document of the world bankdocuments.worldbank.org/curated/en/990501468243556306/pdf/490770... · ft...

Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 49077-CO

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED LOAN

IN THE AMOUNT OF US$300 MILLION

TO THE

REPUBLIC OF COLOMBIA

FOR A

FINANCIAL SECTOR DEVELOPMENT POLICY LOAN

July 8, 2009

Poverty Reduction and Economic Management Department Colombia and Mexico Country Management Unit Latin America and Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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COLOMBIA - GOVERNMENT FISCAL YEAR January 1 – December 31

CURRENCY EQUIVALENT (Exchange Rate Effective as of July 1 2009)

Currency Unit Peso 2151 Pesos = US$1

Weights and Measures: Metric System SELECTED ABBREVIATIONS AND ACRONYMS

AFP Pension Fund Administrator BdR Banco de la República CAR Capital Adequacy Ratio CCCH Central Counterparty Clearing House CFC Commercial Financial Company CPS Country Partnership Strategy CPSS Committee on Payment Settlement Systems DPL Development Policy Loan ETD Exchange Traded Derivative FCL Flexible Credit Line FDI Foreign Direct Investment FOGAFIN Fondo de Garantía de Instituciones Financieras FT Financing Terrorism FSAP Financial Sector Assessment Program GDP Gross Domestic Product GoC Government of Colombia IADB Inter-American Development Bank IFC International Financial Corporation

IMF International Monetary Fund IOSCO International Organization of Securities Commissions MHCP Ministry of Finance and Public Credit ML Money Laundering NBFI Non-bank Financial Institution NDP National Development Program NLTA Non-Lending Technical Assistance NPL Non-Performing Loan OTC Over-the-Counter PFM Public Financial Management PFSAL Programmatic Financial Sector Adjustment

Loan SFC Financial Superintendency of Colombia SME Small & Medium Enterprise SS Superintendencia de Sociedades SSS Securities Settlement Systems UIS Unregulated Investment Schemes WEO World Economic Outlook

Vice President Pamela Cox Country Director Axel van Trotsenburg Sector Director Marcelo Giugale Sector Manager Lily Chu Task Manager Eva Gutiérrez

FOR OFFICIAL USE ONLY

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

COLOMBIA FINANCIAL SECTOR DEVELOPMENT POLICY LOAN

TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY...........................................................................................................1

I. INTRODUCTION ..............................................................................................................................3

II. COUNTRY CONTEXT.....................................................................................................................4

RECENT ECONOMIC DEVELOPMENTS.........................................................................4

MACROECONOMIC OUTLOOK AND CHALLENGES ..................................................8

III. THE GOVERNMENT PROGRAM.................................................................................................21

IV. FINANCIAL SECTOR REFORMS IN THE LAST DECADE AND THE AGENDA FOR FUTURE REFORMS.........................................................................................................................22

V. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY .....................................................27

LINK TO CPS........................................................................................................................27

COLLABORATION WITH THE IMF AND OTHER DONORS .......................................28

RELATIONSHIP TO OTHER WORLD BANK GROUP OPERATIONS .........................30

LESSONS LEARNED...........................................................................................................31

ANALYTICAL UNDERPINNINGS ....................................................................................31

VI. THE PROPOSED FINANCIAL SECTOR DPL ............................................................................33

OPERATION DESCRIPTION..............................................................................................33

POLICY REFORMS SUPPORTED BY THIS OPERATION .............................................34

VII. OPERATION IMPLEMENTATION ..............................................................................................39

POVERTY AND SOCIAL IMPACTS..................................................................................39

ENVIRONMENTAL ASPECTS...........................................................................................40

CONSULTATIVE PROCESS...............................................................................................41

IMPLEMENTATION, MONITORING, AND EVALUATION ..........................................41

FIDUCIARY ASPECTS, DISBURSEMENT, AND AUDITING .......................................42

RISKS AND RISK MITIGATION .......................................................................................43

ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY .................................................................................44

ANNEX 2. POLICY MATRIX........................................................................................................................51

ANNEX 3: FUND RELATIONS NOTE.........................................................................................................53

ANNEX 4: COLOMBIA – ECONOMIC PROSPECTS...............................................................................55

ANNEX 5: COLOMBIA – DEBT SUSTAINABILITY ANALYSIS...........................................................69

ANNEX 6: COLOMBIA- FINANCIAL SECTOR REFORMOS IN THE LAST DECADE...................73

ANNEX 7: COLOMBIA- UPDATE ON THE IMPLEMENTATION OF THE

COUNTRY PARTNERSHIP STRATEGY ...................................................................................................78

ANNEX 8: COLOMBIA – OPERATIONS PORTFOLIO (IBRD/IDA) AND GRANTS.........................83

ANNEX 9: COLOMBIA - STATEMENT OF IFC’S HELD AND DISBURSED PORTFOLIO ............84

ANNEX 10: COUNTRY AT A GLANCE......................................................................................................85

The World Bank Group greatly appreciates the close collaboration of the Government of Colombia in the preparation of this Development Policy Loan. This operation has been prepared by a team composed of: Eva Gutierrez (LCSPF- Task Manager); Rogelio Marchetti, Jane Hwang (LCSPF); Christian Ives Gonzalez, Maria Ivanova Reyes (LCSPE); Teresa Genta-Fons (LEGLA); Mark Hagerstrom (LCC1C); Juan Carlos Belausteguigotia (LCSEN); Maria Dolores Lopez-Larroy (BDM); Jose Janeiro (LOAFC) and Manuel Vargas (LCSFM). The team benefited from comments from other Bank staff including Lily Chu, Esperanza Lasagabaster (LCSPF); Eduardo Somensatto (LCCCO); Jozef Draaisma (LCC1C); David Rosenblatt (LCSPR); Sally Burningham, Reidar Kwan (LCSDE) and peer reviewers Juan Carlos Mendoza (LCRVP); Sophie Sirtaine (ECSPF); and Costas Stephanou (FPDFS). Editorial assistance was provided by Renata Leandro.

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LOAN AND PROGRAM SUMMARY

REPUBLIC OF COLOMBIA FINANCIAL SECTOR DEVELOPMENT POLICY LOAN

Borrower Republic of Colombia Implementing Agency Ministerio de Hacienda y Crédito Público Financing Data Commitment-linked IBRD flexible loan (IFL) with fixed spread and all

conversion options. US dollar denominated, payable in 26 years, including a 7.5 grace period. Level repayments of principal at the standard variable interest rate for US dollars fixed spread loans. The DPL is for US$300 million

Operation Type Single tranche Development Policy Loan Main Policy Areas

The proposed operation supports ongoing reforms to i) strengthen financial prudential regulation and supervision ii) strengthen the framework for the intervention and resolution of unauthorized financial intermediation activities and iii) and to deepen capital markets.

Key Outcome Indicators (by end of 2011)

1. Strengthening Prudential Regulation and Supervision • Under current macroeconomic assumptions, no systemic instability

arises in 2009-2010. • In case credit institutions incur in losses during the year, it will be

determined what percentage of those losses can be absorbed by the reserved constituted with the capitalized 2008 profits without compromising the CAR of the institution. At the closing of the 2011 financial accounts the remaining reserve for the system and the number of institutions for which the reserve has not covered the sustained losses will be reported.

• All financial institutions that collect resources from the public, with the exception of close-fund administrators, have adopted robust systems to monitor and administer liquidity risks. All credit institutions have a positive indicator of liquidity risk as defined by the SFC, or are adopting remedial actions to ensure they will have it.

2. Strengthening the Framework for the Intervention and Resolution of unauthorized Financial Intermediation Activities

• The SS follows up on all requests from the SFC to investigate unauthorized financial intermediation activities.

• Assets recovered from intervened pyramids have been valued and liquidated, and the proceeds distributed among investors according to their creditor status. Assets confiscated in relation to money laundering activities will have been transferred to the appropriate authorities. Actions to recovered assets located abroad have been initiated.

3. Securities Market Reform • Compliance with the current 19 CPSS-IOSCO principles. • The SFC has real time information on the transactions liquidated

through the CCCH. • The range of standardized derivative products traded in Colombia

has expanded to include exchange rate futures, Colombian stock market futures and commodities futures.

• The market has developed and trading volumes of standardized

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derivatives have increased as a share of spot transactions. In particular futures traded over Colombian sovereign bonds, the Colombian stock market index and the market exchange rate of the Colombian Peso vis-à-vis the US Dollar amount to a third of the spot transactions in those assets.

Program Document Objective(s) and Contribution to CAS

The proposed loan would support sustainable growth and alleviation of poverty by:

• Strengthening the financial system to prevent disruptive and costly financial crises; and

• Consolidating the securities markets as a pillar of economic growth to address the needs of individuals and the productive sector.

Risks and Risk Mitigation

The main risk to the operation arises from further deterioration of macroeconomic conditions, which would negatively affect the health of the financial system and/or delay securities market development.

Operation ID Number P116088

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IBRD PROGRAM DOCUMENT FOR A PROPOSED FINANCIAL SECTOR DEVELOPMENT POLICY LOAN

TO THE REPUBLIC OF COLOMBIA

I. INTRODUCTION

1. This single-tranche US$300 Development Policy Loan (DPL) has been requested by the Government of Colombia (GoC). The GoC is facing significant macroeconomic challenges from the current global financial crisis, which has resulted in lower capital inflows and increased borrowing costs. Recent growth and poverty reduction in Colombia has been supported by a stable expansion of the financial system, following the financial crisis that Colombia suffered at the end of the 1990s. As the ongoing global crisis impacts Colombia, the GoC is committed to preserving these gains in financial sector development as part of its broader development strategy. This financing will provide support for the two pronged combined approach the government has been implementing to tackle, in the short run, the impact of the international crisis in the Colombian financial sector, while at the same time proceed with the reforms needed to further develop financial markets in the long run. GoC’s commitment to face these issues and the soundness of the approach as well as the overall impact of these reforms in the Colombian economy underpin the support of this loan.

2. Due to the global crisis, Colombia is facing significant macroeconomic challenges, although sound past macroeconomic policies and measures adopted by the authorities will mitigate the impact of the global turbulence. The sustained period of strong growth and moderate inflation experienced by the Colombian economy in recent years ended in 2008. Growth is expected to contract by 0.7 percent in 2009 and remain subdued in 2010 with a forecasted 1.5 percent GDP growth. Growth perspectives compare favorably to those of other large Latin American countries which –with the exception of Peru− are expected to experience a more severe contraction in 2009. Colombia is relatively well positioned as traditional domestic amplifiers of crises − exchange rate, financial, and fiscal − have been well managed and could help mitigate the impact of the crisis.

3. Colombia’s financial sector appears to be sound and well supervised but government efforts to strengthen its foundations need to continue as the global crisis heightens existing vulnerabilities. The main risk for the system is credit risk, particularly the consumer loan portfolio. However, existing capital and provisions buffers appear adequate to cover potential losses and preserve systemic financial stability. Nevertheless, some small financial companies specialized in car loans could experience difficulties. Market and liquidity risks appear contained so far and systemic risks arising from non-bank financial institutions (NBFIs) appear limited.

4. Ongoing regulatory reforms to strengthen financial sector resilience are well structured. The orientation of several measures implemented by the GoC was later validated by the recommendations issued by the G-20. The increase of banks’ capital and liquidity buffers as a prudential countercyclical measure highlights the regulator’s responsiveness and vision to fence off the impact of the global crisis.

5. The measures adopted in the wake of the collapse of pyramid schemes will discourage unauthorized financial intermediation, preserving the strength of the system and protecting the poor. The collapse of fraudulent pyramid schemes prompted swift action from the authorities −which adopted a new and enhanced framework for the intervention of unauthorized financial intermediaries − avoiding contagion effects to the supervised system. These measures will discourage unauthorized financial intermediation, which will strengthen the financial sector and protect financial consumers and especially the poor, which are disproportionally affected by the collapse of pyramids.

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6. Further development of capital markets in Colombia is necessary to promote savings and to channel those savings efficiently to fund private sector investment and foster growth. The GoC has redoubled efforts to introduce additional regulations to keep on track the securities market reform initiated in 2005. To this end, the authorities issued regulation for an upgraded market infrastructure that increases efficiency and reduces systemic risks to create the conditions for solid market growth. The authorities have also advanced in regulating the securities market intermediaries and the type of transactions that can be negotiated and executed in the market. The regulations have made possible the creation of a central counterparty clearing house and the creation of an exchanged-trade derivatives market. The proposed operation would help achieve the objective of promoting savings and investment needed to sustain growth as identified in the Colombian National Development Program and supported by the current Country Partnership Strategy.

7. The World Bank engagement in Colombia, particularly with respect to policy areas supported by this DPL, has emphasized synergies of IBRD financing with other multilateral organizations. The request of this loan is part of the strategy of the GoC, which has increased its funding from multilateral organizations in the face of a deterioration of the external environment. In May 2009, Colombia obtained US$10.5 billion as a one-year precautionary arrangement under the IMF’s Flexible Credit Line (FCL). Collaboration with other multilaterals is fluid. In particular, World Bank and IMF staff maintains strong coordination and cooperation on both macroeconomic issues as well as financial sector issues.

II. COUNTRY CONTEXT

8. Following the 1999 crisis, Colombia enjoyed a sustained period of growth that supported employment creation and poverty reduction. Real economic growth accelerated from 2.5 percent in 2002 to 7.5 percent in 2007, inflation moderated, and private investment rose from 9.9 percent of GDP in 2002 to over 16 percent in 2007. Colombia’s unemployment rate dropped from over 17 percent in 2002 to approximately 12 percent in 2007. The country’s recovery was driven by favorable external conditions, stable macroeconomic policies and wide-ranging structural reforms.

9. Political stability and improved security contributed to the economic recovery. President Uribe has been in power since 2002 and is credited for the economic comeback of Colombia amid increased security. Congress has approved a Law to call a referendum on changing the Constitution once again to allow President Uribe to run for a consecutive third term next year. The Constitutional Court still has to approve the referendum.

RECENT ECONOMIC DEVELOPMENTS1

10. The sustained period of strong growth and moderate inflation experienced by the Colombian economy in recent years ended in 2008. During 2004-2007, high external demand, improved terms of trade and lower cost of international credit created a favorable environment for growth. During 2008 economic growth slowed down, reflecting past monetary tightening that resulted in a significant reduction in credit growth (from 34.4 percent y-o-y in March 2007 to 18 percent in August 2008) and weakening commodities prices and global demand. In particular, export growth − which had remained relatively resilient− collapsed due to the ongoing global slowdown. The deceleration intensified following the renewed global financial turbulence at end-September 2008. In the last quarter of 2008, GDP contracted by 1 percent y-o-y, and growth for the year as a whole stood

1 See Annex 4 for additional information on macroeconomic developments.

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at 2.5 percent −a third of the growth rate in the previous year. Shocks to fuel and food prices pushed inflation to 7.7 percent at end-2008 well in excess of the Central Bank (Banco de la República, BdR) target of 5 percent for 2009. Positive terms of trade developments in first half of the year were compensated by a collapse in export volume in the second half and declining oil prices. Thus, the current account for 2008 as a whole ended up in a deficit of 2.8 percent of GDP, a similar figure to the one in 2007 (see Table 1).

Table 1: Key Economic Indicators for Colombia, 2003-2008 Indicator 2003 2004 2005 2006 2007 2008 (e) Real GDP growth (%) 4.6 4.7 5.7 6.8 7.5 2.5 Inflation (%) (end of period) 6.5 5.5 4.9 4.5 5.7 7.7 Nominal Exchange Rate (Average) 2877.7 2628.6 2320.8 2361.1 2078.3 1967.7

Current Account Balance (% of GDP) -1.0 -0.8 -1.3 -1.9 -2.9 -2.8 NFPS Revenues (% of GDP) 30.0 30.0 30.6 32.7 33.2 32.0 NFPS Expenditures (% of GDP) 32.5 31.2 30.8 33.7 34.2 31.9 NFPS Balance (% of GDP) -3.2 -1.5 0.0 -1.2 -1.0 0.1 Net Debt of the Non Financial Public Sector (% of GDP)1/

46.7 42.4 38.9 36.0 32.3 31.9

External Debt/GDP (%) 41.5 34.7 26.6 24.7 21.4 19.1 Investment (% of GDP) 18.9 20.1 21.6 24.3 24.3 24.3 Public sector 6.3 5.9 4.9 6.5 7.7 7.3 Private sector 12.6 14.1 16.7 17.8 16.6 17.0

1/ This is defined as gross debt of the non financial public sector but netting out government and government entity bonds held by the public sector itself. Note: Non-Financial Public Sector (NFPS) data includes ECOPETROL. The NFPS balance includes the statistical discrepancy. Data comes from IMF. Source: MHCP, BdR; IMF and World Bank estimates.

11. Fiscal discipline resulted in low deficits and a reduction in public sector debt as a share of GDP, although concerns remain regarding expenditure rigidities. In recent years, fiscal policy aimed at reducing public sector and external vulnerabilities by ensuring debt sustainability. The combination of domestic economic growth, improved international conditions, peso appreciation (which reduces the cost of servicing foreign currency-denominated debt), and revenue-enhancing policy reforms improved the fiscal accounts.2 As a result, the combined public sector deficit improved from 3.7 percent of GDP in 2002 to a balance in 2005. However, budget and legal rigidities that resist spending cuts have slowed the progress of policy reforms on the expenditure side. Despite the strong revenue performance, expenditure dynamics −especially pension expenditures and transfers to sub national governments− have resulted in modest fiscal deficits during 2006-2007. Transfers to the main state-run pension system will continue to expand over the next decade −as payouts greatly exceed new contributions− despite the 2005 constitutional reform that reduced the net present value of pension liabilities by 19 percentage points of GDP. This reform eliminated special regimes for state employees and imposed ceilings on benefits in the public-sector pension system. In 2008, the non- financial public sector reached a surplus of 0.1 percent of GDP ‒ the highest balance since 2005‒ well above the government’s target of -0.9 percent of GDP. This improvement over the government’s target is

2 Policy reforms have concentrated on the revenue side. In 2002, Congress approved Law 788, supported by the Bank’s Fiscal and Institutional Adjustment Loan (FIAL) Program (Loan 7163-CO, approved March 2003). The Law expanded the revenue base for the government by eliminating tax exemptions related to VAT, personal and corporate income taxes. The Law introduced a cap on wage exemptions for personal income tax and eliminated the exemptions on capital gains from the sales of stock, mutual funds, real estate and privileged corporate contracts, forms, funds or bonds.

6

explained primarily by 1.1 percent of GDP surplus by local governments, up from the government’s target of 0.3 percent of GDP. The latter is at least partially the result of the recent central government’s policies to enforce fiscal discipline at the local level.

12. The global financial crisis led to a sharp tightening of financing conditions in Colombia, as well as in a large number of emerging market economies. As the global financial turbulence intensified in the second half of 2008, Colombian financial markets were negatively affected in line with developments in other Latin American countries. The withdrawal of liquidity in financial markets amid increased risk aversion resulted in larger sovereign spreads and stock market losses across the region (see Figure 1). In Colombia, the EMBI spread increased to 740 b.p. at end October, The stock market index declined by a third in line with developments elsewhere. The exchange rate appreciation, prompted in part by tightening monetary policy, reversed and the exchange rate depreciated by about 16 percent since end-August 2008, limiting the loss of reserves during 2008 to US$ 125 million (about 0.5 percent of total reserves). In this context the Central Bank removed the controls to capital inflows, a temporary measure to prevent excessive exchange rate volatility. An increase in credit risk premiums and funding costs pushed the lending rate up by 77 b.p. in the last quarter of 2008. However, subsequent decline in policy rates have brought down lending rates to levels similar to those in early 2007.

13. Markets normalized in the first half of 2009, and global sovereign bond issuance and domestic corporate bond issuance increased. Since end-2008 the stock market index increased by 49 percent while the exchange rate has appreciated by 17 percent and reserves were broadly stable. As market sentiment improved, partly due to the authorities’ actions, the Colombian government was able to successfully place a ten-year US$1 billion bond issue in January with a spread of 503 b.p. over US treasuries, and an additional US$ 1 billion in April at a yield of 7.35 and 435 b.p. spread. Spreads have declined further, standing at about 300 b.p. at end-June 2009. Lower inflation perspectives have prompted a rally in government domestic securities, with the yield on the benchmark domestic paper maturing in 2020 trading at the lowest levels since November 2006. In contrast to other emerging markets, domestic commercial paper markets have been quite active. Issuance in 2009 so far reached more than US$2 billion, about 80 percent of total issuance in 2008.

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Figure 1. Colombia: Stock Market Index, EMBI Spread and International Oil Price

Figure 1(a): EMBI Spreads Chile, Colombia, Latin America & the Caribbean, June 2005-June 2009

Figure 1(b): EMBI Spreads Brazil, Colombia and Mexico, June 2005-June 2009

Chile

Colombia

LAC

0

100

200

300

400

500

600

700

800

900

1000

6/12/05 12/12/05 6/12/06 12/12/06 6/12/07 12/12/07 6/12/08 12/12/08 6/12/09

EMBI Spreads

Chile

Colombia

LAC

Brazil

Colombia

Mexico

0

100

200

300

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600

700

800

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1000

6/12/05 12/12/05 6/12/06 12/12/06 6/12/07 12/12/07 6/12/08 12/12/08 6/12/09

EMBI Spreads

Brazil Colombia Mexico

Figure 1(c): Stock Market Indices, Selected LAC Countries, June 2008 – June 2009

Figure 1(d): Net International Reserves in Colombia, US$ million, June 2008 – June 2009

BRA

CHL

COL

MEX

40

50

60

70

80

90

100

110

120

6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

Stock Market Indices (Jan 1st, 2008 = 100)

BRA CHLCOL MEX

22,000

22,500

23,000

23,500

24,000

24,500

25,000

25,500

6/10/08 8/10/08 10/10/08 12/10/08 2/10/09 4/10/09 6/10/09

Net International Reserves (US$ Millions)

Figure 1(e): Exchange Rates in Selected LAC

Countries, June 2008 – June 2009 (January 1st, 2008 = 100)

Figure 1(f): Exchange Rates in Selected LAC Countries, June 2008 – June 2009

(January 1st, 2008 = 100)

80

90

100

110

120

130

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150

6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

Exchange Rates

COL MEX

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110

120

130

140

150

6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

Exchange Rates

BRA CHL

Figure 1(a): EMBI Spreads Chile, Colombia, Latin

America & the Caribbean, June 2005-June 2009 Figure 1(b): EMBI Spreads Brazil, Colombia and Mexico,

June 2005-June 2009 Source: Banco de la Republica de Colombia and LCSPE Database.

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MACROECONOMIC OUTLOOK AND CHALLENGES

14. Ongoing deleveraging and continued high levels of uncertainty have prompted a sharp downturn in global economic activity, world trade and international commodity prices which will negatively affect Colombia through several channels. In light of external developments, economic activity and the prospects for near-term economic growth in Colombia have deteriorated significantly. The main channels of transmission of the global economic and financial shocks to the Colombian economy are the following:

(a) Weaker external demand. Colombia has a relatively open economy; exports of goods and services are equivalent to over 17 percent of GDP while total trade amounts to about 40 percent. Although exports have become more geographically diversified (beyond the U.S), export volume growth has decelerated significantly. Global demand is expected to decline by 0.5 percent in 2009 compare to 2008. It is estimated that a 1 percent decline in export demand lowers GDP growth by 0.3 percent

(b) Lower oil prices. Colombia received a record-high level of revenue from oil exports in 2008

(US$12.2 billion) as a result of a historically high average oil price for the Colombian mix of crude oil that reached US$134.3 per barrel. The dramatic drop of international oil prices has a significant impact on the country’s public finances and the current account deficit. Oil accounts for about 20 percent of total public sector revenues and 24 percent of total exports on average. In 2009 oil prices are expected to average US$47.2 per barrel. The envisioned decline in oil prices −ceteris paribus− will increase the current account deficit and public sector deficit by 1.8 percent and 0.5 percent respectively.

(c) Lower workers remittances. Workers’ remittances, mainly from Colombians living in the

U.S and Spain, have started to decline since the last quarter of 2008. Remittances amounted to US$1 billion in the first quarter of 2009, 4.2 percent below last year. For the year as a whole they are expected to decline by 3 percent.

