The Colombian Economy and Monetary Policy Jose Dario Uribe

The Colombian Economy and Monetary Policy
Jose Dario Uribe Escobar
Governor, the Banco de la República de Colombia
Speech given at The Florida International Bankers’ Association
(FIBA)
Tuesday 7th October, Miami, Florida.
Introduction
The recent turmoil in financial markets and the heightened
uncertainty about commodity prices and global demand naturally
lead to the question as to how well could the Colombian economy
weather a rapid and large deterioration of the external conditions.
It is hard to think of an economy that is not vulnerable to the
worsening international environment. Colombia is no exception. A
significant portion of our exports is made up by commodities like oil,
coal, coffee and nickel. Other manufacturing exports are sold in
commodity-exporting countries (e.g. Venezuela and Ecuador) and in
the US. A large fraction of FDI inflows is related to the mining sector,
and the country still relies on external savings to fund relatively small
current account and consolidated public deficits.
However, over the last three years, our monetary and financial
policies have been actively geared towards promoting the nominal
and financial stability of the economy, and at curbing any real or
2
financial excesses that could increase its fragility. Monetary policy
reacted in time to early signs of excessive expenditure by the private
sector, the credibility of a low inflation regime was enhanced, the
external liquidity of the country was enlarged, the threat of
unsustainable, low quality credit growth was eliminated, and
regulation of market and credit risk in the financial system was
strengthened. All these actions have significantly reduced the
vulnerability of the Colombian economy in the face of any
deterioration of external conditions that we will come to face and so
increased the degrees of freedom for policy responses.
Our recent monetary policy history
Let me describe the process through which these actions were
taken. Following a deep and protracted recession in the beginning of
the decade, the domestic and external conditions of the Colombian
economy
experienced
continuous
improvement
since
2004.
Consumer and business confidence increased with the progress in
security, while external demand and terms of trade picked up
(Graphs 1 and 2).
As a result, foreign and domestic investment jumped (Graphs 3 and
4), and output and domestic demand growth doubled in the period
2004-2007 with respect to 2000-2003 (Graph 5). Credit expanded
rapidly after years of negative growth rates, following the financial
crisis of 1998-1999 (Graph 6). Also, the currency appreciated in real
terms after 2003 (Graph 7). Inflation declined along the targets
throughout the decade (Graph 8), aided by the appreciation of the
currency and by the presence of a negative output gap that we
3
inherited from the recession and kept thanks to the increased
investment and productivity.
The policy response to these events was two-pronged: We kept real
interest rates low (Graph 9) and decided to accumulate international
reserves. The first part was justified on the grounds of the existence
of a negative output gap and the observed and forecasted fulfillment
of the inflation targets. The accumulation of reserves was aimed at
building up the international liquidity position of the economy, under
uncertainty about the persistence of favorable external conditions. In
addition, intervention in the FX market tried to smooth the
appreciation process. The two components of the policy response
were consistent in the sense that keeping low interest rates was
coherent with the purchases of hard currency by Banco de la
República.
Nevertheless, by early 2006 there were signs of overheating in the
economy, even though inflation had reached its lowest point in
decades. Hence, we started a tightening cycle from low levels of the
real interest rate. Initially, the effects of the increases in the central
bank interest rate were muted by a credit supply shock that followed
a sharp shift in the financial intermediaries´ asset portfolio (Graph
10). The large increase in loan supply not only put the inflation target
at risk, but also threatened financial stability, as banks tend to
loosen standards amid rapid credit expansion and abundant
liquidity.
The
Financial
Superintendency
responded
by
increasing
provisioning requirements on commercial and consumer loans, as
4
well as adopting tougher systems of administration of credit risk for
both types of loans. Early on, regulation of market risk had been
improved. At the same time, Banco de la República imposed
marginal reserve requirements on bank deposits, aiming at
reinforcing the transmission of the interest rate hikes and curbing
excessive credit growth.
