24 September 2018
Economic desknote GlobalMarkets.bnpparibas
sector banks and a review of subsidised lending. As a result, the economy has started to
recover, with record-low inflation and rates despite the persistent fiscal imbalance.
Possible doubts about the upcoming economic agenda and/or the challenges to its
implementation may impact business and consumer confidence, producing a negative bias to
our current projections.
Optimistic scenario:
Robust market reform leads to increased growth and potential growth;
Brazil’s sovereign rating upgraded in the next few years;
Credit spreads narrow;
Neutral real rates fall;
Inflation expectations anchored;
BRL appreciates.
In our optimistic stress scenario, the government would focus on structural reforms that would
increase the economy’s productivity (such as tax reform, credit market reform, trade
liberalization, as well as pension reform) with full support from Congress. We assume a robust
pension reform being quickly submitted to and approved by the Congress, with its content
similar to the original social security reform bill sent by President Michel Temer’s administration
in 2016 (see box 2 for more details about our fiscal assumptions). The central bank would
credibly lower its inflation target to 3.5%.
Under this scenario, the result of major and unwavering reforms would be growth acceleration
and a lower neutral real interest rate. This scenario assumes that Brazil’s sovereign ratings
would be upgraded in the next few years, credit spreads would narrow, neutral real rates would
fall, inflation expectations would be anchored, the BRL would over-appreciate.
In this event, we would expect growth to accelerate due to cyclical and structural factors. The
central bank would be able to test new interest rate lows (Chart 4), and debt dynamics (Chart 5)
would benefit from lower nominal rates as well as the positive dynamics of the fiscal balance
(Chart 8). The only caveat would be the widening current account deficit (Chart 6), but this
remains at a sustainable level until the end of the simulation.
Pessimistic scenario:
Recent recovery ends
Inflation overshoots
Credit spreads worsen
Central bank hikes rates
BRL depreciates
Gross debt deteriorates
For the pessimistic stress scenario, we assume a government that denies the need for pension
and other reforms and unwinds recent institutional gains, such as labour reform and the
spending ceiling law. We assume worsening credit spreads, an over-depreciation of the
currency, higher inflation expectations, a wider primary balance deficit and lower potential
growth.
This could end the recent recovery, and inflation would likely overshoot due to FX pass-through
and the de-anchoring of inflation expectations. We would expect the central bank to be forced to
hike rates significantly, pushing the policy rate back to double digits. The rate dynamics would
likely exacerbate slowing down of growth, while worsen the debt dynamics, helping to push
gross debt to 100% of GDP in just a few years.
Under the pessimistic scenario, while growth would suffer, the positive carryover from this year
would assurance the 2019 GDP growth into positive terrain. In other words, while GDP growth
in the pessimistic scenario is 1.0% on average for 2019, the statistical carryover explains half
the full annual number.
Worst-case: end of recent
recovery
Best-case: virtuous cycle
24 September 2018
Economic desknote GlobalMarkets.bnpparibas
Market implication and Latam Strategy view
Our strategy is based on a positive outcome for the market with a hedge in case of a negative
outcome. Due to the uncertainty about the outcome of the election at this stage, the market has
priced substantial risk into asset prices, making Brazil’s risk premium one of the highest in
emerging markets, although this is likely to fall as the situation becomes clear. Investors
agreeing with our view may consider our directional positions: structurally long the BRL via
options in relative value, and receiving rates at the short end of the DI curve.
Our hedge is a USDBRL call spread 1x2 (USD 50mn x USD 100mn) at 4.00–4.40, maturing one
week after the second round and also a USDBRL one-touch spread (long USDBRL OT at 4.70
and short USDBRL OT at 5.40) maturing two weeks after the second round (see
Brazil:
Additional hedging structure for an election surprise
, 14 September).
Chart 1: GDP growth simulation (%)Chart 2: Unemployment rate simulation (%)
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
0607080910111213141516171819202122
Optimistic case
Base case
Pessimistic case
5.0
6.0
7.0
8.0
9.0
10.0
11.0
12.0
13.0
14.0
0607080910111213141516171819202122
Pessimistic case
Base case
Optimistic case
Sources: IBGE, BNP Paribas
Sources: IBGE, BNP Paribas
Chart 3: IPCA inflation simulation (%)Chart 4: Policy interest rate simulation (%, a.r.)
0.0
2.0
4.0
6.0
8.0
10.0
12.0
0607080910111213141516171819202122
Pessimistic case
Base case
Optimistic case
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
0607080910111213141516171819202122
Pessimistic case
Base case
Optimistic case
Sources: IBGE, BNP Paribas
Sources: IBGE, BNP Paribas
Chart 5: Gross debt simulation (% of GDP)Chart 6: Current account simulation (% of GDP)
0.0
30.0
60.0
90.0
120.0
150.0
0607080910111213141516171819202122
Pessimistic case
Base case
Optimistic case
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
0607080910111213141516171819202122
Pessimistic case
Optimistic case
Base case
Sources: IBGE, BNP Paribas
Sources: IBGE, BNP Paribas
Current strategy
24 September 2018
Economic desknote GlobalMarkets.bnpparibas
Box 1: Cyclical factors in GDP growth
Selic (% annual rate)
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
0607080910111213141516171819202122
Pessimistic case
Base case
Optimistic case
Overall, we expect economic growth to speed up next year, supported by the credit market and assuming our base-
case scenario of continuity on the economic front in 2019.
In terms of cyclical factors, monetary policy is likely to play
an important role in 2019.
Sources: BCB, BNP Paribas
Monetary policy stance (% a. r.)
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
0607080910111213141516171819202122
Optimistic case
Base case
Pessimistic case
Our simulation produces considerable divergences in
scenarios.
Under our pessimistic case, the central bank would need to
act fast to respond to currency depreciation and the
expected unanchoring of inflation expectation, pushing real
rates from expansionary to contractionary.
Under both our base-case and the optimistic scenarios,
monetary policy should be able to remain expansionary for
longer, helping the economy cyclically.
Sources: BCB, BNP Paribas
Non-performing loans (% of total)
Also under our base-case and the optimistic scenarios, the
credit market should help the economy in 2019. On the
supply side, banks have considerably reduced their non-
performing loans as a percentage of their total outstanding
loans, opening room for a greater appetite for new lending
in the coming year.
Sources: BCB, BNP Paribas。