DBRS Morningstar Confirms Colombia at BBB, Trend Changed to Negative

DBRS, Inc (DBRS Morningstar) confirmed the Republic of Colombia’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB and changed the trend to Negative from Stable. At the same time, DBRS Morningstar confirmed the Republic of Colombia’s Short-term Foreign and Local Currency – Issuer Ratings at R-2 (high) and changed the trend to Negative from Stable.

KEY RATING CONSIDERATIONS

The spread of the Coronavirus Disease (COVID-19) and the collapse in oil prices present clear downside risks to Colombia’s growth prospects and public finances. The confluence of these shocks is set to derail Colombia’s slowly-building recovery. The economy accelerated in 2019, posting growth of 3.3% on the back of strengthening domestic demand, and high frequency data points to robust growth in the first few months of 2020. However, the outlook has recently deteriorated: global demand has materially weakened, Colombian authorities have imposed a national lockdown to curb the spread of the virus, a weakening global economy combined with a production dispute between Saudi Arabia and Russia has driven oil prices sharply lower, and elevated risk aversion has led to tighter financing conditions in Colombia.

At a minimum, the combination of these shocks will have a deeply negative impact on economic activity in the second quarter. Although Colombia does not have substantial space to implement stimulatory policies, the country’s strong macroeconomic policy framework should cushion the impact of the shocks and help the economy adjust to evolving conditions. If the shocks prove to be short-lived, markets may recover quickly and the economic damage may be moderate.

However, the Negative trend reflects the high degree of uncertainty regarding the shocks’ magnitude and duration. Output losses could be substantially greater if the containment measures disrupt daily life longer than anticipated and global commodity prices remain low for longer. The incidence of COVID-19 cases is lower in Colombia than in other countries in the region, but the situation is fluid. In addition, the oil-price shock will have an adverse impact Colombia’s external and fiscal accounts. The oil sector accounts for 30% of Colombia’s exports and contributes 1.5% of GDP in fiscal revenues for the central government. Lost oil-related revenues will add to mounting fiscal pressures.

If the shocks prove durable, Colombia’s credit profile could be negatively impacted by a combination of weaker growth, larger fiscal deficits, and exchange rate depreciation, all of which would increase the public debt burden. In order to assess whether there is a material deterioration in credit quality, we will be monitoring the spread of the virus as well as the economic policy response over the coming months.

RATING DRIVERS

Colombia’s ratings are unlikely to be upgraded in the near term. In the medium term, however, the ratings could be upgraded if fiscal accounts consolidate in a durable manner and supply-side improvements in the economy raise economic growth prospects.

On the other hand, the ratings could be downgraded if the impact of the shocks on the economy is larger than currently anticipated, or the medium-term fiscal outlook materially deteriorates.

RATING RATIONALE

Fiscal Policy Can Provide Limited Near-Term Support, But Structural Consolidation Will Require Reform

The coronavirus/oil price shocks will adversely impact fiscal accounts. Prior to the global shocks, the central government planned to reduce the deficit from 2.5% of GDP in 2019 to 2.2% in 2020 and 1.8% in 2021. Meeting the 2020 target could be difficult, notwithstanding higher-than-budgeted dividend transfers from the central bank, as the economic slowdown will reduce non-oil tax receipts. Achieving the 2021 target could be even harder. Lower oil prices, if sustained through 2020, will impact the bottom line in 2021 when corporate income taxes are paid and Ecopetrol dividends are delivered to the government. The government will likely use the limited fiscal space afforded by the structural fiscal rule to help local companies absorb the shutdown and boost healthcare capacity. Nevertheless, policymakers are unlikely to provide substantial stimulus given the concerns over the current account deficit and the need to sustain market confidence.

Beyond the fiscal challenges in 2020 and 2021, the multi-year structural consolidation strategy is not clear. In the absence of revenue-raising measures, achieving the gradual structural tightening implied by the fiscal rule is unlikely, particularly as: (1) revenues will be impacted by declining corporate tax rates and the implementation of the VAT tax credit for capital goods, (2) exceptional one-off revenues fade, (3) rigidities in the spending profile, partly driven by constitutional protections, limit the government’s ability to cut current expenditure, and (4) capital expenditures are already at a low levels.

All of this leaves the government with limited room to maneuver. General government debt ratios have stabilized in recent years, although at a substantially higher level than before the 2015-16 terms of trade shock. Weaker near-term growth amid mounting fiscal pressures and a large exchange rate depreciation would push the debt ratio higher. To put public debt ratios on a clear downward path and protect public investment, the government would likely need to raise revenue.

Growth Outlook Is Moderate Over The Medium Term But External Accounts Pose A Near-Term Vulnerability

Colombia’s growth prospects are slightly better than most of its regional peers. Prior to the recent shocks, the IMF had expected the Colombian economy to expand on average by 3.7% per year from 2021 to 2024. Only Peru was expected to grow at a faster pace among Latin America’s largest economies. Boosting Colombia’s medium-term growth outlook would primarily depend on raising investment and productivity.

