Economic Research | February 2013
Brazil
Understanding The Five Major Puzzles of the Economy
Marcelo Kfoury Muinhos
Head of Brazilian Economic Research
[email protected]
+55-11-4009-3470
Leonardo Porto de Almeida
Economist
[email protected]
+55-11-4009-2947
See Appendix A-1 for Analyst Certification, Important Disclosures and non-US research analyst disclosures
Citi Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. 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 consider this report as only a single factor in making their investment decision.
Summary of the Presentation
We expect global growth (PPP concept) to reach 2.6% and 3.2% in 2013 and 2014 respectively.
Global Concerns
Economic Puzzles in Brazil
▲We do expect a mild global recovery in 2013,
especially in US and Japan.
▲Industrial sector is underperforming badly the
rest of the economy. Industrial Production will
drop 2.5% and GDP will grow 0.9% in 2012.
▲ We revised up our forecasts for US (to 1.9%)
and Europe (-0.6%) in 2013.
▲Emerging Countries should continue leading the
global recovery (China should expand 7.8% this
year).
▲Global Risks (political crisis in Euro zone;
Chinese Growth is a minor risk. Geopolitical risk
in Near East and China/Japan).
▲We have record low unemployment rate and
the economy growing ½ of the potential.
▲Delinquency rate is at very high levels even
with record low unemployment rate.
▲Very loose monetary policy has not been not
able to boost economic activity. Selic is down
525bp and the economy has not reacted yet.
▲Inflation rate above the mid-point of the target
even with economy not doing well.
2
Citi Forecasts for Key Countries
No double-dip on the horizon for world growth. Emerging markets leading the way. Key world risks that may hurt
global recovery (US recovery; European debt crises; High oil prices).
Source: Citi Research
3
China – Hard or Soft Landing?
We do not expect a hard landing in China (7.3% in 2013). Inflation declined to 2.6% in December, below the
aimed level of 4%. Government is expected to be neutral in monetary policy.
4
US – Weak Recovery and Further Monetary Stimulus
US GDP growth has been recovering in a softer pace than in other previous episodes of recession.
5

GDP growth will likely hover around 2% in coming quarters


Fiscal cliff in 2013 (fiscal tightening of around 4% of GDP) and
European crises are the main threats for the GDP recovery.
Deleveraging process is behind the outlook of constrained private
consumption expansion, explaining the lower GDP growth.

Tough political negotiations (debt ceiling negotiations) probably
eliminated the fiscal policy instrument and rises risks of a fiscal
cliff.

Risk aversion tends to appreciate USD, hurting the performances
of US exports.
US – Citi Economic Surprise Index
US economic data has improved gradually amid monetary stimulus
100
50
0
-50
-100
-150
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
Jul-09
Apr-09
Jan-09
Oct-08
Jul-08
Apr-08
Jan-08
Citi Economic Surprise Index - US
Source: Citi Research
6

After several disappointing figures, US economic indicators have
improved recently.

Unemployment rate has been falling very gradually, but it is still
much higher than the 5% pre-crises.

FOMC launch QE3 buying US$40 billion/month in mortgages
assets open ended and extended Operation Twist (OT) up to 2012
year end.

FOMC announced that Fed Funds will be close to zero while
unemployment is greater than 6.5%


Difficulties in filtering a “true” seasonal factor may be behind the
disappointing performances in some economic indicators.
QE3 is expected to last until 2013 year-end according some
FOMC board members.
Euro Crisis – Solvency & Liquidity Crises
High levels of sovereign debts in Spain, Ireland, Portugal, Italy and Greece suggest a problem of solvency not
liquidity.
9
SP
Fiscal Deficit (% of GDP)
8
7
IR
GR
CY
6
SK
5
4
FR
SL
NL
PO
EZ
3
BE
IT
2
1
0
DE
-1
50
70
90
110
130
150
170
Public Debt (% of GDP)
Source: Citi Research
7
Sources: Eurostat and Citi Research

Euro Zone debtGDP has increased trom 73% in 2011 to 94% in
2012 and nominal deficit of 3.2% (7.0% in 2010).

Risks of a banking crises constrain further credit growth,
consequently GDP expansion.

Greece is still a striking outlier country, but Portugal and Ireland
may default part of their debt.


Financial repression is still a burden on local banks, which are
load with sovereign debt from their respective countries.
European countries resolution about ESM resources to financial
system did not address the problem of capitalization of rescue
mechanisms.
Crise Européia – Liquidez ou Solvência
Além do endividamento do setor público, setor privado (famílias e empresas) também está altamente
endividado.
Fonte: Citi Research
8
Fonte: Citi Research

High household debt is a burden to increase consumption in the
short run.

