Economic growth in Colombia expected to pick up with stimulus initiatives

Following congressional approval of a landmark peace agreement, and a late-2016 tax reform package (see analysis), 2017 looks to be a year of significant promise for the Colombian economy. The country has been on the recovery since the 2014 collapse in oil prices, which predominantly affected exports, government revenues and the exchange rate. As a result, the trade balance and current account deteriorated precipitously, the fiscal deficit widened, public debt mounted and the Colombian peso depreciated. However, by letting the external sector act as a shock absorber, the authorities helped ensure that domestic demand was able to pick up some of the slack.

“In the face of large external shocks since 2014, Colombia has had a relatively soft landing compared to some other countries in the region,” Leonardo Villar, president of local think tank Fedesarrollo, told OBG. “Growth has slowed down markedly, but the country did not experience a recession. Assuming there are no surprises, we expect growth to pick up slightly in 2017, and to continue accelerating thereafter.” With the peace agreement expected to boost economic activity, and the country on track to join the OECD before the end of the administration of Juan Manuel Santos, medium-term prospects are bright.

By The Numbers

According to the IMF, Colombia was the fourth-largest economy in Latin America in 2015, both in nominal ($274.1bn) and purchasing power parity terms, after Brazil, Mexico and Argentina. With a GDP per capita by purchasing power parity of $14,130 in 2016, Colombia ranked in the middle of the region’s economies, between the Dominican Republic ($16,049) and Venezuela ($13,761). Measured in US dollars, Colombia’s GDP declined significantly over the 2014-15 period due to the sharp drop in the exchange rate, while real GDP growth measured in the local currency remained positive.

The Colombian economy bounced back from the impact of the global financial crisis, its GDP growth accelerating from a 2009 nadir of 1.7% to 6.6% in 2011. Growth has since trended downward, however, with a marked deceleration following the 2014 collapse in oil prices. Growth fell to 3.1% in 2015 and to 2% in 2016, its lowest level since 2009. However, it is expected to pick up moderately in 2017, but will likely still remain below its long-term potential growth rate. The central bank conservatively forecasts growth of 2% for 2017, while the Economic Commission for Latin America and the Caribbean anticipates 2.7% growth.

Investment and infrastructure development are expected to be the key drivers of domestic demand, and the trade balance should continue to improve. Consumption, however, may further decelerate during the first half of 2017, as the December 2016 hike in value-added tax (VAT) weighs on demand and as consumer confidence continues to sag. In January 2017 the consumer confidence index fell to a historic low of -30.2, below the previous low of -23 in April 2002. March 2017 saw a peak for the year to date, however, with consumer confidence reaching -21.1.

Sectors

The Ministry of Finance forecasts growth of 2.5% for 2017, broadly in line with the market consensus. It also projects, however, that some sectors will not fare as well. After contracting by 6.5% in 2016, the extractive industry, including oil and gas, and coal, is expected to remain weak, contracting by an additional 0.2% in 2017. Agriculture, on the other hand, is expected to pick up from 0.5% growth in 2016 to 2% in 2017, as the El Niño weather phenomenon are unlikely to occur in 2017. Though growth in the industrial sector is forecast to decelerate from 4% to 3.4% in 2017, this can be explained by the expected deceleration in petroleum refining activity, which expanded 24.2% in 2016 when refining capacity at the main Cartagena facility came back on-stream.

The Ministry of Finance forecasts a still-impressive 12% growth in petroleum refining in 2017. Growth in the rest of the industrial sector was expected to accelerate from 1.3% in 2016 to 2% in 2017, as the competitive exchange rate continues to incentivise manufacturing for export and the 2016 tax reform increases investment levels. The supply of electricity, gas and water is expected to swing from 0.1% growth in 2016 to 2.8% growth in 2017, as accelerating expansion rates in the rest of the real economy drive increasing demand for these services. Financial services, meanwhile, are expected to decelerate, from 4.3% growth in 2016 to a still-robust rate of 3.5% in 2017, while modest upticks are expected in retail, hotels, transport and social services.

There is an interesting dynamic at play in the construction sector, which, overall, is expected to slow from 4.7% growth in 2016 to 3.9% in 2017. While housing construction is expected to remain relatively robust, decelerating only marginally, non-residential construction is expected to swing dramatically from 10.2% growth in 2016 to a 5% contraction in 2017. On the contrary, civil works were relatively minimal in 2016, having grown only 2.3% while municipal governments were in a post-election transitional period.

