The Big Idea
Colombia | Finding a ‘BB’ comparable
Siobhan Morden | September 22, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Analysis of relative value for Colombia and across other ‘BB’ credits in Latin America shows a subtle landscape. Almost every credit brings some distinct feature to its debt such as Brazil as an infrequent issuer or Paraguay, Guatemala and Costa Rica as illiquid credits. But the Dominican Republic may be the most comparable to Colombia with a similar stock of sovereign debt outstanding and a similar market beta. Yields across the Dominican Republic and Colombia have converged recently, with 10-year Eurobonds staying within a tight trading range of 0 bp to 40 bp over the past six months and 30-year ranging from 0 bp to 50 bp.
In the middle of this picture is whether Colombia or the Dominican Republic will make the decisive shift out of the ‘BB’ category, and what factors will contribute to this shift. Both countries appear relatively resilient to the prospect of an economic crisis, but key differences in policy priorities and economic trajectories set them apart.
The Dominican Republic stands out with a clearer path towards an investment-grade rating, driven by a commitment to a fiscal anchor and lower debt ratios. On the other hand, Colombia faces stubbornly high inflation and latent supply-side shocks, limiting its policy flexibility and raising concerns about its trajectory.
The downside risks to economic growth have hit both countries hard in 1H2023 at 1.5%; however, Colombia does not have the same policy flexibility under the stubborn high inflation and latent supply-side shocks. The majority of central banks in Latin America have already initiated rate cut cycles with the Dominican Republic one of the frontrunners. BanRep has remained on hold on still stubbornly high inflation expectations, persistent supply-side shocks, indexation, and inopportune wage negotiations in December. It remains a difficult tradeoff on the protracted contamination of inflation expectations through 2024 as well as the prospects for still below trend growth ~2% next year. These stagflationary pressures only adds to the broader noise of policy risks on the uncertain commitment to the fiscal rule, regulatory risks in the energy/mining sectors and the threats to lower productivity/investment for lower trend GDP growth.
The fiscal anchor remains the backbone for debt dynamics, especially considering the already high 57% of GDP net debt ratios. There has been much debate on whether or not the Petro administration would comply with the fiscal rule guidelines; however maybe insufficient debate on whether these guidelines are sufficient condition for regaining an investment grade rating. The fiscal rule committee has been vocal about several weak assumptions including only a gradual adjustment on debt ratios (55% of GDP in 2032), optimistic declining average interest rates (8.6%-6.2%) and risks of lower trend GDP growth (below 3%). The 2024 budget also assumes overly optimistic revenue projections (1% of GDP legal claim revenues) that may disappoint this year and most certainly in the outyears if only a non-recurring revenue. The Petro administration has been typically conservative on budget execution in 2023 and also committed to cut fuel subsidies. Next year is the true test on whether succumbing to political pressures or showing commitment to the fiscal rule. The strong institutions and political establishment may have to engage debate between higher structural spending and/or lower debt ratios. The fiscal rule ceiling/floor at 71%/55% on debt ratio guidelines seem intended to maybe stabilize the debt ratios but not enough to shift the credit back on the sub 30% of GDP low debt ratios of its prior investment grade rating (2011-2017).
There has been a unique shift across the region on fiscal trends post pandemic in 2022 with Colombia showing the highest primary fiscal deficit and the largest increase in spending across the region with the least convergence back to pre-pandemic levels. The medium-term fiscal plan shows a post pandemic 6% of GDP increase in spending from 2019 to 2024 and a clear priority for higher public spending with only a gradual decline in the high fiscal deficits of 4% of GDP over the next few years. The budget management may become increasingly complicated on the uncertain deceleration in trend growth and the potential for stubborn high interest rates. This does not translate into either a funding or fiscal crisis but rather just validates the implied BB credit ratings of current valuations. There are sufficient checks/balances that would prevent against a severe deterioration in policy management with strong institutions and a political establishment that defends the well-known track record of economic stability. However, policy paralysis isn’t sufficient catalyst for regaining the investment grade rating with multi-year stagflation trends, high fiscal deficits, and uncertainty on path towards lower debt service and debt ratios. Meanwhile, DomRep may benefit from a breakaway trend on not only a recent shift in the funding strategy (less Eurobond issuance) but also the prospects for tax reform next year for lower fiscal deficits and commitment of lower debt ratios.