Deutsche Bank

Deutsche Bank Research Emerging Markets Brazil Economics Special Report Brazil: A Recession Is Coming Fiscal tightening, rising interest rates, lower commodity prices, the financial difficulties faced by oil company Petrobras and the growing risk of water and energy shortages all conspire against Brazil's economic recovery. Although we are not yet assuming energy rationing, we believe the risk is already affecting investment decisions, so we have cut our 2015 GDP growth forecast to -03% from 0.3%. The likely decline in GDP in 2015 and the much larger-than-expected consolidated primary fiscal deficit of 0.6% of GDP posted in 2014 will make it more difficult for Finance Minister Joaquim Levy to deliver the targeted primary surplus of 1.2% of GDP this year. While we still expect the government to announce a sizeable spending cut after Congress passes the 2015 budget, we think that additional tax hikes would be necessary to guarantee the 1.2% target. Raising more taxes could aggravate the recession and face strong resistance in Congress, which is becoming increasingly hostile to President Dilma Rousseff. Consequently, we cut our 2015 primary surplus forecast to 0.8% from 1.2% of GDP. We do not believe that cutting the primary surplus target would necessarily make Brazil lose its current investment grade status. It is important to bear in mind that a primary surplus of 1.2% of GDP is not enough to restore public debt sustainability, and would be just the first step toward restoring fiscal solvency, to be followed by additional tightening in the next years. Under current economic conditions, jumping immediately to 1.2% might be just too costly. In our opinion, the government could improve its fiscal policy significantly by promoting transparency, making a strong effort to rein in discretionary spending, introducing reforms to fix structural problems, and indicating the pathway for further improvement in the next years. Nevertheless, given the combination of low economic growth, high inflation, large current account deficit and lack of structural reforms, agencies that currently rate Brazil two notches above investment grade (e.g. Moody's, with its negative outlook) might decide to cut Brazil by one notch, aligning their ratings to Standard & Poor's and raising market volatility. The correction of administered prices (especially of electricity) and the hike in fuel taxes have increased the pressure on inflation, prompting us to raise our 2015 IPCA forecast to 7.2% from 6.6%. We have also raised our year-end SELIC rate forecast to 12.75% from 12.50%, and our year-end FX forecast to BRL2.90/USD from BRL2.80/USD. Date 6 February 2015 Jose Carlos Fana Chief Economist VA Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014. EFTA01097864 6 February 2015 Special Report: Brazil: A Recession Is Coming We now expect GDP to contract by 0.7% this year Several factors conspire against Brazil's economic recovery this year: 1. One of the government's main challenges is to repair its fiscal accounts, raising its primary balance to 1.2% from -0.6% of GDP last year. Although this move would be crucial in restoring policy credibility and confidence (therefore paving the way for the economy to recover in the future), its short-term effects would likely be contractionary. 2. As inflation remains high due to the overdue adjustment in administered prices, the central bank has raised interest rates by 125bps since October and has signaled that the tightening cycle has not yet ended. 3. The decline in commodity prices (ex-oil) is hurting Brazil's terms of trade. 4. The Petrobras bribery scandal has impaired the ability of the country's largest company to access capital markets and finance investments. The state-run oil company accounts for approximately 10% of total investments in Brazil. Assuming a 20% decline in Petrobras capex this year, its negative drag on growth could reach at least 0.4% of GDP. 5. Several construction companies allegedly involved in the bribery scheme are also under intense financial pressure and will likely have to reduce their activities as well, further undermining investments in infrastructure. 