The combination of higher spending at the local level, and increasing investment by the federal government in large-scale infrastructure projects is expected to see civil works register 8% growth in 2017, and promises to be one of the most important drivers of overall GDP growth over the year.

Traditional Exports

With exports accounting for 14.7% of GDP in 2015, Colombia remains a relatively closed economy compared to some of its neighbours. Moreover, its exports are still dominated by four commodities: oil, coffee, coal and ferronickel. The volume of oil production has been in decline; the fall in prices has undermined the sector’s capacity to invest in bringing new production streams on-line or boosting proven reserves. Production fell from 1m barrels per day (bpd) in 2015 to an average of 885,000 bpd during 2016. By the end of the year, production decreased to less than 840,000 bpd. The government is targeting a production rate of 865,000 bpd for 2017. State-owned Ecopetrol, the key player in Colombia’s oil industry, is planning to increase investment to $3.5bn in 2017, part-financed by the divestment of non-core assets (see Capital Markets chapter).

Diversification

Efforts to improve the trade balance through non-traditional exports have been affected by recessions in neighbouring countries in 2015 and 2016 – notably Brazil (-3.8% in 2015), Venezuela (-5.7%) and Ecuador (+0.2%). At the same time, global growth has been relatively sluggish, with expansion of trade flows in particular continuing to underperform relative to historic averages.

In 2015, while oil prices were collapsing, Cecilia Álvarez, former minister of trade and tourism, signalled in an interview with Reuters the authorities’ intention to double non-traditional exports to $30bn by 2018. While the exchange rate has been competitive since mid-2014, allowing manufacturing exports to become favourable, diversification has been rather slow to take hold. “There is a positive aspect to the oil shock Colombia has experienced in recent years: the economy is becoming less dependent on commodity exports, allowing room for industry and services to grow their share of the economy,” Juana Téllez, chief economist at investment bank BBVA Research, told OBG. “As well as being a text-book case of external economic adjustment, recent developments should foster a healthy recomposition of the structure of Colombia’s economy towards more balanced growth.”

For its part, Bancóldex, the national business development bank, is actively working with regional bodies and firms to spur diversification into sectors closely related to current production. “By harnessing big data, we now have a better picture than ever before of the extent to which the Colombian economy is diversified and, importantly, how firms, clusters, cities and regions can move up the value chain by finding the path of least resistance to the manufacture of more sophisticated products,” Claudia Patricia da Cunha Tcachman, manager of dynamic ecosystems at Bancóldex, told OBG.

Trade Balance

From a 2012 peak of $60bn, exports dipped moderately during 2013 and 2014, before falling by a third to $35.7bn in 2015, according to the National Statistics Bureau (Departamento Administrativo Nacional de Estadística, DANE). In 2016 exports dropped by 13%, totalling $31bn for the year as a whole, half of their 2012 level. At the same time, imports have continued to rise, reaching a peak of $61bn in 2014, turning a trade surplus of $4bn in 2012 into a trade deficit of $6.3bn by 2014. DANE figures show that though imports fell to $51.6bn in 2015, this decline was but not enough to offset the collapse in exports that year, leading the trade deficit to fall to $15.9bn in 2015. In 2016 imports totalled $42.9bn. Meanwhile, the recovery in commodity prices, combined with increased coffee production, should boost exports. These trends should contribute to a further narrowing of the trade deficit for 2017.

Current Account

These trade dynamics represented the biggest influence in the widening of the current account deficit, which peaked at 6.4% of GDP in 2015. The economic slowdown increasingly took its toll on imports during 2016, however, with some evidence of import substitution in sectors such as food, clothes and chemicals. At the same time, the price of oil and other commodities began to recover somewhat. This caused the current account to narrow at a faster rate than had been expected.

Figures from the central bank, Banco de la República de Colombia (BRC), show that in 2016 the deficit fell to 4.4% of GDP, and according to Ministry of Finance projections is expected to continue narrowing to around 3.5% in 2017. Continued vigilance will be required in this regard so as to further reduce the country’s exposure to external vulnerabilities, particularly as the US Federal Reserve continues to normalise its monetary policy, for example.

