The Colombian electorate’s rejection in October of a peace agreement with the Revolutionary Armed Forces of Colombia (FARC) sent shockwaves through the country’s business community.
The referendum result did not have an immediate impact on the banking system, which is still contending with foreign exchange fluctuations and challenges arising from the country’s exposure to low oil and gas prices. However, it has made it harder for major tax reforms to be passed in Congress that, if successful, would kick-start the Colombian economy, bring down the country’s fiscal deficit and reinvigorate its infrastructure programme – lifting banks’ prospects in the process.
If not enacted, a downgrade in the credit ratings of the sovereign and the banks could follow. The three main credit rating agencies have already downgraded Colombia’s outlook from 'stable' to 'negative' in 2016.
Setback for government
The government of Juan Manuel Santos – who has been Colombia's president since 2010 and represents the centre-right Social Party of National Unity – suffered a major setback when 50.2% of voters rejected the peace agreement in October’s plebiscite. Many people felt that the government was being too lenient towards members of the rebel group.
In mid-November, Mr Santos announced the government and the FARC had signed a new agreement that met many of the critics’ original concerns. But the details are sparse and it is not yet clear if a fresh referendum will take place.
The business community had expected the peace agreement to unleash a wave of foreign direct investment (FDI) in the country. It was seen as a highly symbolic move that would underpin the country’s stability and attract foreign investors, especially those from the Middle East and Asia who do not have much experience of Colombia.
Currently, the Colombian economy is in worse shape than it has been for many years so an injection of FDI would have been very welcome. The central bank, Banco de la República, expects economic growth of only 2% for 2016 and forecasts similar figures for 2017, compared with average yearly growth of 4.5% between 2011 and 2015. This stands in contrast with neighbouring Peru, which the International Monetary Fund forecasts to expand by 3.9% this year and 4% next.
Terms of trade hit
The biggest problem Colombia has faced has been the drop in oil prices, which has prompted a terms of trade shock. In 2014, oil comprised almost half of the country’s exports – its biggest oil company is 88% state-owned Ecopetrol. Government revenues from oil amounted to 3.3% of gross domestic product in 2013 but are now down to zero, leaving a gaping hole in the budget. Economists estimate that the fiscal deficit will reach 3.9% this year.
The Colombian peso dropped in value by 60% during the 12 months to August 2014 but has held steady since then. The current account deficit reached a maximum of 6.5% at the end of 2015. Annual headline inflation is 6.4%, well above the central bank’s tolerance margin of plus or minus one percentage point around its 3% target.
The government has already tightened spending considerably and Congress is debating a highly controversial tax increase that is expected to reduce the fiscal deficit to 1.5% by 2020 and improve economic growth by 1% annually. The reforms are designed to ensure that Colombia maintains its investment grade rating as credit rating agencies have threatened to downgrade the sovereign if it does not improve its fiscal position.
“The referendum resulted in a paradigm shift in Colombian politics,” says Daniel Osorio, president at New York-based Andean Capital Management. “The key question is whether President Santos now has enough political capital left to ensure that Congress passes the tax reform.”
Juan Pablo Cordoba, president of the Colombian stock exchange, says: “The reality is that the armed conflict in the country was pretty much over five years ago. The agreement would have closed the curtain on the whole episode. The formal finalisation of the conflict remains an important objective.”
Threat to banks
However, the drop in oil prices and the depreciation of the peso during the past two years have weakened Colombia's banks. Their direct exposures to the oil and gas sector equals only 2.5% of gross loans but it amounts to a relatively high 33% of tangible common equity (TCE) – made worse by banks’ low levels of core capitalisation – according to Moody’s. Within Latin America, only Mexico’s exposure to the oil and gas sector is worse, at about 38% of TCE.
Colombian banks’ biggest exposure is to Ecopetrol, which benefits from a big cash cushion and easy access to local capital markets. But exposure to oil industry suppliers – which are facing a number of financial challenges – is a concern for the banks.
The peso’s depreciation precipitated a sharp decline in TCE to risk-weighted assets to a low of 5.6% in March this year from 7.8% at the end of 2014, according to Moody’s. This was mostly down to a drop in TCE at Colombia’s second largest bank, Banco de Bogotá, which has sizeable operations in Central America (where assets are valued in dollars). Bancolombia is the biggest bank in the country, with 22.8% of total assets.
Moreover, analysts say high single borrower concentration is a challenge for most banks. In March 2016, the system’s loan concentration ratio – measured by the 20 largest exposures to TCE – was a high 185%, according to Moody’s.
Infrastructure issues
The extent to which banks support the country’s main infrastructure programme, known as 4G, could make this credit concentration worse. Rating agencies estimate that each of the main banks’ exposure to these projects will range from 1% to 3% of total commercial loans.
The banking system is highly concentrated, with the five biggest players comprising more than 70% of total assets in March 2016. In total, there are 25 commercial banks in operation in Colombia with gross assets of 343,000bn pesos ($108bn).
However, the banks benefit from ample loan loss reserves and from their focus on lower risk payroll-linked consumer loans. The deteriorating economic picture has prompted banks to adopt more conservative lending practices.
