Colombia’s Taxing Downgrade Drama Take

Nationwide protests continue in Colombia despite President Duque’s withdrawal of the 1.5% of GDP fiscal reform program designed to broaden the tax base and rein in debt and deficits. After the bill was pulled, the finance minister stepped down and his successor pledged to send a new proposal to congress quickly for approval before the legislative sessions end in June.  The country’s debt/GDP jumped to over 60% last year from 45% in 2019, while the fiscal deficit soared to almost 8% of GDP from 2.5% a year earlier on temporary suspension of the fiscal rule for emergency pandemic spending. According to the IMF debt will near 65% this year while the deficit widens to 9.5%.

The only major economy to keep paying during the 1980s Latin debt crisis, Colombia has maintained an investment grade rating for a decade now under threat. Failure to pass adequate fiscal measures will result in a downgrade as both Fitch and Standard and Poor’s have their lowest level threshold on negative outlook. The original reform package included privatization plans to raise revenue, but absent replacement medium-term tax reform a downgrade is expected especially if the fiscal rule, which limits the government’s ability to run-up debt, is formally modified.

A downgrade would result in forced selling of local and international bonds, further pressuring the peso, the worst performer in Latin America this year after 10% falls against the USD the last two years. Unlike neighboring Peru where foreign investors hold about half the local bond market, in Colombia the portion is only 5%. Since the central bank has already sold some of its pandemic holdings under a QE program back into the market this year, it can absorb modest position trimming. The stock exchange is also the region’s laggard for a second year running.  After losing 23% in USD terms on the MSCI Index in 2020, year-to-date it has fallen another 17%.

Despite being an oil exporter, Colombia runs a current account deficit.  Last year the gap narrowed to 3.3% of GDP from 4.4%, but it is expected to retrace this year despite rising energy and gold prices. Early in the pandemic the IMF approved a two-year Flexible Credit Line and upped the amount available to USD 17.6 billion six months later. In December investors were surprised that the country drew down USD 5.4 billion. Before the fiscal reform debacle the government told the Fund that it intends to treat the remaining amount as “precautionary.” In the aftermath of the failure of fiscal reform the FCL instead is on tap again this year.

The outbreak of violence, including with guerillas along the Venezuela border, and new wave of Covid-19 already translated to growth rollbacks.  After the economy contracted at a record 6.8% last year, public and private analysts expected a 5% rebound this year.  Now a 3% expansion is possible only absent a ratings downgrade. Foreign investors, both direct and portfolio, are wary of policy stagnation as President Duque’s popularity continues to sink, with opinion polls showing only about 30% support in the run-up to next year’s presidential election. Although the government won widespread praise for granting Venezuelan refugees full legal status over the next decade, the immediate costs cannot be absorbed in the current budget state. It counts on United Nations and other assistance also for its own displaced population, as the latest annual $1.5 billion appeal for the region was only half funded. Fiscal, health, and humanitarian crises will continue to weigh on the financial markets and peso in the run-up to next year’s elections. Credit fundamental and economic discipline downgrades are underlying trends, and a populist lurch from the current frontrunner could invite outright breakdown recalling civil war era investor retreat.

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