Gathering Clouds: Fitch Ratings Just Revised Colombia’s Credit Rating Outlook To Negative From Stable
Fitch Ratings has announced today that it has affirmed Colombia’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘BBB’ and revised the Rating Outlook to Negative from Stable.
Colombia’s Negative Outlook reflects risks to fiscal consolidation and the trajectory of government debt, the weakening of fiscal policy credibility, and increasing risk from external imbalances. Fitch expects that the reduction of government tax revenues beginning in 2020 coupled with rigid spending commitments will make further fiscal adjustment necessary to stabilize and then gradually reduce general government (GG) debt/GDP, which at 42.3% of GDP in 2018 is already above the current ‘BBB’ median of 37.5% and is expected to continue diverging from the median absent a faster fiscal consolidation.
Frequent medium-term budget revisions in recent years, the recent dilution in Congress of permanent tax revenue-raising measures amid rigid expenditure demands and relatively low fiscal buffers are reducing the predictability and credibility of medium-term fiscal policy. Furthermore, Colombia’s external metrics are deteriorating amid a higher current account deficit, lower external liquidity and rising net external debt.
Fitch does not currently anticipate developments with a high likelihood of leading to a positive rating change.
Fitch expects the Financing Law passed in 2018 will weaken government revenues. The initial reform included cutting the corporate tax rates, increasing personal income taxes and broadening the value-added tax (VAT) base. Amid legislative opposition, Congress eliminated or modified many key elements of the reform, most notably the extension of the VAT to basic food items. The final bill therefore will yield roughly half of the revenues of the original proposal, at about 0.7% of GDP. The corporate tax rate cuts and incentives for capital investments incorporated in the law will begin to have a negative impact on tax revenues in 2020, with a reduction of around 0.8% of GDP (and falling further in 2021-2022 as corporate tax rates continue to be cut).
Revenue losses under the Financing Law will hamper fiscal consolidation. The lost revenues will be difficult to make up with the government’s planned tax administration and anti-evasion efforts alone, in Fitch’s view. To fill the budget gap, the government proposes to sell state-owned assets as well as adjust expenditures and improve cash management. Fitch expects the government to meet its 2019 and 2020 central government targets, but only when sales of assets are included in government revenues (nearly 0.6% of GDP in each year). However, these revenues will not recur, and, in order to achieve a sustainable revenue increase and comply with the medium-term fiscal consolidation targets, further fiscal policy adjustments would likely be needed to build the non-oil revenue base (although oil revenues have risen in the last two years due to productivity enhancements at Ecopetrol and some rebound in oil prices, government revenues are still vulnerable to oil price shocks). There is little political appetite for a tax reform currently, though successive governments have built a track record of passing several tax bills over the last two decades.
While the deficit has narrowed, structural improvements in government finances have been relatively modest, with progress somewhat reliant on one-off measures. Colombia’s fiscal rule adopted in 2012 sought to reduce the central government structural deficit to 1% of GDP by 2022. The downward revisions in long-term growth potential and oil price estimates have led to frequent revisions to the actual original targets set out in the rule (but in compliance with the rule). There were revisions in 2016 and 2017 to the actual target. In 2018, the Council revised the fiscal targets again for the entire 2018-2027 period. In 2019, the Council again revised the target to address the significant costs associated with migrants from Venezuela (although the government has pledged to meet the original 2.4% of GDP target). The frequent changes have undermined the predictability and credibility of fiscal policy in Colombia. Furthermore, the government has relied on one-off measures to meet its targets in 2017-2018 with a 0.5% of GDP fine on the telecom sector in 2017 and pre-payment of income taxes from Ecopetrol (0.3% of GDP) in 2018.
GG debt/GDP continues to rise despite lower fiscal deficits over last three years, reaching 42.3% in 2018 up from 39.7% in 2017. Pre-financing, crystallization of contingent liabilities and a weaker exchange rate were key drivers of debt increase in 2018. Although Fitch expects a primary surplus to be achieved at the central government level beginning in 2019, it may not lead to stabilization of the debt to GDP ratio, given the potential for further materialization of contingent liabilities, and exchange rate movements (nearly 30% of GG debt is denominated in foreign currency).
