Despite struggles, capital markets in Colombia have many bright spots

With a total market capitalisation of $93.49bn in September 2015, the Bolsa de Valores de Colombia (BVC) is the fourth-largest stock exchange in Latin America, behind those of Brazil, Mexico and Chile but ahead of Peru’s. Since the end of the commodities boom, which lasted from 2001 to 2012, Latin American stock exchanges have gone through a difficult period, marked by more or less severe declines in share prices and by reductions in liquidity and overall trading volumes. During the course of 2015 investor nervousness over emerging markets, coupled with rising US interest rates in December, prompted a flight to quality, especially US high-quality bonds and dollars. Despite the good shape of Colombia’s economic fundamentals, especially compared to other Latin American countries, the BVC has not been immune to these trends. Trading volumes and market capitalisation have fallen in recent years. The Colcap, a Colombian capitalisation index, last grew in 2012, when it rose by 16.6% to reach 1833 by year-end. The index then fell by 12.4% in 2013 and by 5.8% in 2014, closing at 1513. During 2015, it fell another 29%, closing at 1154.

Looking For The Bottom

The sharp fall in oil prices that began in mid-2014 was a cricital factor pushing down the Colcap in 2015. With oil making up over half Colombia’s exports, lower prices triggered a bear market in stocks and bonds, as well as a sharp depreciation in the Colombian peso. The broader economy also slowed, with GDP growth declining from 4.5% in 2014 to an estimated 3.1% in 2015, according to state projections. The peso’s fall in 2015 discouraged foreign investors from participating in the BVC by reducing the dollar value of local shares and dividends. One investment vehicle affected by the bearish climate, for example, was the Global X MSCI Colombia Exchange Traded Fund, a basket of 29 shares weighted to Ecopetrol and Bancolombia.

Ups & Downs

By industry sectors, energy shares were most affected during 2015. Three energy stocks form part of the Colcap index: Ecopetrol, Canacol Energy and Pacific E&P. Together they now have a weighting of 7.2% of the index, and have suffered steep dips in step with lower oil prices. In the view of some analysts, something of a bubble had occurred in energy shares which had become overvalued before the oil price crash, making the subsequent correction more abrupt than otherwise would have been the case. The example often given is Pacific Rubiales (later renamed Pacific E&P), a company originally set up in Colombia by Venezuelan émigrés that was initially extremely successful. At the peak of the oil boom, in 2011, Pacific E&P’s share price touched COP55,000, worth about $30.13 at the time, but by late 2015 the shares of the company, burdened by comparatively high debt and low prices, had slumped by 85% to trade at around COP8000 ($2.94).

While they followed something of a boom-bust cycle on the BVC, Ecopetrol’s share prices are now seen as limited on the downside, because the firm is not a purely upstream player – 38% of its total revenue as of late 2015 comes from refining operations, where the margins have not been squeezed as tightly as they have in crude oil production. Ecopetrol has also opened a new refinery, Reficar, which will allow it to increase its exports of oil derivatives and stop importing petrol and nafta, improving its bottom line.

Compared to the downward pressure on energy stocks, construction and real estate shares have fared better, reflecting the importance of the government’s large fourth-generation road-building programme, which was gathering pace in late 2015 and is expected to involve investments of as much as COP50bn ($18.4m) over the next seven years. Financial sector shares also fell less than those in other sectors; despite slower economic growth, bank lending and profits remained healthy and the proportion of non-performing loans stayed low. Banks and financial firms today comprise nearly half of the Colcap index.

Although in September 2015 US ratings agency Standard & Poor’s had downgraded its outlook for the Colombian financial sector from “stable” to “negative”, many analysts took the view that the sector would remain strong. They also said many Colombian banks now have a significant presence in Central America, which has been growing more strongly than South America, giving them additional resilience.

Year-End Drop

Towards the end of 2015 analysts were asked to determine whether the Colcap index was bottoming out. In late November the Colcap reached 1070, the lowest level seen since 2009, representing a year-to-date decline of 26.5%. Analysts like Luis Díaz, of the brokerage Acciones y Valores, expected that developments in December could determine the index’s prospective trend over the first few months of 2016. Of particular importance were the outcome of the December OPEC meeting (likely to set the scene for oil prices) and the interest rate decision due to be taken in the same month by the US Federal Reserve. It was thought that both these developments might lead to a further weakening of the index, but as of February 2016, the Colcap had seen a late December 2015 bottom of 1051 and was up at 1173, after a volatile January.

Another analyst, Omar Suárez of the broker Alianza Valores, told OBG, “The Colcap index will be affected by any further drops in oil prices, the normalisation of interest rates expected from the US Fed, and the impact of both these things on the slowing Colombian economy. We have also seen the slowdown having some impact on the latest financial results from Bancolombia. We may see the market reach its floor level in December or the first quarter of 2016.”