Foreign Exchange

Having ranged between $1:COP1700 and $1:COP1900 during the 2010-13 period, the Colombian peso depreciated by about 80% between mid-July 2014 and February 2016, according to the World Bank. It reached a low of more than $1:COP3400 in February 2016 before recovering to levels below $1:COP3000 in early 2017. Given that the currency has been essentially free-floating since the late 1990s, shifting terms of trade are the dominant drivers of fluctuations. Thus, the price of oil is closely correlated with the currency’s performance and explains the bulk of its price movements since 2014. While market participants do foresee possible bouts of volatility, there is a broad consensus that the exchange will be generally stable in 2017.

Inflation & Monetary Policy

Inflation surged from late 2014 onwards, peaking at 9% in July 2016. This was largely due to price increases on foreign goods – following pass-through from the depreciating exchange rate of the local currency – and the effects of El Niño weather phenomenon both in 2015 and 2016, which triggered a spike in food prices.

“Farmers expected a big impact from El Niño in 2015, so they planted fewer crops,” Munir Jalil, chief economist at Citibank, told OBG. “As it turned out, the worst El Niño impact didn’t hit until we saw a double-whammy on food supplies as a result of less planting the previous year on top of the bad weather of 2016. We don’t expect a repeat in 2017.”

While the VAT increase from 16% to 19% included in the tax reform will increase prices during the first half of 2017, the negative impact on consumption is expected to offset some inflationary pressure. As such, analysts expect inflation to continue its downward trajectory through 2017, but to remain just above the 4% level by year-end.

“If it were not for the increase in VAT, inflation would probably ease sufficiently during 2017 to come in below 4% by the end of the year,” Daniel Velandia, director and chief economist at Creditcorp Capital, told OBG. Should inflation continue on this trajectory, analysts expect that it will fall below 4% some time in 2018. The BRC has an inflation target of 3%, with a permitted range of between 2% and 4%.

To tackle inflation, the central bank hiked interest rates aggressively from late 2015 until mid-2016. The combination of tighter monetary policy, along with the fading impacts of currency devaluation and El Niño, had helped bring inflation down to 4.7% by April 2017. This has created space for the BRC to begin a monetary easing cycle, beginning with a 25-basis-point reduction in rates established at its December 2016 meeting. While rates were not further reduced at the January 2017 meeting, the first presided over by Juan José Echavarría, the new governor of the BRC, the easing cycle resumed with a further 25-basis-point cut to 7.25% in February. By April 2017 the nation’s key interest rate was at 6.5%.

As well as bringing down inflation, high interest rates also targeted credit growth and investment, with commercial lending actually contracting in real terms during 2016 (see Banking chapter). Although there are a wide variety of views regarding the likely pace of interest rate cuts during 2017 and 2018, they are largely expected to continue to fall. This will help boost credit growth, investment and economic growth more broadly. Analysts expect the BRC reference rate to finish 2017 below 6%, down from around 7.5% at the beginning of the year.

Despite significant exchange rate volatility in recent years, the fact that the currency is free floating, thus not requiring BRC intervention, means that foreign reserves have remained relatively stable. Reserves stood at $46.9bn in January 2017, up slightly since the end of 2014 when they totalled $46.7bn.

Private Debt

Having comprised some 37.3% of GDP in 1984 and 36.5% of GDP in 1997, credit as a share of the economy periodically contracted in the face of economic crisis. The most recent episode in the late 1990s saw credit dip to 21% of GDP in 2000, from which point it climbed steadily to reach 52.6% of GDP by 2014. Then, when economic slowdown triggered a minor contraction, it reached 47.1% of GDP in 2015, according to the World Bank. However, the combination of improved economic growth and reduced interest rates should spur lending again in 2017 and lead to a further deepening of the financial system over the medium term (see Banking chapter).

External Debt

As the Colombian economy has become more open to trade and investment in recent years, and since its current account deficit widened after the 2014 collapse in oil prices, its external debt growth has accelerated. World Bank data shows that external debt more than doubled from $46.7bn in 2008 to $111bn by 2015. Given that the government still faced relatively large external financing requirements during 2016, it is likely that this trend has continued. Exposure to external debt is considered to be one of the key risk factors by the rating agencies.

