The US-Colombia free trade agreement will significantly boost trade, and increase foreign direct investment.
BY PETER DeSHAZO, TANYA PRIMIANI
AND PHILLIP McLEAN
During the late 1990s, Colombia’s financial system experienced a period of stress, characterized by the failure of several banks and other financial institutions, as well as by the severe deterioration of the whole system’s financial health. The situation was exacerbated by the violent conflict and in 1999 the country’s GDP fell by 4.2 percent, the first contraction in output since the 1930s. Since then, Colombia has successfully turned its economy around through a combination of fiscal reforms, public debt management, reduction of inflation, and strengthening of the financial system. The policies that have been adopted since 1999, supported by three successive IMF arrangements, have placed the country on a path of sustainable growth while reducing poverty and unemployment. Colombia’s economy has also benefited from high commodity prices and a dramatic improvement in the security situation.
Colombia’s fundamentals are strong. The country’s $130-billion economy grew at 6.8 percent in 2006, the highest rate in 28 years and two points faster than the Latin American average. Colombia has reduced its inflation rate from 16.7 percent in 1998 to 4.5 in 2006. Economic growth has reduced unemployment, which dipped from 18 percent in 1999 to 12 percent in 2006. The external sector is led by sustained growth in exports and capital inflows while net international reserves stood at $15 billion in 2006 (covering 6.6 months of imports). Nevertheless, the external current account deficit was 1.6 percent of GDP in 2006 and public-debt to GDP ratio stood at 45 percent.
The 1991 Colombian Constitution created embedded rigidities by constitutionalizing certain components of fiscal policy such as pensions, fiscal transfers to local governments for education and health, and public sector wages. Revenue earmarking and mandatory expenditures amount to about 80 percent of all government outlays. Monetary policy, in contrast, formally delegated to the independent central bank, Banco de la República has proven to be adaptable to economic shocks.
Since 1999, a series of structural reforms have been passed by the Colombian Congress. On the tax side, there has been an effort, albeit insufficient, to raise revenues in order to finance larger expenditures. There has been an increasing reliance on the VAT and financial transaction taxes, and several early reforms, including rate increases, boosted overall tax revenues from 17 percent of GDP in 2000 to about 21 percent of GDP in 2006.104 However, more recent attempts at deeper tax reform have failed. Studies show that Colombia’s tax system remains inefficient and distortive and that reducing distortions and broadening the system’s base would be important to incite more private investment while protecting revenue collection.
Three pension reforms have been approved since 2002, raising contributions, trimming some benefits, and eliminating special regimes, including for teachers and the military. This reduced the actuarial deficit of the pension system from 200 percent of GDP in 2000 to 148 percent of GDP in 2005.Reforms in fiscal decentralization delinked intergovernmental transfers to local and regional governments from current revenues and set spending and borrowing limits on territorial governments in order to avoid a significant widening of the deficit of the central administration and preserving the credibility of fiscal policy.
The Colombian government emerged from the 1999 economic and financial crisis with a relatively heavy debt load. Public debt in absolute terms has increased in recent years, but the debt-to-GDP ratio has declined to from a high of 60 percent in 2002 to around 45 percent in 2006 and the government’s goal is to reduce it to 40 percent by 2010. Since 2004, Colombia’s active liability management system has reduced financing costs, diversified funding sources, lengthened the maturity of debt, lowered foreign exchange rate exposure, and enhanced liquidity in the domestic bond market, lessening the country’s vulnerability to economic shocks. The country has never defaulted on its debt.
Aided by the fiscal reforms and increased oil prices, the combined public sector deficit was reduced from 5.5 percent of GDP in 1999 to 0.8 percent of GDP in 2006 with a primary surplus of 3.6 percent, up from a 1.2 percent deficit in 1999. The central government played an important role in this improvement, reducing its deficit from 6.1 percent in 2002 to 4.1 percent in 2006 thanks to higher tax receipts, lower interest payments and higher oil prices.
EXCHANGE RATE POLICY
The recent wave of foreign investments prompted by high oil prices, improvements in security and market-friendly economic policies, combined with rapid GDP growth, is exerting inflationary pressures. The latest inflation figures (5.22 percent in August) remain slightly elevated, and in its latest quarterly inflation report, the central bank admits that it is likely to miss its inflation target for the year (3.5 to 4.5 percent).
Rising inflows of foreign exchange are also strengthening the peso (11 percent since January this year), which now stands at Ps2,000 : U.S.$1 (from Ps2,239 : U.S.$1 at end 2006), reducing the incentive to bring in short-term capital as interest rates rose.108 With the strong currency cutting into profits, export growth slowed to 12 percent in the first quarter of 2007 from 15 percent in 2006 and Uribe set aside $106 million this summer for subsidies and loans to exporters struggling with the rising peso.
