Colombia: Staff Report for the 2005 Article IV Consultation

This paper discusses Colombia’s 2005 Article IV Consultation, Fourth Review Under the Stand-By Arrangement (SBA), and Requests for Waiver of Nonobservance of Performance Criteria. Real economic growth in Colombia recovered to 4 percent a year in 2003–04. The national unemployment rate declined from 20 percent at end-2000 to 12 percent at end-2004. The health of the financial system continued to improve. The solvency and profitability of the banking system have recovered, reflecting economic growth, a successful recapitalization scheme, and improved supervision.


This paper discusses Colombia’s 2005 Article IV Consultation, Fourth Review Under the Stand-By Arrangement (SBA), and Requests for Waiver of Nonobservance of Performance Criteria. Real economic growth in Colombia recovered to 4 percent a year in 2003–04. The national unemployment rate declined from 20 percent at end-2000 to 12 percent at end-2004. The health of the financial system continued to improve. The solvency and profitability of the banking system have recovered, reflecting economic growth, a successful recapitalization scheme, and improved supervision.

I. From Crisis to Recovery

1. Since 1999, economic policies have sought to strengthen the economy, in the aftermath of the country’s worst economic crisis in 30 years (Box 1.). 1 The strategy focused on fiscal consolidation, lowering inflation, and strengthening the financial system. In mid–1999 the government of President Pastrana designed an economic emergency program to re-establish a credible policy framework. The authorities aimed at cutting the public sector deficit from 5½ to 1½ percent of GDP within three years to return public debt to a sustainable path. This effort was supported by structural fiscal reforms to strengthen the finances of subnational governments, which had accumulated high debt levels in previous years, and to improve the tax and pension systems. In September 1999, the Banco de la República switched to a flexible exchange rate regime, and adopted an inflation targeting framework to anchor inflationary expectations. The crawling exchange rate band—which Colombia had maintained for most of the 1990s—had proved ineffective in reducing inflation and too costly to sustain in the presence of volatile private capital inflows. Congress approved a banking reform to strengthen financial supervision, and the government intervened a number of insolvent financial institutions.

2. The efforts worked well initially but encountered difficulties in 2002. The fiscal tightening advanced through early 2002, although the fiscal targets were eased in 2001 due to slower economic growth and increased security requirements. President Pastrana had been attempting to negotiate a peace agreement with the guerillas, but this effort collapsed in February 2002, coinciding with a deterioration in the security situation (Box 2.). Public spending increased in the run up to the May 2002 elections. In addition, Colombia was affected by concerns about developments elsewhere in the region, which curtailed access to international capital markets for a number of emerging market countries. Together these factors contributed to a sharp depreciation of the currency and raised the country risk premium to a peak of 1,100 basis points in October 2002.

3. In August 2002 the administration of President Uribe took office and strengthened economic policies. It quickly reversed the deterioration in the fiscal position through several revenue measures (a one-time wealth tax, an income tax surcharge, and a broadening of the VAT base) and expenditure restraint. Two pension reforms were also adopted, reducing the actuarial deficit of the pension system from 207 percent of GDP to 187 percent of GDP. Other reforms focused on restructuring and downsizing the nonfinancial public sector, improving financial supervision, and privatizing or liquidating the remaining public banks. Congress also approved in December 2002 a labor market reform that extended regular daytime working hours, lowered the overtime premium for work on Sundays and holidays, reduced severance payments, and cut nonwage costs for certain employee groups.

In addition, the Uribe administration established a policy known as democratic security to try to resolve the civil strife.

4. Initially the recovery proceeded slowly but in 2003–04 economic performanceimproved significantly (Table 1).

Table 1.

Colombia: Selected Economic and Financial Indicators

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Sources: Colombian authorities; and Fund staff estimates and projections.

All annual changes in foreign currency stocks valued at constant exchange rate.

Includes the quasi-fiscal balance of Banco de la Republica, sales of assets, phone licenses, and statistical discrepancy.

Includes bonds issued to recapitalize financial institutions.

Program definition. Assumes no purchases under the current SBA arrangement. Includes valuation changes.

  • Real economic growth recovered to 4 percent a year in 2003–04, compared with a 4 percent decline in real GDP in 1999. The national unemployment rate declined from 20 percent at end-2000 to 12 percent at end-2004, while the poverty rate declined from almost 60 percent in 1999 to 52 percent in 2003.

  • The combined public sector deficit was reduced from 5.5 percent of GDP in 1999 to an unexpectedly low 1.3 percent of GDP in 2004, reflecting an unanticipated rise in the export price of oil to US$36 per barrel and an unusually large surplus of the autonomous local and regional governments. This outturn—together with the real appreciation of the peso during 2004—helped reduce public debt to 53 percent of GDP by end-2004. Also, public sector deposits reached 10 ½ percent of GDP by end-2004.

  • Inflation declined from 9 percent during 1999 to 5.5 percent during 2004—the lowest level in decades—owing to an output gap that reached 4–5 percent in 1999–2000 as well as the effective implementation of the inflation targeting framework.

  • The external sector strengthened, led by sustained growth in exports and a recovery in capital inflows. During 2004, the peso appreciated by 11 percent in real effective terms, prompting the central bank to purchase US$2.9 billion (about one-third of the stock of base money) to limit the appreciation. By end-2004, net international reserves reached US$13.2 billion (123 percent of short-term external debt on a remaining maturity basis).

  • The health of the financial system recovered, as loan quality improved and bank profits increased. The nonfinancial corporate sector had reduced leverage and managed currency risk more prudently, encouraged by the flexible exchange rate regime.

