Statement by María Angélica Arbeláez, Alternate Executive Director for Colombia

The Colombian economy proved resilient to the global financial crisis, and a solid recovery is under way. The pace of monetary tightening envisaged strikes the right balance between restraining credit growth and mitigating incentives for further capital inflows. A sudden acceleration of domestic demand places an additional burden on monetary policy. Colombia’s financial sector oversight is solid, and plans to strengthen cross-border and consolidated supervision are commended. Steep taxation of labor and a relatively high minimum wage are significant hindrances to competitiveness. Colombia’s exchange restrictions remain unchanged.

Abstract

The Colombian economy proved resilient to the global financial crisis, and a solid recovery is under way. The pace of monetary tightening envisaged strikes the right balance between restraining credit growth and mitigating incentives for further capital inflows. A sudden acceleration of domestic demand places an additional burden on monetary policy. Colombia’s financial sector oversight is solid, and plans to strengthen cross-border and consolidated supervision are commended. Steep taxation of labor and a relatively high minimum wage are significant hindrances to competitiveness. Colombia’s exchange restrictions remain unchanged.

On behalf of the Colombian authorities, I would like to thank staff for the constructive meetings held in Bogota. My authorities broadly agree with staff’s assessment and policy recommendations and appreciate that marginal differences in perceptions with regard to some specific aspects were addressed in the staff report.

Economic outlook

The economic recovery began in 2010 and remains strong in 2011. After the solid performance of the economy in the first quarter of this year (5.1 percent year-on-year), the government and the central bank (Banco de la República, BR) recently raised their forecast from 4.5 percent to between 5 and 6 percent for 2011, and they expect the current negative output gap to close before the end of this year. As pointed out by staff, there are no clear signs of overheating, as no price bubbles have been observed in asset markets (e.g. housing, equity) and credit growth remains manageable. Nonetheless, macroeconomic policy strategy has shifted towards tighter monetary policy and a gradual exit from fiscal stimulus policy.

Fundamentals in the economy remain strong. In 2011, inflation is expected to be low (3.1 percent in December year-on-year according to the central bank’s projections). The fiscal deficit will be close to 3 percent of GDP and the public gross debt around 36 percent of GDP. The current account deficit will narrow to 2.6 percent of GDP, financed mostly by FDI inflows, and the level of international reserves remains adequate. In addition, the credit rating on the sovereign debt was raised to investment grade, and the FCL has played a major role in providing protection against tail risks.

Looking ahead, Colombia’s strong institutions coupled with a solid framework that has been put in place (e.g. inflation targeting, flexible exchange regime and an ambitious set of fiscal tools) will allow the government to maintain sound macroeconomic fundamentals. Nonetheless, many challenges remain, such as improving road infrastructure, bringing down unemployment and informality, and improving living conditions for a non-negligible part of the population. The government is taking concrete actions to address these issues and enhance competitiveness, with the medium-term objective of raising the potential growth rate, which today is around 4.5 percent.

Fiscal policy

Colombia has put in place a solid and comprehensive institutional framework in order to ensure discipline and debt sustainability, both at central and regional levels. In 1997 and 2000, three laws were enacted aiming to regulate the regions’ indebtedness and to force fiscal discipline and transparency. With regard to the Central Government, The Fiscal Responsibility and Transparency Law adopted in 2003—which includes a Medium-Term Fiscal Framework and a Medium-Term Expenditure Plan—set specific ceilings of fiscal deficit and financing, and establishes maximum levels of spending. In addition to that, and with the purpose of creating mechanisms for additional savings during boom periods, three ambitious reforms were recently approved by Congress: a) The Fiscal Rule, which limits the structural deficit of the Central Government, creates mechanisms to increase savings from the expected large growth in hydrocarbon export related revenues, and develops rules to manage countercyclical fiscal policies; b) The Fiscal Sustainability Legislative Act, which incorporates fiscal sustainability as a general principle in the Constitution; and c) The Royalties Reform, an amendment to the Constitution that mandates that both regional and central governments save a large amount of hydrocarbon royalties (30 percent). It also directs ways to distribute royalties more fairly among the regions, and seeks to enhance the spending efficiency of such royalties.

As staff has mentioned, the authorities are preparing the supporting legislation and are committed to passing it before 2012. In particular, concerning the Fiscal Rule, it is the highest priority for the Colombian government that the process of developing and monitoring key parameters for the rule is technically robust, transparent and independent, and is committed to acting accordingly. Moreover, the Fiscal Rule is perceived as an essential tool for fiscal discipline and the authorities will gradually reduce the Central Government’s deficit until reaching the target of below 1 percent of GDP from 2022 onwards—as established by the Rule, which will be met through significant spending cuts independent of new tax reforms.

With respect to revenues, the authorities have acknowledged the need to improve the tax structure. Indeed, as mentioned in the staff report the new government enacted a tax reform in 2010, which eliminated some exemptions, broadened the tax base, and gradually dismounted distortionary taxes such as the financial transactions tax. Looking ahead, they see further room to improve the tax structure although through measures that stimulate private activity and reduce the informal economy. Tax adjustments could include broadening the tax base and reducing tariffs (the income tariff of 33 percent is extremely high compared to peers and competitors), and eliminating some VAT rebates. They expect significant results from such measures, as they will generate higher economic dynamism. The Colombian Ministry of Finance valued the recent Fund’s TA mission on tax reform and shares some of the recommendations, and is designing a tax package that will be presented to Congress when they consider conditions are appropriate.