Chipre, Ireland, Portugal and Spain are the countries, where
companies present higher debt.

Chipre, Ireland, Portugal and Spain had the most indebtedness
families at the end of 2011

Firm’s indebtedness increases the cost of credit and constrains the
investiments

Holland’s families present high debt but public sector (70% do PIB)
and firms have less debt than Chipre, Ireland, Portugal and Spain.

Weak currency to boost export should offset high firm’s debt.
Activity – Real GDP Growth, Private Consumption & Investment
We expect 2012 GDP growth to reach 0.9%. For 2013, we expect GDP growth to reach 3.1%. Industry has been
underperforming overall economy since 2010 and contracted this year by around 3.5% (Puzzle 1)
4.0
Indexnumber
120
QoQ GDP Growth
140
3.0
110
135
2.0
100
130
1.0
90
125
0.0
80
120
-1.0
70
115
-2.0
60
110
-3.0
50
105
-4.0
40
100
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
RetailSales
Jan-09
Jul-08
Jan-08
9
Fourth quarter growth will likely keep underperforming potential
output growth again.
Jul-07

Jan-07
Economy has been growing 7 quarter in a row below potential for
the first time since 1996.
Jul-06

Jan-06
We revised our GDP growth in 4Q12 to 0.6% q/q same increase of
the third quarter
Jul-05

2013.IV
2013.III
2013.II
2013.I
2012.IV
2012.III
2012.II
2012.I
2011.IV
2011.III
2011.II
2011.I
2010.IV
2010.III
2010.II
2010.I
2009.IV
2009.III
2009.II
2009.I
2008.IV
2008.III
2008.II
2008.I
Source: IBGE and Citi Research
Jan-05
-5.0
IndustrialProduction
Source: IBGE and Citi Research

Widening gap between retail sales and industrial production
represents the evidence of strong demand amid constrained
supply

Gap on non tradable goods transform in inflation and tight labor
market.
Activity – Gap Between IP & Retail Sales
This weak industrial performance hurts confidence and does not boost investments. Consumption has been the
driver of growth since 2011, but it is loosing some momentum lately
25
130
88
20
120
86
110
84
100
82
2.6
90
80
-2.4
80
78
70
76
15
10
5
0
-5
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Business Confidence Index (LHA)
Capacity Utilization Index (RHA)
Investment
Source: IBGE and Citi Research

Investments have lost momentum since 3Q11 in part because of
the business cycle (growth must come first) and lack of confidence

Private Consumption also showed a softer growth in the 3Q12
Source: FGV and Citi Research

FGV confidence index is a leading indicator for capacity utilization

Slight increase in business confidence suggests no meaningful
recovery in industrial sector ahead and it is a cap for a investment
boom.

Manufacturing is more dependent of advanced countries
developments than GDP, explaining the first puzzle.
(0.9% q/q) compared to previous easing cycles episodes.
10
Jan-04
2012.II
2011.III
2010.IV
2010.I
2009.II
2008.III
2007.IV
2007.I
2006.II
2005.III
2004.IV
2004.I
2003.II
2002.III
2001.IV
2001.I
PrivateConsumption
Jan-03
-10
Activity – Labor Market, Unemployment & Wages
Unemployment rate in December reached 5.4% seasonally adjusted, close to the lowest level, amid high
increase in real wages. Labor market is extremely tight in Brazil despite slow growth (Puzzle 2).
14.0
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
1850.00
1750.00
22500.0
1650.00
1550.00
21000.0
1450.00
19500.0
1350.00
18000.0
1250.00
Real Wages (LHA; s.a.)
Unemployment Rate (s.a)
Source: IBGE and Citi Research

Given central bank estimates for natural unemployment rate at
around 7.4%, labor market remains tight.

Market consensus estimates NAIRU at 6.5%.
16500.0
Mar-02
Aug-02
Jan-03
Jun-03
Nov-03
Apr-04
Sep-04
Feb-05
Jul-05
Dec-05
May-06
Oct-06
Mar-07
Aug-07
Jan-08
Jun-08
Nov-08
Apr-09
Sep-09
Feb-10
Jul-10
Dec-10
May-11
Oct-11
Mar-12
Aug-12
Mar-12
Mar-11
Mar-10
Mar-09
Mar-08
Mar-07
Mar-06
Mar-05
Mar-04
Mar-03
Mar-02
1150.00
Unemployment Rate
11
24000.0
Employment (RHA; s.a)
Source: IBGE and Citi Research

Real income increased by 3.2% y/y in December.