5. Nonetheless, there are still important challenges to continue to strengthen economic Performance:

  • It would be important to continue to find ways to ensure that sustained growth translates into further declines in unemployment and poverty.

  • Ongoing fiscal consolidation is needed to continue reducing Colombia’s public debt, which remains relatively high and vulnerable to a weakening of the peso.

  • While the financial system is healthy, domestic capital markets are shallow and illiquid. This, together with distortionary taxes on financial transactions, has led to a high cost of capital and deterred investment. The mortgage sector has been stagnant, and since 1999 banks have increased their exposure to government securities.

  • The economy remains vulnerable to the risk that the global economic environment becomes less favorable, especially if high world oil prices slow global demand.

  • It is crucial to keep economic policies on track during the upcoming political transition—elections are scheduled for March (congress) and May (presidential) 2006—to ensure that the country continues to build the credibility of its commitment to strong policies.

II. Assessing The Medium-Term Policy Strategy

6. The Article IV consultation discussions provided the opportunity to assess whether the policy strategy followed since 1999 was appropriate. Overall, the staff and the authorities agreed that this strategy had worked well and should be sustained in the coming years to address the remaining challenges.

7. Looking forward. the authorities’ policies over the medium-term seek to sustain real growth of 4 percent a year, while gradually lowering inflation to 2–4 percent a year (Tables 2-4). The government would continue with fiscal reforms to sustain a primary surplus of 2.7 percent of GDP, and it would aim to rely increasingly on domestic currency borrowing to limit the vulnerability of the debt profile to exchange rate fluctuations. The central bank would continue to target inflation. The flexible exchange rate regime would allow the external sector to adapt to shifts in conditions—such as the prospect of a significant decline in the volume of oil exports starting in 2007—and to allow exports to diversify further. The external current account deficit would range from 2½ to 3 percent of GDP through 2010, which could be financed with sustainable net capital inflows. Net international reserves would remain at about 110 percent of short-term debt on a remaining maturity basis. Under these assumptions, public debt is projected to decline to 42.7 percent of GDP by 2010, while total external debt would fall to 32 percent of GDP.

Table 2.

Colombia: Medium-Term Outlook

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Sources: Colombian authorities; and Fund staff estimates.
Table 3.

Colombia: Selected Vulnerability Indicators

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Staff estimates, projections, or latest available observations as indicated in the last column.

Net international reserves in percent of ST debt at remaining maturity (RM) provided.

Current account deficit plus amortization of external debt.

Public sector covers: general government, public enterprises, and quasi-fisca operations of the central bank.

Based on averages for the last five years for the relevant variables (i.e., growth, interest rates).

Overall balance plus debt amortization.

ST debt and maturing medium- and long-term debt, domestic and external, excluding external debt to official creditors. (Short term)

Debt in foreign currency or linked to the exchange rate, domestic and external, excluding external debt on concessional terms. (Short

ST debt and maturing medium- and long-term debt at variable interest rates, domestic and external. (Short term)

Financial sector includes banks and excludes credit unions and public sector specialized institutions.

Sum of on-and off-balance sheet exposure.

Table 4.

Colombia: Summary Balance of Payments, 2000-2008

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Sources: Banco de la Republica; and Fund staff estimates and projections.

Includes movements of short-term assets owned by the public sector abroad.

Includes net portfolio investment.

Does not include valuation changes of reserves denominated in other currencies than U.S. dollars.

Not including Fund purchases under the standby arrangement.

8. This outlook is subject to several risks, including the effects of a currency depreciation on public debt: (i) in the event of an exchange rate shock (assumed for illustrative purposes to be a permanent 30 percent depreciation of the peso vis-à-vis the U.S. dollar in 2006), public debt would reach 54 percent of GDP by 2010 and external debt would amount to 41 percent of GDP (Tables 5 and 6); (ii) a combination of adverse fiscal shocks—high real interest rates, low real economic growth and a weak primary balance—would push public debt up to 54 percent of GDP by 2010; and (iii) a combination of adverse external shocks—higher real interest rates, lower GDP measured both in local currency and in U.S. dollars, and a wider external current account deficit—would raise external debt to 49 percent of GDP by 2010.

A. Strengthening Growth and Employment

9. The authorities noted that a key challenge was to lay the foundation for faster growth, while maintaining real growth of 4 percent a year. 2 The authorities commented that the civil strife deters faster growth by raising security costs and uncertainty, which in turn reduce investment and factor productivity. The estimates of the effect on the conflict on economic activity range from lowering the level of GDP by 4 percent to cutting annual growth by up to 2 percent a year. The authorities see a need for continued fiscal reforms, including by making the tax system more efficient, and steps to deepen the financial system to help lower the cost of capital and encourage investment and growth.

10. The authorities noted that another challenge would be to reduce unemployment further. In February 2005, national unemployment amounted to 14.0 percent, compared with 15.4 percent a year earlier. Studies suggest that the natural rate of unemployment in Colombia is about 10–12 percent. This high level of structural unemployment reflects several factors, including high nonwage labor costs, a relatively high minimum wage, labor market regulations, and an excess supply of lower-skilled workers. Also, the civil strife had created many refugees, adding to unemployment.3 The authorities noted that the labor reform of 2002 had increased the flexibility of labor contracts and improved human capital formation through apprenticeships. They pointed to evidence indicating that the reform had already stimulated additional growth in employment and added that the benefits of this reform would still be felt in the coming years. Staff agreed that the first results of the reform were encouraging.

