Colombia - Macroeconomic consistency and structural reforms

Report No. 9764-CO Colombia: Macroeconomic Consistency and Structural Reforms May 20,1992 Bolivia, Colombia. and Dominican Republic Division , , Country Department III Latin America and the Caribbean Region co FOR OFFICIAL USE ONLY Dm t of the Wodd Bank/ A tiN S , z ~ ~ ~~ ~ ~~/ as *7 ./ ;,.~~~~~~~~~~~~~~~~~~~~~~~~I * 0 Docwe. -f te Wol Bank This document has a retricted distribution and may be used by recipients only in the perfoffaake of their official duties. fts content's may not otherwise bedisclosed without World Bank authoritation.  FISCAL YEAR January 1 to December 31 CURRENCY EQUIVALENT Currency Unit: Peso (Col$) US$1.00 - Col$568.73 Col$1.00 - US$0.0018 (December 31, 1990' ACRONYMS BR Banco de la Repfiblica CARBOCOL Carbones de Colombia S.A. CAV Corporaci6n de Ahorro y Vivienda CEC Cuenta Especial de Cambios CERT Certificado de Reembolso Tributario CF Corporaci6n Financiera CFC Compaflia de Financiamiento Comercial CONFIS Consejo Superior de Politica Fiscal CONPES Consejo Nacional de Politica Econ6mica y Social DANE Departamento Administrativo Nacional de Estadistica DNP Departamento Nacional de Planeaci6n DTF Dep6sito a t6rmino fijo ECOPETROL Empresa Colombiana de Petr6leo EDP Economic Development Plan EMP Economic Modernization Program FCE Fondo de Capitalizaci6n Empresarial FEN Financiera Electrica Nacional FFAP Fondo Financiero Agropecuario FFI Fondo Financiero Industrial FINAGRO Fondo para el Financiamiento del Sector Agropecuario FINDETER Financiera de Desarrollo Territorial S.A. FIP Fondo para Inversiones Privadas FNC Pondo Nacional de Caf6 ICT Instituto de Cr6ditc Territorial IDEMA Instituto de Mercadeo Agropecuario IFI Instituto de Fomento Industrial INCOMEX Instituto de Comercio Exterior IVA Impuesto del Valor Agregado OMA Operaci6n de mercado abierto PNR Programa Nacional de Rehabilitaci6n PROEXPO Fondo de Promoci6n de Exportaciones PSD Primary Structural Deficit QR Quantitative restriction SD Structural deficit TAN Titulo de Ahorro Nacional  FOR OFFICIAL USE ONLY COLOMBIA: MACROECONOMIC CONSISTENCY AND STRUCTURAL REFORMS TABLE OF CONTENTS Page. No. EXECUTIVE SUMMARY .......................... to .......................... i CHAPTER lt RECENT ECONOMIC PERFORMANCE A. Economic Growth Since the 1984-86 Adjustment Program. .......1 B. Indicators of Economic Performance, 1988-90... ......... 3 Supply-Side Sources of Economic Growth ......3.........3 Balance of Payments.... . ............5.... .... 5 External D e b t ...........**..... ..... 9 Employment and Wages .......... . .... ..... . .. .. . 9 Inflation and Interest Rates...*e......s......*......... 10 C. Size, Composition, and Financing of the Fiscal Deficit ........ 12 The Structural Fiscal Deficit ................. .........0 .... 13 Composition of Fiscal Revenues and Expenditures .......... 14 The Financing of the Fiscal Deficit ...................... 16 De Conlsons.. coo..... uo*......i o n....s.... . 17 CHAPTER 2: STRUCTURAL REFORMS A. Recent Structural Reforms..* .... 19 - ~~~Trade Polcolicy..... ............. 0 19 Agricultural Trade Policy...................... o.o ..... 36 Financial Sector Policy. .. . . .. .......... . ... ... 39 Foreign Exchange Controls.*o....... s.......* .... ..... 47 Foreign Direct Investment...................v ...... 50 Labor Legislation..*.. ............. **.*. ....... . ... ..... 50 Public Sector Reforms.e. f o rm.... ............. 51 The Power Sectore....... .. . ............... too ....e... o..* 55 Public Debe........... b.t......00... 57 B. Conlsonsc............ s i on........s..... 58 CHAPTER 3: INFLATION A. The Causes of Inflation: Theoretical Background.............. 62 B. A History of Inflation in Colombia, 1973-857..... 8............ 64 The Increase in Inflation in 1973-74........q.......... 65 The Coffee Boom of the Late 1970s 97.0 8..........9.o..o 68 The Rea: Depreciation of 1985........................ 68 C. The Recent Acceleration of Inflation ........ oo#* .... so* 70 D. The 1990-91 Stabilization Program.......................... 76 E. The Anti-Inflation Program and Trade Liberalization .......... 79 F. Conclusions ........ .*** .............. .............. 80 This document has a restricted distribution and maY be used by recinient, only in the perfnrrr n--i  -2- CHAPTER 4: MACROECONOMIC CONSISTENCY ANALYSIS A. Recent Macroeconomic Developments ...,.................... 83 B. Macroeconomic ConsiLtency Analyeis .......................o... 90 The Simultaneous Achievement of Macroeconomic Stabilization and Structural Reforms ................. 90 The Macroeconomic Consistency Framework . ... ........ 91 Macroeconomic Targets and Fiscal Policy Assumptions .... 95 Consistency of the 1992-94 Economic Development Plan ... 98 The Main Elements of a Consistent, Comprehensive Macroeconomic Policy Package .......................... 103 C. Conclusions .................... o...... oo........ ..................... 105 Bibliographv ................................... .......to............................. 106 Appendices I. RMSM-X and the Projections .....*too....................... 110 II. Statistical Appenip...e.....o n... doi....xo.... 119 LIST OF TABLES AND FIGURES Table No. 1.1 Economic Growth and Its Sources . ........ 4 1.2 Balance of Payments, 1987-91 ............7-9 ........ . .......4...... 6 1.3 Exports, 1980-90 ...... .......................... .........*.. ...... .. 7 1.4 Non-traditional Exports, 1989-90 ............. ,.......... 8 1.5 Nominal and Real Wages and Productivity in Manufacturingt.......4 10 1.6 Money, Inflation, Interest Rates, and Exchange Ratestes....... 11 1.7 Relative Price of Food and Non-Food Items.t e ms....44......... 11 1.8 Structural Financial Indicatorsd...... 0.. *.4 ..14 1.9 Non-financial Public Sector Revenues and Expenditures 15 1.10 Investment of the Non-financial Public Sector ................... 15 1.11 Inflati on Tax and Monetary Base ......d o ea........se.............. 17 2.1 The Import Licensing Regime. ................. 