Fitch expects Colombia’s current account deficit to widen to 4.2% of GDP in 2019, up from 3.8% of GDP in 2018 and 3.3% in 2017. A key driver of the widening deficit was an increase in the repatriation of dividends and interest payments as well as some deterioration in the trade balance. Foreign direct investment only covered roughly half of the deficit in 2018.
The widening current account deficit has led to an increase in external debt and fall in external liquidity indicators. Net external debt has risen to 10.6% of GDP, somewhat above the current ‘BBB’ median of 7.9% of GDP, and external debt service accounts for an increasing share of current account receipts. Coverage of international liquidity has weakened due to rising short-term private debt, higher non-resident holdings of local debt (25% of COP treasury bonds at end-2018) and rising external public and private debt amortizations. Fitch’s international liquidity ratio indicator fell below 100% for the first time since 2005. The international reserve coverage of current account payments also reduced to 7.1 months in 2018 from 7.9 months in 2017 (but still above the current ‘BBB’ median of 4.9 months).
In September 2018, the Central Bank announced a policy to accumulate international reserves, partly to strengthen its liquidity position. As of the end of April 2019, the central bank accumulated over USD4 billion in international reserves. The policy should help improve the external liquidity ratios over the forecast period. The central bank maintains an IMF Flexible Credit Line for USD11.4 billion to mitigate external risks.
After growing 2.6% in 2018, Fitch expects economic growth to accelerate to 3.3% in 2019 driven by domestic demand. Investment is expected to grow with private investment into the 4G infrastructure network accelerating and a boost from local governments (responsible for the majority of public investment). Private investment is expected to pick up as a result of the Financing Law. Weaker than expected first quarter growth, resulting from a fall in construction indicates downside risks to the 2019 forecast. However, Colombia’s five-year growth average at 2.7% is now below the current ‘BBB’ median of 3.6% and is expected to remain so over the forecast horizon.
Colombia’s ratings reflect its long track record of prudent and consistent macroeconomic policies that have underpinned macroeconomic and financial stability. The ratings are constrained by high commodity dependence, limited fiscal flexibility and structural weaknesses in terms of low GDP per capita and weaker governance indicators relative to peers.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns Colombia a score equivalent to a rating of ‘BBB-‘ on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
– Macroeconomic: +1 notch, reflects Colombia’s long track record of prudent and consistent macroeconomic policies, despite a decline in the credibility and predictability of fiscal policymaking.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within the agency’s criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that could individually, or collectively, lead to a downgrade include:
–Failure to implement credible structural measures to put government debt on a stable or downward trajectory;
–A sustained deterioration in Colombia’s external imbalances that lead to a continued rise in the external debt burden and weak external liquidity indicators;
–Growth underperformance relative to the ‘BBB’ median that detracts from per capita income convergence with similarly rated sovereigns
The Rating Outlook is Negative. Consequently, Fitch does not currently anticipate developments with a high likelihood of leading to a positive rating change. However, the main factors that could lead Fitch to Stabilize the Outlook include:
–Fiscal consolidation through credible and predictable policies consistent with an improved trajectory for public debt dynamics;
–Reduced external imbalances that improve external debt and liquidity ratios;
–Higher economic growth that reduces Colombia’s income gap with higher rated sovereigns.
Fitch assumes the oil price averages USD65 per barrel in 2019 and USD62.50 per barrel in 2020.
Fitch has affirmed the following ratings and revised the Rating Outlooks as follows:
–Long-Term Foreign-Currency IDR affirmed at ‘BBB’; Outlook to Negative from Stable;
–Long-Term Local-Currency IDR affirmed at ‘BBB’; Outlook to Negative from Stable;
–Short-Term Foreign-Currency IDR affirmed at ‘F2’;
–Short-Term Local-Currency IDR affirmed at ‘F2’;
–Country Ceiling affirmed at ‘BBB+’;
–Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at ‘BBB’;
–Issue ratings on long-term senior unsecured local-currency bonds affirmed at ‘BBB’.