This Selected Issues paper provides background information and analysis on recent developments and critical issues for the Colombian economy. The study discusses the unemployment and stresses in the financial system and also focuses on fiscal issues. The following statistical data are presented in detail: national accounts at current prices and at constant prices, savings and investment, value of agricultural crops, mining production, structure of regular gasoline prices, indicators of construction activity, minimum wages, producer price index, interest rates, and so on.
I. Introduction and Overview1
1. The eight chapters in this selected issues paper provide background information and analysis on recent developments and critical issues for the Colombian economy. This chapter provides a brief overview of the economic downturn in 1998-99 and the incipient recovery of 2000. Chapter II discusses unemployment, which remains at a historical peak despite the resumption of economic growth in 2000. The subsequent chapters take up the stress in the financial system during 1998-99 (Chapter III), the inflation targeting policy adopted by the central bank (Chapter IV), and the core inflation indicators monitored by the central bank (Chapter V). The final three chapters focus on fiscal issues, including tax and customs reform (Chapter VI), the bank debit tax (Chapter VII), and the second generation reform of the pension systems (Chapter VIII).
2. The roots of the economic difficulties faced by Colombia in 1998-99 can be traced to events in the first half of the 1990s, when a combination of increased public spending, trade and financial sector liberalization, and the announcement of major oil discoveries resulted in a sharp expansion of domestic demand. The changes in the public finances that took place in the 1990s reflected to a considerable extent the political commitments laid down in the 1991 constitution, which sought to increase social spending, particularly on health and education, but were not accompanied by compensating increases in government revenue. In addition, the pension reform of 1993 fell short of dealing with the financial problems of the pension system.
3. The weakening of the fiscal position goes a long way toward explaining the macro-economic performance in the past decade. The opening of the trade system should have produced a real depreciation of the peso, but the increases in public spending and the effect of the expected oil bonanza helped induce a real appreciation (Figure 1).
4. The associated widening of the external current account deficit was readily financed with capital inflows,2 which took the form of foreign direct investment and heavy borrowing abroad by the private sector (Figure 2). These flows tended to reinforce the real appreciation, of the peso, and contributed to a rapid growth of monetary aggregates and credit, helping to fuel a real estate bubble. The expansion in credit took place in the presence of weak financial supervisory practices and regulatory forbearance in the case of the public banks. Meanwhile, the rapidly increasing quasi-fiscal costs of monetary sterilization of the inflows led the authorities to introduce a deposit requirement on external borrowing.3 Real interest rates were kept low (see Figure 1), which continued to fuel domestic demand, and a construction and real estate boom ensued.
5. The fiscal and external imbalances widened in the last half of the 1990s, which, coupled with the political crisis of the Samper administration (1994-98) and the escalating guerrilla violence, led to increased uncertainty and a weakening of confidence.4 The situation was aggravated by external shocks, in the form of a sharp terms of trade deterioration and the effects of the turbulence in the international financial markets in 1998,5 as well as by the uncertainty about the new government’s policies in the face of the continuing fiscal deterioration.6 These events resulted in periodic attacks on the exchange rate in 1998 and 1999, to which the authorities responded by depreciating the exchange rate band on two occasions, and by tightening monetary policy. The peso was finally floated in September 1999, following heavy foreign reserve losses by the central bank.
6. After a notable rise in private debt (both domestic and external) over the course of the 1990s, the sharp increase in real interest rates in 1998 and the depreciation of the peso in 1998 and 1999 led to a marked increase in the debt service burden of the private sector. This event, in conjunction with the weakening of confidence, contributed to a significant contraction in domestic demand. At the same time, the deterioration of market sentiment toward Colombia since 1997 made access to international markets more costly, and the direction of private capital flows was reversed, including through prepayments of external debt. As a result of these developments, real GDP growth slowed to 0.5 percent in 1998 and was negative by 4.3 percent in 1999.
7. The recession helped reduce inflation rapidly (from 16.7 percent in 1998 to 9.2 percent in 1999) and sharply lowered the external current account deficit to near balance in 1999 (from 5.3 percent of GDP in 1998). However, the fiscal position deteriorated further, unemployment increased, and the financial system underwent a period of substantial stress.7
8. To deal with the worsening economic and financial situation, the Colombian authorities introduced a three-year economic recovery program in late 1999, which is being supported by the Fund through a three-year extended arrangement. The program seeks to restore the conditions for the resumption of economic growth, keep inflation on a downward path, and achieve a sustainable external position. To attain these objectives, the program calls for strong fiscal consolidation, financial sector restructuring, structural reforms, and the maintenance of a flexible exchange rate policy.
