Brazil - Economic Briefing January 2004

 Improving Fundamentals

The economy may have exited the recession in the final months of last year.  The low interest rate setting, declining inflation, a stronger exchange rate and declining unemployment are likely to provide a strong backdrop for more pronounced economic growth this year.  In addition, investor confidence is likely to be fuelled by the government’s progress on important structural reforms.

Currency strengthens further at end of year
In December, the currency appreciated 2.1% in nominal terms versus the US$ over the previous month, which resulted in a year-end exchange rate of 2.85 reais to the US$.  The December strengthening raised the annual appreciation to 22.3%.  Last year’s rebound in the exchange rate reflected not only a recovery in investor confidence about the Lula administration’s commitment to economic policy continuity but also a generalized rebound in international investor interest in emerging market assets.  In addition to the currency strengthening, the stock market rebounded 94.3%, strongly bouncing back from the 17.0% drop in the prior year.  Similarly, the spread to U.S. Treasuries of the benchmark composite J.P. Morgan EMBI+ Brazilian sovereign bond dropped to 983 basis points from 1,446 basis points at the end of 2002, the lowest level observed since 1998.  Nevertheless, participants do not expect last year’s currency strengthening trend to persist into 2004.  In fact, the currency is seen to depreciate 7.1% this year to 3.21 reais to the US$ by the end of this year.  

Inflationary pressures abate further but central target overshot
The mid-December consumer price index (IBGE-IPCA 15), which covers monthly price increases up to the 15th of every month, rose 0.46% over November.  The December data came in well above the 0.17% monthly increase observed in November but confirmed the moderation in monthly price increases observed throughout most of the year.  As a result of the more benign price developments observed in December, the annual inflation rate dropped for the third consecutive month from 12.7% in November to 9.9% in December.  The year-end inflation figure was above the 9.3% Consensus figure of last month and also was well above the Central Bank’s 8.5% year-end inflation target.  Nevertheless, the annual inflation rate was within the +/- 2.5% tolerance margin set for 2003.  The anticipated pick-up in economic activity this year and prospects for more accelerated currency depreciation are likely to raise price pressures.  However, year-end inflation is expected to reach 6.2%, which is down 0.1 percentage points from last month’s forecast.  The Consensus figure exceeds monetary officials’ central target rate of 5.5% but is still within the +/- 2.5% tolerance margin.  

Central Bank lowers interest rate again amid moderation of inflation
Currency stability and moderate economic growth served to bring down inflationary pressures last year and gave the Central Bank substantial leeway to lower interest rates.  In its 17 December meeting, the Central Bank decided to lower the benchmark SELIC rate for the seventh consecutive month, from 17.50% to 16.50%.  Monetary authorities justified the monetary loosening with continued optimism about an easing of inflationary pressures.  As a result, the SELIC rate closed the year 850 basis points below the level registered at the end of 2002 and at the lowest level observed since April 2001.  Inflationary expectations this year are likely to rise due to increased economic activity and accelerated currency depreciation.  Nevertheless, Consensus Forecast participants believe that the Central Bank will have additional leverage to bring down the SELIC rate to 14.4% by the end of this year, which is 0.1 percentage point below last month.