Colombia at the Crossroads: The Good, the Bad, and the Uncertain

Colombia at the Crossroads: The Good, the Bad, and the Uncertain April 14, 2017 By Ross H. Brown Introduction Colombia is a country that underwent huge transformations over the past 25 years. As a war-torn country plagued by high levels of crime and poverty as recently as the 1990s, in a relatively short period of time, Colombia took some remarkable steps that have helped to put it on the path towards lasting economic prosperity, development, and growth. However, Colombia s progress is also contrasted in parallel with continuing challenges and setbacks, along with many unknowns that still may derail its current upward trajectory. The rest of this paper will be addressing these issues and what all of this means for potential future foreign investment in Colombia. All analysis contained in this paper are based on independent research and/or personal direct discussions and/or observations I obtained from my recent visit to Colombia as part of a Cornell College of Business/Emerging Markets Institute 2017 Colombia trek which took place in Bogota and Cartagena between March 31 and April 9. Colombia: The Good Colombia s success story is based on its economic growth in recent years. Although GDP growth was only 2% in 2016, during a recent visit to the Colombian Ministry of Finance, Minister Cardenas was quick to point out that not only was such growth higher than most other countries in Latin America for the same time period, but GDP growth is expected to get increasingly higher in the coming years and similarly outpace most of Latin America 1. The government s fiscal deficit is expected to narrow from an estimated 3.3% in the current year to 2.2% of GDP in 2021. Inflation remains somewhat high (at approximately 5.2% at present, which is higher than the government target range of 2-4%), but has shown a tendency to fall in recent months. 2 Similarly, monetary loosening, better access to credit, government transfers and post-conflict investment will support average private consumption growth of 3.4% in 2018. 3. The Colombian Central Bank has been very responsive to changes in the economy, cutting interest rates by 25 basis points to 7.25% in February 2017 and again to 7% in March 2017 to promote higher GDP growth. Government income from oil revenues has drastically fallen, but according to the Finance Minister, the government countered this loss of income both by promoting import substitution as 1 Meeting with Finance Minister Mauricio Cardenas and Cornell Johnson MBA students at the Colombian Ministry of Finance in Bogota on April 5, 2017 2 Colombia Country Report, April 12 2017, Economist Intelligence Unit. 3

well as promoting fiscal and legal reforms designed to stimulate investments and exports 4. Minister Cardenas also noted that the government has large scale plans to invest infrastructure and 4G projects through public-private partnerships, critical areas of investment that is required if the Colombian economy will be able to reach its full potential. The Colombian government also has a longer term strategy to move the Colombian economy away from being dependent on oil revenues to more diversification in other industries such as manufacturing in addition to further development in tourism as well as commodities such as coffee 5. Colombia at present has a BBB credit rating (which is investment grade), which according to the Finance Minister is the highest credit rating in the country s history. Colombia is also in the process of trying to join the OECD (having been approved for membership by 20 of 23 required committees), which the Minister believes will serve as further confirmation of the government s ongoing reforms that is helping to make the country an attractive investment destination. In addition, Colombia is looking to boost its economy through free trade agreements. In addition to the free trade agreement that is already in place between Colombia and the United States, The Pacific Alliance Trading Block (Chile, Colombia, Mexico, and Peru) recently signaled its intentions to begin negotiations with Asian countries (including China) to negotiate a trade deal that will result in increased prosperity for all countries involved. Pacific Alliance Members are also scheduled to meet this month in Buenos Aires with Mercosur members (the customs union comprising of Argentina, Brazil, Paraguay, and Uruguay) to discuss expanding regional trade ties as well. One key positive aspect of the Colombian economy that is often overlooked but will be of particular interest to foreign investors is the country s banking sector. According to the Economist Intelligence Unit, We continue to believe that Colombia s banking system will remain basically sound in the medium term, despite a marginal deterioration in asset quality. Dynamism in financial services will remain an important source of economic growth in 2017. 6 Colombia: The Bad Amidst positive signs of economic growth, Colombia is also faced with numerous challenges. Economically, the exchange rate has continued to demonstrate volatility, with the Colombian Peso devaluing by almost 50% against the dollar since 2013. In recent months, the Colombian Peso appreciated by about 10% against the dollar, but continued volatility in each direction is expected in the near term. Although the Colombian government is making a concerted attempt to diversify the economy away from oil exports, according to the Economist Intelligence Unit, oil exports still accounted for 39% of principal exports in 2015. GDP per head in Colombia is still below the average for Latin America as well. 7 4 Meeting with Finance Minister Mauricio Cardenas and Cornell Johnson MBA students at the Colombian Ministry of Finance in Bogota on April 5, 2017 5 http://www.irc.gov.co 6 Colombia Country Report, April 12 2017, Economist Intelligence Unit 7

