THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

José Dario Uribe1

Let me first thank BCRA for organizing this very interesting seminar and for inviting us to share our experience in these turbulent times. The mere comparison of the shocks our economies have undergone and our policy reactions, let alone the insights of the distinguished economists who join us in this timely event, is of great value for our future policy making.

After the Lehman Brothers bankruptcy in September 2008, the Colombian financial and foreign exchange markets came under stress. However, the outcome of the shock was less severe than for other countries in the region. In what follows, I will briefly describe the macroeconomic context in which the shock occurred, the effects of the shock and the policy response by Banco de la Republica. While doing so, I will advance some reasons for the relatively low impact of the shock on Colombia. Most of them are related to the prevailing regulatory framework.

By the third quarter of 2008, the Colombian economy was experiencing a deceleration of growth. Consumption growth was weakening as a result of the previous tight monetary policy and the effect of the relative price increases of raw materials and foodstuffs on costs and real household income. Public investment fell drastically due to delays in public works

1 Governor of the Central Bank of Colombia. Money and Banking Conference “Lessons and Challenges for Emerging Countries during the Crisis”. Central Bank of Argentina, Buenos Aires August 31, 2009

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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programs. Nevertheless, according to our estimates, there still remained a positive output gap inherited from several years of strong aggregate demand growth.

As another consequence of the relative price shocks, inflation was moving well above its target range for the year (3.5%-4.5%). At the same time, inflation expectations started to rise which threatened to permanently unleash inflation. Hence, policy was further tightened in July. The sharp appreciation of the currency observed in the first half of the year was correcting itself possibly due to changing global risk perceptions and the daily purchases of fixed amounts of dollars by Banco de la Republica in the foreign exchange market.

Immediately after the Lehman failure, the Colombian sovereign risk premium jumped around 500 bps, an increase similar to the one which occurred in other countries (Charts 1 and 2). The currency moved along, depreciating by 15% between September 12th and October 29th. Again, this reaction was comparable to the behavior of other currencies in the region. Domestic public bond interest rates also rose after the shock and the zero coupon curve became steeper as in other economies in the region (Charts 4 and 5). Thus, the heightened risk aversion after the shock produced the usual reaction on the foreign exchange and local bond markets.

Chart 1

COLOMBIA - RISK PREMIA 800 700 600

400 300 200 100 0 04 / 09 07/ / 0 14 07/ 8 / 0 19 07/ 8 / 0 24 07/ 8 / 0 29 07/ 8 / 0 03 07/ 8 / 0 08 08/ 8 / 0 13 08/ 8 / 0 18 08/ 8 / 0 23 08/ 8 / 0 28 08/ 8 / 0 02 08/ 8 / 0 07 09/ 8 / 0 12 09/ 8 / 0 17 09/ 8 / 0 22 09/ 8 / 0 27 09/ 8 / 0 02 09/ 8 / 0 07 10/ 8 / 0 12 10/ 8 / 0 17 10/ 8 / 0 22 10/ 8 / 0 27 10/ 8 / 0 01 10/ 8 / 0 06 11/ 8 / 0 11 11/ 8 / 0 16 11/ 8 / 0 21 11/ 8 / 0 26 11/ 8 / 0 01 11/ 8 /1 08 06 2/ / 0 11 12/ 8 / 0 16 12/ 8 / 0 21 12/ 8 / 0 26 12/ 8 / 0 31 12/ 8 /1 08 2/ 08

Bps

500

CDS 1 YEAR

CDS 5 YEARS

CDS 10 YEARS

EMBI

COLOMBIA

MEXICO

CHILE

PERU

400 MEXICO

300 BRAZIL

BRAZIL

31/12/08

200

26/12/08

28/12/08

14/12/08

30/11/08

16/11/08

02/11/08

19/10/08

05/10/08

21/09/08

07/09/08

24/08/08

10/08/08

27/07/08

13/07/08

29/06/08

15/06/08

01/06/08

Bps. 500

21/12/08

16/12/08

11/12/08

06/12/08

01/12/08

26/11/08

21/11/08

16/11/08

11/11/08

06/11/08

01/11/08

27/10/08

22/10/08

17/10/08

12/10/08

07/10/08

02/10/08

27/09/08

22/09/08

17/09/08

12/09/08

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 3

Chart 2

EMBI - SELECTED COUNTRIES

800

700

600 COLOMBIA

PERU

CHILE*

100

0

Chart 3

NOMINAL EXCHANGE INDEX Sept. 12/08 = 100

150

140

130

120

110

100

90

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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Chart 4 Colombian Government Local Bond Zero-Coupon Rates July 2008- December 2008 1 Year