The unemployment rate close to its lowest level ever suggests
labor market is extremely tight, pressuring inflation upward.

Services sector is more labor intensive explaining the second
puzzle.
Activity – Risks on Energy Rationing
Rain shortage has been disappointing recently, declining the water reservoir levels. So far, we see a likelihood of
around 20% for the government to announce a power rationing.
100
160%
90
140%
80
120%
historical average
100%
80%
60%
% of maximum value
180%
Reservoir Levels
70
60
50
40
30
40%
20
20%
10
Jan
0%
Jan 12
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Source: ONS and Citi Research

Since August/11, precipitation has been underperforming its
Dec
2012
According to ONS, historically, by around 50% of precipitation
Mar
Apr
2011
May
Jun
2010

Aug
2009
Sep
Oct
2001
Nov
Dec
2000
The reservoir level for Southeast/Mid West reached 28.3% in
December/12, significantly lower the average for this month
(54.6%)

occurs between January and April
Hydroelectric generation is largely the most important energy
source in Brazil, representing 77.2% (including Itaipu)

Given its higher cost, the increase in thermoelectric generation will
likely be passed through to consumers/companies, reducing the
promising drop of energy price.
12
Jul
Source: ONS and Citi Research
historical average .

Feb
Activity – Credit To Continue Growing But Less Than Before
Daily average credit concession dropped after the macro-prudential measures. Household indebtedness as
percentage of disposable income continues to increase, but debt burden remains at sustainable level
dailyavg;y/y
35%
50
% ofdisposable
income
44.6
45
25%
40
15%
11.2%
35
30
5%
25
-5%
20
15
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
ConsumerIndebtness
IndividualsConcession
Sources: Brazilian Central Bank and Citi Research
Jul-05
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-05
-15%
13
21.3
ConsumerDebtBurden
Sources: Brazilian Central Bank and Citi Research

Credit continue growing, but with discrepancies within different
credit lines.

Household indebtedness reached 44.6% of disposable income in
November/12

Total credit increased 20.6% in 2010 and decelerated to 16.2% in
December/12.


Household credit increased to 11.2% in December from 1.5% in
November (new credit, daily average, year of year growth)
Household debt burden as percentage of disposable income
reached 21.3% in November/12, higher than the 20% seen in
2009/2010 period.
Credit and Income – The C Class and Access to Banks
People who got access to the middle class C-class matches with new entrants in the Bank system.
8,826
million of people
54%
130
52%
120
65,900
45,646
110
48%
100
46%
million of people
50%
22,526
13,300
105,469
96,200
92,869
63,592
90
44%
80
2005
2006
2007
2008
Formal Job Share
2009
2010
2011
1993
2012
2003
DE Class
C Class
2011
AB Class
Banking Penetration
Source: FGV
14

40 million people have entered in the bank system.

Middle class surged in Brazil in the last 15 years.

Banks did not know the rating score of these people and might
have over lent

Despite of that, Brazil continues to be among the 12 economies
with higher income inequality.

After a first shock delinquency rates, mainly in car loans, banks
have become more conservative generating a second round of
defaults.
Credit – Default Rates and Bank Spreads
Despite the tight labor market, default rates are high (Puzzle 3), constraining the increase of credit supply.
65
9
18.0
60
8.5
16.0
6.0
14.0
5.0
12.0
4.0
10.0
3.0
8.0
2.0
6.0
1.0
55
8
50
7.5
45
%
7.0
7
40
6.5
35
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Sep-12
May-12
Personal loans (RHA)
Jan-12
Sep-11
May-11
Jan-11
Sep-10
Home Appliance loans (LHA)
May-10
Jan-10
Sep-09
May-09
Jan-09
Sep-08
May-08
Overdraft (LHA)
Families' delinquency rate (RHA)
Sources: Brazilian Central Bank and Citi Research
Jan-08
5.5
Sep-07
25
May-07
6
Jan-07
30
Families' Interest Rate Spread (LHA)
15
%
Auto loans (RHA)
Sources: Brazilian Central Bank and Citi Research

Default rate reached 7.8% in December/12. It was 5.7% in
December/10.

Corporate spreads have never recovered the level pre-Lehman
crisis, neither the default rates.

Lending interest rate increased sharply after macro-prudential
measures, but they have returned fully (34.6%), even with the
increasing in the default rates.

Car default rates have increased from 3% to 6% since January
2011, but decreased in December to 5.3%.


