Statement by Maria Angelica Arbelaez, Alternate Executive Director for Colombia, April 29, 2016

Context. A strong policy framework has allowed Colombia to begin to adjust smoothly to the large decline in oil prices since mid-2014. The current account deficit, relative to GDP, widened to historical highs with the steep drop in oil exports. In 2015, macroeconomic policies were tightened to curb the growth in domestic demand and contain inflationary pressures arising from the sharp currency depreciation. A sound financial system and resilient corporate and household balance sheets have also contributed to the smooth adjustment. Real GDP growth slowed last year but still outperformed most countries in the region. The authorities are pressing ahead with their infrastructure program and a completion of the peace process is expected later this year. Outlook and risks. Colombia is facing another large terms of trade shock in 2016, together with tightening global financial conditions. Staff projects real growth to slow further to 2.5 percent in 2016 and gradually rise toward its potential of about 4 percent a year over the medium term, supported by the government's PPP-based infrastructure program and some gradual export diversification. Risks are mainly to the downside, stemming in part from large gross external financing needs, and include bouts of global financial volatility, a protracted period of slower growth in advanced and emerging economies and a further decline in oil prices.

Abstract

Context. A strong policy framework has allowed Colombia to begin to adjust smoothly to the large decline in oil prices since mid-2014. The current account deficit, relative to GDP, widened to historical highs with the steep drop in oil exports. In 2015, macroeconomic policies were tightened to curb the growth in domestic demand and contain inflationary pressures arising from the sharp currency depreciation. A sound financial system and resilient corporate and household balance sheets have also contributed to the smooth adjustment. Real GDP growth slowed last year but still outperformed most countries in the region. The authorities are pressing ahead with their infrastructure program and a completion of the peace process is expected later this year. Outlook and risks. Colombia is facing another large terms of trade shock in 2016, together with tightening global financial conditions. Staff projects real growth to slow further to 2.5 percent in 2016 and gradually rise toward its potential of about 4 percent a year over the medium term, supported by the government's PPP-based infrastructure program and some gradual export diversification. Risks are mainly to the downside, stemming in part from large gross external financing needs, and include bouts of global financial volatility, a protracted period of slower growth in advanced and emerging economies and a further decline in oil prices.

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 been hard hit by the sharp decline in the terms of trade since 2014 that has continued in 2016, compounded by a severe supply shock stemming from El Niño weather phenomenon, weaker growth among trading partners notably Venezuela and Ecuador, and tighter and volatile financial conditions. Despite the coincidence of these adverse set of shocks the economy grew 3.1 percent in 2015, one of the highest rates in the Latin American region.

Given the permanent nature of the decline in oil prices, the economy has been gradually adjusting to a new reality. Indeed, growth slowed down in 2015, and lower domestic absorption is expected to continue in 2016. To ensure an orderly adjustment of the economy, the authorities’ policy responses have been grounded on exchange rate flexibility as the main shock absorber, and on appropriate fiscal and monetary policies.

As a result of the drop in oil prices, the supply weather-related shock and the tightening of financial conditions, the Colombian peso has depreciated significantly, the current account deficit has widened as a percentage of GDP, the sovereign bond spreads have risen, and inflation and fiscal pressures have mounted. Against this backdrop, the central bank (Banco de la República) has tightened the monetary policy and the government has undertaken a fiscal adjustment in order to maintain macroeconomic and external stability, thus supporting confidence. The 4G PPP infrastructure agenda, coupled with the re-entrance into operation of the Cartagena oil refinery, has added to growth and partially offset the negative impact of the shocks. In addition, the authorities have adopted other structural reforms to boost non-traditional exports that will contribute to the adjustment of the current account deficit and help sustain growth.

However, the authorities agree with staff that risks threaten on the downside. The main hazards stem from instability and higher volatility in global financial conditions, disorderly slowdown in China, rising vulnerabilities in emerging markets, further decline in oil prices and weaker growth in Colombian trading partners. To face global financial risks, the authorities are committed to maintaining good macroeconomic policies, a floating exchange rate, keeping an adequate level of international reserves, and closely monitoring banks, corporate and households’ balance sheets in order to ensure financial stability. Access to the FCL also plays an important supportive role.

Fiscal policy

The fiscal stance embedded in the Medium-Term Fiscal Framework is well anchored by the fiscal rule, whose compliance is a priority for the authorities. The drop in oil prices has posed significant fiscal challenges as oil-related revenues declined from 3.3 percent of GDP in 2013 to 0.1 percent in 2016, and interest payments increased 0.7 percent of GDP due to the currency depreciation. The total shortfall of 4 percent of GDP between 2013 and 2016 was absorbed through higher non-oil related revenues of 1.5 percent of GDP (a tax reform was approved in December 2014), spending cuts of 1.2 percent of GDP, and the remaining 1.3 percent of GDP corresponds to a cyclical increase of the deficit allowed by the fiscal rule. These measures permitted compliance of the Central Government’s fiscal deficit target of 3 percent of GDP in 2015, and 3.6 percent of GDP in 2016. The authorities remain committed to making additional adjustments if needed to meet this year’s target.

