Background

Colombia’s current government set an ambitious reform agenda in 2010 to tackle the country’s most pressing problems. On the social side, it focused on reducing poverty rates—which stood above 30 percent per multidimensional measures—and lowering inequality. On the economy, it concentrated on reducing structural unemployment—persistently above 12 percent—and removing barriers to growth, particularly the large infrastructure gap that has been a historic drag on productivity. And on security, on putting an end to the five-decade-long civil conflict that killed 200,000 Colombians and displaced six million.

A strong macroeconomic framework was an essential underpinning for these reforms as they entailed significant changes to public spending, a substantial pressure on the financial system to fund infrastructure projects, and flexibility to absorb potential external shocks. The chosen pillars were thus to maintain exchange rate flexibility as the primary shock absorber; a cautious monetary and financial policy to keep low and stable rates of inflation, contain credit growth and avoid currency mismatches; and commitment to a medium-term fiscal rule to keep spending and debt at sustainable levels.

From 2010 to 2014 authorities had to deal with the effects of a sustained increase in oil prices that was compounded by the doubling in production arising from prior reforms to modernize the hydrocarbons sector. Recognizing the temporary nature of the shock was essential in managing the substantial increase in government revenue and the large appreciation of the peso that followed, while trying to preserve space to adjust once the boom came to an end.

Fall in oil prices and Policy Response

Starting in mid-2014 and lasting over a year, the rapid decline in oil prices generated one of the largest adverse external shocks Colombia’s economy has faced with exports falling 46 percent—a reduction unseen since the great depression of the 1930s. The government’s oil revenue dropped 3 pp of GDP, the current account deficit widened to 6.5 percent of GDP, followed by a reduction in aggregate that led to a slowdown in growth to 2 percent—less than half of pre-crisis levels.

The policy response focused on helping the economy adjust without derailing the structural reform agenda as noted in the report. Building on the strength of the existing macroeconomic framework, authorities opted for an approach in line with Fund’s recommendations in which monetary and fiscal policy recognized the permanent component of the shock and undertook the necessary corrective actions.

On the monetary side, the Central Bank embarked on a tightening cycle with a hike of 325 bp between September 2015 and July 2016, as it had to confront two additional shocks: a severe drought caused by El Niño that led to food shortages and increased energy prices—Colombia’s electricity matrix is largely hydroelectrical—and a truck drivers’ strike that disrupted the supply of goods to major urban areas. The combined effects of the two and the peso’s 60 percent nominal depreciation increased headline inflation to 8.97 percent in July, almost three times the target.

Inflation responded to policy by braking its trend in August and starting a decline to 5.75 percent in December. With expectations now anchored within the target range, inflation continuing to fall and a negative output gap, the Bank has now started to cautiously ease monetary policy with a 25 bp cut in the policy rate in December, and further 25 bp cuts in February and March.

Moving forward the Central Bank will follow a prudent stance based on three factors. First, the increased inflation inertia after two years of exceeding the 3 percent target and the still imperfect anchoring of expectations. These conditions heighten the risk that any supply shock could weaken the credibility of the target.

Second, the uncertainty about potential growth and natural interest rates. Lower terms of trade and smaller growth of the labor force are going against the productivity gains from peace and infrastructure investment, leaving considerable uncertainty on the size of the output gap. Also, smaller potential growth should not necessarily imply lower natural interest rates given the possibility of higher risk premia and rising external interest rates.

And thirdly, the consolidation of external adjustment. Ensuring the current account deficit — expected to fall to 3.5 percent this year—reaches its sustainable level is critical to reduce the external vulnerability of the economy. Ideally, the adjustment will switch to exports, which have started to grow at 30 percent following the recovery in commodity prices and, to a lesser extent, the lagged effects of depreciation and increased efforts at diversification.

Monetary policy should also consider its effects on financial imbalances and risk-taking. Low real interest rates and available external funding can lead to an excessive risk taking by agents that could delay adjustment. However, with the slowdown in credit growth, capital adequacy ratios above regulatory requirements and stress tests indicating provisions would help banks withstand large macro-financial shocks, we fully agree with the report’s assessment that the financial system is sound and broadly resilient.

