Colombia
Dealing with Abundance
June 12, 2007

By Gray Newman and Daniel Volberg | New York, New York

The month of May brought with it one of the most pronounced gains in the Colombian peso, pushing it to the strongest level in more than seven years, and prompted the authorities on two occasions to introduce new controls designed to slow the pressure on the peso to appreciate.  Perhaps the only thing more surprising than the pace at which the Colombia peso gained ground in May was the reaction of the currency markets to the controls introduced last month: the peso market appeared to shrug off the measures from both the central bank as well as the finance ministry. By month’s end, the peso was trading at 1,890 — a level not seen since January 2000 — compared with 2,100 at the beginning of the month.

While the peso has lost some ground in the first days of June, the June sell-off has largely been prompted by a bout of global risk reduction, rather than in response to the measures announced in May.  And even after the modest retreat in early June, the peso is still near levels not seen in more than seven years.

If, as we suspect, the current sell-off turns out to be temporary, we could see, once again, pressure on the Colombian peso to appreciate and with that new concerns over what the authorities could do next.  After all, the failure of the measures in early May to stem the peso’s gains — when the authorities announced that 40% of the proceeds of all dollar borrowing would have to be set aside in non-interest-bearing accounts for six months — was likely what triggered the authorities to introduce capital controls by the month’s end, requiring that all portfolio inflows would also be subject to similar controls.

Although we cannot rule out other possible controls if the peso resumes an appreciating path, we sense a change in thinking among the policy makers that should make even more onerous controls less likely.  President Alvaro Uribe ruled out controls on foreign direct investment this past week and, instead, the finance ministry has begun talk of a new set of subsidies to help out exporters that have been hardest hit by the strength in the Colombian peso.  We expect more announcements during June, which should further ease concerns that the controls announced in May are merely the precursor to even more restrictive measures.

Perhaps the most positive sign is likely to come as early as this week when we expect the finance ministry to announce that it is immediately reducing spending and will move forward with the sale of its stake in ISA, the national utilities company in control of the power grid, as well as putting up for sale an additional 25% holding in ISAGEN, the public monopoly in charge of electricity generation and distribution.  Further encouraging is the decision to use the proceeds of both sales to buy back external debt.  The moves are in line with a part of the recommendations released this past week from an independent commission set up to study public spending.  The independent commission called for an immediate reduction in spending of at least COP1.5 trillion (US$790 million); we expect the finance ministry to announce a reduction of at least COP1 trillion.

We believe that the spending cuts are much needed to reduce the fiscal impulse in a firecracker economy that grew near 8% at the end of last year and that has shown little signs of slowing so far this year. While there is still some question as to the magnitude of the cuts — and whether they include savings likely to be achieved as the stronger-than-expected currency is reducing the peso costs of the servicing of dollar debt — the move is in the right direction.  Moreover, the cuts in spending should help provide room for the estimated COP200 billion (US$105 million) that the authorities announced last week would be available in the form of subsidies and soft loans for exporters hurt by a strengthening peso.

The finance ministry appears to realize that the measures adopted in late May have been ineffectual in stopping the pressure on the Colombian peso, and may, in some cases, have been counterproductive.  We would not be surprised to see a change that would exempt inflows from upcoming equity IPOs from the requirement that 40% of the investment be locked in for six months with the central bank.

Meanwhile, the central bank also seems to have shifted its tactics in dealing with the abundance of dollar inflows.  After engaging in massive reserve accumulation in the first half of the year via discretionary interventions in the currency market, since mid-May the central bank has stopped all discretionary interventions and reverted solely to the use of its call options — an automatic measure whereby the central bank buys dollars if the peso strengthens beyond 2% of its 20-day moving average. Although the central bank has not renounced that it could engage in discretionary interventions in the future, we suspect that its actions speak for themselves.

The central bank appears to have realized that its currency interventions served only to attract more inflows.  After all, unlike its neighbor, Brazil, where inflation continues to come in well below the central bank’s inflation target, in the case of Colombia the intervention policies of the central bank rang false.  With inflation, at 6.2% in May, well above the central bank’s 2007 target range of 3.5-4.5%, it was not difficult to understand that portfolio investors would bet that the intervention would be unsuccessful.

Given inflation well above the upper range of the target, many investors argued that the central bank would be forced to either hike interest rates further or allow the currency to strengthen further.  And while the absolute size of Colombia’s reserve accumulation —some US$4.5 billion in the first five months of the year — might seem modest compared to Brazil’s US$37 billion accumulated in the same time period, as a percentage of GDP Colombia’s reserves actually exceed those of Brazil.

We suspect that the central bank will end up hiking interest rates further — to 9.5% this year — while allowing the currency to float freely.  Although we suspect that the board of the central bank is split on how much more tightening will be needed, we are concerned that inflation is likely to remain well above the upper limit of the band and show only a modest reduction by year-end (see “Colombia: Hitting the Speed Limit”, Global Economic Forum, May 22, 2007).   If our inflation forecast proves accurate, we have little doubt that the central bank will hike repeatedly in an attempt to reassert the primacy of its inflation target over currency considerations.