Colombia has been opening up its economy to international trade. Between 2002 and 2006, the nominal value of Colombian exports doubled, going from $11.9 billion in 2002 to $24.4 billion in 2006. In the January-June 2007 period, exports totaled $13.2 million, representing growth of 17.6 percent over the same period one year prior. This is explained by the way traditional and non-traditional exports have performed, particularly exports to Venezuela, which were up by 47 percent. The growth also stems from higher sales of fuel which accounts for 37.2 percent of the country’s total exports. Imports also showed strong growth, rising to $26.2 billion in 2006 and reflecting the good momentum in industrial manufacturing.
Colombia is an important producer of petroleum, coffee, coal, textiles, and flowers. The main destination markets are the United States (39.6 percent), Venezuela (11.2 percent), and the Andean region (including 6.5 percent to Ecuador). Colombia imports mainly machinery, grains, chemicals, transportation equipment, mineral products, consumer products and metal products. Its major suppliers are the United States (26.5 percent), Mexico (8.3 percent), Brazil (6.5 percent), China (6.3 percent), and Venezuela (5.9 percent). The United States is Colombia’s leading trade partner, and Colombia is currently the 29th-largest export market for U.S. goods.112 Bilateral trade in goods has almost doubled over the past decade, from $9 billion a year in 1996 to approximately $16 billion in two-way trade in 2006, due in large part to the Andean Trade Preference and Drug Eradication Act (ATPDEA), which provides duty-free access to the U.S. market for approximately 5,600 products.
In November 2006, the United States and Colombia signed a free trade agreement (“Trade Promotion Agreement”), which is now awaiting congressional ratification in the United States. This agreement would provide Colombia with permanent preferential access to the U.S. market by eliminating tariffs and other barriers while opening the Colombian market to U.S. exports. The ATPDEA already offers Colombia’s exports preferential access to the U.S. market and therefore the Trade Promotion Agreement, if approved, is likely to have more effect on imports than on exports. Several recent studies estimate that the agreement will lead to moderately higher real GDP in Colombia, significantly more trade, especially with the United States, and more foreign direct investment, with a slight deterioration in the external current account deficit which in 2006 stood at $3 billion. The Trade Promotion Agreement is also likely to enhance Colombia’s ongoing internal economic reforms, further increasing incentives for foreign investors.
CONFIDENCE AND INVESTMENT
As a result of the economic and financial crisis, Colombia lost its investment grade rating in 1999. However, in light of the impressive macroeconomic recovery, the approval of important reforms, higher growth prospects, and positive results on the security front, the outlook for Colombia’s long-term foreign debt ratings has improved. After reaching a maximum of 1,096 basis points in 2002, spreads were below 100 basis points between June 15 and 21, 2007, reflecting the increased confidence of foreign investors in the Colombian market. In June of 2007, Standard & Poor’s (S&P), one of the main international risk rating agencies, returned the investment grade for foreign debt rating, upgrading the country from BB+ to BBB- and making Colombia the third Latin American country to obtain this rating, along with Mexico and Chile. Other rating firms have also modified their positions on Colombia, moving it increasingly closer to investment grade. Moody’s for instance, changed the debt rating from negative to stable in March 2006.
Increased confidence has been reflected in higher levels of foreign direct investment and visits by international tourists. In 2006, over 1 million visitors entered the country (almost twice as many as in 2000), spending $1.5 billion. In 2006, FDI reached $6.5 billion, more than three times the $1.5 received in 1999. During the first trimester of 2007, FDI added up to $2.3 billion growing 114 percent compared to the same period in 2006 and the upward trend is expected to continue.
The country’s efforts in attracting foreign investment and easing trade restrictions were highlighted in the World Bank’s Doing Business 2008 report, and Colombia was singled out as one of the top 10 reformers of 2006-2007. Colombia’s overall ranking for ease of doing business in 2008 was 66 out of the 178 countries surveyed.
The World Bank however also points to the armed conflict as an obstacle to a further strengthening of the economy: “The 40-year old conflict constrains economic growth, threatens vital infrastructure, displaces populations, erodes the fabric of society and generates fiscal costs. Violence also hinders the achievement of optimal policy outcomes to address the country’s fundamental development needs.” Despite broad improvements, the security situation in Colombia continues to play a role. It affects economic performance: resources are diverted from productive uses, production costs rise and uncertainty increases, and capital flows are adversely affected. Experts have indicated that the conflict in the past cost Colombia between 2 and 4 percent of GDP per year. Other studies clearly link drug-trafficking activities with higher crime rates (measured in homicides and kidnappings) and less than optimal growth.
Nevertheless, Colombia has made an impressive recovery since the economic and financial turmoil of the late 1990s and successes in reducing violence and controlling the civil conflict have resulted in good macroeconomic fundamentals, higher growth and increased confidence from investors both in Colombia and abroad.
This column, originally published in Latin Business Chronicle on January 28, 2008, is based on an excerpt of Back from the Brink, a report from the Center for Strategic and International Studies (CSIS). Republished with permission from the CSIS.