Statement by Maria Angelica Arbelaez, Alternate Executive Director for Colombia, June 17, 2015

EXECUTIVE SUMMARY Background: Colombia’s strong economic policy framework, comprising an inflation- targeting regime, a flexible exchange rate, effective financial sector supervision and regulation, and a fiscal policy guided by a structural balance rule, has underpinned strong economic performance in recent years. These policies and institutions also help smooth the large terms of trade shock the country is facing, allowing a gradual adjustment to a new equilibrium. Outlook: In the baseline scenario, growth is expected to decelerate to 3.4 percent in 2015 but gradually return toward potential (4¼ percent) over the medium term and inflation to remain at the midpoint of the central bank’s 2–4 percent target range. The current account deficit would gradually narrow in line with the expected mild rebound in oil prices and the sustained growth in Colombia’s trading partners, while net private capital inflows would remain strong. The authorities are firmly committed to maintaining their sound policy framework and strengthening policy buffers in the period covered by the proposed arrangement. Risks: Risks associated with emerging markets have increased since the 2014 Article IV consultation. Despite strong fundamentals, Colombia is facing a permanent adjustment to weaker external conditions while being vulnerable to tail risks, especially a surge in financial volatility, protracted growth slowdown in trading partners, and a further decline in oil prices. Flexible Credit Line (FCL): The authorities are requesting a successor two-year FCL arrangement for 500 percent of quota (SDR 3.87 billion), which they intend to treat as precautionary, and cancellation of the current arrangement which expires on June 23, 2015. The access requested would provide Colombia with reasonable cover in an adverse external scenario. The authorities consider access to the FCL to be temporary and have signaled their intention to phase out its use as external risks recede. Staff assesses that Colombia meets the qualification criteria for access to Fund resources under the FCL arrangement, and recommends its approval by the Executive Board. Fund liquidity: The proposed commitment of SDR 3.87 billion would have only a marginal impact on the Fund’s liquidity position. Process: An informal meeting to consult with the Executive Board on a possible FCL arrangement for Colombia was held on May 22, 2015.

Abstract

EXECUTIVE SUMMARY Background: Colombia’s strong economic policy framework, comprising an inflation- targeting regime, a flexible exchange rate, effective financial sector supervision and regulation, and a fiscal policy guided by a structural balance rule, has underpinned strong economic performance in recent years. These policies and institutions also help smooth the large terms of trade shock the country is facing, allowing a gradual adjustment to a new equilibrium. Outlook: In the baseline scenario, growth is expected to decelerate to 3.4 percent in 2015 but gradually return toward potential (4¼ percent) over the medium term and inflation to remain at the midpoint of the central bank’s 2–4 percent target range. The current account deficit would gradually narrow in line with the expected mild rebound in oil prices and the sustained growth in Colombia’s trading partners, while net private capital inflows would remain strong. The authorities are firmly committed to maintaining their sound policy framework and strengthening policy buffers in the period covered by the proposed arrangement. Risks: Risks associated with emerging markets have increased since the 2014 Article IV consultation. Despite strong fundamentals, Colombia is facing a permanent adjustment to weaker external conditions while being vulnerable to tail risks, especially a surge in financial volatility, protracted growth slowdown in trading partners, and a further decline in oil prices. Flexible Credit Line (FCL): The authorities are requesting a successor two-year FCL arrangement for 500 percent of quota (SDR 3.87 billion), which they intend to treat as precautionary, and cancellation of the current arrangement which expires on June 23, 2015. The access requested would provide Colombia with reasonable cover in an adverse external scenario. The authorities consider access to the FCL to be temporary and have signaled their intention to phase out its use as external risks recede. Staff assesses that Colombia meets the qualification criteria for access to Fund resources under the FCL arrangement, and recommends its approval by the Executive Board. Fund liquidity: The proposed commitment of SDR 3.87 billion would have only a marginal impact on the Fund’s liquidity position. Process: An informal meeting to consult with the Executive Board on a possible FCL arrangement for Colombia was held on May 22, 2015.

On behalf of the Colombian authorities, I want to thank staff and management for their continued support and the positive response to their request for a new Flexible Credit Line (FCL). I also wish to express the authorities’ gratitude to the Board for the previous FCL arrangements that have been approved for Colombia since 2009. Colombia belongs to a group of countries for which special swap lines are not available and regional liquidity arrangements do not provide adequate coverage. Consequently, the FCL arrangements have been instrumental to cope with heightened external risks in recent years, and have suited well the country’s need for liquidity risk coverage in a highly uncertain environment.

Moreover, the FCL arrangements have been an important complement to the authorities’ wide range of countercyclical policy responses. They have also sent a positive signal to international financial markets on the strength of the economy and enhanced its resilience in the face of adverse external shocks, as reflected in the market assessment of Colombia’s credit risk. A study carried out by the central bank (Banco de la República) found that access to the FCL reduced the sovereign risk premium (EMBI) for Colombia and Mexico, a result shared by the IMF in the reviews of the FCL, PLL, and RFI.

