Colombia - Policy Based Guarantee Operation Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7437-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A POLICY BASED GUARANTEE OPERATION IN THE AMOUNT OF UP TO EURO 238.74 MILLION EQUIVALENT FOR NOTES TO BE ISSUED BY THE REPUBLIC OF COLOMBIA FEBRUARY 12, 2001 Finance, Private Sector and Infrastructure Unit Project Finance and Guarantees Latin America and the Caribbean Region Private Sector and Infrastructure Vice Presidency This document has a restricted distribution and may be used by recipients only in the performance I of their duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENTS (as of January 31, 2001) Currency Unit = Colombian Peso ($) US$ 1.00 = $ 2200 EUR 1.00 = US$ 1.08873 COLOMBIA FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS CAF Corporaci6n Andina de Fomento DTC Depository Trust Company EMBI Emerging Markets Bond Index FSAL Financial Sector Adjustment Loan GDP Gross Domestic Product IDB Inter-American Development Bank IMF International Monetary Fund NAIC National Association of Insurance Commissioners NFPS Non-Financial Public Sector PBG Policy Based Guarantee SEC Securities Exchange Commissioners UST United State Treasuries VAT Value Added Tax SSAL Special Structural Adjustment Loan Vice President David de Ferranti Country Director Olivier Lafourcade Sector Director Danny Leipziger Task Managers Krishna Challa / Suman Babbar  Memorandum and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Policy Based Guarantee Operation for the Republic of Colombia TABLE OF CONTENTS INTRODUCTION ............................................................. 1 MACROECONOMIC PERFORMANCE ............................................................. 2 COLOMBIA'S FINANCING NEEDS ............................................................. 4 ECONOMIC IMPACT OF FINANCING CONSTRAINT AND RISKS ..............................................................5 CURRENT MARKET ACCESS FOR COLOMBIA ............................................................. 5 ELIGIBILITY FOR POLICY BASED GUARANTEE ............................................................. 9 PROPOSED POLICY BASED GUARANTEE ............................................................. 11 APPRAISAL FRAMEWORK ............................................................. 13 RISK ASSESSMENT ............................................................. 15 EVALUATION FRAMEWORK ............................................................. 16 AMENDMENT TO LOAN AGREEMENT (7000-CO) ............................................................. 16 PROCESSING OF THE PROPOSED NOTES ............................................................. 17 RECOMMENDATION ............................................................. 17 ANNEX I: DESCRIPTION AND TERMS OF THE NOTES AND PROPOSED GUARANTEE .............................. 18 ANNEX II: COLOMBIA AT A GLANCE ............................................................. 21 This Policy Based Guarantee has been prepared by Krishna Challa (Sector Leader and joint Task Team Leader, LCCIQ; Suman Babbar (Sr. Adviser andjoint Task Team Leader, PFG); Michel Wormser (Director, PFG); Pankaj Gupta (Financial Analyst, PFG); Vicente Fretes-Cibils (Lead Economist, LCSPE); Zeinab Partow (Country Economist, LCSPE); Thomas Duvall III (Senior Adviser, LEGOP); Elisabeth M Pendleton (Senior Counsel, LEGOP); Jose Augusto Carvalho (Senior Counsel, LEGOP); George L. Bouza (Program Assistant, LCSFE) and Upali W. Perera (Program Assistant, PFG).   Memorandum and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Policy Based Guarantee Operation for the Republic of Colombia INTRODUCTION I . This memorandum seeks the approval of the Board to provide a Policy Based Guarantee (PBG) in the amount of up to EUR 238.74 million equivalent for the Republic of Colombia (Colombia). The operation would support a market borrowing for about US$ 1.5 billion to help meet the large funding needs facing the country. Simultaneously with the issuance of the notes and the provision of the PBG (using a rolling reinstatable structure) in an amount of up to EUR 238.74 equivalent', Colombia would cancel the second tranche of the Financial Sector Adjustment Loan (FSAL)2 for an equivalent amount. Consequently, as a result of the provision of the PBG, there would be no increase in the Bank's overall exposure to Colombia. In the event that the nominal amount of the guarantee is less than EUR 238.74 million, the unutilized part of the FSAL would be available for disbursement to Colombia. 