9. In 2000, the economy improved and the program targets for economic growth, inflation, and fiscal deficit for the year were broadly achieved: real GDP growth accelerated to 2.8 percent; inflation fell to 8.8 percent; the consolidated public sector deficit decreased to an estimated 3.6 percent of GDP (from 5.5 percent of GDP in 1999); and the external current account was in near balance. The recovery was led by the expansion of exports and strong growth in the manufacturing sector. The reduction of inflation was helped by the low pass-through of the exchange rate depreciation. The fiscal consolidation was facilitated by high oil revenues and lower investment spending, and was achieved despite a deterioration of the financial position of the public pension and health systems and a court-ordered increase in public wages.8 To prevent a systemic crisis in the financial sector, the government introduced bank restructuring and recapitalization programs managed by Fogafin, the public deposit insurance agency; relief programs for mortgage debtors; stronger regulations and supervisory practices; and norms to facilitate private debt restructuring.
10. The conditions of the financial sector also improved in 2000, as reflected in a reduction in the level of overall nonperforming loans and an increase in the capital adequacy ratio of the banking sector (from 11.0 percent in December 1999 to 13.8 percent in November 2000). However, the portfolio of mortgage institutions deteriorated from the middle of the year, following an improvement in the preceding six months that resulted from debt relief provided to mortgage holders. Four public banks were liquidated or merged; five private banks were recapitalized with loans from Fogafin; and the two private banks taken over by Fogafin in 1999 are being prepared for privatization or liquidation.
11. The broad monetary aggregate (M3) grew by only 2.7 percent in 2000 and its composition shifted toward more liquid aggregates, mainly as a result of a sharp increase in the demand for currency in the wake of problems faced by some financial institutions and the effects of the financial transactions tax that was introduced at the end of 1998 (0.2 percent on all withdrawals). In contrast, the private sector’s portfolio of domestic financial assets grew by 10 percent due to a large increase in holdings of government securities. Outstanding credit to the private sector was nearly unchanged for the second consecutive year as the economic recovery was financed largely from firms’ own resources. Market interest rates were generally stable, but increased somewhat in the last half of the year in response to increased public sector borrowing, mainly brought about by a shortfall in proceeds from the government’s program to privatize public enterprises and banks (see below). In October 2000, the central bank adopted inflation targeting as the framework for monetary policy.9
12. Colombia’s external current account balance improved somewhat in 2000, showing a surplus of 0.2 percent of GDP. Nontraditional exports were stimulated by the large real depreciation of the peso during the previous two years, and the growth of traditional exports reflected mainly higher international oil prices. The capital account remained slightly negative, as the private sector reduced its external debt while the public debt rose. Colombia placed sovereign bonds in international markets for US$1.8 billion during the year, at spreads of 600–700 basis points.
13. The central bank’s net international reserves rose by US$707 million in 2000, which exceeded the target established under the government’s program by over US$250 million. The exchange markets remained orderly during the year, except during a short period in April/May when political events and increasing difficulties in executing the government’s privatization program put pressure on the peso. The peso depreciated by 19 percent against the U.S. dollar during the year, or 11.5 percent in real effective terms.
14. The government’s ambitious privatization plans for 2000 fell well short of expectations, mainly as a result of episodes of violence against electricity installations, the withdrawal by the city of Bogotà of the plan to sell its telephone company, and the time required to prepare public banks for divestment or liquidation. Other structural reforms evolved about as envisaged. The plans to reform the system of revenue transfers to territorial governments successfully completed the first of two readings by congress; regulations to implement the provisions of the 1999 financial reform law were issued; and legal reforms to help control territorial government spending (Law 617) and to reorganize lottery and gaming activities were approved.