5 Years

15%

10 Years

14%

13%

12%

11%

10%

9%

28/Dic/2008

13/Dic/2008

28/Nov/2008

13/Nov/2008

29/Oct/2008

14/Oct/2008

29/Sep/2008

14/Sep/2008

30/Ago/2008

15/Ago/2008

31/Jul/2008

16/Jul/2008

Chart 5

10 Year Government Bond Zero Coupon Rates Latin America* 21% 19% 17% 15% 13% 11% 9%

Brazil

*7.25 years for Brazil Bl b SEN F

Mexico

Colombia

Peru

28-Dic-08

13-Dic-08

28-Nov-08

13-Nov-08

29-Oct-08

14-Oct-08

29-Sep-08

14-Sep-08

30-Ago-08

15-Ago-08

31-Jul-08

16-Jul-08

7% 01-Jul-08

01/Jul/2008

8%

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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However, the shock had more widespread consequences. As key markets in the U.S. were closed (e.g. the short term commercial paper and the ABS markets), short term external funding for emerging markets was severely hampered. Those countries in which the financial system depended significantly on foreign financing suffered stress in both the foreign exchange and the local short term lending markets as banks and other institutions scrambled to close their foreign currency liquidity gaps.

However, this was not the case for Colombia, where regulation prevented local banks from being exposed to maturity mismatches between currency and foreign currency. It also restricted their non-derivative net foreign asset position to be positive which effectively inhibited the existence of a foreign currency interbank loan market.

In other countries, pressures on the foreign exchange market and financial stability emerged from two things: the exposure of the corporate sector to currency risk and the realization of huge losses after the depreciation of the local currencies against the US dollar. Again, this was not the case of Colombia where capital controls and exchange rate volatility limited the corporate sector’s external indebtedness. At the same time, regulation limited the gross foreign exchange derivative position of banks to five times their net worth or less. This was established to curb bank counterparty risk in a period in which there were large speculative and arbitrage positions against the dollar and had the effect of restricting the currency exposure of the corporate sector.

As a result, the impact of the Lehman shock on the Colombian foreign exchange and short term markets was smaller than it was in other countries. The Colombian peso depreciated less than other currencies in the region during the fourth quarter of 2008 (Chart 1) while Banco de la República’s intervention in the foreign exchange market to support the currency was far lower than elsewhere (Table 1). The interbank overnight interest rates remained close to the policy rate. The spread between the short term deposit interest rates and the policy rate did not increase and financial system deposits continued to grow faster than GDP (Charts 6, 7 and 8).

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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FX Intervention II Semester 2008 (US$ Million) Supporting the Dollar

Colombia Chile* México** Perú Brazil

Supporting the Local Currency

Total

-235 -969 -15.178 -5.810 -25.967

1.112 2.081 -15.178 -5.810 -20.624

1.347 3.050

5.343

*The "sales" of the second semester correspond to the outstanding value of the swaps by the end of the year. ** By December 11th 200 8 the Central Bank had purchased US$ 22.629 million from PEMEX.

