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Statement by Mr. Vargas on the Request for a Successor Arrangement Under the Flexible Credit Line

Author(s):
International Monetary Fund
Published Date:
June 2010
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May 4, 2010

  • I thank the staff for the paper and the Board for considering our request. I want to begin by expressing our gratitude to the Fund for the current FCL expiring in this month. It was a useful and timely instrument, offered to countries with certain characteristics during a difficult juncture for the world and the Colombian economies.
  • From our point of view, the current FCL was part of a wider policy response to the global crisis that involved exchange rate flexibility, countercyclical fiscal and monetary policies, securing precautionary external funding and ensuring a cushion of international liquidity for the country. An adequate stock of international reserves and access to the FCL were key components of this strategy. In addition, the FCL signaled the strength of our economy and policy framework.
  • As such, the FCL gave support to the adoption of countercyclical policies and contributed to a satisfactory performance of the economy in the midst of the global crisis.
  • Economic conditions have improved since our last Article IV Consultation. Leading indicators point to a growth rate higher than previously expected. The Central Bank staff is now expecting economic growth to be around 3 percent for 2010. At the same time, the observed effects of the El Niño supply shock have been smaller than initially projected, while core inflation turned out to be lower. As a result, annual inflation hovers around the lower end of the 2-4 percent inflation target.
  • Even with a better outlook, growth is expected to remain below potential. Hence, we expect that the current negative output gap will probably widen in 2010. Inflation expectations have declined and we do not foresee a large depreciation of the Colombian peso. Under this scenario and with no extreme shocks to commodity prices or to external demand, inflation is forecasted near the lower end of the target range in 2011, with a significant probability for smaller numbers.
  • Facing surprisingly low core inflation figures, the fact that the negative supply shock is apparently smaller than expected and a lower inflation forecast, efficient monetary policy calls for a greater impulse to the economy in order to close the output gap faster. This, in addition to the fall in inflation expectations, prompted the Central Bank during its last meeting to reduce the policy interest rates by fifty basis points to three percent. The Central Bank remains vigilant and ready to adjust the monetary policy stance when serious indications of inflation or financial instability risks emerge.
  • We want to take this opportunity to convey to the Board the motivation of our request to renew the FCL arrangement and, in particular, the rationale for requesting a lower access.
  • The world economy and global financial conditions have markedly improved since our previous request, rendering a much lower probability of a deep world economic downturn, or of a sharp cut in foreign financing for emerging countries, or of contagion from economic troubles elsewhere.
  • Nonetheless, the world economic recovery faces substantial downside risks, stemming from strains in the fiscal position of several countries and persistent fragility in some segments of the financial system. These risks translate into a highly uncertain outlook for our terms of trade, external demand, workers’ remittances, risk aversion and capital flows. The recent behavior of the exchange rates and the price of some commodities is an indication of the degree of uncertainty regarding the markets’ reaction to shocks around the world.
  • Colombia is still recovering from the effects of the global crisis and idiosyncratic shocks to export demand. In this context, it is crucial to sustain a stimulative stance of macroeconomic policy and to carefully unwind it when conditions warrant it. It is important, then, to protect this strategy from the impact of negative external shocks and to avoid undesirable pro-cyclical policy responses. Hence the need for an insurance against such an eventuality in the current state of the world and the Colombian economies.
  • Why are we requesting a lower access? There are two complementary ways to understand this decision. One is to recognize that adverse external shocks are likely to be less serious than a year ago. This is the view reflected in the staff’s paper, in which a milder negative shock is included in the adverse scenario. An alternative view is to acknowledge that the country wants protection against a larger, highly damaging external financing shock that would occur with a probability that is today much lower than a year ago.
  • In other words, despite the absence of large macroeconomic and financial imbalances, we want insurance against a tail risk that, if realized, would involve a severe contraction of expenditure and production, even after a substantial reduction of international reserves.
  • Conventional economic theory states that a risk averse agent will fully insure himself against a potential loss, provided that the probability of the loss is greater than the insurance premium. When the probability of the event is lower than the insurance premium, the amount insured will be less than the potential loss.
  • We consider that the probability of a large, negative shock has declined significantly over the last year, but is still not much lower than the FCL premium. An indication in this regard may be obtained from the behavior of one-year CDS for Colombia, which came down from around 280 bps in the first four months of 2009 to 80 bps in the same period of 2010.
  • Further, our international liquidity position has been consolidated after the SDR allocation and with the program of daily purchases of international reserves currently in place, improving the country’s ability to withstand a large external financing shock.
  • In sum, a lower probability of a negative event and an improved international reserve position are behind the decision to request a lower access under the FCL. In addition, as discussed in the last Article IV consultation, under low foreign currency and term mismatches, anchored inflation expectations and a credible macroeconomic policy framework, exchange rate flexibility would be the main component of our response to an external shock.
  • Communication of the decision to scale back the access to the FCL has followed the basic argument previously presented; that is, under better, but still uncertain external conditions, Colombia still needs an insurance, but a smaller one. The announcement of the request of a smaller access has not produced any negative reaction by the public or the markets. The announcement was made in the context of a stronger local and international position, with unchanged, adequate policy frameworks. The move should be viewed as part of a gradual convergence of macroeconomic policies towards a more normal situation.
  • As pointed in the staff’s document, Colombia continues to meet the qualification criteria for the FCL. The external and fiscal positions are sustainable, the international reserves position is strong, inflation is low and stable, private flows are significant in the capital account of the balance of payments, the financial system is solid and profitable, the country continues to access international capital markets and, above all, monetary and fiscal institutional policy frameworks are strong and credible.
  • As with the current FCL arrangement and previous support facilities from the Fund, we intend to treat the new FCL agreement as precautionary.
  • Support by the Fund to this request will be greatly appreciated and will send an important signal to markets about the Colombian authorities’ commitment to keep implementing sound economic policies and to further enhance strong policy frameworks.
  • Finally, based on our experience and perceptions, we want to offer some general thoughts on the FCL facility that may be helpful in the current and future discussions of this type of arrangements. First, we believe that instruments like the FCL “complete” international liquidity markets and we value the role that the Fund plays in that respect. Counterparty risk is a crucial obstacle in the development of these mechanisms, as highlighted by the events of the global financial crisis. Until this and other problems are solved, origination of insurance instruments like the FCL by the private sector will continue to be limited.
  • Second, since the FCL and other similar contingent mechanisms complete international liquidity markets and are useful to countries, one should expect a positive demand for them at a reasonable price at all times. This implies that international reserves adequacy indicators must be adjusted by the existence and use of those instruments. The calculation of an “optimal” or “adequate” level of international reserves changes when insurance products like the FCL are available, in the same way that household savings may change in the presence of life or property insurance policies.
  • Third, the value of the FCL from the point of view of the insured country significantly depends on the other countries deemed as eligible for the same facility. There is an important signaling effect that depends on the peer countries accessing the facility. This is a key factor to take into account for the success of the FCL or other similar arrangements.

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