August, 2013

¿Y qué está pasando en Brasil?Ilan Goldfajn Chief Economist and Partner, Itaú Unibanco

2

Summary

Why has the Brazilian economy decelerated?

How can economic policy contribute to sustainable growth?

Challenge: Brazil needs to invest more and increase productivity to grow sustainably.

The low growth and full employment paradox (new middle class vs. high labor costs).

3

1

2

3

4

5

6

2010 2011 2012 2013

Brazil Mexico Colombia Chile

0,5

1,5

2,5

3,5

4,5

5,5

6,5

2010 2011 2012

Brazil Mexico Colombia Chile

Growth Disappointed First in Brazil, and Now in Other LatAm Countries

GDP Forecasts for 2012 (%) GDP Forecasts for 2013 (%)

Source: Itaú Unibanco, Latin Focus Consensus Forecasts

4

What Explains the Weak GDP in the Last Couple of Years?

GDP Growth QoQ, SAAR

-2%

-1%

0%

1%

2%

3%

4%

5%

2009.IV 2010.IV 2011.IV 2012.IV

Deleveraging:

Higher real interest rates (+150 bps)

Macroprudential measures (reserve + capital requirements)

Reduction in government current expenditure growth (to 0% from 10%-15%)

Reduced BNDES disbursements

Global risk aversion (VIX up to 40)

High inventories, decelerating growth and imports

Supply Issues:

Fiscal expansion and interest-rate cuts; economy reacts slowly

Excessive interventionism creates higher economic-policy risk

Productivity deceleration seems stronger than cyclical factors; lower potential growth

With low productivity growth, rising wages reduce margins and become a limitation on investment

Inflation accelerates, affecting real income and consumption

Signs of growing net imports

Source: Itaú Unibanco, IBGE

Inventories Exports-imports

5

5,0%

5,5%

6,0%

6,5%

7,0%

7,5%

8,0%

Low Growth, but Tight Labor Market

GDP Growth over 12 Months

Source: Itaú Unibanco, IBGE

Unemployment vs. Real Wages

Unemployment rateReal Wages (rhs)

0%

1%

2%

3%

4%

5%

6%

7%

8%

Mar-10 Mar-11 Mar-12 Mar-13 100

105

110

115

2010 2011 2012 2013

6Source: Itaú Unibanco, IBGE

0,9%

2,8%

0%

1%

2%

3%

4%

1994 2000 2006 2012 2018

0,0%

2,4%

-0,4%

0,0%

0,4%

0,8%

1,2%

1,6%

2,0%

2,4%

Industry Services

Demographics and Growth Composition ExplainTight Labor Market

GDP – Industrial vs. Serviceannualized average growth, 2010T2-2013Q1

Employment by Sector2012 average

Growth in Economically Active Population

16%

8%

75%

IndustryConstructionServicesOthers

7

79,2

128,0

142,9

53,4

Classes ABC- 2003

Classes ABC- 2011*

ClassesABC** - 2014

Faltaráincorporarem 2014

ABC Brackets –

2003

ABC Brackets

– 2014

ABC Brackets –

2011

Still to incorporate

Source: Itaú Unibanco, FGV

+ 48,8 mi

+ 14,9 mi

New Middle Class (Millions of People)

0,48

0,49

0,50

0,51

0,52

0,53

0,54

0,55

0,56

0,57

0,58

2001 2002 2003 2004 2005 2006 2007 2008 2009 2011

1 = totally unequal

0 = totally equal

Gini Index

Lula´s Legacy: New Middle Class and Income Distribution

8

Unemployment rate (u) dynamics determined by the equation:

Unemployment Simulations: Higher Productivity to Grow

E: Employment. Depends on GDP growth and long term wages

PEA (Labor force): labor supplyDepends on demography

Source: Itaú Unibanco

Unemployment Rate (%)

2

4

6

8

10

12

14

2002Q1 2005Q1 2008Q1 2011Q1 2014Q1 2017Q1 2020Q1

GDP grows 3% per annum

GDP grows 4% per annum

GDP grows 1% per annum

Growth at around 3% maintains full employment.

Higher growth would increase wages and inflation. Need higher productivity, or more investment in capital.

9

High Costs Compared to Productivity Level

Source: Itaú Unibanco, KPMG, FMI, Conference Board

0 5 10 15 20 25 30

Brasil

Rússia

México

China

Índia

A preços de 2012 A preços de hoje

0 10 20 30 40 50 60

Brasil

Rússia

México

China

Índia

A preços de 2012 A preços de hoje

Wages (in Dollars) Wages + Labor Benefits (in Dollars)

Productivity (% of U.S.) Per Capita GDP (PPP)

