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. -------------- New Capital Controls -------------- ¶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). -------------- The Squeaky Wheel Gets the Grease -------------- ¶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. -------------- Comment -------------- ¶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