Bottom line
Despite the respite in early June as the pressure for the Colombian peso to appreciate has abated thanks to a global bout of jitters, we suspect that the peso will resume its appreciating path this year to at least 1,850.  And that indeed could bring with it calls for more controls of the type seen in May.  But we doubt that the measures announced in May to freeze a portion of dollar borrowing by locals and a portion of portfolio inflows by foreigners is the beginning of even more draconian measures.  Instead, the authorities appear to have shifted tactics — reducing spending even while targeting modest subsidies to those exporters most hit by the strengthening peso and reiterating the primacy of the central bank’s commitment to control inflation over any currency target.  Both measures should do more to provide Colombia with the macro foundations for good growth in the years to come than attempts to manage the exchange rate with new controls that often have little effect in limiting inflows, but that could begin to damage Colombia’s reputation.

 

 

Middle East/North Africa
Living with Gorillas
June 12, 2007

By Serhan Cevik | Doha

Financial globalization brings more benefits than challenges to emerging economies. Greater openness and closer integration throughout the world in the post-war period have brought tremendous benefits to all countries. However, these far-reaching gains come in waves over a long period of internalization and are not necessarily distributed equally, at least in the early stages, across the global economy. Just like productivity improvements from the proliferation of electricity in the 19th century and telecommunications in the 20th century, the full effect of synchronized business cycles and financial innovations may take decades to come through. Of course, in the interim period, all the countries face a variety of economic and financial imbalances created by structural changes in progress. Beyond social and political consequences, one of the pressing challenges is the issue of absorption, especially for emerging economies. Take, for example, the much-debated case of global liquidity. Whichever way you measure it, global liquidity has kept expanding at a rate much faster than asset creation. Consequently, the overwhelming cycle of liquidity-driven flows has pushed real interest rates lower across the world and fuelled economic activity well beyond the trend growth rate of the global economy. Even today, despite the US slowdown, the state of the world economy is much better than expectations just a few months ago and keeps risk appetite intact. However, although the benefits of globalization outweigh its challenges, abrupt, exaggerated adjustments are still a threat to financial stability.

Global economic fundamentals are strong, but a tightening of market liquidity is a risk. The global economy is going through a — very — gradual rebalancing phase, as the US economy underperforms relative to the rest of the world. There is of course a high degree of uncertainty about the dynamics of rebalancing in today’s world, and a possible deepening of consumer retrenchment in America would still have significant spillover effects. Therefore, as our chief economist Stephen Roach has long argued, the game is not over yet. Indeed, judging from the behavior of current account imbalances, there is little evidence of a meaningful correction at this stage. America’s current account deficit kept widening from 0.5% of global GDP in 1997 to 1.3% in 2000 and 1.8% last year, while the cumulative current account surplus of oil exporters and Asian countries (including Japan) surged from 0.5% of global GDP to 1.7% over the same period. Although there are some signs of adjustment, the process of global rebalancing is slow — mainly because of the complex nature of imbalances arising from structural changes as well as cyclical excesses (see Can the IMF Tame Gorillas?, October 3, 2006). However, the risk is not so much about economic fundamentals but stems from the self-reinforcing cycle of liquidity-driven flows, in our view. In the post-2001 period, starting with ultra-low interest rates, the recycling of current account surpluses has led to an extraordinary accumulation of ‘foreign’ assets around the world (see Pumping Money, May 22, 2007). As net foreign assets of oil exporters and Asian countries increased from 3.7% of global GDP in 1999 to 9.5% last year, we have witnessed the emergence of a new, liquidity-driven risk culture with lower home bias and greater appetite for ‘exotic’ markets and instruments.

Emerging economies stand on stronger footings, but capital flows still create excesses. You can spin anything anyway you like, but globalization has largely been a boon for the developing world. With prudent policies and structural reforms, emerging economies have maintained a rapid pace of growth and even become creditor to the rest of the world. However, having a current account surplus does not necessarily stop the inflow of foreign capital, which soared from US$50 billion a year in the 1980s to US$700 billion in 2006. Although financial globalization eases financing constraints on growth and brings dynamism to corporate sectors, the pool of global liquidity also comes with serious challenges, especially considering the funding structure of capital flows. For example, the outstanding notional amount of derivatives increased from US$5.7 trillion (or 26% of global GDP) in 1990 to US$415.2 trillion (or 789% of global GDP) last year (see Deriving Liquidity, June 4, 2007). These complex, structured instruments certainly help to distribute risk more broadly across financial systems, but have also become a major source of market liquidity for leveraged bets in search of higher returns in a world of low real interest rates. Of course, lacking adequate financial depth and sophistication, emerging economies remain vulnerable to excesses created by the overpowering cycle of capital flows.

Global rebalancing requires exchange rate as well structural adjustments. There are hints of rebalancing in the global economy, like America’s slowly narrowing current account deficit, China’s attempts to cool the pace of economic expansion, and even an increase in real interest rates. As a result, ‘excess’ liquidity — measured by money supply growth minus GDP growth in G5 countries and China — eased from an average of 4.3% between 2002 and 2005 to 0.5% at the end of last year. However, we believe that the explosive growth in derivatives has weakened the link between monetary aggregates and market liquidity. Therefore, the world economy still needs structural adjustments as well as proactive policy updates (like currency revaluation in Asia and oil-exporting countries) to stay on a sustainable growth path.