Statement by Maria Angelica Arbelaez, Alternate Executive Director for Colombia, May 18, 2015

KEY ISSUES Context. Prudent macroeconomic policies have underpinned Colombia’s strong growth during the last few years, which exceeded that of most Latin American peers. Last year, the economy posted real growth of 4.6 percent, and average inflation remained near the center of the target range. Monetary and fiscal policies were mildly supportive of growth. The infrastructure agenda is expected to advance this year. Colombia’s government is engaged in ongoing peace negotiations with the main guerilla group (FARC). Outlook and risks. Starting from a position with slightly positive output gap, Colombia faces a large adverse terms of trade shock. Staff projects growth to slow to 3.4 percent in 2015 and gradually rise toward its potential (around 4¼ percent) over the medium-term supported by the government’s PPP-based infrastructure program and a gradual recovery in oil prices and external demand. Risks are mainly on the downside, including higher interest rates and financial volatility, and a protracted period of slower growth in advanced and emerging economies, and a delayed implementation of the infrastructure program. Macroeconomic policies. Strong headwinds from the severe oil price decline pose significant challenges to the near-term economic outlook. The structural fiscal rule will only partially shield expenditure plans from the oil shock and some fiscal tightening will be required to accommodate lower-than-expected oil revenues. A broadly neutral monetary policy stance will be consistent with achieving the inflation target in the near- term. Medium-term challenges. Colombia’s key challenge will be preserving macroeconomic stability while sustaining strong and inclusive growth through structural reforms. Revenue mobilization is urgently required to protect key social and infrastructure spending while adhering to the medium-term fiscal rule targets amid less favorable external conditions (weaker terms of trade and tighter financing conditions).

Abstract

KEY ISSUES Context. Prudent macroeconomic policies have underpinned Colombia’s strong growth during the last few years, which exceeded that of most Latin American peers. Last year, the economy posted real growth of 4.6 percent, and average inflation remained near the center of the target range. Monetary and fiscal policies were mildly supportive of growth. The infrastructure agenda is expected to advance this year. Colombia’s government is engaged in ongoing peace negotiations with the main guerilla group (FARC). Outlook and risks. Starting from a position with slightly positive output gap, Colombia faces a large adverse terms of trade shock. Staff projects growth to slow to 3.4 percent in 2015 and gradually rise toward its potential (around 4¼ percent) over the medium-term supported by the government’s PPP-based infrastructure program and a gradual recovery in oil prices and external demand. Risks are mainly on the downside, including higher interest rates and financial volatility, and a protracted period of slower growth in advanced and emerging economies, and a delayed implementation of the infrastructure program. Macroeconomic policies. Strong headwinds from the severe oil price decline pose significant challenges to the near-term economic outlook. The structural fiscal rule will only partially shield expenditure plans from the oil shock and some fiscal tightening will be required to accommodate lower-than-expected oil revenues. A broadly neutral monetary policy stance will be consistent with achieving the inflation target in the near- term. Medium-term challenges. Colombia’s key challenge will be preserving macroeconomic stability while sustaining strong and inclusive growth through structural reforms. Revenue mobilization is urgently required to protect key social and infrastructure spending while adhering to the medium-term fiscal rule targets amid less favorable external conditions (weaker terms of trade and tighter financing conditions).

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 show resilience while reducing unemployment with a 4.6 percent growth in 2014. However, the recent deterioration of the terms of trade stemming mainly from the collapse in oil prices, coupled with low growth in Europe and deceleration in China as well as in other Colombian trade partners in Latin America, has changed the economic outlook. Growth is projected to slow down to around 3.5 percent in 2015 and start to recover in 2016 to converge in the next years to a long-term growth of around 4.5 percent.

The authorities expect that part of the decline in oil prices is of a permanent nature that will negatively impact national income. In this scenario, the economy needs to adjust to a new reality in the coming years, and lower domestic absorption may be foreseen. Recent data show a deceleration in consumption and investment in some natural resource sectors and lower proceeds from commodity exports.