15. Unemployment reached a historical high of about 20 percent in 2000. Although the economic downturn clearly contributed to this, the increase may also be related to structural factors. The price of labor with respect to capital more than doubled in the 1990s. There has also been an increase in the unemployment rate of the highest income earners of households, which may tend to push other family members into the labor market in an effort to replace the income loss, thus raising the participation rate. In addition, there has been a mismatch between the skills demanded and those offered by the working age population. Unemployment has been concentrated among young people with low education levels, suggesting that additional resources may need to be allocated to education and training. Overall, the evidence suggests that a significant part of the unemployment problem may be related to structural factors.10
16. After the recession in late 1998 and 1999, the Colombian economy has begun to recover. Fiscal consolidation in the next few years will benefit from the strong (albeit somewhat distortionary) tax package that was approved in December 2000.11 It will also require the completion of a series of on-going structural reforms designed to strengthen further the control over public expenditures; a second generation pension reform;12 improvements in the control of expenditures funded with the territorial transfers (Law 60); and a reform of the health system of the social security institute.
Rulings of the Constitutional Court Affecting Economic Policy13
The constitutional court (CC) in Colombia has in recent years handed down a number of decisions that affect the conduct of economic and financial policy. Some examples of these rulings are set out in the following paragraphs.
In 1996, the CC ruled that the employees of the social security institute (ISS) be granted collective bargaining rights along the lines of the employees in public enterprises, despite the fact that Law 100 (1993) established a different status for them. This decision triggered cost increases for the ISS, making the competition with private health care suppliers more difficult.14
In a 1996 ruling, the CC decided that all retirees would receive 14 pension payments per year. This decision overruled Law 100 that had established 13 payments per year as a general directive and 14 payments only for those who were not granted annual cost-of-living adjustments before 1998. As a result, the annual amount of pension payments increased by around 7 percent.
In 1999, the CC ruled that the executive branch did not have the power to close public institutions as granted by the congress earlier in the year.
In 1999, changing the previous procedures under which housing credits were indexed to interest rates, the court ruled that such credits could be only indexed to past inflation, and that the capitalization of interest contradicted the constitutional principles on housing.
In 1999, a ruling determined that the mortgage debt reduction program introduced by the government should be extended also to debtors in arrears.
Also in 1999, the CC ruled that mortgage debtors who surrender their properties to the creditors would free of any further obligation.
In a decision taken in late 1999, the CC determined that mortgage interest rates be capped at the lowest lending rate in the market.
In 2000, the CC ruled Law 344 (1996) unconstitutional as it mandated a slowdown in the central government’s transfers to a subsidized health plan for people outside the labor market.15
In 2000, the court declared that the approval of the national investment plan had not followed the constitutional procedures, thereby freezing the execution of a number of projects in the areas of agriculture, education, and housing until the procedural issues were resolved.
In late 2000, the CC ruled that public wage increases should, at a minimum, compensate for the inflation of the previous year. This decision reversed the central government’s wage freeze policy for 2000; the ruling involved retroactive payments.
Prepared by Luis E. Breuer.
Colombia was one of the few emerging market economies in Latin America that did not reschedule its external debt in the 1980s and maintained an investment grade rating for sovereign debt until the last half of 1999, which helped facilitate the large capital inflows.
For a detailed discussion of these restrictions, see Chapter IV of SM/99/251.
The political crisis emerged in mid-1995 sparked by allegations of improprieties in the 1994 presidential election campaign and was to haunt the Samper administration for the duration of its mandate.
The turbulence followed the Asian crisis in late 1997, and the Russian and Brazilian events in 1998.
The administration of President Pastrana took office in August 1998.
See Chapter II for a discussion of unemployment issues and Chapter III for a description of stress in the financial sector.
In recent years, the constitutional court has handed down decisions on a number of economic issues, which at times have posed challenges to the fiscal consolidation effort, and modified the regulatory regime of housing finance. The attachment to this chapter presents a list of the main decisions that affected these areas.
The financial transactions tax is described in Chapter VII, inflation targeting in Chapter IV, and the core inflation indicators monitored by the central bank in Chapter V.
Refer to Chapter II.
See Chapter VI for a summary of the tax reform.
See Chapter VIII for a discussion of pension reform issues.
Prepared by José Gil-Diaz.
Law 100 established the ISS as a provider of health services in competition with private service providers.
Law 344 provided the government some discretionary power with regard to the timing and the amounts transferred to the subsidized health plan.