2. The FSAL for an amount of EUR 482.3 million was approved by the Board on November 18, 1999; the Loan Agreement was declared effective on December 7, 1999. The FSAL supports a comprehensive program of financial sector reformn being implemented by the Government of Colombia. Support of this program was presented as one of the highest priorities of the 1999 CAS Progress Report. The main program objectives are to support: (i) required changes in financial sector legislation and regulations to facilitate strengthening of prudential regulations, bank supervision and deposit insurance, and to promote timely, fair and efficient resolution of banks facing financial solvency problems; (ii) strengthening the institutional capacity of the Superintendency of Banks and that of FOGAFIN3; (iii) restructuring, recapitalization, privatization and, if necessary, liquidation of state-owned and "officialized" banks currently under public sector management; (iv) effective implementation of special measures to address the immediate impact on the financial system stemming from economic and other emergencies. The Inter-American Development Bank (IDB) and Corporaci6n Andina de Fomento (CAF) have provided complementary financing to support the financial sector reform program. 3. The 1999 CAS Progress Report recognized that worsening of the economic situation could lead to financing gaps and temporary problems in accessing external financing. However, the report did not specifically envision using the PBG because at that time Colombia was not facing constraints in the capital markets. The PBG is expected to help accelerate Colombia's return to US$ capital markets under its own name, while supporting key structural and social reforms. 4. The FSAL was designed to be disbursed in two tranches; the first tranche4 of EUR 243;561,500 was released in December 1999. All conditions for the release of the second IIn order to provide a US$ denominated guarantee, as per the request of the Republic, the maximum guarantee amount in US$ available under the proposed PBG will be fixed on February 13, 2001. 2 Financial Sector Adjustment Loan - Report No. P7337-CO dated October 20, 1999. 3The deposit insurance and bank resolution agency of Colombia. 4 The first disbursement included the 1% front-end fee on the loan amount of Euro 482.3 million. -1I-  tranche of EUR 238,738,500 have been met. A notice to the Board for the release of the second tranche5 is being circulated. A full description of the policies that the government has undertaken can be found in the President's Report for the FSAL (7000-CO) and the notice to the Board of the release of the second tranche. The Government has already completed: (i) satisfactory implementation of the provisions of the new financial sector legislative framework, including adoption of appropriate regulations and internal procedures by the Superintendency of Banks and FOGAFIN to ensure application of adequate prudential rules, preventive and corrective supervisory actions, and principles of efficient and fair resolution of banks facing solvency problems; (ii) housing finance reform to ensure that the full cost, in real terms, of housing loans is transparent to all parties concerned, and indexing systems for such loans are designed to ensure sustainable payment capacity of the borrowers; (iii) satisfactory implementation of the process for resolution of financial cooperatives; (iv) satisfactory implementation of the institutional strengthening plan for FOGAFIN and the Superintendency of Banks; (v) steps towards privatization or liquidation of the major state- owned or officialized banks and implementation of satisfactory transition plans for liquidated banks; (vi) study to rationalize and increase the efficiency of state-owned second tier financial institutions; (vii) steps to ensure that the special programs being implemented by FOGAFIN on behalf of the government do not jeopardize its capacity to deliver its core functions of deposit insurance and restructuring of problem banks; and (viii) with making available resources in excess of US$ 200 million to FOGAFIN for its bank resolution activities. MACROECONOMIC PERFORMANCE 5. The Colombian government has maintained its commitment to a program of fiscal adjustment and structural reforms, despite difficult economic, political and security conditions. Performance on most fronts has improved significantly in 2000 compared to the previous year's recession. The first review of the government's economic program, supported by a three-year, US$ 2.7 billion IMF Extended Fund Facility (approved by the IMF Board in December 1999), was completed satisfactorily in September 2000. The government has met all performance criteria for December 2000. The second review has been completed satisfactorily and is expected to be presented to the IMF Board in March 2001. 