Figure 2: Remittances in Colombia: Level, Change and Share of GDP

January 2002-May 2009

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

150

200

250

300

350

400

450

2002

Jan M M J S N

2003

Jan M M J S N

2004

Jan M M J S N

2005

Jan M M J S N

2006

Jan M M J S N

2007

Jan M M J S N

2008

Jan M M J S N

2009

Jan M

US

$ M

illio

ns

Remittances Monthly Flow (12-month m.a.) % Change, y/y

Source: WB staff based on data from Banco de la Republica de Colombia.

(d) Lower capital inflows. Capital flows are declining somewhat due to diminished global

liquidity. Capital flows have declined by 3.5 percent in the last quarter of 2008 with respect

9

to the previous quarter. Although FDI flows experienced a significant expansion during 2008, current global conditions might impact negatively on the inflows during the year.

(e) Increased risk aversion. The deterioration in economic perspectives and market turbulence

will likely have a negative impact on risk premiums and credit supply.

15. Factors that typically magnify external shocks resulting in severe economic disruptions do not play an important role in the case of Colombia. In some Latin American countries, external shocks have been typically amplified by severely appreciated real exchange rates, weak domestic financial sectors and public sector balance sheet vulnerabilities. Fortunately, in Colombia’s case, the factors that typically magnify crisis mitigate the impact of the shock.

(a) Flexible exchange rate. Although the nominal exchange rate had appreciated considerably during 2007 and 2008, Colombia entered the turbulence period with an exchange rate value close to its equilibrium level3. The flexible exchange rate acts as a shock absorber helping to counter the deceleration in external demand.

(b) Resilient financial sector. The strength of the financial sector, with healthy financial indicators (see paragraph 25), has prevented a credit crunch, and credit to the private sector − although has decelerated due to lower demand and increased risk aversion− continues to grow at about 8 percent in real terms at end April 2009. Financial dollarization is not a destabilizing factor in Colombia, with foreign currency denominated loans amounting only to 6 percent of total loans. The dollarization ratio is even lower for deposits.

(c) Low public deficits and manageable external debt. Fiscal consolidation and the government public debt management strategy put public debt in a declining path and reduce the share of foreign denominated debt. External debt has almost halved since 2003 due to the sustained FDI flows. Reserves (over US$21 billion, or 11 percent of GDP at end-May 2009) more than doubles the annual external debt amortizations, contributing to ensure current account financing even in the difficult global conditions. Given limited external vulnerabilities, exchange rate pressures would likely be moderate..

16. Overall, Colombia is in a relative better position to confront the global crisis than other Latin American countries. This outcome is a result of the factors discussed in the previous paragraph as well as the countercyclical policies implemented by the authorities (see paragraph 18 and Box 1).

3 See IMF 2008, Staff Report for the Article IV Consultation.

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Figure 3: Impact of the Global Conditions on Growth. A Regional Perspective

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

Mexico Argentina Venezuela Brazil Chile Colombia Peru

Per

cen

tag

e

I Projection Range

Selected Economies in Latin American: Growth Projection 2009

Growth Projection 2009

Source: Consensus Forecasts (as of June 15, 2009).

17. In light of the global environment, economic growth is expected to continue decelerating in 2009. The Colombian economy is officially in recession, as GDP in the first quarter of 2009 contracted by 0.6 percent (preliminary figures subject to revision). For the year as a whole, GDP is likely to contract by 0.7 percent. A modest rebound in economic activity is forecasted for 2010. Lower oil and food prices will reduce inflation to 4.3 percent. The current account deficit is expected to deteriorate to 3.3 percent of GDP. The Non-Financial Public Sector deficit, broadly balanced in 2008, will widen to 3.5 percent of GDP in 2009.

Table 2: Medium-Term Outlook, 2008-2013

2008 2009 2010 2011 2012 2013

Real GDP growth (%) 2.5% -0.7% 1.5% 3.0% 3.8% 4.4%

Inflation (%) 7.7% 4.3% 4.3% 3.9% 3.2% 3.1%

CAB (% GDP) -2.8% -3.3% -2.7% -2.0% -1.8% -1.3%NFPS Revenues (% of GDP) 32.0% 30.0% 30.7% 31.7% 32.0% 32.1%NFPS Expenditures (% of GDP) 31.9% 33.5% 33.1% 32.8% 32.3% 31.8%

NFPS Balance (% GDP) 0.1% -3.5% -2.4% -1.1% -0.3% 0.3%

Investment (% GDP) 24.3% 23.6% 23.8% 24.6% 25.0% 25.1%

External Debt (% GDP) 19.1% 21.4% 20.4% 19.1% 17.7% 15.1%

Nominal Exchange rate (e.o.p. COL$/US$) 1967.7 2304.0 2386.9 2482.4 2561.6 2638.1

Oil price (US$ per barrel) 97.0 47.2 52.7 57.9 63.3 69.3

Reserves (US$ Million) 23,478.8 21,071.1 21,391.7 22,401.0 23,205.4 24,332.9

Memo:3.0% 3.4% 3.0% 3.3% 3.7% 4.9%

NFPS Financing (In % of GDP) 6.9% 10.4% 9.0% 8.1% 7.8% 8.4%Financing Needs (Deficit plus amortizations): 4.0% 7.0% 6.0% 4.8% 4.1% 3.5%Financing Sources: 6.5% 7.0% 6.0% 5.3% 4.2% 3.5% External (Multilateral plus Bonds) 1.0% 1.4% 0.7% 0.6% 0.6% 0.5% Domestic 4.6% 4.1% 4.0% 4.0% 3.6% 3.0%

Other (adjustments, profits Banco de la Republica, other) 0.9% 1.5% 1.2% 0.6% 0.0% 0.0%

Source: WDI, IMF Data, Ministerio de Hacienda de Colombia and World Bank Staff estimations.

11

18. Countercyclical measures implemented by the authorities will mitigate the impact of a global slowdown on growth and employment generation. Monetary policy is, and will continue to be, actively used to counter the effects of the cycle as weakened demand and lower food and oil prices keep inflation on a downward trend. Regarding fiscal policy, the authorities will allow automatic stabilizers to fully operate. In addition, the sharp reduction in public sector debt to GDP ratio during the past years has provided room for some modest fiscal loosening. In this context expenditures are expected to increase by 1.7 percent of GDP. The main measures adopted by the authorities are included in Box 1.

19. The GoC is seeking to further reduce external vulnerabilities by requesting funding from multilaterals. Authorities indicated they plan to obtain US$2.4 billion from multilaterals this calendar year to help cover the envisioned external financing needs for 2009. Colombia also obtained an IMF precautionary flexible credit line to access US$10.5 billion. At end-May 2009, the World Bank has disbursed US$580 million (see Annex 7 for details on the World Bank program with Colombia).

20. While there remains considerable uncertainty as regards to the depth and length of the global recession, neither external nor fiscal sustainability appear at risk. Nevertheless, the current environment characterized by volatility in financial magnitudes and commodity prices poses several downside risks. A fall in oil prices would negatively affect the fiscal outlook and the current account balance. Intensification of the global liquidity squeeze further deteriorates the external balance. To gauge these risks a low growth scenario is evaluated. The scenario shows the impact of a drop of the oil price to a low of US$32 per barrel and a further deterioration of the external environment during 2009. The simulation indicates that Colombia has enough reserves to cushion a potential external financing shock without severely affecting exchange rate stability. This scenario does not pose a serious problem to debt sustainability (See Annex 5).

Table 3: Low Growth Scenario, 2008-13

2008 2009 2010 2011 2012 2013

Real GDP growth (%) 2.5% -4.0% 0.5% 2.0% 2.5% 3.2%

Inflation (%) 7.7% 4.1% 3.5% 3.3% 3.1% 3.0%


NFPS Balance (% GDP) 0.1% -4.0% -2.8% -1.3% -0.7% -0.2%

Investment (% GDP) 24.3% 22.4% 23.3% 24.1% 24.6% 24.7%



Oil price (US$ per barrel) 97.0 32.2 37.7 42.9 48.3 54.3Reserves (US$ Million) 23,478.8 20,551.1 20,626.7 20,393.2 20,389.2 20,436.1

Source: WDI, IMF Data and World Bank Staff estimations.

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Box 1. Countercyclical measures to mitigate the Economic Slowdown

Expansive monetary policy. From mid-2006 to mid-2008, the policy rate was increased by 400 b.p. amid concerns of possible overheating. As result of the renewed global financial turbulence, lending rates increased further in the last quarter of 2008. To inject liquidity in the market BdR expanded monetary base by reducing banks’ reserve requirements and introduced a program of purchases of government paper (US$500 million). From December 2008 to end-June 2009, the sharp moderation in inflation (from 7.9 in November 2008 to 4.8 percent at end-May 2009) has allowed the BdR to reduce interest rates by 550 b.p. and lending rates are now broadly at end-2006 levels. While credit growth has decelerated sharply during the last 12 months, in the latest lending survey by the BdR (May 2009), the majority of respondents ‒particularly in service and manufacture firms‒ anticipate that there will be no change in the amount of credit availability within the next 6 months. The proportion of survey respondents who believe there is sufficient credit in the system is increasing but is still lower than a year ago in April 2008 However, banks have tightened lending criteria with increased attention to the repayment capacity and liquidity position of the borrowing firms. To avoid severe credit disruptions, the authorities have secured US$850 million of funds from the IADB for Colombian public financial institutions (see paragraph 58).

Inflation Developments and Monetary Policy Rates

Source: Banco de la Republica de Colombia

Increased investment in infrastructure. The government has announced a series of measures to invest in infrastructure. The “plan de choque” increases the budget for infrastructure by 25 percent with respect to 2008 to an amount of US$ 2.7 billion. The World Bank will support infrastructure investments with mainly 4 projects in 2009-2010, approximately amounting to USD $1.1 billion. These infrastructure projects are labor intensive and are expected to have a significant impact on employment and growth.

Increased public expenditure in social assistance programs. With respect to the social assistance programs, the government plans to expand the budget for these programs by 18 percent in 2009 reaching US$1.45 billion. The expanded budget includes US$474 million for Familias en Acción ‒a program of cash transfers to poor families conditional on children attending school and meeting basic preventive health care requirements‒, US$240 million for elderly programs, and US$330 million for programs targeted towards the displaced population. These programs protect the poor from the impact of the crisis. The World Bank is supporting Familias en Acción and other social programs with US$ $636.5 million in FY09-10 (see Annex 7).

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The Financial Sector

21. The Colombian financial system is dominated by domestic banks and it is highly concentrated. The system includes a variety financial intermediaries, including pension funds (AFPs), insurance companies, brokerage houses, trust funds and mutual funds. Credit institutions dominate the financial landscape with almost half of total financial sector assets. Banks are by far the largest credit institutions (about 85 percent of total credit institution assets), which also include finance and leasing companies, financial corporations − similar to investment banks, although regulated− and financial cooperatives. The 1999 crisis resulted in substantial consolidation of private banks, whose number declined from over 30 in 1998 to 17 at end 2008. The largest public banks were privatized and only a small public bank remains in the market (5 percent of the assets of credit institutions). The consolidation process resulted in the formation of large domestic financial conglomerates. The two largest conglomerates account for about half of financial sector assets. Foreign penetration is modest compared with other countries. Foreign owned banks control less than a fifth of banking assets but intensively compete with local banks.

Figure 4: Financial Sector Composition

Banking44%

Trust & Mutual Funds27%

Pension Funds15%

Insurance5% Other

9%

Total Assets in the Financial System by Industry (April 2009)

Source: SFC

22. After a long period of decline due to the crisis of the late 1990s, the banking sector begun to recover in 2004. The resolution of troubled institutions and a favorable external environment stimulated growth and propitiated the recovery of banking intermediation. Strong bank profitability− arising from valuation gains on the banks’ government securities portfolio as interest rates declined from post-crisis highs− allowed for an expansion of loan supply. At the same time, the resumption of domestic economic growth, supported by a favorable external environment increased loan demand. Standard financial performance indicators – solvency, profitability, efficiency and asset quality –significantly improved.

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Figure 5: Credit to the Private Sector as Share of GDP in Selected Countries

10.0

15.0

20.0

25.0

30.0

35.0

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45.0

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 200760.0

65.0

70.0

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90.0

Colombia Argentina Brazil Peru Mexico Chile (right axis)

Source: World Bank, World Development indicators.

23. The level of financial development is in line with regional levels given the country characteristics. Credit to the private sector amounts to about 33 percent of GDP, still below the levels reached in the late 1990s before the crisis. It is lower than the levels for Chile and Brazil but higher than average regional levels, controlling for the country characteristics (see Figures 5 and 6). Efforts to reform and develop the securities market have activated the market, although number of issuers is relatively low and the market liquidity needs to improve.

24. The debt market has been growing in the last few years, dominated by public debt instruments. At the end of 2008, Colombia’s outstanding stock of fixed income securities was US$ 81 billion (equivalent to 56 percent of its GDP), of which US$ 44.6 billion was government debt. While it remains limited, the importance of corporate bonds as a source of financing for firms has increased slightly. While in 2005 there were 18 issuances, which were worth US$962 million (0.6 percent of GDP) in the first half of 2009 alone corporate bond issuance reached more than 1 percent of the forecasted GDP for the year.

15

Figure 6: Colombia: Indicators of Financial Sector Development

ACTUAL AND BENCHMARKED LEVELS OF FINANCIAL DEVELOPMENTLatest year availableSIZE EFFICIENCY AND LIQUIDITY REACH

BANKINGBank Credit to the Private Sector Bank Deposits Net Interest Margin(2000-2007), % of GDP (2000-2007), % of GDP (2000-2007), % of Assets

EQUITIESStock Market Capitalization Stock Market Turnover Ratio Number of Listed Firms(2000-2007), % of GDP (2000-2007) (2000-2007), / Mill. of People

BONDSPrivate Bonds Public Bonds(2000-2007), % of GDP (2000-2007), % of GDP

* Includes assets to GDP of pension funds, insurance companies and mutual funds

Note: The predictions are based on pooled, year-fixed effects OLS regressions for the period 2000-07 with the logarithm of X as a dependent variable. For the predictions that take into account regional influences, separate regressions are used that includ

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PrivateBonds

Public Bonds InstitutionalInvestors'Assets*

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Source: Benchmark is dependent upon Country-Specific Characteristics that can affect financial development. Depending on the financial sector indicator used, a range of 31-160 countries were used for the regression analysis. World Bank Project PCN: Financial Indicator Benchmark Project.

16

25. At end-April 2009, the banking system appeared sound and well supervised. The Colombian banking system is well capitalized and very profitable. Following the 1999 crisis, supervision and regulation were revamped. The Financial Superintendence (Superintendencia Financiera de Colombia, SFC) currently supervises all financial intermediaries through on-site follow up and on-site visits (see section IV for details). The Banking system capital adequacy ratio (CAR) stood at 13.8, with all Colombian banks having a CAR well above the 9 percent regulatory minimum. However, it is important to notice that capital ratios include goodwill4. As a result, the loss absorption capacity of Colombian banks’ capital buffers is lower than that of regional peers, leaving the banks more exposed to potential pressure on asset quality.5 Already asset quality has deteriorated due to the economic slowdown, and non-performing loans (NPLs) reach 5.1 percent of total loans while loans classified as on watch or worse amount to 9.7 percent of total loans in April 2009. Provisions cover all NPLs but only 53.7 percent of classified loans on average, with some banks having substantially lower coverage levels (see Figure 7). While those figures compared unfavorably with that of other Latin American countries, it is worth noting that the Colombian definition of NPLs is rather strict as it includes loans past-due 30 days as opposed to the standard 90 days. Despite increased credit losses, profitability remained strong in 2008. Rising interest rates for most of the year and less-than-perfectly competitive system resulted in higher net interest margins. Recently, valuation increases in the portfolio of government securities have boosted profitability. In the first quarter of 2009, credit institutions reported even bigger profits than in the first quarter of 2008.

Table 4: Banking Sector Indicators in Selected Countries CAR NPL Provision/NPL ROE ROA Argentina 16.8 2.5 122.7 13.1 1.6 Brazil N/A 3.8 180.0 14.1 1.2 Chile 13.4 2.7 94.6 14.4 1.1 Colombia 13.8 5.1 102.0 22.6 2.4 Mexico 15.3 3.4 158.7 11.2 1.0 Peru 12.6 1.4 243.5 30.5 2.5 Source: Central Banks and Banking Superintendencies (Argentina December 2008 Data; Brazil NPLs and Provisions April 2009 Data, CAR ROE and ROA December 2008 Data; Chile and Peru March 2009 Data ; Mexico NPL, Provision, ROE, ROA March 2009 Data, CAR December 2008 Data; Colombia CAR, NPL and Provisions April 2009 Data, ROE and ROA February 2009 Data)

26. Some commercial financing companies (CFCs) could experience difficulties if the economic environment deteriorates further. CFCs −which hold 12.5 percent of the credit institutions’ assets − grant credit and finance themselves mostly with certificates of deposit that are protected by the Deposit Insurance Fund (Fondo de Garantía de Instituciones Financieras, FOGAFIN). CFCs have seen NPLs almost double in the last year reaching 7.15 percent of total loans for the sector in April 2009, with proviiouns covering 77.4 percent of those NPLs. Particularly affected are those companies oriented to automotive sector loans, and some may need to increase regulatory capital if the portfolio continues to deteriorate. On the positive side most of the CFCs belong either to a foreign group or a large domestic group and should not have difficulties in raising capital. Some of the smaller independent CFCs, which altogether hold about 4 percent of credit institutions assets, may have to consolidate or liquidate, although such exit is unlikely to pose systemic consequences.

4 Goodwill denotes the difference between the purchase value of a company and the book value of its assets. According to Basel norms, goodwill and other intangible assets should not be included in regulatory capital. 5 Fitch February 2009. “2009: A Year of Reckoning for Latin American Banks”.

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Figure 7: Non-Performing Loans and Provisions

0.0%

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Commercial Consumer Mortgage* Microcredit Total

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Commerical Consumer Mortgage Microcredit Total

Source : SFC. 27. Systemic risks arising from other financial intermediaries appear limited. The value of AFPs’ portfolio holdings were negatively affected by the decline in government securities prices (45 percent of AFPs’ investments) and stock market volatility, particularly in the second half of 2008. This issue was aggravated by the definition and measurement period for the minimum return benchmark. A few AFPs were close to being below the minimum return at the peak of market volatility, and could have had to increase capital. At the time, some market participants and regulators expressed concerns that portfolio reallocations by AFPs could put pressure in the government securities market, which would affect other financial intermediaries. However, these concerns have subsided as the market turn around and pension funds reported a profit of US$1.4 billion in the first quarter of 2009, compared to a loss of US$680 million during the same period last year. All other institutions are relatively small. Brokerage houses had been most affected by the decline in the stock market as mutual funds invest mostly in certificates of deposit from domestic financial institutions. While insurance companies technical margins’ are slightly negative, they are in line with average values in the last 15 years. As in the case of AFPs, the recent rally in the government’s Treasury bonds market has improved profitability for all intermediaries.

28. The collapse of fraudulent pyramid schemes prompted swift action from the authorities avoiding contagion effects to the supervised system. Some fraudulent pyramid schemes −which obtained resources from the public by promising exorbitant rates of return − had appeared in Colombia under sophisticated structures (see section VI for details). The companies masked their fraudulent money-collecting activities under the disguise of service provider companies and prepaid card sales. These fraudulent companies operated in 12 departments with a substantial number of investors, mostly in the low-income bracket. So far, the authorities have received more than 700,000 claims from investors amounting to about 1 percent of GDP. In November 2008, the government closed the pyramid schemes, enacted legislation to strengthen the powers of supervisors to act against such illegal operations (action supported by this operation), and began liquidating assets to return the recovered funds to investors. To help address the social costs, the authorities reallocated funds in the 2008 budget toward targeted social spending. Authorities also indicated investors of the pyramids will not be bailed

18

out. Swift action from the authorities prevented contagion effects to credit cooperatives and other supervised institutions operating in the same market segments.

Macro Financial Linkages

29. During 2005-2006, credit growth accelerated sharply. The favorable macroeconomic environment underpinned credit growth, with growth rates of almost 30 percent in real terms at the beginning of 2007. Credit grew particularly in the consumer segment, with real growth rates close to 50 percent at the height of the credit boom. Increased competition among credit institutions has played an important role, aided by the decline in interest rates. For example, the 90-day fixed-term deposit rate (Depósito a Término Fijo or DTF), which forms the benchmark reference rate for most loans, declined from almost 8 percent in early 2005 to less than 5 percent at end-March 2006. The credit growth outpaced the strong deposit growth and as a result the loan to deposit ratio increased from 81 percent at end-2005 to 93 percent at end-2008. The credit expansion was partly funded with the reduction in banks’ investment portfolio. The decline in the banks’ portfolio of government securities increased liquidity risks while decreasing exposure to market risks. The past credit boom increased corporate and household balance sheet vulnerabilities, which in the current economic environment could result in substantial credit losses for bank. Tightening monetary policy and economic deceleration reduced the real growth rate of credit to 10.6 percent at end-September 2008. Since the global financial turbulence erupted, the growth rate has declined further to 7.9 at end April-2009 due to the deceleration in consumer and housing loans, while commercial lending growth rates remained broadly stable.

Figure 8: Credit Growth and Loan to Deposit Ratio

-15.0%

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Real Credit Growth Rates

Commercial Consumer Total Mortgage (right axis)

75%

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85%

90%

95%

100%

Credit InstituionsLoan to Deposit Ratio

Source: SFC.

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30. Corporate balance sheets appear relatively resilient, although concerns regarding the quality of data remain. A recent IMF paper concluded that the Colombian corporate sector is well capitalized, with relatively low leverage, adequate liquidity, improved profitability, and well hedged6. Balance sheet data from over 20,000 firms revealed that the sector liabilities amount only to half of the assets. Liquid assets cover about 148 percent of short-term obligations mitigating default risks in this portfolio. While average corporate profitability does not compare well with the region, it is close to the maximum levels during the last decade, despite the recent economic deceleration. Data from a much smaller sample, accounting for a fifth of the sector liabilities, pointed to limited foreign exchange exposure (6.5 percent of capital). Further convergence toward international accounting standards, more stringent auditing practices, and effective regulatory enforcement are required to overcome limitations and inconsistencies in reported corporate financial information. These deficiencies might undermine the diagnosis of existing weaknesses across firms and sectors7. In fact, data from the SFC indicates that NPLs are growing fastest among commercial loans, although the NPL ratio for the segment remains modest (2.9 percent in April 2009).

Figure 9: Growth Rate of Non Performing Loans by Segment

-40%

-20%

0%

20%

40%

60%

80%

100%

Commercial Consumer Mortgage Total

Source: SFC.

31. Household balance sheets have stretched substantially as a result of past consumer growth. Although household indebtedness indicators remain well below the levels in the late 1990s, financial burden indicators have risen to the levels observed in the pre-crisis period of the mid 1990s (about 25 percent of disposable income). This is because consumer loans −with lower maturities than mortgages− constitute a larger share of household debt. About 75 percent of loans to households are fixed rate loans, thus being unaffected by policy rates declines. As economic conditions continue to deteriorate and unemployment increases, household debt repayment capacity will continue to decline. Consumer credit accounts for about 27 percent of total loans. On the positive side, the rate of growth

6 See “An Assessment of Financial Sector Indicators for the Colombian Corporate Sector”, IMF, Selected Issues Paper for the 2008 Article IV consultation. 7 A new Law on Accounting and Auditing standards –which will replace existing Colombian standards with International Financial Reporting Standards (IFRS) and ensure standards adjust in line with developing international best practices– has been submitted to Congress.

20

of consumer NPLs has declined substantially as banks improved credit origination practices during 2007.

32. The financial sector can cover the GoC’s additional financing needs without crowding out private sector credit. Domestic financing requirements for the public sector deficit are expected to remain modest at about 4 percent of GDP (close to US$8.5 billion). In recent years, domestic issuance of Treasury bonds has been as high as 5.9 percent of GDP as external debt was substituted with domestic debt.

Main Financial Sector Risks

33. The deterioration of the loan portfolio in the event of a severe economic downturn poses the main risk to the financial system, although measures recently adopted by the SFC provide adequate buffers against such risk. The BdR periodically conducts stress tests using an error correction model to estimate the impact of changes in macroeconomic variables on delinquency rates for banks’ commercial, consumer and household portfolios. The impact on profits is then calculated taking into account the effect of additional provisions and declined interest income due to the higher delinquency. Tests are conducted over a 1-year horizon. The latest tests indicate that in case of a severe macroeconomic shock –similar to the one occurred during the financial crisis of the late 1990s– almost all banks in the system would incur losses amounting to COP$ 1.4 billion8. The SFC also conducts stress tests regularly to calibrate additional provisioning requirements. In the event of an increase in delinquency rates similar to those observed during the crisis, and given current exposures, credit institutions −including financial companies, cooperatives, and other specialized credit institutions− would have to increase provisions by about COP$ 2.2 billion over the next two years. Given concerns regarding the quality of the loan portfolio in the current uncertain macroeconomic environment, the SFC requested credit institutions to capitalize part of the 2008 utilities, a measure supported by this operation. As result of the measure, credit institutions constituted additional capital reserves of about COP$ 2.1 billion. This additional cushion would ensure a CAR level for the system above the 10 percent level during 2009-2010 even in case of severe economic contraction.