6. The risk of water and energy rationing has increased significantly due to the continuation of exceptionally low rainfall at the beginning of the year. The crisis is particularly acute because the authorities failed to act preemptively last year, fearing potentially negative implications for the elections. Water rationing in the state of Sao Paulo is practically inevitable at this juncture, as its main reservoirs are almost empty. Silo Paulo accounts for approximately 30% of Brazil's GDP and water shortage is already affecting production in some sectors (e.g. foodstuff, metallurgical and textiles). The second largest state economies of Rio de Janeiro and Minas Gerais also face an increasing risk of water rationing. It is difficult to estimate the impact of the water crisis on GDP, but we would put a conservative estimate at 0.2% of GDP. 7. The drought has also depleted the reservoirs of hydroelectric power plants, which account for roughly 70% of Brazil's electricity generation. The national aggregate reservoir levels are down to only 20% and failure to recover to at least 35% by the end of the rainy season in April could prompt the authorities to declare energy rationing. Presently, rationing would most likely be less severe than the 20% rationing of 2001, when hydroelectric power plants accounted for roughly 90% of supply and the national electrical grid was not well integrated. A more likely scenario this time would be a rationing of between 5% and 10%. We believe that a 10% rationing for six months could cut GDP growth by approximately 1%. Fiscal tightening has a shoo- run contractional), effect High inflation demands fight monetary policy Pet,obras will likely cut investments Water rationing in the state of Sao Paulo is practically inevitable at this juncture We believe that a 10% rationing for six months could cut GDP growth by approximately 1% Page 2 Deutsche Bank Securities Inc. EFTA01097865 6 February 2015 Special Report: Brazil: A Recession Is Coming 'Figure 1: Reservoir levels 90% 60% 10% 60% 60% 40% 30% 20% 10% <ft 40 to 4,0 se' 54) O4' Cfr &urea OHS +2012 +2013 +2014 +2015 'Figure 2: Industrial production 110 2502- ice 105 100 96 90 65 Source OSE The latest indicators have attested to the weak economic performance at the end of 2014. Industrial production declined 2.8% MoM in December, 1.6% QoQ in 4Q14 and 3.2% in 2014. Other indicators have remained quite weak too, especially consumer and business confidence in most sectors of the economy. We believe that 4Q14 GDP fell 0.1% QoQ. Therefore, we have lowered our 2014 growth forecast to zero from 0.1%. For 2015, in light of what was discussed above, we cut our forecast to -0.7% from +03%. Although we are not yet assuming electricity rationing, we believe that the uncertainty surrounding the energy situation is already affecting sentiment and undermining investment. Investment continues to be the key variable to rekindle growth, as global growth remains sluggish, fiscal solvency issues prevent further expansion in government consumption and credit constraints and rising unemployment hurt household consumption. We estimate that fixed-asset investment fell approximately 7% in 2014 and we project another decline of roughly the same magnitude this year. 'Figure 3: Investment indicators 140 150 120 110 I00 90 / 5ePt l e t t , " St i # 4. 2CO2-10:, —Production of aPlal goods --0wstructionnumials Saves 019E We forecast zero growth for 2014 We cut our 2015 GDP growth forecast to -0.7% from +0.3%. 