B. Sustaining Fiscal Structural Reforms

11. The authorities’ medium-term fiscal framework presented to Congress in June 2004 aims to reduce public debt to 39 percent of GDP by 2015. The authorities estimated that—based on the current outlook—a primary surplus of 2.7 percent of GDP over the medium term would be consistent with this path. The staff recommended that taking advantage of the favorable global economy, especially the high world oil prices, to raise the primary surplus to 3.0 percent of GDP and reduce public debt more quickly. The authorities noted that they wanted to support a sustainable path for public debt, and would adjust the primary surplus if necessary to achieve this objective. They added that a significant share of any oil price windfall would be saved in 2005–06.

12. The authorities and the staff considered that the pace of fiscal adjustment was sensitive to the political climate. While the broad goal of fiscal discipline enjoyed sufficient political support, there was often a strong debate about the nature of the fiscal measures. For example, on several occasions the government had proposed to reform the tax structure by narrowing the number of VAT rates and broaden the base of the VAT and income taxes. However, Congress has resisted steps that could have been perceived as effectively raising the VAT. In December 2003, it approved increases in the wealth tax and the financial transaction tax. In December 2004, the government withdrew its tax proposal in the face of strong congressional opposition. In addition, the constitutional court has used its broad mandate to rule on economic policies. For example, in 2003, the court nullified part of the VAT increase approved in December 2002 and it required the government to increase public wages by at least the rate of inflation in the previous year. In 2004, the court nullified part of the 2002 pension reform (the shortening of the transition period to the new pension regime adopted in 1994), which raised the actuarial deficit of the pension system by 17 percent of GDP.

13. Structural fiscal issues also present significant challenges. The revenues of the state oil company (Ecopetrol) are likely to decline as oil production is projected to fall by 10 percent a year in the period 2005–10, assuming no discoveries of major oil fields that would reverse the decline in proven reserves. The central government (central administration, social security, and decentralized agencies) must contend with rigid noninterest expenditures. The authorities added that, if the demobilization talks were to proceed well, the government would need to provide financial support to help ex-combatants reintegrate into civilian life.

14. Against this background, the authorities and staff discussed the medium term agenda for fiscal structural reforms:

  • Tax reform. With total public revenues of about 32 percent of GDP, the authorities and the staff saw little need for net revenue enhancing measures. However, it was agreed that the current structure of taxes complicated tax collection and discouraged growth. For example, the value added tax includes 8 different rates, many more than in neighboring countries, and a narrow base, with only about 50 percent of eligible goods subject to this tax. Also, the tax system relies on several distortionary taxes, such as the financial transactions tax with a tax rate of 0.4 percent (one of the highest in the region) and a bank stamp tax of 1.5 percent—a very high rate in the context of low inflation. The authorities still believe that simplifying the VAT and the income taxes and phasing out distortionary taxes are important medium-term measures.

  • Spending rigidities. Congress is currently considering a revised budget code designed to cut expenditure rigidities by scaling back revenue earmarking (which applies to about 50 percent of tax revenues), trimming the carry over of spending commitments from year to year, and restricting the ability to make multi-year spending commitments. This revised code is an important step forward but will not resolve all of the difficulties with expenditure management. For this reason, the staff encouraged the authorities to continue to find ways to enhance the flexibility of spending further.

  • Pensions. Congress approved the government’s pension reforms in December 2002 and May 2003 that reduced the actuarial deficit to about 190 percent of GDP (Box 3.). Even with these reforms, the central government’s net pension costs are projected to rise sharply through 2015. In July 2004, the government introduced a constitutional amendment aimed at lowering the actuarial deficit further to about 160 percent of GDP and at reducing net pension costs starting early next decade. The authorities agreed that additional pension reforms would be needed over the medium term. However, they added that it would be very difficult to reduce the actuarial deficit below 140 percent of GDP, reflecting payments to current retirees and to workers who accumulated benefits under the PAYG system. As a result, the nonpension balance of the public sector would have to continue to strengthen over time.

  • Domestic fuel prices. The government’s system of regulating the prices of regular gasoline and diesel has led to an implicit subsidy of about 1 percent of GDP a year for the past five years. The government has been setting wholesale prices well below international levels, which discourages investment by Ecopetrol in upgrading its refining capacity or in exploration and production. Retails prices are also regulated at a fixed margin over the wholesale price to allow for taxes and distribution costs. At the retail level, the price of regular gasoline is the same as in the United States, while diesel is significantly cheaper. Over the past two years, the authorities have been raising these domestic prices faster than inflation to try to cut the implicit subsidy, but these adjustments have not kept pace with the rise in world oil prices since late 2003. The staff urged the authorities to deregulate the wholesale and retail prices of gasoline and diesel over the next few years as a way to eliminate the subsidy and to ensure efficient pricing of gasoline and diesel at all stages of production. The authorities agreed that price deregulation would be an important medium-term reform. However, in the near term, the authorities preferred to retain the current system, which sought to gradually bring domestic wholesale prices in line with international levels to help insulate domestic consumers from price fluctuations.

  • Strengthening social spending. The authorities noted that an important share of social spending (which includes subsidies estimated at 7 percent of GDP excluding pensions)—such as public childcare centers, primary education and subsidized health insurance—has benefited the poor. However, they added that other programs—such as subsidies for tertiary education and housing—have tended to help the middle and upper classes. The authorities intend to channel social spending more effectively and agreed that there may be some scope to trim some poorly targeted subsidies. The government is preparing a poverty reduction strategy to help Colombia achieve its Millennium Development Goals (Box 4.).

