This Selected Issues paper examines conditions in Colombian labor markets, which present a big challenge to the country. At end-2004, the unemployment rate amounted to 12 percent, and about one-third of the labor force was considered underemployed. The paper reviews labor market developments leading up to the reforms. It examines structural issues in the labor markets, reviews the labor market reforms, and analyzes the impact of reforms versus stronger growth. The paper also analyzes various aspects of Colombia’s system of intergovernmental transfers.

Abstract

This Selected Issues paper examines conditions in Colombian labor markets, which present a big challenge to the country. At end-2004, the unemployment rate amounted to 12 percent, and about one-third of the labor force was considered underemployed. The paper reviews labor market developments leading up to the reforms. It examines structural issues in the labor markets, reviews the labor market reforms, and analyzes the impact of reforms versus stronger growth. The paper also analyzes various aspects of Colombia’s system of intergovernmental transfers.

IV. The Development of Hedging Instruments in Colombia1

A. Introduction

1. In Colombia, derivatives markets remain rather small and—notably in the fixed income segment—relatively illiquid. In contrast, derivatives markets in several other Latin American countries have grown considerably, in both trading volumes and the types of instruments available. Brazil and Mexico are, by far, the fastest growing and largest derivatives markets in the region—in relative terms to the sizes of their underlying cash markets. Generally, derivatives markets in Latin America are dominated by interest rate and foreign exchange products, albeit often with features unique to a particular country, reflecting the products traded in the underlying cash markets. These markets are used extensively by local private sector entities to hedge risks associated with raising funds, domestically and in international capital markets. 2

2. More extensive use of hedging instruments in Colombia would provide several benefits.It would enhance the liquidity and depth of Colombia’s local capital market. Colombia experienced episodes of high illiquidity in the market for government securities (TES) in late 2002 and again in mid–2004, and hedging of interest rate risk would give financial institutions additional tools to manage their volatility. This would also help the government increase its reliance on domestic currency financing and minimize its risk to currency fluctuations. More active use of hedging exchange rate risk, especially at longer maturities, would help ease pressures for foreign exchange intervention by the central bank during periods of significant exchange rate volatility.

3. This chapter provides an overview of hedging in Colombia’s financial markets and offers suggestions to encourage greater use of hedging instruments. The main recommendations include (i) establishing a credible reference interest rate to enable reliable pricing of risk, in both the fixed income and foreign exchange markets; (ii) easing the restriction on banks’ cash position in foreign currency; and (iii) further development of the securities market to facilitate the process of financial intermediation. We also discuss how Brazil, Chile, and Mexico have developed their derivatives markets. 3

B. Hedging Instruments

The foreign exchange market

4. Onshore foreign exchange derivatives activity consists mainly of USD/COPforward operations.In 2003, these transactions accounted for about 70 percent of the total volume of derivatives. There is a reasonably liquid over-the counter (OTC) market for currency-based forward contracts, with turnover growing from a monthly average of US$418 million in 1997 to US$5.6 billion in January 2005 (Table). Around 70 percent of the turnover corresponds to transactions carried out by the financial sector (banks and pension funds) and the remainder is attributable to the real sector. Evidence suggests that large nonfinancial corporations have used this instrument to limit their exposure to exchange rate risk (Annex I).

Activity in Forward Foreign Exchange Rate Market by Sector, January 2005

article image
Source: Banco de la República.

5. Liquidity in the forward market is largely concentrated in the one–month contract, which represents about 80 percent of outstanding contracts. There is reasonable liquidity up to 3 months, while the one–year contract is the longest tenor quoted (Figure 1). Transactions in non–deliverable forwards (NDFs) amount to almost 6 times those of the outright forwards (US$2.4 billion compared to US$0.4 billion in August 2004) in the onshore market. In the real sector, hedging of foreign exchange exposure using forwards has grown to about 60 percent of all international trade transactions, measured as the ratio of forward purchases/imports and forward sales/exports (Figure 2). Derivative instruments, known as Operaciones a Plazo de Cumplimiento Financiero (OPCFs) are also traded on the Colombian stock exchange (BVC) (Figure 3).