2012 Prices Current Prices 2012 Prices Current Prices

Brazil

Russia

Mexico

India

Brazil

Russia

Mexico

India

0% 10% 20% 30% 40%

Rússia

México

Brasil

China

Índia

Brazil

Russia

Mexico

India

0 5 10 15 20

Rússia

México

Brasil

China

Índia

Brazil

Russia

Mexico

India

10Source: Itaú Unibanco, BCB

Wages/Exchange-Rate RatioJun/1994=100

Unit Labor CostIn Dollars, Jun/1994=100

Wages Have Grown Compared to the Exchange Rate

20

40

60

80

100

120

140

160

180

200

2000 2002 2004 2006 2008 2010 201250

100

150

200

250

300

350

400

2000 2002 2004 2006 2008 2010 2012

11

Prices in Brazil Remain High

Source: Itaú Unibanco, FMI, The Economist, BIS

Currency Appreciation (+) or Depreciation (-) Measures

Emerging

Developed

Effective real exchangerate (Jun/13, against 04-11

average)

Big Mac Index(Jul/2013)

Prices in relation to the U.S. (PPP) in 2012

South Africa -16.6% -60.0% -34.0%

South Korea -9.2% -24.6% -28.0%

India -7.0% -67.1% -61.0%

Mexico -3.6% -37.3% -33.0%

Chile 3.9% -13.6% -16.0%

Brazil 7.9% 16.0% 2.0%

Colombia 13.3% -1.8% -27.0%

Russia 16.0% -42.0% -20.0%

China 25.0% -42.8% -34.0%

Japan -16.7% -29.8% 29.0%

United Kingdom -10.4% -11.8% 4.0%

Eurozone -6.1% 2.3% 9.0%

Australia 10.3% 1.4% 59.0%

12

Growth in the Long Term Depends More on Productivity

Source: Itaú Unibanco

Potential GDP Growth (%)

We expect an average growth of 2.5 %– 3.0% throughout the decade. End of the boost given by the equilibrium unemployment rate reduction. Economically active population grows at a slower pace. If productivity fails to increase, potential GDP is likely to grow less.

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

1997-2004 2005-2012 2013-2020

Labor Capital Productivity

2.2%

3.7%

2.8%

2.1%

13

Brazil Needs to Invest More to Grow Sustainably

15%

16%

17%

18%

19%

20%

21%

2010 2012 2014 2016 2018 2020

Investment Rate – % GDP

Source: Itaú Unibanco, BCB, IBGE

GDP Growth

2,7%

0,9%

2,1%1,7%

2,2%

0%

1%

2%

3%

4%

5%

6%

7%

8%

2010 2012 2014 2016 2018 2020

14

Challenges in Brazil: Infrastructure and Business Environment

Source: Itaú Unibanco, OECD, U.S. Bureau of Labor Statistics, World Economic Forum

Infrastructure Ranking (2011)(World Economic Forum, 2010-11)

1

2

3

45

47

48

51

68

70

84

89

Hong Kong

Singapore

Germany

Chile

Russia

China

Turkey

Mexico

Brazil

India

Peru

Ranking Ease of Doing Business – 2012

37

43

45

48

89

103

124

130

Chile

Peru

Colombia

Mexico

Uruguay

Paraguay

Argentina

Brazil

15Source: CNI, OECD, Itaú Unibanco

International Comparison: PISA Scores in Brazil Are Low

496

408

350

400

450

500

550

PISA 2009 – Average Test Score (Math, Science, Reading)

Average 2013-2020 GDP : 2.4%

Average 2013-2020 GDP: 3.1%

Average 2013-2020 GDP : 4.0%

16

Tax Burden Is Relatively High

Tax Burden – % of GDP

34%

0%

20%

40%

60%

Swed

en

Fran

ce

Ger

man

y

Hun

gary

Ukr

aine

Pola

nd

Bra

zil

Rus

sia

Spai

n

Aut

ralia

USA

Sout

h K

orea

Arg

entin

a

Turk

ey

Col

ombi

a

Chi

le

Indi

a

Chi

na

Vene

zuel

a

Mex

ico

Ara

b Em

irate

s

Source: Itaú Unibanco, OECD, U.S. Bureau of Labor Statistics, World Economic Forum

17

Less Room for Counter-Cyclical Fiscal Policy

2,7

3,1

2,4

1,7

1,1

0,5

1,0

1,5

2,0

2,5

3,0

3,5

2010 2011 2012 2013 2014

39,1

36,4

35,235,6

36,6

30

32

34

36

38

40

2010 2011 2012 2013 2014

Primary Surplus - % GDP Net Debt - % GDP

Source: Itaú Unibanco, BCB

18

Budgetary and Off-Budget Fiscal Stimulus Have Increased

Primary Fiscal Balance Measures (% GDP)

Source: Itaú Unibanco, Brazilian Central Bank

Quasi-Fiscal Stimuli via Govt. Credit (% GDP)

1.3%1.6%

2.0%

0%

1%

2%

3%

4%

5%

2001 2003 2005 2007 2009 2011 2013

Structural Recurring Conventional

four-quarter rolling

0%

2%

4%

6%

8%

10%

12%

14%

16%

2003 2005 2007 2009 2011 2013

Loans by Workers' Aid Fund (FAT) to banks

Discretionary Central Government Credit for Federal Banks

9.6

14.5%

19

Fiscal: Lower Taxes or Higher Investment

A Lower Interest Rate Burden (% GDP) Incentives Through Tax Breaks (% GDP)

Source: Itaú Unibanco, Brazilian Central Bank, Ministry of Finance

Despite relevant budget rigities in the short run (due to earmarkings), which could only beaddressed through reforms, Brazil could have a higher ratio of public investment...

