ECONOMIC ENVIRONMENT

Global growth was relatively low at the beginning of 2014. However, beginning in the second quarter, the global economy showed signs of acceleration, mainly driven by the US recovery. Even in this benign scenario, some advanced economies, such as the Eurozone, continue to struggle, generating a persistent global growth divergence scenario.

After a negative print in the first quarter GDP, mainly caused by weather effects, the US economy rebounded during the year and expanded 2.4% in 2014. Domestic demand was the main driver. Investments accelerated to 5.2% and private consumption expanded 2.5%. The unemployment rate continued to fall and reached 5.6% in December 2014, its lowest level since 2008. In the context of improving economic conditions, the Federal Reserve, at its meeting in October, ended its monthly assets purchase program. It also kept the interest rate close to zero, although the possibility of hiking rates in 2015 is currently being considered.

The euro area continued to show a fragile economy. Despite the improvement in the GDP growth rate in 2014 ( 0.8% versus - 0.4% in 2013), the risk of deflation continues to threaten the region. Throughout 2014, inflation slowed and ended the year at 0.4%, well below the 2% target of the European Central Bank ( ECB). In reaction to this deflationary risk, the ECB implemented some liquidity support programs during

the year to stimulate credit expansion and as an attempt to tackle the weak domestic demand.

The activity in the euro area is expected to continue to accelerate in 2015, although the recovery will probably continue at a modest pace. We expect the economy to expand 1.3%, but we also forecast a deflation of 0.4%, due to the plunge in oil prices. In this context, the ECB announced in January 2015 a large assets purchase program, with the intention to acquire sovereign and corporate bonds from euro area countries. Even though this measure helps to stimulate the demand side of the economy and fight deflation, structural issues remain to be addressed, such as banking and fiscal union, and the need for continued fiscal adjustment. The recent strengthening of anti- austerity parties in Europe and the upcoming elections in key peripheral economies should increase uncertainty in 2015, and hinder the implementation of necessary reforms to attain sustainable growth.

In China, economic activity continued to show reasonable growth, displaying a modest slowdown. Chinese GDP expanded 7.4% in 2014, down from 7.7% in 2013. The prospective scenario is one of continuing deceleration in the coming years. As the reforms announced in 2013 are implemented, decreasing the economy’s dependence on investments and exports and increasing the importance of domestic consumption, Chinese activity should display more modest growth rates. Apparently, however, these changes tend to be gradual.

Global growth will receive a positive boost from lower oil prices in 2015. Crude oil fell almost 50% in 2014. Even though it contributes to the deceleration of prices in economies threatened by deflation, the fall in fuel prices, reducing household spending on transportation, should favor consumption and positively affect the economic activity of most countries. However, it is important to note that not every country will benefit from the fall in oil prices. Countries whose oil production is an important activity for the economy will undergo significant adjustments in the coming quarters. These changes, which should affect mainly emerging economies, can generate financial turmoil, which may also affect other emerging countries.

Weak growth in developed countries and the slowdown in emerging economies contributed to keep inflation low across the globe. Consequently, monetary stimulus measures were announced by major central banks around the world. This broad global liquidity environment allowed emerging economies with the greatest external and internal imbalances to postpone part of the necessary adjustments. Among the economies that have benefited from this more benign scenario is Brazil, which continued to show high current account

deficit, inflation at the upper limit of the target and a deteriorating fiscal policy in 2014.

The performance of the Brazilian economy in 2014 represented an exacerbation of the pattern of the previous three years, when it suffered from a combination of low growth and high inflation. Our estimates point to a contraction of GDP in 2014, compared to an average expansion of 2.1% in previous years. Despite weak growth, inflation accelerated to 6.4%, up from 5.9% in 2013 and an average of 6.1% in the last three years. This combination of low growth and high inflation reinforces our view that the Brazilian economy is facing supply side restrictions, and not lack of demand. We think that most of the restrictions come from the labor market. However, it is important to note that some adjustments have already started and there are signs that they will continue throughout 2015.