Other analysts added that the disruptive effects of the El Niño weather phenomenon – particularly its impact on the results of hydroelectric generators such as Isagen (affected by drought) – could weigh on the stock market on the short term. However, as is often the case for investors, the combination of fairly short-term negative factors with more positive sentiment about medium to longer-term trends is seen as an important buying opportunity. José David López, an analyst at the brokerage Valoralta, told OBG, “We are at the lowest levels seen since 2009 and that is a good moment to take positions in the market, because these are the price levels at which we can expect to see the beginnings of a recovery.”

BVC Structure & Regulation

The BVC is a relatively young institution, but share trading has a long history in Colombia. As far back as the 16th century a number of Colombian companies issued shares. These were mining and agricultural enterprises functioning under the Spanish colonial system, which issued shares to raise working capital – there was no formal exchange as such. In the late 19th and early 20th century the first signs of industrialisation and the growth of coffee production increased the need for capital. Responding to this need, in 1928 a group of local firms, including Banco de Colombia, Nacional de Chocolates and Banco de Bogotá invested to create the Bolsa de Bogotá stock exchange. Other city exchanges followed. The current BVC was formed in 2001 as a result of a merger of the Bolsa de Bogotá, the Bolsa de Medellín and the Bolsa de Occidente.

The BVC is a commercial company regulated by the Ministry of Finance and Public Credit and supervised by the Financial Superintendence of Colombia ( Superintendencia Financiera de Colombia, SFC). The SFC’s mission is “to preserve public confidence in and stability of the financial system, to maintain the integrity, efficiency, and transparency of the securities market and other financial assets, and to ensure respect for the rights of the consumers of financial and other services”. Four main types of securities are traded: shares (variable income), bonds (fixed income), financial and energy derivatives, and regional shares listed in Chile, Peru, and Mexico which, along with Colombia, are members of the Latin American Integrated Market (Mercado Integrado Latino Americano, MILA).

Technology Diversification

In April 2015, the BVC acquired a 51% stake in Sophos Banking, a technology services firms set up in Colombia by Indian investors. Sophos – which has agreements with a range of global software providers including Infosys, Oracle and Wipro – specialises in systems for banking, finance and stock markets. BVC president Juan Pablo Córdoba said the aim was to have a presence in the Latin American financial technology and services sector, thereby diversifying revenue streams and increasing shareholder value. He added that it made the BVC the first Latin American stock exchange to have incorporated “a specialised portfolio in technology services” as part of its long-term strategy.

Market Reforms

BVC authorities have been calling for government action to reinvigorate Colombia’s capital markets. At the annual congress of the Stockbrokers Association of Colombia, Córdoba called for two reforms: changes to the tax system and changes to the pensions system. In the absence of these reforms, he said the stock exchange was suffering from volatility, low liquidity and reduced margins.

On taxation, he said there is currently an excessive burden on companies operating in the formal sector of the economy. Córdoba called for the government to widen the tax base, increase the efficiency of tax collection and reduce the levels of taxes on companies, steps that would improve the credibility of the government’s approach to public sector funding. “We are all clear that with its current tax system, Colombia will never be competitive,” he said. “To delay tax reform is to postpone solving this problem and to subject the economy to more pain than is necessary.” Pension reform, on the other hand, was described by Córdoba as essential to correct an underlying deficit in pension provision that was generating long-term pressure on the fiscal accounts. Correcting this imbalance would send a positive signal to investors.

Technical Changes

On a more technical front, the BVC is suggesting a number of changes to streamline private debt markets. A working group has been formed with the BVC, the finance ministry and private sector representatives called Visionarios de Deuda Privada (Private Debt Visionaries), which has been discussing a number of potential changes designed to improve liquidity. One modification suggested by the BVC is that instead of using a single discount rate to calculate the liquidity risk of different private debt instruments, different rates should be used, based on volumes and tenors of the papers and other factors. Other technical changes would allow brokers to operate with slightly higher debt ratios. A further suggestion is for the creation of private debt indices or reference rates, which would act as benchmarks to assess performance. The result of such moves would be to deepen and improve the market in private debt with sub-”AA” credit ratings, BVC officials said.

A separate working group, called Visionarios de Renta Variable (Variable Income Visionaries), are recommending steps to improve market liquidity and boost overall trading volumes. These include greater frequency of buy/sell auctions for the less-frequently traded shares, widening the number of price-forming transactions and introducing new regulations to facilitate short selling. By September 2015, buy/ sell auctions for some less liquid shares, which had been restricted to a one-hour period per day, were extended to the full trading day. BVC sources said the initial response had been positive, with some evidence of a consequent increase in trading volumes.

The second change – increasing the number of transactions that are price forming – remained under discussion, as it required SFC approval. Brokers said that at present only around 45% of the total number of transactions in specific shares are used to calculate the official price, and the aim was to increase this. While these reforms were seen as encouraging, analysts said they were unlikely to be enough on their own to revert the trend towards lower liquidity, described as the “drying out” of the market caused by the drop in oil stocks and lower levels of activity by small investors and the pension funds.

