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Global Economic Outlook
Brazil: Q2 2010 Outlook
By Bertrand Delgado
- Above-potential economic activity and above-target inflation expectations will induce the central bank to initiate the tightening cycle on April 28 with a 50-basis-point (bp) hike, though a 75-bp increase cannot be ruled out.
- Although the current account deficit will widen rapidly in 2010, large capital inflows will limit balance-of-payment (BoP) risks; however, the country will become more dependent on external financing, and the Brazilian real (BRL) more vulnerable to sudden changes in risk appetite and global liquidity conditions.
- Deviation from the current macroeconomic policy might create market concerns, especially regarding fiscal standing and the government’s role in the economy.
Outlook Update: No Sharp Inflation Increase
The more-severe-than-expected increase in inflation and inflation expectations at the beginning of the year made us increase our headline inflation forecast to around 5.3% from the previous 4.9%. Seasonal factors affecting food and education prices, as well as hikes in public transportation fares, have had a stronger impact on inflation than previously anticipated. Although we expect inflation to stabilize in April as seasonal factors wear off, the rapid closing of the output gap will likely renew demand-pull pressures, while higher-than-expected wholesale prices will make it difficult for regulated prices to stay low, thus keeping inflation above the 5% mark. In our view, a sharper increase in the inflation outlook is unlikely, given the absence of external supply side shocks stemming from commodity prices, a strong currency and the fact that rapid growth in investment will help in balancing demand-pull inflation pressures. We expect inflation to come down to 4.7% by the end of 2011, given slower economic activity and more restrictive macroeconomic policies.
Figure 1: Output Gap (HP Filter)
Source: IBGE and RGE, Forecast in Box
RGE is revising up Brazil’s economic growth to 5.8% y/y from 5.3% y/y in 2010 (in the 5.5% to 6.5% range) as a result of stronger-than-expected domestic demand, improved global economic and financial conditions and a low base. This implies that economic activity will be growing well above the trend of 3.5% in 2010; however, we point out that strong growth in investment plays a key role in our forecast. The RGE core scenario remains the same as in the last Outlook. We foresee a solid H1 with economic growth of over 6.5% y/y and a deceleration in H2 2010 to more sustainable growth rates of around 5% y/y. In H2 2010, the withdrawal of macroeconomic stimulus, together with an expected global slowdown and a higher base, should reduce the pace of expansion. So far, at the beginning of 2010, labor dynamics are improving, business and consumer confidence remain solid, industrial production and retail sales are reaccelerating and credit expansion remains strong. This indicates that GDP will post solid gains in H1 2010. RGE expects GDP to decelerate to 4.5% in 2011 given the withdrawal of the macroeconomic stimulus and high base.
Figure 2: Monetary Policy Rate (SELIC) and Inflation (IPCA, y/y)
Source: IBGE and RGE, Forecast in Box
RGE continues to believe that the current account deficit will widen sharply to US$49 billion (3.1% of GDP) in 2010 from a deficit of US$24 billion (1.8% of GDP) in 2009 on the back of upbeat domestic demand and a strong/stable currency. Solid capital inflows, however, should cover the wider current account deficit and mitigate BoP risks. We point out that as the deficit widens the more dependent the economy becomes on external financing and the more vulnerable it is to swift changes in risk appetite and global liquidity conditions. Our view takes into account a shrinking merchandise surplus, which will fall to US$8.6 billion in 2010 from US$25 billion in 2009, as well as higher remittances of profits abroad and a wider deficit in services. Although we have revised our growth forecast to the upside indicating strong import growth, exports are also benefiting from solid expansions abroad and high commodity prices. Overall, RGE sees international reserves increasing to US$255 billion in 2010 from US$239 billion in 2009. RGE anticipates the current account deficit will widen slightly to US$62billion, or 3.7% of GDP in 2011, as domestic demand cools off.
Figure 3: Trade Balance Dynamics (US$ Millions, 12-month Rolling Basis)
Source: MDIC and RGE
On the local currency, RGE maintains the view that the BRL will likely stay well supported by wide GDP growth and interest rates differentials. However, sharp reversals in global risk appetite, the real’s overvalued stance in real terms (36% versus 10-year trend) and a possible increase in political volatility as the electoral cycle evolves represent the main risks. Moreover, the finance ministry’s interventionist stance should limit strong appreciation pressures on the local currency beyond the BRL1.7 level. We expect the real to be around BRL1.75 per USD by the end of 2010, ranging between BRL1.7 to BRL2. RGE expects the real to be around BRL1.85 per USD by the end of 2011, within a range of BRL1.7 to BRL2.2.