22 2.2 Licensing Requirements by Sector and Stage of Processing 23 2.3 Production Coverage of QRs by 2-Digit Manufacturing Subsector 24 2.4 Average Tariffs by Economic Activity and Subsector 25 2.5 Average Tariffs and Tariff Surcharges, 1989-94............. 26 2.6 Effective Protection, 1989-94. .................. . 29 2.7 Nominal Tariff and Real Exchange Rate Index, 1989-94 29 2.8 Results of Import License Auctios .31 2.9 Distribution of Tariffs for Auctioned Items.......4e44.......*. 31 2.10 Average Tariffs for Auctioned I t e m s ..... .................. .. 32  -3- Table No. Page No. 2.i1 Trade Liberalization in Latin America........................... o. 35 2.12 Forced Investments, 1990-91.......*.. .*. ..0.0.... ....... ....... . 44 2.13 Reserve Requirements and Forced Investments.........0 ........... 45 2.14 Directed Credit Interest Rateso.*.....o..o.. ... ................ 47 3.1 Macroeconomic Indicators, 19 7 0 - 78.$.............0 ..... 67 3.2 Macroeconomic Indicators, 1978-86o8......86..... ........... .... 70 3.3 Macroeconomic Indicators, 1984-90.. 8 4 - 90....... ........o ...... 72 3.4 Comparison of Macroeconomic Indicators, 1987-88 versus 1989-90- 74 4.1 Monetary Control Instruments, Credit, and Foreign Reserves ...... 84 4.2 Interest Rates Parity ...*..*................. .... 85 4.3 Identies in the Consistency Framework 93 4.4 External Sector Exogenous Variables . .96 4.5 Macroeconomic Consistency Framework, Main Indicators . 99 4.6 Macroeconomic Consistency Framework, Fiscal Program . .102 4.7 Public Investment Program .... .. . . . . ... 102 Fiaure No. 3.1 CPI Inflation, 1967-90 ...................* .............. 65 3.2 CPI Inflation and the Real Effective Exchange Rate .........t e.... 73 3.3 Reserve Money, 1989-91.. ........... ............ 77 3.4 90-Day Interest Rates........................ ................. 78 This report is based on the findings of missions that visited Colombia in February and April 1991. The missions included Erh-Cheng Hwa (LA3C1, macroeconomic analysis), Miguel Kiguel (CECMG, inflation), Kristin Hallberg (LA3C1, structural reforms), Leora Friedberg (LA3C1, macroeconomic modelling), and Martin Kimmig (LA3C1, fiscal analysis). Contributions were also made by Ewald Goetz (LA3AG) and Alberto Valdes (LATAG) on agricultural trade policy, Julie Phillips (LA3TF) on industrial trade policy, and Ana Maria Llorente (Colombia Resident Mission) on macroeconomic data. Marta Cervantes coordinated the production of the report. Kristin Hallberg was the task manager.  EXECUTIVE SUMHARY Recent Economic Performance 1. In late 1984, following the collapse of the coffee boom of the late 1970. and sharp Increases in inflation, current account and fiscal deficits, the Colombian Government introduced an economic adjustment program designed to achieve stabilization and promote overall economic efficiency. Because of the adjustment program, as vell as higher coffee prices and rapid expansion of petroleum and coal exports, fiscal performance improved substantially, and by 1996 the current account showed a surplus for the first time in several years. The rate of GDP growth recovered from an average of only 1.62 per year during 1980-83 and 3.31 in 1984-85 to 5.81 in 1986 and 5.4Z in 1987. But inflation remained unabated reaching 281 by the end of 1985 from previous levels of around 201. As a result of further anti-inflationary policies, more restrictive quotas on coffee exports, and guerrilla attacks on oil pipelines, GDP growth slowed from an average of more than 52 per year during 1986-87 to 3.7Z in 1988. 2. As the slowdown in economic growth continued into 1989, two developments occurred in the middle of the year which further darkened the economic outlook. First, the demise of the International Coffee Agreement reduced international coffee prices by half, sharply cutting earnings from Colombia's main export industry. Second, the assassination of presidential candidate Luis Carlos Gal&n triggered a generalized conflict between the drug traffickers and the Government, with adverse effects on the investment climate, increased fiscal pressures from the security effort, and reduced drug-related revenue. The Government responded quickly to the coffee-drug shock by reducing both the fiscal deficit and domestic credit. Additional adjustment measures were taken in 1990, including a further real devaluation of the peso and greater fiscal austerity. 3. Other internal and external shocks affected the economy in 1988-90: a decline in crude oil prices in 1988 followed by a recovery in 1989 and a sharp increase at the end of 1990 as a result of the Persian Gulf crisis; continued attacks on oil pipelines by guerrilla groups; and slower growth and higher interest rates in industrialized countries. Swings in international coffee and oil prices have had a dominant and volatile influence on both the balance of payments and the consolidated public sector deficit. The refinancing of external commercial debt during the period added to macroeconomic uncertainty and consumed the time and attention of the economic authorities. 4. The slowdown in growth in 1988-90 was mainly seen in manufacturing, infrastructure, construction, and other services, as well as in a contraction of public investment, partially offset by stronger growth in mining and agriculture. The external sector provided the main source of growth in aggregate demand, thanks to the major realignment of the exchange rate in 1985-86 and the aggressive policy of devaluation in 1989-90, and increases in the price and volume of oil exports.  - ii - 5. Despite the improvement in the size of the consolidated public sector deficit since the 1984-86 adjustment program, a large part of the fiscal adjustment was due to temporary factors--in particular, higher coffee ard oil prices. Also public sector savings were lower in 1989-90 compared to 1987-88. The relative stability in the composition of fiscal revenues and expenditures suggests that the Government has not launched any major initiatives to improve the basic structure of fiscal policy since the mid-1980s. Meanwhile, increased reliance on domestic financing of the fiscal deficit has increased pressure on the price level and domestic interest rates. 