(IndustryWire Via Thomson Dialog NewsEdge) COUNTRY BRIEFING

FROM THE ECONOMIST INTELLIGENCE UNIT

Colombia has introduced capital controls in an effort to check the appreciation of the peso, which has risen by 14% against the dollar so far this year. The measure is unlikely to have much impact, for the main factor pushing up the currency is strong foreign direct investment. This in turn points to the success of the Colombian economy at present--although GDP growth and the peso probably will not remain at their currently elevated levels for long.

Although many Latin American currencies have been appreciating against the US dollar, few have done so with the vigour of the Colombian peso, which has already surged by 14% this year. Breaking the Ps2,000:US$1 mark for the first time in seven years, the peso ended May at Ps1,931:US$1, compared with Ps2,239:US$1 at the start of 2007. What is even more remarkable is that this strengthening has occurred in spite of sustained intervention on the part of the Banco de la Repblica (Banrep, the central bank), which purchased US$4.5bn (equivalent to 4.1% of GDP) in the first four months of the year. Although no official data relating to May has been released, there is speculation that the level of intervention increased.

In response to this sustained appreciation, the Colombian authorities decided to take more direct action to stem the rise of the peso. Capital controls on short-term speculative inflows were introduced in late May, requiring investors to deposit 40% of the value of their investment at the Banrep for a minimum of six months. Since no interest is paid on these deposits, short-term inflows face higher costs than long-term investment. Investors can sidestep this new requirement if they pay a charge relating to the length of time their money will remain in the country. This ranges from 1.6% for five months to 9.4% for a day.

Wrong solution

With the peso failing to weaken in the days following the announcement of capital controls, there has been speculation about just how effective the new measures will in stemming the currency appreciation. Portfolio inflows accounted for US$457m in 2006, compared with US$6.3bn in foreign direct investment (FDI) inflows, suggesting that it is FDI--and not speculative inflows--that is putting pressure on the peso. Given that the capital controls do not apply to FDI, as long-term inflows are deemed much more beneficial to the economy, the peso looks likely to remain strong, at least in the short term.

Meanwhile, the ability of the Banrep to continue intervening in the foreign exchange market is likely to become more limited. Intervention has not been fully sterilised, resulting in an increase in the money supply and stronger price pressures. Consumer price inflation rose to 6.3% year on year in April, significantly higher than the Banrep's target range of 3.5-4.5%. Assuming that inflation remains high, the Banrep is likely to prioritise inflation over containing the strength of the peso and so reduce its intervention in the foreign exchange markets.

Fleeting success?

The strength of the peso reflects the economy's outstanding recent performance and its encouraging short-term prospects. However, maintaining this progress in the long term will require structural reforms to tackle long-standing weaknesses in the fiscal accounts. Spending is extremely inflexible, owing mainly to the burden of large transfers to regional governments. These transfers are due to rise by 2.5% each year during the 2006-08 period, but from 2009 they are set rise in line with the growth of central government revenue. In order to rein in this increase, the administration is seeking to pass a reform to cap the growth of transfers. A reform bill was initially submitted to Congress in September 2006, but given that it involves a constitutional reform, debate has been spread over two consecutive legislative sessions.

In late May, Congress voted in favour of the reform in the bill's penultimate debate. The final debate will take place before the current legislative session ends on June 20th. The reform has been extremely contentious, given pressures to increase spending to alleviate poverty, which is still at a high level. As a result, Congress has watered down the original proposal. In spite of some opposition in the legislature, the Economist Intelligence Unit expects the bill to be approved in the final debate.

However, even this reform is unlikely to prevent a widening of the fiscal deficit in the medium term. Revenue will be affected by softening global oil prices and by falling domestic production; meanwhile, spending pressures will remain significant, given the pressure of the ongoing internal conflict, rising social security costs and higher debt servicing costs as interest rates rise. From 2008, moreover, the US Congress could start to scale back aid, placing an additional spending constraint on the Colombian government. In this context, aggressive measures to reduce the actuarial pension deficit, cut regional transfers more substantially and widen the tax base will be needed to prevent a further widening of the fiscal deficit. Even given solid support for President lvaro Uribe, such measures are unlikely.

As for the peso, its recent surge has taken market watchers by surprise; nearly all were expecting a softening in the currency. We had already expected a slowdown in export growth this year, to 4.5% from 7.8% in 2006, although this was mainly due to production constraints rather than currency appreciation. In the unlikely event of the peso continuing to rise against the dollar, the export growth outlook could be even gloomier. We are also expected a moderation in GDP growth, to 5.1% from 6.8% in 2006, on the assumption that tightening monetary policy will gradually feed through to private consumption. The Banrep has raised its benchmark interest rate by 250 basis points since April 2006 and--combined with efforts to drain liquidity from the banking sector--this will curb credit growth.

SOURCE: ViewsWire

Copyright 2007 Economist Intelligence Unit

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