In any case, authorities are fully aware of the importance of safeguarding the financial system given its potential role as a magnifier of risks. They thus stand ready to expand the use of prudential tools, including additional provisions in consumer loans, speedier convergence to Basel III capital standards, and further regulation aimed at limiting currency mismatches and FX liquidity risk of financial intermediaries. It is precisely the fact that currency mismatches of both the private and public sectors have been contained, what allowed the exchange rate to work fully as an automatic stabilizer of external shocks.

Regulatory measures will therefore continue to consolidate capital and liquidity buffers to absorb shocks, as has been done throughout the adjustment process—and as exemplified by the conglomerates bill currently under discussion in Congress.

On the fiscal front, efforts have focused on consolidation in line with the medium-term fiscal rule, while ensuring key structural reforms can be completed and priority social spending protected. Along these lines, last year there was a structural deficit reduction despite an increase in the central government’s headline deficit due to lower oil revenue and higher interest payments. Together with lower spending by local authorities, it amounted to a negative impulse of more than 2 percent that was duly followed by the approval of a comprehensive tax reform in December.

The reform was carefully designed to meet the key macroeconomic requirements of the adjustment strategy. It increased the general VAT rate by 3 percentage points and limited exemptions in personal income tax to replace revenue lost to the oil price shock; reduced corporate taxes rates and simplified tax procedures for small businesses to encourage investment; modernized non-profits taxation and introduced penalties to tackle evasion; created a new carbon tax in line with the stated goal of increasing clean energy sources; and strengthened the tax administration to improve overall efficiency.

In terms of additional revenue, it is expected to produce 0.67 percent of GDP in 2017, gradually increasing to over 3 percent of GDP in the next five years. The immediate increase in VAT rates will certainly have a negative short-run effect on growth via consumption and slow the convergence of inflation to target, but the positive effects on investment of lower corporate tax rates and medium-term growth are estimated to be around 0.3pp, in line with Fund estimates.

Overall, it is a growth friendly reform that balances short-term needs for revenue with the medium-term structural agenda: protects the credibility of the fiscal rule, fosters debt sustainability and ensures infrastructure programs and the peace agreement have sufficient and timely funding.

Outlook and risks

This policy response has so far allowed a relatively smooth adjustment—especially when considering the magnitude and speed of the shocks experienced in the past two years. Growth is expected to rise to 2.5 percent and continue increasing to 3.5 percent by the end of the decade; inflation is falling and set to reach its target in the second half of next year; the labor market has been able to sustain previous years’ gains and maintain unemployment at the 9 percent level; investment rates are the highest among the large Latin American economies; and commodity and non-commodity exports have started to grow and are poised to help lower the current account deficit to sustainable levels.

Moreover, authorities have started to build some policy space that will be critical in facing the more volatile and uncertain external environment described in the report. Together with a strong reserves position and a continued access to the Flexible Credit Line, the policy stance is strengthening confidence in the economy as shown by recent trends in capital flows, credit default swap prices and the stability in credit ratings.

Over the medium term the focus will be on increasing potential growth and ensuring the successful completion of the structural reform agenda. Chiefly among them is the biggest road-building program in the country’s history that will provide faster and cheaper connections among the country’s main centers of production, consumption and trade, and the implementation of the peace agreement. Both will be essential in transforming Colombia into a more prosperous and democratic country.

Finally, and despite the magnitude of the crisis, cumulative efforts have brought significant improvements to millions of Colombians, including through universal healthcare, free basic education and training, and access to sanitation, drinking water and electricity. Sound macroeconomic policy and targeted programs have contributed to almost halving poverty, reducing inequality and maintaining growth in a hostile and uncertain external environment.

Authorities remain committed to a policy of firm and balanced adjustment that takes appropriate account of risks, and to a continued and productive work with the IMF.