DBRS Morningstar Confirms Colombia at BBB (low) Stable

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

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that Colombia’s sound macroeconomic policy framework will likely be preserved through the electoral cycle. Gustavo Petro won the presidency on June 19 by narrowly defeating Rodolfo Hernández in the second round of the presidential election. Petro won 50.4% of the vote, while Hernández garnered 47.3%. Petro’s campaign focused on addressing Colombia’s high income inequality and promised reforms in areas such as taxation, pensions, and environmental policy. If implemented, some policies could end up adversely affecting medium-term growth prospects and public finances. However, in our view, Colombia’s governing institutions will provide effective checks and balances on the incoming administration. Without a majority in congress, Petro will need to build coalitions to pass legislation, which will likely lead to a moderation in the administration’s policy agenda. Overall, we expect continuity in macroeconomic policy. This includes a commitment to sustainable public finances, respect for the independence of the central bank, sound regulation of the financial sector, and exchange rate flexibility.

The Colombian economy has rapidly recovered from the shock of the pandemic. Output in the first quarter of 2022 was 6.8% above the pre-pandemic level (fourth quarter of 2019) and roughly on par with output based on pre-pandemic trend growth. High frequency indicators suggest that growth momentum continued into the second quarter. However, we expect the pace of growth to slow markedly over the next 2-4 quarters, as high inflation erodes consumers’ purchasing power and macroeconomic policies tighten. The IMF forecasts GDP growth of 5.8% in 2022 (which assumes a sharp slowdown given the high carryover from the first quarter) and 3.6% in 2023. Slower growth would be welcome, as the economy appears to be operating above capacity. Year-over-year headline inflation hit 9.1% in May, and the current account deficit (rolling four quarters) widened to 6.3% of GDP in the first quarter, on the back on strong consumption-led demand.

Colombia’s BBB (low) ratings balance the country’s record of sound macroeconomic policymaking with deep governance challenges and ongoing fiscal pressures. After providing large-scale support to the economy amid the pandemic, fiscal policy is starting to tighten. The IMF forecasts that the general government deficit will narrow from 6.8% of GDP in 2021 to 4.6% in 2022 and 2.2% in 2023. Moreover, the general government debt-to-GDP ratio is expected to remain on downward trajectory, as fiscal accounts consolidate and growth converges to potential. However, the government’s spending profile is rigid and there is strong social pressures to deliver more fiscal support. As a result, compliance with the new fiscal rule could be increasingly difficult over time without raising additional revenue.

RATING DRIVERS
Colombia’s ratings could be upgraded in the medium term if fiscal accounts consolidate in a durable manner and public debt ratios materially decline. In addition, the ratings could be upgraded if medium-term growth prospects strengthen on the back of supply-side improvements in the economy.

The ratings could be downgraded if the fiscal outlook significantly deteriorates or medium-term growth prospects materially weaken, thereby complicating efforts to keep public finances on a sustainable path.

RATING RATIONALE

Colombia’s Institutional Checks And Balances Will Moderate Petro’s Policy Agenda; Rule of Law Remains A Key Credit Challenge

Gustavo Petro won the presidency on June 19. Petro ran a campaign that proposed higher social spending financed by large tax hikes, ending new oil exploration and developing renewable energy infrastructure, and reforming the pension system. In our view, congress and the courts will act as a check on the next administration. Petro’s coalition has a minority in the Senate and Chamber of Representatives. The negotiations required to build congressional majorities mean there is likely to be a moderation in policy from the President-elect’s campaign proposals. As a result, we expect broad continuity in the pillars of macroeconomic policy, including respect for the independence of the central bank.

However, the divided political landscape and social polarization raise governability risks. No single party comes close to a majority in the lower house or the senate. Social tensions could worsen if the government is perceived to be unable to sufficiently respond to public demands. In this context, we think the executive-legislative relationship will be particularly important in shaping the political environment over the next four years.

DBRS Morningstar continues to view the rule of law as a key credit challenge. There has been positive news for the country in terms of governance over the last two decades: Colombia has delivered sound macroeconomic management, poverty rates have materially declined, the peace accord with the FARC is advancing, despite setbacks, and Colombians’ participation in the democratic process has strengthened, according to Worldwide Governance Indicators. The country’s record of sound macroeconomic policy management accounts for the one-notch adjustment in the Political Environment building block. However, Colombia compares unfavorably to most similarly rated countries in terms of the rule of law. Even as the 2016 peace accord with the FARC advances, illegal armed groups continue to fight to control territory and the drug trade. The process of extending the state’s presence to remote areas of the country, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking remain important long-term challenges.