In retrospect, these were timely and adequate measures, for the
demand pressures on inflation were building very fast, as illustrated
by the increase in “non-tradable” inflation by more than 100 bps
between September 2006 and September 2007 (Graph 11). These
are the subcomponents of the CPI that closely reflect the impact of
domestic aggregate demand on prices. Also, an analysis of
“vintages” of consumer loans shows a clear drop in credit quality
between 2006 and 2007 that has started to improve again in 2008
(Graph 12).
Foreign exchange policy involved discretionary intervention of
Banco de la República in the FX market since late 2004. In 2007 it
was clear that the tightening of monetary policy was not consistent
with discretionary purchases of dollars by the central bank and that
inflation control could be hindered if FX intervention cast any doubt
on the resolve of the central bank to reach the inflation targets.
Hence, discretionary intervention was abandoned. Instead, capital
controls were introduced to alleviate the appreciating pressure on
the currency and as a complement of the marginal reserve
requirements established by the same time. Purchases of
international reserves were resumed later in 2008 to enhance the
external liquidity position of the country, in the face of increased
5
uncertainty about the external conditions. However, this time the
purchases were made through “rules-based” mechanisms that
minimize the conflict or appearance of conflict with monetary policy.
Price shocks hit the Colombian economy in 2007 and 2008. Some
were idiosyncratic, like weather-related jumps in food prices or
increases in the prices of some food items that were scarce in
neighboring Venezuela. Other shocks were part of the global rise in
the relative prices of food, energy and raw materials. In 2007 the
idiosyncratic shocks and the demand pressures pushed inflation
above target. International prices also contributed to this result, but
their effect was largely compensated by the appreciation of the
currency. In 2008, however, the impact of the international price
shocks has been so sharp, that the appreciation of the peso during
the first semester was not sufficient to prevent substantial increases
in the local food and energy prices, as well as in producers´ costs,
as illustrated by the behavior of PPI inflation (Graph 13).
The macroeconomic results of these shocks are visible in the
economic data for the first semester of this year. On the one hand,
CPI inflation rocketed and deviated substantially from its target
(Graph 8). On the other hand, the economy slowed down from the
high growth rates it reached in the previous two years, driven down
especially by a contraction in private consumption growth (Table 1).
The slowdown is in part an outcome that we were pursuing, since
the high growth rates of domestic demand observed throughout
2006 and 2007 were not sustainable in the long run. Thus, the
deceleration is partially the result of past monetary policy actions.
6
However, not all the slackening in the pace of economic activity can
be attributed to monetary policy. Some of the price shocks may be
understood as a supply shock that simultaneously increases prices
and reduces output, by raising the production costs of firms or
cutting real disposable income of households. These channels
appear to be quite important in Colombia, as illustrated by the
increase in PPI inflation already noted (Graph 13) and by the fact
that around 39% of the CPI basket is represented by items whose
relative prices has risen fast recently (food, transportation, fuel and
public utilities) (Graphs 14 and 15). The deceleration in economic
activity is also explained by a decline in local governments´ fixed
investment related to their post-electoral cyclical behavior, and by a
moderation in manufacturing and agricultural exports due to the
global slowdown and trade restrictions imposed by the government
of Venezuela.
The sharp increase in CPI inflation during 2008 pushed up inflation
expectations or inflation risk premia in the short and in the long run
(Graph 16). Thus the macroeconomic situation we faced by mid
2008 was characterized by increasing inflation and inflation
expectations, a slowdown of economic activity from unsustainably
high levels and cost pressures.
Looking forward, it was clear that the main risk for the economy was
if that the inflationary shock were to become permanent. If we allow
what is originally a large, temporary rise in relative food prices to
become a generalized inflationary spiral, we would seriously
damage Colombia’s growth and economic fundamentals. One
mechanism for this would be through our labour markets, where any
7
attempt to raise wages above productivity to compensate for relative
price movements would generate not just further bouts of inflation
but also structural unemployment and large falls in output.
Therefore, interest rates were raised again in July to signal Banco
de la República´s intention to drive inflation back toward the long
term 2%-4% target. The response of the market was impressive.
After the decision was made, the zero-coupon public bond curve
shifted down by an average of 90 bps at 5 to 15 years maturities and
has stayed low since (Graph 17).
