Morningstar DBRS Confirms Republic of Colombia at BBB (low), Stable Trend

DBRS, Inc. (Morningstar DBRS) confirmed the Republic of Colombia's Long-Term Foreign and Local Currency - Issuer Ratings at BBB (low). At the same time, Morningstar DBRS confirmed the Republic of Colombia's Short-Term Foreign and Local Currency - Issuer Ratings at R-2 (middle). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects our view that 1) Colombia's strong policy frameworks and robust institutional checks and balances are acting to moderate President Petro's reform agenda, and 2) tight macroeconomic policies have helped correct elevated external and internal imbalances. Despite weaker terms of trade, the current account deficit narrowed from 6.1% of GDP in 2022 to 2.5% in 2023. Inflation also declined markedly and expectations remain anchored within the central bank's target range. As a consequence, the Colombian economy slowed sharply in 2023. Output expanded 0.6% last year, down from 7.3% in 2022. However, a gradual recovery appears to be underway. The IMF forecasts growth of 1.1% in 2024 and 2.5% in 2025. We think risks to this forecast are skewed to the upside. Moderate fiscal support, less restrictive monetary policy settings, and real wage growth on the back of lower inflation should support a modest rebound in consumption and investment.

Colombia's BBB (low) credit ratings balance the country's record of sound macroeconomic policymaking with increasing fiscal pressures and deep governance challenges. Following a sizable consolidation in 2023, the Finance Ministry expects the general government deficit to widen from 2.7% of GDP in 2023 and 4.9% in 2024. The government will need to structurally tighten fiscal policy in order to stabilize public debt dynamics and comply with the fiscal rule. However, adjusting fiscal accounts will be politically challenging, especially given the country's divided political landscape and social polarization.

CREDIT RATING DRIVERS
Colombia's credit ratings could be upgraded if fiscal accounts consolidate in a durable manner and public debt ratios materially decline. The credit ratings could also be upgraded if medium-term growth prospects substantially strengthen on the back of supply-side improvements in the economy.

The credit ratings could be downgraded if the fiscal outlook deteriorates relative to current expectations or medium-term growth prospects weaken, thereby complicating efforts to keep public finances on a sustainable path.

CREDIT RATING RATIONALE
The Fiscal Outlook Is The Most Pressing Challenge To The Sovereign Credit Profile

Following a large consolidation in 2023, the fiscal deficit is expected to deteriorate in 2024. The general government fiscal deficit narrowed from 6.3% of GDP in 2022 to 2.7% in 2023. The improvement was the result of revenue-raising effects from the 2021 and 2022 tax reforms, higher oil-related revenue, and better financial results by social security funds. In addition, the government incrementally increased gasoline prices through 2023 in order to reduce the cost of fuel subsidies, with gasoline prices reaching market prices by Q4 2023. However, this year the general government fiscal deficit is expected to increase to 4.9% of GDP. The increase is driven by structurally lower-than-expected tax revenue, higher interest costs, and the normalization of financial returns by social security funds. The government plans to gradually reduce the deficit to 2.6% by 2028, primarily through improvements in tax collection and tight expenditure control.

The government has stated that it is committed to complying with the fiscal rule. The Social Investment Law in 2021 reinstated a structural fiscal rule and introduced an explicit debt anchor (55% of GDP). The Law spells out the central government structural primary balance targets from 2022-25, as fiscal accounts transition to the new rule. The government was compliant with the fiscal rule in 2022 and 2023, and it is aiming to comply with the rule this year. Given the modest negative output gap expected in 2024, below-trend oil-related revenues, and several one-off transactions, the headline central government deficit is expected to increase relative 2023 while still complying with the rule. Next year, the government is seeking congressional approval to fully transition to the new rule in 2025, one year earlier than planned. Due to the design of the rule, this change could enable the government to deliver a slightly smaller adjustment next year. If congress does not pass the amendment, the government may need to tighten policy slightly more than planned.

