Colombia’s investment grade status at stake in tax battle

Colombia’s decade-old status as an investment grade nation will be put to the test as the government of Iván Duque tries to pass a fiscal reform package to steady an economy that has gone haywire during the coronavirus pandemic.

Duque says he will present the package to congress in March with the aim of getting it approved by June. If the timetable slips, there is a danger his proposal will become mired in the country’s legislative and presidential election campaigns for 2022, which will begin in earnest late this year.

“The longer they wait the harder it’s going to be and it increases the risk of a watered-down tax reform,” warned Richard Francis, director of sovereign ratings at Fitch Ratings.

Fitch, like other agencies, will be watching carefully. Both it and Standard & Poor’s rate Colombia BBB- with a negative outlook for the issuance of long-term debt. That is just one notch above non-investment or junk status. Moody’s rates Colombia Baa2, two notches above junk.

If the reform flounders or is diluted, there is a high chance Colombia will be downgraded — demoted from a small group of Latin American investment-grade nations that includes Mexico, Chile and Peru.

That would be a blow to a country that, despite its long civil conflict and well-chronicled lawlessness, prides itself on fiscal rectitude. In sharp contrast to most Latin American nations, Colombia has not defaulted on its debt since the 1930s. Unlike Brazil and Argentina, already deemed junk for the issuance of sovereign debt, it has enjoyed investment grade status since 2011.

“Colombia is a curious country in that people here generally know about the issue of sovereign ratings and follow it closely,” said Munir Jalil, Bogotá-based chief economist for the Andean region at Latin American investment bank BTG Pactual. “Losing investment grade status would hit Main Street Colombia, it would hit morale and dent the government’s image.”

Before the pandemic, Colombia boasted the fastest growing of the region’s major economies. Gross domestic product expanded by 3.4 per cent in 2019 and the fiscal deficit was on a downward trajectory. The country’s debt stood at around 45 per cent of GDP.

But the pandemic has been punishing. One in every 23 Colombians has had coronavirus according to official figures, and the true number is probably higher. Nearly 60,000 people have died.

The economy contracted by 6.8 per cent last year — the worst drop on record — and debt soared to above 60 per cent of GDP. The fiscal deficit has ballooned to around 9 per cent as the government imposed strict lockdowns and announced measures to help businesses and the poor.

The upshot is that Duque has few alternatives but to raise revenue.

“The only way to have a credible fiscal adjustment is through tax reform,” Francis said. “We think it’s essential.”

The government is aiming for a reform worth at least 1.5 per cent of GDP, or $4.4bn, and will try to trim Colombia’s vast web of tax exemptions, which cost the state roughly $20bn a year.

Most of those exemptions are on payments of value added tax, which is set at 19 per cent. By scrapping even some of them, Duque could raise the revenue he needs.

If Colombia doesn’t pass this reform we lose investment grade status for sure.

But politically it will be tough. In 2018, the government tried to abolish VAT exemptions on some basic foodstuffs. The plan caused uproar: it was seen as a tax on the poor and congress watered down the reform package to such an extent that it was revenue neutral.

The political scenario is no more auspicious now than it was then. Duque’s rightwing Democratic Center party has fewer than 20 per cent of the seats in congress and needs the support of other parties. Some have already said they will not consent to a repeat of the 2018 proposals.

“Duque has never been particularly skilful at navigating congressional waters or generating legislative consensus,” London-based consultancy Teneo noted. It predicted the president would have to resort to “the type of pork and patronage campaign that [he] once repudiated” to get his way.

The implications of a downgrade might not be as drastic as some Colombians fear. BTG Pactual’s Jalil estimated it would trigger capital flight of only around $1.5bn in a country with a GDP of $291bn.

“There might be some capital outflows if institutional investors have to sell Colombian bonds, leading to higher borrowing costs, but the initial impact of a ratings downgrade is usually fairly minor,” added Nikhil Sanghani, Latin American economist at Capital Economics in London.

However, Fitch warned that a downgrade would have a knock-on effect and “would negatively affect some corporate, bank and infrastructure ratings”. It said eight of the 21 Colombian companies it rates would be downgraded along with the sovereign.

Furthermore, Duque will not want to go down in history as the president who steered Colombia to junk status.

“If Colombia doesn’t pass this reform we lose investment grade status for sure,” Jalil said. “And even if Colombia does pass it, investment grade is not guaranteed. The rating agencies will look at the size and the impact of the reform before making a decision. It’s not going to be easy.”