6. Thus, with rising inflation and the slowdown in economic growth, Colombia's overall macroeconomic performance deteriorated during 1988-90. Inflation accelerated from 28Z at the end of 1988 to more than 321 at the end of 1990, and GDP growth fell from an average of 5.61 in 1986-87 to an average of 3.51 in 1988-90. Part of the deterioration in economic performance can be explained by the major internal and external shocks that have created a continuing need for stabilization measures. The other major explanation was that the growth response to the correction in macroeconomic imbalances in the mid-19809 could not be sustained without structural reforms to address microeconomic efficiency issues--problems that the Government is currently addressing with its structural reform program (see paras. 7-8 below). The acceleration in inflation was mainly due to inconsistency among the Government's fiscal, monetary, commercial, and exchange rate policies (paras. 19-22). Structural Reforms 7. Recognizing that macroeconomic measures alone would be insufficient to raise productivity and output growth in the long term, in February 1990 the Barco Administration announced an Economic Modernization Program (EMP) to improve the efficiency of resource allocation and use. The EMP contained a set of structural reforms and accompanying macroeconomic policies designed to raise economic growth to 5X per year, bring inflation below 20Z, and reduce the incidence of poverty. The centerpiece of the EMP was a trade reform program aimed at increasing the competitiveness of the tradeable goods sector. Complementary policies were designed to improvo resource mobilization and ensure an adequate supply response of the productive sectors and improved efficiency and effectiveness of the public sector. These structural reforms were to be underpirned hy fiscal and exchange rate policies to maintain internal and external balance. 8. Upon taking office in August 1990, the Gaviria Administration reaffirmed its commitment to the objectives of the EMP and accelerated the implementation of structural reforms. The main elements of the structural reform program implemented in 1990 and 1991 were: * Trade policy. In November, the first phase of the trade reform program was completed ahead of schedule with the elimination of quantitative restrictions on industrial imports. At the same time, the Government announced a schedule of gradual reductions in the levels and dispersion of tariffs to reach an average tariff rate (including the surcharge) of  - iii - 15S in 1994. In July 1991, the Government decided to accelerate the schedule of trade liberalization, adopting the 1992 tariff targets six months in advance. Then, in an August 1991 decision by CONPES, the Government adopted the tariff targets previously scheduled for 1994 for immediate implementation. The reforms lowered average nominal protection (excluding agricultural products covered under the price band system, and automobiles) from 281 to 151 and average! effective protection from 442 to 252. The adoption of the final tariff targets in August 1991 means that the entire program of trade liberalization begun in early 1990--including the removal of QRs as well as a significant reduction in tariffs and in the level and dispersion of effective protection--was achieved in 18 months, rather than the five years originally envisaged. Legislation was passed in late 1990 which modified the institutional framework for import and export policy, including the creation of a Ministry of Foreign Trade and authorizing the conversion of PROEXPO from an export promotion fund to an export-import bank. The system of indirect tax rebates for exporters (CERTs) was also modified. * Agricultural sector. The new administration went beyond the scope of the trade reform program initiated by its predecessors by extending the trade liberalization process to the agricultural sector and implementing other structural and institutional reforms in the sector. IDEMA's monopoly in the import of certain agricultural products was eliminated, and quantitative restrictions on agricultural imports were replaced with a variable tariff scheme. * Financial sector. In the financial sector, the Government's program of structural reforms is intended to lead to more competitive markets capable of mobilizing increased domestic and external resources to finance investmentu in the productive sectors, and providing a wide range of financial instr-,ments at market prices. The Government intends to phase out most directed credit subsidies, maintaining market-priced directed credit facilities for broad economic sectors primarily for the purpose of channelling external sources of funds to the private sector. Correspondingly, most new forced investments have been eliminated. Congress recently passed legislation designed to increase internal and external competition in the financial sector and reduce the segmentation of financial markets. Progress is also being made in selling three of the five banks that fell under Government control during the 1982-85 financial crisis. * Public sector. In the public sector, the Government is establishing a performance planning and evaluation system to promote the modernization of management practices in selected public enterprises, is preparing restructuring of the power sector, and is introducing substantial reforms in the railways, ports, shipping, and low-income housing sectors. The reforms would eliminate public monopolies in these sectors and replace them with incentive structures promoting private sector entry and competition. In addition, the Government intends to privatize public  - iv - assets in the industrial and financial sectors in cases where continued public ownership is not justified on strategic or policy grounds. Public sector employment will be reduced. * Power sector. In the power sector, the Government has prepared a reform strategy that would restructure the sector, gradually