A COLOMBIAN SOLUTION TO A COLOMBIAN PROBLEM:

The argument against higher short term rates in Colombia

 

Central to this discussion is the assumption that inflation weakens the value of the domestic currency and is inherently bad for the economy. Central banks that employ inflation targeting (IT) policies typically offset this weakening of the currency by raising short term rates through calculated actions. The general thinking is that higher interest rates will reduce the money supply and tighten credit, thereby slowing the economy and curtailing price pressure.

 

The 1991 Colombian Constitution extended liberties to the Bank of the Republic allowing it goal and instrument independence to steer the economy, with a stated objective of preserving the purchasing power of the currency (for the previous 20 years, Colombia had suffered domestic inflation rates between 15% and 30% annually). Between 1994 and 1999, the Bank was able to limit inflation to single digit rates through the implementation of floating exchange rate bands (only intervening when the currency strengthened or weakened to undesirable levels, regardless of the prevailing inflation rate). However, due to fiscal and internal imbalances, trade shocks, and a “sudden stop” in 1998-1999, the Bank abandoned floating exchange rate bands in September 1999. The Colombian response was to adopt the full IT framework of the world's largest economies, even though Colombia faces economic challenges that its larger counterparts do not.

For example, the labor force in Colombia is made up of roughly 47% of the population (vs. 50% in the U.S. vs. 49% in the U.K. ). However, the Colombian labor force produces far less per capita ($7100 vs. $42,000 U.S. vs. $30,900 U.K. ). For this reason, a whopping 49.7% of the Colombian population still lives in poverty (vs. 12% U.S. vs. 17% U.K. ). Economically speaking, we can immediately see that Colombian policy should be different from that of the U.S. and U.K. I opposed the abandonment of floating exchange rate bands to begin with; I felt there were other alternatives available to the Bank. Still, having accepted the strategic change, we are now faced with the question of whether to raise short terms rates in the current environment.

 

Inflation targeting would suggest that in light of Colombia 's recent 5.1% GDP growth in 2005 (following 4.8% in 2004), the Bank of the Republic should consider nudging short term rates higher by some margin. I submit that due to the makeup of Colombia 's price pressures and unique issues, higher interest rates would squander the tremendous opportunity Colombia now has to address critical structural issues.

 

Higher interest rates would affect the micro loan industry, which many commercial banks in Colombia are now entering. Micro loans can range anywhere from a few hundred thousand pesos to a few million pesos. This critical access to capital is what allows many individuals to create their own jobs, their own means of supporting their families, and those earnings are multiplied back into the economy as those earnings are spent. Tighter credit and less access to capital reverse that growth. Mid-size and larger companies may delay expansion plans, exploration, and hiring as the cost of capital increases. This slows job growth, and negates the multiplier for new hires and construction spending. Finally, the housing sector is obviously hindered by rising interest rates as fewer Colombian families can afford to finance new homes, which has a draining effect on construction spending and consumer durables spending (think Exito or Home Center , and all the manufacturers who supply them). None of these are acceptable risks during a period when the critical Colombian consumer is more optimistic than at any time in recent history (and, not to mention, an election year).

 

When we dissect inflation in Colombia , we find that there are three sectors of the economy providing 100% of the price pressure: education, healthcare, and agriculture. None of these sectors are especially sensitive to interest rates. Education costs have risen as urban Colombian families have been more able to afford private education for their children. Better public schools could to some degree alleviate this problem (by reducing the perceived superiority of private school). Low interest rates and greater access to capital are also conducive to the creation of new educational services, including classrooms, provided by opportunistic investors. Healthcare costs have increased dramatically as Colombia has imported more and more health products from the United States . The cost of healthcare products in the United States has spiraled in the recent decade for reasons beyond Colombia 's control, which is a circumstance Colombia would have to face regardless of domestic policy. Miraculously though, Colombia adds insult to injury by continuing to impose draconian (28%) levies on goods imported from the United States, making these products even more expensive to end users in Colombia. This obvious detriment may soon disappear with recent progress toward free trade with the United States (more on this later).