Spread has decreased lately and the correlation with delinquency
rate was broken, at least temporarily.
Other loans categories also increased their delinquency rates
recently.

Higher access to credit loans to population with lower income
helps to explain the third puzzle.
Monetary Policy – Cut in Real Rates Earlier than Expected
Despite the significant drop in real interest rate (due to the 525bp decline in Selic rate since August/11), the GDP
recovery remains weak and fragile (Puzzle 4).
0.04
14
0.03
12
0.02
0.01
10
0
8
-0.01
6
-0.02
4
-0.04
-0.03
-0.05
Output gap with unemployment
Sources: Brazilian Central Bank and Citi Research

Output gap using unemployment rate is still positive because
NAIRU is at least 1% above the current level of unemployment.

Output gap using a production function was already negative in
December and should be even more negative in March 2012.
2012Q1
2011Q1
2010Q1
2009Q1
2008Q1
2007Q1
2006Q1
Lower global growth, less expansionary fiscal and credit (BNDES)
policies explain the softer GDP recovery currently.
Output gap with GDP
2005Q1

2004Q1
Even after the decline in Selic rate by 525bp since August/11,
GDP growth continues to underperform the potential for 6 quarters
in a row. Selic rate is expected to be at 6.50% year-end 2013 and
in 2014.
2003Q1

2002Q1
Central Bank changed gears abruptly because of fears of GDP
deceleration in August 2011 and it has been cut aggressively since
then.
2001Q1
16

2000Q1
Oct-12
Apr-12
Oct-11
Apr-11
Oct-10
Apr-10
Oct-09
Apr-09
Oct-08
Apr-08
Oct-07
Apr-07
Oct-06
Apr-06
Oct-05
Apr-05
Oct-04
Apr-04
Oct-03
Source: Citi Research
1999Q1
1.49
0
1998Q1
1997Q1
2
Inflation – Taylor Rule with a Break in the Coefficients
New Policy reaction function for the Central Bank since Dilma took office.
Estimation of Reaction Function of Central Bank
Dependent Variable: Real Interest Rate
Regressors
Constant
Time
Log Swap-Pre (t-1)
LER
Log Expectation - Log Target (t-3)
Break Jan/2011
Output gap
Break Jan/2011
Dummy Jul/2002
R-squared
Coefficient
p-value
0.048316
-0.000193
0.792076
0.052653
1.620336
-8.208308
0.285842
5.006017
0.037942
0
0
0
0
0.0034
0.027
0
0.04
0
0.979193
Sources: Bloomberg and Citi Research
17

After 2011, weight of output gap increase significantly.

On the other hand, the response of inflation deviation to the target decrease sharply.

But it looks like that Central Bank is worried about inflation again.
Inflation – Above Mid-Point of the Target in 2013 and 2014
Our 2013 CPI inflation forecast is 5.6%, above the 4.5% mid-point target, while for 2014 we expect 5.8%. CPI
inflation keeps above the mid point target despite the weak GDP growth (Puzzle 5).
10.5%
12-m accumulated
10.0%
20.0
in %
9.5%
18.0
16.0
9.0%
14.0
8.5%
12.0
8.0%
10.0
8.6%
7.5%
8.0
7.0%
6.0
4.0
6.5%
2.0
6.0%
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
Sources: Brazilian Central Bank and Citi Research

We forecast IPCA inflation at 5.6% in 2013 and at 5.8% in 2014,
both above the mid-point of the target (4.5%).

Services inflation (amounts 20% of CPI basket) continues to
surpass CPI inflation markedly.

Domestic slowdown and tax cuts helped to reduce inflation in
1H12.

Tight labor market is strongly linked to this evidence and helps to

18
May-10
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Sources: Bloomberg and Citi Research
Mar-10
Jan-10
0.0
Exchange rate pass-through has been limited but .
explain the fifth puzzle.
External Sector – FX, Commodities & Export Prices
The strong negative correlation between CRB and BRL lies on the relationship between Brazilian exports prices
and CRB. Another strong evidence is the positive correlation between BRL and risk aversion (measured by VIX).
90
125
80
115
140.00
105
120.00
95
100.00
85
80.00
75
60.00
65
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Higher commodity prices mean higher USD supply, appreciating
BRL.
Jul-07

10
Jan-07
Domestic factors (FX interventions, interest rate differential, etc)
have smaller importance in driving USD/BRL.
20
Jul-06

30
Jul-05
According to our models, global factors (commodity prices and
global risk aversion) explain 60% of the movements in USD/BRL.
40
Jan-05
19