In sum, since 2006, the Banco de la República has raised its interest
rates by 400 bps, imposed marginal reserve requirements on
deposits and accumulated international reserves for US$ 8.7 billion.
These measures have definitely improved the ability of the
Colombian economy to withstand adverse effects coming from the
international turbulence. Let me explain how.
First, as a result of the monetary policy actions, the annual change
of CPI excluding food and regulated prices remained below 4% in
2007 and 2008, and has recently started to go down (Graph 18).
This has left us in a position to reduce inflation in the absence of
further large relative price movements. Moreover, it has helped
consolidate the credibility of the inflation targeting regime and could
reduce the pass-through of a large depreciation that may follow a
deterioration of international conditions.
Second, in the event of an adverse external shock, the accumulation
of international reserves has several benefits from the macro and
8
financial point of view. Given the still imperfect credibility of the
inflation targets and the indexation prevailing in the labor market, it
gives the central bank another tool to deal with a large depreciation
of the currency. Also, it provides a signal about the international
liquidity of the country that may prove useful to deter attacks on the
currency or the deposits of the financial system.
Third, as mentioned, the combined measures of Banco de la
República and the Financial Superintendency induced a fall in credit
growth and an improvement in the quality of lending (Graphs 6 and
12). This set the expenditure patterns of the private sector on
sustainable paths, cut excessive leverage by firms and households,
and left the financial system with a good capital base to absorb the
effects of adverse external events. You will find a profound analysis
of our financial sector and its risks and exposures in our Financial
Stability which has just been published and is on our website.
Conclusion
In summary, our fundamentals are good, and in some very important
areas, have improved in recent years. Of course the current high
levels of inflation and slower growth in Colombia are of concern to
us. On top of this, we are all facing a great uncertainty about what it
is going to happen to world markets. Our strategy will be to continue
improving these fundamentals. One important aspect of this is to
ensure that inflation moves back towards its target.
9
Graph 1
Real GDP Growth of Colombia's trading partners
7,0
6,0
4,0
3,0
2,0
1,0
0,0
-1,0
2000
2001
2002
2003
2004
2005
2006
2007
GDP of Colombia's Trading Partners
Source: WEO, calculations of Banco de la República
2008
proy
*Trading partner's GDP weighed by global commerce
Graph 2
Terms of Trade*
160
150
140
130
120
110
100
90
* Calculated using producer's price index. It is defined as the ratio between the exported price index and the imported price index
Source: Banco de la República
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
80
Jan-90
Percentage
5,0
10
Graph 3
Composition of FDI in Colombia by Sectors
Millions of dollars
9800
8800
7800
6800
5800
4800
3800
2800
1800
800
-200
2002
2003
Other Sectors
2004
2005
Mining Sector
2006
2007
2008 py
Purchases of Private and Public Companies
Source: Banco de la República
Graph 4
Percentage
Investment/GDP ratio
30
28
26
24
22
20
18
16
14
12
10
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
11
Graph 5
Annual Change of GDP and Internal Demand
15
10
Porcentage
5
0
-5
-10
GDP
