DBRS Morningstar Confirms Republic of Colombia at BBB (low), Stable Trend

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 1) Colombia’s strong policy frameworks and robust institutional checks and balances are acting to moderate President Petro’s reformist agenda, and 2) tighter macroeconomic policies are helping rebalance an economy characterized by elevated inflation and a large current account deficit. As Petro aims to advance his legislative agenda, his administration has pledged to ensure fiscal sustainability and comply with the fiscal rule. The central bank is independent and focused on price stability. In addition, Colombia’s governing institutions, including congress and the courts, are acting to moderate reform efforts and preserve the country’s record of prudent economic policymaking.

The economy is starting to rebalance on the back of tighter macroeconomic policies. With activity operating above potential in 2022, inflation climbed to 13.1% year-over-year and the current account deficit reached 6.2% of GDP. Tighter fiscal and monetary policies are expected to slow growth this year, which should ease inflation pressures and reduce the external deficit. Activity indicators over the last six months show that the rebalancing is already underway: imports are trending down, consumer credit is slowing, and real retail sales are contracting. The IMF projects GDP growth of 1.0% in 2023 and 1.9% in 2024. Given the carryover from the first quarter of 2023, this forecast implies a modest contraction over the next three quarters.

Colombia’s BBB (low) ratings balance the country’s record of sound macroeconomic policymaking with deep governance challenges and ongoing fiscal pressures. Fiscal policy is tightening after delivering three years of large-scale support to the economy. The Finance Ministry expects the general government deficit to narrow from 6.5% of GDP in 2022 to 3.3% in 2023 and 2.4% in 2024. Moreover, the general government debt-to-GDP ratio is expected to remain on downward trajectory over the medium term, as fiscal accounts consolidate and growth converges to potential. However, the outlook is clouded by domestic and external risks. Strong social pressure to deliver more fiscal support could weaken fiscal accounts. The divided political landscape and social polarization could also raise governability risks, particularly if the government is perceived to be unable to respond to public demands. On the external front, a shift in risk sentiment could lead to capital outflows and potentially result in strong import compression and slower economic growth.

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

Petro’s Reform Agenda is Facing Resistance in Congress; Rule of Law Remains a Key Credit Challenge

Gustavo Petro came into office with an ambitious agenda that included tax, health, pension, and labor reforms. After winning the presidency in 2022, Petro’s party, Historic Pact for Colombia, joined forces with three traditional parties – the Liberals, Conservatives, and the Party of U – to form majorities in both the lower house and the Senate. The coalition approved a major tax reform in late 2022. However, the alliance disintegrated in April 2023 due to disagreements over the legislative agenda, particularly healthcare reform. This led President Petro to dismiss several ministers, including Finance Minister Ocampo. The fragmentation of the coalition, combined with a recent scandal involving several senior officials, and the political parties’ increasing focus on the October regional and local elections, reduce the likelihood that the Petro administration will be able to pass reforms in the near-term. Nevertheless, with negotiations ongoing, the reforms could still advance after the elections, albeit likely in a modified form.

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 category 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 is Starting to Rebalance But Domestic and External Risks Cloud the Outlook

The Colombian economy rapidly recovered from the shock of the pandemic. GDP in the first quarter of 2023 was 11.4% 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, where output remains well below pre-pandemic trend. Tighter macroeconomic policies should slow the pace of growth this year, thereby helping to rebalance external accounts and ease inflation pressures. In the medium term, Colombia’s growth prospects are relatively good. The IMF estimates medium-term growth at 3.3%, 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, economic policies under the Petro administration pose some downside risks to the growth outlook. In particular, the oil and gas sector could see less investment due to recent tax reforms, which have significantly increased taxes on the sector, as well as the Petro administration’s decision, at least temporarily, to withhold new licenses for oil exploration. Other parts of President Petros’s domestic reform agenda are still under discussion, but if passed could potentially dampen investment and weaken productivity growth.

In addition to domestic risks, global risks are elevated and Colombia’s external imbalances expose the economy to capital flow volatility. The current account deficit widened to 6.2% of GDP in 2022, despite favorable terms of trade. We expect the current account deficit to narrow this year on the back of weaker import demand and lower import prices. Balance of payments data from the first quarter of 2023 indicates that the rebalancing process is underway. Nevertheless, we expect the external gap to remain relatively large at the end of the year.

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.