Foreign Investment

According to the Ministry of Finance, net foreign direct investment (FDI) is expected to have reached $13.6bn in 2016, up from $11.7bn in 2015. Part of the increase came from the $3.3bn sale of majority-state-owned power generator Isagén to a Canadian investor (see Capital Markets chapter). Net FDI inflows are expected to decline to $6.3bn in 2017, as the narrowing current account reduces the imperative to secure external financing. FDI inflows to the oil and gas sector are forecast to continue to decline to $1.7bn in 2017, after having dropped from $2.5bn in 2015 to $1.4bn in 2016. While total FDI inflows into all other economic sectors increased from $9.2bn in 2015 to $11.4bn in 2016, a third of this was accounted for by the Isagén sale. In 2017 gross FDI inflows outside of the oil and gas sector are expected to total $8.1bn.

Public Finances

Public finances were particularly hard hit by the collapse in oil prices, experiencing a 60% drop in oil revenues between 2013 and 2015. Eventually, the withholding tax on Ecopetrol had become negative, meaning the oil sector was by then costing the government money. To avoid fiscal deficit expansion, the government took evasive action in 2014, introducing a series of temporary tax measures. These focused largely on the corporate sector and triggered a sharp decline in investment.

Despite the increase in oil prices during 2016, it became clear by late in the year that the government would need to ready itself for an oil-price scenario where prices were lower for longer, and that comprehensive tax reform was needed.

Per the country’s fiscal rule, Colombia is committed to achieving a structural deficit – adjusted for the state of the economy – of 1% of GDP by 2022. Because the economy was weak during the 2014-16 period, the deficit was permitted to grow from 2.4% of GDP in 2014 to 3% in 2015 and an estimated 4% in 2016. However, with the economy expected to accelerate modestly in 2017, the fiscal deficit will need to contract to 3.3% of GDP to meet the requirements of the fiscal rule. This necessitates both revenue raising and control of spending growth for 2017.

Tax Reform

In December 2016 the government introduced reforma tributaria, a comprehensive tax reform that would permanently replace lost oil revenues while shifting the tax burden from businesses to households. To achieve this, the authorities immediately increased VAT from 16% to 19%, while scheduling reductions in the corporate tax rate from 43% in 2016 to 33% by 2019 (see analysis). It is expected that the tax reform would boost public coffers by $2bn in 2017. This should see tax revenues as a share of GDP edge up slightly, albeit from a relatively low base of 14.7% in 2014, according to the latest World Bank data. While the 2016 tax reform is expected to sufficiently replace lost oil revenues, it has been criticised in some quarters for not being ambitious enough. For example, during its passage through the legislature a controversial proposal to introduce a tax on sugary drinks was removed from the package.

“The 2016 tax reform was an important – and permanent – government initiative that will strengthen the public finances by replacing the significant amounts of oil revenues which have disappeared since 2014,” Citibank’s Jalil told OBG. “It is likely, however, that further revenue-raising reforms will be needed in the medium term to meet important policy objectives, notably including infrastructure and costs arising from the peace agreement.”

The tax reform is also expected to have positive effects on economic growth in the medium term, by switching taxation from direct to indirect sources, and from investment to consumption. Initiatives such as the monotributo (simplified, or single) tax are likely to help sustain the trend towards more small businesses entering the formal sector (see analysis), while the increase in VAT deductibility on capital goods from 2% to 19% is expected to spur investment. Though uncertainty over the prospects for tax reform weighed on investment during 2016, its passage removes this question for the medium term. This should further support the country’s investment environment in 2017.

Ratings

In the face of economic slowdown and mounting debt, Colombia has managed to hold onto its investment-grade rating. In early 2017 Colombia was rated at “BBB”, “BBB” and “Baa2” by S&P, Fitch and Moody’s, respectively. S&P was the only agency among these to give it a negative outlook. “Even with the country on a negative outlook, our baseline expectation is that the ratings agencies won’t downgrade Colombia during 2017,” Andrés Pardo, managing director and head of macroeconomic research at Corficolombiana, told OBG. “However, despite the boost the recent tax reform will give to the public finances, the relatively high level of debt and wide current account deficit mean that the country is more exposed than many to further external shocks.”