  • Revenue sharing. 4 Transfers from the central administration to local and regional governments are constitutionally mandated to increase by 2 percentage points in real terms in the period 2002–05, and by 2.5 percentage points during 2006–08. Starting in 2009, revenue sharing is to return to the pre–2002 system, with transfers growing in line with the average growth in the central government’s current revenues for the preceding four years. Also transfers—now about 35 percent of current revenues—may not be less than 42 percent of current revenues—the share in 2001. The staff and the authorities agreed that—provided current revenues grow in line with GDP—this would lead to a significant increase in the central administration deficit starting in 2009 and in the CPS deficit as well, if local and regional governments were to spend the additional transfers. Staff calculations suggest that holding these transfers constant in real terms would strengthen the central government balance and the overall fiscal position, if the current legal framework continues to restrain the ability of local and regional governments to run deficits. The authorities felt it was too soon to consider modifications to the revenue sharing framework, but intend to prepare by December 2005 a study that evaluates the current system.

  • Strengthening other aspects of fiscal decentralization. An FAD mission on decentralization recommended that the authorities strengthen the monitoring, information flow, and coordination of budgetary policies among different levels of the government. In particular, the mission recommended that the authorities establish an agency that would monitor and coordinate the budgets of the different levels of government. The authorities underlined that the fiscal responsibility laws adopted earlier this decade have controlled spending and indebtedness of regional and local governments, which ran a large overall surplus in 2004. Moreover, the constitution granted a high degree of autonomy to local and regional governments, which made it difficult to create a centralized agency with any meaningful authority. However, the authorities are taking steps to strengthen the quality of information on the operations of all levels of government.

  • Public investment. Colombia participated in the FAD pilot project on public investment. The authorities have been emphasizing the need to increase the level of public investment to improve infrastructure in certain sectors (Box 5.). They agreed fully that any plan to strengthen public investment must be consistent with the medium-term policy framework. They noted that investment of several public companies is constrained by the fiscal targets for the overall public sector, and would prevent these enterprises from carrying out productive investments. Staff encouraged the authorities to intensify the use of public-private partnerships (PPPs) to finance infrastructure investments, provided these projects had strong rates of return and an appropriate degree of risk transfer to the private sector. Staff also urged the authorities to increase the commercial orientation of public enterprises, including Ecopetrol.

C. Continuing to Reduce Inflation

15. Staff and the authorities agreed that the inflation targeting (IT) framework had been useful (Box 6.). In a country, such as Colombia, with a long history of moderate inflation, this framework helps guide the market’s inflation expectations, which—the authorities noted—are now broadly in line with the inflation target for 2005. Over the medium term, the Banco de la República intends to lower inflation by ½ percentage point each year until annual inflation reaches the range of 2–4 percent, broadly in line with inflation in Colombia’s trading partners.

16.The staff and the authorities agreed that the flexible exchange rate regime adopted in September 1999 had served Colombia well. Since 1999, the external sector has experienced several shocks. Colombia’s terms of trade have been volatile, reflecting in part strong fluctuations in the world price of oil. The flexibility of the exchange rate has allowed for continued export growth and diversification, and kept the external current account deficit at sustainable levels. 5 The depreciation of the peso vis–à–vis the U.S. dollar helped sustain modest economic growth in 2002, when access to international capital markets was sharply curtailed for part of the year. The staff noted that since 1999 the private sector appears to managing its foreign exchange risk more carefully. Nonfinancial corporations had cut their peso exposure, while pension funds had built up foreign currency assets, including holdings of Colombian government securities denominated in U.S. dollars. 6 Hedging of exchange rate risk has grown sharply since 1997, and by 2004, forward contracts in foreign exchange were equivalent to about 60 percent of all international trade transactions. 7 Looking forward, the authorities noted that the flexible regime would help the external sector adapt to the prospect of declining oil exports over the next few years by encouraging a further diversification of exports.

17.The staff noted that external competitiveness seemed broadly adequate. Exports performed well 2004—growing by more than 20 percent—even while the peso appreciated significantly in real effective terms. While traditional exports benefited from high commodity prices, industrial exports—which account for almost 40 percent of the total—also increased significantly, aided by the economic recovery in neighboring Venezuela. At end-2004, the peso was 15 percent more depreciated in real effective terms than in September 1999.


Reer Indicators 1/

(Index: 1994=100)

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001

Sources: Central Bank of Colombia; and Fund staff estimates.1/ Using CPI.2/ Using weights from nontraditional exports and imports from 20 trading partners.3/ Relative to 23 countries that compete with Colombia in the U.S. market.4/ Relative to the main 20 trading partners.

18. The authorities were concerned that continued appreciation could present difficulties for external competitiveness. They commented that previous episodes of sustained real appreciation, such as in the early 1980s and the mid-1990s, had often been followed by difficulties. They noted that exports were projected to grow slowly in 2005, partly reflecting the lagged effects of the real effective appreciation in 2004. There was also concern that a strong currency could adversely affect the competitiveness of legitimate crops in the agricultural sector, which employ many low-income workers who might otherwise be involved in the cultivation of illicit crops. For this reason, they had been intervening in the foreign exchange market since late 2003. However, they emphasized that the Banco de la Republica would always give priority to achieving its inflation target. The staff urged the authorities to guard against excessive foreign exchange intervention, which could create inflationary pressures or add to quasi-fiscal costs.