'Figure 4: Business confidence 155 Services --U4SWOW lnduswy 125 110 • 95 90 5, 0 • • • • % % % •• "5 "3 • • 5 5,1 Ce 95IP Somas F0V The unemployment rate averaged 4.8% in 2014, down from 5.4% in 2013, and the lowest on record. Although the average number of employed workers fell 0.1% last year, the labor force contracted by 0.7%. The contraction in the labor force may be explained by slower population growth, increase in government transfers, and rise in school attendance among youngsters. However, the labor participation rate is unlikely to decline further, at the same time that job origination will most likely fall due to negative GDP growth. We expect average unemployment to climb to 6.0% in 2015. We expect unemployment to rise significantly this year Deutsche Bank Securities Inc. Page 3 EFTA01097866 6 February 2015 Special Report: Brazil: A Recession Is Coming For 2016, we also lowered our GDP forecast to 1.5% from 1.9%, assuming that the water and energy problems will be alleviated by then, that Petrobras will stabilize and that the fiscal adjustment will continue, reducing the risk of losing the investment grade status and shoring up confidence. We remain skeptical about structural reforms (upon which faster growth depends). 'Figure 5: Unemployment to — Unemployment — Seasonally-as:floated 7 6 103 4 90 'Figure 6: Consumer confidence 150 140 133 120 *-% 110 63 je, r Sages Mt Sewed WGE —Consumer confidence Current coMaions ••••• - — Expectations • 95` a a c' Alt 1r 1 -lb .9 aaaa 4* 4' 4, A more distant fiscal target The authorities have announced more measures to raise the primary fiscal surplus this year. As market participants had widely expected, the government has raised the CIDE tax on fuel. Although a 90-day grace period was required for the tax to be effective, the government astutely raised another tax (PIS/COFINS) temporarily in order to start collecting revenues right away. The authorities expect to collect BRL12.2bn with the CIDE tax in 2015. The downside, of course, is the average 8% increase in gasoline prices (which adds roughly 30bps to the IPCA consumer price index). A more surprising move was the hike in the IOF tax on consumer loans to 3.0% from 1.5%, which the government expects to generate BRL7.4bn this year. The previous economic team used the IOF extensively as an instrument to stimulate consumption and it was probably difficult for President Dilma Russeff to accept a tax hike that should further dampen consumption. The govemment has also raised the PIS/COFINS tax on cosmetic products, a measure that will generate an estimated BRL0.4bn only in 2015. Finally, the authorities have decided to raise the PIS/COFINS tax on imports as of June, expecting it to generate BRL0.7bn. Of the three aforementioned measures, this is the only one that will require congressional approval. I Figure 7: Estimated fiscal savings (°/0 of GDP) Increase in primary balance of local governments to 0% of GDP 0.2 Increase in IPI tax on cars, appliances 0.1 Increase in CIDE tax, PIS/COFINS on imports, !OF tax on consumer loans 0.0 New rules for unemployment benefits and pensions 0.3 Elimination of electricity subsidies 0.2 Total 1.2 Stint ROOM Death. Fat Fuse* crOvinatn‘ The government has raised fuel taxes, as expected Page 4 Deutsche Bank Securities Inc. EFTA01097867 6 February 2015 Special Report: Brazil: A Recession Is Coming However, the fiscal adjustment's starting point is much worse than expected. The public sector posted a consolidated primary fiscal deficit of BRL32.5bn (0.63% of GDP) in 2014, the first primary deficit since 1997. The deficit compared to a surplus of 1.9% of GDP in 2013. The central government posted a deficit of BRL20.5bn, while the states and municipalities had a deficit of BRL7.8bn and SOEs a deficit of BRL4.3bn. In December alone, the consolidated deficit reached BRL12.9bn (compared to our forecast of BRL2bn), as states and municipalities posted a much larger-than-expected deficit of BRL11.3bn. The nominal deficit (which includes interest on the public debt) surged to 6.70% of GDP in 2014 from 3.25% in 2013, the largest since 1998. The net public debt climbed to 36.7% of GDP in 2014 from 33.6% of GDP in 2013, while the gross public debt jumped to 63.4% from 56.7% of GDP. IFigure 8: Primary fiscal balance The fiscal adjustment's starting point is much worse than expected I Figure 9: Nominal fiscal deficit 5/3% % of GDP. 12m .8% % oll313P. 12m 4/3% 30% iPtitittiVispet/liV San Ott Ororsmeatnit Ammo, redvsreesseeee violas