...but the choice was to use the fiscal leeway created by a lower interest burden (due to astrucutrally Lower Selic) to reduce taxes. If the amount of tax breaks had been used in publiccapital spending, federal investment could have doubled (from 1.4% of GDP today).

1,4%

1,6%

1,2%

1,3%

1,4%

1,5%

1,6%

1,7%

2013E 2014E

4.8%

2.9%

1%

2%

3%

4%

5%

4%

5%

6%

7%

8%

2005 2007 2009 2011 2013Interest Bill Nominal Budget Deficit (RHS)

20

Is There Political Room for Reforms?

Coaliton Support RateGovernment Leader Support Lower House Votings

Source: Centro Brasileiro de Análise e Planejamento (Cebrap); Valor PRO, Datafolha

94%

88%

81%82%

90%

92%

86%

80%

90%

78%

72%

70%

75%

80%

85%

90%

95%

2003 2005 2007 2009 2011 2013

Tax and labor reforms would boost GDP growth in the long term. However, with falling government support rates, it becomes harder to pass relevant reforms.

Government's Approval Rate% of good or great

0

10

20

30

40

50

60

70

80

90

1987 1992 1997 2002 2007 2012

J. Sarney (8.1)

Collor(29.4)

I. Franco(24.2)

FHC (38.6)

Lula (54.0)

Dilma(54.3)

21Source: Itaú Unibanco, BCB, Bloomberg

More Exchange-Rate Intervention in Brazil

Exchange Rate – Reais per Dollar

1,50

1,60

1,70

1,80

1,90

2,00

2,10

2,20

2,30

1,50

1,60

1,70

1,80

1,90

2,00

2,10

2,20

2,30

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13

Dollar Sales

Dollar Purchases

Capital Control Measures

22

The Impact of Exchange-Rate Pass-Through

Source: Itaú Unibanco

0,1%

0,5%

0,6%

0,7%

0,0%

0,1%

0,2%

0,3%

0,4%

0,5%

0,6%

0,7%

0,8%

1 2 3 4

Exchange Rate Pass-Through – 10% Devaluation of the Brazilian Real

Number of Quarters After Devaluation

Exchange rate Base case 10% devaluation 20% devaluation

IPCA 2013 5.9% 6.4% 6.9%

IPCA 2014 5.8% 6.0% 6.2%

23Source: Bloomberg and Itaú Unibanco

Dual Inflation in Brazil

Inflation (IPCA) Breakdown12-month inflation, seasonally adjusted

Break-Even Inflation, %5-year bonds

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2006 2007 2008 2009 2010 2011 2012 2013

Services Industry IPCA

5,8%

4%

5%

5%

6%

6%

7%

2008 2009 2010 2011 2012 2013

24Source: Itaú Unibanco, Bloomberg

Also Less Room for Counter-Cyclical Monetary Policy

Yield-Curve Pricing of Selic Rate

6%

7%

8%

9%

10%

11%

12%

13%

14%

2008 2009 2010 2011 2012 2013 2014 2015

25

Conclusion

Brazil: What explains the slower growth? Deleveraging in the economy; high costsreducing margins, production and investment.

Despite the low GDP growth, the labor market remains tight due to demographicconditions and growth composition.

There are challenges (more investment, better business conditions, education) whichneed to be adressed to enable sustainable long term growth.

Fiscal policy: need more investment and efficiency.

The Inca trail: no return for the middle class.

26

Appendix

27

Brazil: Our Expectations for the Short Term

Source: Itaú Unibanco and BCB

2012 2013 2014

Economic Activity

GDP % 0.9 2.1 1.7

InflationIPCA % 5.8 5.9 5.8

Monetary PolicySelic Rate % 7.25 9.75 9.75

FiscalPrimary Surplus 2.4 1.7 1.1

Balance of PaymentsExchange Rate (eop) 2.08 2.30 2.40Current Account (% GDP) -2.4 -3.5 -2.9

28

Long-Term Scenario

Source: Itaú Unibanco

29

More Trade Defense Measures Have Been Implemented

Source: Itaú Unibanco, Global Trade Alert

0 50 100 150 200 250 300 350

Russian FederationArgentina

IndiaBelarus

ChinaBrazil

KazakhstanGermany

UKItaly

FranceSpain

BelgiumAustriaPolandIreland

Netherlands

As of July/2013

Since the Financial Crisis, Brazil has been increasing the number of trade protectionmeasures. In September 2012, 100 products, mostly manufacturing inputs, had their import tariff

increased. Recently, with the currency weakening, they have been removed. Last month, a new anti-dumping legislation came in force, to quicken this kind of measure.

Implemented Trade Protection MeasuresTrade Protection Measures

0

10

20

30

40

50

60

70

80

90

0

5

10

15

20

25

30

35

jul/10 set/10 nov/10 jul/11 nov/11 jun/12 jul/13

Tariff measure

Trade defense measure

Export subsidy

Trade finance

Nontariff barrier

Other

Total (right)

numberof measures