19. The authorities noted that trade liberalization has helped strengthen external competitiveness. In the late 1980s and early 1990s, Colombia lowered its average tariff from more than 40 percent to the current level of about 11 percent, and now there are no economically significant nontariff barriers. As a result, exports have doubled from 8 percent of GDP in 1987-88 to over 16 percent of GDP in 2004, with strong diversification into exports of industrial and other nontraditional products. In this period, non-oil exports doubled from about 6 percent of GDP to 12 percent of GDP. Colombia, together with Peru and Ecuador, is negotiating a free-trade agreement with the United States, with a view to liberalizing trade further.

20. The authorities agreed with staff that it would be important to continue to facilitate the development of market-based hedging mechanisms. While hedging has increased significantly since 1997, the market is very short term, with 80 percent of forward contracts maturing one month. The staff suggested several steps to strengthen the use of hedging instruments. The establishment of a single reference interest rate would allow for more credible valuation of derivatives contracts and improve disclosure in the financial statements. Also easing the limit on banks’ foreign currency cash position (which has not been allowed to be in a negative balance since March 2004) would give banks more flexibility to take forward positions with offsetting spot transactions. The authorities have requested technical assistance in this area from the Fund’s International Capital Markets Department.

21. The government purchased net international reserves to prepay an expensive emergency loan from the IDB in the amount of US$1.25 billion in early April 2005. After this operation, net international reserves amounted to 110 percent of short-term debt with a remaining maturity. The authorities and the staff agreed that this would still provide an adequate reserve cushion. The central bank emphasized that the government was purchasing the reserves, using the proceeds from issuance of government securities, and that the central bank was not granting a credit to the government.

D. Creating A More Effective Financial Sector

22. The authorities agreed with the main conclusions of the FSSA update (Box 7.). They noted that the efforts to improve financial supervision and restructure weak banks, together with the economic recovery, had strengthened the financial system.

23. The Superintendency of Financial Institutions (SIF) intends to continue strengthening the legal and regulatory framework. It plans to address the challenges associated with the new risk-based provisioning system, in part by expanding its technical staff significantly over the next few years to monitor the risk assessments of financial institutions. The authorities noted that this new framework would allow for a more accurate measurement of market and other risks and of the value of foreclosed assets, which would probably lead to some increase in provisioning and capital. They supported the recommendation to grant more autonomy to the SIF, but added that in 2003 Congress had rejected a draft law to grant budgetary independence to the SIF.

24. The authorities agreed that banks held a large and growing share of their assets in government securities, increasing their exposure to interest rate and liquidity risk. This situation reflected in part limited opportunities for loans or investment to the private sector. However, they added that banks were exposed to less credit risk.

25. The authorities commented that the mortgage sector remained stagnant for several reasons. Demand for mortgages was weak, as many home buyers were still reluctant to acquire mortgage debt even 5–6 years after the crisis. Also several judicial and regulatory decisions have discouraged banks from offering mortgages. During the 1999 crisis, the constitutional court ordered a retroactive change in the indexation formula used in mortgages, leading to a significant decline in the outstanding value of mortgages. In addition, the court set a limit on the real interest rate on most mortgages. Moreover, completing a foreclosure often takes up to 5 years. The authorities noted that many mortgage banks have recovered by diversifying into consumer and corporate lending and that the few remaining weak mortgage banks were operating under restructuring plans. They added that the program to securitize mortgages that began in 2003 would help mortgage banks restructure their balance sheets further.

26. The authorities shared the view that domestic capital markets could play a more important role in financing investment. For this reason, the government submitted to Congress a new securities market law, with approval expected by June 2005, and was drafting a new corporate accounting law. These laws would provide more security and transparency to securities trading by protecting investors’ rights, improve contract enforcement, and reduce regulatory arbitrage. Both the staff and the authorities agreed that several distortions—such as the financial transactions tax and the bank stamp tax of 1½ percent—contributed to financial disintermediation (Box 8.).

III. Short-Term Macroeconomic Outlook

27. Economic policies in 2005–06 have been framed in the context of this medium-term strategy. The specific goals are to support real economic growth of 4 percent a year and lower inflation to 5 percent during 2005 and to 3–5 percent during 2006. The CPS deficit would amount to 2.5 percent of GDP in 2005, assuming an export price of oil of US$31 per barrel as a prudent baseline and a gradual decline in the surplus of local and regional governments to historical levels. In 2006, the CPS deficit would decline to 2.0 percent of GDP, lowering public debt to about 50 percent of GDP by end-2006. These targets will be lowered by a significant share of any oil price windfall. Monetary policy would continue to be conducted in the context of an inflation targeting framework, and the exchange rate regime would remain flexible. The external current account deficit would rise to about 2½ to 3 percent of GDP in 2005–06, reflecting a fall in the volume of oil exports as well as the lagged effects of the real exchange rate appreciation during 2004. Net international reserves would remain comfortable at US$12.3 billion in 2005 (110 percent of short-term debt on a remaining maturity basis), reflecting the reserves purchased to prepay the IDB loan.

28. The authorities will seek to advance structural reforms already before Congress. They intend to press for congressional approval by June 2005 of several measures: (i) the revised budget code; (ii) the constitutional amendment to reduce the actuarial deficit of the pension system; and (iii) the new securities market law. They noted that Congress is now considering the draft law for the legal framework for demobilization of paramilitaries and other combatants, and may consider a possible free trade agreement with the United States in the second half of 2005.

29. The authorities will continue to build support for the rest of the structural reform agenda. However, they commented that it would be difficult to introduce new reforms to congress ahead of the elections.

