Colombia has solid fundamentals, but the economy remains dependent on oil prices. We believe that the peso’s outlook will be driven largely by external factors.
President Santos is currently in the middle of his second and final 4-year term, which ends in 2018. His focus remains on concluding long-awaited peace talks with the FARC and ELN rebel groups. Those talks with the FARC appear to have borne fruit, as the two sides signed a formal peace accord and ceasefire back in June. Details to the broad agreement are still being worked out. Then, it must still be approved by a referendum that is likely to be held this fall.
Vice President Germán Vargas Lleras could be a strong candidate in 2018. His right-wing Cambio Radical (CR) party did well in local and regional elections in October 2015, winning the mayoralty of Bogotá as well as several governorships.
The economy is slowing. GDP growth is forecast at around 2.5% this year before accelerating modestly to around 3.0% in 2017 and 3.5% in 2018. GDP rose 2.5% y/y in Q1, and is tracking less than 2% so far in Q2. As such, we see downside risks to the forecasts. Past tightening has led to a sharp slowdown in consumption, with retail sales dropping y/y for two straight months and in three of the past four.
Price pressures are still rising, with CPI up 9.0% y/y in July. This is the highest rate since June 2015, and suggests that the tightening cycle has not ended. The next central bank policy meeting is August 31, with median forecast of no change. With inflation more than double the top of the 2-4% target range, we think there is a chance of a hawkish surprise then. Factors arguing against another hike are the weak economy and strong peso.
Fiscal policy has remained prudent, but the budget deficit has grown nonetheless. Unlike many of the commodity exporters, Colombia was prepared for the downside of the commodity cycle. Spending cuts were pushed through this year, which were needed to offset the loss of revenues from the oil sector. The IMF estimates that the budget deficit came in around-3% of GDP in 2015. It is expected to widen slightly to around -4% this year before narrowing to around -3.5% in 2017.
The external accounts bear watching. Lower oil prices have hurt exports (which have contracted y/y every month since October 2014), but slow growth has helped reduce imports. The current account gap was about -7% of GDP in 2015, but is expected to narrow slightly to around -6% in 2016 and around -4.5% in 2017. FDI covers a large portion of the deficit, however. Foreign reserves have been steady, but at $47 bln in July, they cover over 9 months of import and are about 4 times larger than short-term external debt. Thus, Colombia’s external vulnerability remains low.
The peso has outperformed this year after a poor 2015. In 2015, COP lost -25% vs. USD. This put it behind only the worst performers ARS (-35%), BRL (-33%), and ZAR (-25%). So far this year, COP is up 9% YTD and is lagging only the best performers BRL (+24%), ZAR (+15%), and RUB (+14%). Our EM FX model shows the peso to have VERY WEAK fundamentals, so this year’s outperformance should ebb.
USD/COP appears to be on track to test the May low near 2817 and then the November 2015 low near 2785. After that is the June 2015 low near 2508 and then the May 2015 low near 2352. Much will depend on external factors, as the peso is highly correlated to WTI oil prices. The -0.618 correlation coefficient (daily percentage changes) is second only to the Russian ruble (-0.716) amongst the major EM currencies.
Policymakers have acted to prevent excessive moves in the exchange rate. Last October, it started selling dollar call options when the exchange rate weakened more than 5% from its 20-day moving average. It later adjusted the trigger to 3% this February before eliminating the program altogether this June. Given the excessive weakness since in 2014-215, we do not think current COP strength is a concern yet.
Colombian equities have outperformed this year after a terrible 2015. Last year, MSCI Colombia was -43% while MSCI EM was -17%. So far in 2016, MSCI Colombia is up 27% YTD, and compares to 13.5% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Colombia at a NEUTRAL position.
Colombian bonds have outperformed this year. The yield on 10-year local currency government bonds is -127 bp YTD. This is behind only Brazil (-467 bp), Indonesia (-160 bp), and Russia (-128 bp). With inflation likely to remain high and the central bank still in hawkish mode, we think Colombian bonds will start underperforming.
The latest update of our own sovereign ratings model showed Colombia’s implied rating fall two notches to BBB-/Baa3/BBB-. The drop in oil prices has really taken a toll on the economy. Downgrade risks to actual ratings of BBB/Baa2/BBB are thus picking up. Indeed, we agreed with Fitch’s move in July to cut its outlook from stable to negative whilst at the same time cutting its local currency rating a notch to BBB, also with negative outlook.