Risk drivers and outlook

Over the last decade, the macroeconomic situation of Colombia has improved considerably. Benefiting from benign external conditions and thanks to a solid policy framework, the country has enjoyed sound economic growth and falling inflation. Moreover, by increasing production the country has proven relatively resilient to the adverse evolution of international oil prices, and buffers in the form of international reserves remain large.

Because ample liquidity is combined with a rather limited reliance on short term debt, Credendo Group assigns to Colombia the most favourable classification for short term political risk (Cat. 1). Considering the medium to long term, key additional Colombian strengths include a high investment rate and modest external indebtedness. But dependence on the oil sector and sizeable debt service payments make for some vulnerability to external shocks. Furthermore taking into account the prevailing security threats (linked to left-wing rebel groups as well as criminal gangs), Credendo Group assesses the MLT political risk in Colombia as average (Cat. 4).

As for the business environment, Colombian institutional quality remains to be improved. Along with the recent depreciation of the peso, this explains why Credendo Group classifies the systemic commercial risk in Colombia in its middle category (B on a scale from A to C).

Facts & figures

Pros

  • Strong policy framework
  • International confidence
  • High savings and investment rates
  • Solid liquidity buffers

Cons

  • High degree of labour informality
  • Infrastructure gaps
  • Security situation remains fragile
  • Oil dependence

Main export products

  • Hydrocarbons (43.4% of 2013 current account receipts), manufactures (14.2%), coal (9.1%), private transfers (6.0%), tourism (3.1%), gold (3.0%), coffee (2.6%)

Income group

  • Upper middle income

Per capita Income

  • USD 7,560

Population

  • 48.3 M

Description of electoral system

  • Presidential: 4-year term, 2-term limit, last election: May 2014
  • Legislative: 4-year term, last election: March 2014

Head of State and of government

  • President Juan Manuel Santos

Country risk assessment

Entrenched democracy

Democracy is well entrenched in Colombia, the strong preference for civilian government arguably dating back to Simón Bolívar’s increasingly authoritarian – yet vain – efforts to protect the unity of Gran Colombia, the post- colonial state that he had founded in 1819 and that encompassed much of northern South America. Gran Colombia dissolved in 1830, with the secession of Ecuador and Venezuela. Soon after that, two political parties became dominant in Bogotá: the Liberals and the Conservatives. The struggle for power between the two at numerous occasions sparked civil war. Panama became an independent country in 1903 in the aftermath of the ‘War of a Thousand Days’, and the period known as ‘La Violencia’ ushered a military coup in 1953. However, attesting to the Colombian commitment to democracy, the coup was the only one in the 20th century and military rule was undone in 1957, making it very short-lived by regional standards.

The political duopoly of the Liberal Party and the Conservative Party lasted until 2002, when independent candidate Álvaro Uribe won the presidential election. Unmatched in popularity owing to economic recovery and an improving security situation, Uribe managed to amend the constitution to allow presidential re-election, which he easily secured in 2006. Unable to run for a third term, Uribe was succeeded by his defence minister Juan Manuel Santos in 2010. While Santos broadly continued his predecessor’s economic policies, the latter grew increasingly critical of the new security agenda, and, in particular, fiercely opposed the peace negotiations that  the government and the Marxist rebels of the FARC (Fuerzas Armadas Revolucionarias de Colombia) have been engaged in since November 2012. Uribe therefore endorsed the bid of Óscar Iván Zuluaga to unseat Santos in the presidential election of May 2014. Zuluaga proved unsuccessful, however: despite winning the most votes in the first round, he only secured 45% whereas Santos obtained 51% of votes in the second round.

Challenging road to peace

The fact that the main disagreement between the two most popular presidential contenders pertains to security highlights the predominance of this issue in Colombian politics. Indeed – quite paradoxically – while historically being more committed to democracy and constitutional stability than regional peers, Colombia has suffered more violence. Crucially, given impetus by the success of the Cuban revolution in 1959, left-wing guerrillas of the FARC and the smaller ELN (Ejército de Liberación Nacional) have been involved in an armed conflict with the government since the 1960s. In addition, there are the criminal gangs that emerged from the remnants of the right-wing paramilitary groups that were formed in the 1980s and 1990s to confront the leftist rebels. These are heavily involved in drug trafficking and – according to the government – have in recent years overtaken the FARC and the ELN as the biggest security threat in Colombia.