Under the new normal of oil prices, the government is aware that further revenue mobilization is needed in the years to come in order to comply with the fiscal rule and help the adjustment of the current account deficit. Indeed, they are in the preparation phase of the structural tax reform that will be submitted to Congress in the second semester of this year and that should be approved no later than December 2016. The report and recommendations of the tax expert commission have been an important input, and other institutions such as the IMF, the IDB and the OECD are also supporting the government in fine tuning the proposal.

Mainly due to the exchange rate depreciation, public debt increased around 5 percentage points of GDP since 2014 (the Central Government’s net debt grew from 35 percent of GDP in 2014 to 40 percent expected in 2016). However, in accordance to the fiscal rule targets, debt will decline gradually to reach around 29 percent of GDP in 2024.

Monetary Policy and External Position

Inflation targeting serves the economy well. As a result of the supply shock and the depreciation of the Colombian peso, inflation breached the upper bound of the target in 2015 (range of 2-4 percent) and continued to increase in 2016. The central bank started increasing the policy rate in September 2015 to contain temporary inflation pressures and anchor inflation expectations. Inflation is expected to return to target in 2017, as supply shocks recede and the pass-through from depreciation fades.

Exchange rate flexibility has been the main shock absorber and the peso depreciated strongly until early 2016, with a slight reversal in the last month. The freely floating framework has been complemented since October 2015 by a rules-based contingent FX auction program aiming at mitigating excess volatility. This mechanism has not been triggered yet. The current account deficit widened last year to 6.5 percent of GDP, and is expected to narrow gradually as domestic absorption adjusts and expenditure switching effects kick in. For 2016 the deficit is projected at 6 percent of GDP, but in dollar terms the reduction will be significant (from USD19 billion in 2015 to USD16 billion), remaining comfortably financed by FDI and portfolio inflows.

Financial sector

The financial sector remains sound, liquid, profitable, well provisioned and capitalized, and has sufficient buffers to cope with shocks. Stress tests conducted by the central bank and the Bank Superintendency to financial entities and corporate to assess risks of lower growth, exchange rate depreciation, lower oil prices and external financial tightening, show that, in general, the impact on the capital adequacy ratio and liquidity of credit institutions is limited and would not pose a significant threat to the vulnerability of the financial system.

However, the authorities continue to push ahead with the reform agenda and are finalizing the implementation of the FSAP recommendations. They are moving forward with the adoption of best practices in line with Basel III. In addition, since December 2015 the supervisor has the authority to request higher buffers (levels of capital and liquidity) to individual financial institutions that reveal higher risks. Finally, a law that grants more power to regulate and supervise financial conglomerates is being discussed in Congress.

The authorities continue to closely monitor financial stability risks. Corporate debt has increased as well as that of households in line with deeper financial inclusion, but both remain low by international standards. In addition, the share of foreign currency denominated debt of corporate is low (one third of total debt) with no evidence of large currency mismatches. The regulation of foreign currency in banks’ balance sheets is stringent, so their exposure and currency mismatches are contained. The Central Bank has recently tighten the regulation to limit currency mismatches and extended it to conglomerates, and has also imposed liquidity requirements at a consolidated level, important steps to manage cross-border risks.

In October 2015, the FSB, the IMF and the World Bank assessed the Colombian bank resolution regime against the principles exposed in the “FSB Key Attributes of Effective Resolution Regimes for Financial Institutions” (KA). This assessment was carried out as a voluntary request by the authorities, the first time the KA was applied to non-G20 countries. The pilot assessment found out that Colombia has a large and diversified financial system compared with similar countries with significant cross-border institutions, and the authorities have strong powers to manage weak and failing financial institutions. However, the Colombian resolution regime has room for improvement and the authorities are planning a way forward to implement the very useful recommendations made.

Structural Reforms

The continuous reform process is at the core of the Government’s agenda. The social and economic strategies, policies and targets for the next four years are outlined in a development plan law (Plan Nacional de Desarrollo 2014–2018) which is also in line with OECD requirements in some areas. The three pillars are peace, equity and education, which will be developed through, among others, social mobility, rural transformation, and improved competitiveness and infrastructure. The last two areas are critical for the transition to a more diversified economy and less dependent on commodity exports. As shown in the staff report, Colombia is making enormous progress on infrastructure with the successful 4G PPP program complemented by the tertiary roads projects. At the same time, the government is implementing other reforms to boost non-traditional exports, such as a new simplified custom status, tariff reform, education and human capital measures in order to reduce mismatches between labor force supply and demand, and is working closely with businessmen in order to take better advantage of free trade agreements.

Colombia: 2016 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Colombia
Author: International Monetary Fund. Western Hemisphere Dept.