introduce tariffs based on long run incremental costs, and encourage private investment. * Public debt. A new public debt law strengthens the financial relationship between the Central Government and decentralized public sector entities, and eliminates the duplication of instruments for fiscal and monetary policy. * Foreign investment. A new foreign investment strtute brings most regulations governing international investment into one investment code, and establishes equal treatment of domestic and foreign investors. Access to the domestic market by foreign investors will be encouraged by permitting access to all sectors of the economy except those restricted for security or strategic reasons, and greater automaticity in the approval process for new foreign investments. - Labor legislation. Congress has passed legislation designed to reduce the segmentation of labor markets, increase labor mobility, and reduce labor costs. * Foreign exchange controls. Congress also passed legislation designed to relax foreign exchange controls, though stopping short of a full liberalization of foreign exchange transactions. 9. The structural reform program initiated by the Barco Administration and accelerated and expanded by the Gaviria Administration marks a significant break from the inward-oriented development model of the past. The past year in particular was an active and creative period in which, encouraged by the consensus within the Government and between the Governrment and the private sector to adopt significant reforms, Congress passed a large number of important laws. The main challenges now facing the Government are to prevent backtracking, to strengthen institutional capacity, to monitor the supply response of the private sector and remove remaining barriers to that response, and to continue to adopt complementary policies. 10. The main reason behind the Government's decision to complete the trade liberalization process quickly was the unexpected strength in the balance of peyments observed over 1990-91 and projected for 1991-94, which complicated the achievement of the Government's inflation targets. Recognizing that tight monetary policy was becoming less effective and more costly as an anti- inflation instrument, and hoping to lessen pressure for drastic fiscal adjustment and/or continued real exchange rate appreciation, the Government opted for a significant acceleration in trade liberalization to achieve its macroeconomic objectives. The decision was also promoted by pressures for faster liberalization in the Andean Pact and the Group of Three (Mexico, Venezuela, and Colombia). Lastly, the Government wished to reduce the  - v - uncertainty felt by domestic producers which was seen as a factor constraining private investment. Noting that the accelerated trade liberalization will have a fiscal cost of 0.2% of GDP in 1991, 0.6Z in 1992, 0.42 in 1993, and 0.0X in 1994, the CONPES document proposes that additional fiscal revenue measures and expenditure cuts be made to maintain macroeconomic balance. 11. The recent reform of the indirect tax rebate system for exporters may have failed to eliminate the subsidy element of CERTs. In addition, the program is still being used to promote, via higher CERT rates, certain export market destinations. This suggests that further reforms are needed in the CERT regime, reducing CERT rates in order to eliminate export subsidies. An alternative would be to abolish CERTs, replacing them with the existing Plan Vallejo duty drawback scheme combined with a direct rebate of non-trade taxes paid by exporters. The Government is currently in the process of clarifying the role, functions, and sources of funds of the newly created Banco de Comercio Exterior. This redefinition of export promotion activities should consider carefully the appropriate role of the public sector in export promotion and financing, concentrating public resources in areas of market failure where private sector activities are insufficient. 12. In the agricultural sector, the variable tariff system needs to be reviewed to ensure that over time it does not increase average effective protection, and its application should be restricted to basic agricultural commodities rather than extending to their derivatives and substitutes. The objectives and operation of the agricultural price support system need to be clarified as part of the Government's current efforts to define the objectives and functions of the Agricultural Marketing Institute (IDEMA). The price support system should be designed in conjunction with the variable tariff system to achieve an appropriate set of incentives and not increase protection for agricultural commodities above that granted to other sectors. It may also be appropriate to accelerate the planned elimination of trade revenues earmarked for IDEMA, and in no case should IDEMA receive these revenues beyond the two-year transitional period. 13. The Government's recent financial sector policy reforms and its proposed reforms for 1991-94 appropriately aim at increasing competition and efficiency in the sector, and at reducing the distortions created by the system of forced investments and directed credit. While the reforms maintain public sector involvement in credit markets through second-tier rediscount facilities, the plannod sources of funds, pricing policies, and generality of these funds should reduce the bias against the development of private long- term credit and capital markets. An exception is the system of agricultural credit, where portfolio requirements on financial institutions continue to create distortions in the allocation of credit and, as long as interest rates on required loans to the agricultural sector are below market rates, impose a tax on f4n-ncial intermediaries. 14. As with other parts of the structural reform program, the main unfinished business in the financial sector is the implementation of reforms and the monitoring of sectoral performance to see that the effiriency objectives of the reforms are being achieved. This is particularly important  - vi - in the area of competition policies, where the authorities will need to study changes in marxet atructure and conduct, and develop a set of performance indicators for the sector. 