Colombia's domestic and regional developments call for careful handling

As one of the larger economies in Latin America, Colombia has a track record of above-average GDP growth, a reputation for sound macroeconomic management and market-friendly policies. In 2015-16 it has demonstrated resilience, absorbing a significant oil price shock, with petroleum accounting for roughly half of total exports. It has managed to absorb this shock while maintaining positive, albeit slower, growth. Looking forward to 2016 and beyond, despite continuing global headwinds, a gradual recovery is expected, driven in part by a programme of transport infrastructure investment. A peace settlement ending a long-running internal armed conflict is also expected to yield a peace dividend in the form of lower security costs, the opening up of previously closed areas of the country to development, and higher economic growth.

Strong Fundamentals

In 2014 Colombia was the fourth-largest economy in the Latin America and Caribbean region, with a GDP of $377.7bn, in current US dollars and a population of 47.8m, according to data from the World Bank. Colombia also accounted for 6.1% of total regional GDP, behind Brazil (37.9%), Mexico (20.9%) and Argentina (8.7%), but ahead of Chile (4.2%) and Peru (3.3%). However, this ranking may underrepresent Colombia’s true regional importance, because of the exchange rate and other distorting factors. A 2014 ranking based on purchasing power parity compiled by the World Bank suggested that Colombia was the third-largest economy, with this ranking placing it ahead of Venezuela, while Argentina was not ranked due to a lack of reliable data.

Colombia is a strategically significant economy in several ways. It is the fifth-largest country in the region by surface area and the third by population. It has both an Atlantic and Pacific coast, and a diverse territory that includes both parts of the Amazon rainforest and the Andes mountain range. Along with Chile, Peru and Mexico, Colombia is a member of the Pacific Alliance, a group of outward-looking Latin American countries that favour free trade and seek to attract foreign investment. Colombia is also rich in natural resources, including oil and gas, rare metals, coal, emeralds and gold. It has significant current and potential future agricultural production, including traditional exports such as coffee. In October 2015 The Economist highlighted the importance of the as of yet undeveloped Llanos Orientales, or Eastern Highlands, which are said to have an agro-industrial potential comparable to Brazil’s Cerrado region for soya and other crops such as palm oil.

However, less positively, like a number of Andean countries, Colombia has played an important role in the illicit processing of coca into cocaine for supply to the US and Europe. Poor logistics pose a particularly important challenge. With a series of north-south mountain ranges and valleys, the country’s main cities and economic hubs have traditionally been poorly connected to each other and to key export ports. Additionally, in some parts of the country rebel groups have posed a security threat to transport, particularly roads and oil pipelines. In 2014 the Colombian Chamber of Infrastructure reported that the cost of shipping a container from the capital, Bogotá, to Cartagena’s port, which is 1000 km overland, is three times as much the cost of shipping the same container from Cartagena to Shanghai – a journey of nearly 10,000 km by sea. The government has been addressing this critical issue with a major transport infrastructure programme which, it is hoped, will reduce logistics costs and increase export competitiveness. According to Juan Gabriel Pérez, executive director of Invest in Bogotá, “Logistics and mobility are probably the issues of utmost importance for the competitiveness of Bogotá. Therefore, we are undertaking an ambitious logistics plan in cooperation with public and private entities from the capital.”

Economics Of Peace

A major political development due in 2016 was the signing of a peace settlement between the government and one of Colombia’s two main rebel groups, the Revolutionary Armed Forces of Colombia (Fuerzas Armadas Revolucionarias de Colombia, FARC). Both sides have committed to signing an agreement by March 23, 2016. The economic implications of a peace deal, which could bring Colombia closer to ending half a century of internal conflict, are both important and hard to predict with any degree of precision. On the whole, peace is seen as positive for the economy, with talk of a peace dividend materialising in the shape of a faster long-term economic growth rate. Important areas of the country, such as the Llanos Orientales, could be opened up for development. The Altillanuras, or High Plains, have at least 10m ha that could be used for commercial farming, doubling Colombia’s cultivated area. Alfredo Bula, CEO of Fonade, told OBG, “At the moment there is limited government presence in rural areas and remote municipalities. In the coming years increasing government services in these areas is an absolute priority, as these are the regions which need the greatest levels of support.”