Figure 4: Real Effective Exchange Rate vs. Nominal Value (USD/BRL)
Source: BIS, Bloomberg and RGE
Finally, RGE maintains the view that regardless of which of the main two contenders, Jose Serra or Dilma Rousseff, takes power, the country’s successful macroeconomic policies will most likely be maintained. These policies include an inflation targeting regime, flexible foreign exchange policy and judicious fiscal management. However, the markets will pay close attention to fiscal dynamics and initiatives for structural reform after the elections. Brazilians will go to the polls on October 3, 2010, to elect a president, all governors, the entire lower chamber of the legislature and two thirds of the senate. Parties have until June 20, 2010, to nominate their presidential candidates and other officials. According to the latest Datafohla poll (March 2010), Jose Serra—potential presidential candidate from the Social Democratic Party (PSDB) —leads opinion polls with 36%, followed by current President Lula da Silva’s former Chief of Staff Dilma Rousseff and presidential candidate from the Workers Party (PT) who garnered 27%. Serra also leads polls in a would-be second round with 48% against Rousseff’s 39%.
How Do We Differ from Consensus: Less Hawkish than the Markets on the SELIC
Our survey of growth estimates found a range of 4.8% to 6.5%, with growth averaging 5.5% y/y for 2010, so our GDP forecast at 5.8% y/y in 2010 falls slightly above the average. However, we expect growth forecasts to be revised up closer to our estimates. RGE and the consensus expect domestic demand to drive growth; however, it seems that the main difference is in growth expectations in external demand. RGE believes the U.S. will experience a “U-shaped” business cycle, and the global economy will recover slowly in 2010, while most of the consensus appears to foresee stronger global economic performance.
Another key difference between RGE and the general market view is in monetary policy, where we expect a more gradual approach than the markets. The markets, via the DI curve, are pricing in a total of 330 bps with aggressive hikes early in the cycle (April to July).
Risks to Our Forecast: Domestic, Global Demand and Political Volatility
A potential upside risk is the possibility that domestic and global demand will grow faster than expected in an election year, not only making our growth forecast look conservative but also exerting additional pressures on inflation and inflation expectations via stronger demand-pull inflation pressures and higher commodity prices. In this scenario, our monetary policy call would need to be revised to higher interest rates in 2010 with front-loading in the tightening process.
Another potential risk to our scenario is a sharp increase in political volatility as a result of a hard-fought presidential race that would induce markets to worry about the future of economic policy, especially fiscal policy and government intervention in the economy. Any indication of a worsening in the current macroeconomic policy will have negative ripple effects on the markets and fundamentals. Currently, the main candidates back a stronger role of the government, while only Serra has been somewhat critical of the central bank’s actions during the crisis.
Finally, heightened global risk aversion as a result of potential systemic risks, such as those within the EU and worse-than-expected economic performance in the U.S. will derail our core scenario.
Policy Implications: Increasing Fiscal Spending and Rate Hikes
For fiscal policy, strong economic growth in 2010 should help fiscal standing, though the electoral cycle may pose challenges to overall fiscal health. Over the medium term, a more austere fiscal policy—especially on the spending side—and optimization of the tax system are necessary in our view. Fiscal data up to February 2010 suggest that the primary surplus has increased by 57% to BRL17 billion (3.3% of GDP), where the central government has experienced a sharp increase of 125% to BRL12.8 billion (2.5% of GDP). Meanwhile, the nominal deficit dropped to 2.1% of GDP in February 2010 from 3.1% of GDP in February 2009, and net public debt has fallen to 42.1% of GDP from 42.8% of GDP in December 2009. Strong economic activity that boosted tax revenues, together with a withdrawal of tax incentives in October 2009, is responsible for the positive result in early 2010. However, we see fiscal spending increasing as the electoral period unfolds and the presidential race becomes tighter. Given RGE’s forecast that the economy will experience strong growth in 2010, monetary policy will be adjusted slowly, and the currency will stay relatively stable. While fiscal accounts will experience some consolidation after the elections, the primary fiscal surplus is likely to reach 2.7% of GDP, and the net public sector debt-to-GDP ratio should stabilize at 42%. We highlight, however, that the likely risk is a higher primary fiscal surplus, perhaps closer to the government target of 3.3% of GDP, and to a lower net public debt of about 41% of GDP.
As for monetary policy, RGE maintains the view that the central bank will raise the SELIC rate by 250 bps to 11.25% in 2010 from the current 8.75%. We expect the COPOM to hike a total of 250 bps in 2010 via a gradual increase of 50 bps each meeting starting in April and ending in October. Unless current inflation and growth dynamics—as well as their expectations—deteriorate sharply, we do not see the case for an aggressive tightening cycle. Moreover, the intensification of political noise due to the presidential and general elections in October 2010, together with an uncertain global outlook, might keep the central bank from hiking rates aggressively anytime soon. RGE anticipates that COPOM will stay on hold at 11.25% in 2011 given that the economy will likely cool off and inflation expectations will probably move closer to the central target. The government is expected to emphasize stronger sustainable growth over the medium to long term without compromising inflation dynamics.