There are also increasing concerns by foreign investors regarding the commitment of the Colombian government to protecting investor rights due to the recent seizure by the Colombian government of Electrificadora del Caribe SA in March 2017, which is owned by the Spanish company Gas Natural. Gas Natural subsequently filed a suit against Bogota with the United Nations Commission on International Trade Law. Whereas the Colombian government claims it seized the asset because the electricity provider was unable to provide service to all customers along Colombia s Caribbean coast, Gas Natural replied by noting that the Colombian government forced it into a corner 8 because it is owed more than 1.3 billion Euros by customers who haven t paid their bills. In addition, Gas Natural executives say Bogota does little to control thousands of Colombians illegally tapping into power lines. 9 Gas Natural s case against Bogota would increase the number of investor-state arbitrations against Colombia to five. 10 Finally, even though the Colombian government is taking important steps to address the critical issue of developing infrastructure in the country, the recent government contract kickback scandal involving the Brazilian Company Oderbrecht (Oderbrecht admitted to paying $11 million in bribes to Colombian government officials to win the contract) and the project that was designed to dredge the Magdalena River, which is much needed, is now put on hold; Japan s Sumitomo Mitsui Bank recently pulled $250 million in funding from the project as well. The scandal has also raised investors concerns about putting billions into projects they fear could become tainted by corruption allegations, officials said, delaying and undermining plans for the country s ambitious new infrastructure network. 11 The Colombian government is allegedly in talks with Power China to take over this project, but the outcome of this negotiation is not certain. Regardless, the Oderbrecht scandal at minimum is expected to delay the Magdalena project and highway construction by at least two years. 12 According to Colombia s infrastructure agency, transportation costs amount to about 30% of the country s businessproduction costs compared with about 10% in the US, studies have shown. 13 The Oderbrecht scandal is also adding to overall political instability in the country. In addition to the Magdalena kickback scandal, allegations surfaced that Oderbrecht also provided illegal financing to the presidential campaign of the current President Santos, leading to an increasing public perception of the current Colombian presidential administration as being clouded under corruption. In addition to the controversial peace treaty that Mr. Santos signed with the FARC (see section below for more information), the Oderbrecht scandals will lead to a potentially volatile environment when legislative and presidential elections are scheduled to take place in 8 Gas Natural Sues Colombia Spanish Utility Accuses Bogota of Local Electricity Provider s Expropriation, by Jeannette Neumann. The Wall Street Journal (Europe Edition). 23 March 2017 9 10 11 Deal Muddies Colombia River Project, by Sara Schaefer Munoz and Kejal Vyas. The Wall Street Journal (Asia Edition). 21 March 2017 12 Plea Muddies Colombia s Big River Project, by Sara Schaefer Munoz and Kajal Vyas. The Wall Street Journal. 20 March 2017 13