The Economy Has Recovered But The Growth Outlook Is Clouded By Political And External Risks

The Colombian economy has rapidly recovered from the shock of the pandemic. Output in the first quarter of 2022 was 6.8% above the fourth quarter of 2019 and roughly on par with pre-pandemic trend growth. The strength of the recovery compares favorably to regional peers, such as Mexico and Peru, which still face sizable output gaps. However, the pace of growth is set to slow over the next few quarters as high inflation erodes consumers’ purchasing power and macroeconomic policies tighten. Over the medium term, Colombia’s growth prospects are relatively good. The IMF estimates medium-term growth at 3.4%, which is the fastest among Latin America’s largest economies and middle-ranked among a broader set of emerging markets. Colombia’s economic resilience and medium-term growth outlook account for the one category uplift relative to the scorecard in our assessment of the Economic Structure and Performance building block.

However, uncertainty around the direction of economic policy under the incoming administration poses downside risks to the growth outlook. Even if some of the more ambitious reforms pledged during campaign are not supported in congress or are blocked by the courts, the Petro administration will have more discretion on issues such as freezing new licenses for oil exploration, which could dampen investment.

In addition to domestic political risks, global risks are elevated and Colombia’s external imbalances expose the economy to capital flow volatility. The current account deficit widened from 3.4% of GDP in 2020 to 6.3% in the first quarter of 2022 (rolling four quarters). The increase was due to the strong domestic recovery, higher import prices, and rising primary income payments abroad. The deficit was largely financed with a mix of net direct investment, flows into portfolio debt securities, and public sector borrowing from the international bond market and multilateral lenders. For the remainder of the year, we expect the current account deficit to narrow on the back of higher commodity export prices and moderating import demand, although the external gap will likely remain relatively large.

Colombia’s credible macroeconomic policy framework and flexible exchange rate should help the economy adjust to evolving global conditions in an orderly manner. Colombia also holds $58 billion in reserves and has access to about $10 billion in the form of a Flexible Credit Line with the IMF. This provides some protection against downside tail risks. Nevertheless, large gross external financing needs leave the economy vulnerable to shifts in investor sentiment. A risk-off episode in global financial markets could lead to capital outflows, currency depreciation, and wider credit spreads. The resulting adjustment would likely entail strong import compression and slower economic growth.

The Fiscal Deficit Is Set To Narrow In 2022 And 2023 But Additional Tightening Could Be Needed

Fiscal policy is starting to tighten after providing large-scale support to the economy over the last two years. According to the IMF, the general government ran a deficit of 7.0% of GDP in 2020 and 6.8% in 2021. The deficit is set to decline in 2022 and 2023 on the back of cyclical and structural factors. From the cyclical perspective, revenue will benefit from the rapid pace of economic growth and the sharply higher oil prices. Oil-related revenues to the central government come in the form of Ecopetrol dividends and corporate income tax receipts, while local governments benefit from royalty payments. However, it is important to note that the revenue gains from higher oil prices are being largely offset by gasoline subsidies. The net benefit of higher oil prices will depend on how quickly the government plans to converge local regulated prices with global market prices. On the structural side, the government passed the Social Investment Law in September 2021. The Law extends some pandemic-related spending programs through 2022 and raises permanent tax revenue starting in 2023. Overall, the net fiscal adjustment starting in 2023 is estimated at about 1.0% of GDP. Supported by these cyclical and structural tailwinds, the IMF projects the general government deficit to narrow to 4.6% of GDP in 2022 and 2.2% in 2023.

In addition to raising revenue, the Social Investment Law strengthened the fiscal framework. The Law reinstates a structural fiscal rule, after being suspended in 2020 and 2021 due to the pandemic, and introduces an explicit debt anchor. Independent oversight by the new Autonomous Fiscal Rule Committee should help build credibility in the new framework. The Law spells out the central government structural primary balance targets from 2022 to 2025, as fiscal accounts transition to the new rule. Given the current fiscal and economic outlook, the next government appears well-positioned to meet the targets in 2022 and 2023, but compliance in the following years could be more challenging given the strong social pressures for additional fiscal support.

Government debt is higher in the wake of the COVID-19 shock but the debt-to-GDP ratio has started to decline. Gross general government debt (unconsolidated) increased from 52% of GDP in 2019 to 66% in 2020. The 13 percentage point of GDP increase was due to the large fiscal deficit, the sharp contraction in GDP, and peso depreciation (over one-third of the debt is denominated in foreign currency). However, the debt ratio declined to 65% in 2021 and is expected to fall to 61% in 2022, largely on the strength of the economic recovery. On a consolidated basis, general government debt increased from 43% of GDP in 2019 to 57% in 2021. The consolidated debt-to-GDP ratio is expected to decline to 55% in 2023. The composition of the central government debt is generally favorable, with a relatively long average maturity structure and 95% of liabilities carrying fixed rates. The IMF projects the debt-to-GDP ratio will remain on downward trajectory over the next six years, as the primary government balance shifts to a surplus in 2023 and growth converges to potential.

