Bond Vigilantes Still Call the Shots in One Latin America Nation

(Bloomberg) -- In a world of freewheeling fiscal stimulus, Colombia is the rare country wringing its hands over its deficit.

While the U.S. mulls a fresh $1.9 trillion in aid and the European Union plans a 1.8 trillion euro ($2.2 trillion) package with nary a whimper in their respective debt markets, Colombia is doing everything it can to ward off the wrath of bond vigilantes. After a relatively modest pandemic spending push widened the deficit, officials are planning $5 billion in tax increases and spending cuts, plus an additional $5 billion of state asset sales. They’ve vowed to scale back fiscal aid despite Colombia’s worst economic contraction on record.

It’s part of an all-out effort by Colombia, which hasn’t defaulted since the Great Depression, to convince investors that it will do what it takes to remain one of the few investment-grade sovereign credits in Latin America.

So far, it isn’t enough. Colombia’s borrowing costs blew up during the pandemic and its bonds now trade more like junk than high grade. Dollar-denominated notes maturing in seven to 10 years are yielding about 2.5%, almost half a percentage point higher than similarly rated peers, according to data compiled by Bloomberg.

“Policy makers are walking this tightrope between trying to help support the economy and not aggravate public debt risks,” said Nikhil Sanghani, an economist at Capital Economics Ltd. in London. “In an ideal world, Colombia would be able to do more and offer more support to the economy.”

The situation highlights the disparate treatment developing nations experience as developed peers get a pass to swell their deficits. While rich governments can borrow and spend mostly without worry of repercussions from investors, countries already burdened with endemic poverty are forced to pinch pennies and withhold much-needed economic aid.

Vitor Gaspar, the director of the International Monetary Fund’s fiscal affairs department, says the dynamic risks fueling a further divergence of economic prospects in rich and poor countries.

“You have a country like the U.S. that has ample fiscal space that can provide relief to the economy,” he said on the Bloomberg Surveillance podcast Jan. 29. “At the other extreme, we have low-income countries that basically had to tackle the emergency of Covid-19 by changing the composition of public spending.”

The dynamic is also at work in other developing nations. In Brazil, investors have been up in arms about pandemic-era aid even though it has been widely credited with reducing poverty and briefly buoying the economy. Speculation is building that the central bank will have to raise interest rates next month to shore up the currency. Romania’s new government finds itself seeking to appease investors by curbing a budget deficit at the same time it’s tackling a health crisis that resulted in one of the highest death tolls in the EU’s east.

Read more: Brazil Traders Pile Into Rarest of Bets in Zero-Rates World

But Colombia seems a particularly poignant example, partly because it’s one of few countries to reliably meet obligations in a region synonymous with serial defaulters. Even during Latin America’s lost decade in the 1980s, when more than a dozen countries defaulted, Colombia paid its debts.

Colombia’s tax legislation, which is expected to be introduced by government allies in coming months, would raise as much as $5.5 billion a year, or 2% of gross domestic product, starting next year. Meanwhile, plans to sell stakes in government-owned utilities, including electricity transmission company Interconexion Electrica SA, could bring in $5 billion.

That would go a long way in narrowing a budget deficit expected to reach 7.6% of GDP this year. While that’s down from about 8.9% last year, it’s far higher than the 2.5% in 2019, before the government abandoned its so-called fiscal rule that limited deficit spending.

Few dispute the notion that Colombia needs to eventually rein in outlays and return to those deficit reduction targets. But some question whether the government is moving too quickly, especially as coronavirus cases are again spiking. The vaccine rollout may take until next year before enough people are inoculated to reach immunity.

Both S&P Global Ratings and Fitch Ratings rank the country BBB-, the lowest level above junk status, with a negative outlook. Moody’s Investors Service classifies the country at Baa2, two steps above speculative grade and also with a negative outlook.

With a downgrade likely in the offing, Colombia’s 10-year dollar notes yield about 2.73%. Meanwhile, similar notes issued by junk-rated Paraguay, Morocco and Serbia yield an average of 35 basis points less, according to data compiled by Bloomberg.

Colombia regained its investment grade rating a decade ago, but investors treat it like a lower-rated country, in part, because it looks like one on paper.

Debt levels are forecast to rise to 62% of GDP this year from 45% before the pandemic, 7 percentage points higher than the median for peers in the BBB bucket. Its current account deficit is three times wider than countries with a similar credit rating, according to estimates from Fitch Ratings.

If history is a guide, a downgrade would lead to a temporary spike in borrowing costs that abates over time. That’s what happened to Brazil back in late 2015, when credit agencies began to cut it to junk.

A year prior, Brazil spreads were more than 100 basis points lower than the emerging-market average. After the cuts began, spreads peaked at some 73 basis points higher than the average for developing nations, according to JPMorgan’s EMBI Global index.

The increase eventually moderated though. By early 2017, Brazil spreads dropped to more than 60 basis points below the average for emerging markets.

By proposing a tax increase in the midst of a pandemic, President Ivan Duque’s government intends to signal to investors that it’s serious about getting its finances firmed up, according to Andres Pardo, who was economic adviser to Duque in 2019.

“Colombia’s fiscal situation is weak,” said Pardo, now chief Latin America market strategist for XP Investments. “It’s at a point where it can spiral into something worse, and then it’s not a question of losing investment grade but being cut more notches and have investors price in higher risk.”

©2021 Bloomberg L.P.