IV. Staff Appraisal

30. The economic policy strategy of fiscal consolidation, lowering inflation and strengthening the financial system has been effective. This approach has benefited from the favorable global economic environment in recent years. Since 1999, real economic growth has recovered, while unemployment and poverty have declined. Inflation has fallen to the lowest level in decades. The external sector has strengthened, with sustained export growth and restored access to international capital markets. The financial system has returned to a sound position.

31. The authorities’ intention to maintain this strategy in the coming years is welcome. Their framework is wisely based on an outlook for steady economic growth, which—together with the effects of the 2002 labor reform—should contribute to further reductions in unemployment. The plan to maintain fiscal discipline to lower public debt to 39 percent of GDP by 2015 will help diminish risks further. The central bank will continue to target inflation in the context of a flexible exchange rate regime. Financial supervision will continue to strengthen and the new securities market law, if approved, would help broaden domestic capital markets.

32. The main challenge to this strategy comes from the need to sustain the pace structural fiscal reforms to keep public debt on a sustainable path. The reforms already presented to Congress—the revised budget code and the pension reform—will play an important role in containing expenditure growth. Over the medium term, reforms will be needed in several areas. The staff welcomes the authorities’ intention to continue to build support for steps to simplify the VAT and the income tax and scale back distortionary taxes. The constitutional amendment for pension reform currently before Congress represents an important step forward to reduce the actuarial deficit further. It would be crucial to consider additional pension reforms as quickly as feasible to help limit the expected rapid rise in net pension costs. The staff encourages the authorities to deregulate the domestic prices of gasoline and diesel over the medium term to eliminate the implicit subsidies and to allow for efficient pricing of these products. The system of fiscal decentralization needs to be strengthened by modifying the revenue sharing mechanism, which presents a significant risk and weakens the credibility of the authorities’ fiscal strategy. The staff urges the authorities to consider steps to limit the increase in transfers—preferably to the rate of inflation—to strengthen the medium-term position of the central administration and of the combined public sector. The staff also encourages the authorities to establish an agency that would help ensure a close coordination of fiscal policy at all levels of government.

33. The inflation targeting framework has helped guide inflation expectations. During 2004, the central bank achieved the lowest inflation rate in decades and expectations for 2005 are broadly in line with the inflation target. The plan to gradually reduce inflation to the range of 2–4 percent a year is appropriate.

34. The flexible exchange rate regime has served Colombia well. Over the medium term, continued exchange rate flexibility will be essential to help the economy adjust to the prospect of a significant decline in oil production and exports. The staff judges that external competitiveness is broadly adequate, in view of the broad-based growth in exports in 2004 and the sustainable level of the external current account deficit. The staff sees the appreciation of the peso vis-à-vis the U.S. dollar during 2004 as a market-based response to increased confidence in the Colombian economy and a favorable external environment. The staff urges the authorities to guard against pressures for excessive foreign exchange intervention, which could generate inflationary pressures or raise quasi-fiscal costs through sterilization operations. In this regard, the staff agrees that continued trade liberalization would strengthen export competitiveness further.

35. The financial system has recovered from the 1999, owing to the government’s financial restructuring operations as well as the economic recovery. It will be important to continue to strengthen the legal and regulatory framework for financial supervision. The new securities law will encourage a deepening of domestic capital markets. Also phasing out the financial transactions tax and the bank stamp tax would promote financial intermediation. With more opportunities for lending and investment, banks would be able to gradually diversify their portfolio away from government securities and limit their risk to interest rate fluctuations and to the sovereign. In the mortgage sector, decisions intended to protect borrowers are actually making it more difficult for borrowers to acquire housing.

36. Colombia has accepted the obligations of Article VIII, Sections 2, 3, and 4. However, the authorities have not indicated a timetable for removing the two remaining restrictions. For this reason, staff does not recommend approval of these restrictions.

37. It is proposed that the next Article IV consultation will be held on the 24–month cycle, subject to the provision of decision No. 127 94, (02/76) on Article IV consultations.

The Economic Crisis of 1999

In the 1970s and 1980s, Colombia’s real economic growth averaged 4 percent a year. Inflation—anchored by a crawling peg with the US dollar—was moderate but stable, ranging from 20–30 percent a year. In the mid 1990s growth accelerated, supported by strong private capital inflows owing to (i) foreign direct investment in the oil sector, (ii) large scale privatizations, and (iii) financial inflows following steps to liberalize the capital account.


Real GDP Growth and Inflation

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001


Current Account and Net Inflows

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001


Public Sector Debt and Fiscal Deficit

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001

Capital flows reversed abruptly in the aftermath of the Asian and Russian crises of 1997/98, forcing a sharp adjustment of the current account. In late 1998, the crawling exchange rate band came under intense pressure. At first, the Central Bank defended the arrangement with high interest rates, causing severe stress for the financial sector. A banking crisis ensued, which was concentrated in poorly supervised public banks and mortgage lending institutions. In September 1999, the Central Bank floated the peso. The sharp devaluation that followed reinforced financial stress for many companies, which had accumulated sizeable foreign currency liabilities.

In 1999, real GDP fell for the first time in more than 30 years. The economic downturn coincided with an deterioration in Colombia’s security situation. Moreover, public debt increased sharply, owing in part to the effect of the depreciation on foreign currency debt and the cost of recapitalizing the banking system. In late 1999, the sovereign lost its investment grade rating for foreign currency debt over concerns about the sustainability of Colombia’s long-term fiscal position.