34. Market risk, although increasing, remains modest. Data from the SFC shows that banks’ market risk −measured according to a Value-at Risk model− increased by 50 percent from November 2008 to February 2009 (see Figure 10). The increment is mostly due to the increase in the holdings of government securities. The declining trend in the size of banks’ investment portfolio has recently reversed as economic perspectives deteriorated, risk aversion increased and inflation expectations moderated. The BdR reports that from August 2008 to February 2009, credit institutions increased their holdings of Treasury bonds by US$2.6 billion. However, market risk remains modest as a percentage of regulatory capital (4 percent) and below the levels at end-2006.

35. Colombian financial institutions continue to maintain adequate liquidity buffers although sustained credit growth in past years has increased banks liquidity risks. A new liquidity regulation, supported by this operation (see paragraph 74), establishes requirements for the management of liquidity risks and forces credit institutions to maintain liquid assets to cover liabilities potentially due within one week. Additionally, the BdR’s liquidity risk indicator –current liabilities minus liquid assets and tradable investments (with prices adjusted by a haircut)− reflects that liquid assets exceed liquid liabilities for all institutions. Nevertheless, liquidity buffers have declined due to past credit growth (from -25.0 percent at end-2005 to -5.8 percent at end-2008). Only a severe stress

8 The scenario considers a negative GDP growth of 6.8 percent, a 13.7 percent contraction in internal demand, a 4.2 percentage point increase in unemployment rates, a 450 b.p. increase in interest rates and an 8 percent decline in housing prices. The tests used information on exposures at end-2008.

21

scenario poses serious liquidity risks. In the event of a 12 percent withdrawal of deposits, institutions holding about 60 percent of total banking assets would have to recur to illiquid assets to met liquidity needs9.

Figure 10: Market Risk for Banks

0

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1,000,000

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7

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Source: SFC.

III. THE GOVERNMENT PROGRAM

36. The GoC’s general strategy is laid out in two documents: the National Development Plan and Visión Colombia 2019. In anticipation of Colombia’s bicentennial anniversary, the National Planning Department launched an initiative to develop a longer term vision for the country and a strategy to reach it. The process involved the development of a proposal, Visión Colombia II Centenario: 2019 - Propuesta para Discusión, followed by rounds of discussions with citizens and sub-national governments to refine the vision and generate national ownership. The process culminated in the elaboration of Visión Colombia 2019, a longer term policy planning document outlining objectives over the next fifteen years. The document considers several policy areas aiming to create an economic environment that guarantees greater levels of well-being. Visión Colombia 2019 and the National Development Program (NDP) 2002-2006 which was based on the results of a broad consultative process, constituted two of the main inputs for the formulation of the NDP 2006-2010: Estado Comunitario: Desarrollo para Todos. The plan lays out a comprehensive set of programs to implement in these four years and provides guidance for monitoring results and outcomes. The new NDP was formally adopted through Law 1151 of July 2007.

37. Both documents identify financial development as key for improving competitiveness to ensure high sustainable growth. High sustainable growth constitutes one of the five pillars of Visión Colombia 2019, which also include peace and security, promotion of equity, environmental sustainability and state reform to better serve citizens. The program recognized that developing a competitive business sector requires increasing financing to private sector companies. To do so, it

9 The 12 percent withdrawal rate corresponds to the average of the highest drop in deposits of each institution during the period 1994-2008

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proposes to progressively deepen financial markets by raising the ratio of broad money to GDP from 40 percent to 80 percent by 2019. The ongoing securities market reform supported by this DPL constitutes an essential block in the strategy to achieve this objective, and the subsequent NDP 2006-2010 explicitly referred to this reform. The NDP also indentifies securities market reform as a priority to deepen Colombian financial markets in order to promote high sustainable growth. To promote savings and to channel those savings efficiently to fund private sector investment and foster growth, the NDP envisions a comprehensive reform of the securities market regulatory framework. The NDP specific objective with respect to securities market development is to increase market capitalization and the value of transactions to the average level in Latin America by 2019.

38. Capital markets have a relevant impact on the productivity of the corporate sector, through the provision of financing and risk management tools. Capital markets have a direct impact on the business sector, offering an alternative to bank debt financing (i.e. bond instruments) and owners’ capital contributions (i.e. equity instruments) as well as risk management instruments. Capital markets also have an indirect effect on business productivity, as the domestic public debt market and money market provide the basis for the effective pricing of corporate bonds.

39. As the global financial crisis erupted the authorities focused on mitigating the effects of the crisis to avoid economic recession and preserve social gains. In order to contain the effects of the crisis, the authorities adopted countercyclical monetary and fiscal policies and increased funding from multilaterals. In the financial sector area, the authorities focused on strengthening the financial sector so that financial instability would not amplify the impact of the shocks. To avoid dispersing government and regulators focus and efforts beyond controlling the impact of the crises, and to revise the mid-term strategy as necessary in light of developments, the draft Financial Reform Law was withdrawn from Congress and was reintroduced in May after including some amendments related to crisis management although unfortunately some of those amendments were not approved by Congress (see paragraph 52).

IV. FINANCIAL SECTOR REFORMS IN THE LAST DECADE AND THE AGENDA FOR FUTURE REFORMS

40. Strengthening the financial sector and developing capital markets have been at the core of the financial development agenda in the last decade. The reforms have resulted in a different financial landscape with a consolidated banking sector, more prudent supervision and regulations, and the development of a capital market. Following the 1999 banking crisis, recovery efforts included addressing insolvent state-owned banks –through privatization, liquidation or recapitalization–, and deleveraging risk in housing finance through securitization of the mortgage market. As the situation stabilized, focus shifted to revamping financial sector regulation and supervision in order to strengthen financial sector stability. In order to deepen financial intermediation and provide alternative and efficient sources of funding to corporations, the authorities launched a comprehensive securities market reform. The government efforts of the past 10 years have been extensively supported by the World Bank and other multilaterals through a number of operations including loans, technical assistance, analytical work and policy dialogue. This section summarizes some of the most important reforms undertaken in the last decade (see Annex 6 for details) as well as the most recent reform developments.

41. On the institutional side, a single financial supervisor was created in early 2006 to improve coordination, reduce the scope for regulatory arbitrage and strengthen overall financial regulation and supervision. Based on Decree 4327/2005, the banking, insurance and pension’s

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supervisory agency (Superintendencia Bancaria) and the securities supervisory agency (Superintendencia de Valores) merged in January 2006 into an integrated financial supervisor (SFC). This merger was supported by the Second Programmatic Financial Sector Adjustment Loan (PFSAL II). Even though the technical and organizational challenges of integrating the two agencies were significant, the merger process proceeded smoothly. Market participants indicated that the objectives of the merger have been achieved to a large extent.

42. In addition to regulatory reforms and capital market development, substantial efforts have also been devoted to promote financial outreach and inclusion. A decree in 2006 established a public-private partnership trust fund, Banca de las Oportunidades. The goals of this trust fund were to increase access to finance to provide targeted financial education, as well as technical assistance for financial intermediaries, partial credit guarantees for micro credit institutions, and targeted subsidies. The Credit Information Law (Ley de Habeas Data) regulated the activities of the credit reporting industry to improve the legal framework underpinning the supply of credit. Correspondent banking arrangements, which refer to bank partnerships with typically non-bank commercial outlets in order to provide a range of banking services through them, were allowed and regulated in order to expand access to banking services. All these reforms were supported by the Business Productivity and Efficiency DPL programmatic series. The introduction of differentiated interest rate ceilings for micro loans has allowed the expansion of credit. However, interest rate caps on mortgages continue to hamper the access to credit to low income households and banks cannot fully charge for the risks associated to lending to this segment. A program of housing subsidies aimed to facilitate access to finance was introduced, although the subsidies are poorly targeted and also benefit upper-income households.

43. Financial sector supervision and regulation has been substantially strengthened in the last decade. The Financial Reform law of 1999 was instrumental in facilitating the resolution of troubled institutions and in upgrading regulation. Supervision now covers all financial institutions on a consistent basis, using on-site examination and off-site monitoring. The Financial Reform Law of 2003 further upgraded the regulatory framework as well as the banking resolution procedures. Financial supervision has been revamped, with a movement towards a risk-based supervision framework. Among the new regulations, financial institutions have been obliged to adopt, where applicable, internal systems to manage credit, market, and more recently liquidity and operational risks. Such systems comprise policies, procedures and a corporate governance structure to deal with each type of risk − including internal limits, remedial actions, and contingency plans− as well as a framework to measure each particular risk.

44. Already prior to the global financial crisis, Colombia introduced countercyclical provision regulations in line with recent recommendations by the G-20. Under the new regulations, lending institutions constitute additional specific provisions in the boom part of the cycle that can be used to compensate for higher expenses due to increased provisioning during the downturn. At present, the SFC instructs each year whether the institutions need to provision in excess or below expected losses. In 2007 and 2008, the SFC instructed institutions to constitute the countercyclical provision according to the difference between two transition matrices (one with through-the-cycle probabilities of default and other with probabilities of default based on more recent observations) provided in the norm. The countercyclical provisions for commercial loans entered into effect in July 2007, while the countercyclical provisions for consumer loans entered into effect in July 2008. As of end-March 2009, countercyclical provisions reached US$800 million. Currently, the SFC is contemplating the possibility of allowing credit institutions to accumulate or deplete countercyclical provisions according to their delinquency experiences and financial strength. The main drawback of the scheme is that the specific nature of the provisions limits the flexibility for reallocation among

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delinquent loans and raises tax issues. The reform proposal aims at addressing these issues but in the future, the adoption of a generic countercyclical provision should be considered10.

45. As the global crisis erupted, the authorities took measures to increase their preparedness against an eventual emergency. In 2008, the financial supervisory authorities conducted a crisis simulation exercise designed and executed with the assistance of World Bank staff to test the framework for resolution, largely introduced after the 1999 crisis and therefore untested. The exercise pointed out the need for greater clarity in the sequencing of actions and responsibilities of the different institutions involved in the process. In light of the experience, the authorities have requested funding from FIRST to finance technical assistance to draft internal protocols to clarify resolution procedures. The Financial Surveillance Committee −including representatives of the SFC, the Ministry of Finance (Ministerio de Hacienda y Crédito Público, MHCP), the BdR and FOGAFIN− has intensified its activities to coordinate actions across agencies involved in financial sector stability issues and develop contingency plans.

46. To further strengthen the deposit insurance scheme, the copayment was eliminated in early 2008. FOGAFIN guarantees deposits and certificates of deposit issued by credit institutions up to about US$10,000 per person per institution11. This limit covers 98.5 percent of depositors and 20 percent of total deposits. The institutions pay a risk-adjusted insurance premium. Currently, funds cover about 5 percent of total deposits. To increase confidence in the system, the copayment by depositors was eliminated in early 2009, in line with IMF recommendations12. To further strengthen the framework, consideration should be given to extend the premium to all debt liabilities and to better publicize the existence of the fund. FOGAFIN has recently launched a revision of the available tools to facilitate the resolution of insolvent institutions and to ensure prompt repayment of depositors.

47. World Bank has supported the development of Colombian capital markets in all its stages. Given the number of areas to be regulated and the complexity of issues involved, securities markets reform is typically a multi-year process. This reform requires substantial effort in the regulation and implementation of normative through supervision and the creation of new entities such as those responsible for the operation of the new clearance and settlement systems. The 2005 Securities Law aimed at developing a regulatory framework flexible enough to deal with innovations. To implement the Securities Law, the GoC has been issuing a substantial body of regulatory decrees. Those decrees regulated important aspects of securities markets under four big areas: supervision and regulation, infrastructure, architecture and market operations. Recent regulations addressed the professionalization of market participants and clarified the framework for the resolution of securities intermediaries. A new and improved regulatory framework for collective investment vehicles is expected to promote securities market development. The authorities have also placed substantial efforts to develop government securities markets and the money market, which in turn will have a substantial effect on private sector issuances and the availability of longer term investment options. The World Bank has supported this reform through a variety of operations.

10 In contrast to specific provisions, generic provisions are not allocated to any particular loan and thus its use is quite flexible. Specific provisions are tax-exempt as they reflect expected incurred loans, in contrast to generic provisions which provide a general buffer. 11 FOGAFIN guarantees the difference between the actual and minimum return on mandatory pension funds administer by AFPs. It also guarantees the payment of insurance annuities in case of insolvency of the insurer. 12 See IMF 2008 Article IV staff Report.

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The Financial Sector Reform Agenda for the Future

48. The global financial crisis has prompted an ongoing revision of financial architecture and regulation issues that will shape the future reform agenda. In light of the experience from the current crisis, and to prevent future ones, G-20 leaders charged a working group (Working Group on Enhancing Sound Regulation and Strengthening Transparency) with the responsibility for making recommendations to (i) strengthen international regulatory standards, (ii) enhance transparency in global financial markets and (iii) ensure all financial markets, products and participants are appropriately regulated or subject to oversight, depending on their circumstances. The group issued a recent report with recommendations in several areas.

49. The World Bank is engaged with the Colombian authorities regarding the issues for reform identified by the G-20 in the context of the preparation of this operation. In addition to the call for coordination among standard setters, the report included recommendations regarding the scope of financial regulation and supervision, the need for supervision of systemic risks, enhanced capital and liquidity buffers once the crisis subsides, and the adoption of infrastructure supportive of financial stability. Box 2 summarizes the main issues and recommendations for future financial reform in Colombia in light of the global reform agenda, and reflects the Colombian response to some of these issues.

50. Areas where further reform is also needed include strengthening the independence of the superintendence and legal protection of supervisors. Generally, banking rules are established by the MHCP and enforced by the SFC. The current banking law provides autonomy to the Superintendency to regulate and provide technical guidance for the sector. However, in Colombia the chief bank regulatory is appointed by the President of the Republic, which leaves it susceptible to political pressures. The SFC budget is partially subjected to the discretion of the public sector expenditure guidelines. Supervisory authorities and their officers should be protected against lawsuits for actions taken in good faith while discharging their duties.

51. Implementation of effective consolidated supervision would eliminate an important regulatory gap. The SFC can categorize financial conglomerates and require their consolidation for certain reporting and prudential purposes. However, there are no consolidated minimum solvency requirements for the entire group, which currently apply only at the level of individual credit institutions and the bank holding company. In addition, there are still important legal gaps in the definition of a financial conglomerate (i.e. presumption of subordination or ‘dominant influence’), and the scope and conduct of consolidated supervision (e.g. development of a comprehensive and consistent risk assessment methodology), which do not allow supervisors to fully monitor all relevant dimensions of an economic group. The need for multiple institutional vehicles to undertake different activities, due to the absence of a universal banking license, and the restrictions on equity investments for certain financial institutions and other reasons (e.g. tax, security, control) have encouraged the proliferation of complex organizational structures, including several holding companies controlled by their ultimate beneficiary owners via “shell” investment-vehicles (often offshore). The banking and securities businesses tend to be concentrated under the bank holding company, while other financial and real sector activities are controlled through holdings above and/or parallel to the bank. There is currently no regulatory requirement for the creation of a separate financial holding company that would assemble together the different financial institutions of mixed-activity economic groups. The authorities have received technical assistance from the World Bank to develop a framework for consolidated supervision and regulation.

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Box 2 Financial Reform Agenda in light of the G-20 Recommendations

Regulatory and Supervisory Scope. All financial intermediaries are licensed, regulated and supervised in Colombia. Moreover, the existence of a sole supervisor (SFC) further reduces the scope for regulatory arbitrage. However, in this strict regulatory environment, shadow financial intermediaries may arise periodically in order to avoid regulation and supervision. To be able to expand the purview of regulation and supervision, the legal definition of financial intermediation could be revised to include all leveraged credit activities. To facilitate financial innovation and diminish the incentives for shadow intermediation, consideration could be given to allow for unregulated financial institutions, as long as they can only borrow funds from the regulated credit institutions. At the same time as reviewing the perimeter of regulation, some adjustments to the regulation of the core would help enhance its effectiveness. Implementation of effective consolidated supervision and regulation would eliminate an important gap in the existing framework and allow for increased intergroup exposures, improving financial sector efficiency. Rationalization of some of the existing financial intermediary licenses would also improve efficiency. It is also important to note that official regulation of all financial intermediaries, as opposed to market regulation, imposes high burden on the regulators and expands the scope of the safety net and lender of last resort facilities. Hence, for this regulatory construct to work properly it is essential to ensure the independence of the SFC and legal protection for the supervisors. The discretionary powers of the SFC should be enhanced by allowing it to request additional capital charges to cover idiosyncratic risks. A wide set of tools to manage the resolution of failed institutions and promptly repay protected depositors will also be key to preserve the credibility of the system. Regulation and Supervision of Systemic Risks. Colombia, as most other countries, could improve its framework to prevent the buildup of systemic risks. Ex-ante, prudential norms to internalize systemic liquidity risks should be adopted. Ex-post, access to systemic liquidity facilities and deposit insurance should be properly priced to account for these risks. Regarding systemic solvency risks, BdR measures to manage the cycle and prevent credit booms could include capital and/or generic provisioning requirements to cover unexpected tail risks for financial institutions, in addition to traditional monetary policy instruments. Decisions regarding the adoption of these instruments should be taken jointly with the SFC. To strengthen the system and properly manage incentives, prudential regulations and deposit insurance premium should be calculated through-the-cycle and account for systemic risks. In this aspect, Colombia is ahead of the curve as it has already implemented through-the-cycle provisioning regulations. Enhance capital and liquidity buffers once the crisis subsides. Colombia’s regulatory standards have yet to align to Basel rules, as Tier 1 capital is not measured on the basis of full deduction of intangibles, which could lead to an artificially overstated ratio. The authorities have prepared a norm to address this shortcoming to be issued as the turbulence subsides. The recently issued liquidity regulation, supported by this operation, would help improve liquidity management at the institutional level. Future adoption of systemic liquidity requirements would increase liquidity buffers. Enhancements to supporting policies and infrastructure: In this area recommendations include adopting compensation practices to promote prudent risk taking; the greater standardization of derivatives contracts and the use of risk-proofed central counterparties; improved accounting standards that better recognize loan-loss provisions and dampen adverse dynamics associated with fair-value accounting and effective enforcement of international standards including the IOSCO code of conduct for credit rating agencies. Colombia is already advancing in some of these areas. A new Law on Accounting and Auditing standards –which will replace existing Colombian standards with International Financial Reporting Standards (IFRS) and ensure standards adjust in line with developing international best practices– was approved by Congress in early June. A standardized derivatives market, supported by this operation, was launched in 2008. In addition, the authorities are currently developing a proposal to settle OTC derivative transactions through a centralized clearing system.

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52. Congress recently approved the Financial Reform Law, although its implementation requires substantial regulation and its main components do not enter into effect immediately. The main components of the Financial Reform Law (approved by Congress on June 18, 2009) include the introduction of a system of multiple alternative funds −known as multifondos− and consumer protection elements. The multifondos reform allows AFPs to constitute and manage different portfolios so younger workers can choose a higher risk and return portfolio than older workers. The consumer protection aspects regulates standards regarding information, customer service and dispute resolution mechanisms. It also forbids the inclusion of certain terms in financial contracts which would limit competition and restrict the freedom of consumers to terminate the contract and enables the SFC to establish sanctions for financial institutions which violate the requirements established in the Law. The World Bank provided technical assistance to the authorities in these areas ahead of the preparation of the Law. However, the Financial Reform Law is a framework Law, and needs substantial regulation to be implemented, in particular in the multifondos component. The consumer protection component of the Law is expected to enter in effect in July 2010 while the multifondos component is expected to enter into effect 14 months after the promulgation of the Law which is expected to occur by end-July 2009. The MHCP has expressed interest in requesting technical assistance from the World Bank for the preparation of the necessary regulation.

53. Unfortunately, some of the provisions that were recently included in the Financial Reform to help address some of the issues related to the regulatory and supervisory scope were not approved. As the global financial crisis erupted the authorities withdrew the Law from Congress to be able to include new elements. In April, the authorities submitted a new version to Congress for approval which included provisions that would increase the discretionary powers of the SFC and allow it to impose differential requirements across institutions and request additional capital outside of the prompt corrective action framework. While legal protection of supervisors would have remained an issue, a provision would have allowed for the coverage of the legal costs incurred in the defense of supervisors, unless it were proved they acted in bad faith. Another provision enhanced the powers of the SFC to request information, including from abroad, regarding operations of institutions that form part of Colombian financial groups. However, none of these provisions was approved in the final version of the Law. However, the powers of the SFC have been improved somewhat to the extent that new provisions (i) allow the SFC to request external audits, (ii) decisions by the SFC in regards of intervention and resolution of institutions can only be subject to administrative recourse, and (iii) the SFC has to authorized the investments abroad of foreign subsidiaries of Colombian financial institutions. The Law did introduced a provision to provide emergency liquidity facilities trough a special fund administer by the MHCP to financial intermediaries other than credit institutions ‒such as collective portfolios and brokerage houses‒, which do not have access to BdR facilities.

V. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY

LINK TO CPS

54. The current Country Partnership Strategy (CPS) covers fiscal years 2008-11 and is aligned with the country’s development goals as expressed in the 2006-2010 NDP (Plan Nacional de Desarrollo) and Colombia Visión 2019. The authorities requested World Bank support for five pillars of the NDP. The current CPS provides a flexible menu-based mix of financial and analytical services for each pillar tailored to the country’s evolving needs (see Annex 7).

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Table 5. Colombia's Priorities per Pillar in the National Development Plan

55. The proposed operation would help achieve the objective of growth identified in the NDP and supported by the CPS. The NDP period and provides guidance for monitoring results and outcomes. Since the CPS is driven by the Government's NDP, the Bank evaluates ‒as one dimension under its results-monitoring of the CPS‒ how effective the Government is in achieving its own development vision and objectives. The proposed operation supports the pillar related with achieving sustainable growth by strengthening the financial sector and developing the capital markets. The outcome to which the CPS expected to contribute in this area was the achievement of a private sector credit to GDP level of 27 percent, in order to support an average growth rate of 5.2 percent during the period and a yearly average investment rate over 25 percent of GDP. The current global crisis will prevent from achieving the ultimate growth objectives, but the proposed operation would contribute to maintain a level of private sector credit to GDP above 27 percent (private sector credit amounted to 33 percent of GDP at end-2008) mitigating the negative impacts on the crisis.

56. The proposed operation is within the envelope envisioned in the current CPS. The CPS proposes to maintain an active IBRD lending program of up to US$4 billion. Programming is done on an annual basis, synchronized with the national budget process, and based on a demand-driven “menu” approach.

COLLABORATION WITH THE IMF AND OTHER DONORS

57. Bank and IMF staff maintains strong coordination and cooperation on macroeconomic policies. The Fund had a US$613 million precautionary stand-by arrangement with Colombia through the end of 2006, and no disbursements were made during the period. Colombia recently obtained US$10.5 billion as a one-year precautionary arrangement under the IMF’s Flexible Credit Line (FCL). The Fund conducted the mission for the 2008 Article IV the first week of November. Bank staff attended the IMF team’s Article IV pre-mission briefing and there have been frequent consultations both on macroeconomic issues and financial sector issues.

Peace and Security for Citizens

Promotion of Equity High Sustainable Growth Environmental Sustainability

A State at the Service of its Citizens

Consolidate "Democratic Security" Policy

Poverty and Vulnerable Populations

Macroeconomic Conditions

Integral Management of Water Resources

Requirements of Communal State

Displacement, Human Rights and Reconciliation

Market and Labor Relations

Productivity and Competitiveness

Territorial Environmental Planning

Challenges of a Communal State

Social ProtectionHigh Impact Sector-Specific Programs

Sustainable and Competitive Production Processes

Access to CreditAgro/Competitiveness and Growth

Prevention/Control of Environmental Degradation

Livable CitiesSaving, Investment and Finance

Strengthen National Systems (SINA) to Promote Environmental Governance

Equity and Rural Development

Physical Capital Formation

Infrastructure for Development

Energy Supply

Risk ManagementInstitutions and National Policies

Traversal Themes run throughout the pillars and include Gender, Youth, Ethnic Groups and Intercultural Relations, Culture Demography and Development, Science and Technology, Migration Policy, Foundations and Cooperatives, Promotion of Economic Solidarity, International and Regional Dimensions of Development.