Chart 6

Spread between the Interbank Overnight Rate and the Policy Rate 2008 20

-

Basis Points

-20

-40

-60

-80

02-Dic-08

02-Nov-08

02-Oct-08

02-Sep-08

02-Ago-08

02-Jul-08

02-Jun-08

02-May-08

02-Abr-08

02-Mar-08

02-Feb-08

02-Ene-08

-100

* Deflated by CPI ex - food

20081226

20081205

20081114

20081024

20081003

20080912

20080822

20080801

20080711

20080620

20080530

20080509

20080418

20080328

20080307

20080215

20080125

20080104

Chart 8

Deposit Real Growth Rates

Real Growth of the Deposits in the Financial System *

17,0%

16,0%

15,0%

14,0%

13,0%

12,0%

11,0%

10,0%

9,0%

8,0%

7,0%

19-Dic-08

05-Dic-08

21-Nov-08

07-Nov-08

24-Oct-08

10-Oct-08

26-Sep-08

12-Sep-08

29-Ago-08

15-Ago-08

01-Ago-08

18-Jul-08

04-Jul-08

20-Jun-08

06-Jun-08

23-May-08

09-May-08

25-Abr-08

11-Abr-08

28-Mar-08

14-Mar-08

29-Feb-08

15-Feb-08

01-Feb-08

18-Ene-08

04-Ene-08

Basis Points

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 7

Chart 7

Spread between the Average Deposit Interest Rate and the Policy Rate 2008

-140

-160

-180

-200

-220

-240

-260

-280

-300

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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Credit growth remained strong even for foreign-owned banks (Chart 9), which work as subsidiaries in Colombia and are subject to the same regulatory framework as domestic banks. However, lending interest rate spreads did rise in October 2008 thus reflecting a larger risk premium, especially for prime and corporate treasury loans (Chart 10). Our financial system survey showed tightening local credit conditions in the fourth quarter (Chart 11) and both firms and banks reported anecdotal evidence regarding more expensive credit with shorter maturities. Interestingly, throughout 2009 the behavior of foreign and domestic banks in the local loan market has diverged. Foreign banks have drastically cut their exposure to consumer credit while domestic banks have kept high rates of growth of loans (Chart 9).

At the same time the external credit lines available to the Colombian Banks were reduced and their cost raised (Chart 12). Nonetheless, the use of those lines remained below the approved amounts and declined along with them (Chart 13). This reflected, among other things, a dramatic fall in the demand for funding linked to international trade (Chart 14). Chart 9

Real Growth of the Colombian Financial System Loans

25,0%

20,0%

%

15,0%

10,0%

5,0%

0,0%

Local Banks * Deflated by CPI ex - food

Foreign Banks

Total

4/08/2009

4/07/2009

4/06/2009

4/05/2009

4/04/2009

4/03/2009

4/02/2009

4/01/2009

4/12/2008

4/11/2008

4/10/2008

4/09/2008

4/08/2008

4/07/2008

4/06/2008

4/05/2008

4/04/2008

4/03/2008

4/02/2008

4/01/2008

-5,0%

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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Chart 10

Lending-Deposit Interest Rate Spreads 2008 900 850

Basis Points

800 750 700 650 600 550

Average Lending Rate - Deposit Rate

19-Dic-08

05-Dic-08

21-Nov-08

07-Nov-08

24-Oct-08

10-Oct-08

26-Sep-08

12-Sep-08

29-Ago-08

15-Ago-08

18-Jul-08

01-Ago-08

04-Jul-08

20-Jun-08

06-Jun-08

23-May-08

25-Abr-08

09-May-08

11-Abr-08

28-Mar-08

14-Mar-08

29-Feb-08

15-Feb-08

01-Feb-08

18-Ene-08

04-Ene-08

500

Corporate Treasury Rate - Deposit Rate

Prime Lending Rate - Deposit Rate

Chart 11

Observed and Expected Tightening of Requirements for New Bank Commercial Loans Approval (Survey) (% of Respondents) 80,0% 70,0% 60,0% 50,0% 40,0% 30,0% 20,0% 10,0%

Observed

Expected (previous quarter survey)

Sep-09

Ago-09

Jul-09

Jun-09

May-09

Abr-09

Mar-09

Feb-09

Ene-09

Dic-08

Nov-08

Oct-08

Sep-08

Ago-08

Jul-08

Jun-08

May-08

Abr-08

0,0%

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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Chart 12

External Indebtedness through the Financial System: Stock and interest Rate 3.500,0

6,50

3.300,0

6,00

3.100,0

5,50

4,50 2.500,0 4,00 2.300,0

Interest Rate (%)

5,00

2.700,0

3,50 2.100,0 3,00

1.900,0

2,50

1.700,0 1.500,0

2,00 Ene

Feb

Mar

Abr

May

Jun

Jul

Ago

Sep

Oct

Nov

Dic

Ene

Feb

Mar

2008

Abr

May

Jun

2009 Stock

Interest Rate

Chart 13

External Credit Lines of the Colombian Financial System Approved Amounts and Use 9.000 8.000 7.000 6.000 5.000 4.000 3.000 2.000

2008 Approved Amount

Use (Stock)