Labour Market

Despite the economic slowdown in recent years, the labour market has held up reasonably well, with unemployment continuing its steady decline from 11.3% at the end of 2009, to 8.4% at the end of 2013. It reached an all-time low of 7.3% in November 2015. Notwithstanding seasonal variations, the unemployment rate has, on average, remained relatively stable since. Analysts expect to see moderate increases in the average unemployment rate for 2017 overall. As typically happens in Colombia, the rate jumped in January 2017 to 11.7%, moderately below the rate for the same month in 2016.

Despite steady progress in recent years, close to two-thirds of Colombians are still employed in the informal sector. However, since the third quarter of 2011 the proportion of workers in the informal sector declined steadily from 71.5% to 64.3% by the fourth quarter of 2016. Progress has been even more impressive in major urban areas, where the informality rate fell from 58.1% in the first quarter of 2010 to 50.6% by mid-2016 and to 47.4% by January 2017.

Colombia’s minimum wage, often seen as a proxy for economy-wide wage trends, was increased by 7% for 2016, and by a further 7% for 2017 to reach $1.18 per hour. Reflecting the inflationary environment, however, this translated to real increases of only 1.5% for 2016 and an estimated 2.5% for 2017, assuming an inflation rate of 4.5% for the year.

Human Capital

Although education and skills levels among Colombians remain below those in the most advanced countries, there have been significant improvements in recent years. According to the OECD’s PISA Survey, which examined 52 education systems, Colombian students achieved the second-largest improvement in scores in science between 2006 and 2015. The survey determined that Colombian students’ reading levels were on a par with those in Mexico, lower than those in Chile and ahead of those in Brazil. Similarly, their scores in mathematics were comparable with Peru, ahead of Brazil, but lagging those in both Chile and Mexico.

National Development Plan

Every four years, in line with the presidential mandate, Colombia is legally obliged to promulgate a national development plan aimed at nationwide social and economic progress. It covers all sectors of the economy, including investment and spending targets, with infrastructure typically being a key component.

The National Development Plan 2014-18 rests on three core pillars: peace, equity and education. Although construction has not yet begun, one of the main infrastructure projects foreseen in the plan is a metro for Bogotá. Tackling rural poverty and inequalities between urban and rural areas are also a key focus. “Investing in infrastructure is absolutely critical to Colombia’s short- and long-term development,” Gabriela Piraquive, chief economist at the National Planning Department, told OBG. “Through the National Development Plans – as well as the latest road programme – the aim is to mobilise as much private investment as possible through public-private partnerships and other mechanisms. Given the nature of infrastructure investment, this is always challenging. The key is to find ways to boost the confidence of investors and to establish risk management mechanisms that facilitate the investment of private capital.”

Colombia Repunta

In February 2017 the government announced the launch of its Colombia Repunta stimulus plan, which aims to stimulate growth over the subsequent 18 months. In addition to including investments in infrastructure, housing, schools and post-conflict projects as well as support for productive sectors of the economy, the plan aims to add 1.3 points to GDP growth and create more than 750,000 new jobs in 2017. It also removed import duties from 3400 products, and as a result the private sector is expected to save $360m, which can be directed at investment and creation of jobs.

4g Road Plan

Announced in 2015, the fourth generation (4G) road concession plan envisaged some $24bn in financing in three waves over the course of eight years. In total more than 4000 km of new or improved roads are included in the plan. After a series of delays, the first 4G projects achieved financial closing in late 2015 and in 2016. A further dozen closings are anticipated in 2017. As construction activity picks up pace through 2017, it will likely be a strong driver of economic growth. By increasing connectivity and competitiveness, the new roads are also likely to boost the country’s long-term potential growth rate.

However, further delays and challenges in securing financing could cause some of the activity to be pushed back to 2018 or later. Governance and security issues are considered particular risk factors in this regard. The 4G plan is part of a broader $70bn transport infrastructure masterplan, which runs until 2035 and covers all modes of transport.

Outlook

Although growth has slowed as a result of the oil price shock, the Colombian economy has been resilient, partly due to reforms implemented by the government in the past few years. With major developments in the pipeline, a historical peace agreement renewing optimism, as well as the recovery of non-oil exports and oil prices, the economy is expected to pick up in 2017 and accelerate in the years to come.