Monetary Policy in Colombia

Hernando Vargas

Banco de la República

April 2005

I. Monetary Policy Strategy

II. Recent Trends in the Economy

III. Monetary and Exchange Rate Policies

IV. Is Inflation picking up?

V. Is there an Asset Price Bubble?

I. Monetary Policy Strategy

• Inflation Targeting since 1999….

• …. with strong FX intervention since 2004

II. Recent Trends in the Economy

International conditions have favored growth and currency appreciation

• Terms of trade (Oil, Coal, Coffee etc)

• External Demand for “non-traditional” exports (Venezuela and the U.S.)

• Workers´ remittances

• Low external interest rates and sovereign spreads

• High FDI

Internal conditions have favored growth of output and aggregate demand

• Low domestic interest rates

• Improved balance sheets of the financial system, households and firms

• Growing business and consumer confidence

• Increasing productivity? (imports of capital goods and foreign competition)

Results: High growth rates of output and aggregate demand

Internal Demand and GDP(Real annual Growth)

0%1%2%3%4%5%6%7%8%9%

10%

2000 2001 2002 2003 2004 2005

Source: DANE

Internal Demand GDP

Results: Negative output gap possibly closing….

…. Although there is great uncertainty regarding the measures of output gap

Output Gap

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

1995

T1

1996

T1

1997

T1

1998

T1

1999

T1

2000

T1

2001

T1

2002

T1

2003

T1

2004

T1

2005

T1

(% Potential Output)

Results: Strong nominal and real currency appreciation

Nominal Exchange Rate

1800

2000

2200

2400

2600

2800

3000

Mar

-00

Jul-

00

Nov

-00

Mar

-01

Jul-

01

Nov

-01

Mar

-02

Jul-

02

Nov

-02

Mar

-03

Jul-

03

Nov

-03

Mar

-04

Jul-

04

Nov

-04

Mar

-05

Jul-

05

Nov

-05

Mar

-06

Real Exchange Rate Index -RERI- (1994 = 100)

80

90

100

110

120

130

140

150

Mar

-00

Sep-

00

Mar

-01

Sep-

01

Mar

-02

Sep-

02

Mar

-03

Sep-

03

Mar

-04

Sep-

04

Mar

-05

Sep-

05

Mar

-06

RERI based on PPI RERI based on CPI

Results: Decreasing inflation on target

Source: Banco de la República, DANE

Annual Consumer Inflation and Inflation Targets

3.5

4.5

5.5

6.5

7.5

8.5

9.5

10.5

Mar

-00

Jun-0

0

Sep

-00

Dec

-00

Mar

-01

Jun-0

1

Sep

-01

Dec

-01

Mar

-02

Jun-0

2

Sep

-02

Dec

-02

Mar

-03

Jun-0

3

Sep

-03

Dec

-03

Mar

-04

Jun-0

4

Sep

-04

Dec

-04

Mar

-05

Jun-0

5

Sep

-05

Dec

-05

Mar

-06

Inflation Target Annual Consumer Inflation Annual Non-Food Inflation

III. Monetary and Exchange Rate Policies

Low short term interest rates and large CB intervention in the FX market (especially since 2004)

So far, the signals coming from interest rate policy and FX intervention have been consistent

Foreign Exchange Intervention and Monetary policy repo - rate

-300

-

300

600

900

1,200

Ja

n-0

0

Ju

l-0

0

Ja

n-0

1

Ju

l-0

1

Ja

n-0

2

Ju

l-0

2

Ja

n-0

3

Ju

l-0

3

Ja

n-0

4

Ju

l-0

4

Ja

n-0

5

Ju

l-0

5

Ja

n-0

6

5.0

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

Monthly net fx purchases Monetary policy repo rate

%

Some features of FX intervention

• Discretionary intervention since september 2004 (before: “rules-based” auctions of options)

• No time-frame or amounts are announced

• No specific level of the exchange rate has been targeted

• Sterilization – CB has “defended” the short run interest rate:

– OMOs– Reductions in REPO loans to banks– Government deposits in the CB– Sales of international reserves to the Government

