Colombian growth to slow even if oil prices recover - Capital Economics
Latin America Economics

Colombian growth to slow even if oil prices recover

Latin America Economics Focus
Written by Quinn Markwith

Fears about the coronavirus have weighed on oil prices and clouded the near-term outlook for Colombia’s economy. But even if – as we expect, the virus is brought under control soon and oil prices recover, growth will probably be a lot weaker than most predict in 2020-21. This in turn means that the policy rate is likely to be left on hold this year, rather than being hiked as markets are pricing in.

  • Fears about the coronavirus have weighed on oil prices and clouded the near-term outlook for Colombia’s economy. But even if – as we expect – the virus is brought under control soon and oil prices recover, growth will probably be a lot weaker than most predict in 2020-21. This in turn means that the policy rate is likely to be left on hold this year, rather than being hiked as markets are pricing in.
  • Colombia’s GDP growth accelerated from 2.6% in 2018 to 3.3% in 2019, outperforming all other major economies in the region. This was supported by a pick-up in both fixed investment and household consumption growth, which offset a surge in imports.
  • The coronavirus has created uncertainty over the outlook. The price of oil – Colombia’s single largest export – has fallen from $70pb in January to $56pb now. But this doesn’t seem to have changed the optimistic consensus view. The median analyst forecast (collected in February) is still for growth to hold up at 3.2% this year and next. The government expects growth of 3.7%.
  • The consensus points to an important tax reform and a turnaround in the construction sector that will boost investment, and the ongoing influx of Venezuelan migrants that could support private consumption. While these factors will support growth, there are good reasons to expect a slowdown.
  • To start with, the investment surge is likely to unwind. Its strength last year was caused by a boost from the tax reform, and a pick-up in oil-related activity. But the effects of both have already peaked. The construction sector is likely to remain weak due to oversupply in the housing market. What’s more, private consumption has started to cool and will likely continue to soften. Household’s real income growth will probably slow in 2020 due to weaker formal employment and higher inflation.
  • A couple of one-off revenue measures will allow the government to postpone the fiscal tightening that we had previously anticipated for this year. But we still expect GDP growth to slow to 2.8% this year.
  • Moreover, growth is likely to weaken further in 2021, when we expect that the government will restart fiscal tightening. Although the budget deficit is not particularly large, the authorities are concerned about preserving the sovereign’s credit rating. We think that growth will slow to 2.5% in 2021.
  • Lower oil prices are a downside risk to our 2020 and 2021 forecasts. If oil prices remain low for longer, it may prompt us to shave an additional 0.3-0.5%-pts off of our growth forecasts.
  • One consequence of weak growth is that the central bank probably won’t tighten monetary policy this year as many expect. We think rates will remain unchanged this year, at 4.25%, whereas market pricing points to a 25bp hike. Lower-than-expected interest rates and a large current account deficit also mean that the Colombian peso will likely remain weak. Even if oil prices recover, we expect it to end the year at 3,450/$ this year (versus 3,425/$ now).
  • Weaker growth will increase the chances of a backlash against the current government’s agenda for fiscal prudence. This is particularly concerning ahead of the presidential and legislative elections scheduled for 2022. A populist lurch to the left would become more likely.

Colombian growth to slow even if oil prices recover

In this Focus, we explain why we disagree with the optimistic consensus view that the Colombian economy will maintain its recent strength over the next couple of years. We start by taking a closer look at Colombia’s exceptional performance in 2019, before turning to the reasons why we think that last year was the peak in the cycle. We conclude with our forecasts and what they mean for monetary policy and the exchange rate.

An exceptional 2019

Most of Latin America’s major economies faltered last year – Argentina’s and Mexico’s contracted, Chile and Peru’s slowed sharply, and Brazil’s only managed sluggish growth. In contrast, Colombia’s picked up for the second year in a row.

The acceleration in Colombian GDP growth, from 2.6% in 2018 to 3.3% in 2019 was driven entirely by investment and private consumption. Investment and household consumption had their best performances since before the oil price crash in 2014. Stronger growth in these sectors more than offset a larger drag from net exports. (See Chart 1.)

Chart 1: Contribution to Change in Real GDP Growth
(2018 vs. 2019, %-pts)

Sources: Refinitiv, CE

An optimistic consensus

The coronavirus has created uncertainty over the outlook. The price of oil – Colombia’s single largest export – has fallen from $70pb in January to $56pb now. But this doesn’t seem to have changed the optimistic consensus view. The median analyst forecast (collected in February) is still for growth to hold up at 3.2% this year and next. The government is even more optimistic, anticipating a further pickup to 3.7%.

Most investors seem to share our central view that the effects of the coronavirus will fade in the short term, and that commodity prices will recover. Indeed, investors are still pricing in a 25bp hike in Colombia this year in anticipation of strong growth keeping inflation high.

The optimists have pointed to an important tax reform, which will see the corporate income tax lowered further this year, and the ongoing migration of Venezuelans, as factors that will support investment and spending. However, we think that the view held by most analysts, that these factors will provide enough of a boost to see growth hold up well above 3%, is too rosy. As we explain in the next two sections, we think that the boost from these two factors has passed its peak, and that these fading tailwinds will cause growth to slow.