15. There are other areas of financial sector reform in which more work needs to be done. TLe roles and functions of second-tier financial institutions--particularly FINAGRO and the Banco de Comercio Exterior, and BR consistent with its role as specified under the new Constitution--need to be clarified. The strategy for FINAGRO should be explicitly transitional, to provide adequate financing for the agricultural sector and a means of channelling external sources of funds only as long as private financial sector activities are underdeveloped. The relationship and respective responsibilities of FINAGRO and Caja Agraria alra need to be clarified. Other areas in which more work needs to be done inclu4e the design and implementation of mechanisms to price and allocate rediscount funds, and the adoption of additional measures to encourage capital market oevelopment. 16. The Government has stated its intention to privatize all or part of the Instituto de Fomento Industrial (IFI), but this issue should also be raised with other public first-tier financial intermediaries. Continued public ownership of financial institutions may be justified to serve remote areas (as in the case of some of the activities of Caja Agraria) or to increase competition in private financial markets, though international experience suggests that the latter objective is rarely achieved by public institutions. In the absence of a clear justification for public ownership, strategies for privatization of these institutions should be designed and implemented. 17. In the public sector, the Government has made remarkable progress in obtaining passage of major legislation required to achieve its proposed reforms in ports, railways, agricultural marketing, and low-income housing. The focus must now shift to implementation and strengthening institutional capacity, maintaining a clear policy direction and avoiding slippage. To date, progress in implementing the new legislation has been mixed. Substantial advances have been made in implementing the reforms in low-income housing and railways and in preparing three public banks for privatization, but implementation of new legislation in the ports sector has been plagued by a lack of coordination and clarity in the reform objectives that inspired the law. To address these issues, a more active leadership role by the National Planning Department (DNP) is required. There have also been delays in finalizing performance plans for some of the decentralized public sector agencies. In the power sector, further elaboration of the sector strategy is required, particularly with respect to the tariff structure9 the new regulatory environment, and the conditions for private investment. With regard to power tariffs, the policy of long-run incremental cost priciig that has been initiated should be more aggressively implemented. Finally, the Government's decentralization objective requires that the responsibility for providing public goods be transferred to the departments and municipalities, and that local institutional capacity be strengthened.  - vii - 18. The structural reforms in the productive sectors and the public sector reduce direct state intervention in production and resource allocation, shifting these decisions to the private sector. In the wake of the structural reform program, the Government faces a new set of questionss what is the appropriate role of the government in a liberalized economy, and how should state intervention be redirected? It is likely that the focus of state intervention will shift to the provision of public goods for reasons of market failure, in addition to the public sector role in economic stabilization and income redistribution. This reorientation of the Government's role is expected to bring increased attention to the social sectors, infrastructural development, and environmental protection. Inflation 19. The acceleration of inflation in 1989-90 to rates exceeding 30% per year is difficult to explain on purely fiscal grounds: though the fiscal deficit increased during the first half of 1990 and was partly financed through money creation, the average fiscal deficit in 1989-90 was actually lower than it was in 1987-88. The main force fueling the recent acceleration of inflation seems to have been the aggressive policy of devaluation undertaken in 1989 and 1990 in anticipation of the trade liberalization program. The Government's exchange rate policy was inconsistent with fiscal and monetary policies and the initial speed of trade reform. 20. Upon assuming office in late 1990, the Gaviria Administrarion initiated an anti-inflation program with the objective of reducing inflation to 22Z by the end of 1991. Fiscal policy was tightened in late 1990; aided by high petroleum prices, the fiscal deficit fell to 0.1% of GDP for 1990 as a whole. Though the fiscal element of the Government's stabilization strategy was significant, the main instrument of the anti-inflation program has been contractionary monetary policy--limiting the growth in base money to an annual rate of 18-20Z, increasing placements of open market instruments, and imposing a 100% marginal reserve requirement. Though drastic monetary measures appeared to be partly successful in reducing domestic demand and changing inflationary expectationst their efficiency was eroded by massive capital inflows. Tight monetary policy combined with slower than anticipated sort demand and higher oil prices resulted in a substantial accumulation of -'reign exchange reserves that the Banco de la Republica (BR) attempted to sterilize through open market operations. This strategy is becoming costly for BR. In addition, the increase in intermediation margins and financial disintermediation that have resulted from tight monetary policy conflict with the objectives of the Government's trade and financial sector reforms. 