COLOMBIA'S STRENGTHENING PESO -- THE PRICE OF

C O N F I D E N T I A L BOGOTA 003635

SIPDIS

SIPDIS

E.O. 12958: DECL: 05/17/2017
TAGS: ECON EFIN CO
SUBJECT: COLOMBIA'S STRENGTHENING PESO -- THE PRICE OF
SUCCESS

REF: BOGOTA 3703

Classified By: Classified By: Econ Counselor Lawrence J. Gumbiner per E
.O. 12958 Sec.
1.4(c)


1. (C) Summary. The Colombian Peso has been among the
fastest appreciating currencies in the world thanks to strong
economic prospects and improved security conditions.
Political pressure from the export sector led the Central
Bank to intervene heavily on the foreign exchange market
during the first four months of the year in an unsuccessful
attempt to stop the peso's rise. The Bank now seems to be
changing focus away from the exchange rate and back to its
mandate of inflation control, and the central government is
exploring ways to curb appreciation through more orthodox
means such as achieving savings in the fiscal account.


2. (U) The Colombian Peso (COP) has appreciated by more than
11 percent relative to the dollar since the beginning of the
year, and 16 percent in the past 12 months. It broke the
psychological COP2,000/USD1 barrier on May 16, closing at
1,995/1. The strengthening of the currency has been driven
mostly by a substantial increase in foreign direct investment
(FDI) due to improved economic prospects and better security
conditions. The large inflow of capital associated with the
strong economy has led to an expansion of credit and a surge
in aggregate demand which - coupled with dwindling excess
capacity - has resulted in a sharp rise in inflation. Most
analysts believe that the peso will soon bottom out, but are
not anxious to place a number on that floor since many
predicted it would never dip below 2100/1.


3. (C) Political pressure has led the Central Bank (BanRep)
to pursue contradictory monetary responses to the rising peso
and the above-trend rate of inflation (reftel). It has
responded to the COP's appreciation by intervening heavily on
the foreign exchange market while simultaneously seeking to
control inflation by raising interest rates. Considering
that appreciation of the currency could actually help to
control inflation, the BanRep's conflicting objective of
trying to stem appreciation under an inflation targeting
regime is clearly driven by political concerns over export
competitiveness and economic growth.

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New Capital Controls
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4. (U) At a May 6 extraordinary meeting, the BanRep explored
alternate methods to halt the peso's appreciation and at the
same time halt inflation through capital controls. They
adopted three new measures requiring:
1) Increased reserve requirements to 27% from 13% for
checking accounts; 12.5% from 6% for savings accounts; and 5%
from 2.5% on fixed term deposits of less than 18 months.
2) Increased reserve requirements on external loans to
discourage short-term borrowing in the private sector. The
BanRep now requires that 40% of the value of any external
loan be deposited for six months at the central bank. Dollar
loans will be converted to pesos at the official rate and the
BanRep will not pay interest.
3) Limit on leveraged positions for local foreign exchange
intermediaries of 500%. That means that banks can only
intervene 500 times their net worth on the derivatives
market, and is meant to control currency speculation.


5. (U) During its monthly meeting on May 18, the BanRep
raised interest rates for the fifth time this year to 8.75%.
Following the meeting, the board of directors emphasized the
bank's commitment to inflation, maintained its year-end
inflation target of 3.5-4.5%, and expressed confidence that
the measures taken on May 6 would have the desired effects on
monetary policy. BanRep President Uribe has admitted that
the official target will likely be exceeded, but states that
the Bank will maintain its target nonetheless. The consensus
view among outside economists is that 2007 inflation will
reach 5.15%.


6. (C) The May 6 capital controls imposed by the bank should
reduce the growth of credit, but will not stem the
appreciation of the peso since its rise in value has been
caused by long-term investments rather than speculative
portfolio inflows. Privately, BanRep officials admitted to
econoffs that the bank has practically run out of room to
continue buying dollars to sterilize its interventions. They
recognize the market's rejection of the BanRep's mix of
monetary policy, including the recent capital controls, and
have emphasized their commitment to inflation-fighting.
BanRep officials have also called publicly for the government

to focus on the fiscal side to stop peso's appreciation.


7. (U) The GOC is looking for alternative mechanisms to
prevent peso appreciation other than additional capital
controls. Finance Minister
Oscar Zuluaga announced the creation of a special committee
to analyze the fiscal accounts of the central government and
explore mechanisms to reduce the fiscal deficit. The GOC
also announced that the government would freeze debt at
December 2006 levels in response to claims that the state is
not doing enough about the peso's appreciation. (Note: The
freeze does not mean the government will stop borrowing but
that debt will stay between 30 and 32 percent of GDP as of
the end of 2007. End Note).

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The Squeaky Wheel Gets the Grease
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8. (U) The GOC is also expected to announce a plan to
subsidize sectors affected by the appreciating peso. The
main goal, according to Zuluaga, would be to protect
employment in export-oriented sectors that are
labor-intensive. The initial draft of the initiative calls
for government subsidies of a portion of the social security
contributions each company has to make per employee.
The amount of the subsidy would vary based on the difference
between the
actual exchange rate and a reference exchange rate yet to be
determined.

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Comment
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9. (C) To protect the inflation target, the BanRep will have
to stop resisting currency appreciation. In fact, the
stronger currency would help both cool off the economy and
reduce inflation via the tradable goods channel. The GOC's
willingness to look for savings in the fiscal account, rather
than pressuring the BanRep to intervene in the exchange
market, is a positive move, and one that has a greater chance
of success given the higher than expected tax revenues
collected thus far in 2007.
Drucker