However, compliance with fiscal rule will be challenging for the next government. The government’s spending profile is rigid and strong social pressures lean toward delivering more – not less – fiscal support. Some pandemic-related social spending is set to expire at the end of 2022, for example, but it could be politically difficult to allow such programs to elapse, especially during a period of high inflation. As a result, compliance with the rule over time could depend on raising additional revenue. Alternatively, easing the fiscal restraint by changing the rule, which would require congressional approval, could lead to higher deficits and interest costs, thereby weakening the outlook for debt sustainability. Our view of the risks to the debt outlook account for the one-notch adjustment relative to the scorecard result in the Debt and Liquidity building block.

The Central Bank Is Rapidly Tightening Monetary Policy In Response To Rising Inflation And Overheating Demand

Strong domestic demand, supply chain disruptions, and surging commodity prices are contributing to a sharp rise in prices. Year-over-year inflation hit 9.1% in May 2022, which is down from 9.4% in April 2022 but up from 3.3% in May 2021. Food prices have played a large role in the increase but inflation has become increasingly broad-based. Consumer prices excluding food and regulated items rose from 2.5% in December 2021 to 5.9% in May 2022. Inflation would be even higher if not for gasoline subsidies. Given the strength of aggregate demand and the presence of indexation mechanisms, we expect inflation to decline gradually. According to the central bank’s June 2022 survey, median inflation expectations hit 8.6% for December 2022 and 4.7% for December 2023.

With inflation expectations for end-2023 above the upper band of the target range and the economy operating close to or above potential, the central bank is shifting the monetary policy stance. From September 2021 to May 2022, the central bank raised the policy rate by 425 basis points to 6.0%, with 200 basis points coming in just the last two months. As a result, monetary policy accommodation has been largely withdrawn and the stance is now closer to neutral (based on the ex-ante real policy rate). According the survey expectations, the policy rate is expected to increase another 250 basis points by the end of 2022, which would thereby put monetary policy in a firmly contractionary stance. In our view, risks to the inflation outlook are skewed to the upside and, therefore, the central bank may need to tighten monetary policy more than currently expected in order to re-anchor inflation expectations.

The banking system has weathered the pandemic relatively well and appears to be in a strong position to navigate increased macroeconomic volatility. As the economy recovered in 2021, profitability and asset quality indicators returned to pre-pandemic levels. Capital metrics ended 2021 higher than before the pandemic, as banks aimed to converge toward Basel III capital requirements by 2024. Regulatory forbearance measures provided during the pandemic have been largely phased out and non-performing loans remain at relatively low levels. In addition, banks are lending more to households and businesses. In May 2022, consumer credit increased by 11% in real terms relative to one year ago, while corporate lending growth increased by 3%. The pace of consumer lending is worth monitoring, as sustained high rates of growth could signal excessive borrowing and weaken household balance sheets.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
The Resource and Energy Management factor affects Colombia’s ratings. The economy is vulnerable to oil price shocks, with petroleum products constituting roughly 35% of Colombia’s exports, 10-20% of foreign direct investment inflows, and 5-10% of general government fiscal revenues.

Social (S) Factors
The Human Capital & Human Rights factor affects the ratings. Similar to other emerging market economies and many of its regional peers, Colombia’s GDP per capita is relatively low at US$6.2k (US$16.4k on a PPP basis). This largely reflects the low level of labor productivity. In addition, organized criminal gangs continue to commit human rights abuses, especially against journalists, community leaders, and human rights activists.

Governance (G) Factors
The three governance factors affect the ratings, including (1) Bribery, Corruption and Political Risk, (2) Institutional Strength, Governance, and Transparency, and (3) Peace and Security. According to Worldwide Governance Indicators, Colombia ranks in the 48th percentile for Control of Corruption and in the 34th percentile for Rule of Law. Colombia ranks in the 53rd percentile for Voice & Accountability and in the 56th percentile for Government Effectiveness. While Colombia has made progress in reducing violence, the country still ranks very low (23rd percentile) on Political Stability and the Absence of Violence/Terrorism.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/398853.

Notes:
All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

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, Tullet Prebon Information, World Bank, NRGI, Brookings, BIS, World Federation of Exchanges, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar 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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