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58. The Inter-American Development Bank (IADB) also supports the Government agenda to foster competitiveness to ensure high sustainable growth. The IADB Operational Strategy 2007-2010 for Colombia supports as well the main pillars of the Governments NDP. Specifically, in the area of developing mechanisms to ensure access to finance for private corporations, recent IADB projects have focused on ensuring a sustained flow of credit to the private sector and sub-national governments. Collaboration between Bank staff and IADB staff working on these operations has been fluid.

• In 2008, the IADB approved a US$650 million for BANCOLDEX, a second tier public development bank. The operation provides domestic and foreign currency funds through credit lines that will in turn be provided to domestic financial institutions to extend commercial credit. It also provides co-financing and risk-sharing products and technical assistance.

• In 2008, the IADB also granted a credit line of US$200 million to FINDETER a public

financial institution that provides funding for investment programs of sub-national governments, to finance the program "Financiamiento a Entidades Prestadoras de Servicios Públicos". The objective of this program is to fund infrastructure projects and the provision of public services in different Colombian Departments.

• In 2009, IADB has undertaken two programs to provide funds for SMEs. They launched a

program for small and medium businesses to become more competitive, thereby facilitating access to finance for them (FINPYME). Also Bancolombia joined IADB’s Trade Finance Facilitation Program (TFFP). FINPYME is part of the Inter-American Investment Corporation and is a collaboration of Colombian universities, the Chamber of Commerce and Banks. The program will perform diagnostic reviews of SMEs by management experts. Banks will be able to provide technical assistance for business improvements as well is offer a variety of financing options. The TFFP is a program that encourages economic growth through expanding financing availability for international trade activities of Latin American and Caribbean countries. As part of this program, IADB extends guarantees to cover letters of credit, promissory notes, bid bonds, performance bonds, advance payment bonds and other instruments used in international trade transactions that are issued by Bancolombia.

• The Multilateral Investment Fund (MIF) has provided funding to various microfinance

programs13. In 2007, the project “Creation of New Microfinance Institutions to Increase Access to Microentrepreneurs’ was developed to increase the financial services to SMEs through the creation of specialized banks in microfinance in Colombia. Also, MIF investment in the Colombia Opportunity Fund ‒a venture capital fund to support SMEs‒ was approved in 2008.

59. The US Agency for International Development (USAID) Economic Growth Strategy also addresses barriers to improve competitiveness in order to foster growth. Securing the Future: A Strategy for Economic Growth (2008) aims to (i) improve the environment for enterprise growth and competitiveness; (ii) strengthen economic policy and governance; (iii) create sound, well-governed financial systems; (iv) support legal and institutional reform; (v) support microfinance programs and business services for micro and small enterprises; and (vi) build trade capacity. The Bank team meets periodically with the USAID Mission in Colombia and there has been close collaboration particularly on areas related to financial sector reform and the potential impact of fiscal reforms on

13 The MIF, part of the IADB group, provides technical assistance, grants and investment funding to public and private organizations engaged in innovative development projects.

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competitiveness. USAID is also supporting, jointly with the IFC, the process of preparation and dissemination of regional (i.e., at the Colombian sub-national level) Doing Business reports.

RELATIONSHIP TO OTHER WORLD BANK GROUP OPERATIONS

60. This operation builds on the work conducted by several operations and non-lending services that have strengthened the financial system and developed the capital markets. During the last decade, several World Bank operations have supported the policies of the authorities regarding the financial sector in the context of a fluid and ongoing policy dialogue with the GoC. Several other bank operations support the other pillars of the NDP that are also included in the CPS. Some of the key operations in the financial sector area include (see Annex 6 for details):

• The Financial Sector Adjustment Loan Series which supported the 2003 Financial System Reform Law as well as insurance and pension system reform. The loan series also supported the adoption of risk supervision framework, the creation of an integrated financial supervisor (the SFC), dismantling of insolvent state banks and the approval of the 2005 Securities Law.

• The Business and Productivity and Efficiency DPL series which supported the merger between bank and securities supervisors into the SFC, and policies regarding (i) access to finance and money market development, (ii) regulations developing aspects of the 2005 Securities Law and (iii) the reform of the framework to deal with ML/CFT.

• NLTA on Financial Competitiveness, which looked at issues of financial deepening and competitiveness, including issues related to credit information, financial taxation, insolvency procedures and financial sector structure.

• FIRST: Colombia Money market development, which aimed at strengthening the primary and secondary market for government securities. In the context of this project the World Bank provided technical assistance in the analysis, design, and implementation and testing of a technological platform for the securities borrowing and lending operation.

• Financial Crisis Simulation exercise. The exercise tested how the authorities would work together in managing a financial crisis, and provided recommendations for follow-up work to strengthen crisis management arrangements in Colombia.

• NLTA on Pensions and Financial Sector Deepening which provided input regarding (i) the introduction of multifondos schemes for mandatory retirement pensions (ii) supervision and regulation of financial conglomerates (iii) consumer protection legislation, and (iv) the regulation of OTC markets.

61. The IFC has also been promoting the development of capital markets and access to finance for underserved sectors. The IFC has sought to increase the efficiency of capital markets and develop a sound regulatory framework. This has included initiating the first Colombian Peso-denominated bonds issued by a multilateral financial institution, assisting with the establishment of Colombia’s first secondary mortgage company, strengthening institutional investors, and consolidating the domestic capital market with partial credit guarantees for corporate bonds as well as debt and equity facilities to leading financial groups. Additionally, the IFC has provided support for housing finance, micro, small and medium enterprise financing, and the domestic securities market through equity investments and debt facilities. In housing finance, the IFC provided support for the development of the mortgage sector through partial credit guarantees, which included support for the issuance of nonperforming mortgage-backed securities. IFC also has projects in the pipeline that will help promote mortgage lending, standardize the underwriting criteria for loans and help build a pool of mortgage securities for the capital markets. The IFC is planning an equity investment to support Covinoc Equity. Covinoc specializes in the recovery of nonperforming assets in the financial system and will thereby help in maintaining its ability to administer loan and other financial asset portfolios.

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LESSONS LEARNED

62. The design of the proposed operation takes into account the lessons learned from the overall program with Colombia and in general from Bank work with other middle-income countries. In particular, the most important lessons are the following:

(a) Operations should be focused and avoid large and complex policy matrices. Rather than seeking to cover an extensive list of measures the design of this DPL has sought to concentrate on those that address the cornerstones of financial sector strength –including capital and liquidity buffers and powers to intervene in the sphere of financial intermediation− as well as the remaining key areas of securities market reform pending regulation.

(b) The importance of flexibility to respond to changing circumstances. In order to implement a lending program that best addresses Colombia’s needs as a creditworthy middle income country, the Bank needs the flexibility to be able to respond quickly to changing circumstances. This is particularly important in the context of the current global financial and economic crisis.

(c) The value of prior strong analytical work. In preparing private sector development and financial sector policy-based operations, the Bank should lead with its comparative advantage which is bringing to bear strong technical capacity and ample cross-country experience. The Borrower must be confident that its dialogue with the Bank will add value to its own efforts. The Bank has maintained a very fruitful dialogue with the GoC during the current CPS period , as well as in previous years, leading to the preparation of analytical work that has assisted Colombia in the capital market reform supported by this DPL

(d) The need to take into account the political economy of reform. In designing a policy-based operation, political factors and the legislative needs of the country need to be understood and included in the dialogue with the client. To be able to address the needs of the borrower in a timely manner, the proposed operation contains a strong package of reforms that did not required Congressional approval.

(e) The commitment of the Government is central in ensuring the success of the program. Previous policy-based and investment operations all pointed to the important role of strong government leadership in their success. The proposed operation effectively responds to the GoC’s own priorities and commitment as reflected in the actions already taken as well as the fact that the policy thrust supported by this operation lies directly along the key policy axes of the Government’s NDP and the strategy to face the global financial crisis.

(f) Coordination with other international financial institutions, such as the IMF, is critical to ensure a consistent policy approach towards borrowers. This proposed operation builds on close collaboration with the IMF on overall economic policy and financial sector advice.

ANALYTICAL UNDERPINNINGS

63. Analytical work undertaken by the Basel Committee. As enhancing supervision of liquidity became more relevant, global bank supervisors from global central banks and supervisory agencies

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endorsed the Basel Committee's Principles for Sound Liquidity Risk Management and Supervision14. These principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process, as introduced in the regulation supported by this operation. The role of supervisors is highlighted, including the responsibility to intervene to require effective and timely remedial action by a bank to address liquidity risk management deficiencies.

64. Work undertaken by the international forums Financial Sector Working Groups. After the deepening of the current financial turmoil, the G30 Financial Regulatory Systems Working Group released the report “Financial Reform: A Framework for Financial Stability”15 where they proposed four core recommendations: i) gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated. ii) the quality and effectiveness of prudential regulation and supervision must be improved, including better-resourced prudential regulators and central banks operating within structures that afford much higher levels of national and international policy coordination; iii) institutional policies and standards must be strengthened, with particular emphasis on standards for governance, risk management, capital, and liquidity, and also guarding against procyclicality; iv) the infrastructure supporting financial markets must be made more transparent and much more robust and resistant to potential failures of even large financial institutions. The G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency also has published several reports underlying the importance of such reforms (see paragraph 48). The “Financial Stability Forum Report on Addressing Procyclicality in the Financial System” notes that addressing procyclicality in the financial system is an essential component of strengthening the macroprudential orientation of regulatory and supervisory frameworks16. The report presents the importance of strengthening the regulatory capital framework so that the quality and level of capital in the banking system increases during strong economic conditions and can be drawn down during periods of economic and financial stress, as done in the regulation supported by the proposed operation.

65. The 2005 Colombia FSAP update identified the modernization of the regulatory framework for securities markets as key to increase liquidity, to stimulate investment and to promote economic growth. The report noted that the review of the securities regulatory regime would contribute to create an efficient institutional framework. Essential factors in the reform include the introduction of suitable regulations, supervision capable of enforcing the regulations and the implementation of international standards. The FSAP indicated that the amendment of regulatory framework planned by the GoC was in line with best international practices and would improve investor’s rights protection, promote market efficiency, integrity and trustworthiness among parties, and prevent systemic risks. The 2005 FSAP noted that market depth and liquidity were attributable to the scarce supply of investment securities by local corporations, and deficiencies in the clearance and settlement systems, in addition to investment restrictions, issuance costs, taxation and the lack of fixed income hedging instruments. Some of these constraints are addressed in the policy actions supported by this operation.

66. World Bank Technical Assistance Reports. As previously discussed, the World Bank has provided extensive technical assistance in financial sector issues to Colombia. This operation has specially benefited from the inputs provided by two reports; (i) FIRST Money Market Development report discussion on securities trading platforms and (ii) NLTA Pensions and Financial Sector Deepening report regarding the regulation of OTC markets.

14 BIS, Basel Committee's Principles for Sound Liquidity Risk Management and Supervision, September 2008. 15 G30 Financial Reform Working Group, Financial Reform: A Framework for Financial Stability, January 2009. 16 Financial Stability Forum, Report on Addressing Procyclicality in the Financial System, April 2009.

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VI. THE PROPOSED FINANCIAL SECTOR DPL

OPERATION DESCRIPTION

67. The proposed operation supports ongoing reforms to strengthen financial sector resilience and deepen securities markets to sustain growth. Recently adopted prudential measures increase banks’ capital buffers and enhance the supervision of liquidity risks. Also, in the wake of the recent collapse of pyramid schemes, the framework for the intervention of unauthorized financial intermediaries has been substantially strengthened. The latest securities market regulations complete financial markets to ensure efficient risk-sharing and capital allocation and reduce systemic risks. The regulations have made possible the creation of a central counterparty clearing house and the creation of an exchanged-trade derivatives market. The upgrades in market infrastructure and its regulation, norms enhancing investor protection and the regulation of derivative activities will help develop further the Colombian securities market. The proposed operation would help achieve the objective of promoting savings, investment and finance to achieve sustainable growth as identified in the Colombian NDP and supported by the current CPS.

68. The proposed operation is single-tranche Development Policy Loan in the amount of US$300 million. At this stage, a US$300 million transaction is appropriate in light of the financing needs of the authorities and the strength of the package of financial sector reforms undertaken. The only condition of effectiveness will be the standard issuance to the Bank of the legal opinion referred to in Section 9.02 of the General Conditions. Such opinion shall be issued by the Head of the Legal Affairs Group of the Directorate of Public Credit and National Treasury of the MHCP.

69. In addition, the World Bank continues its dialogue with the authorities regarding future financial sector reforms. The dialogue is fluid regarding both reforms to be implemented in the medium-term arising from G-20 agenda as well as those related to the implementation of the Financial Reform Law. An additional DPL could be considered for the next year to support the implementation such reforms if necessary.

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Box 3: Good Practice Principles on Conditionality Principle 1: Ownership: The CPS is directly aligned with the country’s development goals expressed in the 2006-2010 National Development Plan and Colombia Visión 2019. The government requested World Bank support for five pillars of the NDP. The proposed operation would help achieve the objective of growth-as identified in the National Development Plan-by supporting authorities’ efforts to strengthen the financial sector and continue developing capital markets. Principle 2: Coordinated Accountability Framework: The program document defines the actions agreed with the government and summarizes expected outcomes in a program matrix. Contact with other multilaterals which also support policy actions in key program areas such as macroeconomic stability and financial sector development has been fluid, including during the preparation of the operation. Principle 3: Customization: The program document supports a substantial portion of the authorities’ development strategy to strengthen the financial sector and develop the capital markets, which have been at the core of the financial development agenda for the government in the last decade. Furthermore, the DPL has been specifically designed around Colombia’s current problems in face of the global financial turmoil and its recent challenges in adopting measures to discourage unregulated financial intermediation activities affecting the sector. Principle 4: Criticality Actions: The program matrix contains 5 prior actions considered to be the most critical policies to achieve the program’s objectives. Principle 5: Transparency and Predictability: The program matrix clearly states expected outcomes and indicators in a transparent manner. Progress towards meeting the long term goals of the program will be monitored under the new FY12-FY15 CPS for Colombia.

POLICY REFORMS SUPPORTED BY THIS OPERATION

70. The reforms supported by this operation are summarized in the Policy Matrix contained in Annex II and have already been implemented by the authorities. The supported reforms cover three main areas and are described in the following paragraphs.

Strengthening Prudential Regulation and Supervision

71. Strengthening the financial system to withstand the headwinds of the global crisis is a priority for the authorities. Financial crises exert an important toll in terms of output decline, which in turn has negative consequences in terms of poverty and social indicators. Leaven and Valencia estimate that the average costs of financial crisis amount to 16 percent of GDP17. In addition to the costs in current GDP losses, financial crisis result in financial disintermediation which in turn has an important negative effect on potential output. While the 1999 Colombian financial crisis had a relatively modest effect in terms of GDP growth (about 4 percent contraction in 1999 followed by positive growth in 2000), private sector credit as a share of GDP remains modest and has yet to recover its pre-crisis level.

72. To improve the resilience of the Colombian credit institutions, the SFC adopted a countercyclical policy by instructing credit institutions to capitalize 2008 profits in December

17 Laeven, L. and F. Valencia, 2008. “Systemic Banking Crises: A New Database”, Working Paper No. 08/224, International Monetary Fund.

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2008. To increase capital buffers, the SFC instructed credit institutions to retain part of the profits obtained during the period June-December 2008 to constitute a capital reserve18. Credit institutions will use the capital reserve to absorb eventual credit losses during the next two years. At end-2010, the unused part of the reserve could be used at the discretion of the institutions. The aim of the instruction, as in the case of the countercyclical provisions, is to strengthen institutions resiliency by constituting buffers in good times to mitigate the effect of the deterioration in credit quality during the downward part of the cycle.

73. Total retained profits for the system amounted to about COP$2.1 billion. The SFC, taking into account the results of the stress-tests to assess the potential impact of credit losses (see paragraph 33), established the percentage of profits to be capitalized by credit institutions. The percentage −ranging from 90 percent to the average profit capitalization of the last three years− is a function of the institutions’ non-performing loan portfolio, provisions and regulatory capital. If shareholder meetings failed to approve the retention of profits proposed by the SFC, a norm would be issued forcing the capitalization. All institutions approved the retention of profits for, at least, the amount indicated by the SFC. As a result of the measure, the CAR of the credit institutions increased to 15 percent in January 2009, up from 13.4 percent at end-2008 while for the banks increased from 12.7 percent to 14.1 percent. The measure brought the Colombian banking system’s capital level close to the level in other countries in the region.

74. The SFC also introduced a norm to enhance liquidity buffers and improved the supervision of liquidity risks. The new regulation (Circular Externa 16/2008) mandates financial institutions, except for insurance companies, to develop and implement internal systems to measure and administer liquidity risks with a view to improve their preparation to manage such risks. The internal systems should comprise policies and procedures to deal with liquidity risk − including internal limits, remedial actions, and contingency plans− as well as a framework to measure such risk. In the case of credit institutions, the new regulation provided a standardized framework to compute the liquidity gap (assets minus liabilities) for different time brackets. To increase liquidity buffers and prevent reliance in short-term wholesale funding, credit institutions shall now hold enough liquid assets to cover liabilities potentially due within one week19.

Strengthening the Framework for the Intervention and Resolution of Unauthorized Financial Intermediation Activities

75. Financial intermediation is strictly regulated in Colombia. Financial activities including deposit taking, securities intermediation and the public offering of securities require SFC authorization. In addition, Decree 1981/1988 states that collecting money from the public in a massive and habitual manner without the proper authorization is an administrative and criminal offense. The Banking Law (Estatuto Organico del Sistema Financiero, EOSF) provides the SFC with the authority to conduct on-site inspections on unregulated entities, as well as to examine their records, when there is evidence that the entity is undertaking a financial activity without authorization. In addition, it provides the SFC with the authority to impose certain precautionary measures on entities

18 Evidenced by Letter No2009037259-000-000, issued by the SFC on May 8, 2009. 19 The regulation mandates credit institutions to compute a liquidity risk indicator (Indicador de Riesgo de Líquidez, IRL) as the difference between liquid assets and liquidity requirements. Liquid assets are defined as cash and tradable securities (adjusted by a haircut) minus mandatory reserve requirements. Foreign currency and securities denominated in foreign currency have also a haircut for exchange rate risk. The liquidity requirements are the expected net cash-flows during the next seven days, including assets minus liabilities maturing within one week (both on-balance and off-balance sheet) plus a proportion of current account and savings deposits (based on historical observations of withdrawals). The IRL has to be positive.

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that undertake financial activities without authorization, although it required that the evidence meet the standards set by Decree 1981. Such measures include: (i) immediate suspension of the activities undertaken; (ii) liquidation of the entity; and (iii) fast and progressive liquidation of the operations undertaken illegally. Failure to comply with the order of suspension carried an administrative penalty of up to 61 million pesos (Decree 2269/1987, which regulates Article 65 of the Administrative Code). According to Article 316 of the Law 599/2000, taking money from the public in a massive and habitual manner without authorization constitutes an offense punishable with up to six years in prison.

76. A particular type of unauthorized financial intermediary, unregulated investment schemes (UIS), had grown quickly in Colombia. The schemes had expanded quickly through a system of referrals by existing members and offered unusually high returns (up to 300 percent within 6 months). Such schemes are pervasive and persistent phenomena and emerge on a regular basis even in developed countries with strong regulatory frameworks, as shown by the recent experience in the United States with an US$50 billion alleged Ponzi scheme run by Bernard Madoff. The Colombian UIS drew funds mostly from the poor, but their appeal broadened over time. One of the largest schemes, Grupo DMG, had been in operation for three years, and had over 60 branches in Colombia as well as offices in Venezuela and Ecuador. DMG operated a sophisticated scheme; it distributed pre-paid credit cards which investors could use to buy appliances and consumer electronics from selected retailers. Customers could also collect points which could be redeemed for cash after several months. The scheme offered a return of 150–300 percent on this investment. Customers also became salesmen. It remained current on its obligations for three years, even after other schemes collapsed.

77. The authorities had been aware of the existence of such UISs, but taking measures under the existing legal framework proved difficult. As the SFC became aware of such activities, it issued public warnings in newspapers regarding the unregulated nature of the schemes and imposed precautionary measures for several UISs. Such measures mainly included an order to cease the illegal activities and return the money collected from the public, based on a restitution plan to be submitted by each entity to their regulatory agency or to the district court. In the case of DMG, the SFC also passed the investigative file to the Prosecutor’s office, specifically to the unit in charge of money laundering crimes. However, the requirements established by the Decree 1981/1998 to consider that such misconduct has taken place are quite onerous. The SFC had to extensively document and prove that financial resources were being collected from the public over an extended time. Doing so requires accounting information, which is difficult and time consuming to collect given the unreliability of the accounting records of the UIS and the intensive use of cash that prevailed in such schemes, preventing any traceability of transactions. In addition, in many cases sophisticated schemes were designed to resemble legal activities, and this complicated the collection of evidence. Even in cases where the SFC was able to impose precautionary measures, some of the schemes continued to operate by creating new vehicles different from the ones initially penalized.

78. The measures adopted by the GoC in late 2008 and supported by this operation strengthened the framework for the intervention of UIS, allowing for swift action against existing pyramid schemes. The collapse of a scheme called DRFE (the Spanish initials for “Fast, Easy Money in Cash”) led to rioting and violent protests in 13 cities in Colombia. On November 17, 2008 the Government declared a state of social emergency by Decree 4333/2008. According to the Colombian constitution, it is possible to regulate certain topics by Decree under the state of emergency. Under these powers, the government issued two other important decrees to strengthen its ability to deal with UIS, stop their operation and recover funds. The Constitutional Court announced that Decrees 4333, 4334 and 4335 were in compliance with constitutional requirements in all the relevant issues supported by this operation.

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(a) Decree 4334/2008 provides the government, via the Superintendency of Companies (Superintendencia de Sociedades, SS), the authority to intervene in the operations of any entity that undertakes the collection of resources or cash from the public without authorization. The SS can act “de motu propio” or at the request of the SFC. The burden of proof to intervene is substantially reduced. The SS can now intervene if there are “notorious and objective facts” that the SS considers proof of collection of resources from the public. Administrative intervention (a legal mechanism similar to conservatorship) comprises a wide range of measures aimed at halting the operation of UIS and establishing an organized procedure to return resources to the affected persons. Thus, it allows the SS to take strategic and precautionary measures, including taking control of the entity and possession of all its assets, ordering the freeze of assets, and returning funds to the affected persons. All those measures can be imposed by the SS directly, without the need for court approval.

(b) Decree 4335/2008 provides the heads of local governments (Mayors and Governors) with the power to impose certain precautionary measures (including closing of the premises) on entities located in their respective jurisdictions that are undertaking financial activities without authorization.

79. The measures adopted in this area will discourage unauthorized financial intermediation, preserving financial sector stability and protecting the poor. Unauthorized intermediaries, even if they are not fraudulent like the pyramid schemes, are more prone to failure given the lack of supervision and regulation. The collapse of these intermediaries could undermine the confidence in the regulated financial system and have potential sever consequences. Also the regulation will help prevent the socio-economic strife that occurs when a large number of households are suddenly exposed to losses. Finally, the regulation will protect financial consumers from these unregulated intermediaries. The poor, which according to anecdotic evidence are specially targeted by these intermediaries, would benefit most from these regulations20. With the powers provided by these regulations several smaller UIS have been intervened in the first half of 2009 sending a powerful signal on the consequences of such type of activities.

Securities Market Reform

80. The proposed operation supports the implementation of most of the remaining key aspects of securities market reform. Specifically, the supported reforms upgrade market infrastructure with a view to reduce systemic risks and encourage market development. The reforms also review the regulation of securities intermediation activities and, for the first time, regulated derivative operations.

Upgrading Market Infrastructure

81. Efficient market infrastructure fosters market development by reducing transaction costs and systemic risks. Transaction costs are reduced as volumes and market liquidity increase, which depends on confidence in the safety and reliability of the settlement and trading arrangements. Upgrades in market infrastructure are necessary to develop certain products such as exchange-traded derivatives. To ensure efficient and smooth functioning of the systems, the adoption of these infrastructure upgrades need to be properly regulated. This has been done through the approval of a package of decrees during 2007-2008.

