity; 7% for urban bus fares; 7% for bottled cooking gas; 8% for water and sewage tariffs; and 13.5% for health insurance premiums. We revised our estimate for 2018 inflation upward to 4.1%, from 3.8%. Our expectation of a weaker exchange rate more than offset the downward effect related to a slower rebound in economic activity and an even higher unemployment rate. Breaking down the estimate, we expect market-set prices to rise 3.5% and regulated prices to climb 5.8%. The main factors behind our below-target forecast are the negative output gap, lower inertia from 2017 inflation and anchored expectations. As already mentioned in this report, inflation below the target range midpoint starting in 2Q17 and inflation expectations below 4.5% create an opportunity to consider a reduction in the inflation target for 2019. We regard a 4.25% target as appropriate, given that expectations stand at that level. Falling inflation expectations 5.6% 5.4% 5.2% 5.0% 4.8% 4.6% 4.4% 4.2% Source: BCB (Focus Survey) Median inflation expectations (IPCA) 2017 2018 2019 2020 4.40% 4.25% 4.25% 4.0% 3.90% 3.8% Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 The main risk factors for inflation are still tied to domestic politics. Heightened political uncertainties hinder reforms and needed adjustments in the Page 3
economy, potentially causing additional impact on risk premiums and the exchange rate. Along with a negative effect on economic activity, setbacks in terms of approving reforms may also require alternative fiscal measures, such as tax hikes and/or the reversal of tax breaks, which tend to have an upward impact on inflation, at least in the short term. As for the external scenario, notwithstanding more favorable signs at the margin, there are still risks related to possible changes in economic policy in the main developed nations, which could eventually lift risk premiums and depreciate the local currency. Substantial slack in the economy may contribute to a sharper decline in inflation. The negative output gap (difference between potential and effective GDP) may prompt faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months showed evidence of a more widespread disinflation process, which has been affecting these segments in particular. As for prices for food consumed at home, given the favorable supply shock and the recent evolution of agricultural retail prices, we cannot rule out seeing even more beneficial behavior than our current call. A lower inflation target for 2019 would reinforce the outlook for lower inflation and anchored expectations. The median of inflation estimates for the year, measured by the Central Bank s Focus survey, declined to 3.9% from 4.0%, although the currency depreciated during the past month. The median expectation for 2018 was unchanged at 4.4%. Median estimates for 2019 and 2020 remained at 4.25%, probably already assuming the possibility of a lower inflation target for the 2019 calendar year. Monetary policy: Heightened uncertainties should prompt a slower easing pace The minutes of the Monetary Policy Committee (Copom) in May stressed that the effects of heightened uncertainties surrounding reforms on the prospective inflation path are not trivial. High levels of uncertainty for long periods may have a disinflationary impact by hurting economic activity, but also affect estimates for structural interest rates. In that context, the Copom felt the need to reduce uncertainties about the future path of monetary policy by signaling a moderate deceleration in the pace of rate cuts in its next meeting, in July. We expect the Copom to slow the pace to 75 bps in July and to 50 bps in the following meetings, moving at that speed until the Selic rate reaches 8% by year-end. Activity: Uncertainties lead to a slower rebound GDP expanded 1.0% in 1Q17, after eight consecutive quarters of declines. The result was deeply influenced by strong agricultural production and favorable statistical carryover from