However, some factors may compensate for the economic decline: the reduction in poverty and the strength and formalization observed in the labor market can mitigate the slowdown in consumption; investment in public works and construction is expected to remain strong; and depreciation will gradually bolster non-traditional exports and curve imports. In addition, the ambitious package of infrastructure projects (4G) whose construction begins in 2016 is estimated to support growth and to add around 0.7 percentage points to the potential output, and the re-entrance into operation of the Cartagena oil refinery late this year will also bolster manufacturing performance.

The authorities acknowledge that the room for countercyclical policies to offset growth slowdown may be limited: fiscal space is restricted by the fiscal rule, and the scope for supportive monetary policy depends on the magnitude of the slowdown, inflation expectations and the degree of the pass-through of depreciation to inflation. In this context, the authorities are focusing their efforts on moving ahead with structural reforms to boost non-traditional tradable sectors and help them make the most use of the recovery in the US and of free trade agreements recently signed by Colombia.

The authorities agree with staff that risks threaten on the downside. The main hazards stem from instability and higher volatility in global financial markets associated with monetary policy normalization in the US and intensification of sovereign distress in the Euro Area, rising vulnerabilities in emerging markets, and lower growth in Europe, China and important Colombian trading partners. In addition, a further decline in oil prices would have a pronounced impact on investment and growth. To face global financial risks, the authorities are committed to maintaining good macroeconomic policies and strong fundamentals, floating exchange rate, keeping an adequate level of international reserves and closely monitoring banks, corporate and households’ balance sheets.

Fiscal policy

The fiscal stance embedded in the Medium-Term Fiscal Framework is well-anchored by the fiscal rule. According to new data released by the Ministry of Finance on May 19th, the Central Government posted a structural deficit of 2.30 percent of GDP, smaller to the 2.32 percent recorded in 2013, and a headline deficit of 2.43 percent, similar to that of 2013 (2.36%). The Combined Public Sector reached a deficit of 1.8 percent of GDP due to a reduction in the surplus of sub-national governments resulting from the political cycle and higher investment. For 2015 the situation is more challenging, as oil-related revenues are expected to drop and debt service to increase as a result of the exchange rate depreciation. Owing to the smoothing of the mining and economic cycles, the fiscal rule allows this year for a higher total deficit. The rest of the adjustment will come from increasing revenues from the tax reform approved in December 2014, and a budget cut, although protecting social spending.

Under the new normal of oil prices, the government is fully aware that further revenue mobilization will be needed in the years to come in order to comply with the fiscal rule. Indeed, it commissioned a group of independent experts to design a comprehensive tax reform, which counts on the advice of multilateral organizations, such as the IMF and OECD. Among others topics, the group will focus on tax administration, VAT, personal income taxes, non-profit organization taxes and tax simplification. The final blueprint has to be submitted to the government by the end of October 2015, but proposals on specific areas will be delivered before that deadline in order to have time to go through Congress, if necessary.

Complying with the fiscal rule is a priority for the authorities, even in the midst of less favorable conditions. They are convinced on the virtual cycle of fiscal discipline: lower fiscal deficit leads to higher confidence, lower interest rates, more investment, stronger economic growth and higher tax revenues. Fiscal consolidation is also necessary to strengthen the current account balance over the medium term.

Monetary Policy and External Position

Inflation targeting serves the economy well and inflation expectations are firmly anchored. In 2014 inflation was 3.6 percent and it is expected to finish this year in the upper part of the target range of 2-4 percent. Headline inflation went up due to agricultural supply shocks and some pass-through effect from depreciation, but it is projected to abate by the end of the year. Core inflation measures are within the target range. The monetary policy stance has remained supportive in the context of an economy expected to slowdown starting from near full utilization of productive capacity. Looking ahead, the room for monetary easing will depend on whether the expected slowdown exceeds or falls short of the adjustment required to ensure the nominal and financial stability of the economy, on the extent to which inflation expectations remain anchored to target and on the size of the pass-through effect. Fueled by capital flows, the central bank (Banco de la República) continued to build up international reserves in 2014 and stopped its program of FX purchases by the end of that year, as reserve buffers became broadly adequate for normal times and most indicators were close to pre-crisis levels.