In that regard, medium-term growth prospects are constrained by several factors. Notwithstanding significant advances in the government’s fourth-generation infrastructure program, Colombia’s large infrastructure gap is a major impediment to growth. Underdeveloped infrastructure increases transportation costs, thereby limiting access within the domestic market and acting as an obstacle to international competitiveness. In addition, Colombia’s labor market is characterized by high structural unemployment and widespread informality. Finally, the economy is relatively closed and, therefore, does not fully benefit from the potential efficiency gains derived from greater integration into global markets. Consequently, strengthening the country’s growth prospects will depend in part on the government’s ability to advance a comprehensive agenda that addresses these interlinking constraints.

The recent wave of migration from Venezuela presents fiscal and political challenges, but it also presents a medium-term growth opportunity. The overall impact will depend on the scale of the migration, as well as the willingness and capacity of Colombia to integrate new arrivals into the economy. The IMF notes that if two-thirds of the Venezuelan migrants and returning Colombians are between the ages of 14 and 65, the working age population in Colombia would increase by about 2 million in 2020, or by 6% relative to the 2015 level.

While Colombia’s medium-term growth prospects are better than most in the region, the country’s large external imbalance exposes the economy to capital flow volatility in the near term. The current account posed a deficit of 4.3% of GDP in 2019. If the sharp decline in commodity prices witnessed in March 2020 is sustained, the deficit will likely widen further in 2020, even after incorporating the offsetting effects of lower imports and reduced repatriated profits. Colombia’s credible macroeconomic policy framework and exchange rate flexibility should help the economy rebalance in an orderly manner. Substantial reserves and a flexible credit line with the IMF also provide some protection against global tail risks. Nevertheless, capital flows could slow or even reverse if global financing conditions deteriorate. The resulting adjustment would likely entail import compression and slower growth.

The Central Bank Is Providing Monetary Stimulus And Injecting Liquidity To Ease Market Tensions

Amid mounting downside risks to the growth outlook, the central bank cut its policy rate by 50bps from 4.25% to 3.75% on March 27th. Additional easing could be forthcoming at the next meeting on April 30th. Going forward, however, the central bank will need to balance two countervailing forces: the inflationary effect stemming from currency depreciation with the deflationary effect of below-trend economic activity. The central bank has also taken several steps to maintain liquidity in the financial system and facilitate the transmission of the recent cuts. These include increasing repo auctions, enlarging the number of institutions that can participate, and expanding collateral eligibility. These measures were topped up on March 23rd with the announcement that the central bank would buy up to COP12 trillion pesos (US$3.0 billion) of public and private debt.

Colombia’s financial system is well-positioned to support businesses and households even if the economy weakens. The banking system is profitable and well-capitalized. Moreover, asset quality indicators, which deteriorated in 2017 and early 2018, improved over the course of 2019. The absence of widespread currency mismatches in the corporate and banking sectors mitigates the adverse effects of exchange rate movements. Furthermore, bank funding relies mostly on domestic deposits, which insulates the system to some degree from turmoil in external markets.

Institutional Quality Is A Credit Challenge

Iván Duque was elected president in June 2018 after defeating Gustavo Petro in a second-round vote. While the new administration has passed several significant economic reforms, the president has, at times, had problems advancing his legislative agenda given the difficulty of building a coalition across a divided congress. While the administration still aims to pass pension and labor reforms, the President’s low popularity and the intense public attention on the coronavirus could complicate those efforts.

Notwithstanding Colombia’s record of sound macroeconomic management, DBRS views the broader issue of institutional quality in Colombia as a credit challenge. According to the World Bank Governance Indicators, Colombia compares unfavorably to most similarly rated countries in the area of rule of law. The peace accord with the FARC is advancing, despite some recent setbacks and challenges. However, the process of extending the state’s presence, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking remain long-term challenges.

ESG CONSIDERATIONS

Resource & Energy Management (E), Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), Institutional Strength, Governance & Transparency (G), and Peace & Security (G) were among key drivers behind this rating action. Petroleum products constitute roughly 1/3 of Colombia’s exports, and the country is vulnerable to oil price shocks. Similar to other emerging market economies and many of its regional peers, per capita GDP is relatively low, at US$6.5k (US$15.5k on a PPP basis). According to World Bank Governance Indicators, Colombia ranks in the 45th percentile for Control of Corruption, the 53rd percentile for Voice & Accountability, the 38th percentile for Rule of Law, and the 50th percentile for Government Effectiveness. Colombia has made significant progress in reducing violence within Colombia through a peace deal with insurgents (the FARC), but still ranks very low (18th percentile) on Political Stability and the Absence of Violence/Terrorism. These considerations have been taken into account within the following Building Blocks: Fiscal Management and Policy, Economic Structure and Performance, Balance of Payments, and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
https://www.dbrsmorningstar.com/research/359288.

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 (September 17,2019): https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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, UNDP, 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 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.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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