riessor•nav meows) Source: Oa In light of last year's record primary deficit, reaching the surplus target of 1.2% in 2015 would be tantamount to an adjustment of 1.8% of GDP. In addition, the government would likely have to get another 0.2% of GDP to cover an increase in mandatory spending. The measures announced so far should save approximately 1.2% of GDP (assuming that the government will manage to obtain BRL18bn in savings from the changes in unemployment benefits and pension rules, which is far from granted due to growing political resistance against these measures). Figure 10: Federal spending on social security and welfare 10% • Balsa Familia BLOM. F1MV 9% • unemployment benefits, mono • Social seetrity :7: . fi 8% .0, 40,06 )4r,eiteittreeiteiveit Sat ON Partflo tatnewdno• I Figure 11: Public debt (% of GDP) es to 55 50 41 4O 3$ % ol GDP — Gross pubic debt — Net domestic debt — Nei magic debt 30 S 00 jr5 .3' 4, "31 4 :4 K5 ,t• 1 for "Pw # fr eto*.e, / /0. t Sarre Oar Finance Minister Joaquim Levy would still need at least 0.8% of GDP, according to our calculations. We believe that roughly half of this amount Deutsche Bank Securities Inc. Page 5 EFTA01097868 6 February 2015 Special Report: Brazil: A Recession Is Coming could be achieved through spending cuts, which are to be announced after Congress passes the 2015 budget (likely by the end of February). In terms of extraordinary revenues, we are assuming that what the government collects this year (e.g. by outsourcing its payroll management) will be just enough to match last year's amount. The remaining 0.4% of GDP would therefore have to be obtained by either raising more taxes or by undoing some of the tax cuts introduced in the previous years (especially the reduction in payroll taxes), which could exacerbate the recession. Furthermore, we believe that the authorities should be prepared to deal with additional pitfalls. We see three main risks: First, although it is possible that the normalization of payments that had been delayed during the year contributed to a deepening of the fiscal deficit in the last months of 2014, transparency is low and the size of potential fiscal "skeletons" inherited by the new economic team remains unclear. For example, the fiscal watchdog TCU, claims that there is an unaccounted stock of approximately BRL40bn in financial transactions. Second, lower-than-expected GDP growth could hurt tax collection and further complicate the fiscal adjustment. We estimate that every 1% decline in real GDP could reduce total tax revenues by approximately 0.4% of GDP. Third, there is a risk that the National Treasury may have to provide some financial aid to Petrobras. Therefore, we are cutting our 2015 primary surplus forecast to 0.8% from 1.2% of GDP. Figure 12: Central government primary fiscal balance (BRLbn) 2013 2014 change %change Total revenues 1.181.1 1.224.0 42.9 3.6% Personal income tax 105.3 114.7 9.4 9.0% Corporate income tax 187.5 194.5 7.0 3.7% IPI tax 47.1 51.6 4.5 9.6% IOF tax 29.4 29.8 0.4 t.3% Import tax 37.2 36.7 -0.5 -1.4% PIS?COFINS?CSLL 319.2 313.3 -5.9 -1.8% Royalties 36.5 39.4 2.9 8.0% Concessions 22.1 7.9 -14.2 -64.1% Dividends 17.1 18.9 1.8 10.5% Social security 307.1 337.5 30.4 9.9% Total spending 1.104.1 1.241.3 137.2 12.4% Transfers 190.0 210.2 20.2 10.6% Personnel 202.7 219.8 17.1 8.4% FAT (inc. unemployment benefits) 44.7 54.4 9.7 21.7% Subsidies 10.2 9.0 -1.2 -12.0% LOAS 33.5 37.9 4.4 13.1% CDE (energy) 7.9 9.2 1.3 17.0% Administrative 788.6 223.1 34.5 18.3% Investments 63.2 77.5 14.3 22.6% Social security 357.0 394.2 37.2 10.4% Primary balance -17.2 -94.2 -122.4% las % of GDP) 1.6% -0.3% Sant. nv A crucial question is whether failure to meet the primary surplus target of 1.2% of GDP would cost Brazil the investment grade status. It is important to bear in mind that a primary surplus of 1.2% of GDP is not enough to restore public debt sustainability (we estimate that something closer to 2.5% would be needed). The 1.2% target was presented as the feasible first step toward restoring fiscal solvency, to