21. The stabilization strategy could be strengthened by ensuring consistency in the use of the various policy instruments and by a comprehensive approach to reducing inflation. This could be achieved by shifting the roles of money and the exchange rate in the disinflation effort, and supporting the program through a more robust fiscal balance. The share of the adjustment burden borne by fiscal, exchange rate, and commercial policies will need to be carefully chosen in order to minimize the conflict between macroeconomic and structural reform objectives.  - viii - 22. One of the most important lessons of the recent acceleration of inflation is that it is difficult to actively manage all instruments-- monetary, fiscal, exchange rate, and commercial policies--and achieve macroeconomic consistency. The experience suggests that the Government should consider allowing greater flexibility in exchange rate determination, giving greater weight to market forces to set this price. This would increase the effectiveness of monetary and fiscal policies to achieve targeted reductions in inflation. The macroeconomic consistency analysis contained in the last chapter of this report (written in November 1991) suggests that the recent undervaluation of the real exchange rate has been corrected, and that the risk of a substantial real appreciation has been considerably lessened by the measures adopted since July 1991. The Government should continue its efforts to reduce the fiscal deficit. A crucial nominal variable--for fiscal reasons but more importantly as a symbol of the Government's commitment to its inflation targets--will be the increase in public sector wages negotiated for 1992. A public sector wage settlement that is forward-looking and consistent with inflation targets will also help to lessen pressure for exchange rate appreciation. Macroeconomic Consistency Analysis 23. The last chapter of this report (written in November 1991) analyzes the consistency of the Government's Economic Development Plan (EDP) for 1992- 94. The analysis shows that the EDP's macroeconomic targets, structural reforms, and public investment program are close to internal consistency: to achieve the targeted reduction in inflation and increase in the rate of economic growth, the public sector deficit would need to be further reduced to 0.2% to 0.8Z of GDP during 1992-94. The macroeconomic program could finance a public investment program of about 8.1X of GDP, consistent with the level proposed in the EDP. 24. These results depend not only upon improved fiscal policy, but also on more flexible management of the exchange rate. Some appreciation of the real exchange rate would help to restore internal balance by mitigating inflation and allowing non-inflationary financing of domestic investment, and external balance by slowing the accumulation of international reserves. A consistent policy package would reduce real interest rates, thereby discouraging capital inflows in the short run and stimulating investment and economic growth in the long run. To achieve the growth target, productivity growth would also need to increase, which is the essence of the structural reform program.  CHAPTER 1t RECENT ECONOMIC PERFORMANCE 1.1 This chapter reviews economic developments in Colombia since publication of the last Country Economic Memorandum. After a brief discussion of the 1984-86 economic adjustment program and its results, the chapter describes the internal and external shocks suffered in 1989-90 and shows recent trends in production, investment, the balance of payments, inflation and interest rates, external debt, and employment and wages. The chapter then analyzes the adjustment in and financing of the consolidated nonfinancial public sector deficit since 1987. 1.2 The chapter concludes that with rising inflation and a slowdown in economic growth, overall macroeconomic performance has deteriorated in 1988-90 relative to 1986-87. Some of the deterioration in economic performance can be explained by major internal and external shocks that continue to have significant impacts on the fiscal and external accounts and create the need for stabilization measures. The other major factor was that the growth response to the correction in macroeconomic imbalances in the mid-1980s could not be sustained without structural reforms to address microeconomic efficiency issues--problems that the Government is currently addressing with its 1990-94 structural reform program. The chapter also concludes that despite the improvement in the size of the fiscal deficit since the 1984-86 economic adjustment program, a large part of the fiscal adjustment was due to temporary factors--in particular, higher coffee and oil prices and the real devaluation of the peso. In addition, the relative stability in the composition of fiscal revenues and expenditures suggests that the Government has not launched any major initiatives to improve the basic structure of fiscal policy since the mid-1980s. Greater reliance on domestic financing of the fiscal deficit has increased pressure on the price level and domestic interest rates. A. Economic Growth Since the 1984-86 Adiustment Proaram 1.3 In late 1984, following the collapse of the coffee boom of the late 1970s and sharp increases in inflation and the fiscal deficit, the Colombian Government introduced an economic adjustment program designed to achieve stabilization with growth. Devaluation of the nominal exchange rate was sharply accelerated; the fiscal deficit was reduced through both tax increases and expenditure reductions; public sector investment was streamlined; and import restrictions imposed during the early 1980s were rolled back. Other reforms were initiated in the areas of public sector management and decentralization. 1.4 The 1984-86 adjustment program, together with higher coffee prices and rapid expansion of petroleum and coal exports, substantially improved fiscal performance, and the current account showed a surplus for the first time in several years. Nontraditional exports and private investment grew rapidly. As a result, the rate of GDP growth recovered from an average of only 1.6% during 1980-83 and 3.3% during 1984-85 to 5.81 in 1986. 