In addition, the instrument’s availability has provided space to strengthen the policy framework and to build policy buffers. Indeed, since 2010 economic fundamentals have strengthened. The fiscal stance has substantially improved; inflation has remained most of the time within the target range of 2–4 percent and expectations well anchored; the current account deficit continued being comfortably financed by FDI; international reserves have been continuously building up; flexible exchange rate has played the main shock absorber role, and Colombia has had full access to international capital markets with improved funding conditions. The financial sector has remained sound and the authorities have made significant progress in strengthening regulation and supervision.

The authorities have also continued to undertake important structural reforms in key areas such as fiscal, labor market and formalization, royalties, health system and infrastructure, among others. Congress recently approved a Development Plan that outlines reforms for the next four years founded on three main pillars: peace, equity, and education. These objectives will be developed through several measures to improve competitiveness and infrastructure, social mobility, and rural transformation, besides others. Colombia has also made enormous progress in reducing poverty, informality and unemployment, as well as in boosting financial inclusion.

The Colombian economy has shown resilience during the global crisis. However, the recent sharp decline in oil prices and the lower-than-expected external demand have changed the economic outlook. Growth is projected to slow down in 2015 and start to recover in 2016 to gradually converge to long-term growth. Since part of the decline in oil prices is of a permanent nature, the economy needs to adjust to a new reality in the coming years.

At the same time, significant external risks persist; in particular, higher volatility in global financial markets associated with monetary policy normalization in the U.S.; rising vulnerabilities in emerging markets; lower growth in China and in other important Colombian trading partners; and a further decline in oil prices. Under the presence of these downside risks, the Colombian authorities see the FCL as an important protection tool to support an orderly and smooth structural adjustment of the economy.

Recent developments and policy responses

For the Colombian authorities it is clear that a first line of defense against the outcomes of these shocks is a strong macroeconomic policy framework that provides the country with resilience and with the ability to pursue countercyclical policy responses. This framework rests on three pillars, namely: an inflation targeting regime with exchange rate flexibility; a sustainable fiscal policy; and a strong financial system.

Backed by the inflation targeting regime and with inflation expectations firmly anchored, in 2014 inflation was close to the midpoint of the target range of 2–4 percent and it is expected to finish this year in the upper bound. The monetary policy stance has remained supportive in the context of the slowdown of the economy, and some room for monetary easing may linger looking ahead, provided that inflation expectations continue to be anchored and the pass-through effect remains low. The central bank continued to build up international reserves in 2014 and stopped its program of FX purchases by the end of that year, as exchange rate depreciated strongly and reserve buffers became broadly adequate for normal times. The current account deficit widened last year although comfortably financed by FDI and is expected to narrow gradually in dollar terms as domestic absorption adjusts and expenditure switching effects kick in.

The fiscal stance is guided by the fiscal rule. In 2014 the Central Government posted a structural deficit smaller to that recorded in 2013. The Combined Public Sector reached a slightly higher deficit resulting from a reduction in the surplus of sub-national governments due to the political cycle and higher investment. In 2015 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 and 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 and has commissioned a group of independent experts to design a comprehensive tax reform.

The financial sector remains profitable and well provisioned and capitalized, and the authorities have been making significant progress in adopting the FSAP recommendations. They 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, as well as improving the supervision of conglomerates. They continue to closely monitor financial stability risks. Data show that household debt has risen but remains below the level established by the IMF as risky; corporate private debt is also manageable with a low share of foreign currency denominated debt and no evidence of large currency mismatches; and the strict regulation of foreign currency in banks’ balance sheets contain their exposure and currency mismatches.

Request of the FCL

Based on the authorities’ estimations of the impact of the materialization of the aforementioned external shocks, they are requesting a new FCL for 3.87 billion SDR, 500 percent of the quota and the cancellation of the current arrangement. This access level would help cover the bulk of financing needs in an adverse scenario, and the remaining would be absorbed through international reserves.

The authorities want to reiterate that they consider the FCL as a temporary facility and its exit dependent on external conditions. Consistent with this, the access requested today as a percentage of the quota is almost half of that obtained in 2009. In addition, the amounts requested relative to the scale of the economy have been declining since 2009, which means that the relative level of protection against tail risks provided has been reduced (see table below).

Selected Indicators: Size of the FCL

(in percentage)

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Source: Banco de la República

As mentioned in the formal request letter, the authorities expect that as U.S. monetary policy normalizes, related global financial volatility will recede. In addition the economy will adjust over time to much lower oil prices. As the adjustments take place and global risks affecting Colombia reduce substantially, the authorities’ intention is to phase-out the use of the facility. They also remain committed to continue strengthening the policy framework, fundamentals and buffers to further reinforce resilience to external shocks.

Colombia: Arrangement Under the Flexible Credit Line and Cancellation of the Current Arrangement
Author: International Monetary Fund. Western Hemisphere Dept.