20 For a discussion on the effects on UIS and the operations of pyramids in Colombia see Carvajal, A., Monroe, H., Pattillo, C. and Wynter, B., 2009. “Ponzi Schemes in the Caribbean”, Working Paper No. 09/95, International Monetary Fund.

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82. Securities settlement systems (SSSs) are a critical component of the infrastructure of securities markets and its function needs to be properly regulated. Weaknesses in SSSs can be a source of systemic disturbances to securities markets and to other payment and settlement systems. As pointed in the CPSS-IOSCO recommendations, problems at a major user of an SSS could result in significant liquidity pressures or credit losses for other participants. In addition, disruption of securities settlements can spill over to any payment system used by the SSS or any payment systems that use the SSS to transfer collateral21. The new regulation (Decree 1456/2007), strengthens SSSs by establishing the criteria to determine the finality of settlements in securities transactions, providing legal certainty to market participants undertaking said transactions. Previously, trades could be nullified although they had been agreed by participants creating market instability and insecurity. The reform forces participants to settle their positions executing the guarantees if necessary to secure payment and preventing the unwinding of positions in case of bankruptcy. The regulation also establishes requirements for the administrators of SSSs. The regulation also establishes the requirements for the bylaws of the SSSs, including procedures to ensure delivery-versus-payment for all securities transactions among domestic participants.

83. Another important infrastructure upgrade to foster market development is the adoption of automatic trading systems. To ensure the efficient functioning of the trading systems, the authorities regulated automatic trading and registration systems. Decree 1120/2008, establishes a series of requirements including authorization by the SFC, the duties of trading systems administrators, information technology, security and transparency requirements. The reform responds to the needs introduced by the technological changes with a view to protect investors’ rights and reduce operational risks in trading systems.

84. Finally, a central counterparty clearing house (CCCH) was established and regulated to launch an exchange-traded derivative market. Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes an initial margin from both sides of the trade to act as a guarantee. An ETD market requires a CCCH, which is a financial services company that provides clearing and settlement services for financial transactions (the payor actually pays the clearing house, which then pays the payee). Following the issuance of Decree 2893/2007, which regulated the functioning of the CCCH −including its corporate structure and governance, registration and capital requirements− the standardized derivatives market started operating on September 1, 2008. So far, the only future traded in the standardized market is a future over a notional 5 year government bond. Soon it is expected that other futures begin to trade including futures on the stock market index, exchange rate futures and commodities futures. Currently, there is a proposal to settle OTC derivatives through the CCCH to improve transparency, reduce counterparty and systemic risks in line with G-20 recommendations.

Enhancing Market Architecture and operations

85. Capital markets cannot flourish without a solid market structure. Therefore, developing the securities markets requires appropriate regulation of intermediaries and the operations and transactions that can be negotiated and executed in the market. In this area, the authorities have placed substantial emphasis in the last two years.

86. The new regulation regarding intermediation activities reflects the stricter requirements for transparency, corporate governance and professionalism imposed by the Law 964/2005 in

21 See CPSS-IOSC0 (2001) “Recommendations for Securities Settlement Systems”, BIS, OISCU-IOSCO.

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order to protect investor rights. The regulation defines what constitute securities intermediation and securities operations. It establishes the principles, policies and procedures applicable to securities intermediaries –including know-your-costumer rules– to enhance market intermediaries’ professionalism. In particular, the regulation establishes the distinction between “professional investors” and “investor clients”. The latter need to be offered advice consistent with their lack of expertise (a measure to protect investor rights). Only brokerage houses can act as securities brokers. Proprietary investments of the brokerage house need to be strictly separated from clients’ investments to protect their investments in case of legal actions against the broker and to avoid misuse of client resources on risky investments on behalf of the broker. (Decree 1121/2008).

87. The regulation also increases the transparency of OTC markets. The Decree 1121/2008, defines what is an OTC market, who can participate in the market and what type of operations can be performed. In order to increase transparency of the market, it requires mandatory reporting of all OTC transactions to a securities trading registry, regulated by the SFC. OTC derivative transactions shall be settled through systems that guarantee delivery-versus-payment.

88. Finally, derivative products have been regulated for the first time in Colombia to promote hedging of market exposures among market participants, particularly pension funds and insurance companies. To this end, the authorities regulated derivatives trading (both in OTC and ETD markets), including trough the issuance of accountancy criteria, as well as the treatment of exposures for the purpose of computing counterparty credit risks in line with international standards (Decree 1796/2008). Risk hedging products are fundamental to cope with the macroeconomic and financial volatility that characterizes emerging economies and pose significant growth risks. In addition, the development of derivative products fosters securities market development which in turn supports economic growth. Risk hedging will stimulate trading in other products as investors will be better equipped to manage their exposures to different risks while deep and liquid derivative markets enhance price formation for the underlying products.

VII. OPERATION IMPLEMENTATION

POVERTY AND SOCIAL IMPACTS

89. The proposed operation supports policies that seek to reduce poverty, through fostering sustainable economic growth. A favorable stronger, more efficient, and more diversified financial system and capital market can provide the opportunity to private enterprises (the engine of economic expansion) to access a larger amount of resources. The relationship between capital market development and economic growth is well established in the economic literature. Schumpeter (1911) argued that the services provided by financial intermediaries are paramount for technical innovation and economic growth22. Hicks (1969) believed that technological innovation alone did not ignite the sustained growth in eighteenth century England; financial innovations were the sine-qua-non of the industrial revolution23. In a seminal paper, Levine and Zervos (1996) found a positive correlation between an index of capital market development −including factors such as market capitalization, total value traded and turnover ratios− and long term growth using panel data24. Several studies have also

22 Schumpeter, J.A., (1911). The Theory of Economic Development. Harvard Univ. Press, Cambridge, MA. 23 Hicks, J.,(1969). A Theory of Economic History. Clarendon Press, Oxford. 24 See Levine, R. and Zervos, S. (1996) “Stock Market Development and Long Run Growth”, World Bank Economic Review, Vol. 10, No 2, pp. 323-339.

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found feedback effects between financial development and macroeconomic growth25. Capital market development not only promotes economic growth but it can also improve income distribution as capital markets level the playing field facilitating the access to finance without the need of collateral. The proposed operation advances the CPS’s aim of promoting fast and sustainable growth through stimulating private sector activity and investment.

90. Prevention of financial crises is also essential to poverty alleviation. Years of consistent economic growth throughout the 1980s and early 1990s lifted many households out of poverty in Colombia, but the macroeconomic crisis at the end of the 1990s eradicated more than a decade of progress. As previously indicated, Leaven and Valencia estimate that the average costs of financial crisis amount to 16 percent of GDP26. In addition to the costs in current GDP losses, financial crisis result in financial disintermediation which in turn has an important negative effect on potential output. In the case of Colombia, as stable economic growth resumed in the last few years national poverty measures have begun to improve again. The ongoing global financial and economic crisis has severely deteriorated macroeconomic conditions and heightens financial sector vulnerabilities. For example, in light of the recent crisis, Ravallion (2009) has estimated the global declining trend of poverty will be continue but at a less precipitous rate27. As the global economy continues to contract in 2009, he anticipates in absolute terms more than 64 million people will fall into further poverty measured at US$2 a day and the continued progress of global poverty decline will continue albeit at a slower pace with varying degrees of impacts on income distribution and inequality. In strengthening the financial system through greater market integrity and enhanced prudential regulation, the proposed program helps to reduce the risk of future financial crises.

91. The measures adopted to prevent the growth of unregulated financial intermediaries would help protect savings of low-income households. Although data on the earnings of investors of the failed pyramid schemes is not available, there is substantial anecdotic evidence that low-income households were the primary customers of the pyramid schemes that collapsed recently, and many modest families lost their savings as a result. The measures supported by this operation would help preventing the formation and growth of such fraudulent schemes by granting authorities the power to intervene swiftly.

92. The overall distributional effects of the policies supported by the program document are not likely to be significant. The program can be reasonably expected to contribute to reducing poverty in Colombia, but its impacts would be difficult to quantify because the drivers of economic growth and poverty reduction are multiple and intertwined. Many of them, including international economic conditions and commodity prices, are beyond the control of the GoC or the scope of this program (see reference to analytical work on poverty paragraph 63-66 and Annex 6).

ENVIRONMENTAL ASPECTS

93. This loan is not expected to have a significant effect on the environment. None of the three policy areas covered by this operation (strengthening prudential regulation and supervision, strengthening the framework for the intervention and resolution of unauthorized financial intermediation activities and reforming securities markets) are expected to have a direct and significant

25 See for example Luintel, K., and Khan, M. (1999) “A quantitative reassessment of the finance–growth nexus: evidence from a multivariate VAR”, Journal of Development Economics, Vol 60. No. 2, pp 381-405. 26 Laeven, L. and F. Valencia, 2008. “Systemic Banking Crises: A New Database”, Working Paper No. 08/224, International Monetary Fund. 27 Chen, S., Ravallion, M., “The Impact of the Global Financial Crisis on the World’s Poorest” Vox Research-based policy analysis and commentary from leading economist” April 30, 2009.

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effect on the environment. They could have an indirect effect through increased economic growth and production but Colombia is well prepared to address them.

94. The GoC is better prepared to identify potential environmental impacts and to address them given an ongoing program of reforms to improve its environmental management capacity. The GoC has engaged in a number of activities to protect the environment and has embarked on an extensive environmental reform program with the support of the Bank. The government prepared a strategy outlined in the 2006-2010 NDP, which focuses on guaranteeing sustainable growth and reducing poverty by improving cross-sectoral planning and calling for the strengthening of the National Environment System (SINA). As a result, the GoC now has greater institutional capacity to plan and implement policies to ensure environmentally sustainable development. Institutional capacity is expected to keep improving in the future and the Bank plans to keep accompanying the GoC in this process through the Programmatic Series of Development Policy Loans for Sustainable Development and the Sustainable Development Investment Loan.

95. The Programmatic Series of Development Policy Loans for Sustainable Development is contributing to strengthen the GoC’s environmental policy framework and institutional capacity. The first loan of the program was completed in FY06 and provided groundwork for many of the strategies and reforms included in the NDP. The second operation of the program, which was completed in June 2007, focused on the development and passage of sustainable development policies to improve the effectiveness and efficiency of the SINA and integrate the principles of sustainable development into the key sectors of water and urban air quality. Finally, the third loan of the program focuses on the results of implementing the sustainable development policies supported by the previous operations.

CONSULTATIVE PROCESS

96. The value of a broad consultative process to feed in the design of the operation to ensure country ownership and the success of the reforms is necessary for broad social support. The World Bank, in its long engagement on financial sector issues with Colombia (see Annex 6), has maintained a close dialogue with financial authorities, financial institutions and the users of financial services (consumer associations as well as representatives of the corporate sector). Such close dialogue was followed also in the preparation of this operation. The measures to strengthen the financial sector and to strengthen the framework to intervene in unauthorized financial intermediaries enjoy broad support among stakeholders. The securities market reform was identified as a key reform in the NDP 2002-2006 that was preceded by a broad consultative process with broad stakeholders, including several rounds of discussions with citizens and sub-national governments to ensure national ownership.

IMPLEMENTATION, MONITORING, AND EVALUATION

97. The objectives of the proposed operation are aligned with those identified by the civil society in creating the National Development Plan. The formulation of the NDP 2006-2010 was by Visión Colombia 2019 and the NDP 2002-2006. Both documents were results of an extensive consultative process with broad stakeholders, including several rounds of discussions with citizens and sub-national governments to ensure national ownership. NDP 2006-2010 long term goal is to achieve higher, sustainable economic development in Colombia. The proposed DPL is directly supporting the 2006-2010 NDP’s objective through the implementation of the securities reform, indentified as a prioritary reform in the DNP. Other measures supported by this DPL are motivated by the current financial crisis and the management of its effects, which prevents civil society consultations. However, the objectives of such measures are fully aligned with the objectives of identified in the NDP of promoting sustainable growth.

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98. The MHCP is responsible for the implementation of the proposed DPL as well as for coordinating actions among the concerned agencies including, in particular, the SFC and the BdR. Together with the MHCP, these institutions will collect the necessary data to assess implementation progress and report it to the Bank, taking into account both process advances and service statistics, survey and other data that might be used to assess the achievement of the program’s end outcomes.

99. Under the current dialogue with the GoC, Bank’s staff will coordinate with a Financial Regulation division of MHCP to monitor the progress of the implementation of the proposed operation. This division of the MHCP will prepare reports on the progress in achieving the loan objectives towards the expected outcomes during the entire period of the loan. The indicators used to monitor the achievement of objectives are included in the Policy Matrix in Annex 2.

FIDUCIARY ASPECTS, DISBURSEMENT, AND AUDITING

Fiduciary Aspects

100. In general, Colombia’s fiduciary environment for DPL operations is considered adequate. Particularly, important progress has been made in the modernization of the Public Financial Management (PFM) systems and institutions at the central government level, as explained in Box 3. The Bank continues to contribute to this effort, through PFM-related investment lending and analytical/advisory services support.

Box 4: Public Financial Management

Colombia has made important progress toward improving transparency and enhancing accountability in its public financial management (PFM) systems. The national tax administration has undergone significant improvements over the last five years in its systems and practices. Similarly, controls in public expenditure have been strengthened through a comprehensive integrated financial management system, implementation of a standard internal control model, and reforms to the procurement system, such as the recently approved Procurement Law. However, there is still, room for reducing transaction costs and exposure to waste and abuse, through the implementation of risk management tools, better procurement practices and audit mechanisms.

The administration’s current strategy, documented in the National Development Plan’s pillar of “A State at the Service of its Citizens: Efficient and Effective Government”, provides inter alia for the continuous improvement of public sector administrative models and expenditure efficiency. The NDP explicitly addresses important PFM areas such as budget management, asset administration, procurement reform, internal controls, and results-based management.

Relevant improvements to the procurement system, such as the introduction of merit evaluation as criteria for selection of consultant services, create an opportunity to converge with international good practice. Framework contracts are also foreseen, which should translate into important savings in public procurement. However, there are several aspects of the reform which are still underway and will need to be evaluated as their implementation progresses.

A public financial management and procurement performance study is currently underway.

Disbursement and Auditing

101. Following the Borrower’s request(s) for withdrawal from the loan account, the funds would be transferred into an account of the BdR denominated in US dollars. BdR would

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immediately credit the disbursed amounts to an MHCP National Treasury Account, thus becoming available to finance budgeted expenditures to be accounted for in the national integrated financial information system (SIIF). Upon request from the Bank, MHCP would provide written confirmation of the cited transaction.

102. An IMF central bank safeguards assessment of the BdR found no systematic vulnerabilities as of 2003 and 2005. Nothing further came to the attention of the DPL preparation team that caused it to believe that the control environment into which the loan proceeds will flow is other than adequate.

103. Because of the described conditions, no additional fiduciary arrangements (e.g. dedicated accounts subject to audit) are deemed necessary for this DPL.

RISKS AND RISK MITIGATION

104. The main risk to the operation arises from further deterioration of macroeconomic conditions, which would negatively affect the health of the financial system. The aim of the reforms supported by this operation is to strengthen the financial system and develop securities market to ensure high sustainable growth. A more protracted economic slowdown could hamper financial sector stability and limit trading volumes in the securities markets. In particular:

• As conditions deteriorate, the authorities may be pressured to grant regulatory forbearance. Under the baseline growth scenario this risk has low probability and low impact. Under the low-growth case scenario the pressure will mount at the time that the deterioration in economic conditions impact the balance sheet of financial institution. In this case, this risk has medium probability and medium impact. In cases of systemic financial distress there could be a case for regulatory forbearance, tackling the problems through a well designed financial sector support program is the best solution to install confidence in the system and prevent financial disruptions. The authorities have proven in the past its ability to move market participants in the desired direction using either legal powers or moral suasion and have handled financial crisis efficiently and with relatively low costs.

• There could be inability/lack of resources and/ or preparedness at the supervisory level to handle complex situations such as the eventual failure of a large institution. This risk has low probability and medium impact. The regulator has been monitoring the situation for some time now and has been preparing itself for critical situations (see paragraph 45).

• The foreseeable weak macroeconomic environment, both domestic and global, over the medium term will likely delay the desired vibrant growth of securities market. This risk has medium probability and medium impact. The GoC has shown strong commitment to develop securities market despite delays.

105. Finally, there is a risk that Colombia’s current level of public debt could pose a risk to the country’s macroeconomic stability. On the basis of the sustainability analysis undertaken (see Annex 5), debt levels appear to be manageable in the near term, even when considering possible adverse economic shocks.

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ANNEX 1: LETTER OF DEVELOPMENT POLICY

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Mr. ROBERT B. ZOELLICK Presidente Banco Mundial Banco Internacional de Reconstrucción y Desarrollo 1818 H Street, N. W. Washington, D. C. 20433 Estados Unidos de América

Dear Mr. Zoellick: The second administration of President Álvaro Uribe Vélez remains committed to the implementation of the structural reforms set forth in the 2006-2010 National Development Plan. These reforms aim at preserving macroeconomic stability and the integration in the global economy. The implementation of these reforms, as well as the reforms included in the structural reform program 2002-2006, prompted a sustain period of growth, reduction in unemployment and poverty levels, declining inflation, improved public debt management and fiscal deficit reduction. The reforms also strengthened the institutional framework. Many of these reforms have been endorsed by the World Bank. However, the global financial crisis has affected Colombia through several channels, including reduced capital inflows and exports, weakened domestic demand, and lower fiscal revenues. To ensure the sustainability of the economic program, the Government of Colombia is requesting a Financial Sector Development Policy Loan to the World Bank. This operation will support ongoing reforms to strengthen financial sector resilience and deepen securities markets to sustain growth. The reforms would help achieve the objective of promoting savings, investment and finance to achieve sustainable growth. The lessons from the economic crisis of the 1990s have been applied in the present circumstances. The Colombian Government has adopted countercyclical policies to mitigate the effects of the global crisis. The Government has sought the consistency of fiscal and monetary policies, respecting the autonomy of the Central Bank. Fiscal policy aimed to mitigate the impact of the crisis while preserving medium-term debt sustainability. To this end, automatic stabilizers have fully adjusted; lower tax revenues have translated into higher fiscal deficits while expenditures have been protected to sustain internal demand. Indentified expenditures priorities include infrastructure, to promote productivity and competitiveness, and social expenditures to sustain the consumption of the most vulnerable segments of the population. Monetary policy has been loosened to counter the effects of the cycle as weakened demand and lower food and oil prices keep inflation on a downward trend. Fiscal and monetary policy loosening have contributed to the exchange rate flexibility. In addition, the financing strategy adopted during this period has been proactive, flexible and transparent for the markets. In the present circumstances, the Government is making all efforts to obtain the financing necessary to implement its economic program. The investment plan funded by the Government is designed to support economic growth and employment. Regarding the financial system, the Government has improved the resilience of the sector by strengthening financial supervision. In the current context, the government has intensified its efforts to ensure financial sector resilience and reinforce the confidence in the system to avoid that deterioration in economic conditions and could hamper financial intermediation, which in turn would have severe consequences. The Government has also proceed with the implementation of the securities market reform,

49

which started in 2005 and has been supported by the World Bank through its different stages, to promote savings and to channel those savings efficiently to fund private sector investment and foster growth. The Government strategy of strengthening the financial sector has resulted in a series of measures and regulations. To improve the solvency of the Colombian credit institutions, the Financial Superintendency of Colombia (SFC) adopted a countercyclical policy by instructing credit institutions to retain part of the profits obtained during the second semester of 2008 in a capital reserve. Credit institutions will use the capital reserve to absorb eventual credit losses during the next two years. The SFC also introduced a norm regarding liquidity risk management (Circular Externa 16/2008) establishing the requirements for the internal liquidity risk management systems of the financial institutions. The internal systems should comprise policies and procedures to deal with liquidity risk − including internal limits, remedial actions, and contingency plans− as well as a framework to measure such risk. Credit institutions shall now hold enough liquid assets to cover liabilities potentially due within one week. Said measure increases liquidity buffers and prevents reliance in short-term wholesale funding. Financial intermediation is strictly regulated in Colombia. According to article 333 of the Constitution and the Colombian Laws, the activities related to the management, use and investment of resources collected from the public are of public interest and the only entities legally authorized to conduct such activities are those subject to the supervision, control and surveillance of the SFC or of the Superintendence of the Cooperative Economic Sector. However, in the last years several schemes by which resources were collected from the public outside the legal sphere had proliferated across the country. A significant portion of the population had invested their savings in these schemes, which expanded quickly thanks to the false expectations generated by the promised exorbitant returns. Such investments carry great risks, as they are not subject to any prudential regulation and supervision and lack the assurances and guarantees that apply to the authorized financial sector. The collapse of the entities conducting such activities can also negatively affect the confidence on the regulated financial system through contagion effects, with potentially severe consequences. As such schemes grew in the different Colombian Departments, the judicial and administrative authorities (including the SFC) adopted several measures. Nevertheless, the collapse of some of these unauthorized investment schemes in late 2008 led to rioting and violent protests in several Departments which had a significant number of investors in such schemes. These events underlined to the need to (i) adopt a framework that allows for swift action in the event of illegal collection of resources from the public to prevent the proliferation of such activities, and (ii) establish expedite procedures to promptly restitute investors in such schemes (specially the poor) through the sale of the confiscated assets. In November 2008, the Government issued a series of Decrees for these purposes under the legal powers granted in the case of “State of Social Emergency”. Among these Decrees, it is worth noticing

• Decree 4334/2008 which provides the Superintendency of Companies (Superintendencia de Sociedades, SS), the authority to intervene if there are “notorious and objective facts” that the SS considers proof of collection of resources from the public without authorization. The SS can act “de motu propio” or at the request of the SFC. Administrative intervention allows (without the need for court approval) for the adoption of a wide range of measures including halting the collection operations, taking control of the entity and possession of all its assets, and the orderly return of funds to investors.

• Decree 4335/2008, which provides the heads of local governments (Mayors and Governors) with the power to impose certain precautionary measures (including closing of the establishments) on entities located in their respective jurisdictions that are undertaking financial activities without authorization. The SS would be notified immediately of such actions.

50

The Government has taken measures to act against the schemes that collected illegally resources from the public and to compensate the affected investors through the administration and liquidation of the confiscated assets and the prosecution of those responsible. We are confident that these measures will discourage unauthorized financial intermediation. Regarding securities market reform, a series of Decrees implemented some of the key areas of the Securities Market Law of 2005 (Law 964/2005). The package of Decrees that regulate the upgraded market infrastructure (Decrees 1456/2007, 2893/2007, 1120/2008), including securities settlement systems, trading and registration systems and the central counterparty clearing house. The improvement in the market infrastructure will reduce transaction costs, allow for the trading of standardized derivatives products and will reduce systemic risks, fostering market development. It is also worth noticing the new regulation of securities intermediation and securities operations (Decree 1121/2008). Such regulation establishes the principles, policies and procedures applicable to the securities intermediaries ‒including “know your customer rules”‒ to increase their professionalism. The regulation of derivatives (Decree 1796/2008) comprises accountancy criteria, as well as the treatment of exposures for the purpose of computing counterparty credit risks in line with international standards. These regulations made possible the creation of formal standardized derivatives markets, which started functioning in September 2008. Reforms in the financial sector proceed, as the Government is aware of the remaining areas that need revision. On June 18, 2008, Congress approved the Financial Reform Law which will be enacted within a month. Nevertheless, the main components of the reform (financial consumer protection and the adoption of a “multifondos” scheme for the pension capitalization plans) will not enter into effect until July 1, 2010 and fourteen (14) months after the enactment of the Law respectively. This is not only due to the substantial regulatory efforts necessary to implement the Law, particularly on its “multifondos” component, but also to the changes that need to be implemented in the institutions. While the Colombian Laws include consumer protection aspects, it was necessary to formulate a legal framework specific for the financial sector to establish consumer rights and the obligations of the financial intermediaries, as well as to give legal status to the norms regarding the provision of financial information. The reform introduces the figure of Financial Consumer Ombudsman and establishes stricter transparency requirements for fees and a the requirement of Customer Service System (SAC). The multifondos scheme aims at optimizing the risk-adjusted rate of return of the individual capitalization pension plans. The multifondos will allow the Pension Fund Administrators (AFP) to offer different funds (at most four, depending on the regulations issued by the Government), with different risk profiles depending on the age and the risk tolerance of the investor. In closing, the Government of the Republic of Colombia reiterates its commitment with the Financial Sector Development Policy Loan program described in this document. The Government wishes to express its gratitude for the technical support and financial assistance provided by the World Bank. Yours sincerely

51

AN

NE

X 2

. PO

LIC

Y M

AT

RIX

Obj

ecti

ves

Key

Iss

ues

Pri

or A

ctio

ns

Med

ium

-Ter

m O

utco

me

Indi

cato

rs (b

y en

d-20

11)

1. S

tren

gthe

n Pr

uden

tial

Reg

ulat

ion

and

Supe

rvis

ion

Incr

ease

d ca

pita

l bu

ffer

s im

prov

e re

silie

nce

to

the

econ

omic

do

wnt

urn.

