Mission Concluding Statement 

March 24, 2015

An International Monetary Fund (IMF) mission, headed by Valerie Cerra, visited Bogotá during March 10-24 to conduct the country’s annual Article IV consultation, part of the IMF’s regular surveillance of all member countries. At the end of the discussions, Ms. Cerra issued the following statement:

Colombia’s impressive growth record over the recent past and progress in social indicators were underpinned by skillful implementation of a strong policy framework that ensured macroeconomic stability and strengthened external resilience. The recent decline in oil prices poses new challenges and is already affecting the near term outlook for fiscal revenues and growth. However, policy space is ample to safely navigate through the shock and the authorities’ commitment to sound macroeconomic management, including the adherence to the fiscal rule, is firm. With medium-term prospects set to improve, the structural reform agenda will continue to support competitiveness and improvement in social outcomes.

Economic context and outlook

1. A strong policy framework and prudent macroeconomic policy management have underpinned Colombia’s vigorous economic growth during the last several years, which has been among the highest in Latin America. Colombia’s robust and broad-based growth in recent years has contributed to a decline in poverty, informality, inequality and unemployment. Confidence in the authorities’ macroeconomic policies and the improved security situation supported an impressive rise in private investment. Foreign direct investment inflows have been buoyant, and have been complemented by a strong appetite for Colombia’s sovereign debt, steady upgrades in the sovereign credit rating, and a recent increase in Colombia’s weight in global bond indices. As a result, the government has been able to lengthen the average maturity of its debt, issue at historically low yields, and widen the foreign investor base. The inflation targeting framework has served to maintain low inflation and anchor inflation expectations. The central bank has taken advantage of the abundant capital inflows to rebuild net international reserves, which provide a buffer against external shocks and are complemented by access to the IMF’s Flexible Credit Line. Prudent financial supervision and regulation have anchored financial deepening and macro-financial stability.

2. Brisk growth continued in 2014, with macroeconomic policies remaining mildly supportive. Real GDP rose by 4.6 percent, boosted by strong expansion in civil works in the construction sector. The central government fiscal balance remained broadly unchanged from 2013, and met the structural balance target embedded in the fiscal rule. Although the central bank normalized the monetary stance as inflation reverted to the midpoint of the target band, low real interest rates and strong credit growth supported economic activity.

3. Strong headwinds from the severe oil price decline pose significant challenges to the near-term economic outlook.  The sharp fall in world oil prices poses significant challenges to monetary and fiscal policy management, as it implies a permanent decline in national income and a sharp peso depreciation that puts some upward pressure on the price level. The mission projects growth to slow to about 3½ percent in 2015, which would still compare favorably with most other countries in the region. The deceleration reflects subdued private investment, especially in the oil sector, a slowdown in private consumption, and a tightening of planned public spending. The medium-term outlook is favorable, however, with growth projected to bounce back gradually to nearly 4½ percent by 2019, supported by infrastructure investment and some improvements in world oil prices and external demand.

4. The external environment continues to pose further downside risks. The expected increase in U.S. interest rates would raise the cost of debt financing and could lead to a surge in financial volatility. A protracted period of slower growth in advanced and emerging markets, especially in key regional trading partners, would lessen Colombia’s exports receipts. Slow global growth and a continued increase in global oil supplies could further weaken oil prices. Any materialization of these shocks could further diminish Colombia’s economic prospects, particularly if the impact of the large oil price shock turns out worse than expected.

Economic challenges and policies

5. The broadly neutral monetary policy stance appears consistent with the inflation target. The current rise in headline inflation reflects the temporary impact of an agricultural supply shock and some pass-through from exchange rate depreciation which are expected to unwind toward the end of the year. If growth slows more than expected, there is scope for monetary policy easing as long as inflation expectations remain anchored.

6. As a result of the strengthening of the fiscal framework during the last few years, Colombia is in a strong fiscal position to navigate the oil price shock. The combination of a revamped oil-related royalty system and a structural fiscal rule will partially shield fiscal expenditure from the decline in oil prices. At the same time, the large magnitude of the oil shock and the ensuing weaker than expected oil revenues (dividends in particular) requires expenditure adjustments this year in order to comply with the fiscal rule targets. Stronger subnational spending due to the forthcoming electoral cycle will dampen the effect of central government fiscal restraint on growth. In all, this experience will provide an opportunity for the fiscal rule committee to revisit the operation of the fiscal rule. The mission considers that the practice of setting the long-run oil price by smoothing oil prices over several years has been an appropriate way to phase adjustment to oil shocks, but the sensitivity of fiscal revenues to oil prices may be much larger than previously considered.