6. Real GDP is estimated to have grown by about 3 percent in 2000 (compared with the sharp GDP contraction of 4.3 percent in 1999). The main engine of economic growth during 2000 has been the recovery of exports, both traditional and non-traditional, as well as a moderate expansion of domestic demand. Manufacturing output is estimated to have expanded by about 9 percent, and inflation ended the year at 8.8 percent, well below the 10 percent inflation target. Interest rates have come down from their historic highs exceeding 15% in real terms to 1-4% in real terms during the last six months. Unemployment, however, has remained at about 20 percent since the beginning of 2000. In response, much of the government's current investment program focuses on social safety net strengthening targeted to mitigate the impact of the recession on the poor. 7. Colombia's fiscal performance was significantly better than envisaged during 2000, primarily because of higher than projected oil revenues and lower than projected capital spending. Notwithstanding a number of setbacks, including the constitutional court decision of late October 2000 to retroactively raise public sector wages and the financial deterioration 5Notice to Board "Financial Sector Adjustmnent Loan (Loan 7000-CO) - Second Tranche Release" SecM200 1- 87, dated February 2, 2001. -2 -  in the public pension and health systems (partly as a result of both high oil revenues and low capital spending), the target Non Financial Public Sector (NFPS) deficit of 3.6 percent of GDP was achieved in 2000 (down from a deficit of 5.5 percent of GDP in 1999). 8. Monetary developments over the past year were characterized by broad money increases of 4-5 percent per annum over the last few months of 2000, with a significant increase in the public holding of government securities. There has been a notable shift in the composition of the monetary aggregates toward more liquid instruments, including currency, partly because of the introduction of the financial transaction tax and low bank deposit rates. Financial system credit to the private sector has picked up recently as the initial phase of the economic recovery from last year's recession was helped by increased utilization of already installed capacity. 9. Since the Central Bank's decision in September 1999 to abandon the currency-trading band in favor of a free float of the peso, the exchange market has remained orderly. The peso has depreciated by about 11 percent since it was floated, with a weakening in April-May 2000 reflecting political events and difficulties in advancing the privatization program. The successful privatization of the state owned coal mining company - CARBOCOL6 in October 2000 and the clarification of prospects for the government's remaining privatization agenda, as well as the fulfillment of its external and domestic financing requirements for the year helped to stabilize the peso in the latter half of 2000. 10. For the year 2000, the current account balance is estimated to have posted a surplus of about 0.2 percent of GDP, compared to a deficit of 0.2 percent of GDP recorded in 1999; the trade surplus rose to about US$ 3 billion, nearly 50 percent higher than a year earlier. While imports are estimated to have expanded by about 9 percent for the same period, following a fall of nearly 25 percent in 1999, high oil prices and a more competitive exchange rate boosted exports, which are estimated to have grown by about 15 percent in 2000. The capital account, on the other hand, was in near balance, reflecting a fall in foreign direct investment (about 20 percent less compared to the previous year), net repayments by the private sector and reduction in the financial system's external indebtedness, which were compensated by net inflows to the non-financial public sector including those from the multilaterals. Net international reserves remained at more than six months of imports of goods and services. 11. The decline in foreign direct investment reflects the current lack of investor interest in Colombia due to stepped-up guerrilla activity and delays in the implementation of the government's privatization program. Consequently, the increase in domestic financing needs and in external indebtedness have been much higher than projected. Total external debt is expected to reach 45 percent of GDP at the end of 2000, up from 36 percent in 1998 and 43 percent in 1999. Public sector external debt is projected to reach about 26 percent of GDP by end-2000. The Government's debt management strategy aims to stabilize Colombia's total external debt at about 43-44 percent of GDP over the medium term. 12. For 2001, the Colombian economy is projected to grow at 3.8 percent, with the following macroeconomic targets: a public sector deficit of 2.6 percent of GDP, a current account balance of negative 1.7 percent of GDP, an inflation rate of 8 percent and international reserves covering five and a half months of imports. The country's future economic performance will depend mainly on bringing the fiscal program on a sustainable 6The largest coal exporter of Colombia. - 3-  path. In an effort to deal with fragile public finances in 2001, the decline in oil production, and the continued deterioration of the health and pension systems, the Congress approved a tax package in December 2000 that will yield about 1.8 percent of GDP in 2001. The tax package included an increase in the value added tax (VAT) from 15 percent to 16 percent; the introduction of a custom surcharge of 1.2 percent and an increase in the financial transactions tax from 0.2 percent to 0.3 percent. 