General government debt nearly returned to prepandemic levels in 2023 but is expected to increase over the next two years. Gross general government debt increased from 52% of GDP in 2019 to 67% in 2020 amid the shock of the pandemic. Due to peso appreciation, high inflation, and better fiscal results, the debt ratio fell back to 54% by 2023. The debt ratio is projected to increase to 56% in 2025 and then stabilize on the back of an improving primary balance. The composition of the central government debt is generally favorable, with a long maturity structure and the vast majority of liabilities carrying fixed rates. However, higher debt servicing costs are putting more stress on public finances. Interest payments increased from 3.0% of GDP in 2019 to 4.1% in 2023, even as the debt-to-GDP ratio was roughly the same. Government bond yields are down from their highs in late 2022 but are still elevated relative to the average over the last decade. Moreover, approximately one-third of the debt is denominated in foreign currency, which leaves the public balance sheet exposed to peso depreciation.

Declining Investment Points To A Weaker - Albeit More Balanced - Growth Outlook

Over the last four years, the Colombian economy has demonstrated a high degree of resilience in the context of various global and domestic shocks. Following the pandemic, output quickly recovered and generated a large positive output gap. Policymakers responded by tightening macroeconomic policies, which reduced external and internal imbalances, and thereby put Colombia in a better position to grow in a sustainable manner. However, estimates of potential growth have been revised down in line with expectations of weaker investment. The IMF estimates medium-term growth at 3.0%; two years ago, projected growth potential was 3.4%, and five years ago, it was 3.7%. Economic policies of the Petro administration could be contributing to the weaker investment outlook, along with policy uncertainty as several major pieces of legislation are still under consideration. In particular, the oil and gas sector could receive less investment due to recent tax reforms, which have significantly increased taxes on the sector, as well as the Petro administration's decision to withhold new licenses for fossil fuel exploration. Other parts of President Petros's domestic reform agenda are still under discussion, but if passed could potentially dampen investment and weaken productivity growth.

On the positive side, tight macroeconomic policies have led to a large adjustment in the external accounts. Despite less favorable terms of trade, the current account deficit narrowed from 6.1% of GDP in 2022 to 2.1% (rolling four quarters) in the first quarter of 2024, almost entirely on the back of import compression. We believe the correction is close to completion, as imports should stabilize with the recovery in domestic demand. Net FDI inflows fully covered the external deficit, in addition to helping offset net portfolio outflows. Colombia's credible macroeconomic policy framework and flexible exchange rate is helping the economy adjust to evolving global conditions in an orderly manner. Colombia also holds $60 billion in reserves and has access to about $8 billion in the form of a Flexible Credit Line with the IMF. This provides some protection against downside tail risks.

Inflation Is Declining And Expected To Converge To The Central Bank's Target Range In 2025

Prices rapidly increased in the post-pandemic period due to a series of supply shocks and strong demand. Annual inflation peaked at 13.3% in March 2023. In particular, food prices increased markedly due to higher fertilizer prices in 2022 and extreme weather in 2023, which damaged crops and infrastructure. Excessive demand relative to supply also put upward pressure on prices more generally. Price pressures are now dissipating as supply shocks recede and demand moderates. Nevertheless, rising regulated fuel prices, widespread indexation across the economy, and weather-related effects on food prices have slowed the pace of disinflation. In May 2024, annual inflation declined to 7.2%.

Amid moderating inflation and decelerating activity, the central bank started its easing cycle. Policymakers lowered the policy rate from 13.25% in November 2023 to 11.75% in May 2024. Nevertheless, monetary policy settings remain very tight. The ex-ante real policy rate is above 7.0%, which is clearly in restrictive territory, and it will likely remain restrictive through the end of the year even as the policy rate gradually declines. The credibility of the inflation-targeting regime has helped anchor expectations. According to the central bank's Economic Expectations Survey (June 2024), annual inflation (median) is expected to decline to 5.7% by December 2024 and 3.8% by December 2025, which is within the central bank's 2-4% target range.

