The Case of Colombia

Introduction

In this chapter, we characterize the joint history of monetary and fiscal policies in Colombia since 1960 following the framework presented in chapter 2. Our analysis focuses on the joint evolution of inflation, economic performance, and the fiscal deficit of the Colombian central government and its sources of financing in the period between 1960 and 2017. As a first examination of our objects of interest, figures 1, 2, and 3 present the evolution of the total fiscal deficit of the central government (as a percentage of GDP), CPI inflation in Colombia, and real GDP per capita (against a counterfactual trend of 2 percent growth). With regard to the fiscal deficit, three periods can clearly be identified. In the first period, between 1960 and 1970, fiscal deficits were relatively small, averaging 0.43 percent of GDP. In the second period, between 1971 and 1990, fiscal deficits doubled on average (1.05 percent). Finally, during the third period, between the early nineties and the latest data available, deficits were the largest on average (3.27 percent between 1991 and 2017). We highlight the fact that the fiscal deficit peaked in the years during which banking crises occurred: 2.75 percent in 1982 and over 6 percent of GDP in 1999, during the year of the worst economic crisis since the beginning of the twentieth century.

These three periods also translate into the evolution of inflation: between 1960 and 1970, inflation was low on average (excluding the unusual peak of 1963, inflation averaged 8.4 percent); between 1971 and 1990, average inflation persistently increased to an average of 23.1 percent; and finally, after 1991 inflation gradually and persistently decreased, reaching an average level of 3.9 percent after 2010, the lowest levels of our time window. Significantly, the recession of 1999 coincided with a rapid decrease in inflation.

Finally, real GDP per capita grew at an average pace of 2.16 percent for the period of analysis. This number, although above a benchmark rate of 2 percent for the United States, was not sufficient to allow the economy to achieve a perceivable degree of convergence. Figure 3 highlights the two major banking crises that Colombia experienced in 1982 and 1999.

Following from the previous analysis, we divide the Colombian experience after 1960 into three periods, which are differentiated by the financial structure of the fiscal deficit, the institutional setup of monetary and fiscal policies, the levels of inflation, and the relative economic performance against Latin American peers. The first period, from 1960 to 1970, was characterized by both a low average inflation rate and a low average fiscal deficit. During this period, monetary emission, through both increases in the monetary base and seigniorage, was the main source of financing. Foreign debt also played a role in financing toward the end of the period.

During the second period, 1971‑1990, the Colombian economy experienced high and persistent inflation and higher fiscal deficits, this time in the context of frequent use of monetary emission to finance government expenditures and heavily controlled foreign exchange markets, particularly after international finance dried up in the wake of the Latin American debt crisis of the early eighties. Throughout this period, the nominal exchange rate was heavily controlled, following a government-predetermined upward trend (crawling peg).

The third period, from 1991 to 2017, registered the highest average fiscal deficit, the highest peak in the deficit, and the worst economic recession since the early twentieth century, the peak in the deficit and the recession occurring in 1999. Despite high deficits and a severe crisis, inflation kept a persistent downward trend, back to one-digit levels after 2010. This event occurred in the context of a newly independent central bank, increasingly flexible exchange markets, and a reorientation of deficit finance toward the domestic capital markets.

The division of our time window into three separate periods also allows us to illustrate the use of the conceptual framework in chapter 2 to understand the evolving relationship between monetary and fiscal policies in Colombia. Specifically, the first two periods were characterized by fiscal dominance, institutionally defined as a nonindependent central bank. In the first period, fiscal discipline allowed inflation to be kept at relatively low levels. In the second period, an expanded fiscal deficit led to increased inflation under the frequent use of monetary emission to finance government expenditures.

In 1991, a new constitution enshrined monetary dominance via an independent central bank in charge of reducing inflation and accountable to Congress. Significantly, from 1993 to 1999, the central bank kept a managed floating scheme of currency corridors. In this context, the increased fiscal deficits of the early nineties did not lead to increased inflation (monetary emission to finance the fiscal deficit all but disappeared after 1991). Instead, large deficits created relatively large external imbalances, leaving the economy vulnerable to a sudden-stop shock of the sort that occurred in the late nineties, which drove the economy into a harsh recession without an easy resort to nominal depreciations or monetary finance. Since then, monetary independence, together with increased fiscal discipline and the adoption of a floating exchange rate, allowed the economy to recover a certain degree of persistent macroeconomic stability, as evidenced by low historical inflation and fiscal deficits close to the average of our time window.