March and May 2018, respectively, and has decisively already led to a heightened level of distrust by ordinary Colombians towards the current government and legislature. According to the Transparency International 2016 Corruption Perception Index, Colombia is ranked 90 of 176 countries, worse than China, Brazil, India, Cuba, Ghana, Albania, Jamaica, Saudi Arabia, Uruguay, and Chile, amongst others 14. Colombia: The Uncertain Even more than the positive upsides and negative downsides related to the current investment climate in Colombia, there are four key short-term uncertainties regarding Colombia s future that should give investors the most pause and need to be monitored closely before making a final decision to invest or not in the country. First, the outcome of the peace process remains highly uncertain. Whereas President Santos ratified through the Colombian legislature the peace treaty with the FARC, this was not without controversy. Not only was the ratification itself done without holding a second referendum after changes to the initial agreement were made (the initial agreement was voted down in a popular referendum), but the provisos in the peace treaty that were approved by the Colombian legislature were highly controversial and continue to not be accepted by a large portion of Colombian society. Specifically, the lack of holding individuals of the FARC liable for any crimes they committed against Colombian citizens along with guaranteeing the FARC political representation are viewed by many Colombians as particularly onerous. It is far from certain that many Colombians, who view the manner in which the peace treaty with the FARC was signed (without a second popular referendum) along with the more controversial provisos of the peace treaty will actually accept the peace process once implementation begins in earnest. Furthermore, the peace treaty was only signed with the FARC; the ELN, which is the other guerilla group that fought a decades-long insurgent war against the Colombian government, remains in a state of rebellion against Bogota. As recently as February 2017, the ELN took responsibility for setting off a bomb in Bogota that left one person dead. The peace process with the FARC itself also will lead to a second uncertainty, which is the destabilization of the drug trade and how this may impact overall stability in Colombia. For years, the FARC was a very active player in the narcotics trade in Colombia and beyond. From the standpoint of transnational crime, this was by no means a positive development. However, from the standpoint of stability of drug trafficking routes and mitigating violence within Colombia and acts of violence committed against ordinary citizens and innocent bystanders, the FARC having undisputed control of this territory was better than having the territory up for grabs between different drug cartels. With the FARC possibly moving out of this business, there will inevitably a power vacuum for control of FARC-controlled territory, which could lead to turf wars akin to what happened historically within Colombia between the Medellin and Cali cartels. As a way to partially stave this threat off and to also capture some of this business into the Colombian economy, the Colombian government has taken the radical approach to partially 14 https://www.transparency.org/country/col

legalize the drug trade by authorizing a Canadian company called PharmaCielo to legally produce medical marijuana for commercial sale. 15 However, the issue of legalizing drugs or in the very least modifying the approach to how it deals with the drug trade in Colombia could have significant political and larger economic implications for the country. The United States gave billions of dollars to Colombia to combat the drug trade; an about face of the type that the Colombian government is pondering at present may not be well-received by the Trump Administration and may not only lead to a cutoff of needed financial aid to the country but also a revision of the free trade deal that Colombia has with the United States. The third uncertainty at present is the situation in Venezuela and in particular how the current refugee crisis will impact not only the Colombian economy but also national security and internal stability. Of all the uncertainties mentioned, this one poses the most danger because the Colombian government seems the least prepared and willing to recognize it, let alone proactively address it (at least publicly). In July of 2016, Martin Gottwald, a senior UN refugee official, was quoted as saying of the Venezuelan refugees entering Colombia It s a silent arrival of a lot of people who are crossing the border and staying illegally in the Colombian side the avalanche is probably going to increase If you consider that 100,000 people crossed the border to stock up on supplies at the weekend, if a minimal percentage, let s say 10%, stayed (in Colombia), we re already talking about quite large numbers. 16 The crisis that Colombia is facing with regards to Venezuelan refugees should not be underestimated. Whereas Colombia has so far been able to some degree absorb the Venezuelan refugees entering the country, it is highly unlikely that this situation will be able to continue. If the situation in Venezuela continues to deteriorate over the coming months (which seems increasingly likely, especially without a forceful and constructive role of the US in helping to diffuse the crisis there), Colombia will begin to increasingly bear the brunt of the refugee outflows with no financial or social infrastructure to accommodate them. The closest parallel to the situation with Venezuelan refugees in Colombia is rapidly facing is what happened in 1971 with India and Pakistan vis-à-vis Bangladesh. India went to war with Pakistan in part because it could not absorb the mass number of refugees crossing over the border into India from Bangladesh (then East Pakistan), and it threatened internal stability within India. Whereas the total number of refugees coming over from Bangladesh into India was cumulatively higher (approximately 10 million) than the number of refugees who have most likely come into Colombia thus far, the question is not of an absolute total number but how many refugees can a country absorb. India decided to take military action when around 10 million refugees had crossed over into its country and diplomatic channels with Pakistan had been exhausted; however, at the time, India was a country with a population of 548 million people, so 10 million refugees, or 1.8% of the population, was a bridge too far for India and forced it to take military action. If one is to assume that 1 million people from Venezuela have fled into Colombia (which is not an unreasonable assumption), a country with a population of 48 million people, one would see that Colombia has already absorbed a higher percentage of refugees (2%) 15 After Long Drug War, Colombia Joins Pot Trade, by Nicholas Casey. The New York Times. March 10, 2017 16 https://www.yahoo.com/news/venezuelans-fleeing-crisis-flood-colombia-un-185006307.html