Figure 1.
Figure 1.

Composition of Forward Markets

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Figure 2.
Figure 2.

Real Sector Coverage with Forwards

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Source: Bolsa de Valores.
Figure 3.
Figure 3.

OPCF Positions

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Source: Bolsa de Valores.

6. Trading in the offshore market is in the form of NDFs and is not regulated. Tenors for this instrument are for up to one year. The NDF market for the peso is among the smaller ones within the Latin America, with an average daily turnover of US$50 million. Deals are executed in New York, with the tasa de cierre representiva del mercado (TRM) or closing market price rate on Reuters being used for settlement. Anecdotal evidence indicates that a private FX options market has been growing.

7. As a regional comparison, the Mexican peso is one of the most liquid emerging market currencies, in both the spot and foreign currency derivatives (swaps and forwards).4 Much of the foreign currency trading activity moved offshore during the past five to six years, with foreigners mainly using foreign currency forards and swaps to express their views on the currency and interest rates (without having to take the cross-border risk).

8. In Chile, the main instruments are forwards for short-term foreign exchange rate protection and currency swaps for longer-term foreign exchange protection. These instruments are primarily traded between financial institutions and between financial institutions and large firms.

9. In Brazil, foreign exchange derivatives account for around half of all derivatives positions, reflecting the strong demand for currency hedges.5 Trading in currency derivatives is particularly high compared with the underlying foreign exchange market. That said, this market is widely characterized as suffering from a shortage of currency hedge supply. This is in part because local institutional investors have no foreign currency positions—in direct contrast to say, Chile’s institutional investors—and the amount of U.S. dollar receivables by exporters and banks are insufficient to meet the demand for dollar hedge by entities with short dollar positions. To address the shortage of hedging opportunities, the authorities issued U.S. dollar-linked debt, and then unbundled the product into a domestic currency security and a currency swap to provide a more efficient foreign exchange hedging instrument.

The domestic fixed income market

10. The existence of fixed income derivatives instruments remains very limited in Colombia. Exchange-traded futures (Operaciones a Plazo de Cumplimiento Financiero OPCFs) include commodity futures (oil and Brazilian Arabic and Soft Arabic coffee) and fixed income futures. However, it currently appears that agents are more interested in developing the hedging market for foreign exchange. Market participants appear sanguine about existing debt positions, given the ample liquidity in the government debt market, amidst falling domestic interest rates (Figure 4). However, it seems appropriate, in this low interest rate environment, to foster the development of derivatives instruments.

Figure 4.
Figure 4.

Historical Yield Curves of Colombian Government Debt (COP)

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Source: Bloomberg.

11. In contrast to Colombia, fixed income derivatives are the most liquid instruments in Brazil. Indeed, they represent the benchmark interest rate yield curves. Regulatory developments have paved the way for the development of an onshore credit derivatives market, and it is anticipated that the credit derivatives market will provide price discovery for the cash market, thus improving secondary market liquidity and increasing the securitization of corporate sector debt. The interest rate derivative market is largely focused on hedging and speculative position–taking, based on expectations about the future direction of the key benchmark interest rate.

12. In Mexico, interest rate derivatives—both OTC and exchange-traded—have grown quite rapidly.6 The Mexican OTC market in interest rate swaps (IRS) and forward rate agreements (FRAs) has been expanding steadily over the past 5–6 years and is currently almost as liquid as the underlying bond market. The exchange-traded interest rate derivatives market was almost nonexistent prior to 2001, but has since picked up sharply; the TIIE–28 future contracts is the most traded instrument on the local derivatives exchange, MexDer.