13. The policy package supported by the IMF program for Colombia focuses on some of the reforms necessary to address macroeconomic issues currently faced by the country. The current administration has advanced in enacting a number of these reforms - a legislation to create territorial government pension funds, a law that curtails the current expenditures of local governments, and the recently approved tax bill. However, the government must deepen its fiscal reforms needed to ensure fiscal sustainability in the medium term. COLOMBIA'S FINANCING NEEDS 14. Colombia's public sector financing requirements are significant under current market conditions. Colombia has met its financing needs for 2000, and for the year 2001, Colombia's total funding gap is about US$ 2.5 billion. It is estimated that total foreign financing gap would be about US$ 2.2 billion, excluding any proceeds from privatization. Further details on Colombia's financing gap are summarized below. Table 1: Colombia.l Financing Needs 1999 - 20027 Sources and Uses 1999 2000 2001 2002 Total needs: (In % of GDP) 5.5 3.6 2.8 1.8 NFPS deficit 6.0 3.6 2.6 1.8 Rest of the public sector (0.5) 0 0.2 0 Sources: (In % of GDP) Net Foreign Financing 1.3 1.8 2.6 1.75 Net Domestic Financing 3.4 1.5 0.15 0.0 Privatizations 0.7 0.3 0.05 0.05 Total needs: (In million US$) 4757.6 2977.8 2471.3 1664.5 NFPS deficit 5190.1 2977.8 2294.8 1664.5 Rest of the public sector (432.5) 0 176.5 0 Sources: (In million US$) Net Foreign Financing 1124.5 1458.7 2241.3 1614.5 Net Domestic Financing8 2941 1260.1 150 0 Privatizations 692 259.0 80.0 50.0 15. Colombia has managed to finance about US$ 400 million this year in addition to about US$ 300 million pre-financed in the year 2000 for the year 2001. Therefore, Colombia's current net foreign financing requirements for 2001 are about US$ 1.5 billion. This gap is expected to be closed through a combination of market borrowings (including the proposed guaranteed notes) and disbursements from multilaterals. While there are risks associated with not fulfilling the financing needs, including lack of interest on Colombia's bonds in the 7The projections for 2001 and 2002 are as of January 31, 2001. 8Represents the net funding requirements, i.e. gross funding requirements minus amortizations of existing debt. -4 -  international market and lack of progress in the privatization program, the impact of failing to close the financing gap are estimated to be more serious. ECONOMIC IMPACT OF FINANCING CONSTRAINT AND RISKS 16. The financing needs of the government, if not bridged, could pose a threat to economic recovery as early as this year. While stagnant demand for financial system credit, resulting from high levels of existing installed capacity, has allowed the public sector to increase its internal indebtedness without excessive pressure on domestic interest rates, this situation may change in the near future. Moreover, the higher interest rates resulting from increased competition for resources could threaten the health of the financial sector. As an integral part of its economic program, in order to relieve pressure on the domestic market and help set the stage for sustainable economic growth, the government is working towards enhancing Colombia's access to external financing. 17. It is in the context of these financing needs and Colombia's prudent strategy of external financing for funding gap, that the Colombian authorities have requested Bank support through the use of a PBG to mobilize the remaining financing needs. Enhanced access to external finance provided by the use of the PBG would relieve the pressure on the domestic market and help set the stage for a sustained recovery. CURRENT MARKET ACCESS FOR COLOMBIA 18. As discussed earlier, for 2001, Colombia's remaining foreign financing gap is about US$ 1.5 billion; however, its financing alternatives are limited. Not only are general market conditions difficult, but because of investor perception of Colombian credit, currently it is not feasible for Colombia to raise large amounts in the US$-capital markets among its traditional emerging markets investor base at a reasonable cost (see para 25 for more details). Access to the US$-capital markets by Emerging Market Credits 19. Since the middle of the fourth quarter 2000, the capital markets in the U.S. - both equity and debt - have been hostile to new issuance. The high-grade9 market has only been open to those issuers willing to pay a significant premium to secondary market trading levels. The market is still under the impact of recent problems faced by Turkey and Argentina. Moreover, fears of an economic slowdown in the US, the poor performance of the S&P and the NASDAQ, and credit-specific events have caused investors to pull money out of the markets, which resulted in the closure of the high-yield'