Security Situation

Colombia’s civil strife—whose roots go back to the 1950s—reached a peak in the late 1990s and early 2000s. All indicators of violence—such as homicides, kidnappings, and acts of economic sabotage—rose to extremely high levels. About one-third of the country’s municipalities were controlled by the guerillas by 2000.

There are three main illegal armed groups, with about 30,000 combatants. The FARC (Revolutionary Armed Forces of Colombia) is a peasant-based guerilla group that started as a communist militia and now comprises about 15,000 fighters. The ELN (National Liberation Army) grew out of Cuba-inspired student protests and now counts about 5,000 guerilla fighters. The AUC (United Autodefense Forces of Colombia) is a loose association of paramilitary organizations with an estimated 10,000 fighters. Some paramilitaries served originally to protect landholdings against the FARC and the ELN. All three groups are considered terrorist organizations by the United States and the European Union. They finance themselves with kidnappings, robberies, and extortion. Moreover, the FARC and the AUC are deeply involved in the drug trade, with each group earning US$100–300 million a year from this source.

After taking office in August 2002, the Uribe administration laid out a democratic security strategy. The government stepped up pressure on insurgents by strengthening the army, increasing police presence in rural areas, and granting the military a wide range of police powers. It also eradicated coca plantations to undercut the financial base of the illegal armed groups. It also initiated demobilization negotiations with groups that agree to end hostilities.

Thus far, the policy has yielded notable successes:

  • Between 2002 and 2004, this policy resulted in sharp declines in homicides and kidnappings and in acreage devoted to coca cultivation. Also, by 2004 all municipalities were under government control.

  • Demobilization talks have started with the paramilitaries, and by end-2004, several thousand paramilitary fighters had handed in their weapons. Congress is currently debating a legal framework for demobilization to decide criminal penalties for ex-combatants, determine how to fund reparations to the victims of the violence, and establish programs to help ex-combatants reintegrate into civilian life.

  • However, the FARC has shown no interest in entering into peace talks, and intensified its attacks on the Colombian military in early 2005

Pension Reforms

  • In December 1993, Congress approved a pension reform that sought to provide adequate and sustainable retirement benefits for workers. It strengthened the pay-as–you-go (PAYG) system by raising contributions and reducing retirement benefits. It also established a fully funded, private system that coexists with the PAYG system. With a few exceptions, workers can choose either system and have the right to change systems once every three years.

  • However, this reform excluded the generous special pension regimes for certain kinds of employees, such as teachers. It also established a long transition period for workers already participating in the PAYG system.

  • As a result, the actuarial deficit of the pension system reached 210 percent of GDP by 2002. In December 2002 and May 2003, Congress raised contribution rates and cut retirement benefits again and shortened the transition period. However, the constitutional court subsequently reinstated the original transition period, leaving the government with significant increases in net pension costs over the next decade and an actuarial deficit close to 190 percent of GDP.

Colombia: Social Security, 2003-2015 1/

(in percent of GDP)

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Source: Ministry of Finance.

Net pension costs of ISS, excluding transfers from the central administration.

  • In June 2004, the government presented a constitutional amendment for pension reform that proposes inter alia to eliminate all special pension regimes and remove the 14th monthly pension payment for new retirees, which would lower the actuarial deficit to 160 percent of GDP and reduce net pension costs starting next decade. The proposed amendment also clarifies the definition of acquired rights to pave the way for possible additional pension reforms. Congress must decide on this reform by June 2005.

  • The authorities noted that—even after the government exhausts all reform efforts—the actuarial deficit will remain at 140 percent of GDP, reflecting payments to current retirees and to workers who accumulated benefits under the PAYG system.


In the past 25 years, progress in alleviating poverty has been modest. Despite robust growth and large increases in subsidies and transfers, Colombia’s poverty rate declined from 59 percent in 1978 to 52 percent in 2003. By regional standards, poverty and income inequality in Colombia are high. Other social indicators, however—such as access to safe drinking water, life expectancy and infant mortality—compare favorably with neighboring countries.

Labor market rigidities limit formal employment and contribute to poverty. These include high nonwage labor costs, extensive labor market regulation, and a lack of high-skilled workers. Studies suggest that the structural unemployment rate is 10–12 percent. Moreover, about one-third of the workforce is underemployed, but preliminary evidence indicates that the reforms passed in the 2002 to increase labor market flexibility have encouraged more formal employment.

Another source of poverty is the civil strife. The number of internal refugees (“desplazados”) increased sharply in the late 1990s, and is estimated at about 2–3 million—out of a total population of 45 million. Desplazados are often from rural areas and have little formal education. As a consequence, they depend heavily on work in the informal economy and humanitarian assistance from NGOs, such as church support groups, as well as from the government.

Colombia: Social Indicators

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Financing Higher Investment

Colombia has sustained relatively high public infrastructure investments, compared with other countries in the region. In recent years, public investment has averaged 7½ to 8 percent of GDP, well above the average for Argentina, Brazil, Mexico, Peru, and Uruguay. About two-thirds of this investment is carried out by local and regional governments. Access to basic household services such as water, sanitation, and electricity is high by regional standards. However, the World Bank has found that Colombia’s infrastructure lags behind other Latin American countries in areas such as paved roads.