That being said, it is obvious that, should an encompassing peace agreement with the FARC be reached, this would significantly enhance the Colombian business environment and reduce political risk. Crucially, in the medium term, enhanced stability would further encourage investment and improve resource allocation, thus boosting growth. Up to now, the government and FARC negotiators have struck deals on rural development, political participation and drug trafficking. After his re-election, Santos’ ambition is to reach consensus on the two remaining topics on the agenda – victims’ reparations and the contentious issue of rebel reintegration – and to start implementation efforts by early 2015. Fostering the President’s position to pass implementing laws related to a potential agreement, the legislative elections of March 2014 saw his ruling coalition retain a working majority in Congress. Yet while this scenario offers a clear perspective of finally resolving the now five-decade-old conflict, major pitfalls remain. Most clearly, there is the risk of certain FARC factions rejecting the eventual agreement and breaking away to form criminal gangs. The extent of such fragmentation is difficult to predict. On the one hand, the FARC negotiators have been effective in implementing recent unilateral ceasefires, demonstrating their  control over the organisation. On the other hand, a host of criminal activities – ranging from drug trafficking to illegal gold mining, kidnapping and extortion – today represent a major source of income for the rebels. It may prove hard to lure them away from these undertakings in favour of other employment opportunities.

Solid policy framework

Fierce disagreement about security policies masks fundamental political consensus on macroeconomic management. Indeed, both the Santos administration and the Uribista opposition advocate the continuation of liberal economic policies and openness to international trade.

On the domestic front, sound countercyclical policy-making by both fiscal and monetary authorities has made for effective demand management.

Colombia_Graph1EN

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A fiscal stimulus (including increased mortgage subsidies) was implemented in 2013 to address the slight economic slowdown. As a result, the overall budget balance deteriorated from a surplus of 0.2% of GDP in 2012 to a deficit of 0.9% in 2013 and total public debt increased from 32% of GDP to 35% over the same period. With the output gap now closed, fiscal policy stands to switch to a more neutral stance in order to stay in line with the structural balanced budget rule and with the principle of sustainable public finance inscribed in the constitution. In this context, given that oil revenues are under pressure due to declining international prices and that expenditure efficiency gains will be difficult to achieve, a key medium-term challenge for the authorities will be to broaden the non-commodity tax base by reducing labour informality.

Monetary policy until recently was accommodative, too. In March 2013, faced with slowing economic growth and a level of inflation below its 2-4% target range, the Central Bank lowered its policy interest rate to 3.25%. It kept it at that level until April 2014 to subsequently gradually hike it to 4.5% as the output gap closed and the rate of inflation recovered. Owing to the credible policy framework, inflation expectations all along remained anchored at the 3% centre of the Central Bank target range. Apart from targeting inflation, monetary authorities have also  been committed to exchange rate flexibility and – slightly contradictory – to building international reserves. With regard to the latter, the Central Bank notably kept acquiring foreign exchange even as international investor risk aversion spiked following the US Federal Reserve’s announcement in May 2013 that it would gradually undo its extremely accommodative monetary stance.

Much-strengthened financial supervision and regulation attest to the overall sound state of the banking sector. Indicators of profitability, liquidity and both the level and provisioning of non-performing loans are all favourable, and the only minor vulnerabilities pertain to the excessive exposure to large borrowers and international links to subsidiaries of Colombian banks in Central America.

Colombian adherence to liberal economic principles has also been apparent in its increasing international ties.  For one thing, relations with both Ecuador and Venezuela – severely eroded in part due to Uribe’s confrontational ways – have improved considerably under the Santos administration. Regional trade has also benefited from the dynamic drive towards economic integration within the Pacific Alliance, a trade bloc of four also including Mexico, Peru and Chile that in total encompasses 36% of Latin American GDP and that is characterised by a shared commitment to pro-market policies. Furthermore, the politics of openness extend beyond the region and  Colombia has signed many free trade agreements, including one with the US that entered into force in May 2012 and one with the European Union that is being applied since August 2013.

