Statement by Maria Angelica Arbelaez, Alternate Executive Director for Colombia, May 19, 2014

KEY ISSUESContext. Colombia’s economic performance has been robust, underpinned by a verystrong policy framework. Last year, real GDP grew by 4.3 percent, with low inflation. The country has a strong external position; the financial system is sound; and fiscal policy remains guided by a structural fiscal balance rule. The authorities intend to undertake an ambitious infrastructure program to be executed through public-private partnerships.Outlook and risks. Real GDP growth is projected to converge to potential (about4½ percent) in 2014, with inflation remaining within the 2–4 percent target range. The medium-term outlook is favorable, but risks are tilted to the downside. Colombia’s important and growing ties with the global economy expose the economy to external risks. The most important sources of risk are a decline in oil prices, a deterioration in global financial conditions, and volatility from the normalization of monetary policy inthe U.S.Near-term policy mix. The current policy mix is broadly adequate. As the ongoingeconomic recovery takes hold, monetary and fiscal policies are expected to shift to a more neutral stance. Colombia continues to rely on a flexible exchange rate to absorb external shocks. The authorities are also taking advantage of abundant foreign inflows, primarily foreign direct investment, to strengthen their international reserve buffer.Medium-term challenges. Colombia’s key challenge is to sustain strong and inclusive growth with macroeconomic stability. To this purpose, it will be important to: (i) adhere to the fiscal consolidation plan, supporting it with revenue mobilization; (ii) address the infrastructure gap, without increasing fiscal risks; (iii) enhance the social security system by increasing coverage and improving equity, and containing health care costs;(iv) address remaining weaknesses in financial sector supervision; and (v) foster financial inclusion.

Abstract

KEY ISSUESContext. Colombia’s economic performance has been robust, underpinned by a verystrong policy framework. Last year, real GDP grew by 4.3 percent, with low inflation. The country has a strong external position; the financial system is sound; and fiscal policy remains guided by a structural fiscal balance rule. The authorities intend to undertake an ambitious infrastructure program to be executed through public-private partnerships.Outlook and risks. Real GDP growth is projected to converge to potential (about4½ percent) in 2014, with inflation remaining within the 2–4 percent target range. The medium-term outlook is favorable, but risks are tilted to the downside. Colombia’s important and growing ties with the global economy expose the economy to external risks. The most important sources of risk are a decline in oil prices, a deterioration in global financial conditions, and volatility from the normalization of monetary policy inthe U.S.Near-term policy mix. The current policy mix is broadly adequate. As the ongoingeconomic recovery takes hold, monetary and fiscal policies are expected to shift to a more neutral stance. Colombia continues to rely on a flexible exchange rate to absorb external shocks. The authorities are also taking advantage of abundant foreign inflows, primarily foreign direct investment, to strengthen their international reserve buffer.Medium-term challenges. Colombia’s key challenge is to sustain strong and inclusive growth with macroeconomic stability. To this purpose, it will be important to: (i) adhere to the fiscal consolidation plan, supporting it with revenue mobilization; (ii) address the infrastructure gap, without increasing fiscal risks; (iii) enhance the social security system by increasing coverage and improving equity, and containing health care costs;(iv) address remaining weaknesses in financial sector supervision; and (v) foster financial inclusion.

The Colombian authorities are grateful to the mission team for the constructive and fruitful discussions held in Bogota. They broadly agree with the staff’s assessment and policy recommendations.

Economic outlook

The Colombian economy has continued to perform well. The growth rate was 4.3 percent in 2013, and is projected at 4.5 to 5 percent in 2014. Growth has been driven by strong consumption and investment with construction and agriculture as the leading sectors. Exports and manufacturing were subdued but started to recover bolstered by both the exchange rate depreciation and a more dynamic external demand. In the medium term, the four generation infrastructure project (4G) is estimated to add around 0.7 percentage points to the potential output, currently at 4.6 percent.

The authorities agree with staff that although the outlook is favorable, as other emerging markets (EMs) Colombia is also subject to a variety of shocks. One major risk is the uncertain and potentially disruptive process of monetary policy normalization pursued in the U.S. So far the “tapering” has produced an adjustment in asset prices throughout the EMs with diverse effects according to countries’ fundamentals. The next step that involves raising policy interest rates could be more disruptive, as some past episodes suggest. Although these changes would come as a result of a stronger US economy and higher external demand for EMs, adverse shocks through world financial markets could overwhelm any positive effect stemming from real channels. In addition, Colombia could be affected by a Chinese slowdown not only directly, through decreases in prices and quantities of commodity exports, but also indirectly, through a declining export demand from regional markets that depend significantly on exports to China (e.g. Ecuador, Peru, Chile etc.)1. Both policy normalization in the U.S. and a slowdown of the Chinese economy could trigger adverse reactions in other EMs and impact the Colombian economy via financial contagion. Finally, further deterioration in the Venezuelan economy (our second partner in manufacturing exports) and/or in other countries in Latin America could also impact the Colombian economy through different channels.

Colombia’s strong policy framework, that has been its first line of defense, rests on three pillars: sustainable fiscal policy, a strong financial system, and an inflation targeting regime with exchange rate flexibility. This framework, well backed by the FCL, has provided the country with resilience and with the ability to pursue countercyclical policy responses. Indeed, economic policies supported last year’s growth, while being prudent and keeping fundamentals strong. In 2013 inflation held in the lower bound of the target range; fiscal targets were met; the current account deficit remained relatively low and comfortably financed with FDI inflows; the level of international reserves increased and continue to be adequate; and the financial sector stayed sound and well capitalized.