13. In contrast to the other two countries, the market for interest rate derivatives in Chile is very small. In recent years, OTC derivatives in interest rates and fixed–income assets (central bank bonds, bonds and credit notes denominated in Chilean pesos and issued by resident commercial banks and financial institutions) have also been made available. Exchange-traded derivatives such as futures contracts on the IPSA and options on stocks have been very illiquid. 7

C. Steps to Foster Hedging

Establish a clear reference interest rate

14. Although Colombia has one of the longest yield curves for domestic currency bonds in Latin America, of up to 15 years, the absence of an appropriate benchmark interest rate for the settlement of contracts in cash markets is one of the main weaknesses of the money market. The development of a timely and credible reference rate for use by market participants across different financial operations such as credits, futures, forwards, and swaps is crucial for the consistent and accurate pricing of cash and derivative market instruments. Currently, the government is preparing a strategy to deepen the repo market, which would include the development of securities lending facilities. 8 The authorities are refocusing their bond issuance program to increase liquidity in the 2–5 year segment of the yield curve, while starting to issue treasury bills under one year. These reforms would substantially improve liquidity for short-term debt instruments (short-end of the of the yield curve) by providing a credible “anchor” for interest rates.

15. Presently, the most widely used reference interest rate is that of the 90–day certificates of deposit (DTF). However, the use of the DTF in its current formulation is considered to be a major barrier to establishing credible pricing of domestic securities. The main problem associated with the DTF rate is that it does not appear to reflect the market environment—the DTF has remained practically flat since 2002, while the average cost of funding has fallen in line with the reduction in inflation (Figure 5.). 9 It would be difficult to change the DTF as the official reference rate, given its importance in many laws. However, the formula used in its calculation could be changed to incorporate: (i) rates that are provided by a spectrum of market makers; and (ii) rates that would reflect market movements, and enable clear transmission of monetary policy decisions and credible pricing of risk. It would also be useful to publish a reference interest rate daily, instead of weekly.

Figure 5.
Figure 5.

Domestic Interest Rates1/

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Sources: Central Bank of Colombia; and staff estimates.1/ The average funding rate corresponds to the weighted average interest paid on deposits in the Colombian financial system.

16. As a comparison, the central bank of Mexico introduced in March 1996 a floating peso reference rate, known as theTasa de Interes Interbancaria de Equiliibrio (TIIE). The central bank of Mexico provides a 28-day TIIE daily and a 91-day TIIE on a weekly basis. All floating rate debt, a large proportion of bank loans and the most liquid interest rate derivatives are based on the 28-day TIIE, which uses bid-ask quotes presented by financial intermediaries to the central bank. This rate has become a credible benchmark for bank loans and security yields, and represents the underlying rate for futures and swap markets, as noted earlier.

17. Similarly, overnight rates are one of the most important elements of the local market in Brazil.Banks usually express their cost of funding as a percentage of the CDI interest rate—the uncollateralized overnight interbank loan rate. It is an average of all interbank overnight transaction rates, and is the rate at which the floating parts of interbank swaps accrue. The CDI rate is the most widely-traded benchmark rate and is particularly important to the BM&F swap contracts. Another key interest rate is the Selic interest rate—the Brazilian central bank–controlled repo rate on public bonds. 10 The most liquid fixed income securities, as well as a large part of domestic debt are linked to both CDI and the Selic rate. There can be differences between these two rates, which affect asset pricing, especially for short-term financial instruments.

Standard valuation of forward foreign exchange positions

18. A clear reference interest rate would help lead to a standard method for valuing positions in foreign exchange. An accepted forward differential curve is needed in order to provide a standard mechanism for the pricing of market risk. The implied forward differential is calculated based on or interest rate parity, as follows:

fs1=rCOLrUSD1+rUSD,
A04lev3sec12

where (f/s–1) is the actual forward differential, rCOL is the peso interest rate and rUSD is the U.S. dollar interest rate, and (rCOLrUSD)/(1+rUSD) is the implied forward differential. In other words, the implied forward differential changes depending on the selection of the representative interest rate. For example, two banks could use different interest rates (deposit rates or money market rates) for computing market risk and for valuing the same transaction in forward markets. Thus, there may be cases in which the implied foreign exchange forward curves are different simply because agents choose different interest rates for valuation purposes. Figure 6. shows a marked difference between the actual and implied forward differentials (of around 5 percentage points for 30 days) when deposit rates for both the United States and Colombia are used in the calculations. However, the difference between the implied and actual curves is much narrower at the short-end (about 1 percentage point for 30 days) when the money market rate for Colombia and the LIBOR rate are used instead.