Jun

Abr

2009

May

Feb

Mar

Dic

Ene

Oct

Nov

Sep

Jul

Ago

Jun

Abr

May

Feb

2007

Mar

Dic

Ene

Oct

Nov

Sep

Jul

Ago

Jun

Abr

May

Feb

Mar

1.000 Ene

US$ Million

Stock (US$ Million)

2.900,0

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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Chart 14

3.500,0

4.800

3.300,0

4.600

3.100,0

4.400

2.900,0

4.200

2.700,0

4.000

2.500,0

3.800

2.300,0

3.600

2.100,0

3.400

1.900,0

3.200

1.700,0

3.000

1.500,0

E x te rn al In d e b te d n e ss

5.000

2 0 07 -0 1 2 0 07 -0 2 2 0 07 -0 3 2 0 07 -0 4 2 0 07 -0 5 2 0 07 -0 6 2 0 07 -0 7 2 0 07 -0 8 2 0 07 -0 9 2 0 07 -1 0 2 0 07 -1 1 2 0 07 -1 2 2 0 08 -0 1 2 0 08 -0 2 2 0 08 -0 3 2 0 08 -0 4 2 0 08 -0 5 2 0 08 -0 6 2 0 08 -0 7 2 0 08 -0 8 2 0 08 -0 9 2 0 08 -1 0 2 0 08 -1 1 2 0 08 -1 2 2 0 09 -0 1 2 0 09 -0 2 2 0 09 -0 3 2 0 09 -0 4 2 0 09 -0 5 2 0 09 -0 6

T ra d e

Total Trade (X+M) Subject to Foreign Finance and External Indebtedness through the Financial System (US$ Million)

Trade

External Indebtedness

Meanwhile, the global economy slumped, terms of trade dropped and the external demand for Colombian products slowed down. Consumer and business confidence indicators collapsed thus driving domestic spending down. Policy makers were then left facing the dilemma of high and increasing inflation on the one hand and a growing deterioration of both the external and domestic economic outlook on the other. Thus, while the picture became clearer, monetary authorities started to relax policy gradually. Capital controls were lifted in October and domestic reserve requirements were reduced in November. Liquidity provision was increased substantially as reflected by the negative and decreasing spread between the overnight interbank interest rate and the policy rate as the end of the year approached (Chart 6). Finally, policy rates were lowered by 50 bps in December, the first such move among emerging economies. A rapid sequence of cuts ensued, dropping the policy rate from 10% in November 2008 to 4.5% in June 2009.

A key component of the policy reaction was the flexibility of the exchange rate. This was possible because currency mismatches were small and inflation expectations remained partially anchored despite the large shocks to the price of food, energy and raw materials. Exchange rate flexibility was fundamental in many senses. First, it enabled us to avoid the

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

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need to follow the pro-cyclical monetary policies of the past. Second, it worked as an absorber of the shocks hitting the current account of the balance of payments (terms of trade, export demand and workers’ remittances). And third, it prevented dollar demand pressures that liquidity-thirsty global financial institutions would have exerted under a peg regime.

In summary, in the last quarter of 2008 our economies underwent a rapid transition from a supply shock situation to a global financial crisis and a world recession. My take from the Colombian experience is that, as a regime, the inflation targeting framework with financial stability complements has fared well and done the best possible job of withstanding the storm. This was mostly due to the fact that the financial stability measures taken before the crisis, when the economy was booming, enabled us to avoid large mismatches and to moderate leverage. The results were:

-The financial system was strong enough to absorb a large external shock and policy makers could focus on dealing with its macroeconomic consequences.

-The regime was flexible enough to accommodate a gradual path of disinflation under a preannounced path after the relative price shocks pushed inflation far above target.

-At the same time, this flexibility allowed the central bank to maintain the liquidity of the financial system in a period of stress.

Our challenge ahead consists of carefully examining our financial regulatory framework to shore up some aspects such as countercyclical provisioning and bank capital requirements. Simultaneously, we must strive to enhance financial deepening and enlarge the set of financial instruments available to Colombian firms and households. However, we must do so without significantly increasing systemic risk or depriving policymakers of the tools they need to face shocks. In such a task, difficult tradeoffs must be made, most importantly, perhaps, the one between the financial integration of the Colombian economy and the scope for systemic risk and macroeconomic management.