be followed by additional tightening in the next years (when the target would be raised to 2.0% of GDP). Under current economic conditions, jumping immediately to 1.2% might be just too painful We are cutting our 2015 primary surplus forecast to 0.8% from 1.2% of GDP We believe Brazil could keep the investment grade even with a lower primary surplus target this year Page 6 Deutsche Bank Securities Inc. EFTA01097869 6 February 2015 Special Report: Brazil: A Recession Is Coming and economically inefficient. In our opinion, the government could improve its fiscal policy significantly by promoting transparency, making a strong effort to rein in discretionary spending, introducing reforms to fix the structural problems, and indicating the path for further improvement in the next years. Higher inflation The government's decision to finally normalize administered prices is already putting a lot of pressure on inflation. The IPCA consumer price index rose 1.24% MoM in January, the steepest increase since February 2003. In 12 months, the IPCA climbed 7.14%, the largest gain since September 2011. Administered prices surged 2.50% MoM in January, led by electricity and bus fares. We do not expect much relief in February (we forecast 1.10% MoM), as the index will be hit by higher fuel prices (due to the tax hike) and by the seasonal adjustment in school tuitions. We expect the 12-month IPCA to climb to 7.57% in February, further distancing itself from the 6.50% ceiling of the inflation target's tolerance band. 'Figure 13: IPCA 1.4% . M08476 IMP MOM% YoY% r 8.D 1.2% Administered prices are putting pressure on inflation 'Figure 14: IPCA breakdown 17% 15% 7.0 13% 10% 5.0 11% G.D 9 5% 3 7% 02% 08% 069. 04% I~IIIII'III Illl 009. I I 4.0 96 4 44 0 0 0 >b. 4, .1. 4 4 7 1 . . %%% A 4, 0 M % s VI rye:Pito #1 1 rd' 9 04' 1 1 oej‘ / dP .. ,% 5 5 47e .> 4 tfc, .0.0‘ Santo. WOE YOY% — Headline Inflation Inf — Services —Food — AdMISIGted I Source:0SE We estimate that the increase in fuel taxes and public transportation, together with the government's decision to eliminate electricity subsidies, will likely make administered prices climb a hefty 10% this year. Consequently, although the deceleration in economic activity will contribute to a slowing of the inflation of non-tradable goods and services, we raised our 2015 IPCA forecast to 7.2% from 6.6%. 'Figure 15: IPCA breakdown weight 2008 2009 2010 2011 2012 2013 2014 2015F Food 16% 10.7% 0.9% 10.7% 5.4% 10.0% 7.6% 7.1% 6.5% Tradablea • 23% 4.4% 4.0% 3.8% 3.9% 2.7% 5.4% 4.7% 5.2% Non-tradables • 39% 6.9% 5.6% 7.6% 8.8% 7.6% 8.2% 7.9% 7.0% Monitored 23% 3.5% 4.7% 3.1% 6.2% 3.7% 1.5% 5.3% 10.0% IPCA 100% 6.0% 4.3% 5.9% 6.5% 5.8% 5.9% 6.4% 7.2% Sway WE OS Marts f•1 exciuding food The COPOM raised the SELIC overnight rate by 50bps to 12.25% in January, in line with market expectations. The COPOM minutes sent a somewhat ambiguous message, claiming that "the scenario of convergence of inflation to 4.5% in 2016 has become stronger" (even though the BCB claimed that its inflation forecasts for 2016 remained "relatively stable" and above the target), We raised our 2015 !PGA forecast to 7.2% from 66% Deutsche Bank Securities Inc. Page 7 EFTA01097870 6 February 2015 Special Report: Brazil: A Recession Is Coming but also stating that the progress obtained in the fight against inflation was "not yet enough? Our interpretation of the document was that the tightening cycle was not over yet, but the BCB kept the door open for another 50bp hike or a 25bp hike at the next meeting on March 4. The BCB finds itself between the proverbial rock and a hard place, as inflation expectations remain unanchored (despite some decline in long-term forecasts, market participants still do not see inflation dropping below 5% before 2019), while economic activity is collapsing. Our impression is that it will be difficult for the COPOM to reduce the tightening pace to 25bps in March, as February inflation will likely accelerate to 7.6% YoY, approximately. Thus, we now expect the BCB to raise the SELIC by 50bps to 