Credit growth has dropped to 10% annually from 15% two years ago. Mortgages and commercial credit are the main drivers of loan growth, whereas the expansion in consumer loans is declining to about 8% in November 2016 from 14% in June 2015.
Prudent lending means that the past due loans rate was only 2% of total loans last year but analysts expect this to rise to 2.5% next year, mostly due to the tougher economic circumstances.
Stronger opposition
The referendum outcome strengthens the position of former president Álvaro Uribe of the right-wing Democratic Centre party, who campaigned against the peace deal. His party, which holds 20 of the 102 seats in the Senate, has opposed many aspects of the tax reforms.
“The result has given Mr Uribe more power and his supporters in Congress will be in a stronger position to bargain with the Santos government,” says Andean Capital Management’s Mr Osorio. “Many people thought that Mr Uribe’s days of being at the centre of power were behind him but that is no longer the case.”
Colombia has the second highest corporate income tax in the world and the highest in Latin America, and the reforms would mean big Colombian corporations do not have to pay as much. Under the current tax regime, the effective rate would increase to 43% by 2018, but the changes would reduce this to between 30% and 35%.
The package also includes raising VAT to 19% from 16% on non-food goods and broadening the tax base by making many small businesses declare their income for the first time.
“Following the result of the plebiscite, it is not necessarily a good time for major tax reforms,” says Erich Arispe, a director in the sovereign ratings group at Fitch Ratings. “However, the country’s debt burden must be stabilised. The magnitude of the deficit means that not only must the government continue to run a tight ship in terms of spending but also increase taxes.”
Most analysts expect Congress to approve the changes by the end of 2016 but there is a risk they could be delayed or watered down. If that happens, experts are concerned that Colombia could lose its hard-won investment grade rating, which would pose a perilous threat for its economic prospects. It would increase the cost of debt financing for the state and probably for large companies as well.
“If the tax reforms are passed, this should be viewed positively by rating agencies, result in a more balanced tax regime and incentivise corporates in the country,” says Moises Mainster, senior country officer for the Andean region at JPMorgan. “This should unlock a great deal of investment and [it would] be excellent news for the economy.”
Infrastructure projects
Colombia currently has a series of huge infrastructure projects under way that are expected to add at least 1% to economic growth during the next few years. It is using a form of public-private partnership (PPP) to roll out a $12bn highway expansion programme. This involves the widening and upgrade of 7000 kilometres of roads and includes the revamping of major highway links between Bogotá, Medellín and the important Pacific port city of Buenaventura.
Under this initiative, concessionaires pay all of the upfront construction cost; this capital outlay is 75% funded by debt and 25% by equity. Some 31 of the total of 40 highway projects have already been put out to tender and awarded to consortia composed mostly of Colombian and multi-national engineering and construction companies. A credit rating downgrade would raise the debt costs of the remaining nine projects and could lead to some being shelved.
“The more complicated fiscal position already means that the government is not approving any new projects that require a contribution from the state,” says Luis Andrade, president of national infrastructure agency ANI. “However, a great deal of infrastructure can be built under the PPP model and it has been an effective way of involving foreign firms in developing the country’s infrastructure. The participation of international companies means that projects are less likely to become delayed.”
The state is paying the concessionaires of all 31 existing projects a total $1bn a year for the next 20 years. In addition, they are expected to raise a further $1bn a year through tolls for the next 20 to 25 years.
Foreign investment
Mr Andrade says originally Colombian firms were assuming about 70% of the equity in the projects but this became difficult for them to finance. They then introduced foreign firms into the shares structure and today there is a 50:50 mix between Colombian and international companies.
ANI is also in charge of awarding concessions for the upgrade of 51 airports throughout the country. The four most important projects, at El Dorado, near Bogotá, and the cities of Medellín, Cali and Cartagena, are all being developed under the PPP model.
Since 2010, $1bn has been invested in El Dorado airport to make it one of Latin America’s largest and most modern hubs. Under the latest project, an additional $400m will be invested in the international and domestic terminals. “Air passenger numbers in Colombia have been increasing at between 5% and 10% a year,” says Mr Andrade. “The government’s goal is to have one of the best national airport systems in Latin America.”
Bogotá airport is expected to reach saturation point within a decade and the government is planning a second $1bn airport, dubbed El Dorado 2, 20 kilometres away from the existing one.
In September, the municipality of Bogotá axed plans for an underground metro system in the capital and instead backed a $5bn elevated overground version. The project is still at a design stage and the municipality will be in charge of the tendering process, with construction expected to be completed by 2025.
“The economy’s main challenge is to culminate successfully in the adjustment to the recent shocks and transform more of its productive capacity into tradable goods, different than oil and mining,” says Ana Fernanda Maiguashca, a Colombian central bank board member. “The infrastructure projects are a central part of that process, since it is one important hurdle in terms of productivity. That is why the so-called 4G projects are at the centre of the investment scenario both for public and private players.”
The referendum result was a major setback to the Colombian government but the planned tax reforms should stabilise the country's fiscal situation and incentivise big corporations to invest. Banks have a high exposure to the weakened oil and gas sector but should be able to weather the terms of trade shock.