A key observation is that, for the period of analysis, large fiscal or monetary imbalances in Colombia, relative to other Latin American countries, were extremely rare in at least two aspects. First, fiscal deficits were generally small and peaked at only around 6 percent of GDP at the end of the 1990s. Second, although the use of monetary emission to finance the government was frequent, it was never sizable compared to other countries: monetary emission to finance fiscal deficits was more than 2 percent of GDP only during two small time windows, 1977‑1978 and 1991‑1992. Remarkably, the Colombian government did not default on its foreign or domestic debts during the period of study.

The rarity of large fiscal or monetary imbalances or extended periods of large monetary emission for budget finance purposes in Colombia could have contributed to a relatively stable macroeconomic environment during the period of analysis. The Colombian economy has been relatively less volatile than several of its Latin American peers: during this period, it has experienced no hyperinflationary episodes (although, as discussed, inflation was high and persistent during the seventies and the eighties), and growth has been relatively stable: the worst recession since records began occurred in 1999, with a trough in real growth of -4.2 percent in 1999, a relatively small contraction compared to other Latin American economies.1

A more stable macroeconomic environment did not, however, foster long-term macroeconomic performance in Colombia relative to the rest of Latin America. As discussed before, real per capita GDP growth in Colombia was only slightly above the reference rate of 2 percent during the period. Figure 4 shows that the Colombian economy did not significantly outperform comparable Latin American economies. The growth experience reflected in figure 4 also coincides with the division of our time window: During the first period, the Colombian economy diverged from other Latin American economies; by 1970, Colombian GDP per capita reached a minimum of slightly less than 0.8 times that of the region. We name this period divergent fiscal dominance. During the second period, the Colombian economy converged relatively quickly, especially during periods of coffee booms, and after avoiding negative economic growth during 1980s. We name this period convergent fiscal dominance. Finally, the experience during the third period has been mixed: divergent during the first year and rapidly converging afterward (a trend that continues to this day). We name this period monetary dominance.

Relative stagnation in Colombia amid a stable macroeconomic environment can possibly be understood if we consider the complex relationship between financial repression and fiscal or monetary imbalances throughout our period of analysis. Prior to 1991, as discussed, fiscal deficits and monetary finance were small but frequent. At the same time, existing evidence indicates that policymakers routinely employed heavy financial repression to control key monetary aggregates (Hernández Gamarra and Jaramillo Echeverri 2017). Convergence was thus a matter of commodity price shocks. After 1991, although financial repression was gradually abandoned, macroeconomic imbalances began to build up, creating the conditions for the financial crisis of the late nineties. Afterward, the solid and stable macroeconomic framework has allowed the economy to reach a relatively rapid degree of convergence.

Data

To understand the role that monetary and fiscal policy has played in Colombia, we focus on how the national central government has financed its fiscal deficit since 1960. We exclude local governments and government-owned firms from our analysis for three main reasons. First, Colombia has a centralized government in which local governments finance their expenses mostly with transfers from the central government. Since 1968 the central government has been required by law to transfer resources from value-added tax and social security to local governments, and with the new constitution of 1991, transfers increased. Local governments can levy particular local taxes, and some local governments even issue bonds that are publicly traded, but the latter sources are not the most important for financing.2

Additionally, the national central government is in charge of shaping fiscal policy and is the only governmental body that may be able to influence monetary policy. Finally, we are able to collect consistent data on how the national central government finances its fiscal deficit that go back to 1960. Therefore, when we refer to debt, deficit, expenditures, income, and so on, we are referring to claims on the central national government.

We use data from Junguito and Rincón (2007) for most data series since 1960. We are not able to identify indexed debt, so we can only discriminate between debt issued in Colombia, which we denote as domestic debt, and debt issued abroad, which we denote as foreign debt. We assume that foreign debt is issued in US dollars and that domestic debt is issued in Colombian pesos, since debt issued in different currencies has little relevance.3 Our data allow us to discriminate between interest rate expenditures on domestic debt and those on foreign debt. It is worth mentioning that interest on domestic debt includes interest on loans by the central bank to the government before 1991. Similarly to how we deal with domestic and foreign debt, we assume that interest payments on foreign debt are in US dollars, while interest payments on domestic debt are in Colombian pesos.

We update most series from Junguito and Rincón (2007) using data from Banco de la República Colombia (the central bank). We also use data from the central bank for inflation and exchange rates. To update the series for interest payments on debt, we rely on the Ministerio de Hacienda.