Monetary and exchange rate policies

The central bank (Banco de Republica, BR) maintained an expansionary stance to support the economy while keeping inflation under control. As a response to slow growth in the first semester of 2013 and the negative output gap, and with the inflation rate in the lower bound of the target, the authorities have held the policy interest rate at 3.25 percent since April 2013. However, they began to move to a more neutral interest rate as the economy started to recover. In a context of inflation converging towards 3 percent, a more dynamic domestic demand (output gap close to zero) and rising employment, the BR raised the policy rate by 25 basis points at the end of April 2014. The objective of the BR is to achieve efficient monetary policy normalization by means of a timely and gradual adjustment of the policy stance. Delays in the start of this adjustment risked introducing sharper interest rate movements in the future with adverse effects on output and employment volatility.

The exchange rate has been the main shock absorber. After the announcement of the tapering by the U.S. Federal Reserve, the currency depreciated significantly with no negative consequences for the economy or inflation. Indeed, a credible long-term inflation target, a subdued exchange rate pass-through and low currency and FX term mismatches have been both consequences and conditions for the successful operation of the monetary and FX policy strategy.

The monetary authorities have continued to build-up reserves with the objective of keeping indicators at adequate levels. International reserves are accumulated through the program of pre-announced daily purchases in the FX market. The pace of accumulation is guided by a strategy that takes into account pre-crisis levels of several indicators (that proved to be an adequate buffer), and the average of levels of those indicators during the floating period. This strategy indicates the need for continued strengthening of the country’s external liquidity position. It is worth noting, however, that the pursued level of international reserves is considered adequate for precautionary purposes but would be insufficient to cope with tail risks.

The external position continues to be strong and, according to the authorities, there is no evidence of a statistically significant exchange rate misalignment. In 2013 the current account deficit stood at 3.4 percent of GDP, similar to that of 2012, and comfortably financed with capital inflows (5.3 percent of GDP) of which FDI constitutes the largest fraction. The deficit is mainly associated with high imports in line with economic activity (related to FDI and to retail and industrial sectors) and high profit remittances from foreign companies. The authorities estimate that the current account deficit will slightly narrow in the coming years on account of higher exports.

Fiscal policy and stance

A strong framework, both at the central and subnational governments (SNGs), has supported fiscal consolidation, and helps to anchor fiscal discipline and promote savings2. In 2013, the fiscal target dictated by the fiscal rule for the central government of 2.4 percent of GDP was met (0.9 percent for the combined public sector) with higher than envisaged revenues that allowed for higher public investment. The consolidation will continue gradually in the next years in order to reach a structural deficit of the central government of 1.9 percent of GDP in 2018 and levels below 1 percent in 2022 onwards—which in turn will bring down public debt to 26 percent of GDP.

The authorities welcome the selected issues paper on the fiscal rule. The main finding is that, even in a very adverse scenario (much more pessimistic than that assumed by the government) the adjustment would be at most 2 to 2.5 percent of GDP. The authorities are fully aware of the need for an adjustment based on raising revenues rather than cutting spending, but consider that the magnitude could be smaller as: GDP is expected to grow at least at the potential level or higher should positive effects on infrastructure materialize; oil and mining revenues might be larger (government’s assumptions are rather conservative); and other revenues would become stronger as a result of the proceeds of the 2012 tax reform as well as envisaged tax administration improvements. Indeed, efforts in the latter front have been significant: tax revenue almost doubled in four years (COP 66 trillion in 2010 against 112 trillion in 2014). It is also important to reiterate that the fiscal rule enjoys broad support among key actors in Colombia and the government is fully committed to meeting its targets.

Financial sector

The financial sector continues to be sound, with healthy corporate and households balance sheets, strong credit quality and profitability. The solvency ratio of close to 15 percent is well above the regulatory minimum (9 percent) and, since August 2013, it complies with the quality of capital required by Basel III. Colombian credit institutions hold ample liquidity and are required to satisfy a liquidity indicator in line with the Liquidity Coverage Ratio of Basel III. Liquidity regulation for non-banking institutions is being evaluated and enacted. Currency and maturity mismatches of financial intermediaries are closely monitored and regulated.

The recent expansion of Colombian banks in Central America takes advantage of long-term business opportunities and diversifies some risks for financial conglomerates, although it poses challenges for regulators and the Central Bank. The authorities have acknowledged this new source of risk, and have undertaken mitigating actions. Firstly, closer ties with monetary and financial supervision authorities in Central America have been established with the purpose of obtaining and sharing more and better information; secondly, Colombia’s international reserves position has been reinforced.

Medium-term challenges

The Colombian authorities concur with staff on the important challenges ahead, and want to underscore the progress achieved in deepening inclusive growth and addressing infrastructure gaps.

Unemployment has continued to decrease, and reached in 2013 a historically low level of 9.6 percent. More importantly, job creation has been mainly in the formal sector (bolstered by the 2012 tax reform which significantly reduced labor costs) representing an enormous change in the Colombian labor market. In addition, poverty and extreme poverty have constantly declined and income inequality has improved. A further substantial reduction of inequality is envisaged in the next years as result of the full effect of the 2012 tax reform, whose main purpose was redistributive. In addition, the programs adopted by the government to broaden pension’s coverage for the population that does not qualify for a pension as well as to strengthen financial inclusion will also contribute to reduce inequality. Finally, the government has put in place an ambitious infrastructure project (four generation) through APPs that is expected to boost competitiveness and growth.

1

Colombian exports to China accounted for roughly 9 percent of total exports in 2013 and 24 percent of total Colombian exports were sold in 2013 to countries with significant trade links with China (excluding the US).

2

Fiscal Transparency and Responsibility Law, Fiscal Rule, Traffic Lights and Fiscal Responsibility Law for SNGs, fiscal sustainability added as a principle in the Constitution and Royalties Reforms.