Internal Demand
Graph 6
Total Gross Real Credit
Annual Growth Rate
30,0%
20,0%
10,0%
0,0%
-10,0%
-20,0%
Aug00
Total Credits deflated by CPI
Aug01
Aug02
Aug03
Aug04
Aug05
Aug06
Aug07
Aug08
Jun-08
Sep-07
Dec-06
Mar-06
Jun-05
Sep-04
Dec-03
Mar-03
Jun-02
Sep-01
Dec-00
Mar-00
Jun-99
Sep-98
Dec-97
Mar-97
-15
12
Graph 7
Real Exchange Rate Index deflated by CPI
1994=100
160
140
120
100
80
60
Aug-90 Aug-92 Aug-94 Aug-96 Aug-98 Aug-00 Aug-02 Aug-04 Aug-06 Aug-08
Graph 8
Annual Inflation (CPI) and Inflation Target
11,0
10,0
9,0
8,0
6,0
5,0
4,0
Inflation
Target
Sep-08
Ene-08
May-07
Sep-06
Ene-06
May-05
Sep-04
Ene-04
May-03
Sep-02
Ene-02
May-01
Sep-00
3,0
Ene-00
%
7,0
13
Graph 9
Real Deposit Interest Rate (CD's)
Deflated by CPI without food
6,0%
5,0%
4,0%
3,0%
2,0%
1,0%
90 days CD's
A u g -0 8
F e b -0 8
A u g -0 7
F e b -0 7
A u g -0 6
F e b -0 6
A u g -0 5
F e b -0 5
A u g -0 4
F e b -0 4
A u g -0 3
F e b -0 3
A u g -0 2
F e b -0 2
A u g -0 1
0,0%
Average since 1986
Graph 10
Investments /Total Assets
Apr-08
Jan-07
Oct-05
Jul-04
Apr-03
Loans / Total Assets
Investments /Total Assets
35,0%
32,0%
29,0%
26,0%
23,0%
20,0%
17,0%
14,0%
11,0%
8,0%
5,0%
70,0%
68,0%
66,0%
64,0%
62,0%
60,0%
58,0%
56,0%
54,0%
52,0%
50,0%
Jan-02
Loans / Total Assets
Loans and Investments / Total assets
14
Graph 11
Annual CPI Inflation
6,0
5,5
5,0
4,5
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Jan-06
4,0
Non Tradable CPI without foodstuffs and administered prices
Source: DANE, Calculations Banco de la República
Graph 12
Loans at risk/Total Loans by vintages: Consumer loans
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Semester 1
Semester 2
2006 - I
Semester 3
2006 - II
2007 - I
Semester 4
2007 - II
2008 - I
Semester 5
15
Graph 13
Producer's Price Index
(annual change)
Table 1
Annual GDP Growth by Type of Expenditure
2006
2007
2008-I
2008-II
Total Consumption
Private Consumption
Public Consumption
Gross Investment
6.0
6.5
4.2
19.2
6.5
6.7
5.9
20.6
3.3
3.4
3.1
13.1
2.8
3.1
1.7
8.4
Gross Fixed Investment
Change in Inventories
Exports
Imports
17.2
37.0
7.5
16.2
17.5
45.0
11.9
19.0
8.1
48.1
14.1
15.4
7.8
11.7
11.6
10.5
GDP
Internal Demand
Internal Demand
without Change in
Inventories
6.8
8.7
8.1
7.7
9.7
8.8
4.5
5.7
4.4
3.7
4.2
3.9
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
18,0%
16,0%
14,0%
12,0%
10,0%
8,0%
6,0%
4,0%
2,0%
0,0%
-2,0%
-4,0%
Source: DANE
Total
Administered Prices
Sep-08
Jul-08
Foodstuffs
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
Total
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Jan-06
Sep-08
Jul-08
May-08
Mar-08
Ene-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Ene-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Ene-06
16
Graph 14
Annual Consumer's Inflation
15,0
13,0
11,0
9,0
7,0
5,0
3,0
Source: DANE.
Graph 15
Annual CPI Inflation
11,0
9,0
7,0
5,0
3,0
17
Graph 16
Monthly average of Inflation Expectations derived for Government Bonds (TES)
1, 5 y 10 years,
January 2005 to September 2008†
9%
8%
7%
6%
5%
4%
1 year
5 years
10 years
Observed Inflation
Graph 17
Public bonds zero coupon curves 2008
13,25%
13,00%
12,75%
12,50%
12,25%
12,00%
11,75%
11,50%
11,25%
11,00%
10,75%
10,50%
10,25%
10,00%
1
2
3
4
5
25-Jul*
6
7
8
9 10
01-Sep**
11
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Jan-06
Nov-05
Sep-05
Jul-05
May-05
Mar-05
Jan-05
3%
18
Graph 18
Annual CPI Inflation
4,0
3,9
3,8
3,7
3,6
CPI without foodstuffs and administered prices
Source: DANE, Calculations Banco de la República
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
3,5