DBRS Confirms Republic of Colombia at BBB, Stable Trend

DBRS, Inc. has confirmed the Republic of Colombia’s long-term foreign currency issuer rating at BBB and long-term local currency issuer rating at BBB (high). In addition, DBRS has confirmed the short-term foreign currency issuer rating at R-2 (high) and the short-term local currency issuer rating at R-1 (low). The trend on all ratings is Stable.

The rating confirmation is underpinned by Colombia’s sound macroeconomic management and solid medium-term growth prospects. Near-term challenges, however, are intensifying. External and fiscal deficits have widened amid lower oil prices, weaker demand from regional trading partners and less favorable external financing conditions. Inflation has also accelerated due to weather-related shocks and pass-through from peso depreciation. The government has responded by tightening macroeconomic policy, which is moderating domestic demand and facilitating a gradual reduction in macroeconomic imbalances. Despite current headwinds to growth, Colombia’s medium-term prospects are comparatively strong and could outperform expectations, particularly if the fourth generation (4G) infrastructure program advances, comprehensive tax reform is passed, and an agreement on the peace deal is reached.

The Stable trend rests on the assumption that revenue-raising tax reform will be passed by the end of the year. If tax reform is not passed, concerns about fiscal sustainability will intensify and likely result in downward pressure on the ratings. DBRS does not foresee upside risk to the ratings over the next year. However, comprehensive tax reform that addresses fiscal sustainability concerns combined with supply-side measures – such as execution of the 4G infrastructure program – could put upward pressure on the ratings over the medium term.

The immediate challenge – high external and fiscal imbalances – stems from a large terms-of-trade shock. The current account deficit widened to 6.5% of GDP in 2015 as lower oil prices and weaker regional demand led to a sharp decline in exports. Although the availability of external financing has enabled Colombia to continue growing at a moderate rate, the size the current account deficit exposes the economy to capital flow volatility. On the fiscal side, oil-related revenues declined over 3% of GDP from 2013 to 2016. Tax increases and spending cuts have partially offset the deterioration, but the central government deficit is still expected to widen from 3.0% of GDP in 2015 to 3.6% this year.

Tighter macroeconomic policies are facilitating an orderly adjustment to the oil-price shock. The central bank raised interest rates 200 basis points from September 2015 to March 2016 and further tightening is expected. Real exchange rate depreciation is improving export competitiveness and curbing imports, without putting excessive stress on the banking or corporate sectors. As domestic demand moderates, the current account deficit should narrow and inflation expectations should converge toward the target. This process already appears to be underway: labor market conditions are loosening, credit growth is slowing and consumer confidence is weakening. The IMF expects GDP growth to slow from 3.1% in 2015 to 2.5% this year.

However, tax reform is required to comply with the fiscal rule and anchor fiscal sustainability. Fiscal accounts are under pressure from several structural factors: lower oil-related revenues, the expiration of several taxes and higher spending associated social development and post-conflict commitments. A commission of experts proposed tax reform in December 2015. The main recommendations included raising additional revenue and shifting the burden of direct taxation from corporates to individuals in order to allow for a lower single corporate tax rate. Tax reform based on the commission’s recommendations would be credit positive, as it would help achieve several objectives simultaneously: gradually reduce the deficit in line with the fiscal rule; support an orderly external rebalancing; and benefit medium-term growth by improving competitiveness. The government plans to submit tax reform to Congress in the second half of this year.

In the medium term, Colombia’s growth prospects are strong compared to regional peers. The IMF expects Colombia to expand 4.0% per year on average from 2018-2021, the fastest pace among Latin America’s largest economies. Investment remains high, although commodity-related sectors will likely experience a decline in capital spending. The 4G infrastructure program will have positive growth effects on the demand side in the near term while increasing the economy’s growth potential. Moreover, the implementation of free trade agreements, the creation of the Pacific Alliance and strengthening commercial ties with Asia are likely to foster investment and improve productivity as Colombia integrates into the global economy.

Colombia’s credit strengths are countered by several underlying weaknesses that constrain productivity performance and economic diversification. Colombia’s large infrastructure gap is a major impediment to growth. Underdeveloped infrastructure increases transportation costs, limiting access within the domestic market and acting as an obstacle to international competitiveness. According to the 2015-2016 Global Competitiveness Report by the World Economic Forum, Colombia ranked 110th out of 140 countries in terms of the quality of overall infrastructure.

In addition, the labor market is characterized by high structural unemployment and widespread informality. Reforms in 2010 and 2012 have fostered better outcomes. The unemployment rate has declined and the trend has clearly been in favor of formal employment creation. However, despite five consecutive years of solid economic growth, the urban unemployment rate still averaged 10% in 2015 and nearly half of the workforce is informal. This has negative implications for productivity, social security coverage and income inequality.

The economic benefits of peace could be substantial over the long term as human and physical capital, previously diverted by the conflict, will be reallocated toward more productive sectors of the economy. Nevertheless, public security will remain a high priority of the government, even if a peace deal is signed. The process of extending the state’s presence, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking will remain long-term challenges.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under 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 under Rating Scales.

The sources of information used for this rating include Banco de la República, Ministerio de Hacienda y Crédito Público, DANE, Superintendencia Financiera de Colombia, The Conference Board Total Economy Database, IMF, Haver Analytics, DBRS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 11 December 2006
Most Recent Rating Update: 30 April 2015

For additional information on this rating, please refer to the linking document under Related Research.