But there are also downsides, with concerns that the process of reincorporating former guerrillas into society could be complex and costly, and that some demobilised combatants may join criminal gangs and heighten security risks. More widely, there was a degree of uncertainty over how the extra costs of a peace settlement – including victim reparations, land distribution and resettlement, and increased social programmes – were to be met. According to a study by the state’s economic planning department, ending the decades-long conflict that has killed 220,000 people and displaced millions could lift Colombia’s long-term potential economic growth rate from the current 4% to 5.9%. The study also suggested that annual inward-bound foreign direct investment (FDI) could triple from the current $12bn to $36bn as a result of a peace deal. Carlos Iván Villegas Giraldo, president of public investment firm Central de Inversiones, told OBG, “The nation’s economic performance in recent years, alongside the improvements achieved in peace and security, make Colombia a very attractive market for investment.”

Many other positive impacts have been mentioned in regards to the Colombian economy, including the growth of inward tourism as an important motor of development and foreign exchange earnings. A peace deal will allow greater investment in transport infrastructure and better logistics connections between regions, as well as between Colombia and international trade routes.

Fiscal Challenges

There are concerns regarding the short- and medium-term impacts of the peace process. It is widely believed that in order to honour commitments on reparations to victims of the conflict and to tackle the deep social inequalities that were part of it (see analysis) the government will have to increase both its overall tax and expenditure levels as a proportion of GDP. A January 2015 OECD study suggested that the peace settlement will require additional expenditures equivalent to 1% of GDP in the period from 2015 to 2018, especially in the agricultural sector. The debate is not so much about whether that should be done, but how.

Some in the private sector feel they have been overburdened by high tax rates, and therefore view plans for fiscal reform with a degree of apprehension. Eduardo Soto Ferrero, president of local consultancy Invercor, told OBG, “The peace process is looking irreversible. Foreigners are perhaps more optimistic about its consequences than we Colombians. Our concern is that we do not yet know what the overall bill will be in terms of public spending, and in the current global circumstances it would not be wise for the government to boost its debt.”

The levels of violence in the country have already fallen significantly. In fact they decreased most sharply around 2002/03, allowing an improvement in growth and investment levels. So in some ways the peace dividend is already tangible. Nonetheless, as part of consolidating peace the government will need to increase spending in areas such as health care, public works and education.

Strong Management

In the past 10 years Colombia has consistently out-performed many of its Latin American peers in terms of GDP growth. In the decade to 2014 Colombian growth averaged 4.3% per annum compared to 3.6% for Latin America and the Caribbean as a whole. As the commodities super-cycle has come to an end, both Colombian and regional growth has slowed. However, the Colombian economy has shown significantly greater resilience in the face of this global headwind. In 2014 Colombia’s economy grew by 4.6%, a reduction from the 4.9% registered the preceding year. The region as a whole, meanwhile, experienced a sharper deceleration, with growth in 2014 at 1.4%, down from 2.7% in 2013.

In October 2015 Bogotá-based daily Dinero reported that third-quarter government data showed GDP growth at 3%, which is higher than expected and better than most other countries in Latin America and on par with the US and Spain. In late 2015 the Economic Commission for Latin America and the Caribbean updated its regional growth forecast to expect a contraction of 0.4% in 2015 and a slight uptick of 0.2% in 2016. However, while Latin America as a whole is forecast to experience standstill growth, Colombia is set to remain in positive territory and see high growth, a reflection of its status as a growing player in the region.

IMF Approval

In June 2015 the IMF completed its Article IV consultation process with the Colombian authorities and issued a press release, which praised the country’s “sound macroeconomic policy management” that underpinned robust economic performance over the preceding decade. It noted that GDP grew by 4.6% in 2014, while unemployment stood at 9%. The fall in international oil prices in late 2014 caused the peso to depreciate against the US dollar. In 2014 the current account deficit (CAD) widened to 5.2% of GDP, but this was offset by inflows of portfolio investment and FDI. The consolidated public sector deficit had also increased to 1.6% of GDP in 2014, pushing public sector debt to around 39% of GDP. At that point the IMF was expecting GDP growth to slow to 3.4% in 2015, “given a subdued outlook for investment, especially oil-related, and private consumption”.

Inflation, which was running at 4.6% in March 2015, was expected to diminish to 3.6% year-on-year (y-o-y) by December of the same year. The IMF said it expected the growth rate to rise back towards the long-term trend rate of 4.25% over the medium term, but warned of downside risks such as higher interest rates, financial volatility and lower global growth. While the IMF’s broad and positive assessment of the Colombian economy did not change fundamentally, as the year progressed and some of the risks materialised, it adjusted down its forecasts for growth and inflation. The IMF World Economic Outlook, prepared in October 2015, revised its estimates for 2015 GDP growth down to 2.5%, with inflation expected to remain above the government’s 2-4% target band, at 4.4%. For 2016 the IMF predicted a modest acceleration in the growth rate to 2.8%, with inflation coming back down into the target band at 3.5%.