Large Fiscal Consolidation After Three Years of High Deficits

The general government balance is expected to narrow from 6.5% of GDP in 2022 to 3.3% in 2023 and 2.4% in 2024. The large improvement this year stems from the revenue-raising effects of tax reforms in 2021 and 2022, higher oil-related revenue, a reduction in fuel subsidies, and better financial results by social security funds. Importantly, the government has been increasing gasoline prices every month since October 2022 in order to reduce the fiscal cost of fuel subsidies, with the expectation of eliminating gasoline subsidies by the end of 2023 and diesel subsidies by the end of 2024. In addition, regional and local governments are expected to run higher surpluses in 2024, as it usually takes newly elected subnational governments time to design and execute their spending plans.

The Social Investment Law in 2021 reinstated a structural fiscal rule, after being suspended in 2020 and 2021 due to the pandemic, and introduced an explicit debt anchor (55% of GDP). The Law spells out the central government structural primary balance targets from 2022-25, as fiscal accounts transition to the new rule. In addition to the planned consolidation this year and next, some additional tightening will be required in 2025. The government has stated that all proposed reforms will be implemented in a manner that is consistent with the rule.

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 2021. The 14 percentage point of GDP increase was due to large fiscal deficits, the sharp contraction in GDP in 2020, and peso depreciation. However, the debt ratio declined to 65% in 2022 and is expected to fall to 62% in 2023. On a consolidated basis, general government debt increased from 43% of GDP in 2019 to 58% in 2021. The consolidated ratio is expected to decline to 54% in 2023. The composition of the central government debt is generally favorable, with a long maturity structure and 93% of liabilities carrying fixed rates. However, approximately 40% of the debt is denominated in foreign currency, which leaves the public balance sheet exposed to peso depreciation. The IMF projects that the debt-to-GDP ratio will remain on a gradual downward trajectory over the next six years, as the primary government balance shifts to a surplus this year and growth gradually converges toward potential.

Elevated Inflation is Expected to Converge to the Central Bank’s 3% Target in 2025

A series of supply shocks in the context of strong demand have led to rapidly rising prices. Annual inflation peaked at 13.3% in March 2023 before moderating to 12.4% in May. In particular, food prices increased markedly, due to higher fertilizer prices in 2022 and, more recently, excessive rainfall that damaged crops and infrastructure. Import prices increased on account of a large currency depreciation last year. In addition, excessive demand relative to supply has put upward pressure on prices more generally. Price pressures are now dissipating, although rising regulated fuel prices and widespread indexation across the economy may slow the pace of disinflation.

In response to elevated inflation, the central bank has raised the policy rate by 1150 basis points to 13.25% in just 20 months. Given the economic deceleration and recent signs of moderating inflation, the tightening cycle has likely come to an end, or is close to it. The ex-ante real policy rate is above 6.0%, which is clearly in restrictive territory and will likely become more restrictive in the second half of the year as inflation expectations decline. According to the central bank’s Economic Expectations Survey, annual inflation (median) is expected to decline to 9.0% by December 2023 and 5.0% by December 2024, which is still above the central bank’s 2-4% target range.

The financial system is well-prepared to manage a slowdown in the domestic economy as well as a more challenging global environment. Currency mismatches across banks, corporates, and households are limited. Banks are primarily funded by local deposits with strong liquidity ratios. They are also highly capitalized, and holdings are largely held mark-to-market. While consumer lending increased rapidly in 2021 and 2022, consumer credit has levelled off over the last six months due to higher rates, lower demand, and higher reserve requirements on certain loans.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
The Resource and Energy Management factor has a significant effect on Colombia’s ratings. The economy is vulnerable to oil price shocks, with petroleum products constituting roughly 35% of Colombia’s exports, 10-25% of foreign direct investment inflows, and 5-15% of general government fiscal revenues. This factor is taken into account in the Balance of Payments and Fiscal Management and Policy building blocks.

Social (S) Factors
The Human Capital & Human Rights factor has a significant effect on the ratings. Similar to other emerging market economies and many of its regional peers, Colombia’s GDP per capita is relatively low at US$6.7k (US$18.8k 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. This factor is taken into account in the Economic Structure and Performance building block and the Political Environment building block.

Governance (G) Factors
The three governance factors have a significant effect on 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 43rd percentile for Control of Corruption and in the 35th percentile for Rule of Law. Colombia ranks in the 50th percentile for Voice & Accountability and in the 52nd percentile for Government Effectiveness. While Colombia has made progress in reducing violence, the country still ranks very low on Political Stability and the Absence of Violence/Terrorism (17th percentile). This factor is taken into account in the Political Environment building block.

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 (May 17, 2022) 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/416426.

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 (August 29, 2022)
https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the 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 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 the 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.

The 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, management and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
This is a solicited credit rating.

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