The FX exposure of the Government has been reduced…

CENTRAL GOVERNMENT GROSS DEBT1990-2005

0.0

10.0

20.0

30.0

40.0

50.0

60.0

% P

IB

Domestic 4.2 3.5 5.8 5.7 5.1 6.2 7.1 9.3 11.1 16.7 22.2 24.9 29.0 28.6 29.0 33.0

Foreign 12.7 11.7 10.8 8.9 7.2 7.4 7.2 8.6 11.2 14.9 18.3 22.1 25.4 24.8 20.7 16.8

Total 16.9 15.2 16.6 14.6 12.3 13.7 14.4 17.9 22.2 31.6 40.4 47.0 54.4 53.5 49.7 49.8

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

2003 pr 2004 pr 2005 prCurrent account (US$ Mill) -974.3 -938.4 -1,930.4Current account as % GDP -1.2 -1.0 -1.6Private sector - Capital and financial account (excludes FDI) (US$ Mill) -494.8 254.0 495.3FDI (US$ Mill) 820.0 2,974.6 5,568.8Public Sector - Capital and financial account (US$ Mill) 378.0 -36.1 -2,729.8Change in gross international reserves -183.8 2,541.1 1,728.7

Sells of international reserves to Central Government 0.0 500.0 3,250.0p: preliminarySource: Banco de la República

COLOMBIA - BALANCE OF PAYMENTS

…But market risk has increased in the financial system

(greater reliance on the domestic market)

Public debt holdings (TES) of Pension Funds (%)

16.12%

23.20% 23.36%

30.99%

37.27%

0%

10%

20%

30%

40%

50%

2001 2002 2003 2004 2005

Peso-denominated foreign debt: Attractive but limited option

Greater fiscal adjustment + better market risk regulation?

Investments as a percentage of total assetsCredit Institutions

7%

12%

17%

22%

27%

32%

37%

Feb

-97

Feb

-98

Feb

-99

Feb

-00

Feb

-01

Feb

-02

Feb

-03

Feb

-04

Feb

-05

Feb

-06

Why has the CB maintained low interest rates?

IT: Conditional inflation forecasts on target:

– Negative output gap– Currency appreciation– Inflation expectations close to targets

Why has the CB intervened in the FX market?

• Initially, to restore the level of international reserves after the 2002-2003 episode

• Later, to protect the “tradable” sectors of the economy from what seemed to be a temporary appreciation:– TOT and external demand reversal (Oil and

Venezuela)– Fall in the future volume of oil exported (reserves

depletion)– 2006: Electoral year

However, appreciation has lasted longer than expected…

• TOT did not fall. In particular, high oil prices have:– Increased the value of exports– Kept high growth rates in Venezuela and Ecuador – Attracted FDI

• External interest rates and spreads unexpectedly low for an unexpected longer period

• Strong coal exports and FDI• Purchases of Colombian corporations by foreign

investors …. Confidence?

Has the FX intervention been effective?

• The Col peso has appreciated…

• …but less and with lower volatility than other regional currencies since 2005, despite of a larger fall in the Colombian “spreads”….

Nominal Exchange Rate (Index) (January 2005=100)

Feb-

05

Apr

-05

Jun-

05

Aug

-05

Oct

-05

Dec

-05

Feb-

06

Apr

-06

Source: Datastream

747984899499104109

COLOMBIA CHILE BRASIL

Embi + (Index)(January 2005=100)

30

50

70

90

110

130Ja

n-05

Feb

-05

Mar

-05

Apr

-05

May

-05

Jun-

05

Jul-

05

Aug

-05

Sep

-05

Oct

-05

Nov

-05

Dec

-05

Jan-

06

Feb

-06

Mar

-06

Apr

-06

Source: Bloomberg

Colombia Brazil Chile

• However, it is difficult to extract clear conclusions about the effectiveness of intervention:

– Counterfactual?– International comparisons require to control for other

effects

• If appreciation persists, there might be conflicts between FX intervention and the inflation target, especially if the output gap turns positive at a fast rate:

