Apontamentos de Tiago Berriel em Encontro com Investidores

External Outlook

 The external scenario has been favorable, as a stronger global economic activity has mitigated the effects of possible changes in the economic policy of globally important economies.

 Doubts remain regarding the implementation and possible external repercussions of the US new government's economic policies that may affect international trade, increase fiscal stimulus and promote financial deregulation.

 There are also uncertainties about the outlook for the Chinese economy, regarding the evolution of commodities prices and about the appetite for emerging economies’ assets.

 Despite those uncertainties, the US, as well as other globally important economies, have experienced a recovery of economic growth.

The Resilience of the Brazilian economy

 Developments in recent weeks resulted in a perception by economic agents of an elevated uncertainty regarding the speed of the process of reforms and adjustments in the Brazilian economy. After the news coming from the political arena, domestic markets show some volatility in the following days.

 In response to this volatility, the Brazilian Central Bank (BCB) took firm action in order to maintain the full functionality of the markets, including the exchange rate market.

 Acting in coordination with the Ministry of Finance, the BCB promoted exchange rate swap and repo auctions in order to provide liquidity to the markets. To that end, the Central Bank and the National Treasury have several tools at hand.

 Those actions were successful in reestablishing the former stability to domestic financial markets.

 Notwithstanding those developments and the temporary higher volatility observed in the domestic financial markets, it is important to stress that the Brazilian economy nowadays shows greater capacity to respond to both internal and external shocks, due to its more robust balance of payments and to the progress in the disinflationary process and in the anchoring of expectations.

 The balance of payments’ position is more comfortable. In April, the current account deficit in twelve months reached 1.1% of GDP. At the same time, direct investment reached 4.5% of GDP, over four times the deficit.

 Besides that fact, the floating exchange rate regime has proven to be an effective first line of defense against external shocks, which does not prevent BCB from using the instruments at its disposal to both ensure the proper functioning of the foreign exchange market and smooth the impact of shocks in the FX market.

 International reserves’ position is around US$375 billion, approximately 20% of GDP. This buffer acts as an insurance in moments of turbulence.

 The stock of FX swaps was reduced from US$108 billion in the beginning of 2016 to a current level of US$28 billion, giving BCB more room for maneuver.

 Low inflation and anchored inflation expectations would allow BCB to focus on preventing second-round effects of relative price adjustments that may occur over time, not reacting to primary effects of such shocks. This applies to the favorable food supply shock and to adverse shocks.

The domestic economic outlook

 The domestic economic policy has shifted course one year ago and the reforms implemented in this short period have already shown positive results, thus the importance of continuing in the right path.

 Regarding the Brazilian sovereign risk, the CDS fell from around 500 bps, at the beginning of 2016, to below half that level currently.

 The progress in the structural fiscal reform agenda has been positive and its continuity (particularly by undertaking the pension system reform) will be relevant to the future performance of the Brazilian economy.

 After two years of recession, recent data confirm the scenario of stabilization and the prospects of gradual economic recovery.

 In the first quarter of 2017, Brazilian economy grew 1% when compared to the last quarter of 2016. Part of this result is due to the favorable performance of agribusiness, although both manufacture and services showed signs of stabilization. The external sector has contributed to this recovery, with a 4.8% exports’ growth surpassing the 1.8% imports’ growth.

 In recent months, both the government’s and Central Bank’s efforts have been effective in containing inflation and anchoring expectations.

o Inflation developments remain favorable. Disinflation is widespread and convincingly encompasses the IPCA components that are more sensitive to the business cycle and to the monetary policy. Food price disinflation constitutes a favorable supply shock.

 Inflation annualized fell from 10.7% in December 2015 to 3.6% in May 2017.

 Market inflation expectations collected by the Focus survey are around 3.6% for 2017, 4.3% for 2018 and 4.25% for longer horizons.

 Both market expectations and Copom’s inflation forecasts are declining. Considering the scenario with interest rate and exchange rate paths extracted from the Focus survey, Copom’s forecasts are around 4.0% for 2017 and 4.6% for 2018. Such scenario assumes an 8.5% per annum interest rate at the end of both 2017 and 2018.

Current risks to the scenario

 It is necessary to monitor possible impacts from the recent elevated uncertainty on the prospective path of inflation.

 On the one hand, if sustained over a long period, elevated uncertainty regarding the evolution of reforms and adjustments in the economy can have detrimental effects on economic activity, and hence be disinflationary. On the other hand, the impact of uncertainty on price setting and on estimates of the structural interest rate can influence on the opposite direction. There is also the possibility that the above-mentioned effects cancel out and the prospective trajectory turns out to be equivalent to the previous trajectory.

 In general, the current Copom's conditional projections involve greater uncertainty.

 There are the following risks to the baseline scenario:

o The main risk factor is the elevated uncertainty regarding the speed of the process of reforms and adjustments in the Brazilian economy. This arises from both a higher probability of scenarios that may hinder this process, and the difficulty in assessing the effects of these scenarios on the determinants of inflation. These determinants include economic activity, inflation expectations, estimates of the structural interest rate, and prices of relevant financial assets. Other risks to the baseline scenario are described below.

o The global outlook, despite currently favorable, entails a considerable level of uncertainty and might make disinflation more difficult.

o Disinflation in food and industrial prices might produce second-round effects on inflation. Notably, it might contribute to further declines in inflation expectations and inflation in other sectors of the economy.

o Economic activity points to stabilization in the short run and to a prospect of recovery, but the economy resumption might be more (or less) gradual and delayed than anticipated.

