Colombia Walks a Tightrope

Summary

• Colombia’s fiscal vulnerability stems from its low savings rate, which restrains investment, and hinders competitiveness.
• Months of societal chaos, including nationwide strikes, protests, and blockades, have led the government to significantly rollback necessary fiscal consolidation. This will come at a price.
• Further public sector dissaving will crowd out investment, and ultimately force the hand of the monetary authorities. Interest rates are set to rise.

Market Implications

• Colombia will likely join other EM central banks in hiking rates.
• Investors should avoid/underweight Colombian bonds.
• The currency is vulnerable to further weakness.

Colombian policymakers are trapped or, at the very least, have an incredibly small margin for further error. The Covid-19 pandemic continues to batter the Andean nation’s healthcare system, while rolling lockdowns have weighed heavily on economic activity and, importantly, decimated the fiscal accounts (Chart 1).

A necessary yet exceptionally poorly handled tax-reform proposal to shore up the public finances has been scrapped, all the while unleashing ongoing societal chaos. However, a failure to control deteriorating public debt dynamics will undermine investor confidence in Colombian assets.

Moreover, the real (inflation-adjusted) policy rate is currently negative and simply too low to compensate investors for risk. Unsurprisingly, markets are already beginning to front-run the central bank.

Lower growth/higher interest rates will be the price to pay to balance the large public sector’s dissaving and protect the currency amid the political volatility.

Colombia’s Original Sin: A Low Savings Rate

Colombia’s main macro imbalance is its extremely low overall savings rate. At a mere 15% of GDP, national savings are insufficient to finance investment spending amounting to a meagre 19% of GDP (Chart 2). Not only has the Andean nation’s savings rate been low, but it has been falling steadily since 2008.

Low capital expenditures limit a nation’s productive capacity, resulting in lower national income, less available savings, and, ultimately, restraining the country’s growth potential.

Absent a larger national savings pool and persistent public dissaving, a depreciated currency and/or higher interest rates have served as the main mechanisms to constrain private sector capital expenditure.

Explosive Public Debt, Manageable…For Now

Colombia’s public debt dynamics are worrying. A decade’s worth of fiscal deficits coupled with heavy pandemic-related spending has led to the public sector’s gross debt doubling. It is estimated to end the year at 64% of GDP (Chart 3).

Although public debt levels are not yet extreme, domestic borrowing costs are much higher than both nominal GDP growth and contracting nominal government revenue growth, with the five-year local currency bond yielding 6.2%. All else equal, this means the debt-to-GDP ratio will jump much higher unless growth (and revenue) sustainably booms, soon.

Colombia’s public debt metrics require a credible exit plan of some sort. Without one, public debt levels will get out of hand, fast. If the politics will not support or facilitate it, financial markets will force the adjustment.

Soaring Political Risk, Amid Pandemic and Structural Income Shock

When Colombian President Iván Duque tabled a structural tax reform package to shore up the nation’s ailing fiscal accounts in mid-April, the political chaos unleashed by the resistance to the reforms was unthinkable.

The reform attempt has sparked a socio-political fuse leading to the most widespread wave of protests, urban conflict, mass strikes, and national outrage in the nation’s recent history.

Seeking to appease protestors and dampen the societal chaos, Duque withdrew the fiscal reform, the finance minister resigned, and a national dialogue has begun to take form, though protests continue.

Despite all this, it is important to step back and view the current mass protests and social chaos in Colombia through a wider lens. Similar chaotic protests have occurred in the region in recent years – in Chile, Peru, and Ecuador for instance.

Two meta trends are playing out in Colombia, the region, and other EM countries.

(1) Middle-class politics:
The unprecedented rise of the middle class over the past decade in Colombia, Latin America, and EM more broadly (Chart 4) has come with major political implications. Middle classes demand policies that favour them, irrespective of whether these policies are good for growth and/or stability.^[1] Rather than simply asking for wealth transfers, middle classes want governance reforms (i.e., less corruption, better healthcare, etc.), and these involve investment and fiscal outlays, regardless of the fiscal accounts.^[2]

(2) Inequality exacerbates economic shocks:
Colombia, and Latin America particularly, have world-leading rates of inequality coupled with extremely low social mobility. When large negative income shocks hit these societies – such as with Covid now or the commodities/oil complex bust from 2014, or both – political tensions rise rapidly.
What is happening in Colombia, and the region, should be unsurprising and will not wash away with marginally higher commodity prices.

Adjustment Paths and Investment Recommendations

The government’s new finance minister is currently undertaking a roadshow with numerous stakeholders and suggesting they will table a new version of the fiscal reform during the next legislative session, which begins in late July.

Details are still quite murky, but it appears the Duque government will keep fiscal policy extremely loose and target a fiscal deficit of 7% of GDP in 2022. More importantly, it appears the government wishes to reform the fiscal rule that aimed to straitjacket fiscal dissaving. While the details are scant and still being worked out, the government apparently wants to use the debt-to-GDP ratio as its fiscal anchor rather than the budget balance. This is problematic.

Brazil attempted a similar dance back in 2015 with disastrous consequences. Also, targeting the debt-to-GDP ratio will open the floodgates to ‘reclassify’ the public sector’s liabilities and use accounting gimmicks to stabilize the fiscal dynamics. Unsurprisingly, local currency bond yields have already begun to shoot up in recent days.

Politically, the new ‘reform light’ will go over more smoothly. However, even assuming this somewhat lighter version of the fiscal reform is passed, the near-term growth outlook for the economy is poor.

• As Chart 2 showed, local interest rates are already beginning to rise.
• Narrow (M1) money supply growth, a reliable leading indicator of capital investment and private sector credit growth, which is near nominal contraction as it is, has downshifted materially.
• The country will still face a non-negligible fiscal drag next year.
• Importantly, a serious fall in Colombia’s oil capex in recent years has caused output to fall significantly (Chart 5). As such, the economic impulse from stronger oil prices on economic activity, and importantly on the currency, will be marginally lower than in previous years.

As to investment recommendations:

Long-dated interest rates have risen sharply of late, and the 10/1-year swaps curve is incredibly steep at nearly 300bp. We suggest to be underweight/avoid Colombian bonds. Investors should look to hedge near-term currency risk. Finally, the nation’s MSCI COLCAP equity index looks quite weak, and equity markets may undershoot.

1. Weisner, Eduardo, The Political Economy of Macroeconomic Policy Reform in Latin America (Northampton: MA Edward Elgar Publishing, 2012). ↑

2. For example, many Colombian protesters, understandably, are outraged at perceived tax hikes during an economic and healthcare crisis, while corruption remains rampant. ↑