Investment set to slow

Before explaining why we think investment growth will slow, it is useful to look at why investment was strong in 2019. Investment growth was entirely dependent on one sector last year. Chart 2 decomposes investment into four main components. The blue bars show the average real growth rate of investment between 2008 and 2018, and the percentage point contribution of its components. The black bars show these for 2019. The key takeaway is that 2019 was unique in that machinery and equipment investment did all the work.

Chart 2: Contribution to Fixed Investment
Growth (%-pts)

Sources: Dane, Capital Economics

Sustaining such growth – let alone stronger rates – looks unrealistic. Last year’s growth of machinery and equipment investment, of 14.2% y/y, was well above its average growth rate of 4.7% seen over the past decade. Furthermore, we estimate that around half of the pick-up in machinery and equipment investment growth last year was related to activity in the oil sector. But the rise in oil-related investment mainly occurred during the first half of 2019 before cooling over the remainder of the year. We don’t expect this sort of increase in oil-related activity to be repeated this year or next, regardless of whether oil prices rebound. If this component of investment alone were to just return to its average growth rate, this would shave 0.6%-pts off the headline GDP growth figure.

What’s more, the latest activity data suggest that the surge in investment had already started to cool at the end of last year. Machinery and equipment investment slowed from 14.5% y/y in Q3 to 8.4% y/y in Q4, and capital goods imports slowed too. (See Chart 3.)

Chart 3: Capital Good Imports & Investment (% y/y)

Sources: Refinitiv, DANE

Last year’s strength also appears to be related to a boost from an important tax reform that was in large part implemented at the start of 2019. The tax reform is broadly aimed at simulating investment by lowering the tax burden for companies. The two most important features for investment are a decrease in the non-financial corporate income tax rate from 37% in 2018, to 30% by 2022, and the ability to claim credit against income tax for the VAT paid on both the importation and domestic purchase of capital goods.

However, most of the positive effects have already occurred. The ability to claim income tax credit on capital goods was introduced at the start of 2019. And the larger share of the drop in corporate income taxes (from 37% to 33%) happened in 2019 as well. The reductions between now and 2022 will be a more gradual 1.0%-pt per year. (See Chart 4.)

Chart 4: Corporate Income Tax Rate (%)

Sources: MHCP, IMF

Finally, we think that the consensus expectation for a recovery in construction is likely to be disappointed this year. Residential construction investment has been held back by oversupply in the housing market, which shows little sign of ending. This was reflected in falling new house prices over 2019. (See Chart 5.)

Chart 5: New House Prices (%y/y, 12m avg.)

Source: Banco de Colombia

All told, we expect fixed investment growth to slow from 4.6% last year to around 3.5% in 2020.

Household consumption to lose steam

Like investment, household consumption had an exceptionally strong 2019. It grew at its fastest pace since 2013. This was the single largest contributor to the improvement in GDP growth last year.

However, while retail sales grew by an impressive 7.3% last year, consumer confidence deteriorated over the course of the year, to its lowest point since 2016. Furthermore, some of the latest economic activity data suggest that private consumption started to cool in the latter half of 2019. While it’s not a particularly strong relationship, the slowdown in the purchase of big-ticket items such as vehicles towards the end of 2019 may suggest that more broad-based weakness is yet to come. (See Chart 6.)

Chart 6: Household Consumption
& Vehcile Sales (% y/y)

Sources: Refinitiv, Capital Economics

Moreover, it is difficult to square private consumption’s strength last year with the weakness in the formal labour market. (See Chart 7.) The unemployment rate increased, nominal wage growth fell significantly over the course of the year, and inflation picked up from 3.2% in 2018 to 3.5% last year, which eroded real wage growth. All of this should have prevented consumption from accelerating. One possible explanation is that the influx of Venezuelan migrants, many of whom work outside the formal labour market, boosted spending.

Chart 7: Private Consumption
& Employment Growth (% y/y)

Source: Refinitv, DANE

While it is difficult to ascertain its size, we think that the boost from immigration has started to fade and will continue to weaken this year for two reasons. First, according to the IMF, the rate of Venezuelan migration peaked in 2018. Growth in working age population migrants peaked at around 3% y/y in 2018, eased in 2019, and is set to slow further this year. (See Chart 8.) If we account for a lag between the time of their arrival and when they begin working and spending, the boost to consumption was likely at its strongest point at the start of last year.

Second, while government spending related to Venezuelan migration is set to increase marginally this year, most of the pick up (from 0.1% of GDP to 0.4%) occurred between 2017 and 2019. (See Chart 8 again.) This means that any boost to private consumption growth related to government transfers is also likely to have peaked last year.

Chart 8: Growth in Working Aged Migrants & Government Expenditure on Migrants

Sources: IMF, Bloomberg, Capital Economics

Adding to our downbeat view on consumption, we think that the weakness in the formal labour market is likely to continue. While we expect inflation to ease towards the end of the year, we still think it will average 3.8% over this year, up from 3.5% in 2019. This will weigh on real incomes. All told, expect private consumption to slow from 4.6% in 2019 to around 3.5% this year.