Figure 6.
Figure 6.

Forward Differentials

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

Source: Bloomberg.

19. The establishment of a standard method for calculating the implied forward curve would also improve disclosure. Presently, banks report their open forward positions in their balance sheets, using interest rates of their choice. This means that individual institutions with identical positions may actually show different valuations on their books.

Ease restrictions on cash position and the investment holding period

20. Another obstacle is the restriction imposed on banks’ foreign currency cash positions against having a negative balance.This regulation was issued in March 2004, and could impede the development of the foreign exchange derivatives market. To date, it has reportedly precluded some banks from hedging their purchase of foreign currency forwards (usually from exporters and pension funds) in the spot market, beyond a certain point (Box 1.). Even though the aggregate data suggest that the foreign currency cash position for the banking system remains positive overall (Figure 7.), discussions with market participants indicate that individual banks have, from time to time, had to stop trading in this market when they reached their cash position limits. This “friction” could potentially lead to market stoppages, acting against government’s efforts to improve the smooth functioning of local markets. Another potential concern is that some banks may choose to “speculate” on one side of the transaction by not hedging their open forward position, to circumvent the restriction. One way to soften the effects of this restriction may be to set it as a share of the financial ntermediaries’ equity, which would preserve the prudential regulatory capacity of the government.

Figure 7.
Figure 7.

Stock of Forward Purchases from and Sales to the Real Sector by the Interbank Sector

Citation: IMF Staff Country Reports 2005, 162; 10.5089/9781451808872.002.A004

21. The incidents of “friction” in the purchase of U.S. dollar forwards by banks, relative to the desire by exporters and pension funds to sell the currency forward, have reduced the forward premium on the U.S. dollar. The narrowing forward differential has led to resistance from some exporters against hedging; discussions with market participants suggest that exporters are reluctant to lock into “unattractive” forward rates. The increasing pressure from the demand and supply imbalance has also resulted in a wide spread between the implied and actual forward curves, especially at the short end.

22. These banks were initially able to overcome this cash restriction by tapping into offshore interest in negotiating “synthetic pesos”—attributable to the strengthening peso and the attractive interest rate differential between the Colombian peso and the U.S. dollar. This trade involved offshore investors borrowing U.S. dollars in the United States, converting the loan into pesos and investing the loan in peso TES bonds, while purchasing U.S. dollars in the forward market. The imposition of a one–year holding period on offshore investors in local markets, since December 2004, caused further friction in forward exchange rate market by making such transactions very costly. 11 A potential concern is that banks are looking for vehicles to circumvent these restrictions, potentially decreasing the transparency in this market.

Restrictions on Foreign Currency Cash Position of Banks

We define a bank’s net worth (PP) as:

(1)PP=AL,
Box 1.

where A represents the bank’s total assets, and L its total liabilities. Its foreign currency cash position (CP) is defined as:

(2)CP=PPFBFS
Box 1.
=ALFB+FS,
Box 1.

where FB is the purchase of forwards in foreign currency and FSis the sale of forwards in foreign currency. If we assume that the bank buys an additional $100 forward, then the new net worth and offsetting cash positions are:

(3)PP1=(A+100)Land
Box 1.
(4)CPi=PP1FB+FS
Box 1.
=[(A+100)L]+FS(FB+100)
Box 1.
=ALFB+FS.
Box 1.