Exchange rate flexibility has been the main shock absorber and the peso depreciated quickly and strongly, although it is broadly aligned with fundamentals. The current account deficit widened last year to 5.2 percent of GDP, and is expected to narrow gradually in dollar terms as domestic absorption adjusts and expenditure switching effects kick in. As a percentage of GDP the deficit will remain close to 5 percent due to the impact of the real depreciation of the COP on the dollar valuation of GDP. The reduction in dollar terms of the current account deficit will be mirrored by declines in FDI and portfolio inflows. The decrease in FDI will be especially felt in the oil and mining sectors. The reduction in portfolio investment will occur after an atypical year in 2014, when the increase of the weight of Colombian local public bonds in Emerging Economy benchmark indices induced record inflows of this kind.

Financial sector

The financial sector is sound, profitable and well provisioned and capitalized. As mentioned by staff, the authorities have been making significant progress in adopting the FSAP recommendations. Given that 2015 will be marked by lower growth, depreciated exchange rate and lower oil prices, the authorities are devoting their efforts to preventing negative spillovers to the financial system both through adopting regulatory measures and implementing a strict vigilance. As an example, following its mandate to monitor the financial system’s stability, the Financial Superintendency conducted stress tests on the loans associated with the oil sector, which accounts for 1.9 percent of the total portfolio. The results show that even under a downgrade in the rating scale of these loans (up to three notches), the impact on the capital adequacy ratio of credit institutions is limited and would not pose a significant threat to the vulnerability of the financial system. Risks to the financial sector stemming from depreciation are also limited given low exposure to foreign currency and mismatches, both in banks and corporate.

The Colombian authorities are committed to strengthening financial institutions capital and moving forward with the adoption of best practices in line with Basel III and Pillar 2 of Basel II. Nevertheless, it is important to analyze the regulatory framework in a comprehensive way. There are some more conservative aspects of the Colombian regulation than the principles proposed by the international standard setting bodies and some others in which regulatory measures taken in the country already cover some of the aspects raised by international best practices. Accordingly, the comparisons made among jurisdictions regarding solvency levels should consider these characteristics.

Authorities continue to closely monitor financial stability risks. Data show that household debt has increased in line with deeper financial inclusion, reaching historically high levels (30 percent of disposable income) while the financial burden has also risen, but remains below the level established by the IMF as risky. Corporate private debt is also manageable (37 percent of GDP), with a low share of foreign currency denominated debt (11 percent of GDP) and no evidence of large currency mismatches. The regulation of foreign currency in banks’ balance sheets is strict, so their exposure and currency mismatches are contained.

Structural Reforms

A comprehensive development plan1 is being discussed by Congress outlining the social and economic strategies, policies and targets for the next four years. It is founded on three pillars: peace, equity and education which will be developed through, among others, the following cross-cutting strategies: improving competitiveness and infrastructure, social mobility, and rural transformation. On infrastructure, besides the 4G project, other measures are envisaged to enhance urban transportation, broaden access to technologies of information and communication and bolster social housing. On social mobility, actions are concentrated on improving education, attention to early childhood, health care services delivery, and labor market. In addition, important measures will be adopted and powers granted to the government to reform the agricultural sector, redesign the institutionality and modify land management. Finally, the plan also incorporates actions to boost competitiveness and reduce informality.

Social progress

We welcome staff’s analyses on social aspects in the selected issues papers. Although there is still much to be done, Colombia has made enormous progress on reducing poverty, inequality and informality, as well as on boosting financial inclusion. Indeed, between 2010 and 2014 4, 4 million people were lifted out of poverty and 2.6 million out of extreme poverty. The poverty rate declined from 37.2 percent to 28.5 percent in four years, and extreme poverty from 12.3 percent to 8.1 percent. The government’s goals are to reach 25 percent of poverty and 6 percent of extreme poverty by 2018. Inequality has also decreased although slowly. Colombia has put in place many measures to achieve more inclusive growth, but time is needed to bear fruit. For example, a tax reform was undertaken in 2012 with the main objective of reducing inequality and generating formal employment. Increasing education attainment and improving quality are also key priorities of the Development Plan. Although it takes time to have an impact on inequality, better education, lower poverty, higher formal employment and financial inclusion are powerful tools to tackle it. Indeed, unemployment declined from 12 percent in 2010 to 9.1 percent in 2014, with the majority of new employment being in the formal sector, as presented by staff.

1

El Plan Nacional de Desarrollo 2014-2018 “Todos por un nuevo País