Itaú BBA - COLOMBIA: How much depreciation is necessary for a faster current-account deficit adjustment?

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COLOMBIA: How much depreciation is necessary for a faster current-account deficit adjustment?

August 24, 2016

The currency remains vulnerable to changes in external financial conditions.

In spite of a sharp weakening of the Colombian peso over the past two years, the current-account deficit is narrowing only gradually and it remains wide. 

As oil prices recover, internal demand slows and the exchange-rate depreciation benefits the non-commodity tradable sectors, we expect the deficit to continue to narrow, but only slowly. Given the loose monetary policy stance in the core economies, we think the financing that allows a smooth reduction of the deficit is available.

However, as the outlook for the global economy remains uncertain, we can’t rule out scenarios in which markets demand a faster adjustment of Colombia’s external imbalance. In this report, we calculate the exchange-rate depreciation that would be necessary to bring the current-account deficit to a more sustainable level by 2018 – currently we do not expect that to happen for at least the next three years. We present the calculations for various combinations of internal demand growth and oil prices.

Our exercises show that in spite of the sharp depreciation of the Colombian peso that has already taken place, the currency remains vulnerable to changes in external financial conditions.

Colombia’s current-account deficit remains very wide. In the four-quarter period ended in 1Q16, the deficit reached 6.1% of GDP. Among the core emerging economies, Colombia’s deficit was the widest in 2015. At the margin, it is running only somewhat lower: according to our own estimation, the seasonally adjusted deficit was 5.6% of GDP in 1Q16 and the evolution of the trade balance suggests that the deficit correction in 2Q16 continued to be slow.

The very slow narrowing of the current-account deficit has happened despite sharp depreciation of the Colombian peso over the past two years. Since oil prices started to fall, the Colombian peso has been one of the worst-performing currencies. The deterioration of Colombia’s terms of trade (worse than that experienced by other countries in Latin America) and a resilient internal demand (domestic demand excluding inventories grew a robust 3.6% in 2015) kept the external deficit wide. In 2Q16, Colombia’s terms of trade were 23.5% below its average level in 2012, a period of high commodity prices. Terms of trade in Brazil, Chile, Peru and Mexico fell, on average, 15.9% in the period. As a result, Colombia’s four-quarter rolling net energy balance (defined as the difference between exports and imports of energy products, including coal) fell to 3.7% of GDP in 2Q16, less than half of the 10.1% peak reached in 1Q12. The fact that around 50% of the foreign direct investment that Colombia has received since 2003 went to the Mining sector (largely oil, but also coal) provides a buffer for the current account: as oil prices affect the profitability of oil companies, lower oil prices are also reducing profit remittances and, consequently, the income-balance deficit. 

Looking ahead, Colombia’s current-account deficit will probably continue to narrow. As lower oil prices bite fiscal revenues and the exchange rate pushes inflation up, real wages are falling and fiscal and monetary policies are becoming tighter. Adding this to the diminishing appetite of oil companies to invest, internal demand will likely grow substantially less over the next few years than in 2015. In addition, over time the weaker exchange rate benefits manufacturing exports and is an incentive for import substitution. Finally, oil prices are already improving and we expect some further recovery ahead. In our baseline scenario, the Brent barrel price will finish this year at USD 52, before stabilizing at USD 54 per barrel from 2017.

In this context, we expect the current-account deficit at 5.5% of GDP this year, 3.9% in 2017 and 3.3% in 2018. While this means that the current-account deficit of Colombia would remain wide for a few more years, we think that financing would be available considering the loose monetary-policy stance in the core economies.

However, as the outlook for the global economy remains uncertain, we can’t rule out scenarios in which markets demand a faster adjustment of Colombia’s external imbalances, by cutting financing to the country. In this report, we calculate the exchange-rate depreciation that would be necessary to bring the current-account deficit to a more sustainable level in 2018. We present the calculations for different combinations of internal demand growth and oil prices.

We run four equations to make our estimations: i) net energy balance as a function of oil prices and oil production; ii) exports of services and manufacturing goods as a function of global GDP growth and real effective exchange rate (REER); iii) imports of services and non-energy goods as a function of final domestic demand and REER; and iv) income payment abroad as a function of nominal exchange rate and oil prices. In these equations, most of the impact on the modeled variables is lagged. For simplicity, we assume that the remaining components of the current account (transfers, investment income received from abroad and exports of commodities other than energy) will remain constant in dollar terms, but not as a proportion of GDP, given that the exchange-rate depreciation will impact the nominal GDP in dollars in our simulations.

With these equations, we first estimate the depreciation necessary to bring the current-account deficit to 2% of GDP, which is approximately the average deficit level that Colombia has experienced since 2000. Specifically, we estimate what the one-off depreciation is in 3Q16 (that is, a depreciation in 3Q16 and then a constant real exchange rate in the following quarters) that brings the deficit to 2% in 2018, for a combination of three scenarios for oil prices (our baseline scenario described above; USD 80 per Brent barrel from 3Q16 on and USD 30 per barrel from 3Q16 on) with two scenarios for internal demand growth (0% and 2% annualized growth from the second quarter of this year on).

We show the results in the table below. Besides the real exchange-rate depreciation, we also show the level of USDCOP in 3Q16 that is consistent with each depreciation rate (assuming that the currencies of the remaining trade partners will remain constant, in real terms, against the dollar). In the more adverse scenario (low oil prices and moderate internal demand growth), the Colombian peso would need to weaken by 21%. In the more benign scenario (high oil prices without internal demand growth), an appreciation of 11% would be consistent with bringing the deficit to 2% of GDP in 2018. In an intermediate scenario for oil prices (our baseline) and moderate internal demand growth, we calculate a depreciation of 14%.

We also calculate the depreciation necessary to erase the deficit altogether by 2018 (so a context of even harsher external financial conditions for Colombia) for the same combination of oil prices and domestic demand growth. In all six scenarios, the Colombian peso would have to weaken from its 2Q16 level. Based on our estimations, we calculate that the extra depreciation necessary to zero the deficit, relative to the depreciation that brings the current account to -2% of GDP, ranges from 11.2% to 17.5%, depending on the combination of domestic demand growth and oil prices. In the more adverse scenario (oil at USD 30 per barrel and internal demand growth of 2.0%), the depreciation (from 2Q16) that narrows the deficit to zero in 2018 would be 34%.

In all, these exercises show that in spite of the sharp depreciation of the Colombian peso that has already taken place, the currency remains vulnerable to changes in external financial conditions. The ongoing tightening of macro policies contributes to reducing the vulnerability of the currency by lowering internal demand growth, but sizable additional exchange-rate depreciation is likely if uncertainty over the global economy returns, limiting capital flows to emerging economies. These calculations, given already high inflation, point to a somewhat tricky environment for local monetary easing.


 

João Pedro Resende


 



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