industrial production. Nevertheless, the report showed that improved fundamentals (falling interest rates, better corporate balance sheets, higher commodity prices since 1Q16 and confidence levels) were benefiting the economy. For 2Q17, GDP is likely to contract slightly, by -0.2% qoq/sa. Our forecast is based on a mild decline in agricultural GDP and unfavorable statistical carryover from several GDP components after weak readings in March. Coincident indicators for April and May point to a scenario of stability that does not reverse the unfavorable statistical carryover effect during the quarter. We revised our estimate for GDP growth in 2017 to 0.3% from 1.0%, given the outlook for a slower rebound in the second half. The prospect of slower growth is consistent with the complexity of the scenario, uncertainties surrounding reforms. Furthermore, our new forecast incorporates slightly weaker figures in 1H17. Growth to rebound more slowly as uncertainties rise 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% 2013.IV 2014.IV 2015.IV 2016.IV 2017.IV 2018.IV Source: IBGE, Itaú quarter-over-quarter Realized Forecast Page 4
Our forecast for GDP growth in 2018 now stands at 2.7% of GDP. The revision (from 4.0% previously) was prompted by the same events that will affect 2H17, as well as a significantly less favorable statistical carryover due to a slower recovery in 2017. Destruction of formal jobs slows down gradually. According to the Labor Ministry s Caged registry, 59,900 jobs were destroyed in net terms in April. The seasonally adjusted three-month moving average receded to -56,000 from -62,000 and continues to slow down (see chart). The unemployment rate measured by PNAD was virtually stable at 13.2% (applying our seasonal adjustment). Both readings were slightly better than anticipated. Assessing the outlook for the labor market, our economic expectations are consistent with the unemployment rate at 14.0% by YE17 (13.8% previously) and 14.3% by YE18 (13.6% previously). We expect the unemployment rate to peak in 3Q18, at 14.3%. Unemployment will continue to climb when the recovery begins, because the contracting cycle in economic activity has not yet had a full impact on the labor market. Destruction of formal jobs slows down in April 300 250 thousands, 3-month moving average 200 150 100 50 0-50 -100-150 -200 Apr-09 Apr-11 Apr-13 Apr-15 Apr-17 Source: Caged, Itaú Page 5
Forecast: Brazil 2011 2012 2013 2014 2015 2016 2017F 2018F Economic Activity Real GDP growth - % 4.0 1.9 3.0 0.5-3.8-3.6 0.3 2.7 Nominal GDP - BRL bn 4,376 4,815 5,332 5,779 6,001 6,267 6,649 7,178 Nominal GDP - USD bn 2,612 2,463 2,468 2,455 1,802 1,797 2,017 2,020 Population (millions) 197.4 199.2 201.0 202.8 204.5 206.1 207.7 209.2 Per Capita GDP - USD 13,234 12,362 12,278 12,106 8,811 8,721 9,711 9,656 Nation-wide Unemployment Rate - year avg (*) - 7.4 7.1 6.8 8.5 11.5 13.7 14.3 Nation-wide Unemployment Rate - year end (*) - 7.5 6.8 7.1 9.6 12.6 14.0 14.3 Inflation IPCA - % 6.5 5.8 5.9 6.4 10.7 6.3 3.7 4.1 IGP M - % 5.1 7.8 5.5 3.7 10.5 7.2 1.3 4.5 Interest Rate Selic - eop - % 11.00 7.25 10.00 11.75 14.25 13.75 8.00 8.00 Balance of Payments BRL / USD - eop 1.87 2.05 2.36 2.66 3.96 3.26 3.50 3.60 Trade Balance - USD bn 30 19 2-4 20 48 60 50 Current Account - % GDP -2.9-3.0-3.0-4.2-3.3-1.3-1.1-1.8 Direct Investment (liabilities) - % GDP 3.9 3.5 2.8 3.9 4.2 4.4 4.1 4.3 International Reserves - USD bn 352 379 376 374 369 372 372 372 Public Finances Primary Balance - % GDP 2.9 2.2 1.7-0.6-1.9-2.5-2.4-2.1 Nominal Balance - % GDP -2.5-2.3-3.0-6.0-10.2-9.0-8.1-7.6 Gross Public Debt - % GDP 51.3 53.7 51.5 56.3 65.5 69.9 74.7 77.2 Net Public Debt - % GDP 34.5 32.3 30.6 33.1 36.0 46.2 50.3 53.9 Source: IBGE, FGV, BCB and Itaú (*) Nation-wide Unemployment Rate measured by PNADC Macro Research Itaú Mario Mesquita Chief Economist Tel: +5511 3708-2696 Click here to visit our digital research library. Page 2
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