The financial system has managed the slowdown in the domestic economy relatively well. Credit growth levelled off in 2023 amid lower loan demand and higher provisioning requirements on certain loans. Non-performing consumer loans increased from 4.5% in April 2022 to 8.3% in April 2024, and banks have set aside additional provisioning. Overall, we see financial stability risks as contained. Banks are highly capitalized, liquid, and primarily funded by local deposits. In addition, currency mismatches across banks, corporates, and households are limited.

Petro's Reform Agenda Is Facing Resistance In Congress; Rule Of Law Remains A Key Credit Challenge

Gustavo Petro came into office with an ambitious agenda that included tax, health, pension, and labor reforms. After winning the presidency in 2022, Petro's party, Historic Pact for Colombia, joined forces with three traditional parties - the Liberals, Conservatives, and the Party of U - to form majorities in both the lower house and the Senate. The coalition approved a major tax reform in late 2022 and a pension reform was recently passed following laborious negotiations. However, Petro's congressional alliance has largely disintegrated due to disagreements over the legislative agenda. The fragmentation of the coalition and Petro's low popularity reduce the likelihood that other proposed reforms, such as health and labor, will advance in the near term. Nevertheless, discussions with congress will likely restart this fall, and legislation could still advance in the second half of the Petro administration, albeit likely in a modified form.

We continue to view the rule of law as a key credit challenge. There has been positive news for the country in terms of governance over the last two decades: Colombia has delivered sound macroeconomic management, poverty rates have materially declined, the peace accord with the FARC is advancing, despite setbacks, and Colombians' participation in the democratic process has strengthened, according to Worldwide Governance Indicators. The country's record of sound macroeconomic policy management accounts for the one category adjustment in the Political Environment building block. However, Colombia compares unfavorably to most similarly rated countries in terms of the rule of law. Even as the 2016 peace accord with the FARC advances, illegal armed groups continue to fight to control territory and the drug trade. The process of extending the state's presence to remote areas of the country, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking remain important long-term challenges.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS   

ESG Considerations had a significant effect on the credit analysis.

Environmental (E) Factors   
The following Environmental factor had a significant effect on the credit analysis: Resource and Energy Management. The economy is vulnerable to oil price shocks, with petroleum products constituting roughly 35% of Colombia's exports, 10-25% of foreign direct investment inflows, and 5-15% of general government fiscal revenues. This factor is taken into account in the Balance of Payments and Fiscal Management and Policy building blocks.
 
Social (S) Factors  
The following Social factor had a significant effect on the credit analysis: Human Capital & Human Rights. Similar to other emerging market economies and many of its regional peers, Colombia's GDP per capita is relatively low at US$7.0k (US$19.3k on a PPP basis). This largely reflects the low level of labor productivity. In addition, organized criminal gangs continue to commit human rights abuses, especially against journalists, community leaders, and human rights activists. This factor is taken into account in the Economic Structure and Performance building block and the Political Environment building block.
  
Governance (G) Factors  
The following Governance factors had a significant effect on the credit analysis: (1) Bribery, Corruption and Political Risk, (2) Institutional Strength, Governance, and Transparency, and (3) Peace and Security. According to Worldwide Governance Indicators, Colombia ranks in the 41st percentile for Control of Corruption and in the 38th percentile for Rule of Law. Colombia ranks in the 54th percentile for Voice & Accountability. While Colombia has made progress in reducing violence, the country still ranks very low on Political Stability and the Absence of Violence/Terrorism (23rd percentile). These factors are taken into account in the Political Environment building block.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/434945.

Notes:

All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (October 6, 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are monitored.

The primary sources of information used for this credit rating include the Ministerio de Hacienda y Crédito Público, Banco de la República, Superintendencia Financiera de Colombia, DANE, IMF, Tullet Prebon Information, World Bank, NRGI, Brookings, BIS, World Federation of Exchanges, and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS did not have access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

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