 

But most important for Colombia , with regard to inflation, is agriculture. According to the DANE, over 50% of Colombia 's current price pressure comes from rising agriculture prices. Colombia satisfies substantially all of its agriculture demand domestically, and prices have risen dramatically. This is due to two factors: 1) increased foreign demand and 2) errant spraying under Plan Colombia . Increased demand and accidentally damaged crops have caused agriculture prices to skyrocket. Food costs obviously represent a greater portion of lower income families' budgets than higher income families' budgets. Remember, 49.7% of the Colombian population lives in poverty. Therefore, rising agriculture prices have an absolutely choking effect on the general population. Quite simply, if Colombia could control its crop prices, they could theoretically curb inflation by 50%, thereby eliminating the Bank's perceived need to restrain industry by raising rates.

 

President Uribe and Congress can help curtail Colombian inflation better than the Bank of the Republic at this point, in my opinion. First, Colombia obviously will require better logistics in spraying under Plan Colombia . There is little excuse for spraying the country's legitimate produce supply under a $7 billion U.S. led drug eradication program. If we can drop a smart bomb on an enemy target the size of an outhouse in Iraq , we can certainly avoid spraying acres of food supply in Colombia . Meanwhile, the country should also pursue a policy of huge farm subsidies to increase production of critical crops, even if it means deficits. Colombia currently runs a deficit of approximately $1.3 Billion, or 0.013% of GDP. They can afford this. World coffee and sugar prices are both at historically high levels, both being among Colombia 's many agricultural offerings. As demand for sugar based ethanol continues to rise in Brazil and elsewhere, deficits incurred during a government led expansion of dedicated acreage could be balanced in short order. At the same time, the government would be creating viable alternative products for coca farmers whose services are currently held hostage to guerillas and paramilitaries (of course, new fields would require military protection which would increase the cost of a subsidy program for the Colombian government). In short, greater agricultural production A) directly addresses the price pressures that average Colombians face, B) limits the production of illicit drugs (by redirecting labor), C) creates hundreds of thousands of jobs, which D) reduces the number of potential recruits for FARC and paramilitary forces by reducing the levels of despair and desperation that lead to enlistment. Part of a subsidy program, in an effort to control costs to the Colombian government, should include low cost loans to farmers for seed and equipment, where the Colombian government represents itself as guarantor for qualified farmers (e.g. those who were previously coca farmers but making a change for the better of the country). This empowers the farmer and gives the farmer ownership in his enterprise and access to capital. At the same time, it addresses the inflation question directly as compared to central bank tinkering.

 

Currently Colombia is pursuing a free trade pact with the United States that will devastate its agriculture industry. Lower cost crops produced in the United States will flood the Colombian market, which in theory would be good for consumers and therefore inflation. However, this will drive existing farmers out of their principal businesses. The result: some will produce coca to survive and others will be ruined. The latter would become yet another problem for the government to address. Meanwhile, the same trade arrangement would require greater and greater Colombian exports of rice to the United States (read: rice prices will be higher, not lower). In my view, the answer lies not in importing cheaper crops, but rather increasing acreage inside Colombia dedicated to specific produce. A universal free trade pact will force even more people into poverty who will not be absorbed by the jobs created in urban areas. Urban Colombia cannot march ahead while leaving rural Colombia behind. I fear that the Casa Narino, in its zeal to become a larger world presence, may actually divide the country further if it pursues policy that alienates the campesino. Therefore, Colombia should pursue trade agreements that function harmoniously with the unique composition of its economy, rather than blanket policy that only shuffles burdens from one class to another.

 

In summary, the question of inflation in Colombia can be addressed directly from the Casa Narino by recalibrating import duties, accommodating investment in more classrooms, and subsidizing farm operations to increase agricultural production in a country that is already accustomed to satisfying its own domestic demand for produce. Meanwhile, following the U.S. or U.K. model of inflation targeting completely misses the core issues, affecting only those segments of the economy that least need adjustment. No, what is needed is a Colombian solution to a Colombian problem.

- Finis L. Cole II

Originally published on Colombianblog.com 07/05/06 ©2006 Cblog Inc.