DBRS Confirms Republic of Colombia at BBB, Stable Trend

DBRS, Inc. (DBRS) confirmed the Republic of Colombia’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB. At the same time, DBRS confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The BBB ratings balance Colombia’s credible macroeconomic policy framework with ongoing fiscal pressures. Since experiencing a large terms of trade shock in 2014, sound macroeconomic policies have facilitated an orderly rebalancing in the economy. Inflation has converged to the central bank target. The current account deficit has narrowed substantially. Moreover, a gradual economic recovery is underway on the back of strengthening domestic demand. With subdued inflation pressures, monetary policy is now slightly expansionary, which should help the recovery gain momentum. GDP growth is expected to increase from 2.7% in 2018 to 3.5% in 2019 and 3.6% in 2020. Despite improving cyclical conditions, medium-term growth prospects are constrained by supply-side factors, such as poor infrastructure, widespread labor informality, and limited trade penetration.

The key challenge for the ratings is the fiscal accounts. While a series of tax increases and spending cuts over the last few years have largely offset lower oil-related revenues, the consolidation strategy going forward is not clear, particularly given the recent cuts in corporate taxes. Further consolidation measures will likely be needed to put public debt ratios on a clear downward trajectory. The crisis in Venezuela also presents downside risks, as a sharp increase of immigrants would potentially require more spending. The trajectory of the ratings will depend in part on policymakers’ ability to allocate sufficient public resources to achieve the country’s growth and security objectives while ensuring fiscal sustainability.

RATING DRIVERS

While an upgrade in the near term is not likely, the ratings could experience upward pressure in the medium term if fiscal accounts consolidate in a durable manner and supply-side improvements in the economy raise economic growth prospects.

On the other hand, the ratings could be lowered if the fiscal outlook materially weakens. Failure to achieve the ambitious structural deficit targets set out in the fiscal rule would not necessarily put downward pressure on the ratings, provided that the government continues to demonstrate a clear commitment to fiscal sustainability.

RATING RATIONALE

The Fiscal Consolidation Strategy Looks Challenging And Downside Risks Are Increasing

Gradual fiscal consolidation since the 2014 oil price shock has facilitated the economy’s rebalancing and helped maintain fiscal credibility. The central government aims to further reduce the deficit from 3.1% of GDP in 2018 to 2.7% this year, which is in line with the targets established by the fiscal rule’s independent Consultative Committee. The adjustment should be supported by some modest revenue-raising measures, higher oil prices last year, and the cyclical recovery. However, the consolidation strategy for the following years is not clear, particularly as: (1) full tax credit on VAT paid on capital goods and lower corporate tax rates will start impacting revenues, (2) rigidities in the spending profile, partly driven by constitutional protections, limit the government’s ability to cut current expenditure, and (3) capital expenditures are already at a low levels.

The situation in Venezuela also presents downside risks. Colombia’s fiscal outlook already incorporates spending of 0.5% of GDP in 2019 to provide basic public services for an estimated 1.2 million Venezuelan migrants living in Colombia. However, the fiscal shock could be substantially larger if the crisis in Venezuela intensifies and the inflow of migrants significantly increases.

All of this leaves the government with limited room to maneuver. Public debt dynamics have stabilized but at a substantially higher level than before the terms of trade shock. Additional revenue will likely be needed to protect public investment and put public debt ratios on a clear downward path.

Colombia’s Growth Prospects Are Moderate – Constrained by Structural Factors

Colombia’s growth prospects are slightly higher than most of its regional peers. The IMF expects the Colombian economy to expand on average by 3.7% per year from 2019-2024. Only Peru is expected to grow at a faster pace among Latin America’s largest economies. However, with an aging population, Colombia’s medium-term growth outlook will primarily depend on raising investment and productivity.