E

nhan

ced

supe

rvis

ion

on l

iqui

dity

ris

ks t

o en

hanc

e fi

nanc

ial s

tabi

lity

Impl

emen

tatio

n of

a

coun

terc

yclic

al

polic

y in

stru

ctin

g cr

edit

inst

itutio

ns t

o re

tain

a p

ortio

n of

the

ir p

rofi

ts e

arne

d du

ring

Jun

e-D

ecem

ber

2008

. Fi

nanc

ial

sect

or i

nstit

utio

ns r

egul

ated

by

the

SFC

(e

xcep

t fo

r in

sura

nce

com

pani

es)

are

bette

r pr

epar

ed

to

man

age

liqui

dity

ri

sks

thro

ugh

the

impl

anta

tion

of in

tern

al s

yste

ms.

• U

nder

cu

rren

t m

acro

econ

omic

as

sum

ptio

ns,

no

syst

emic

in

stab

ility

ari

ses

in 2

009-

2010

.

• In

cas

e cr

edit

inst

itutio

ns i

ncur

in

loss

es d

urin

g th

e ye

ar,

it w

ill

be d

eter

min

ed w

hat

perc

enta

ge o

f th

ose

loss

es c

an b

e ab

sorb

ed

by t

he r

eser

ved

cons

titut

ed w

ith t

he c

apita

lized

200

8 pr

ofits

w

ithou

t com

prom

isin

g th

e C

AR

of

the

inst

itutio

n. A

t the

clo

sing

of

the

201

1 fi

nanc

ial

acco

unts

the

rem

aini

ng r

eser

ve f

or t

he

syst

em a

nd t

he n

umbe

r of

ins

titut

ions

for

whi

ch t

he r

eser

ve h

as

not c

over

ed th

e su

stai

ned

loss

es w

ill b

e re

port

ed.

• A

ll fi

nanc

ial

inst

itutio

ns t

hat

colle

ct r

esou

rces

fro

m t

he p

ublic

, w

ith t

he e

xcep

tion

of c

lose

-fun

d ad

min

istr

ator

s, h

ave

adop

ted

robu

st s

yste

ms

to m

onito

r an

d ad

min

iste

r liq

uidi

ty r

isks

. A

ll cr

edit

inst

itutio

ns h

ave

a po

sitiv

e in

dica

tor

of l

iqui

dity

ris

k as

de

fine

d by

the

SFC

, or

are

ado

ptin

g re

med

ial

actio

ns t

o en

sure

th

ey w

ill h

ave

it.

2.

Stre

ngth

en

the

Fram

ewor

k fo

r th

e In

terv

entio

n an

d R

esol

utio

n of

Una

utho

rize

d Fi

nanc

ial

Inte

rmed

iatio

n A

ctiv

ities

Pow

ers

for

prom

pt i

nter

vent

ion

and

reso

lutio

n w

ould

de

crea

se

the

likel

ihoo

d su

ch

oper

atio

ns

and

prev

ent

them

fro

m g

row

ing

and

beco

me

syst

emic

ally

im

port

ant.

In c

ases

whe

re f

inan

cial

int

erm

edia

tion

activ

ities

are

bei

ng p

erfo

rmed

out

side

of

lic

ense

d in

term

edia

ries

, th

e SS

can

ta

ke c

ontr

ol o

f sa

id e

ntiti

es,

orde

r th

e fr

eezi

ng o

r th

eir

asse

ts a

nd r

etur

n th

eir

reso

urce

s to

th

e af

fect

ed

pers

ons.

M

ayor

s an

d G

over

nors

can

clo

se t

heir

pr

emis

es o

n pr

ecau

tiona

ry g

roun

ds.

• T

he S

S fo

llow

s up

on

all

requ

ests

fro

m t

he S

FC t

o in

vest

igat

e un

auth

oriz

ed f

inan

cial

inte

rmed

iatio

n ac

tiviti

es.

•

Ass

ets

reco

vere

d fr

om i

nter

vene

d py

ram

ids

have

bee

n va

lued

an

d liq

uida

ted,

and

the

pro

ceed

s di

stri

bute

d am

ong

inve

stor

s ac

cord

ing

to t

heir

cre

dito

r st

atus

. A

sset

s co

nfis

cate

d in

rel

atio

n to

mon

ey l

aund

erin

g ac

tiviti

es w

ill h

ave

been

tra

nsfe

rred

to

the

appr

opri

ate

auth

oriti

es.

Act

ions

to

reco

vere

d as

sets

loc

ated

ab

road

hav

e be

en in

itiat

ed.

3.

Secu

ritie

s M

arke

t Ref

orm

Mar

ket I

nfra

stru

ctur

e. P

revi

ousl

y ex

istin

g in

fras

truc

ture

di

d no

t ad

dres

s so

urce

s of

sys

tem

ic r

isks

in

sec

uriti

es s

ettle

men

t. A

bsen

ce

of a

CC

CH

pre

vent

ed t

radi

ng o

f de

riva

tives

in th

e ex

chan

ge.

Upg

radi

ng

infr

astr

uctu

re

by

(i)

stre

ngth

enin

g se

curi

ties

clea

ring

an

d se

ttlem

ent

syst

ems,

(i

i)

regu

latin

g au

tom

atic

tr

adin

g an

d re

gist

ratio

n sy

stem

s,

(iii)

re

gula

ting

cent

ral

coun

terp

arty

cle

arin

g ho

use.

• C

ompl

ianc

e w

ith th

e cu

rren

t 19

CPS

S-IO

SCO

pri

ncip

les.

• T

he S

FC h

as r

eal t

ime

info

rmat

ion

on th

e tr

ansa

ctio

ns li

quid

ated

th

roug

h th

e C

CC

H.

• T

he

rang

e of

st

anda

rdiz

ed

deri

vativ

e pr

oduc

ts

trad

ed

in

Col

ombi

a ha

s ex

pand

ed

to

incl

ude

exch

ange

ra

te

futu

res,

C

olom

bian

sto

ck m

arke

t fut

ures

and

com

mod

ities

fut

ures

.

52

Obj

ecti

ves

Key

Iss

ues

Pri

or A

ctio

ns

Med

ium

-Ter

m O

utco

me

Indi

cato

rs (b

y en

d-20

11)

Mar

ket

Arc

hite

ctur

e an

d O

pera

tions

. E

xist

ing

regu

latio

n on

int

erm

edia

tion

activ

ities

had

ye

t to

in

corp

orat

e st

rict

er

requ

irem

ents

fo

r tr

ansp

aren

cy,

corp

orat

e go

vern

ance

an

d pr

ofes

sion

alis

m i

mpo

sed

by t

he

Law

964

/200

5 in

ord

er to

pro

tect

in

vest

or r

ight

s .

Der

ivat

ive

prod

ucts

w

ere

not

regu

late

d

Ado

ptio

n of

mes

ures

to e

nhan

ce m

arke

t ar

chite

ctur

e an

d op

erat

ions

by

(i

) im

prov

ing

the

prof

essi

onal

ism

of

in

term

edia

ries

se

curi

ties

mar

ket,

(ii)

pr

otec

ting

inve

stor

ri

ghts

, (i

ii)

incr

easi

ng

tran

spar

ency

an

d (i

v)

regu

latin

g de

riva

tive

prod

ucts

.

•

The

mar

ket

has

deve

lope

d an

d tr

adin

g vo

lum

es o

f st

anda

rdiz

ed

deri

vativ

es h

ave

incr

ease

d as

a s

hare

of

spot

tra

nsac

tions

. In

pa

rtic

ular

fut

ures

tra

ded

over

Col

ombi

an s

over

eign

bon

ds,

the

Col

ombi

an s

tock

mar

ket

inde

x an

d th

e m

arke

t ex

chan

ge r

ate

of

the

Col

ombi

an P

eso

vis-

à-vi

s th

e U

S D

olla

r am

ount

to a

thir

d of

th

e sp

ot tr

ansa

ctio

ns in

thos

e as

sets

.

EV

IDE

NC

E O

F C

OM

PL

IAN

CE

WIT

H P

RIO

R A

CT

ION

S IN

TH

E P

OL

ICY

MA

TR

IX

The

me/

Sect

or

Evi

denc

e P

rese

nted

Incr

easi

ng c

apita

l and

liqu

idity

buf

fers

•

Let

ter

No2

0090

3725

9-00

0-00

0, is

sued

by

the

SFC

on

May

8, 2

009.

•

Cir

cula

r E

xter

na 1

6/20

08, w

hich

est

ablis

hes

the

crite

ria

for

the

syst

ems

to a

dmin

iste

r liq

uidi

ty r

isks

. St

reng

then

ing

the

Fram

ewor

k fo

r th

e In

terv

entio

n an

d R

esol

utio

n of

U

naut

hori

zed

Fina

ncia

l In

term

edia

tion

Act

iviti

es

• D

ecre

e 43

34/2

008,

whi

ch r

egul

ates

the

inte

rven

tion

and

liqui

datio

n of

una

utho

rize

d op

erat

ions

by

whi

ch f

inan

cial

res

ourc

es f

rom

the

publ

ic a

re c

olle

cted

. •

Dec

ree

4335

/200

8, w

hich

pro

vide

s th

e he

ads

of lo

cal g

over

nmen

ts w

ith th

e po

wer

to im

pose

pre

caut

iona

ry m

easu

res

on e

ntiti

es th

at

are

unde

rtak

ing

fina

ncia

l act

iviti

es w

ithou

t aut

hori

zatio

n

Secu

ritie

s M

arke

t Ref

orm

• D

ecre

e 14

56/2

007,

whi

ch r

egul

ates

sec

uriti

es c

lear

ing

and

settl

emen

t sys

tem

s.

• D

ecre

e 11

20/2

008,

whi

ch r

egul

ates

sec

uriti

es tr

adin

g an

d re

gist

ratio

n sy

stem

s.

• D

ecre

e 28

93/2

007,

whi

ch r

egul

ates

cen

tral

cle

arin

g of

cou

nter

part

ris

k.

• D

ecre

e 11

21/2

008,

whi

ch r

egul

ates

inte

rmed

iatio

n in

the

secu

ritie

s m

arke

t, by

ext

ensi

vely

am

endi

ng R

esol

utio

n 40

0/19

95.

• D

ecre

e 17

96/2

008,

whi

ch r

egul

ates

der

ivat

ives

and

str

uctu

red

prod

ucts

.

53

ANNEX 3: FUND RELATIONS NOTE IMF Executive Board Approves US$10.5 Billion Arrangement for Colombia Under the Flexible Credit Line Press Release No. 09/161 May 11, 2009 The Executive Board of the International Monetary Fund (IMF) today approved a one-year SDR 6.966 billion (about US$10.5 billion) arrangement for Colombia under the Flexible Credit Line (FCL). The Colombian authorities have stated they intend to treat the arrangement as precautionary and not draw on the line. The FCL is available to countries, such as Colombia, that have demonstrated a very strong track record of sound macroeconomic policies and institutional frameworks. The arrangement for Colombia is the second commitment in Latin America and the third overall (following arrangements for Mexico and Poland) under the IMF’s FCL, which was created in the context of a major overhaul of the Fund’s lending framework on March 24, 2009 (see Press Release No. 09/85 and Public Information Notice No. 09/40). The FCL is designed to help countries’ crisis prevention efforts by providing the flexibility to draw on the credit line at any time. Disbursements are not phased nor conditioned on compliance with policy targets as in traditional IMF-supported programs. This flexible access is justified on the basis that the strict qualification criteria for the FCL provides assurances that sound economic policies will remain in place to confront the challenges ahead. Following the Executive Board discussion, Mr. John Lipsky, First Deputy Managing Director and Acting Chair, made the following statement: “During the last decade, Colombia has maintained a very strong macroeconomic performance, underpinned by solid institutional policy frameworks. GDP growth has been robust. The inflation targeting regime brought inflation down to single digits. Anchored on its medium term fiscal framework, Colombia’s debt ratios have declined substantially. The flexible exchange rate regime and prudent debt management have helped to reduce balance sheet vulnerabilities. Strong supervision and regulation have kept the financial system sound. “Notwithstanding its very strong fundamentals, Colombia’s near term outlook has been adversely affected by the global environment. While the flexible exchange rate absorbed the first round effects of the global crisis, weak external demand has led to a contraction of exports and a considerable slowdown in economic activity. Nonetheless, the financial system has not experienced major strains since the onset of the global crisis, and the Government of Colombia has maintained access to international capital markets at favorable terms. “The authorities’ policy response to the global crisis has been prudent and appropriate. With inflation abating, monetary policy has been eased. The authorities are also allowing automatic fiscal stabilizers to operate fully, while preserving medium-term fiscal sustainability. The exchange rate has been an effective shock absorber with limited rules-based intervention to smooth volatility, and reserve losses have been small. The authorities have taken timely steps to protect the financial system by increasing the deposit insurance coverage. They have also averted a possible liquidity crunch by securing external financing to the state-owned foreign trade bank which is providing loans to banks and corporations facing reduced access to external trade credit. “The one-year arrangement under the IMF’s Flexible Credit Line, which the authorities intend to treat as precautionary, will play an important role in bolstering confidence in the authorities’ policy framework

54

and strategy at a time of heightened global uncertainty. Colombia’s strong fundamentals and institutional frameworks, its proven track record of sound macroeconomic policies, and the additional insurance provided by the FCL arrangement, give confidence that the authorities are well prepared to manage potential risks and pressures in the event that the global environment deteriorates further,” Mr. Lipsky said.

55

ANNEX 4: COLOMBIA – ECONOMIC PROSPECTS

LCSPE

Macroeconomic Monitoring

Latin America and the Caribbean Region Poverty Reduction and Economic Management Department

Economic Policy Sector Unit

Economic Prospects for Colombia

Summary

• The Colombian economy is facing the impacts of a sharp aggregate demand contraction in its major trading partners and continued strained global financial conditions. In the near term, economic activity is likely to contract as external demand drops and domestic and external credit conditions remain tight.

• Sound macroeconomic policies implemented in recent years have substantially improved the country’s economic resilience against crisis. The flexible exchange rate, the decline in foreign external debt (which has almost halved since 2003 due to the sustained FDI flows), and adequate reserve level (over US$21 billion, or 11 percent of GDP at end-May 2009) that more than doubles the annual external debt amortizations contribute to ensure current account financing even in the difficult global conditions. Fiscal consolidation and the government public debt management strategy put public debt in a declining path and reduce the share of foreign denominated debt. The authorities’ successful placement of US$2 billion of 10 year bonds in international markets in addition to securing funds from multilaterals in order to meet public sector external financing requirements further reduces financial vulnerabilities. Given limited external vulnerabilities, exchange rate pressures would likely be moderate.

56

Economic Prospective for Colombia

A. RECENT ECONOMIC DEVELOPMENTS

1. The Colombian economy is in recession and it is facing the impacts of a sharp aggregate demand contraction of its major trading partners and continuing strained global financial conditions. Economic growth already decelerated in the first three quarters of 2008 and actually turned negative during the last quarter, thereby bringing GDP growth for the year at a modest 2.5 percent. In the near term, economic activity is likely to contract as external demand drops and domestic and external credit conditions remain tight. On the basis of recent developments in economic activity, the Bank’s base scenario for Colombia includes GDP growth of -0.7 percent in 2009 and a modest rebound of economic activity in 2010. Growth perspectives for 2009 are in line with the recent downward revision by the Banco de la Republica, which places the economic pace for this year within a -1 percent to 1 percent range. 2. Prior to the onset of the global economic downturn, Colombia exhibited high economic growth within a framework of enhanced macroeconomic stability. The Colombian economy experienced strong and sustained growth over the 2003-2007 period supported by the favorable external environment and sound economic policies. Real economic growth accelerated from 2.5 percent in 2002 to 7.5 percent in 2007, inflation moderated during the period, and the current account deficit remained modest despite strong domestic demand, particularly in investment. Strong growth supported unemployment reduction from over 17 percent in 2002 to approximately 12 percent in 2007. High external demand, improved terms of trade and lower cost of international credit created a favorable environment for growth, supported by the improved security situation in Colombia and stable macroeconomic policies.

Table 1: Key Economic Indicators for Colombia, 2003-2008 Indicator 2003 2004 2005 2006 2007 2008 (e) Real GDP growth (%) 4.6 4.7 5.7 6.8 7.5 2.5 Inflation (%) (end of period) 6.5 5.5 4.9 4.5 5.7 7.7 Nominal Exchange Rate (Average) 2877.7 2628.6 2320.8 2361.1 2078.3 1967.7

Current Account Balance (% of GDP) -1.0 -0.8 -1.3 -1.9 -2.9 -2.8 NFPS Revenues (% of GDP) 30.0 30.0 30.6 32.7 33.2 32.0 NFPS Expenditures (% of GDP) 32.5 31.2 30.8 33.7 34.2 31.9 NFPS Balance (% of GDP) -3.2 -1.5 0.0 -1.2 -1.0 0.1 Net Debt of the Non Financial Public Sector (% of GDP)1/

46.7 42.4 38.9 36.0 32.3 31.9

External Debt/GDP (%) 41.5 34.7 26.6 24.7 21.4 19.1 Investment (% of GDP) 18.9 20.1 21.6 24.3 24.3 24.3 Public sector 6.3 5.9 4.9 6.5 7.7 7.3 Private sector 12.6 14.1 16.7 17.8 16.6 17.0

1/ This is defined as gross debt of the non financial public sector but netting out government and government entity bonds held by the public sector itself. Note: Non-Financial Public Sector (NFPS) data includes ECOP$ETROL. The NFPS balance includes the statistical discrepancy. Data comes from IMF. Source: MHCP, BdR; IMF and World Bank estimates. 3. In 2008 economic growth decelerated sharply as internal demand growth cooled down. In the fourth quarter of 2008, y-o-y economic growth stood at -1 percent, the lowest growth rate since

57

2003, partly reflecting past monetary tightening that resulted in a significant deceleration in credit growth (from 31.8 percent y-o-y at end-2006 to 17.1 percent y-o-y in December 2008). In the third quarter of 2008, export growth which had remained relatively resilient, collapsed due to the ongoing global slowdown. The fourth quarter followed a similar negative path, and the current account for 2008 ended up in a deficit of 2.8 percent of GDP, a similar figure to the one in 2007.

Figure 1. Real Growth Rate of Selected Macro Variables

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV

2003 2004 2005 2006 2007* 2008*

Per

cen

t

Exports Imports GDP

Source: Departamento Administrativo Nacional de Estadística (Dane). 4. Prices have been following a declining trend after the fuel and food price hikes. Shocks to fuel and food prices pushed inflation to 7.7 percent at end-2008 well in excess of the Central Bank’s target of 5 percent for 2008. In spite of this, inflationary pressures have been decelerating already since end-2008 as the external price shock was corrected. As a result, Banco de la Republica authorities have lowered the policy interest rate aiming at a reactivation of the economy while prices are expected to continue on a downward path.

58

Figure 2. Inflation and Central Bank’s Policy Rate.

Source: Banco de la Republica de Colombia. 5. Continued low fiscal deficits propitiated a reduction in public sector debt, although concerns remain regarding expenditure rigidities. In recent years, fiscal policy has aimed to reduce public sector and external vulnerabilities by ensuring debt sustainability. The combination of domestic economic growth, improved international conditions, peso appreciation (which reduces the cost of servicing foreign currency-denominated debt), and revenue-enhancing policy reforms improved the fiscal accounts.28 As a result, the combined public sector deficit decreased from 3.7 percent of GDP in 2002 to a balance in 2005. However, budget and legal rigidities that resist spending cuts have slowed the progress of policy reforms on the expenditure side. Despite the strong revenue performance, expenditure dynamics −especially pension expenditures and transfers to sub national governments− have resulted in modest fiscal deficits during 2006-2007. Transfers to the main state-run pension system will continue to expand over the next decade −as payouts greatly exceed new contributions−, despite the 2005 constitutional reform that reduced the net present value of pension liabilities by 19 percentage points of GDP by eliminating special regimes for state employees and imposing ceilings on benefits in the public-sector pension system. In 2008, the non financial public sector balance reached a surplus of 0.1 percent of GDP, the highest balance since 2005. This figure was above the government’s target of -0.9 percent of GDP. This improvement over the government’s target is explained primarily by 1.1 percent of GDP surplus by local governments, up from the government’s target of 0.3 percent of GDP. The latter is at least partially the result of recent central government’s policies to enforce fiscal discipline at the local level.

6. As the global financial turbulence intensified in the second half of 2008, Colombian financial markets were negatively affected in line with developments in other Latin American countries although conditions have improved during 2009. The withdrawal of liquidity in financial markets amid increased risk aversion resulted in larger sovereign spreads and stock market losses across the region. In Colombia, the EMBI spread increased to 740 bps at end October, 2008 but since then it has declined to 282 as of early June 2009. The Colombian government successfully placed a ten-year US$1 billion dollar bond issue, and another US$1 billion in April. The stock market index declined by a third in line with developments elsewhere in 2008 but has since recovered by 49 percent by mid-June 2009. The exchange rate appreciation, prompted in part by tightening monetary policy, reversed and the exchange rate depreciated by about 16 percent from August 2008 to December 2008, limiting the loss of reserves during 2008 to US$125 million (about 0.5 percent of total reserves). In this context the Central Bank removed the controls to capital inflows, a temporary measure to prevent excessive exchange rate volatility. To some extent, the exchange rate depreciation was a welcome development given its impact

28 Policy reforms have concentrated on the revenue side. In 2002, Congress approved Law 788, supported by the Bank’s Fiscal and Institutional Adjustment Loan (FIAL) Program (Loan 7163-CO, approved March 2003).

59

on competitiveness. However since end-2008 to mid-June 2009 the exchange rate has appreciated by about 17 percent. An increase in credit risk premiums and funding costs pushed the lending rate up by around 77 basis points in the last quarter of 2008 with respect to the first quarter of the same year, but declines in policy rates since December 2008 have brought lending rates down reaching levels similar to those in early 2007.

60

Figure 3. Colombia: Stock Market Index, EMBI Spread and International Oil Price

Figure 3(a): EMBI Spreads Chile, Colombia, Latin America & the Caribbean, June 2005-June 2009

Figure 3(b): EMBI Spreads Brazil, Colombia and Mexico, June 2005-June 2009

Chile

Colombia

LAC

0

100

200

300

400

500

600

700

800

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1000

6/12/05 12/12/05 6/12/06 12/12/06 6/12/07 12/12/07 6/12/08 12/12/08 6/12/09

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Brazil

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Mexico

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EMBI Spreads

Brazil Colombia Mexico

Figure 3(c): Stock Market Indices, Selected LAC Countries, June 2008 – June 2009

Figure 3(d): Net International Reserves in Colombia, US$Million, June 2008 – June 2009

BRA

CHL

COL

MEX

40

50

60

70

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6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

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BRA CHLCOL MEX

22,000

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24,500

25,000

25,500

6/10/08 8/10/08 10/10/08 12/10/08 2/10/09 4/10/09 6/10/09

Net International Reserves (US$ Millions)

Figure 3(e): Exchange Rates in Selected LAC Countries, June 2008 – June 2009

(January 1st, 2008 = 100)

Figure 3(f): Exchange Rates in Selected LAC Countries, June 2008 – June 2009

(January 1st, 2008 = 100)

80

90

100

110

120

130

140

150

6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

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COL MEX

80

90

100

110

120

130

140

150

6/15/08 8/15/08 10/15/08 12/15/08 2/15/09 4/15/09 6/15/09

Exchange Rates

BRA CHL

Source: Banco de la Republica de Colombia and LCSPE Database.