Third Quarter

In December 2015 Mauricio Cárdenas, the minister of finance and public credit, told Caracol Radio that he expected the final GDP growth rate for that year to be 3.2%, marginally down on the official 3.3% forecast. The minister’s calculations were based on third-quarter data that showed slightly above-expectations GDP growth of 3.2% during that period. In addition he said he was estimating fourth quarter growth of 3.4-3.5%. “It’s a good result and demonstrates the economy has resistance and has been able to handle the fall in oil prices,” Cárdenas said. Inflation, however, continued to be significantly above the government’s 2-4% target band, and the IMF’s earlier predictions, at 6.39% in November 2015, reflecting the impact of peso depreciation and El Niño weather patterns on agriculture and food prices.

According to third quarter data from London-based economic research firm Capital Economics, y-o-y growth was led by the retail sector (4.8%), agriculture (4.5%) and financial services (4.3%). Manufacturing grew by 2.5%, while mining, which includes oil and gas production, contracted by 1.1%. Construction was subdued with growth of 0.8%. GDP growth in the first nine months of the year totalled 3%, lower than the 4.9% rate achieved in the first nine months of 2014. The Economist Intelligence Unit reported that unemployment increased slightly in 2015, rising from 7.9% in October 2014 to 8.2% in the same month a year later.

Peso Down, Interest Rate Up

A key economic policy decision made by the government in 2015 was to absorb a large part of the terms of trade shock through the exchange rate. In effect, the Colombian peso was allowed to depreciate against the US dollar, and the central bank, Banco de la República de Colombia (BCR), held back from large-scale interventions to support the currency. In 2015 the peso depreciated by 25% against the dollar, with the value rising from $1:COP2400 at the beginning of the year to $1:COP3174 by year-end.

The economic authorities appear to have been motivated by two considerations. The first was that peso depreciation would initiate a necessary rebalancing and adjustment process, helping to narrow the wide CAD as imports became more expensive and non-traditional exports became more competitive. The second was that depreciation would allow Colombia to conserve its safety buffer in the form of foreign currency reserves. The process had a cost, however, as it elevated the risk of a pass-through effect raising the domestic inflation rate, as well as increasing financial volatility, which could add to investor nervousness and uncertainty.

The rising inflation rate was attributed to an inflationary pass-through effect from peso depreciation, which was particularly acute in products with a large proportion of imported components, like motor vehicles, coupled with higher food prices, due to El Niño-related drought, and increases in controlled public utility tariffs. Faced with rising inflation, which would later rise to 6.39% by November of that year, the BCR raised its reference interest rate by 25 basis points in September to 4.75%, followed by hikes of 50 basis points (to 5.25%) in late October and of another 25 basis points (to 5.5%) in late November.

After the long-awaited rise in US prime interest rates in December 2015, further pressure was expected to be placed on the peso, and analysts awaited a further tightening of Colombian interest rates. An outstanding issue for 2016 is whether monetary tightening will reach a level at which it might threaten the strength of economic recovery. Jose Dario Uribe, governor of the BCR, is focused on trying to tread a middle path. Commenting on the November 2015 interest rate hike, he said, “Faced with the temporary shocks, an attempt to bring inflation back to the target quickly would produce excessive changes in interest rates and a high cost in terms of employment and economic activity. An excessively slow response would also have costs.”

Household Spending

Consumption accounted for 79.9% of Colombia’s GDP in 2014, and was dominated by household consumption (61.2% of GDP), which plays a major role in determining the country’s growth rate. Consumption’s share of GDP has fallen a little in recent years as fixed investment has grown in importance from 18.8% in 2004 to 25.5% in 2014. Exports have held relatively steady as a proportion of GDP, while imports have expanded modestly. In 2014 imports represented 21.5% of GDP and exports accounted for 16%, meaning that net exports were down 5.5%, acting as a drag on the overall growth rate. Future growth will be sensitive to household spending, which is expected to moderate as consumer confidence continues to be affected by the oil price shock and as companies seek to rein in the pace of wage increases, which have been higher than productivity gains. However, in the medium to long term the outlook for household spending is positive, driven by population growth, the expansion of the middle class and the expected peace settlement with the FARC.

Government consumption accounted for 18.3% of GDP in 2014, and is expected to grow modestly in 2016. Although there are strict limits on the structural fiscal deficit, which must be progressively reduced, Colombia’s medium-term fiscal framework – also known as the fiscal rule – allows for the overall deficit to be expanded during “negative cycles” in the economy (see analysis). Impetus for growth will also come from gross fixed capital formation, in particular the public-private partnership (PPP) road-building programme.