Turbulent external environment

The strong Colombian policy framework has underpinned investor confidence. As such, abundant international liquidity has in recent years flowed into the country. This dynamic has made for ample refinancing options for the sovereign and large Colombian firms, and – because the net inflows have consistently outweighed the current account deficit – for increasing official foreign exchange reserves. As of end-May 2014, the latter covered the equivalent of 5.7 months of goods and services imports, indicating a solid liquidity position. Moreover, owing to particularly strong inflows of non-debt-creating foreign direct investment, Colombian external debt ratios have much improved over the last decade.

Colombia_Graph3EN

The structural current account deficit notwithstanding, external debt as a share of GDP (current account receipts) declined from 35% (170%) in 2004 to 25% (133%) in 2013.

Apart from benign external financing conditions, Colombia until recently also benefited from booming international oil prices. Indeed, with an output of about 1 million barrels per day in 2013 (up from some 0.6 million in 2008), the country is South America’s third largest producer and hydrocarbons – representing more than 40% of current account receipts – are by far its most important export product. The fact that Colombia, in spite of its oil wealth, posts a current account deficit, is largely explained by the flip side of financial inflows: external interest payments and profit repatriations by international firms.

Colombia_Graph4EN

As of late, Colombia has come to face the reality that increased international ties also entail increased external vulnerability. In particular, declining oil prices have negatively affected export earnings as well as public finances (more than 15% of total public revenue is oil-related). Considering financial flows, US Federal Reserve tapering has increased market volatility and is likely to drive up interest rates in the medium term. The downside risk is for this to further raise debt-servicing costs, which are already projected at a rather elevated 42% of 2014 current account receipts. Furthermore, increasing trade relations entails vulnerability to adverse economic conditions abroad. Two particular concerns come to mind: the slowdown of the Chinese economy weighing on international commodity prices, and the crisis in Venezuela undermining external demand. Yet, all in all, Colombia seems well placed to contain these downside risks. First and foremost, given that the official international reserves are supplemented by a sizeable sovereign wealth fund (that was built up using the oil windfall), Colombian liquidity buffers are vast. Besides, a two-year Flexible Credit Line amounting to some USD 6 billion that was approved by the IMF in June 2013 mitigates liquidity tail risk. The authorities are also committed to allowing the flexible exchange rate to serve as a first macroeconomic adjustment mechanism. Finally, with regard to the Venezuela risk, it should be noted that Colombia has over the past several years already significantly reduced its dependence on that country’s ailing market.

Towards inclusive growth

As a consequence of favourable external conditions and supported by a strong policy framework, annual Colombian GDP growth averaged 4.8% over the last decade. Domestically, the economic expansion was supported by a steady increase in investment that was financed by higher domestic savings. Note that the importance of investment has not merely boomed nominally, but as a percentage of GDP as well and that it is expected to continue doing so in the years ahead.

Colombia_Graph5EN

Another component of domestic demand that grew substantially was private consumption. In this regard, the contribution of reduced unemployment – which at end-2013 stood at a decade-low of 9.7% – is evident, but it  only partly explains the boost. Increasing credit to the private sector – which at end-2013 amounted to some 39% of GDP – fills the gap. Yet, even though the situation is improving, subpar financial inclusion remains a key impediment to more broadly based growth in Colombia.

In a general sense, stubbornly high levels of informality undermine the inclusiveness of economic growth in Colombia. Indeed, despite much headway over the last decade, poverty and inequality rates remain high. Informality is regarded as one of the root causes of this observation. Informal work is associated with higher rates of inequality because minimum wages and other forms of social protection (with the exception of the inclusive health system) are lacking, and productivity gains are relatively hard to achieve for informal labourers and small businesses, as access to credit is subdued. In order to address the situation, the government has provided incentives for formalising low-earning labour, including the introduction of more progressive income taxation.

Colombia’s important infrastructure gaps constitute another key impediment to higher growth, now projected at 4.5% of GDP over the medium term. Illustrating the inadequacy of roads in particular, the Global Competitiveness report ranked the country 126th out of 144 on the quality of transport infrastructure. Though extremely challenging geography and sabotaging rebel activity explain the problem to some extent, inefficiency of past investments has also contributed. To tackle the problem, the government is embarking on a substantial infrastructure program. As the investment projects will be implemented through public-private partnerships, it will be of key importance to minimise the associated risk for public finances.

Analyst: Sebastian Vanderlinden, s.vanderlinden@credendogroup.com