– Reduction of the credibility of the IT or the effectiveness of FX intervention

– Nevertheless, there is ample scope for sterilization:

• CB profits > 0• Small interest rate differential

IV. Is Inflation picking up?

External conditions in 2006-2007 still favor aggregate demand growth and appreciation

(or a small depreciation at best)

• High TOT in 2006 and no strong reversal in 2007

• High growth rates of trading partners

• No strong reversal in capital flows

• Possibly large FDI inflows (mining)

….Although this scenario is subject to great uncertainty, especially regarding capital flows

On the basis of this scenario we forecast a reduction of inflation in 2006 and a rise in

2007…Inflation Forecast

3.0

4.0

5.0

6.0

7.0

2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 Q4

(%)

3.0

4.0

5.0

6.0

7.0

(%)

• 2006: Appreciation, decline in growth of food prices and some regulated prices

• 2007: Negative output gap closes, pressures on non-tradable goods prices and on some regulated prices

Inflation Forecast

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07

(%)

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

(%)

Headline Non-Food Food

• The low initial level of real interest rates and the closure of the output gap (pressure on non-tradable goods prices) will require increases in the interest rates in the future…

• … However, the timing and the size of such moves will depend on the behavior of the economy. In particular, there is uncertainty on:

– The importance of the (one time effect?) increases in productivity and competition. F. ex. many non-tradable sectors still show low or decreasing rates of inflation (expectations or productivity/competition?)

– The evolution of the exchange rate: A faster reversal of the spreads or capital flows will probably require faster and larger increases of the interest rates

V. Is there an Asset Price Bubble?

….No or not a relevant one

• Two key macroeconomic variables:

• …do not show signs of large macro imbalances so far

• Three key asset prices: Real Estate, Stocks, Public Bonds

Current Account Real Fin. SystemBalance (% GDP)* Credit Growth**

2003 -1.2% 1.2%2004 -1.0% 1.7%2005 -1.6% 4.5%2006 -1.6% 10.0%

* 2006: Projection

* Gross local currency loans. Average for the year. 2006: First quarter.

Source: Banco de la República

Real Estate: Not at this point…

Real Price of New Homes Sold

75

80

85

90

95

100

Ja

n-9

9

Ju

l-9

9

Ja

n-0

0

Ju

l-0

0

Ja

n-0

1

Ju

l-0

1

Ja

n-0

2

Ju

l-0

2

Ja

n-0

3

Ju

l-0

3

Ja

n-0

4

Ju

l-0

4

Ja

n-0

5

Ju

l-0

5

Ja

n-0

6

dec

emb

er/9

8=

10

0

Bogotá

Real Estate: Not at this point…

Price-Rent ratio for the Housing Market (New Houses)

(Average 1994-2005 = 100)

80

85

90

95

100

105

110

115

120

125

130

Jan

-94

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Real Estate: Not at this point…

Relative Price of Housing

50

70

90

110

130

150

170

190

Mar

-82

Mar

-84

Mar

-86

Mar

-88

Mar

-90

Mar

-92

Mar

-94

Mar

-96

Mar

-98

Mar

-00

Mar

-02

Mar

-04

Mar

-06

Real Estate: Not at this point…Adjusted Mortgage Loans of the Financial System

Annual Grow th (Monthly average of w eekly data)

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

Ene-0

3F

eb-0

3M

ar-

03

Abr-

03

May-0

3Jun-0

3Jul-03

Ago-0

3S

ep-0

3O

ct-

03

Nov-0

3D

ic-0

3E

ne-0

4F

eb-0

4M

ar-

04

Abr-

04

May-0

4Jun-0

4Jul-04

Ago-0

4S

ep-0

4O

ct-

04

Nov-0

4D

ic-0

4E

ne-0

5F

eb-0

5M

ar-

05

Abr-

05

May-0

5Jun-0

5Jul-05

Ago-0

5S

ep-0

5O

ct-

05

Nov-0

5D

ic-0

5E

ne-0

6F

eb-0

6M

ar-

06

Cartera bruta

Real Estate: …but this market must be closely monitored

• Housing is an important component of households´ assets and mortgage credit may become again significant in households´ debt