61

B. Macroeconomic Outlook and Debt Sustainability

7. Ongoing deleveraging and continued high levels of uncertainty have prompted a sharp downturn in global economic activity, world trade and international commodity prices which will negatively affect Colombian through several channels. In light of external developments economic activity in Colombia and the prospects for near-term economic growth have deteriorated significantly. The main channels of transmission of the global economic and financial shocks to the Colombian economy are the following: (a) Weaker export revenues. Colombia has a relatively open economy (exports of goods and services

are equivalent to over 17 percent of GDP while total trade amounts to about 40 percent of GDP). In particular, oil exports represent on average about 24 percent of total exports. While exports have become more geographically diversified towards other countries/regions beyond the U.S., export volumes have decelerated in the fourth quarter growing by only 6.3 percent, y/y, in real terms versus a strong expansion during the same period in 2007 (19 percent). This has translated into a deceleration in GDP, which contracted by -0.7 percent y-o-y during the fourth quarter of 2008 (compared to 8 percent in the same period in 2007). Global demand is expected to decline by 0.5 percent in 2009 compared to 2008. It is estimated that a 1 percent decline in US growth, the main trade partner of Colombia, lowers real export growth by 0.3 percent.

(b) Lower oil prices. Colombia received a record-high level of revenue from oil exports at US$12.2

billion in 2008 as a result of a historically high average oil price for the Colombian mix of crude oil at US$134.3 per barrel. The dramatic drop of international oil prices averaging US$41 per barrel for the Colombian mix has a significant impact on the country’s public finances as oil accounts for about 20 percent of total public sector revenues. In 2009, oil prices are expected to average US$47.2 per barrel. The envisioned decline in oil prices −ceteris paribus− will increase the current account deficit and public sector deficit by 1.8 percent and 0.5 percent of GDP respectively (this is compared to the counterfactual that prices stay at 2009 levels).

Figure 4. Price of Colombia Crude Exports

0

20

40

60

80

100

120

140

J F M AM J J A S O N D J F M AM J J A S O N D J F M AM J J A S O N D J F M A

2006 2007 2008 2009

US$/Barrel


(c) Lower workers’ remittances. Workers’ remittances, mainly from Colombians living in the U.S

and Spain, have started to decline since the last quarter of 2008. Remittances amounted to US$1 billion in the first quarter of 2009, a 4.2 percent decline from a year ago. For the year as a whole they are expected to decline by 3 percent.

62

Figure 5: Remittances in Colombia: Level, Change and Share of GDP

January 2002 – May 2009

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

150

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02Ja

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US

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Remittances Monthly Flow (12-month m.a.) % Change, y/y


(d) Lower capital flows. Capital flows are expected to decline somewhat due to diminished global liquidity. Capital flows have declined by 3.5 percent from the third quarter to the last quarter of 2008. Although FDI flows experienced a significant expansion during 2008 current global conditions might impact negatively on the inflows during the current year.

Figure 6: Foreign Direct Investment and Credit to Private Sector.

0.0%

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2002 2003 2004 2005 2006 2007 2008

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2006 2007 2008 2009

Gross Domestic Credit to Private Sector (Current Col$ M) % Change, y/y

(e) Increased risk aversion. The deterioration in economic perspectives and market

turbulence will likely have a negative impact on risk premiums and credit supply. The latest lending survey indicates that Colombian financial intermediaries expect a contraction in credit supply.

63

8. However, factors that typically magnify external shocks resulting in severe economic disruptions are not present in Colombia. In some Latin American countries, external shocks have been typically amplified by severely appreciated real exchange rates, weak domestic financial sectors and real and financial dollarization. Fortunately, in the Colombian case, the factors that typically magnify crisis act as a muffler. Colombia entered the turbulence period with an exchange rate value close to its equilibrium level29. The flexible exchange rate acts as a shock absorber helping to counter the deceleration in external demand. The strength of the financial sector, with healthy financial indicators, has prevented a credit crunch, and credit to the private sector− although has decelerated reflected lower demand and increased risk aversion− continued to grow at about 9 percent in real terms at end-April 2009. Financial dollarization is not a destabilizing factor in Colombia.

9. Despite the impact of global conditions, Colombia is in a better position to confront the global crisis than other LAC countries. This outcome is a result of the countercyclical monetary policy together with the fiscal stimulus through higher public sector investment over 2009. However, growth prospects in Colombia stand at negative levels for 2009.

Figure 7. GDP Growth of selected countries in Latin America, 2009.

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

Mexico Argentina Venezuela Brazil Chile Colombia Peru

Per

cen

tag

e

I Projection Range

Selected Economies in Latin American: Growth Projection 2009

Growth Projection 2009

Source: Consensus Forecasts (as of June 15, 2009).

10. In light of the current environment, economic growth expected to continue decelerating in 2009. GDP growth is likely to contract by 0.7 percent in 2009, while lower oil and food prices will reduce inflation to 4.3 percent. The current account deficit is expected to deteriorate to 3.4 percent of GDP. The Non-Financial Public Sector balance, broadly balanced in 2008, will widen to -3.5 percent of GDP in 2009.

29 See IMF 2008 art. IV.

64

Table 2: Medium-Term Outlook, 2008-13 2008 2009 2010 2011 2012 2013

Real GDP growth (%) 2.5% -0.7% 1.5% 3.0% 3.8% 4.4%

Inflation (%) 7.7% 4.3% 4.3% 3.9% 3.2% 3.1%


NFPS Balance (% GDP) 0.1% -3.5% -2.4% -1.1% -0.3% 0.3%

Investment (% GDP) 24.3% 23.6% 23.8% 24.6% 25.0% 25.1%




Reserves (US$ Million) 23,478.8 21,071.1 21,391.7 22,401.0 23,205.4 24,332.9

Memo:3.0% 3.4% 3.0% 3.3% 3.7% 4.9%

NFPS Financing (In % of GDP) 6.9% 10.4% 9.0% 8.1% 7.8% 8.4%Financing Needs (Deficit plus amortizations): 4.0% 7.0% 6.0% 4.8% 4.1% 3.5%Financing Sources: 6.5% 7.0% 6.0% 5.3% 4.2% 3.5% External (Multilateral plus Bonds) 1.0% 1.4% 0.7% 0.6% 0.6% 0.5% Domestic 4.6% 4.1% 4.0% 4.0% 3.6% 3.0%

Other (adjustments, profits Banco de la Republica, other) 0.9% 1.5% 1.2% 0.6% 0.0% 0.0%

Source: WDI, IMF Data, Ministerio de Hacienda de Colombia and World Bank Staff estimations.

11. Despite limited space for pursuing an aggressive counter-cyclical policy, the measures implemented by the authorities will likely mitigate the impact of a global slowdown on growth and employment generation of the domestic economy. Monetary policy is, and will continue to be, actively used to counter the effects of the cycle as weaken demand and lower food and oil prices keep inflation on a downward trend. The sharp reduction in public sector debt to GDP ratio during the past years has provided room for some fiscal loosening and expenditures will increase by 1.7 percent of GDP. The main measures adopted by the authorities include:

• Expansive monetary policy. Monetary policy had been tightened substantially between mid 2006 and mid-2008, the policy rate was increased by 400 b.p. amid concerns of possible overheating of the economy. In the last quarter of 2008 a reduction in banks’ reserve requirements and the program of purchases of government paper (USD 500 million) reversed the stance of monetary policy and the monetary base has expanded since end-September 2008. Since December 2008, the Central Bank has been reducing interest rates to counteract the sharp economic deceleration, as inflation moderated.

• Increasing credit supply to buy durable goods. On March 9 the Banco de Comercio Exterior de Colombia (Bancoldex) published a document on the financial mechanisms to support retail of durable goods. The objective of the program is to inject liquidity into the market and it is targeted for the automobile and electrical appliance sectors. Two main aspects are questionable about this program: (i) it is not clear whether this measure will help to boost consumption as consumers have been showing a resilience to purchase durable goods even with dropping interest rates (see Encuesta de Opinion del Consumidor); and, (ii) it is not clear the reasoning behind the selection of sectors to favor with the program.

• Increasing public expenditure in social assistance programs. With respect to the social assistance programs, the government plans to expand the budget for these programs by 22 percent in 2009 reaching COP$$3,100 billion (includes COP$1,092 billions for Familias en Accion, COP$553 billion for elderly programs, and COP$760 billion for programs targeted towards the displaced population). The overall macro

65

impact of these programs is small given that it will only affect the purchasing power of a relatively small segment of the population. In this regard, it will be more useful for the government to target employment generation programs as these could have a greater impact in the economy.

• Increasing investment in infrastructure. The government has announced a series of measures to invest in infrastructure. The “plan de choque” increases the budget for infrastructure by 25 percent with respect to 2008 to an amount of US$2.7 billion. The World Bank is anticipating to support infrastructure investments with mainly 4 projects pipelined in 2009-2010, approximately amounting to US$$1.1 billion These infrastructure projects are labor intensive and are expected to have a significant impact on employment and growth.

12. Despite successful sovereign bonds placements in global markets, the GoC is seeking to reduce external vulnerabilities by requesting funding from multilaterals. Authorities announced plans to request US$2.4 billion from multilaterals this calendar year to help cover the envisioned external financing needs for 2009. On April Colombia requested an IMF precautionary flexible credit line to access US$10.5 billion.

13. Sound macroeconomic policies implemented in recent years have substantially improved the country’s economic resilience against crisis. The flexible exchange rate, the decline in foreign external debt (which has almost halved since 2003 due to the sustained FDI flows), and adequate reserve level (over US$23 billion, or 11 percent of GDP at the end of May 2009) that more than doubles the annual external debt amortizations contribute to ensure current account financing even in the difficult global conditions. Fiscal consolidation and the government public debt management strategy put public debt in a declining path and reduce the share of foreign denominated debt (see Table 1). Given limited external vulnerabilities, exchange rate pressures would likely be moderate.

14. While there remains considerable uncertainty as regards to the depth and length of the global recession, neither external nor fiscal sustainability appear at risk. While risks to the macroeconomic projections for 2009 and 2010 are on the downside, external and fiscal sustainability are not a major concern. However, the current environment characterized by volatility in financial magnitudes and commodity prices poses several downside risks. A fall in oil prices would negatively affect the fiscal outlook and the current account balance. Intensification of the global liquidity squeeze further deteriorates the external balance. To gauge these risks a low growth scenario is evaluated. The scenario shows the impact of a drop of the oil price to a low of $32 per barrel and a further deterioration of the external environment during 2009.The simulation indicates that Colombia has enough reserves to cushion a potential external financing shock without severely affecting exchange rate stability. In addition, NFPS expenditures are expected to increase in nominal terms keeping the ratio to GDP at the same levels as in the baseline scenario; this is assuming that Government authorities would protect public demand to help boost the economy in the event of a series contraction. This scenario does not pose a serious problem to the public debt sustainability (See Table 4).

Table 3: Low Growth Scenario, 2008-13

66

2008 2009 2010 2011 2012 2013

Real GDP growth (%) 2.5% -4.0% 0.5% 2.0% 2.5% 3.2%

Inflation (%) 7.7% 4.1% 3.5% 3.3% 3.1% 3.0%


NFPS Balance (% GDP) 0.1% -4.0% -2.8% -1.3% -0.7% -0.2%

Investment (% GDP) 24.3% 22.4% 23.3% 24.1% 24.6% 24.7%



Oil price (US$ per barrel) 97.0 32.2 37.7 42.9 48.3 54.3Reserves (US$ Million) 23,478.8 20,551.1 20,626.7 20,393.2 20,389.2 20,436.1

Source: WDI, IMF Data and World Bank Staff estimations.

67

Key Commodities: Recent Trends and Prospects Commodity prices have been declining during the past months and expectations are that most relevant prices will continue to soften and just a few will moderately increase. This is particularly important for a country like Colombia where oil exports represent approximately 25 percent of total merchandise exports, followed by coal (12 percent), coffee (6 percent) and ferronickel (6 percent). The graphs that follow present the favorable recent trends that major commodities for Colombia have exhibited in the past years and how they are expected to behave over the medium term.

Figure 8. International Price of Colombian Commodities

Monthly Trend and Projections for 2009-2012

0

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p)

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(p

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020406080

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Jan-

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09F

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p)

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)20

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200.0

220.0

240.0

260.0

280.0

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320.0

340.0

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07F

eb-0

7M

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7A

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7M

a y-0

7Ju

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7A

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7S

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7O

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7N

ov-0

7D

ec-0

7Ja

n-08

Feb

-08

Mar

-08

Apr

-08

Ma y

-08

Jun-

08Ju

l-08

Aug

-08

Se p

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09F

eb-0

9M

ar-0

9A

pr-0

9M

ay-0

920

09 (p

)20

10 (p

)20

11 (p

)20

12 (p

)

Coffee - Arabica in current US$ (cents/kg)

0

10,000

20,000

30,000

40,000

50,000

60,000

Jan-

07F

eb-0

7M

ar-0

7A

pr-

07M

ay-0

7Ju

n-07

Jul-0

7A

u g-0

7S

e p-0

7O

ct-0

7N

ov-

07D

ec-0

7Ja

n-08

Feb

-08

Mar

-08

Ap

r-08

Ma y

-08

Jun-

08Ju

l-08

Aug

-08

Se p

-08

Oct

-08

No

v-08

Dec

-08

Jan-

09F

eb-0

9M

ar-0

9A

pr-

09M

ay-0

920

09 (

p)

2010

(p

)20

11 (

p)

2012

(p

)

Nickel in current US$ ($/mt)

Source: Based on data from DECPG (projections as of June 1st, 2009).

68

Annex

Colombia Latest Data 180 days Range Change Over Earlier PeriodsAvailable Low High 1 day 7 days 30 days 90 days 180 days

Sovereign Spreads (bp)

JP Morgan EMBI Global 12-Jun-09 282 276 542 4 -4 -71 -205 -252JP Morgan EMBI Plus 12-Jun-09 280 276 542 3 -4 -71 -208 -254Eurospread 15-Jun-09 272 267 563 4 4 -76 -204 -253EMBI Global Emerging Markets EME 12-Jun-09 417 411 786 3 -1 -95 -259 -353EMBI Global Regional LAC 12-Jun-09 461 457 805 4 -12 -106 -245 -330

Credit Default Swap 12-Jun-09 208 204 496 0 4 -55 -229 -194

Corporate SpreadsJP Morgan CEMBI Broad 12-Jun-09 481 465 908 8 3 -171 -421 -326JP Morgan CEMBI Broad Emerging Markets 12-Jun-09 532 527 977 2 -4 -148 -395 -405

GBI - EM (% yield) 12-Jun-09 9.1 8.0 10.5 0.0% 2.2% 10.5% -6.3% -15.0%

Interest Rates (%) 10-Jun-09 6.0 6.0 9.5 0.0 0.0 0.0 -2.0 -3.4

Policy Interest Rate (%) 11-Jun-09 5.0 5.0 9.5 0.0 0.0 -1.1 -3.0 -4.4

Inter Bank Rate (%) 11-Jun-09 5.0 5.0 9.5 0.0 0.0 -1.1 -3.0 -4.4

Stock Market Index 12-Jun-09 9,673 7,456 9,673 0.4% 2.4% 8.6% 23.1% 25.1%

Reserves (US$ mn) 10-Jun-09 23,510 23,073 24,894 5 -78 4 420 -361

Exchange Rate (/US$) [Deprec.(-) / Apprec.(+)] 15-Jun-09 2,017.9 2,015.2 2,608.9 -0.1% 3.5% 10.9% 15.5% 7.1%

One year forward Exchange Rate (/US$) 15-Jun-09 2,125.2 2,123.8 2,741.0 -0.1% 3.7% 10.3% 15.3% 9.2%Brent crude price ($/bl) 12-Jun-09 70.9 34.6 71.8 -1.2% 4.9% 22.3% 55.9% 60.9%

15-Jun-09

Short Term Monitoring Daily Report

Source: LCSPE Database.

Credit Ratings for Colombia

As of June 15, 2009 Moodys Rating Standar & Poor's Fitch

Colombia Sovereign Rating (foreign currency) Ba1** BB+ ** BB+** Colombia Sovereign Rating (local currency) Baa3*** BBB+ *** BBB- *** Memo: Minimum Investment Grade Rating Criteria Baa3 BBB- BBB- Note: *** Investment grade rated; ** just below the investment grade rating. Source: LCSPE Database

69

ANNEX 5: COLOMBIA – DEBT SUSTAINABILITY ANALYSIS

Debt Sustainability Analysis

Debt Sustainability Analysis. Colombia’s present level of net public debt, at about 31.9 percent of GDP (down from a peak of 49.5 percent in 2002) is manageable even when considering possible adverse economic shocks. Many recognize (including the government) that debt needs to decline slightly further as a share of GDP, due to its fiscal cost and the financing vulnerabilities to which it exposes the county. The government’s target is to reduce the level of net public debt to 21.9 percent of GDP by 2019, but given the government’s re-scheduling of the debt they could easily reach a target of 19.1 percent of GDP. We analyze the debt prospects in four different ways: i) a baseline projection; ii) an analysis of policy response that would be necessary for the government to meet the debt reduction target of 19.1 percent of GDP in the face of a high case scenario; iii) projection of what would happen to debt ratio in a high case scenario but there was no fiscal policy response, and iv) an analysis of the sustainability of total public plus private external debt.

The baseline scenario makes the following key assumptions:

2008 2009 2010 2011 2012 2013Real GDP growth (%) 2.5% -0.7% 1.5% 3.0% 3.8% 4.4%Inflation (%) 7.7% 4.3% 4.3% 3.9% 3.2% 3.1%Nominal Exchange rate (e.o.p. COL$/US$) 1,967.7 2,304.0 2,386.9 2,482.4 2,561.6 2,638.1Oil price (US$ per barrel) 97.0 47.2 52.7 57.9 63.3 69.3Primary Balance (% GDP) 2.6% 1.0% 1.7% 2.0% 2.0% 2.0%Implicit Interest Rate 10.5% 7.6% 7.4% 7.4% 7.6% 7.2%

In this scenario, the government achieves its target of reducing the debt ratio to 19.1 percent of GDP in ten years.

The high case scenario makes the following assumptions:

2008 2009 2010 2011 2012 2013Real GDP growth (%) 2.5% -4.0% 0.5% 2.0% 2.5% 3.2%

Inflation (%) 7.7% 4.1% 3.5% 3.3% 3.1% 3.0%

Nominal Exchange rate (e.o.p. COL$/US$) 1,967.7 2,558.0 2,634.0 2,726.2 2,808.6 2,888.6


Primary Balance (% GDP) 2.6% 0.6% 1.6% 2.0% 2.0% 2.0%Implicit Interest Rate 10.5% 6.8% 7.3% 7.2% 7.4% 7.0%

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Table 1 Debt Sustainability with Shocks and Policy Adjustment

Type of shock Primary surplus required to achieve the target debt ratio (19.1 percent by 2019)

Baseline scenario (see above) 2%

High Case 2.7%

If these shocks materialized and policy remained passive, with primary balances unchanged at 2 percent, debt ratios would jump initially and then decline, but the government would not achieve its target for reducing the debt ratio to 19.1 percent of GDP. Under the high case scenario, the ratio would peak at close to 37.1 percent of GDP in 2010, then slowly fall to about 25.9 percent in 2019. This level of debt is certainly high and would put considerable fiscal pressure on the government, but it is not explosive and could be contained by maintaining a primary balance of 2 percent of GDP, which is within the historical experience of Colombia.

Figure 1: Public Debt Sustainability Even Without a Policy Response to Shock.

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

As share of GDP

Baseline

High Case Scenario

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External Debt Analyzing the sustainability of the external debt requires a model that incorporates another set of key macroeconomic variables, such as Colombia’s current account, and allows us to model another set of different shocks, particularly one to inward international capital flows. Total external debt service (public and private) has fallen from a high of above 67 percent in 2002 to more manageable levels of less than 30 percent now,

Colombia’s total external debt profile (public and private) is likely to be sustainable. Total external debt is expected to decline to 15.1 percent of GDP under our baseline scenario. Total external debt reached nearly 48 percent in 2001 without a crisis, in an economic environment that was less favorable than today. In our high case, a transitory peak of 24.4 percent total external debt in would put pressure on financing, but is expected to be manageable.

Table 2 Baseline Case Scenario 2008 2009 2010 2011 2012 2013

(US Billion, otherwise indicated)Debt 46.3 44.9 43.8 42.4 40.9 36.6Change in Debt -1.4 -1.1 -1.5 -1.5 -4.4

Current Account Balance -6.8 -6.9 -5.8 -4.5 -4.2 -3.2

Non-Debt Flows FDI, portfolio flows and capital n.e.i. 10.3 5.9 7.2 6.9 6.5 8.7 Change in Reserves (i) -2.7 2.4 -0.3 -1.0 -0.8 -1.1

Key Macroeconomic AssumptionsGDP (US$) 242.3 209.9 215.2 221.7 230.8 242.1GDP (COP Billions) 476,713.5 483,684.8 513,698.8 550,274.2 591,176.1 638,789.4Exchange Rate (COP/US$) 1967.7 2304.0 2386.9 2482.4 2561.6 2638.1Inflation (%) 7.7 4.3 4.3 3.9 3.2 3.1Growth Rate (%) 2.5 -0.7 1.5 3.0 3.8 4.4Depreciation (%) 7.7 4.3 4.3 3.9 3.2 3.1

(as a share of GDP)Debt 19.1% 21.4% 20.4% 19.1% 17.7% 15.1%Current Account Balance -2.8% -3.3% -2.7% -2.0% -1.8% -1.3%Non-Debt Flows 4.2% 2.8% 3.4% 3.1% 2.8% 3.6%Change in Reserves -1.1% 1.1% -0.1% -0.5% -0.3% -0.5%(i) Negative indicates acumulation of reserves

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Table 3 High Case Scenario

2008 2009 2010 2011 2012 2013(US Billion, otherwise indicated)Debt 46.3 44.2 42.7 40.7 38.9 34.1Change in Debt -2.1 -1.5 -1.9 -1.8 -4.8

Current Account Balance -6.8 -2.9 -2.0 -2.1 -2.5 -2.8

Non-Debt Flows FDI, portfolio flows and capital n.e.i. 10.3 2.1 3.7 3.8 4.4 7.7 Change in Reserves (i) 2.9 -0.1 0.2 0.0 0.0

Key Macroeconomic AssumptionsGDP (US$) 242.3 181.5 184.2 187.9 193.2 200.4GDP (COP Billions) 476,713.5 464,299.6 485,285.9 512,316.3 542,610.9 578,808.0Exchange Rate (COP/US$) 1967.7 2558.0 2634.0 2726.2 2808.6 2888.6Inflation (%) 7.7 4.1 3.5 3.3 3.1 3.0Growth Rate (%) 2.5 -4.0 0.5 2.0 2.5 3.2Depreciation (%) 7.7 4.1 3.5 3.3 3.1 3.0

(as a share of GDP)Debt 19.1% 24.4% 23.2% 21.7% 20.1% 17.0%Current Account Balance -2.8% -1.6% -1.1% -1.1% -1.3% -1.4%Non-Debt Flows 4.2% 1.1% 2.0% 2.0% 2.3% 3.8%Change in Reserves 0.0% 1.6% 0.0% 0.1% 0.0% 0.0%(i) Negative indicates acumulation of reserves

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ANNEX 6: COLOMBIA- FINANCIAL SECTOR REFORMS IN THE LAST DECADE

Strengthening Financial Sector Supervision and Regulation

1. The Financial Reform law of 1999 was instrumental in facilitating the resolution of troubled institutions and in upgrading regulation. Immediately following the crisis, the Superintendency of Banks was given the legal authority to compel banks to improve their loan-portfolio quality and solvency levels and it was able to facilitate the liquidation or merger of institutions, provided certain conditions are met. Housing credit institutions −Corporaciones de Ahorro y Vivienda, at the heart of the banking crisis− were forced to convert into banks or liquidate. Financial cooperatives, previously unregulated and supervised by a less capable regulatory body, were brought under the umbrella of the Superintendency, and a deposit guarantee fund was created for this institution (FOGACOOP). Supervision now covers all financial institutions on a consistent basis, using on-site examination and off-site monitoring. The World Bank provided assistance towards this positive direction.

2. The Financial Reform Law of 2003 further upgraded the regulatory framework as well as the banking resolution procedures. The reform introduced a prompt corrective action framework including guidelines for disciplinary rules based on risk considerations, considering gradual levels of sanctions for varying breaches of regulatory compliance. Norms for the identification of risks associated with financial groups were revised. It also improved the bank resolution process and deposit insurance operational framework and supported the privatization and liquidation of state-owned banks through procedures such as the “carve-out.” This process entailed FOGAFIN to take good assets from troubled banks placing them in a trust that in turn, backs the corresponding deposit liabilities of the intervened bank through a securitization scheme. This Financial Reform was supported by the World Bank’s PFSAL I and II programs.