1.5 The Barco Administration, which took office in August 1986, continued the economic adjustment program. Despite a sharp decline in coffee prices, GDP growth was maintained at 5.4% in 1987. The effect of the drop in coffee prices on the balance of payments was offset by a large increase in private  transfers and an increase in non-coffee exports, particularly petroleum and coal. The current account showed a small deficit (0.1Z of GDP) in 1987. Despite the strengthening of Central Administration revenues as a result of the tax reform, however, the fiscal balance deteriorated to register a deficit of 1.81 of GDP. 1.6 Inflation began to accelerate at the end of 1985, increasing from 20% in 1986 to 24Z in 1987 and 28X in 1988 (the reasons for the acceleration of inflation are discussed in Chapter 3 of this report). The authorities responded by reducing credit expansion and increasing permitted agricultural imports. Because of this tighter liquidity, more restrictive quotas on coffee exports, and guerrilla attacks on fuel oil pipelines, economic growth slowed in 1988 to a rate of 4.1Z. The current account deficit rose to 1.0% of GDP in 1988 and the fiscal deficit increused somewhat to 2.7Z of GDP. 1.7 As the slowdown in economic growth continued into 1989, two developments occurred in the middle of the year which further darkened the economic outlook. First, the demise of the International Coffee Agreement (ICA) in July reduced the price of coffee in international markets by half, sharply reducing earnings from Colombia's main export industry. Second, the assassination of presidential candidate Luis Carlos Gal&n in August triggered a generalized conflict between the drug traffickers and the Government. The conflict adversely affected the investment climate, increased fiscal pressuree from the security effort, and reduced drug-related revenue. 1.8 The economic authorities responded quickly to adjust to the fiscal impact of the coffee-drug shock by tightening credit policies and cutting investment and subsidies. As a result, the fiscal deficit was reduced to 2.0% of GDP in 1989, and inflation fell from its high of 28.11 in 1988 to 26% in 1989. Economic growth continued to decelerate to 3.41 in 1989. 1.9 Additional measures were adopted in 1990 to adjust to the coffee-drug shock: (a) a devaluation of the real exchange rate by 11.41 by the end of 1990, reflecting a decision to devalue beyond the December 1986 benchmark used thus far; and (ii) an increase in fiscal austerity through a variety of measures, including eliminating major subsidies in the coffee sector, enforcing a decline in the real domestic coffee price, holding down public sector wage increases to below expected inflation for 1990, postponing public sector investments in selected areas, incurring arrears to suppliers, and raising domestic gasoline and electricity prices in real terms. 1.10 Other internal and external shocks affected the balance of payments during 1988-90. Crude oil prices fell by 231 (US$4 per barrel) in 1988, resulting in a loss of US$218 million in export earnings. Oil prices recovered in 1989, and then rose another US$4 per barrel in 1990 because of the Persian Gulf Crisis. Attacks from guerrilla groups, however, have caused an estimated loss of two months of oil export revenues in each year. Coffee prices have recovered only modestly since the collapse of the ICA in mid-1989. However, the Government's strategy of increasing the volume of coffee exports through improved marketing and domestic transportation (from 10.8 million bags in 1989 to 14.0 million in 1990) effectively neutralized the negative impact  of the ICA demise on the balance of payments. Another factor influencing the balance of payments situation was the slow economic growth of the G-5 countries in the late 1980a, and the increase in global interest rates. 1.11 Swings in international coffee and oil prices have also had a strong influence on the consolidated public sector deficit. Decentralized public sector revenues are highly dependent on surpluses or deficits of the National Coffee Fund (FNC) and ECOPETROL, and payments from these institutions affect Central Government revenues as well. Coffee- and oil-related fiscal revenues amounted to 1.9% of GDP in 1989 and 2.82 in 1990, compared to structural deficits (the total nonfinancial public sector deficit excluding coffee- and oil-related fiscal revenues) of 3.9Z of GDP in 1989 and 3.0Z of GDP in 1990. 1.12 Thus, after the recovery of economic growth in 1986-87 that followed the economic adjustment program, the rate of economic growth has diminished, indicating a deterioration in overall macroeconomic performance. GDP growth fell from an average of 5.6Z in 1986-87 to 4.1% in 1988, 3.4Z in 1989, and an estimated 4.1% in 1990. This represented a decline in the per capita GDP growth rate from 3.6% in 1986-87 to 1.9% in 1988-90. Part of the slowdown in economic growth can be explained by the series of internal and external shocks that occurred during the period and required continued stabilization measures. The other major factor was that the growth response to the correction of macroeconomic imbalances in the mid-1980. could not be sustained in the absence of structural reforms to address microeconomic efficiency issues. With the objective of raising economic growth in the long run through improved resource allocation and use, the Government implemented a comprehensive structural reform program in early 1990--the subject of Chapter 2 of this report. B. Indicators of Economic Performance, 1988-90 Supply-Side Sources of Economic Growth 1.13 The slowdown in economic growth was mainly due to disappointing performance in manufacturing, construction, and some other services, partly due to a contraction in public investment, and offset by stronger growth in mining and agriculture. Minint grew at 11.6% in 1989, mainly because of increases in production of crude oil and coal, and contributed 14.5% of the expansion in GDP (Table 1.1). Stimulated by high support prices, aariculture grew 4.3Z in 1989 and 6.7Z in 1990, based on the strength of production of soybeans, wheat, rice, corn, and sugar, contributing 31Z of the growth in GDP. 1.14 Because of the slowdown in overall economic growth, industry (manufacturing, mining, construction) grew about 2.9Z per year on average over 1989-90, below the 6% annual rate achieved during 1986-87. Within the industrial sector, manufacturing (excluding coffee manufacturing) grew 4.0% in 1988 and 5.2% in 1989, then dropped off to 1.3% in 1990. Thus, despite its relatively high share in GDP (equivalent to the size of the agricultural sector), manufacturing contributed only 6.2% to GDP growth in 1990, compared with 222 during 1986-88.  - 4 - Table 1.1: Economic Growth and Its Sources 1986 1987 1988 1989P 1990' Output Growth, X Change, 1975 pesos GDP 5.8 5.4 4.1 3.4 4.1 GDP per capita 3.8 3.4 2.2 1.6 2.3 Private consumption 3.2 3.8 3.7 3.2 3.5 Public consuwption 1.4 5.6 9.9 5.6 7.1 Fixed Capitat Formation 7.6 0.8 10.9 -5.2 -2.9 Private Sector 28.0 4.8 11.5 12.4 -2.4 Public Sector -14.9 -5.8 4.8 -15.1 -3.6 Exports 20.7 7.8 0.3 8.4 16.7 Imports 4.1 5.3 6.6 -2.8 10.8 Sources of Growth, K of GDP, 1975 pesos Demand Side 100 100 100 100 100 Foreign denand 44.4 10.3 -24.1 56.5 35.2 Domestic demand 55.6 89.7 124.1 43.5 64.8 Sutolv Side 100 100 100 100 100 Agriculture 12.7 25.4 14.7 26.9 34.9 Mining 24.9 16.1 4.7 14.5 3.4 Manufacturing' 15.3 27.9 18.4 28.5 6.2 infrastructure' 2.6 7.3 8.8 9.9 11.1 Construction and ServicesW 44.5 23.3 53.4 20.3 44.4 Memo: Tradable sectory 59.3 66.0 29.4 75.9 55.5 p - preliminary, e - estimated I Excluding coffee. Transportation, electricity, gas and water, and communicatfons. 3/ Including coffee manufacturing. 4/ Agriculture, mining, and manufacturing. Source: DANE. 1.15 Within the manufacturing sector, certain light manufacturing categories consistently registered strong growth over the period 1987-89, particularly those with a major export orientation. The strongest peirformers were footwear and clothing (growing by an average of 137 annually), tvood and wood products (16%), non-electric machinery (9X); leather products, paper and paper products, and chemical products (5.5-6.0%). Among these industries, clothing, leather products, and chemicals also led in industrial exports (para. 1.21). Despite their strong performance, exporting manufacturers failed to make a significant difference in aggregate manufacturing performance, since they account for such a small weight in the sector. 1.16 The contribution of the infrastructure sector, particularly communications, to economic growth grew from 8.8% in 1988 to 10.5Z in 1989-90. The services sector contributed only 20.3Z to growth in 1989, then rebounded to 44.4Z in 1990 on the strength of banking and government services.  -5- 1.17 Investment (excluding inventory investment) has declined in real terms since the record growth of 10.9Z in 1988. The stagnation of investment stemmed primarily from contraction in Rublic investment. Some of this contraction was reasonable, such as the cuts in inefficient investment in the electricity subsector. Some Was anticipated, such as the winding down of large investments in the mining sector. Finally, some cuts were made in the social sectors and in infrastructure in order to accommodate the financial constraint faced by the public sector. Private investment grew 12.4% in 1989, but declined by 2.41 in 1990, apparently due to uncertainties as structural reforms were introduced. Balance of Payments 1.18 In 1988 and 1989, the current account of the balance of payments showed a small deficit (equivalent to about 0.5% of GDP). Exports in both years were weak. In 1988 guerrilla attacks limited petroleum and mining output, and coffee exports suffered as Colombia's quota of coffee exports in the ICA was cut. In 1989 the collapse of coffee prices dampened exports. In 1990, the current account turned to a surplus equivalent to .8Z of GDP (Table 1.2). The strength in the trade balance was the main factor explaining the US$626 million increase in foreign exchange reserves in 1990. The capital account was in surplus in 1988 and 1989, while it was slightly negative in 1990, since disbursements from multilateral institutions were lower than anticipated. 1.19 Several factors explain the improvement in the balance of payments. First, the Government undertook an aggressive exchange rate policy (i.e., higher rates of devaluation) in anticipation of the trade liberalization program initiated in February 1990.11 The real exchange rate index (December 1986-100) increased from 97.7 in December 1988 to 105.0 in December 1989 and 117.0 in December 1990. Second, the Government's conservative fiscal policy, to some extent, supported a competitive exchange rate. Except for a brief period during the first half of 1990, the fiscal deficit has been kept to 2% of GDP or less. Third, in addition to the increase in oil prices caused by the Persian Gulf crisis in 1990, the volume of petroleum exports has continued to increase as a result of investments made in the oil sector in the late 1970s and early 19809. A steady inflow of transfers, averaging close to US$1 billion per year, also helped strengthen the balance of payments. Finally, with respect to the capital account, the Government has been able to maintain commercial bank exposure by rolling over the repayment of principal. I/ Colombia has had a crawling peg exchange rate system since 1967. In the short run, the authorities can influence the level of the real exchange rate by management of the nominal exchange rate. In the longer run, the equilibrium value of the real exchange rate depends on the "fundamentals" -- the demand and supply of traded goods, restrictions to trade, the terms of trade, and the amount of external borrowing and capital inflows. These variables are themselves influenced by the level and composition of government expenditures.  -6- Table 1.2: Balance of Payments, 1987-90 (USS millions) 1987 1988 1989P 1