In that regard, growth prospects are constrained by several factors. Colombia’s large infrastructure gap is a major impediment to growth. Underdeveloped infrastructure increases transportation costs, thereby limiting access within the domestic market and acting as an obstacle to international competitiveness. In addition, Colombia’s labor market is characterized by high structural unemployment and widespread informality. Finally, the economy is relatively closed and, therefore, does not fully benefit from the potential efficiency gains derived from greater integration into global markets. Consequently, strengthening the country’s growth prospects will depend in part on the government’s ability to advance a comprehensive agenda that addresses these interlinking constraints.

Inflation Is On Target But The Current Account Deficit Is Widening

Monetary policy is slightly expansionary amid muted inflation pressures. The central bank has left the policy rate unchanged at 4.25% since April 2018. With inflation expectations anchored and a modest negative output gap, policy will likely remain supportive of growth in the near term. Accommodative policy has largely fed through to lending rates. Although corporate borrowing has not picked up due to the weak demand, Colombia’s financial system is well-positioned to support businesses as cyclical conditions strengthen. The banking system is profitable and well-capitalized. Moreover, asset quality indicators, which deteriorated in 2017 and early 2018, are starting to improve in tandem with the recovery.

The rebound in domestic demand is reflected in the widening current account deficit. The external gap increased from 3.3% of GDP in 2017 to 3.8% in 2018, driven in part by rising capital goods imports. The current account deficit is expected to remain relatively large, which could expose the economy to capital flow volatility. However, inflows of foreign direct investment provide a steady source of external financing, and global financing conditions have eased following the recent decisions of several major central banks. If external conditions deteriorate, exchange rate flexibility should help the Colombian economy adjust. At the same time, substantial reserves provide some protection against global tail risks.

Institutional Quality Is A Credit Challenge

DBRS expects continuity in macroeconomic policy under the Duque administration. Iván Duque was elected president in June 2018 after defeating Gustavo Petro in a second-round vote. The success of the new administration in advancing its legislative agenda, including pension reform later this year, will largely depend on the President’s ability to build a coalition across a divided congress.

Notwithstanding Colombia’s record of sound macroeconomic management, DBRS views the broader issue of institutional quality in Colombia as a credit challenge. According to the World Bank Governance Indicators, Colombia compares unfavorably to most similarly rated countries in the area of rule of law. The peace accord with the FARC is advancing, despite some recent setbacks and challenges. However, the process of extending the state’s presence, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking remain long-term challenges.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (low) – BBB range. The main points discussed during the Rating Committee include (1) the fiscal outlook, (2) the economic and fiscal impact of Venezuelan migrants, and (3) factors driving the current account deficit and the composition of the external financing.

KEY INDICATORS

Fiscal Balance (% GDP): -2.2 (2018); -2.6 (2019F); -1.0 (2020F)
Gross Debt (% GDP): 50.5 (2018); 49.2 (2019F); 47.3 (2020F)
Nominal GDP (USD billions): 333.1 (2018); 336.6 (2019F); 352.8 (2020F)
GDP per capita (USD thousands): 6.7 (2018); 6.7 (2019F); 6.9 (2020F)
Real GDP growth (%): 2.7 (2018); 3.5 (2019F); 3.6 (2020F)
Consumer Price Inflation (%, eop): 3.2 (2018); 3.0 (2019F); 3.0 (2020F)
Domestic credit (% GDP): 62.4 (2017); 61.5 (Sept-2018)
Current Account (% GDP): -3.8 (2018); -3.9 (2019F); -3.8 (2020F)
International Investment Position (% GDP): -47.5 (2017); -46.5 (2018)
Gross External Debt (% GDP): 40.0 (2017); 39.6 (2018)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 164% (2017); 143% (2018)
Governance Indicator (percentile rank): 47.0 (2017)
Human Development Index: 0.747 (2017)

Notes:

All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include Ministerio de Hacienda y Crédito Público, Banco de la República, Superintendencia Financiera de Colombia, DANE, IMF, UNDP, Tullet Prebon Information, World Bank, NRGI, Brookings, BIS, World Federation of Exchanges, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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