12.75% in March, and keep the door open for a 25bp hike or no hike in April. Then, some deceleration in 12- month inflation in 2Q15 and further deterioration in economic activity will likely prompt the BCB to interrupt the tightening cycle in April and abandon its pledge to make inflation converge to the 4.5% target in 2016 (we forecast 5.6% for next year). IFigure 16: Expected IPCA, Focus survey 14 7.2 8.7 8.2 5.7 5.2 2016 2016 —2017 Qd Source SOS Foote ante We expect the SELIC rate to climb to 12.75% in March I Figure 17: IPCA and inflation targets to roves 70 60 50 40 10 20 10 / I Source. a Bat 08 erre:tut. Our scenario now contemplates the SELIC rate peaking at 12.75% in March, initiating an easing cycle at the beginning of 2016, and dropping to 10.50% by the end of that year. Should energy rationing become necessary and put even more pressure on inflation (through even higher energy prices and a weaker BRL), we believe the BCB would prefer to accommodate the supply shock and focus on the deceleration in aggregate demand. Therefore, we would probably still not see the SELIC rate above 13% in that scenario. Regarding the latest reshuffle at the BCB board, we do not expect it to lead to significant changes in the conduction of monetary policy. BCB President Alexandre Tombini has appointed economist Tony Volpon as Director for International Affairs. Volpon, currently the head of emerging markets research at Nomura Securities, is the first director chosen by Tombini from outside the BCB ranks. We believe it is positive that Tombini has decided to bring an outsider with large experience in the private sector. On the other hand, Economic Policy Director Carlos Hamilton will leave the BCB and will be replaced by current International Affairs Director Luiz Awazu Pereira. In our opinion, Hamilton was the most hawkish member of the COPOM, and his departure could give the committee a somewhat more dovish tone. Page 8 Deutsche Bank Securities Inc. EFTA01097871 6 February 2015 Special Report: Brazil: A Recession Is Coming A weaker BRL ahead Although the Brazilian economy did not grow last year, the current account of the balance of payments posted a record USD90.9bn (4.2% of GDP) deficit, compared to USD81.1bn (3.6% of GDP) in 2013. The increase in the deficit was mainly due to the trade balance (a USD3.9bn deficit in 2014 versus a USD2.4bn surplus in 2013) and equipment leasing (-USD22.7bn vs. — USD19.1bn), reflecting mainly an increase in the leasing of oil equipment. The balance of payments still posted a surplus of USD10.8bn in 2014, as foreign direct investment totaled USD62.5bn (down from USD64bn in 2013, and significantly lower than the current account deficit of USD90.9bn), foreign portfolio investment amounted to USD31.7bn (down from USD37.0bn), long- term external borrowing reached USD71.8bn (vs. USD60.8bn), debt amortization totaled USD49.8bn (vs. USD60.1bn), Brazilian assets abroad led to a loss of USD40.8bn (following the USD48.5bn deficit in 2013), and short- term capital flows reached USD22.3bn (vs. USD17.2bn). We forecast that the current account deficit will decline to USD77bn in 2015, as we expect lower oil prices and the domestic recession to compensate for the fall in export prices. However, because GDP measured in dollars will be smaller, the deficit will not fall below 4.0% of GDP. We project USD60bn in FDI this year. Since foreign direct investment is no longer enough to finance the current account deficit, Brazil is more dependent on portfolio flows that are more volatile and vulnerable to global liquidity conditions. IFigure 18: Main export products (USDbn) Product 2013 2014 2014/13 Share of total Soybeans 31.03 31.41 1.2% 14.0% Mining (incl. iron ore) 35.09 28.44 -18.9% 12.6% Oil and fuel 22.40 25.18 12.4% 11.2% Transportation material 32.19 21.76 -32.4% 9.7% Meat 16.30 16.93 3.9% 7.5% Chemicals 14.68 15.10 2.9% 6.7% Metallurgical products 13.33 14.50 8.8% 6.4% Sugar 11.98 9.48 -20.9% 4.2% Mechanical products 9.00 8.75 -2.8% 3.9% Pulp & paper 7.16 7.22 0.9% 3.2% Coffee 5.25 6.47 23.2% 