• Recently, banks have reduced significantly the mortgage interest rates

Mortgage loans share of household credit

20%

30%

40%

50%

60%

70%

80%

1994

01

1994

08

1995

03

1995

10

1996

05

1996

12

1997

07

1998

02

1998

09

1999

04

1999

11

2000

06

2001

01

2001

08

2002

03

2002

10

2003

05

2003

12

2004

07

2005

02

2005

09

Stocks: Large price inceases related, among other things, to foreign purchases of colombian companies

Colombia Stock-Exchange General Index

10

30

50

70

90

110

130

150

Jul-0

2S

ep-0

2N

ov-0

2E

ne-0

3M

ar-0

3M

ay-0

3Ju

l-03

Sep

-03

Nov

-03

Ene

-04

Mar

-04

May

-04

Jul-0

4S

ep-0

4N

ov-0

4E

ne-0

5M

ar-0

5M

ay-0

5Ju

l-05

Sep

-05

Nov

-05

Ene

-06

Mar

-06

Ann

ual G

row

th (%

)

Colombia Stock-Exchange General IndexUS Dollars

0

20

40

60

80

100

120

140

160

180

Jul-

02

Se

p-0

2N

ov-

02

En

e-0

3M

ar-

03

Ma

y-0

3Ju

l-0

3S

ep

-03

No

v-0

3E

ne

-04

Ma

r-0

4M

ay-

04

Jul-

04

Se

p-0

4N

ov-

04

En

e-0

5M

ar-

05

Ma

y-0

5Ju

l-0

5S

ep

-05

No

v-0

5E

ne

-06

Ma

r-0

6

An

nu

al G

row

th (

%)

Stocks: There may be a “bubble” component…, but it is not macroeconomically important

• Stocks represent less than 5% of household´s portfolios,

• … less than 15% of pension funds portfolios,

• … and less than 5% of bank´s portfolios

However, it might be an important indicator of portfolio shifts

Domestic Public Bonds: Market risk is a concern, but prices are mostly related to external factors

10-yearTES Yield vs. 10-year US Treasuries Yield

-

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

2-Ja

n-03

2-M

ar-0

3

2-M

ay-0

3

2-Ju

l-03

2-S

ep-0

3

2-N

ov-0

3

2-Ja

n-04

2-M

ar-0

4

2-M

ay-0

4

2-Ju

l-04

2-S

ep-0

4

2-N

ov-0

4

2-Ja

n-05

2-M

ar-0

5

2-M

ay-0

5

2-Ju

l-05

2-S

ep-0

5

2-N

ov-0

5

2-Ja

n-06

2-M

ar-0

6

0.0

1.0

2.0

3.0

4.0

5.0

6.0

10-year TES Yield 10-year US Treasuries Yield

10-yearTES Yield vs. EMBI Colombia

-

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

02-J

an-0

3

02-M

ar-0

3

02-M

ay-0

3

02-J

ul-0

3

02-S

ep-0

3

02-N

ov-0

3

02-J

an-0

4

02-M

ar-0

4

02-M

ay-0

4

02-J

ul-0

4

02-S

ep-0

4

02-N

ov-0

4

02-J

an-0

5

02-M

ar-0

5

02-M

ay-0

5

02-J

ul-0

5

02-S

ep-0

5

02-N

ov-0

5

02-J

an-0

6

02-M

ar-0

6

0

100

200

300

400

500

600

700

800

10-year TES Yield EMBI Colombia

END

Workers´ Remittances

◄

COLOMBIA: WORKERS REMITTANCES1994-2005

788

1,297

1,578

2,021

2,454

3,0603,170

3,314

0

500

1000

1500

2000

2500

3000

3500

1998 1999 2000 2001 2002 2003 2004 2005

US

D M

illio

ns

Workers RemittancesSource: Balance of Payments- Banco de la República

High FDI (Gross)

