Lunes 11 de Diciembre 2017
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The market is assuming former-President Sebastián Piñera will win the November presidential election, although some pundits warn that it is still premature to view such an outcome as a foregone conclusion. (Photo: SebastianPinera.cl)
Thursday, February 9, 2017
Perspectives

Slower Peru Growth, Uncertain Chile Polls


Peru sees slower growth amid corruption scandals, while Chile sees uncertain election outcome.

BY FRANCO UCCELLI

News that a large Brazilian builder admitted bribing government officials over a 10-year period starting in 2005 has sent shockwaves through Peruvian society. Apart from capturing much public attention, the news appears to already be having a sizable impact on people’s growth expectations for this year, sending private and public forecasters alike back to the drawing board to try to assess the extent to which the latest scandals may delay the execution of ongoing infrastructure investment projects and postpone the initiation of new ones. It is estimated that the direct impact on this year’s real GDP growth of the cancellation of a large contract with Odebrecht to build a gas pipeline could be as much as 0.5 percent, with the indirect impact believed to be just as high. Against this backdrop, the government recently announced that it was lowering its growth forecast for 2017 to 3.8 percent from a previous 4.8 percent estimate, with even more conservative private sector projections putting the figure in the 3.3-3.6 percent range, in line with growth potential of 3.5 percent, as estimated by the IMF. We note that so far there are no allegations that any current senior public sector officials, some of whom served in government during the past decade, including President Kuczynski and Prime Minister Zavala, may have been involved in any corrupt practices.

Current monetary policy stance is moderately expansionary. Whether one subscribes to the view that the current monetary policy stance is moderately expansionary or not, the fact still remains that the central bank’s belief that it is indeed moderately expansionary should be enough to drive monetary policy decisions in the near term. The math is quite simple here: the reference rate currently stands at 4.25 percent and inflation expectations at 2.9 percent, resulting in a real interest rate of around 1.4 percent. Since the 1.4 percent figure is below the 2 percent threshold regarded to be the neutral interest rate level, the current policy stance is viewed as moderately expansionary. With the most recent growth projections in line with estimated potential and inflation roughly in line with the (relatively low) official target range, most local observers believe the central bank is likely to keep the reference rate unchanged at 4.25 percent in the foreseeable future, and we concur.

Recent adjustments to bank reserve requirements should not be interpreted as an easing signal. Last December the central bank lowered bank reserve requirements, prompting speculation that it may have been a first step toward the adoption of an easier monetary policy stance. This is likely not the case at all, as the decision was seemingly intended to smooth the credit cycle and boost lending after growth in new credit rose at its lowest pace in more than one decade in 2016. The central bank has made it quite clear that it manages the reference rate to address inflation issues and manages reserve requirements to address the credit cycle, so recent changes to bank reserve requirements should not be viewed as part of a concerted effort to ease monetary conditions. Nor does the central bank use the reference rate to change the price of credit. It has been also noted that intervention in the FX market, which is not rules-based and hence discretionary, does not respond to changes in inflation dynamics, but is rather meant to contain excessive volatility in the exchange rate.

A shift to nominal deficit targets is intended to increase transparency of fiscal accounts. Last July, the Kuczynski administration inherited what it has described as a worrisome fiscal situation, with the yearly deficit tracking 3.8 percent of GDP and expenditures, particularly current, troubled by very pervasive inertia. The new government quickly moved to change that by imposing limits on total spending—and not just capex, as had been done before—effectively forcing all ministries to cut current spending. Swift action on the expenditure side and windfall income at the end of the year enabled the government to narrow the deficit to 2.7 percent of GDP, outperforming the 3.0 percent-of-GDP target. Despite the better-than-expected result, the government has opted to maintain its 2.5 percent of GDP deficit target for 2017, perhaps to compensate for the expected decline in the growth rate, and has made the nominal, rather than the structural, deficit its new official target, also adding expenditure targets to guarantee compliance with its consolidation plans. The adoption of nominal targets is intended to increase the level of transparency of the fiscal accounts by eliminating the discretionary element imbedded in the calculation of the structural balance.

New local bonds will be Euroclearable, but the jury is still out on the old ones. The government has confirmed that it will indeed make its local bonds Euroclearable starting sometime in April or May. Initially, the Euroclear feature would apply only to new bond issues, with the decision to make existing issues Euroclearable as well contingent on the success of the overall process. The government focus going forward will be on giving more liquidity to a few benchmark points in the yield curve, with private sector operators speculating that, given the success of a recent large liability management transaction, the government will likely undertake additional transactions of the sort, but probably not until the Euroclearable option becomes fully operational. Since all debt service payments for 2017 have already been pre-financed and the government remains committed to its fiscal deficit target for this year, the issuance of any additional net debt would likely be to pre-finance next year’s obligations and not to cover a larger-than-expected fiscal shortfall.

Political interests may diminish opposition pressures on current administration. While many local pundits had believed that losing the presidential election in a second round vote against President Kuczynski would turn the Fuerza Popular party of Keiko Fujimori, which won a congressional majority, into a bitter opposition force, that bleak view appears to have been toned down considerably. While not seen as willing to rubber stamp any and all government initiatives, people now believe it is the best interest of Fujimori’s party that President Kuczynski achieve some degree of success while in government, as the two parties are ideologically aligned, so that a Kuczynski failure would severely limit Fujimori’s chances of winning the next presidential election. Faced with a common adversary in the political left, it is now expected that the two orthodox parties will find common ground and be able to work together on critical issues. This would clearly be positive for the Kuczynski administration and its aim to approve a number of reforms.