2.9% TOTAL 242.21 225.12 -7.1% 100.0% Smear $EM While the BCB continues to intervene in the FX market by offering USD100mn in FX swaps every day, the outstanding stock of these instruments has reached approximately USD110bn, and we believe it will be increasingly difficult to continue extending the program (which is now scheduled to expire at the end of March). As a matter of fact, Finance Minister Joaquim Levy recently stated that he does not intend to keep the FX "artificially overvalued." While the BCB (not the Finance Ministry) is in charge of FX policy, we believe that this statement could be an indication that the government is willing to accept a weaker exchange rate. Prospects of negative GDP growth this year do not bode well for the BRL either, especially when it could prompt the rating agencies to downgrade Brazil's sovereign debt. Although we still do not expect S&P to put its Brazil rating below investment grade, Moody's and Fitch currently rate Brazil two notches above investment grade and we would not be surprised if at least one of them (e.g. Moody's, with its negative outlook) were to downgrade Brazil this year. Consequently, we revised our year-end FX forecast to BRL2.90/USD from BRL2.80/USD. While we believe that the risk is now tilted toward an even A current account deficit f 4.2% of GDP in 2074 FD/ no longer finances the entire current account deficit The government seems to accept a weaker BRL We revised our yearend FX forecast to BRL290/USD Deutsche Bank Securities Inc. Page 9 EFTA01097872 6 February 2015 Special Report: Brazil: A Recession Is Coming weaker currency, we continue to assume that the government will continue to work on adjusting its policies to restore confidence and pave the way to a gradual economic recovery in 2016. !Figure 19: Balance of Payments (USDbnl 2011 2012 2013 2014 2015F Current account -52.5 -54.2 -81.1 -90.9 -77.0 Trade balance 29.8 19.4 2.4 3.9 6.0 Net interest payments -9.7 -11.8 -14.2 44.1 -14.5 Profits and dividends 48.2 -24.1 -26.0 -26.5 -24.5 International navel -14.7 -15.6 48.3 -18.7 -17.0 Other services -22.7 -24.9 -28.3 -29.6 -29.0 Transfers 3.0 2.8 3.4 1.9 2.0 Financial account 111.1 73.1 76.2 101.8 77.0 FDI 66.7 85.3 64.0 62.5 60.0 Portfolio investment 7.1 10.7 37.0 31.7 30.0 Long-term disbursements 83.6 57.8 60.8 71.8 75.0 Brazilian assets abroad -20.9 49.3 45.0 37.2 40.0 Short-term capital, others 12.3 8.4 18.4 22.9 15.0 Long-term amortization son. Ott 09 (maws 47.7 49.7 -60.1 49.8 -63.0 'Figure 20: Current account and foreign capital flows 100 93 00 40 20 0 USDIn 12m . CurreAl aCCOuM defiC4 — - Penrose o p / 'Figure 21: Selected current account components Sant ICS I Sarre *CB •--PrOMS & div.000(19 ' w!.I010t931 'Illetiv3000fid Iffivel - Lasting Jose Carlos de Faris, Sao Paulo, (+55)11 2113-5185 Page 10 Deutsche Bank Securities Inc. EFTA01097873 6 February 2015 Special Report: Brazil: A Recession Is Coming 'Figure 22: Main Macroeconomic Forecasts 2009 2010 2011 2012 2013 2014E 2015F 2016F Economic Activity Real GDP (%YoY) -0.3 7.5 2.7 1.0 2.6 0.0 17 1.6 Nominal GDP (RSbn) 3,239.4 3,770.1 4,143.0 4,392.1 4,844.8 5,111.1 6,413.7 6,742.2 Nominal GDP (USSbn) 1,625.6 2,1419 2,476.1 2,2616 2,246.4 2,171.7 1,928.9 1,986.9 GDP per capita IUSSI 8,499.8 11,0919 12,896.1 11,306.0 arms 10,7118 9,444.0 9,647.2 Household consumption I%YoY) 4.4 6.9 4.1 3.2 2.6 0.9 0.0 1.0 Investment (%YoY) -6.7 21.3 4.7 -4.0 6.2 -7.4 -7.6 3.9 Industrial production (e/SYoY) -7.4 10.6 0.4 -2.3 2.3 -3.2 -3.0 2.6 Unemployment Rate I%) 8.1 6.7 6.0 5.6 6.4 4.8 6.0 6.6 Prices IPCA I%) 4.3 6.9 6.6 6.8 6.9 6.4 7.2 5.8 IGP-M I%) -1.7 11.3 5.1 7.8 6.6 3.7 6.7 5.0 Fiscal Accounts Primary balance (% of GDP) 2.0 2.7 3.1 2.4 1.9 -0.6 0.8 1.6 Nominal balance (% of GDP) -3.3 -2.6 -2.6 -2.6 -3.3 -6.7 -6.6 -4.3 Net government debt (% of GDP) year end 42.1 39.1 36.4 36.3 33.6 36.7 38.4 40.6 External Accounts Trade balance (USSbn) 25.3 20.2 29.8 19.4 2.4 -3.9 6.0 12.0 Current account balance (USSbn) -24.3 -47.3 -62.6 -64.2 -81.1 -90.9 -77.0 -80.0 Current account balance 1% of GDPI -1.5 -2.2 -2.1 -2.4 -3.6 -4.2 -4.0 -4.1 Foreign direct investment (USSbn) 25.9 48.6 66.7 66.3 64.0 62.5 60.0 66.0 Debt Indicators 239.1 288.6 362.0 378.6 376.8 374.1 374.1 374.1 Gross external debt (USSbn) Gross external debt l% of GDP) 277.6 361.9 404.1 440.6 482.8 554.7 581.7 606.7 Interest and exchange rates 17.1 16.4 16.3 19.6 21.6 26.5 30.2 30.9 Overnight interest rate 1%. eopl Exchange rate (BRUUSS, eopl 8.8 10.8 11.0 7.3 10.0 11.8 12.8 10.6 Exchange rate (BRUUSS, average{ 1.74 1.67 1.88 2.04 2.34 2.66 2.90 3.00 Samar lisebtel Seale.