The government is assessing ways to finance higher infrastructure investment while safeguarding public debt sustainability. One option is to make more use of Public-Private Partnerships (PPPs)—private investment under PPPs is not reflected in the public sector accounts. Since the early 1990s, Colombia has been one of the most active countries in Latin America in developing PPPs. There have been some 150 contracts for private participation, leading to estimated investments on the order of US$5 billion since 1991. Contractual approaches have included BOTs, concessions, joint ventures, and licenses. A sophisticated methodology has been developed to evaluate contingent liabilities of the public sector, which are published in the government’s medium-term fiscal framework.

Another option is to increase the commercial orientation of public enterprises. In 2004, ISA, an electricity transmission company, was excluded from the definition of the public sector, after its commercial orientation was determined against a set of preliminary criteria proposed by Fund staff. ISA has significant private ownership, strong protection of minority shareholder rights, an arms-length relationship with the government, and a sound financial condition.

Inflation Targeting (IT) Regimes in Latin America

Colombia is one of the five countries in Latin America and 20 countries worldwide that conduct monetary policy based on an IT framework. It is intended to help discipline policy discussions and communicate policy actions to the public. This framework entails: (i) a stated commitment to price stability as principal goal of monetary policy; (ii) an explicit target for inflation; (iii) a high degree of transparency with regard to monetary policy formulation; and (iv) some mechanism for accountability.

Key Characteristics of the Inflation Targeting Regime Among Latin American Countries

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Sources: Kuttner K. (2004), in the “Future of Inflation Targeting”, Reserve Bank of Australia, 2004.; and central banks’ websites.

Colombia’s performance under IT compares favorably with other IT countries. Albagli and Schmidt-Hebel (2004) looked at the typical deviation of actual inflation from the target and the typical large inflation episode for countries with IT in the period 1990–2003. Switzerland, England, Chile, and Sweden are among the most accurate IT countries, with fewer episodes of target misses and shorter spells of deviations.


IT Performance Rankings According to Inflation Deviations and Large Deviations Episodes

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001

Source: Albagli and Schmidt-Hebel (2004), By How Much and Why Do Inflation Targeters Miss Their Targets?, paper presented at the Conference “Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting”, sponsored by the Federal Reserve of Atlanta, October 2004.

Financial System Stability Assessment Update: Main Findings

  • Since the 1999 FSAP, financial sector legislation has been improved, the banking system has been recapitalized, and the supervisory framework has been revamped. The financial sector appears relatively stable and resilient to potential adverse shocks. However, the banking system still faces considerable challenges. Solvency and profitability of commercial banks have improved, but provisioning for nonperforming loans could be strengthened, especially in the mortgage sector. Bank capital adequacy may be overstated by some over-valuation of foreclosed assets and under-estimation of market risk. The mortgage sector has improved its performance, but a few institutions remain weak.

  • The legal and regulatory framework could be strengthened further. The Superintendency of Banks needs to keep pace with the technical and administrative requirements of implementing the new risk-based system for determining capital and provisioning standards. The Superintendency would benefit from greater autonomy and independence, and the legal framework needs to effectively protect bank supervisors and the Superintendent. Some of the funds lent for bank recapitalization have been prepaid and the prospects for repayment of remaining Deposit Insurance Fund (FOGAFIN) credits appear favorable as most recapitalized banks have regained market access or are backed by prominent financial holding companies. However, the two largest institutions are still under FOGAFIN control.

  • Banks allocate a significant share of their portfolios to government securities. The government response to the crisis and the lower demand for credit have increasingly transformed credit risk exposure into a market risk or sovereign risk exposure. The government’s success in lengthening the maturity of its debt has, to a large extent, transferred interest rate and liquidity risk from the public sector to the banking sector.

  • Credit risk and interest rate risk are the main vulnerabilities. The impact of the greatest interest rate shock on capital would come from a precipitous rise in the yield curve. Foreign exchange risk appears limited, while equity price risk affects mostly finance corporations.

  • Private capital markets continue to be illiquid and shallow, with most resources channeled through the banking sector. This reflects the scarce supply of investment securities by local corporations, and deficiencies in clearance and settlement systems. In this context, the modernization of the securities markets regulatory framework is critical to increase liquidity, stimulate investment and promote economic growth. The corporate insolvency regime introduced under emergency conditions during the crisis has not yet been replaced by new instruments more favorable to financial intermediation.

The Financial Transactions Tax (FTT)

The FTT was introduced in 1998 as a transitory measure to finance the fiscal cost of the banking crisis. The tax rate was set initially at 0.2 percent and then raised to 0.3 percent in 2001 (and made permanent) and further to 0.4 percent in 2004. It is mostly levied on transactions through savings and checking accounts, credit cards and loan disbursements.

The FTT contributes to financial disintermediation. Kirilenko and Perry (2004),1/ using data for Argentina, Brazil, Colombia, Ecuador, Peru, and Venezuela, found that on average the FTT has resulted in a permanent erosion of the tax base-disintermediation–ranging from 4 cents for every dollar of revenue for Venezuela to 44 cents for Colombia. This disintermediation has undermined the productivity of the FTT as a revenue source in Colombia.


Tax Collection and Produtivity of the FTT

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001


Money Multiplier (M3) and Number of Checks Processed

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001


Currency in Circulation

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001


Money Multiplier and FTT Collection, December 1999 to December 2004

Citation: IMF Staff Country Reports 2005, 154; 10.5089/9781451808865.002.A001

Sources: DIAN; Banco de la República; and Fund staff estimates.1/ Kirilenko, A. and Perry, V. (2004), “On the Financial Disintermediation of Bank Transaction Taxes,” mimeo.
Table 5.

Colombia: External Debt Sustainability Framework, 2000-2010

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.