Figure 5 shows the evolution of debt as a fraction of GDP. Three things are worth noting. First, since 1970 foreign debt has been greater than domestic debt, up until the 1990s. At that point, domestic debt surpassed foreign debt. This point marks the launch of the market for bonds issued by the government. Second, this point also coincided with a big increase in both domestic and foreign debt. Finally, during the last ten years, foreign debt has decreased, while domestic debt has continued increasing, although during the last five years, foreign debt has increased. As seen in one of the simulations below, this increase is not the result of a real exchange devaluation.

Periods of Analysis

We identify three main periods in Colombia since 1960 that correspond to different dynamics in inflation, the fiscal deficit, the structure of financing of the deficit, and the institutional structure of monetary policy. The first period, divergent fiscal dominance, covers the window from 1960 to 1970; the second, convergent fiscal dominance, period covers the nineteen years from 1971 to just before the promulgation of a new constitution in 1991; and the third and final period, monetary dominance, spans from 1991 to 2017, which is the latest data point in our analysis.

Table 1 summarizes the budget accounting for the three periods that we analyze. The economic institutions mainly determined the main source of government financing of its deficit: monetary emission in the first two periods and domestic debt in the final ones. Together with variations in the predominant source of financing, changes in the main components of the fiscal deficit took place over time. More specifically, we observe that until the early 1990s, most of the fiscal deficit was accounted for by the primary deficit. Beginning in 1992, interest payments on domestic debt as a share of the deficit increased, as did the share of interest payments on foreign debt a few years later (see figure 6). Additionally, we observe that the maximum deficit reached in each of the three periods is increasing over time, which suggests increasing macroeconomic imbalances, although smaller than those observed elsewhere in Latin America. Both the primary deficit and the fiscal deficit peaked in 1999. Figure 7 shows the evolution of the fiscal deficit and its main sources of financing throughout our time window.

Table 1. Summary of Budget Accounting (percentage)

Before proceeding to a detailed analysis of the three periods, we provide some elements of the historical background of the joint determination of monetary and fiscal policies prior to 1960. Since the creation of the Banco de la República Colombia in 1923, the law opened the door to the possibility of the central bank extending direct loans to the central government. Despite the nominal independence of the central bank (the minister of finance only became a member of the board of directors of the central bank in 1931, and even then without the right to vote), in practice the borrowing limit was customarily bypassed by informal agreements between the government, Congress, and the central bank to enact laws that would allow the latter to directly purchase public debt instruments issued by the government (not included in the category of direct loans). This tradition persisted after the central bank was reformed in 1951, particularly after the minister of finance acquired veto power in the board at the same time as the composition of the latter was altered to include representatives from the productive sectors of the economy. The tradition also continued after 1963, when the board of directors was replaced by the monetary board, in practice composed fully by members of the government, and lasted until the constitution of 1991 made it harder for the central bank to make loans to the government (Hernández Gamarra and Jaramillo Echeverri 2017).

Debt Simulations

In analyzing how the government financed its fiscal deficit, we treat transfers as a residual. In this section, we analyze the role that these transfers played in the dynamics of debt. Figure 21 contrasts the observed evolution of debt to GDP with the implied evolution of debt had transfers equaled zero every year. The cumulative effect of transfers accounts for close to slightly over 60 percent of GDP by the end of the period of analysis, which implies average transfers of 1 percent of GDP.

We also analyze the role played by the real exchange rate in debt dynamics. In figure 22 we compare the observed dynamics of debt to GDP with the implied evolution of debt with a fixed real exchange rate. The real exchange rate of 2007 is close to the average real exchange rate across our sample, so the implied evolution of debt keeps the real exchange rate fixed to the observed real exchange rate of that year. It is worth noting that both lines follow essentially the same path for most of the period, and at low levels. This is consistent with the fact that debt was low up until the early nineties. Episodes such as the real exchange rate appreciation of the late seventies and the real exchange rate devaluation of the mid-eighties are evident, but the disparity is not considerable.

The real exchange rate appreciation of the early nineties is not perceptible since this event coincides with a surge in domestic debt. The real exchange rate devaluation after the economic crisis of the late nineties is evident, however, and accounts for slightly more than 6 percent of GDP in 2002.

Discussion

One implication of the framework in chapter 2 is that inflation will naturally result as a consequence of fiscal deficits when there is fiscal dominance. When there is monetary dominance, fiscal deficits need to be relatively controlled, otherwise risking costly fiscal or financial crises. In the end, the question of fiscal or monetary dominance is a question about the institutional structure (determined by historical, economic, and political factors) of a given country.

