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Colombia: The Fiscal Rule Committee sets a slower fiscal consolidation path. While the new figures are more plausible, the update raises questions about the flexibility of the fiscal rule

 

May 9, 2018 (Investorideas.com Newswire) In its latest annual meeting, the independent Fiscal Rule Committee (FRC) decided to carry out significant changes to fiscal targets for the upcoming years following revisions to the main parameters of the rule, including long-term oil prices and potential GDP growth, as well as to methodological issues. As a result, the Committee postponed the convergence of the fiscal deficit of the Central Government (CG) towards 1% of GDP until 2027 vs 2022 previously (see chart 1). For 2018, the deficit target was kept at 3.1% of GDP (which will be met, in our view) whereas that for 2019 was increased from 2.2% to 2.4% of GDP, closer to our long-held estimate of 2.7% of GDP.

While we think that the new targets from 2019 onwards are more plausible (i.e. the adjustments are not completely unexpected as the previous figures were highly unlikely to be met amid structurally lower economic growth and oil prices), this is the fourth year in a row that fiscal deficit goals are increased, raising questions about the degree of flexibility of the fiscal rule. Having said that, we highlight that the new fiscal targets still imply that the CG's net debt would fall from 2019 onwards (see chart 2).

We continue to think that credible measures will have to be taken by the next government to maintain a consolidation path and avoid further rating actions, as the future fiscal outlook remains challenging despite the revisions made by the FRC. Recall that rating agencies have recently stated that their own projections already considered a less demanding fiscal adjustment in the upcoming years compared to the one assumed in the 2017 Medium Term Fiscal Framework (MFMP). Thus, we believe that the key factor is to undertake additional actions aimed to avoid loss of credibility. Although we are of the view that the likelihood of Colombia losing its investment grade status remains rather low, we do not rule out Fitch or Moody's deciding to cut the rating to BBB- in the upcoming moths, in line with the grade currently held by S&P since Dec-17.

  • Adjustments in the output gap and the estimated elasticity of non-oil tax revenues to GDP led the FRC to revise the fiscal path for the upcoming years. Following the new estimates of potential GDP growth and the projections of effective economic growth for the next years, the FRC predicts that the output gap will close at a slower pace ahead, meaning that it will remain in negative ground until 2025. For instance, the new output gap estimate for 2018 stands at -3.8% vs -3.0% before, while that for 2019 currently is -4.0% vs -2.7% a year ago (see chart 3). In addition, the FRC decided to change the estimated elasticity of non-oil tax revenues to GDP from 1.0 to 1.15 from 2019 onwards, the result of analyzing empirical evidence (see chart 4). The combination of these factors leads to a wider cyclical room (economic cycle), allowing a slower convergence of the fiscal deficit towards 1% of GDP
  • That said, we think that the FRC gave more flexibility to the government through the oil cycle as well. Recall that the total fiscal room provided to the government by the fiscal rule comes from the economic cycle (the difference between the effective economic growth and potential GDP growth) and the oil cycle (the difference between observed oil prices and the estimated long-term oil price). As mentioned above, the new estimates from the FRC increased the fiscal room provided by the economic cycle. On the other hand, the minutes of the FRC shows that there was a discussion around the gap between the effective oil price projected and the new calculated long-term oil price (the oil cycle) because, under the new estimates, the former would stand at USD 65 in 2019, above the latter of USD 62, entailing a positive gap (see charts 5 and 6). Interestingly, the FRC advised the government to use the estimated path for the long-term oil price as the effective price rather than force it to a stronger fiscal adjustment given an initially calculated positive gap. Thus, the assumed oil prices from 2019 onwards will be the same as the estimated long-term oil price under the argument of high uncertainty around projections, meaning a null oil cycle.
  • Although the new fiscal targets are more plausible, we think that the changes carried out by the FRC are not net positive once the fiscal path has been widened for four years in a row, raising questions about the flexibility of the fiscal rule. Having said that, it is worth noting that, despite the slower convergence of the fiscal deficit in the upcoming years, the CG's net debt would fall from 2019 onwards. In fact, this would be consistent with our projection of a relative stabilization of indebtedness next year assuming a fiscal deficit of 2.7% of GDP (instead of 2.4% of GDP as estimated by the FRC).
  • Recall that rating agencies have affirmed in recent months that a change in the fiscal rule is not credit negative per se. Moody's stated that a revision or an amendment of the fiscal rule was not credit negative per se, as it could be replaced with one that incorporates the new reality of lower oil prices and slower growth and, if it remains committed to fiscal prudence, it could end up enhancing the credibility of the policy framework. On its part, Fitch said that credibility and indebtedness are key factors and so, seeing debt/GDP ratio converging to the BBB median is important. In any case, this agency said that it is likely that a 1% of GDP fiscal deficit as set in the fiscal rule by 2022 is not strictly necessary to meet that goal once “probably 2% or thereabouts would be sufficient” (note that the new estimated fiscal deficit for 2022 is 1.5% of GDP). Yesterday, Fitch said that the reaction of the government and the new administration to the announcements of the FRC is yet to be seen whereas stating that the fiscal rule is an important factor for the sovereign rating.

Accordingly, we think that preserving credibility and making the required efforts to reduce indebtedness are the key factors as the fiscal path remains demanding despite the targets revisions. Thus, we believe that the proposals by the spending Commission will have to be seriously considered by the next government. On the other hand, we do not rule out a slower pace of reduction of the corporate income tax, which is set to be cut from the current 37% to 33% in 2019. This is because each 1% of the income tax represents ~0.1% of GDP in fiscal revenues, so that a reduction of 4pp would fully offset the additional revenues coming from higher-than-initially expected oil prices (we estimate that an increase in oil prices of USD 10 can lead to ~0.4% of GDP of higher fiscal revenues the following year). Overall, significant efforts on both the spending and revenue sides should be undertaken as the new parameters imply that the fiscal deficit has to be cut by 0.7% of GDP in 2019.

For charts, tables and the full report, see the pdf file

Daniel Velandia, CFA
+ (571) 3394400 ext. 1505
dvelandia@credicorpcapital.com

Camilo Durán
+ (571) 3394400 ext. 1383
caduran@credicorpcapital.com


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