Over the short term, the fiscal adjustment in 2011 was delayed due to severe flooding in the country. The floods cost around 0.5 percent of GDP in 2011, and the total reconstruction costs are estimated to be between 2 and 3 percent of GDP. It must be noted that the authorities have tackled this negative shock by increasing taxes and reducing spending to ensure an unchanged fiscal stance, highlighting their commitment to fiscal stability.

Moreover, the budget for 2011 that was approved before the tax reform of 2010 was not modified according to the expected additional revenues. Therefore, the revenues driven by the reform—which have been higher than expected—combined with the spending lower than envisaged, will likely result in a lower deficit by around 0.4 percent of GDP than the one projected by the authorities (3.4 percent of GDP for the combined public sector). Should these circumstances materialized, and considering that the target for 2012 is a further significant reduction, the authorities perceive that the fiscal policy would not be pro-cyclical.

Monetary policy

The inflation targeting regime adopted in the late 1990s, has served the economy well, as it has brought down inflation significantly, has increased monetary policy credibility and has anchored inflation expectations, giving the authorities the flexibility and opportunity to react to the rapidly changing macroeconomic environment.

After two years of an accommodative monetary stance, that helped the country to cope with the global financial crisis, the BR started tightening monetary policy in 2011. Since February, it has raised its benchmark interest rate by 25 basis points every month, with the double objective of keeping inflation low/stable and smoothing the business cycle. The path toward a neutral monetary stance remains a precautionary and medium-term policy: in circumstances of high commodity prices and higher hydrocarbons’ production, close vigilance is warranted in order to avoid overheating and potential financial imbalances. In the short run, despite contained inflation (3.2 percent year-on-year in June) and inflation expectations, the BR is carefully monitoring the evolution of asset prices and credit, and is prepared to act promptly should signs of overheating appear.

Capital inflows

Colombia is also fully committed to exchange rate flexibility. The authorities see the exchange rate as the most important shock absorber to mitigate the effects of the surge in capital inflows. As staff pointed out, capital inflows have continued to increase, mostly under the form of FDI, although recently portfolio flows have risen as well. The Colombian authorities believe this is a positive trend, but they recognize some potential effects associated with a surge in these inflows, such as financial instability and excess exchange rate appreciation. The main policy response that the central bank has used to contain excess appreciation in the currency has been the program of pre-announced daily purchases of foreign exchange (US$20 million per day). However, it is worth mentioning that besides correcting exchange rate misalignments, the main objective of interventions has been to build up international reserves. The central bank has found that this transparent, small and predictable intervention is more effective than a large-scale and unpredictable accumulation of international reserves. According to BR’s analyses, interventions have been effective, especially when the amounts were fixed and when the exchange rate was excessively low (misaligned). There are two reasons for that, first because the likelihood of misalignment is higher and second because interventions with fixed amounts are not a signal of defending a specific level that the markets could subsequently attack.

Looking ahead, and should inflows keep rising, the policy response will depend on the nature of these inflows (private sector external indebtedness is being closely monitored) and whether the impact is mainly on the exchange rate or on the broader stability of the financial system. Given the complexity of this situation, the BR’s purpose is to clearly identify the problem and adopt the adequate solution.

Unemployment, informality and poverty

High structural unemployment rate is one of the major challenges for the Colombian government. The economic downturn of 2008 entailed an increase in unemployment, after several years of reduction. However, improvements have been observed in 2011: the unemployment rate in May was 11.1 percent compared to 12 percent in May of 2010, and the decline was especially strong in rural unemployment which went down from 8.6 percent to 7.5 percent. In addition, the quality of labor has enhanced, as salaried employment has grown while non-salaried has declined.

The authorities recognize that labor costs are high in Colombia, but several studies show that their reduction may have a limited impact on employment creation, aside from being politically difficult. Under these circumstances, the strategy to tackle unemployment—and bringing it down to one digit—gives weight to the promotion of larger-scale economic activity (focused on labor intensive sectors such as road infrastructure and agriculture). Nonetheless, the authorities have also taken steps to reduce labor costs and incentive formalization. The Formalization and First Employment Law was recently enacted, which dictates the reduction of labor taxes with the view to promote formalization of small businesses and to stimulate employment for youth, where unemployment is concentrated. Although the law is still new, its impact has been remarkable: it is estimated that around 400,000 small and medium businesses were formalized.

Finally, successive Colombian governments have been doing strong efforts to reduce poverty and have put in place several programs, including subsidies and targeted assistance schemes. Indeed, although still high, it has substantially decreased over the past years. Using the standard and comparable index of poverty based on income used by the World Bank—defined as the percentage of the population living with less than USD 2.5—we observe that poverty has declined from around 20 percent in 2000 to 16.4 percent in 2009 (close to Latin American average) and the goal of the government is to reach 9.0 percent in 2014. Other calculations of poverty using different methodologies show different figures. In the chart presented by staff in Box 3, the poverty index of each country is defined domestically therefore they are not comparable. Indeed, the poverty line defined as the value of the basic market basket in Colombia (as well as in Mexico) almost double the value used in other Latin American countries; therefore the rate of poverty appears to be much higher. Nonetheless the government acknowledges that poverty is still high and all efforts are focused on attaining a more balanced and pro-poor growth.

Colombia: 2011 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Colombia
Author: International Monetary Fund