CHILE: UNCERTAIN ELECTION OUTCOME

Real GDP growth has slowed considerably since 2013 owing largely to the end of the commodities supercycle, which had boosted copper prices and hence Chile’s export revenues, and a deterioration of domestic confidence levels, which were affected by the rejection of a series of government reforms and generalized discontent with social and political institutions. Against this somber backdrop, economic activity is expected to stay soft this year, with real GDP expanding by a relatively muted and well below potential 2 percenty/y after growing only 1.5 percent in 2016, before strengthening to 3.2 percent in 2018, boosted by anticipated recoveries in business confidence and commodity prices and more clarity on the political front, with a more pro-growth, market-friendly government expected to win the November 2017 election.

Given its faster than expected decline, inflation has become much less of a concern. After exceeding the upper bound of the 3 percent (+/-1 percent) official target during much of 2014, 2015, and the first half of 2016, inflation has moderated a lot faster than expected, even raising concerns among some local observers about the possibility of inflation undershooting the target, something that the authorities view as highly unlikely. Indeed, since more than half of the decline has been related to lower prices for some food items, rather than to more structural factors, inflation expectations have remained well anchored around the midpoint of the target range, suggesting that inflation has become less of a concern and that an aggressive policy response is improbable. Some local observers believe the recent disinflation process has not been related at all to weak activity levels but rather to the stabilization of the exchange rate, and they utilize simple math to argue their point. After depreciating 15 percent (round numbers), the argument goes, the CLP has appreciated roughly 5 percent, implying a total correction of 20 percent. Assuming a 10 percent pass-through effect, this should have produced a 2 percent decline in inflation, and that is precisely what the latest numbers show, supporting the disinflation due to currency stability theory.

An aggressive easing cycle does not appear to be in the cards. While economic growth remains relatively weak and well below potential and inflation has declined much faster than expected, there is a lack of consensus on the proper pace and degree of monetary policy easing that should be undertaken to reactivate economic growth. Indeed, central bank authorities, who are widely regarded to be fairly conservative, appear to be much more focused on medium- and long-term trends than market players, who are much more sensitive and reactive to short-term volatility. As such, there is a clear disconnect between official expectations of an orderly mean reversion (and hence support for a cautious approach to monetary policy adjustments) and the market view that a series of cuts to the reference rate are needed to bolter economic growth and prevent inflation readings from undershooting the target. Since the job of a policy analyst is to predict what will likely be, rather than what should be, we stand by our out-of-consensus call that only one more 25bp rate cut will be forthcoming in the first quarter (as early as this month but no later than March), before the central bank shifts to a wait-and-see mode. This view is predicated on the notion that the central bank does not generally react to short-term changes to inflation dynamics and its belief that growth in the well-balanced economy has all the elements to converge toward its potential in the next couple of years, making it unnecessary to implement a more active policy stance. As we believe the central bank is not in the business of stimulating growth, but rather in the business of simply smoothing the economic cycle, we expect it to adopt a more measured approach than what the market is currently pricing in.

Broad FX stability is likely to prevail. Despite undergoing a cyclical slowdown, the Chilean macro economy has managed to remain broadly stable and keep its imbalances (fiscal, external, etc.) well contained and, perhaps more importantly, quite manageable. As the economy recovers supported by a gradual rebound in copper prices and as current FX valuations remain close to equilibrium levels, the exchange rate is expected to stay fairly stable at current levels over the next couple of years, helping in turn to keep inflationary pressures in check.

Fiscal stance is poised to remain supportive. The fiscal deficit widened to 2.8 percent of GDP in 2016 from 2.2 percent in 2015. Notwithstanding the deterioration, last year’s deficit was lower than the 3.1 percent of GDP shortfall the government had targeted for the period, partly owing to the under execution of the budget. While the government intends to maintain an expansionary fiscal stance in 2017, it also remains firmly committed to its structural balance rule, which has contributed to increase the central bank’s degree of freedom, added predictability and credibility to fiscal policy, made long-term public spending sustainable, lowered the need to raise foreign capital in periods of financial distress, and calls for a reduction in the structural deficit of 0.25 percent of GDP per year. Although the latest government forecast envisages the nominal deficit climbing to 3.3 percent of GDP in 2017, this number is widely expected to be revised a bit lower, supported by better than expected tax revenues.

November presidential election could elicit a much-needed confidence shock, but its outcome is still uncertain. By and large, the market is assuming a positive election outcome, with right-of-center former-President Sebastián Piñera expected to win the November presidential election, before adopting a more business-friendly policy stance and eliciting a much-needed confidence shock, which would in turn boost consumption and investment and ultimately economic growth. However, some pundits warn that it is still premature to view such an outcome as a foregone conclusion. While Piñera has yet to make his candidacy official, a left-of-center candidate, Alejandro Guiller, has made important gains in recent polls, suggesting that the election will be closer than expected. That being said, and despite the potential challenge from the leftist candidate, most people believe the political outlook will turn increasingly promising as there is more clarity on Piñera’s chances of winning the election and of turning the Chilean economy around.

Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on recent trip reports to Peru and Chile. Republished with permission. 


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