7. Revenue mobilization is urgently required, in order to protect social and infrastructure spending, and given the dim outlook for oil prices. In order to meet the central government’s planned reduction in the structural deficit between 2015 and 2020, the Medium-Term Fiscal Framework (MTFF) envisages reductions in expenditure ratios, leaving limited room to accommodate social and infrastructure expenditure pressures. Given the need to protect space for key expenditure programs and given the subdued outlook for oil revenues, swift revenue mobilization is of the utmost importance. The mission welcomes the creation of an independent expert commission to advise on reform measures to make the tax system more progressive and efficient. Revenues should be mobilized in a way that simplifies the existing tax structure, increases progressivity, broadens the tax base, and facilitates private investment by ensuring international competitiveness. Some options could include replacing traditional corporate taxation with CREE’s simplified exemption structure, substituting the traditional personal income tax with an extended IMAN, and increasing the VAT rate. If sufficient revenues could be gained from these sources, they could help reduce existing non-conventional taxes (e.g., personal wealth tax, financial transaction tax, VAT on capital goods) to foster investment and growth. Enormous gains in revenue could be achieved through improving tax administration, including by imposing criminal penalties for tax evasion, increasing the number of officials, and strengthening the information technology of the tax administration authority.

8. Expeditious implementation of the investment program would support medium term growth and competitiveness. Although Colombia compares well with peers in some areas of infrastructure, such as the quality of electricity supply, a significant road infrastructure deficit generates bottlenecks and hinders competitiveness and inclusive growth. In this regard, the mission supports the authorities’ 4G infrastructure program of road concessions, and their progress in managing risks, including by standardizing PPP contracts, requiring completion of functional units before committing budget resources, and allocating resources to a contingency fund to plan for most contingent liabilities. The mission supports the authorities’ continued efforts to develop alternative financing options and instruments for risk hedging, including by amending the financial regulatory framework to facilitate investment by institutional investors, and would also welcome using proceeds from the sale of the power company Isagen to increase resources in the development fund.

9. The exchange rate depreciation triggered by the oil price shock is providing a useful buffer. Although the oil price decline has contributed to further widening of the current account deficit, it is projected to remain mostly financed by FDI. Although some pick up of non-traditional exports due to exchange rate depreciation is expected to occur over the medium-term, further efforts to diversify the economy would lower reliance on oil receipts and help dampen current account volatility. The planned fiscal consolidation will also play a role in strengthening the current account balance over the medium term.

10. The authorities’ efforts to enhance cross-border supervision will help maintain financial system soundness. Financial soundness indicators are strong and credit growth buoyant. The new capital adequacy measure introduced in 2013 has strengthened banking system loss absorbency. A planned further transition to an enhanced Basel III capital adequacy measure and risk-based capital buffers will provide additional resilience of banks against the larger risks stemming from cross-border linkages and domestic operations. Regulation and supervision over the holding company of financial conglomerates will be strengthened by the timely passage of a draft bill before Congress.

11. The authorities’ medium-term structural reform agenda, enshrined in the national development plan rightly targets key areas to foster inclusive growth. Despite significant progress over the past decade, Colombia’s poverty, inequality, youth unemployment, and informality are still elevated. Moreover, the high minimum wage relative to the average wage continues to hinder labor formalization, particularly for youth and unskilled labor. Labor market formalization has improved as a result of the 2012 tax reform, which lowered taxation on labor. The mission welcomes the overall thrust of the development plan. Going forward, planned reforms to make pension and health contributions more flexible would further reduce labor informality and strengthen the social safety net. Female labor participation should also increase through easier access to maternity leave benefits while more streamlined regulation, aligned with OECD standards, will lower uncertainty for firms by improving the investment environment and facilitating resource planning. A centralized database of vacancies at municipal level, developed by the Labor Ministry, will support first-job seekers, mainly unemployed youth, in their job-search and application process. A pension reform to expand coverage in a sustainable way and strengthen the social safety net of the poor (such as a non-contributory pension that covers all poor) would boost inclusiveness and combat poverty in a more significant way. The development plan’s goal to improve access to quality education would help reduce inequality and promote medium-term growth prospects. The mission strongly encourages the authorities to continue their efforts in fostering innovation and economic diversification noting that, as the peace process takes hold, further opportunities for institution building and rural development will surface, which will help improve growth prospects and inclusiveness, and strengthen competitiveness.

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The mission wishes to thank the Banco de la República, the Ministerio de Hacienda y Crédito Público, and other ministries, and public and private sector entities for their cooperation, open discussions, and hospitality.