In the case of Colombia, the period between 1960 and 1990 is one in which the institutional structure of monetary policy clearly configured an equilibrium of fiscal dominance, chiefly through the lack of independence of the central bank from the government and its goal of promoting economic development in a context of heavily controlled foreign exchange markets. Within this period (1960‑1970), inflation was relatively low when fiscal deficits were low and duly increased under the expectation of widened fiscal deficits in the late seventies and early eighties. In contrast, the institutional reforms created by the constitution of 1991 promulgated monetary dominance in the form of a newly independent central bank. In this context, larger fiscal deficits could not be financed by monetary emission and left the economy exposed to external financing shocks. Since 2000, an equilibrium with monetary dominance and enhanced fiscal discipline mechanisms has allowed the Colombian economy to maintain macroeconomic stability and gradually lower inflation.

It has been argued elsewhere that a reason for the macroeconomic stability that Colombia endured throughout its history is the memory of a hyperinflation episode at the beginning of the twentieth century, during a civil war. In four years (1900‑1903), inflation was over 50 percent per year, and in 1901 it reached 327.6 percent. This led the economic authorities of the time to create a new currency, also named the peso, by slashing two zeros from the previous currency. With this change, the new peso was at parity with the US dollar (Junguito and Rincón 2007). A practical question that is left to be addressed is why and how, during the prolonged period of fiscal dominance between 1960 and 1991, inflation never increased to levels remotely comparable to those of other Latin American economies that suffered recurrent hyperinflationary episodes.

One potential explanation in this respect has been proposed by Hernández Gamarra and Jaramillo Echeverri (2017) in the form of the dynamic relationship between monetary discipline and financial repression in Colombia. Even though macroeconomic imbalances were not large prior to 1991, this was not necessarily because policies were prudent. Financial repression may have helped to avoid large, undesirable macroeconomic fluctuations. This is consistent with the fact that although macroeconomic volatility was low, the Colombian economy did not catch up perceivably faster than other Latin American countries. It is also consistent with the fact that the Colombian experience of fiscal dominance only yielded convergence to other comparable Latin American economies as a consequence of commodity price shocks (particularly coffee booms).

Specifically, Hernández Gamarra and Jaramillo Echeverri (2017) argue that there is a historical, negative correlation between the growth of the monetary base and the money multiplier. This suggests that as the monetary base increased, the growth of credit did not necessarily follow suit, which might help to explain why inflation in Colombia never went beyond 30 percent per year during this period. The reason for this negative comovement is consistent with the active use of reserve requirements throughout the period. In fact, the (inverse of the) money multiplier moves hand in hand with the reserve requirements (see figure 24). Together, figures 23 and 24 suggest that when the monetary base increased, the monetary authorities also increased the reserve requirements. In this way, the extra cash that was printed by the central bank did not necessarily translate into more loans.

In particular, reserve requirements were actively used to counteract economic events, which caused a rapid accumulation of foreign exchange reserves. For instance, during the coffee boom of the late 1970s, foreign reserves doubled from 1975 to 1976 and reached US$1.0 billion (b). Two years later, they reached US$2.5 b. In 1977 the monetary board imposed a marginal reserve requirement of 100 percent on deposits over the level observed by January 31, 1977. Additionally, reserve requirements increased from 34 percent to 46.5 percent in various reforms in the following two years (Avella Gómez 2007). Consistent with this argument, the short-lived spike in inflation during the early 1980s may have been related to the fact that higher growth in monetary emission was not immediately accompanied by either rises in the reserve requirement or reductions in the money multiplier.10

Since 2000, the combination of monetary dominance and fiscal discipline has allowed the economy to achieve macroeconomic stability without the need for financial repression. The fact that GDP growth in Colombia remained well above zero during the global financial crisis of 2008‑2009 is indicative of the increased resilience of the economy to external shocks.

Together with fiscal discipline, an enhanced prudential financial regulation since 1999 has also been a key factor behind the macroeconomic stability in Colombia, and behind a relatively rapid convergence to the GDP per capita of other Latin American economies.

Notes

We would like to thank Mauricio Avella, Ricardo Kerguelen, Johanna López Velandia, Ignacio Lozano, Marc Hofstetter, Laura Mojica, José Antonio Ocampo, Guillermo Perry, Hernán Rincón, Miguel Urrutia, Andrés Velasco, and the Centro de Apoyo a la Investigación Económica del Banco de la Repóblica Colombia. We also thank Jesahel Higuera for his job as research assistant. The views expressed herein are those of the authors and not necessarily those of Banco de la Repuóblica Colombia or its board of directors.

References