In other words, the cash position remains unchanged as a result of the forward operation. However, the bank must now sell $100 in exchange for pesos in the spot market, in order to hedge the open forward position. Since this cash position is for foreign currency only, the purchase of pesos (increase in local currency cash position) is not recognized. Effectively, the foreign currency cash position now becomes:

(5)CP2(A100)LFB+FS
Box 1.

Thus, as FB→ ∞, that is, as the hedged forward purchase transactions increase, CP2 → 0. When CP2 = 0, the forward purchase transactions must cease.

Given the existing central bank restriction on the foreign currency cash position, the bank would no longer be able to buy foreign currency forwards (usually from exporters and pension funds) once the position is at zero. The only way for the bank to build more “capacity” to purchase foreign currency forwards would be to (i) increase the sale of foreign currency forwards (usually to importers); and (ii) simultaneously purchase foreign currency (sell pesos) in the spot market to hedge these open forward position. The first part of this transaction would not change the foreign currency cash positions, per equation (4), but the second (hedging) leg would have the opposite effect to equation (5). In other words, as FS → ∞, that is, the hedged forward purchase transactions increase, CP2 →∞.

Strengthen the domestic capital market

23. The Securities Market Law (SML), currently before Congress, would strengthenthe domestic hedging market (futures, options, swaps) in several ways (Box 2.). It would address the issue of counter–party risk in the trading of derivatives, which is an important concern to the extent that trading is not immune to credit risk. The SML would require the establishment of centralized clearing and settlement systems, which would improve the protection of and reduce the risks to investors, and thus reduce costs.

Key Features of the Draft Securities Market Law

Objectives: Foster a liquid and efficient capital market by enhancing investors’ rights, preventing systemic risks and promoting more confidence on investment and trading of securities.

Investor Protection and Enforcement: The law adopts principles of corporate governance and dissemination of information oriented to foster the transparency and equity among investors. At the same time, the law unifies the, currently disperse, criteria to describe infractions and establishes severe penalties for felonies in securities trading.

Regulation and Supervision: Under the proposed law, entities conducting similar types of capital markets activities—either bank or non bank intermediaries—would be subject to same standards of surveillance. This would reduce incentives to pursue regulatory arbitrage.

Settlement and Trading: The principle of finality would become a cornerstone in the trading of securities. By this principle, securities trading are deemed as final transaction. This would enhance the legal protection for trading, as the assets cannot be set aside in favor of a third party as a consequence of another contract liability. The law establishes central counterparty risk clearing houses, which assume all obligations involving the trading of securities, and thereby reduce risks and costs.

D. Concluding Remarks

24. The development of well–functioning money markets is a critical first step in developing hedging instruments in both, domestic and foreign currencies. Towards this end, the establishment of a credible reference interest rate is crucial. In the meantime, the authorities would need to revisit the restriction imposed on banks’ foreign currency cash positions, as this could impede the development of the foreign exchange derivatives market. On a broader scale, the passage of the SML would promote greater confidence in the market, by enhancing investors’ rights and reducing systemic risks.

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ANNEX I: Exposure of the Corporate Sector to Foreign Currency Risk

The foreign exchange exposure of a particular industry sector in Colombia can be estimated using factor analysis.1 Essentially, this entails estimating a regression of the stock return of a particular firm or industry on exchange rate changes, while controlling for returns on the overall stock market. The econometric model is specified as follows:

(1)Ri,t=a+b1Rs,t+b2Rm,t+ϵi,t,
A04ann01

Where Ri, t is the stock return for sector i in period t, Rs, t is the rate of change in the Colombian peso relative to the U.S. dollar, Rm, t is the return on the overall stock market and ei, t is an independent and identically distributed error term. The coefficient b1 measures the exchange rate exposure of a sector. A higher number for the coefficient b1, either positive or negative, represents a higher exposure of a particular sector to changes in the exchange rate.