Monetary policy in the present context

 There is no direct and mechanical relationship between an elevated uncertainty and monetary policy.

 The flexibility of the inflation targeting regime allows for the adjustment of monetary policy to possible prospective scenarios.

 The BCB has communicated the economic rationale that guides its decisions, making explicit the contingencies that determine the evolution of the monetary policy. That contributes to an increase in transparency and to an improvement in the Monetary Policy Committee communication.

 Taking into account anchored inflation expectations, inflation forecasts at the target for 2018 and a little below target for 2017, and the high level of economic slack, the scenario prescribes the continuation of the monetary easing cycle, considering the current risks around the baseline scenario and the estimates of the extension of the cycle.

 The extension of the monetary easing cycle will depend on the evolution of economic activity, on the other aforementioned risk factors, on the projections and inflation expectations (IPCA) for 2018 and 2019, and on the structural interest rate estimates for the Brazilian economy. The recent elevated uncertainty regarding the evolution of reforms and adjustments in the economy hampers a more timely reduction of estimates of the structural interest rate and makes them more uncertain. These estimates inherently involve uncertainty and may be reassessed over time.

 During its most recent meeting, Copom decided, unanimously, to reduce the Selic rate to 10.25% per annum and concluded that a moderate reduction in the pace of monetary easing should be appropriate at its next meeting. Evidently, such pace will continue to depend on the evolution of economic activity, on the balance of risks, on possible reassessments of the extension of the cycle, and on inflation forecasts and expectations.

The real interest rates

 The policy rate (Selic) is in a downward trend, given that inflation expectations are anchored around the target, actual inflation is declining, and there is a high level of economic slack.

 Real interest rates (nominal rates minus inflation) are also declining, presenting values close to its historical minima. Several measures confirm this fact:

 The real ex-ante rate, measured by the 12-month pre-fixed interest rate (from the swap DI market) minus the 12-month expected inflation, after reaching approximately 9% per annum in September 2015, has remained stable at around 7% during 2016 and declined afterwards, reaching the current level of 4.5% per annum.

 When using the Focus expected Selic (instead of the pre-fixed interest rate) trajectory for the next 12 months to calculate the current real interest rate, we find values close to 4.2%.

 When we consider the real interest rate implied in the NTN-Bs (inflation indexed government bonds) traded in the market, we also observe a decline to the current level of 5.3%.

 From a historical perspective, the current level (4.2% – 5.3%) of real interest rate is low. Over the past decade, the real interest rate in the Brazilian economy has fluctuated, showing a clear downward trend. It has declined from over 20% during the nineties, to around 10% over the past decade, reaching an average of 5% since then (considering a period of unsustainable real rates around 2% during the previous administration).

The BC+ agenda

 BCB has moved forward in several fronts within its work agenda BC+.

 The agenda is structured in four pillars aiming at: increasing financial citizenship; improving the Central Bank legal framework; increasing the efficiency of the financial system and reducing the cost of credit.

 The BC+ agenda contains several actions for the sustainable reduction of the interest rate spread, paving the way for lowering credit cost.

 Among these actions, there are the following: encourage compliance, stimulate operations with attached collaterals, reducing administrative costs, increasing competition in the financial system, and reducing subsidized lending.

 Examples of these actions include:

o Simplification of reserve requirements rules. Ratios, collection dates and form of accomplishment related to reserve requirements were harmonized, aiming at reducing the compliance cost of financial institutions. Moreover, additional surcharges imposed on time and saving deposits were removed in the last six months.

o Improve financial system collaterals. Mandatory electronic registering propitiates higher legal certainty, agility and transparency.

o Improvement of the efficiency and reduction of the cost of using credit cards. BCB has recently adopted measures in the credit card market to improve competition by extending access, allowing the practice (previously legally forbidden) of sales with price differentiation based on means of payment (cash versus credit card), and limiting the period of revolving credit use.

o Modernization of the remuneration rate. A new rate, TLP, will serve as a base rate for BNDES (Brazil’s main development bank) lending operations. This will propitiate a higher power to the monetary policy, reinforcing the decline of the economy’s structural interest rate, nurturing long-term private financing, boosting the securities market, improving public sector accounts dynamics, and also providing more agility to BNDES’ loan management.

 Revision of the legal framework for punitive actions pertaining to our national financial system. New regulation has been published in order to heighten the efficiency and efficacy of BCB’s legal and administrative procedures to conduct punitive processes, enabling more agile and modern punitive actions.

Final Remarks

 Brazil has robust buffers and thus its economy is therefore less vulnerable to both internal and external shocks.

 Several reforms and adjustments have boosted confidence and reduced the risk perceived for the Brazilian economy. Persisting in this direction, particularly by approving the pension system reform and other reforms to raise productivity, will be important for the sustainability of the disinflation process and the decrease of the structural interest rate.

 Once again, empirical evidence has corroborated the relevant and effective role played by monetary policy implementation and by the overall economic policy in promoting inflation control.

 Real and nominal interest rates are falling in Brazil. The policy rate (Selic) fell by 400 bps during the past few months and is expected to fall further. The real interest rate has also receded from values close to 9% in September 2015 to a range between 4.2% and 5.3% currently.

 The scenario prescribes the continuation of the monetary policy easing cycle, considering the current risks around the baseline scenario and the estimates of the extension of the cycle. The flexibility of the inflation-targeting regime allows for the adjustment of monetary policy to possible prospective scenarios.