No New Offerings

In the context of slower economic growth, corporate interest in launching new IPOs has waned. There were no significant IPOs in 2015, with plans for one by cement and energy conglomerate Grupo Argos being shelved. Bancolombia and Grupo Aval launched the last major IPOs in 2014. Future IPOs include coffee retailer Juan Valdez, which announced it will go public by 2018. According to a report by law firm Baker & McKenzie and consultancy Oxford Economics, merger and acquisition (M&A) activity in Colombia was depressed in 2014-15, but was likely to pick up again in 2016. Written in mid-2015, the report said the number of Colombia-based M&A deals would drop by 29% to 48 in 2015, and their value would be down by 8.7% to $2.4bn, relative to the preceding year. It predicted that there would be a recovery in both the number of deals and their value in 2016, with total M&A activity to exceed $3.4bn. The report said the “completely flat” 2014-15 IPO market would also start a recovery in 2016, and reach over $250m a year by 2018. It said the recovery in M&A activity and IPOs would be driven by a rising global economy, with the US doing particularly well.

At M&A consultancy Invercor, president Eduardo Soto Ferrero told OBG that he was “a little pessimistic” on the immediate outlook for Colombian M&A activity. The combination of low oil prices, uncertainty over tax reform and the weakness of the Colombian peso had, in his opinion, created something of a hiatus. On the whole, he noted, foreign investors tended to be more optimistic than Colombians over the economic implications of a peace settlement with rebel groups. Soto Ferrero’s view was that the process looked promising, but there were questions over what the settlement might mean in terms of public spending and how that would affect tax and debt levels.

Invercor vice-president, Jorge Soto Pareja, noted that various developments might stimulate investor interest in Colombia. One was if the government decided to move ahead with the proposed sale of its 57.6% stake in power generator Isagen, and use the proceeds to help fund its ambitious road-building programme. The sale, initally thought capable of bringing in COP5trn ($1.8bn), was completed in January 2016 for COP6.5trn ($2.4bn), with a consortium led by Canadian firm Brookfield Renewable Energy as buyer. The sale had overcome opposition in Congress, where some senators tabled a bill to require congressional approval for such divestments. Soto Pareja believed that successful Isagen privatisation, along with progress in the road-building scheme, would help stimulate investor interest in 2016.

There was also an upside to the depreciation of the peso. It made Colombian assets relatively cheaper to acquire for incoming investors and also boosted the competitiveness of certain non-oil exports, such as the sale of flowers to the US market. The combination of depressed oil prices and a peace settlement might also trigger other types of diversification such as a major and positive re-assessment of the country’s eastern region. “In agriculture the thing to watch is what we call the East Plains – the llanos orientales,” Soto Pareja told OBG. “There is fertile and available land there. Generally speaking there is agricultural and agro-industrial potential for investors in a range of activities, including timber, rubber and palm oil.” He also noted that some of Colombia’s conglomerates have already begun to invest there.

Tax Burden

The corporate sector in general – and capital markets in particular – stress the importance of tax reform. Colombia has traditionally had a relatively low tax revenue as a proportion of GDP, not more than 20%, compared to an OECD average of 35%. Many analysts recognise that because of this and because of rising demands on public spending, tax revenues as a proportion of GDP need to increase, but there is a concern that the current burden on the corporate sector is too high. The OECD has stated that despite a strong fiscal position, “the tax system does not promote efficiency and fairness as much as it could, and tax evasion is pervasive. Formal sector companies face a high and complex tax burden, and only few individuals pay income or wealth taxes.”

“In Colombia, companies are taxed much more heavily than individuals. There is a need to simplify the tax code and shift the burden back a little bit, taking it off the companies and back onto individuals,” Juan Camilo Domínguez, a senior associate at Credicorp Colombia, told OBG. Domínguez noted that while the corporate income tax was 34% back in 2014, a series of subsequent temporary surtaxes had taken the real effective rate up to 39%, with further increases due to raise it to 43% in 2018, falling back down to 34% by 2019. The danger is that this relatively high taxation rate may have a negative effect on investor sentiment. On a more positive note, Domínguez also highlighted a decrease of the equity tax (1.15% in 2015 for large companies, due to fall gradually to 0.4% in 2017 and to disappear from 2018 onwards. This tax was of some concern, as it was levied independently of whether a company made a profit or a loss. Additionally, further uncertainty over future tax reforms in 2016 might persuade some investors to hold back.

Outlook

Despite these concerns, Colombia’s capital market is positioning itself for a recovery, based on two key positive factors. One of these is the expected peace settlement due to be reached in 2016. President Juan Manuel Santos Calderón has said, “The impact on economic growth is going to be very positive” – he estimates a signed peace agreement could ultimately boost GDP by 1.5 percentage points a year. Edward Glossop, an emerging markets analyst at Capital Economics, told OBG that, “financial markets will undoubtedly rally”, although he was more conservative about the short-term impact on growth, estimating it at half a percentage point. The second reason to expect a stock market rally is that Colombia’s fundamentals are positive and profits can be expected to improve as short-term obstacles – like the worst commodity price slump in years – begin to recede in 2016.