◄

FOREIGN DIRECT INVESTMENT FLOWS (millions of dollars)

2003 pr 2004 pr 2005 prFOREIGN DIRECT INVESTMENT FLOWS 1,758 3,117 10,192

Mining (petroleum, coal and others) 905 1,775 3,219 Privatizations and private firms sales - 23 5,032 Other sectors 852 1,320 1,941 pr: preliminarySource: Banco de la República

Low domestic interest rates

Policy Interest Rate

4

6

8

10

12

14

%

Policy Expansion Rate

◄

Real 90-days Interest Rate (interest rate for fixed-term deposits)

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

6,0

Mar

-00

Jun-

00

Sep-

00

Dec

-00

Mar

-01

Jun-

01

Sep-

01

Dec

-01

Mar

-02

Jun-

02

Sep-

02

Dec

-02

Mar

-03

Jun-

03

Sep-

03

Dec

-03

Mar

-04

Jun-

04

Sep-

04

Dec

-04

Mar

-05

Jun-

05

Sep-

05

Dec

-05

Mar

-06

%

Real Interest Rate Average (since 1986)

Improvement of balance sheets of the financial system, households and firms

◄

Capital Adequacy RatioCredit Institutions

10%

11%

12%

13%

14%

15%

16%

17%

Feb

-96

Oct

-96

Jun-

97

Feb

-98

Oct

-98

Jun-

99

Feb

-00

Oct

-00

Jun-

01

Feb

-02

Oct

-02

Jun-

03

Feb

-04

Oct

-04

Jun-

05

Feb

-06

Households Financial Debt/Financial Assets

0%

10%

20%

30%

40%

50%

60%

70%

1996 1997 1998 1999 2000 2001 2002 2003

Private Corporate Sector Debt/Equity

0%

5%

10%

15%

20%

25%

30%

35%

2000 2001 2002 2003 2004

Growing business and consumer confidence

Consumer Confidence

25.1

13.9

-30

-20

-10

0

10

20

30

40

Nov

-01

Feb

-02

May

-02

Aug

-02

Nov

-02

Feb

-03

May

-03

Aug

-03

Nov

-03

Feb

-04

May

-04

Aug

-04

Nov

-04

Feb

-05

May

-05

Aug

-05

Nov

-05

Feb

-06

Source: Fedesarrollo

(Index)

◄

Manufacturing Cofidence Indicator(Trend component)

-30

-20

-10

0

10

20

Jan-

00A

pr-0

0Ju

l-00

Oct

-00

Jan-

01A

pr-0

1Ju

l-01

Oct

-01

Jan-

02A

pr-0

2Ju

l-02

Oct

-02

Jan-

03A

pr-0

3Ju

l-03

Oct

-03

Jan-

04A

pr-0

4Ju

l-04

Oct

-04

Jan-

05A

pr-0

5Ju

l-05

Oct

-05

Jan-

06

Source: Fedesarrollo and Banco de la República

Increasing productivity?

◄

Imports of Capital Goods(Last 12 Months)

3000

3500

4000

4500

5000

5500

6000

6500

7000

7500

8000

8500

May

-98

Sep

-98

Jan

-99

May

-99

Sep

-99

Jan

-00

May

-00

Sep

-00

Jan

-01

May

-01

Sep

-01

Jan

-02

May

-02

Sep

-02

Jan

-03

May

-03

Sep

-03

Jan

-04

May

-04

Sep

-04

Jan

-05

May

-05

Sep

-05

Jan

-06

Source: DANE

US$ Millions

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Growth

Imports

Annual Growth

Inflation expectations close to targets

Annual Inflation Expectations Banks and Brokers

(Expectation made in month i for month i one year ahead)

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

Sep

-03

Nov

-03

Jan-

04

Mar

-04

May

-04

Jul-0

4

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Jan-

06

Mar

-06

◄

Annual Inflation Expectations Banks and Brokers

(Expectation made in month i for december of the same year)

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

Sep

-03

Nov

-03

Jan-

04

Mar

-04

May

-04

Jul-0

4

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Jan-

06

Mar

-06