4G Road Programme

The fourth generation (4G) road concession programme is playing a critical role. This PPP-based programme has been valued at around $25bn and by boosting the construction sector is expected to add 0.4 percentage points to GDP growth between 2015 and 2022. The first 4G road concessions were awarded in 2015, and work is set to start in 2016. However, the total investment curve is expected to be “bell shaped”, with the biggest spending coming in the middle years of its lifetime. Its contribution in 2016 could represent between 0.2 and 0.3 percentage point of GDP. “Despite some difficulties, we believe in the significance of 4G projects for the country, and in their contribution to improved competitiveness and improved connectivity,” Nuno Figueiredo, general manager of Moto-Englil Colombia, told OBG.

The Economist Intelligence Unit reported in December 2015 that another stimulus for the construction sector will come from a government employment and productivity programme known as the Stimulus Plan for Production and Employment II (Plan de Impulso a la Producción y el Empleo II, PIPE II), which seeks to build new classrooms and offer preferential mortgage interest rates for residential units and other projects. PIPE II is estimated at a total cost of $6.2bn for the 2014-18 period.

Oil & Gas

The oil and gas sector, hard hit by the slump in international oil prices in 2014 and 2015, may begin a modest recovery in 2016. Oil prices are expected to begin bottoming out and Colombian production may recover slightly. There will also be a significant positive impact from the completion of expansion and modernisation work at the Refinería de Cartagena (REFICAR). Production at the refinery was sharply reduced in March 2014, and it began a phased return to full operations in late 2015. Refining is one of Colombia’s most significant industrial sub-sectors, responsible for 19% of manufacturing output and 2% of GDP.

According to estimates by BBVA Research, REFICAR’s resumption of full operations will make a 0.7 percentage point contribution to GDP growth in 2016. However, with that downstream exception and given the depth of the recent hydrocarbons slump, investment in upstream oil and gas will at best be modest over the next few years.

Trade Balance

The oil shock had an immediate effect on the balance of trade. Colombia had been registering a balance of trade surplus, but in late 2014 it moved sharply into deficit, where it stayed throughout 2015. A gradual narrowing of the trade deficit is expected in 2016 as oil exports may begin a modest recovery and as the effects of currency depreciation eventually begin to have an impact on other, non-traditional exports. According to the National Administrative Department of Statistics, exports were down by some 35% y-o-y in the first 10 months of the year to hit $30.7bn. The biggest cause of this decline was lower oil export revenues. As a result of lower international prices (which were down by around 45% in the year to October 2015) and lower Colombian production (down by 3% in the first 10 months of 2015), total Colombian oil sales contracted by 51% in the period from January to October 2015, relative to the same period a year earlier. Worryingly, the hoped-for recovery in non-traditional exports on the back of a more competitive exchange rate was not yet making itself felt. Excluding emeralds and gold, non-traditional exports fell by 10% in value in the first 10 months of 2015, with sharp falls in exports of flowers, fruit, milling products, chemicals, plastics and vehicles.

Some analysts have been particularly concerned about the size of the CAD. Capital Economics has estimated that Colombia’s CAD will be around 6% of GDP in 2015, a level which it has described as “unsustainable”, suggesting that adjustment will be necessary through further reductions in domestic demand. In December 2015 Cárdenas said he was estimating the CAD at around 6.2% of GDP or $18bn, which he too described as unsustainable.

Outlook

According to Juan Camilo Domínguez, an associate partner at the Credicorp financial group, in 2015 Colombia was undergoing a necessary process of macroeconomic adjustment, following the oil price drop. “As in Mexico, the importance of Colombia’s oil sector as a proportion of GDP or as a source of employment is limited, but it does play a critical role as a source of fiscal revenues for the government. The public sector’s total spending represents around 30% of GDP and is an important engine for economic growth,” said Domínguez. In his view, subject to oil price movements, the Colombian economy should continue decelerating until mid-2016, when it should begin to recover. Credicorp expected GDP growth of 2.5% in 2016, rising to 3.5% in 2017. “The big risk I see is the CAD, which has now widened to around 6% of GDP, reflecting worsening terms of trade. An adjustment in demand is necessary. The peso depreciation is going to be helpful here, reducing imports and creating conditions for an improvement in exports,” he told OBG. From a growth perspective, the large 4G road building programme will act as a counter-cyclical stimulus and support the growth rate.