50
Jul-04
Sources: Bloomberg, Brazilian Central Bank and Citi Research
3.90
3.70
3.50
3.30
3.10
2.90
2.70
2.50
2.30
2.10
1.90
1.70
1.50
60
Jul-03
TermsofTrade(RHA)
USD/BRL(RHA)
70
Jan-03
Jan-11
Jan-09
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
EffectiveRealExchangeRate(LHA)
VIX Index(LHA)
Jan-06
160.00
Index 135
Jan-04
180.00 Index
Sources: Brazilian Central Bank and Citi Research

Only recently have global crises produced an increase in risk
aversion.
External Accounts – Trade Balance, FDI & Current Account
Risks ahead with current account deficit widening, but financing in the near term has been easy lately.
US$ million; 12-m accumulated
● FX more volatile closely linked to risk aversion
and commodity prices.
100,000
80,000
● We expect USD/BRL around 2.10 by year-end
2013 and 2.05 in 2014.
60,000
40,000
● We expect Current Account deficit of US$68
billion or 3% of GDP
20,000
0
● FDI should reach US$55 billion this year.
-20,000
-40,000
-60,000
Trade Balance
Current Account
FDI
Sources: MDIC and Citi Research
20
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
-80,000
● China’s share in Brazilian exports has more
than doubled since 2005, while US’ share is
about half, due to USD depreciation.
Fiscal Accounts – Debt to Remain in a Downward Trend
In 2012 expenses growth accelerated, while public revenues slowed down on the back of the lower GDP growth
and tax reductions. Full primary fiscal target (3.1% of GDP) will likely not to the accomplished.
13.0
11.0
% RealGrowth
(YoY)
50
9.0
45
7.0
40
5.0
Net Debt / GDP (%)
3.0
37.5
35.1
35
30.2
30
1.0
25
-1.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010* 2011 2012
(f)
Revenues Expenses
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
(*)ExcludePetrobrascapitalization
Sources: Brazilian Central Bank and Citi Research
21

In 2012, the increase in minimal wage, several fiscal packages
and the weaker revenues indicates risks to the fiscal target.

Hence, we revised down our primary surplus to 2.0% of GDP in
2013.
21.3
20
Negative
Base
Positive
Sources: Brazilian Central Bank and Citi Research

The base case scenario indicates a downward trend for the debt
ratio, helped by the maintenance of positive primary surplus and
lower interest rates.
Brazil – Summary of 2012-2014 Outlook
Brazil Macroeconomic Indicators.
2007 2008
2009
2010 2011
2012
Real GDP Growth (%-market prices)
5.4
5.1
-0.2
7.5
2.7 0.9 (f)
Inflation (IPCA)–end of period (%)
4.5
5.9
4.3
5.9
6.5
5.8
Nominal Interest Rate Selic (end of period, % p.a) 11.3 13.8
8.8 10.8 11.0
7.3
Exchange Rate (end of period R$/US$)
1.8
2.3
1.7
1.7 1.88 2.04
Public Sector – Primary Result (% GDP)
4.0
4.1
2.1
3.0
3.1
2.4
Nominal Result (% GDP)
-2.3 -1.8
-3.0
-2.2
-2.6
-2.6
Net Public Sector Debt (% GDP)
42.9 36.0 42.7 40.4 36.5 35.1
Trade Balance (US$ billion)
40.0 24.8 25.5 20.1 29.8 19.4
Current Account (US$ billion)
3.6 -28.2 -24.2 -45.2 -52.6 -54.2
Current Account (% PIB)
0.3 -1.8
-1.6
-2.4
-2.2
-2.5
International Reserves (US$ billion)
180.3 206.8 239.1 288.6 354.1 378.4
Total External Debt (US$ billion)
197.7 186.5 204.5 255.2 297.3 212.7
Source: Citi Research
3.1
4.
5.6
2
5.
8
7.3
7.
2.10 2.05
3
2.0
2.
5
-2.4 -2.2
34.5 33.3
10.0 7.0
-68.0 -68.8
-3.0 -2.7
384.4- 384.
4
218.7 224.
7
Risks
Opportunities
▼ External: Global monetary and fiscal
normalization (too fast, too soon?), stability of
financial system.
▲ World Cup (2014); Olympics (2016); Housing
PAC; and Pre-Salt (Deep Water Oil).
▼ Domestic: Growth below potential (3.5%) again
in 2012.
22
2013 (f) 2014(f)
Economic and Market Analysis Team
23
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