Headline GDP growth to weaken from here

A couple of one-off revenue measures including payment of central bank profits and an emergency dividend from Ecopetrol (worth 1.0% of GDP) will narrow the budget deficit. As a result, the fiscal tightening that we had previously anticipated for this year is likely to be postponed until next year. But this only means that growth will not slow as sharply as it would have otherwise. All told, the slowdown in investment and private consumption that we expect will likely see headline GDP growth slow to around 2.8% this year.

We expect that growth will weaken further next year as fiscal tightening begins to bite. The current government is fiscally conservative and is very concerned about its credit rating (which was downgraded in 2018). This was demonstrated last year when it cut capital spending in order to make room for expenditures related to the Venezuelan crisis and to accommodate weaker than anticipated revenues in the latter half of the year.

Admittedly, it’s possible that the government will use further one-off measures to postpone fiscal tightening again. However, we doubt that these would again be large enough for the government to avoid the spending cuts that are necessary to meet their fiscal targets. We expect that oil prices will rebound and reach our current forecast for $75pb by end 2020 and 2021. But we don’t think that this would provide enough offsetting revenue for the government, as oil export revenues over the course of the year would still average no higher than they did in 2019. All told, we think that growth will slow to 2.5% in 2021.

Downside risks stemming from oil prices

There are also significant downside risks to our forecast stemming from the coronavirus (especially for 2020). We estimate a substantial hit to the Chinese economy in Q1, and if growth is kept weak for longer due to lingering effects, there is a growing risk that commodity prices remain subdued over this year.

Table 1 shows how some of our key forecasts for this year would change if oil prices were to stay around their current level ($55pb) over this year.

Table 1: Forecasts – High and Low Oil Prices (End-2020)

Indicator

Oil at $55pb

Oil at $75pb
(Core Forecast)

Trade Balance (% GDP)

-3.0%

-2.0%

Current Account (% GDP)

-5.0%

-4.0%

Fiscal Balance (% of GDP)

-2.4%

-2.4%

GDP Growth (%)

2.3-2.5%

2.8%

Sources: Refinitiv, CE

Lower oil prices this year would cause a significant loss of export revenues. Colombia’s current account deficit would likely widen to a worrying 5.0% of GDP. And while most of this deficit would still be covered by FDI, this would increase the risk of a more dramatic slowdown in the economy over the next couple of years. A loss of oil revenues for the state would make a fiscal squeeze this year likely. All of this would prompt us to lower our 2020 GDP forecast of 2.8% by 0.3-0.5%-pts.

Conclusions

While we are downbeat on Colombia relative to the consensus, it’s worth noting that we still think that its economy will outperform most other major economies in the region over the next two years (aside from Peru). (See Chart 9.)

Chart 9: 2020 & 2021 GDP Growth Forecasts

Source: Capital Economics

There are a few key implications of our view that growth will slow. First, with economic growth likely to disappoint expectations, the central bank won’t raise interest rates. More recently, markets have moved closer to our view, but are still anticipating one 25bp hike over the next 12 months. (See Chart 10.)

Chart 10: Policy Interest Rate & Forecasts (%)

Sources: Bloomberg, Capital Economics

Admittedly, inflation is likely to remain near the central bank’s 4% target over the first few months of the year. But we doubt that policymakers will be concerned by this. The rise in inflation will mostly be due to a temporary food price pressures. Inflation expectations remain low, and a deceleration of growth will reduce concerns of the output gap closing. While the current account deficit is large, the central bank has historically looked through this, and has explained that it isn’t too concerned because most of the deficit is covered by foreign direct investment. We expect that the policy rate will remain on hold at 4.25% for the duration of this year and next. As such, lower than anticipated interest rates are likely to see local currency sovereign bond yields fall this year.

Second, lower-than-expected interest rates, along with a relatively large current account deficit, mean that the Colombian peso will remain weak even if oil prices recover. We forecast the peso to end the year at 3,450/$ (from 3,425/$ currently).

Third, weaker growth is likely to further fuel the recent backlash against the current government’s agenda of fiscal prudence. President Iván Duque’s 2018 tax reform was hard won, and with his political capital waning, it looks likely to be his only major fiscal reform while in office. This policy relies on stronger growth over the coming years in order to make up for what is likely to be a net reduction in tax revenues from the reform itself by 2022. But based on our downbeat forecast, this will not be possible. And over time it will likely only become even more politically challenging for the current government to remedy any fiscal shortfall.

All of this will become more concerning ahead of the presidential and legislative elections in 2022, where a populist lurch to the left would become more likely if growth were to slow and austerity to be stepped up. This would likely result in less fiscal discipline, meaning that there is a significant risk that Colombian bond yields rise well above their current levels over the medium-term.


Quinn Markwith, Latin America Economist, +44 20 7808 4072, quinn.markwith@capitaleconomics.com