As for economic activity in 2014, we should highlight the performance of industry. Even with an increase of 7.5% of mineral extraction, industry should have retreated 2.0% in 2014. The service sector also disappointed. It should have expanded only 0.8% in 2014, the smallest increase since 2003. On the demand side, we estimate that the household consumption also presented its worse performance since 2003, growing only 1.0%. Investment also disappointed, falling 8.1%, according to our estimates. Even with the stagnation of activity, the unemployment rate remained near its historical low, since the slowdown in the number of employees was more than offset by the fall in the number of people looking for jobs.

Regarding inflation, prices increase in the service sector continued to pressure the IPCA. This is a laborintensive sector, and therefore more susceptible to tight conditions of the labor market. Therefore, we see the dynamic of the service sector inflation in the last few years as being compatible with our vision of economic growth being limited by supply conditions. Another factor that contributed to keep inflation under pressure was the currency devaluation: the exchange rate depreciated from R$/ US$ 2.36 in December 2013 to R$/ US$ 2.66 in December 2014. In contrast, regulated prices, which accelerated from 2013, grew less than free prices and contributed to keep inflation in 2014 below the ceiling of the Central Bank’s tolerance range of the inflation target ( 6.5%). This scenario should not be repeated in 2015, as regulated prices will likely advance 9.5%. Thus, in October, the Monetary Policy Committee ( Copom) started a new interest rate hike cycle. The base rate ( Selic) that started 2014 at 10.0%, ended the year 1.75 p. p. ( percentage points) higher, at 11.75%.

The Brazilian external accounts continued to deteriorate in 2014. The country recorded a current account deficit of US$ 90.9 billion, or 4.2% of the GDP, the worst result in thirteen years. It also posted its worst trade balance since 1999, since the surplus of US$ 2.6 billion in 2013 turned into a deficit of US$ 3.9 billion in 2014. This swing was caused by a decrease of 7.0% in exports, partially compensated by a decrease of 4.4% in imports. It is also worth noting the fall in commodities prices over 2014, which will negatively affect the trade balance in 2015. The price of iron ore, which corresponds to 11% of Brazilian exports, fell about 47% over the year. As in 2013, the country had to rely on less stable sources for financing the high current account deficit, since foreign direct investment was not sufficient to cover the negative result.

Brazilian public accounts also deteriorated in 2014. The public sector, which recorded a 1.9% of GDP primary surplus in 2013, posted a primary deficit of 0.6% in 2014, its first deficit since 2002. The main driver of the result was the dynamics of revenues, which retreated 2.6% in real terms. Primary expenses expanded 6.0% in real terms, a similar pace to the previous years. In this negative scenario, the government promised to restore its fiscal health and reach a 1.2% of GDP primary surplus in 2015, increasing to 2.0% in 2016 and 2017. However, the

expected weak GDP growth in 2015 and the rigidity of government expenses will hamper the achievement of the surplus target, which we believe can only be achieved trough a strong cut in government investments and increase of tax burden.

In addition to the process of rebalancing the economy, which should contribute to a recovery in economic agents’ confidence, in order to resume a more vigorous and sustainable path of growth, it will be necessary to increase the productivity of the Brazilian economy. In our view, this can only be achieved by raising the aggregate savings rate, improving business environment, increasing investment and implementing institutional reforms.

It is important to mention that the investment rate has been fluctuating between 17% and 19.5% of the GDP since 2008, which, in our opinion, is insufficient to keep a sustainable GDP growth over 2.5%. Little has been done to increase Brazilian productivity in the last years, and new measures tend to generate results only in the medium term.

After a difficult year in 2014, we expect that the Brazilian economy will face an even more challenging scenario in 2015, when the economy will probably shrink and inflation will reach 7.5%. However, we believe the adjustment initiated in late 2014 will show positive results in 2016.