* as t footman 'Figure 23: Long-term forecasts GDP % IPCA % BRUUSD eop Selic avg. 2010 7.5 5.9 1.87 10.0 Feb-15 1.10 7.57 12.25 2011 2.7 6.5 1.88 11.7 Mar-15 0.60 7.23 12.75 2012 1.0 5.8 2.04 8.5 Apr-15 0.55 7.11 12.75 2013 2.5 5.9 2.34 8.4 May-15 0.45 7.09 12.75 2014E 0.0 6.4 2.66 11.0 Jun-15 0.30 6.99 12.75 2015F -0.7 7.2 2.90 123 Jul-15 0.40 7.41 12.75 2016F 1.5 5.6 3.00 11.0 Aug-15 0.35 7.51 12.75 2017F 2.7 5.2 3.10 115 Sep-15 0.50 7.44 12.75 2018F 3.0 5.6 3.21 115 Oct-15 0.40 7.42 12.75 2019F 2.5 5.2 3.31 113 Nov-15 0.50 7.41 12.75 2020F 2.5 5.0 3.41 11.0 Dec-15 0.60 7.21 12.75 2021F 2.8 5.0 3.51 115 Jan-16 0.70 6.64 12.25 Samar Nenaraialivora 08 kvec.nu Samar 08 faeces° 'Figure 24: Monthly forecasts IPCA MoM% IPCA YoY% SELIC% Deutsche Bank Securities Inc. Page 11 EFTA01097874 6 February 2015 Special Report: Brazil: A Recession Is Coming Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at httcrligm db com/ger/disclosure/DisclosureDirectory easr Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Jose Carlos Faria Page 12 Deutsche Bank Securities Inc. EFTA01097875 6 February 2015 Special Report: Brazil: A Recession Is Coming Regulatory Disclosures 1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. 2. Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at htto://gm.db.com. 3. Country-Specific Disclosures Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. 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Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority. Deutsche Bank Securities Inc. Page 13 EFTA01097876 6 February 2015 Special Report: Brazil: A Recession Is Coming Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may — by construction — lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements. Page 14 Deutsche Bank Securities Inc. EFTA01097877 David Folkerts-Landau Group Chief Economist Member of the Group Executive Committee Raj Hindocha Global Chief Operating Officer Research Marcel Cassard Global Head FICC Research & Global Macro Economics Richard Smith and Steve Pollard Co-Global Heads Equity Research Michael Spencer Regional Head Asia Pacific Research International Locations Ralf Hoffmann Regional Head Deutsche Bank Research, Germany Andreas Neubauer Regional Head Equity Research, Germany Steve Pollard Regional Head Americas Research Deutsche Bank AG Deutsche Bank AG Deutsche Bank AG Deutsche Securities Inc. Deutsche Bank Place GroBe Gallusstrage 10-14 Filiale Hongkong 2-11-1 Nagatacho Level 16 60272 Frankfurt am Main International Commerce Centre. Sanno Park Tower Corner of Hunter & Phillip Streets Germany 1 Austin Road West,Koveloon, Chiyoda-ku, Tokyo 100-6171 Sydney, NSW 2000 Tel: Hon Ko Jap Australia Tel: Tel: Deutsche Bank AG London Deutsche Bank Securities Inc. 1 Great Winchester Street 60 Wall Street London EC2N 2ED New York, NY 10005 United Kingdom United States of America Tel: Tel: Global Disclaimer Ma inlomation rod Opinion w the raper:ware grammatry Mogul* flank AG or ono 01 Os again «Oat:nay 'Drat:Ulm Sank) Ma inlommtion Ryan is balawd m Lv raiabla and has Maw obtainog front pubic aourtus tabwrod lobs nalabla NOUN/ Bark «Om nOtaormolatron as to en 0:curacy of cOnspristanoss of aigh inlonnatiOn. Mut:aft Bank may ammo in saunas irsincsates. on a prom otary toss of othadvity in a mignon traonsisicat with %ha via" Tann in %ha «south rspOm F aldritak others ream DaulsOit Bonk. including almtagisto addles staff may law a view' that is irgonssiait with Val taun in this tor...arch • upon. 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