We apply the factor analysis model in equation (1) using Ordinary Least Squares with correction for serial correlation in the error term, to the following sectors: consumer discretionary, consumer staples, financials, industrials and utilities. To calculate sectoral and overall stock market returns we use Datastream sectoral indices, derived from companies listed in Colombia Stock Exchange; the sample covers January 1998 to October 2004. The sensitivity of equity returns of each sector to exchange rate changes is presented in (Table).

The results suggest that the consumer staples sector has been the most exposed to foreign exchange risk over the period January 1998 to October 2004 holding period.2 However, when the data is split into two sub–samples, from January 19, 1998 to July 2, 2001 and from July 3, 2001 to October 4, 2004, the results show that the foreign exchange exposure of the consumer staples became insignificant in the latter period. This may suggests that the companies in this particular sector may have improved their risk management over time by using hedging or other operational techniques, thus offsetting any significant impact from exchange rate movements on its profits, and therefore in its stock price.

Table. Colombia: Foreign Exchange Exposure of Industry Sectors 1/

article image
Sources: Datastream; S&P; IFC; EMDB; and staff calculations.

T-statistics in italics; bold fonts indicate significance at the 5 percent level or lower.

The sub-samples were defined on the basis of the merger of the IGBC index of the Colombian Stock Exchange with Medellin and Occidente on July 2001.

2

As a comparison, Chan–Lau (2004) finds that the financial sector in Chile has been the most exposed to foreign exchange rate risk, although the consumer staples sector was consistently exposed as well

1

Prepared by Roberto Garcia–Saltos (WHD) and Li Lian Ong (ICM).

2

As an example, virtually all of the 40–50 Brazilian firms that have access to international financial markets raise U.S. dollar-denominated funds in these markets. They then turn to the local derivatives market to swap the external financing obligations into Brazilian reals with an interest rate indexed to the Interbank Certificate of Deposit (CDI) rate. This illustrates the importance of local derivatives markets for local entities which need to manage the currency and interest rate exposures that come with raising funds in international markets.

3

For further details on these markets, seeMathieson, Roldos, Ramaswamy and Ilyina (2004).

4

The trading in Mexican peso–U.S. dollar futures on the Chicago Mercantile Exchange (CME) is very active, with many market participants saying that price discovery in the peso market takes place in Chicago.

5

This includes the cupom cambial traded both in OTC markets, and the Brazilian Mercantile and Futures Exchange (BM&F).

6

Brazil and Mexico have among the most liquid offshore markets in credit derivatives. These markets are largely dominated by plain–vanilla credit default swaps (CDS) on sovereign issues of U.S. dollar-denominated international bonds, which are used by international investors to either augment or hedge the credit risk exposure of their bond portfolios.

7

The Chilean authorities have implemented several measures to encourage the development of the local derivatives market. The measures include allowing banks to short-sell securities and pension funds to lend securities and to use derivatives instruments for hedging purposes. However, these measures have not had significant effect, due to implementation delays and the existence of restrictions, such as the prohibition of pension funds from writing options or trading yield spreads (which would entail short-selling securities).

8

The most common transactions are repurchase (“repo”) agreements in the Colombian money market. A repo is an operation in which the seller of the securities agrees to repurchase them at a specified time and price; the collateral is usually held at the central securities depository (DCV). The repo is the main monetary policy instrument in Colombia, and is widely used by the treasury for its cash management operations. The central bank and the treasury account for more than 90 percent of the repo market which had, during 2003, a daily average turnover equivalent to US$872 million.

9

The weak link with market conditions is further noted by the relatively low and declining volatility of the DTF rate compared to other market–determined rates. Furthermore, the share of the 90–day certificates of deposit to total deposits has fallen. This has occurred even as the concentration of financial instruments—as measured by the Herfindhal index—has increased.

10

This interest rate serves as (i) the overnight interest cost of government credit; (ii) the rate set by the central bank for borrowing and lending money to banks; and (iii) the rate at which floating rate government bonds accrue on a daily basis.

11

Recently, the government announced its decision to dismantle this restriction within the next six months.

Colombia: Selected Issues
Author: International Monetary Fund