comprising of its total population than India did when it decided to go to war and invade East Pakistan to stop the flow of refugees. The time frame to decide on military action against Venezuela, if this issue is on the Colombian government s radar screen, will be a question of months, if not sooner. If the Colombian government does nothing to stop the flow of refugees, in the short term, this may prove viable, provided that stability is restored to Venezuela and refugees begin to return home. However, this approach would be the equivalent of playing Russian roulette, as if order is not restored in Venezuela, and the refugee flows are not reversed, the possibility for Colombia to destabilize will grow exponentially. All of this in turn leads to the fourth uncertainty, which is the upcoming legislative and presidential elections scheduled to take place in 2018. In normal times, the period leading up to elections is filled with some degree of uncertainty. However, given the lingering divisions over the peace process, external challenges in the region from neighboring Venezuela and Ecuador, and internal tensions over corruption and a general lack of trust that the Colombian public has for establishment politicians, the possibility of wild card candidates (either on the far right or far left) and political parties gaining wide popularity should not be excluded from the realm of the possible. Implications and Recommendations for Foreign Investors Given the current volatile factors in Colombia, it would be wise to refrain from investing for approximately six months and to then re-evaluate the situation and issues raised in this paper. Colombia as a market has tremendous potential to be a huge generator of profit growth and value enhancement in one s investment portfolio; however, there are a lot of uncertainties that one is dealing with that should resolve themselves in the near term future and allow for a better investment decision. If one does decide to invest in Colombia regardless, there are several recommendations that will help mitigate investment risk: Buying futures or forward options contracts to avoid exchange rate volatility 17 Incorporate political risk into expected future cash flows and reduce expected returns accordingly From a direct investing perspective, using WACC to discount back may be challenging because it may be hard to identify proper market betas for the cost of equity; using Internal Rate of Return (or modified Internal Rate of Return) or even the Payback method may be more practical when trying to determine what kind of returns and timeline would be needed to make a salient investment 17 The Colombian Ministry of Finance on its web site indicates that both over the counter (OTC) as well as futures trading is currently taking place. However, it does not indicate the source of counter-party risk; if such trading is linked to Colombian banks, then a more in-depth investigation of the Colombian banking system than this paper has given time to may be needed before such a strategy is ultimately decided upon.

If one does proceed with using WACC for determining investment calculations, since Colombia does have dollar-denominated debt, using the sovereign risk premium method and adding that to the WACC may be prudent (although it is also imperfect) Due to ongoing challenges with infrastructure, assume that operating expenses (especially transport) will be significantly higher (i.e., 30%) than in a market like the US A safe and conservative investment may be investing in Colombian sovereign debt that is issued in US dollars; the Colombian government is very determined to maintain good standing with international creditors and most likely is paying a slight premium on dollardenominated debt, so the likelihood of default will low and an arbitrage opportunity is likely to exist when compared with US-issued T-bills that pay lower interest rates. Investing in Colombian stocks, both due to inflation and market volatility, would be a riskier investment and require a relatively high yield to make financial sense Investments in industries such as high tech startups, commercial air passenger airlines, and commodities such as coffee are probably fairly low risk from the standpoint of running afoul of the Foreign Corrupt Practices Act (FCPA); investing in any industries that are more infrastructure focused such as telecommunications, natural resources, or construction is more likely to give one exposure to possible FCPA issues and should be avoided unless one can be extremely such pitfalls are avoidable