3. Financial supervision has also been revamped, with a movement towards a risk-based supervision framework. Among the new regulations, financial institutions have been obliged to adopt, where applicable, internal systems to manage credit, market, and more recently liquidity and operational risks. Such systems comprise policies, procedures and a corporate governance structure to deal with each type of risk − including internal limits, remedial actions, and contingency plans− as well as a framework to measure each particular risk. While the regulations allow for institutions to develop their own models to measure credit, liquidity and market risk, in practice all institutions still use the reference models provided in the regulation. Regulations regarding the adoption of internal systems were first issued in 2002 regarding credit risk and in 2007 for market risk, when a Value-at-Risk based market risk capital requirement was introduced for credit institutions and brokerage houses. In 2007 a regulation was issued regarding internal systems to manage operational risks. This regulation instructs institutions to set up a registry of events that cause such risks and the associated losses. Historical loss experiences will be used in the future to determine capital charges for operational risks. The regulation regarding the management of liquidity risks, supported by this operation, was introduced in 2008 (see paragraph 74).

4. Since the 1999 crisis, substantial reforms to the insurance sector regulatory and supervisory framework have been supported under various Bank operations. In 2003, the government determined the timing, risk and technical tools to determine the solvency margin. In terms of reserve requirements, insurance companies must have risk reserves, mathematical reserves, pending-claims reserves and reserves for deviation of claims. There are regulations as to what is permissible by the insurance companies. For example, insurers are able to make loans only against securities and the transfer of resources between banks and insurance companies are regulated like an

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intercompany investment. PSAL I focused on the insurance industry, linking insurance risks to solvency margins and technical requirements, while PSAL II encouraged transparency in the pension market by emphasizing disclosure of markets risks of investment portfolios and reform rules concerning investments in foreign securities. Currently, the solvency norm is being revised to include market and counterparty risk capital charges.

5. Important steps were introduced for the prevention of money laundering (ML) and financing of terrorism (FT). Combating ML/FT is a key element in promoting a strong and sound financial system by avoiding reputational and legal risks. The strategy to improve the framework for ML/FT supervision includes the coordination of regulators, legal enforcement agencies and financial sector authorities. To this end the GoG reorganized the Interinstitutional Coordination Commission on ML (Comisión de Coordinación Interinstitucional Contra el Lavado de Activos, CICLA), a measure supported by the First Programmatic Business and Productivity and Efficiency DPL. Budgetary and institutional capacities have been also improved. Financial institutions were obliged to adopt internal systems to manage ML/FT risks in 2007.

6. The new Bankruptcy Law, enacted in 2002, substantially improved corporate solvency procedures. In the emergency context of the crisis, the legal framework for insolvency and restructuring was adjusted to support distressed debtors. This imbalance away from creditors and financial creditor’s rights hampered insolvency procedures and stymied the execution of restructuring plans30. Since then, improvements in the contractual framework, including the reform of the insolvency framework and the 2002 Bankruptcy Law have strengthened confidence in financial contracts. Improvements to strengthen creditor rights include (i) the possibility of judicial validation of out-of-court reorganization agreements, (ii) the simplification of procedures for an accelerated recognition of controversial claims in insolvency proceedings, (iii) the establishment of provisions to streamline and encourage actions seeking personal liability against directors and officers of the insolvent company, (iv) the adoption of modern rules for the treatment of the international aspects of insolvencies with cross-border impact and (iv) the suppression of “consensual priorities” and of “internal creditors” .

Capital Markets

7. The 2005 Securities Law aimed at developing a regulatory framework flexible enough to deal with innovations. The World Bank supported the merger of the three stock exchanges −Bogotá, Medellin and Cali− and aided in the drafting and implementation of a new Securities Law (Law 964/2005) which established a new framework for the capital markets. The law was supported under the PFSAL II. In order to facilitate the development of efficient capital markets, the Securities Law provides a general framework to deal with key areas through the issuance of Decrees that could be easily amended (see Table 1). This flexibility would allow to adapting the regulations to advances in the technology and organization of the securities business, and to facilitate the development of new products and services. The Law applies to businesses on standard securities, such as stocks and bonds, as well as on standardized derivatives contracts traded in organized markets.

30 For example, voting procedures in restructurings were creating artificial majority outcomes; because shareholders were allowed voting rights with creditors. During insolvency actions, the proper identification of who was entitled to be a creditor delayed the process.

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Table 1: The 2005 Reform of the Colombian Securities Market

Ultimate Objective

Intermediate Objectives

Key areas to be Regulated

Promote sustainable growth through the development of securities market as a channel to facilitate access to finance

Promote the development and efficiency of the securities market Preserve the well functioning, equity, transparency, discipline and integrity of the securities market, and the public trust in it Protect Investors Rights Prevent and manage systemic risk in the securities market

Issuance and public offering of securities Securities brokerage business

Management of collective investment vehicles (except pension funds, which operate under their own legal framework)

Depositaries and administrators of portfolios Registration and trading of securities, futures, options, and other derivatives Corporate Governance Credit-risk rating agencies Self-regulated entities Storage and dissemination of market data Other activities involving securities Clearing and settlement of transactions with securities

8. To implement the Securities Law, the GoC has been issuing a substantial body of regulatory decrees. Those decrees regulated important aspects of securities markets under four big areas: supervision and regulation, infrastructure, architecture and market operations. These included public tender offers, repo31 and sell-buyback32 transactions −the most important money market

31 A “Repurchase agreement”, usually called “repo,” represents a transaction in which a counterpart sells securities to another with a simultaneous agreement to repurchase the same securities at a specified future date.

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operations currently in use in Colombia− and the formation of self-regulatory bodies. Some of those decrees received the support of the Second Programmatic Business Productivity and Efficiency Development Policy Loan. Another important milestone in the securities market reform was the regulation and organization of an Information System for the Securities Market (SIMEV)33.

9. Recent regulations addressed the professionalization of market participants and clarified the framework for the resolution of securities intermediaries. To increase the professionalization of securities market participants, new regulations require certification for certain activities (Decree 4668/2007). The certification needs to be renewed periodically (every 2 or 3 years) through exams. The norm also regulates the functions of the institutions that certify securities professionals. A new Decree (2555/2008) clarifies the mechanism of resolution of failed securities brokerage firms. Prompt and effective resolution minimizes systemic risks, preserves the integrity and the efficiency of the system as well as the public confidence in it and protects investor rights. All of these factors will contribute to the securities market development. Under this regulation, FOGAFIN will appoint the management and liquidator of the failed institution, as in the case of banks, and will supervise their activities in this area, concurrently with the SFC. Before this decree was enacted, the responsibility for failed institutions was not clear.

10. The new regulatory framework for collective investment vehicles will contribute to promote securities market development. The new regulation (Decree 2175/2007) establishes an appropriate framework for collective investment vehicles −other than pension funds, which have their own regulatory regime− as collective investment mechanisms with collective results. Previously, inadequate regulation prevented an effective development of the sector. The regulation establishes the responsibilities of the administrator, the type of collective vehicles that can be established and their objectives. It also regulates the nature of the investors’ participations and the need for contracts to align the interests of administrators and investors.

11. The authorities have also placed substantial efforts to develop government securities markets and the money market. The development of a liquid market of government securities may have a major effect on private sector issuances and the availability of longer term investment options. The GoC has been able to issue instruments in local currency at various maturities, ranging from 90 days to approximately 15 years. This large spectrum of maturities, associated with increased volumes, provide benchmarks for private securities and distinct investment horizons for the several segments of the investor base. To develop a liquid and efficient money market the authorities developed a strategy for short-term debt issuance and developed local repurchase agreement and Treasury bills markets. A FIRST project assisted by World Bank staff, provided support on this area. In January, 2008 the Indicador Bancario de Referencia (IBR), a money market interbank reference rate was launched. IBR

32 A “sell-buyback” (or “simultaneas” in Colombia) used to be treated as two separate trades: a spot sale and a forward repurchase. Since the economic rationale of repos and sell-buybacks are essentially the same, to avoid different legal, accounting and tax treatment between these instruments, Decree 4708-2005 defines both as single transactions between counterparties. 33 SIMEV comprises three registries maintained by SFC: a) the National Registry of Securities and Issuers (RNVE), b) the National Registry of Agents of the Securities Market (RNAMV), and c) the National Registry of Professionals of the Securities Market (RNPMV). Registration at RNVE is mandatory for entities that intend to issue and sell securities to the public, and to have these securities publicly traded in one of Colombia's trading systems. There are presently 482 registered entities, and SFC publishes their institutional and financial information, as well as fines and other administrative sanctions applied to them. RNAMV and RNPMV are registers for natural persons (individuals) licensed to work in the securities market as intermediaries, risk managers, or investment advisors.

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would allow the development of money markets and the development of hedging tools which could reduce the volatility impacts.

12. GoC also authorized the creation of clearing and settlement systems for foreign exchange transactions to take place on organized exchanges and the basis for the development in the activity of commodity exchange(s).34 The former responds to the need of some categories of institutional investors to go through organized exchanges as opposed to over-the-counter (OTC) for their foreign exchange transactions. The latter could play a useful role in financing and risk mitigation of agro-related sectors. The World Bank has provided technical assistance in this area.

34 Decree 700/2006.

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ANNEX 7: COLOMBIA- UPDATE ON THE IMPLEMENTATION OF THE

COUNTRY PARTNERSHIP STRATEGY

Background

1. The existing Country Partnership Strategy (CPS) for Colombia, covering the FY08-11 period, was discussed by the Board on April 2008. The implementation of the strategy, now at the beginning of its second year, has proceeded along the lines proposed in the document, and the approach has been adapted slightly to respond to the changing circumstances in the country.

2. This annex provides a short summary of the progress made in the CPS implementation, as well as the changing conditions in the country due to the international economic crisis. The objectives are to provide an overview of the implementation of the strategy and to explain the role of the proposed operation within the CPS.

3. The CPS was initially designed to be flexible and innovative in responding to Colombia’s financial and development needs. It also reflected the desire by the Authorities to maintain a strong financial and knowledge-based relationship with the Bank. The CPS was closely aligned with the National Development Plan, which established clearly defined priorities, following extensive consultations with the civil society.

4. The structure of the proposed program of support for Colombia was based on six pillars: i) Peace and Security, (ii) Equity, (iii) High and Sustainable Growth, (iv) Environmental Sustainability, (v) Good Governance and (vi) Transversal Themes. It was governed by five principles of engagement: (i) a base level of borrowing of around US$ 4 billion (for the FY08-11 period) with an increasingly active IFC program (in the range of US$300/400 million per year), complemented by a diverse set of analytical and advisory services as well as specialized grants; (ii) flexibility in delivering agreed volumes of lending to facilitate greater efficiency and to leverage global and sub national resources; (iii) selectivity in areas of support within the framework of the country’s own National Development Plan to ensure value-added; (iv) responsiveness in meeting demands for knowledge with a broad range of instruments, and, (v) coordination within the World Bank Group, and with other donors, in support of the National Development Plan.

5. Colombia has made considerable progress in the implementation of its development program and has strengthened its solid partnership with the Bank to become one of the most active Middle-Income Countries institution-wide. The Bank in turn has responded with a support program that is helping the country confront the impact of the current international economic crisis, while maintaining the focus on long term development challenges.

The Evolving Program

6. The flexible design of the CPS has proven to be extremely helpful. It allowed the World Bank to respond in a timely and effective manner to the changing needs of Colombia. In the initial stages of the CPS, the authorities were focused on the innovative instruments available from the Bank, and were particularly interested in domestic currency financing, as well as mix of investment and development policy lending. More recently, as the Colombian economy begun to feel the impact of the international financial crisis, the government has requested rapid responses that ensure the financing required to maintain crucial government programs. The international crisis has also triggered a major increase in the support being requested by the Government for both financial and technical support for confronting the negative effects of a worldwide economic downturn.

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7. Since the April 2008 discussion of the CPS, the Board has approved loans to Colombia in the amount of US$ 1.85 billion. Net commitments, however, were US$ 1.7 billion due to the cancellation of a large component of an existing loan. Most of these approvals took place on December 2008, when the Board considered three important loans: (a) Social Safety Net II- Familias in Accion for US$636.5 million; (b) Sustainable Development III for US$450 million; and (c) a CAT-DDO for US$150 million. The first two loans were identified in the CPS, and their amounts were established according to the financing needs required to protect the most vulnerable in society from the emerging crisis. The CAT DDO was introduced to the program in order to provide the Government with a contingency line, in case of a major natural disaster; however, this loan replaced the cancellation of remaining balances of an investment loan that supported activities for natural disaster mitigation. The overall approvals so far this fiscal year, have been slightly above the US$1.0 billion a year envelope provided under the CPS, primarily due to the Bank’s response to the Government’s requests.

8. Disbursements since the endorsement of the CPS have been around US$1.3 billion, while the overall exposure to Colombia, following scheduled amortizations, has risen to approximately US$ 5.95 billion. The CPS had established a ceiling for the exposure of US$7.4 billion by the end of FY11. The portfolio includes investment operations with an accelerated disbursement profile. Hence the Bank has been in close consultation with the Authorities to ensure that the composition of the Bank’s lending program does not generate an excessive increase in their exposure to the Bank.

9. Several grants have been approved since April 2008. They are designed to assist in a broad range of topics, including environmental issues, peace and development, civil society voice and participation, and labor re-integration. Currently there are 20 grants in effect for a total of $41 million of undisbursed funds. All grants in the Colombia portfolio correspond to one or more CPS goals and pillars. Given the predominance of GEF funds, a significant portion of the trust fund portfolio is focused on environmental issues.

10. The Bank has also been actively engaged in transferring knowledge through direct involvement in key areas of policy dialogue and a broad AAA work program. The Bank’s knowledge work is covering many issues, from labor markets, health policy, social protection, to poverty measurement and public sector reforms. One of the most successful mechanisms of support has been a series of rapid assessments of public sector management that are being carried out in several municipalities and departments. These assessments are becoming an effective instrument to expand the engagement with sub-national governments. Noteworthy, has also been rapid response by the Bank to the Government’s request for assistance in reviewing its poverty figures. Overall, the Bank is fully engaged in the process of helping establish systems of monitoring and evaluation, to measure the effectiveness of public programs.

11. The country’s close engagement with the Bank, under the framework of this CPS period, has placed Colombia as the 7th largest portfolio in the Bank Group (measured by level of exposure) and the third in the region, behind Brazil and Mexico. With 17 active projects, covering a wide variety of sectors (infrastructure, education, peace, rural development, environment, governance and budget support), the Bank has built a solid basis in all pillars of the CPS.

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Largest IBRD Borrowers Colombia: Trend in Lending (Level of exposure as of March 31, 2009) (April 30, 2009)

12. The Bank’s program, under this CPS, has also been responsive to the client’s needs and its desire to innovate. Colombia was one of the first countries to make use of the Bank’s new contingent financing under the revised DDO guidelines. This instrument has been used in two of the loans approved so far under the CPS. The Authorities have also taken advantage of many of the services provided by the Bank’s Treasury. The authorities decided to fix the interest rate for most of the existing loans, at a time when international rates were at relatively low levels. They have also moved aggressively, with Treasury’s support to swap domestic currency liabilities for the dollar liabilities incurred to the Bank. Colombia was also instrumental in the development of the new policy on extending IBRD maturities, first applied to the ICETEX loan, a student loan program supported by the Bank.

The IFC Program

13. To bolster the role of the private sector, the IFC has increased the level of its activities in recent years and the prospects look good for continued investments at the current pace of $250m per year. Commitments in FY08 totaled $264 million, comprising eight projects: US$31 million in infrastructure (1st port investment in Colombia), US$25 million in manufacturing, US$15million in a private equity fund (1st investment in Colombia), and US$209 million in the financial sector. In FY09, so far, IFC committed US$45 million for the Municipality of Bogota (street rehabilitation program), US$50m for the expansion of Colombia’s leading airline, US$2.1 million in microfinance, US$30 million to a fertilizer producer, US$16 million for the construction of two run-of-river hydropower plants and US$20 million for feasibility/environmental studies in a gold mine.

14. At the end of March 2009, IFC's disbursed and held portfolio totaled US$642 million and US$839 million, respectively, or more than 3 times the level of FY05. Syndicated loans (B loans) for which IFC is lender of record amounted to US$218 million. The Country is the third largest country exposure in LAC and 8th in the world.

Portfolio Trend

Lending Volume Approvals (FY01-09, US$M)

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76.3 5.9

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3.63

Miles de Millones US$

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The Emerging Future Lending Program

15. Given the lending envelop provided in the CPS, the Bank is working on a series of operations that could amount to US$2.3 billion for the next two fiscal years. These operations include continued support for the conditional cash transfer program (Familias in Acción); several infrastructure projects, such as Urban Mass Transit projects in six major cities; flood control of the Rio Bogota; solid waste management; support for public sector management and the justice sector; additional financing for the peace and development program; and agricultural and rural development. This proposed Financial Sector DPL is one of two possible policy based loans that might be extended during the next two fiscal years.

16. Several of the proposed loans under preparation could have accelerated disbursement profiles. As a result, the proposed program could easily reach the exposure level guidelines recommended under the CPS. Under the is expected disbursement profile for the loans recently approved, the Bank is ensuring that the Government can count on disbursements of approximately US$1.0 billion for calendar year 2009. As of June, US$550 million had already been disbursed. This pattern of disbursement could be maintained for calendar year 2010, depending on the financing needs of the Government. Such trend of disbursements would generally ensure that the Bank would remain within the current CPS guidelines on both commitments and exposure.

17. The Bank and IFC have been working closely together to foster the cooperation outlined in the CPS. Both institutions are working in a complementary program to support a large infrastructure initiative, Ruta del Sol, which will entail building a 1,000 km four lane highway from Bogota to the north coast of Colombia. This will be done under a public private partnership arrangement. The IFC is also exploring ways to complement the Bank’s support for the ICETEX student loan program, by attracting the interest of local commercial banks in this area of lending. IFC’s current pipeline for the last quarter of FY09 is $140m and includes one project in agribusiness, 3 in financial markets, one in general manufacturing, one in infrastructure, and one in health and education. The corporation is expecting to commit $250m this FY.

18. Given the fast disbursing nature of the Familias en Accion loan, along with the recently disbursed environmental DPL and proposed financial sector DPL, Bank exposure is projected to rise rapidly. The Country Department’s projection for future exposure is displayed below and shows that at the end of FY11, total exposure could surpass the U$7.4 billion suggested in the CPS. The Bank is closely monitoring exposure and is maintaining an intensive dialogue with the Government on possible adjustments that may need to be made in the future lending program in order to comply with exposure restrictions.

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Figure A: Colombia’s exposure to IBRD by Fiscal

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84

ANNEX 9: COLOMBIA - STATEMENT OF IFC’S HELD AND DISBURSED PORTFOLIO

ColombiaCommitted and Disbursed Outstanding Investment Portfolio

As of 5/31/2009(In USD Millions)

Committed Disbursed Outstanding

FY Approval Company Loan Equity**Quasi Equity *GT/RM

Partici pant Loan Equity

**Quasi Equity *GT/RM

Partici pant

2009 Abocol 30 0 0 0 0 30 0 0 0 02009 Avianca 35 0 15 0 0 0 0 15 0 00 Bancamia 3.63 0 0 0 0 3.63 0 0 0 00/02/06 Bcsc 0 25.03 0 0 0 0 25.03 0 0 02008 Bogota muni 45 0 0 0 0 0 0 0 0 00 Capital_bolivar 0 6.78 0 0 0 0 6.78 0 0 00/04/07 Cartones america 30.07 0 0 0 0 29.31 0 0 0 02009 Caruquia 6.45 0 1.2 0 0 3.15 0 1.2 0 02004/06 Carvajal s.a. 78.69 0 30.34 0 0 78.69 0 29.57 0 02008 Cga 64.7 1.35 32.01 0 125.03 64.7 1.35 20.44 0 74.852001 Chmc 0 11.12 0 3.6 0 0 6.3 0 0 06/7/2003 Davivienda i 0 100 65 0 100 0 97 65 0 1002008 Finandina 0 10.1 0 0 0 0 10.1 0 0 02006 Fundacion social 25.61 0 18.04 0 0 25.61 0 18.04 0 02008 Giros y finanzas 0 0 6 0 0 0 0 0 0 02009 Greystar 0 9.48 0 0 0 0 9.48 0 0 00 Guanaquitas 6.55 0 1.3 0 0 1.84 0 1.3 0 02006 Interbolsa 0 3.04 0 0 0 0 3.04 0 0 02007 Kappa 20 10 0 0 0 10 0 0 0 02008 Muelles el bosqu 13.65 0 0 0 0 13.65 0 0 0 02007 Procafecol 0 14.15 0 0 0 0 6.15 0 0 02002 Proteccion 0 3 0 0 0 0 3 0 0 00 Seguros_bolivar 0 37.85 0 0 0 0 37.85 0 0 02007 Sodimac colombia 35.53 0 0 0 0 35.53 0 0 0 02008 Tecnoquimicas 0 25 0 0 0 0 25 0 0 02008 Tribeca fund i 0 15 0 0 0 0 0.71 0 0 00 Wwb cali 5.36 0 0 0 0 5.36 0 0 0 00 Wwb popayan 3.58 0 0 0 0 3.58 0 0 0 0

Total Portfolio: 403.82 271.9 168.89 3.6 225.03 305.05 231.79 150.55 0 174.85

85

ANNEX 10: COUNTRY AT A GLANCE

Colombia at a glance 6/29/09

Latin LowerKey Development Indicators America middle

Colombia & Carib. income(2008)

Population, mid-year (mill ions) 44.5 561 3,435Sur face area ( thousand sq. km) 1,142 20,421 35,510Population growth (% ) 1.2 1.2 1.0Urban population (% of total population) 74 78 42

GNI (Atlas method, US$ bi ll ions) 180.4 3,252 6,543GNI per capita (Atlas method, US$) 4,100 5,801 1,905GNI per capita (PPP, international $) 8,260 9,678 4,585

GDP growth (%) 2.5 5.7 10.2GDP per capita growth (%) 1.3 4.4 9.1

(mo st recent estimate, 2003–2008)

Poverty headcount ratio at $1.25 a day (PPP, % ) 16 8 ..Poverty headcount ratio at $2.00 a day (PPP, % ) 28 17 ..Life expectancy at birth (years) 73 73 69Infant mortali ty (per 1,000 l ive births) 17 22 38Child malnutrition (% of children under 5) 5 4 25

Adult li teracy, male (% of ages 15 and older ) 92 92 88Adult li teracy, female (% of ages 15 and older) 93 90 77Gross primary enrollment, male (% of age group) 117 120 112Gross primary enrollment, female (% of age group) 115 116 109

Access to an improved water source (% of population) 93 91 88Access to improved sanitation faci li ties (% of population) 78 78 55

Net A id Flows 1980 1990 2000 2008 a

(US$ mill ions)Net ODA and offic ial aid 90 89 187 731Top 3 donors (in 2007) : United States -14 -19 105 404 European Commiss ion 0 5 15 74 Spain .. 7 13 64

Aid (% of GNI) 0.3 0.2 0.2 0.4Aid per capita (US$) 3 3 5 17

Long-Term Economic Trends

Consumer prices (annual % change) 26.4 32.4 8.7 7.7GDP implic it deflator (annual % change) 27.6 26.1 25.9 7.7

Exchange rate (annual average, local per US$) 47.3 502.3 2,087.9 1,967.7Terms of trade index (2000 = 100) .. .. 100 132

1980–90 1990–2000 2000–08

Population, mid-year (mill ions) 27.2 33.2 39.8 44.5 2.0 1.8 1.4GDP (US$ mil lions) 33,399 40,274 94,053 242,268 3.7 2.8 4.9

Agr iculture 19.9 16.7 10.4 8.6 2.9 -2.6 3.0Industry 32.5 37.9 29.8 36.5 5.0 1.5 4.9 Manufacturing 23.9 20.6 15.4 16.2 3.5 -2.5 5.3Services 47.6 45.4 59.9 54.8 3.1 16.0 4.8

Household final consumption expenditure 70.2 66.4 66.9 63.1 3.0 1.7 4.5General gov 't final consumption expenditure 10.1 9.4 18.9 16.4 4.2 10.5 4.3Gross capital formation 19.1 18.5 15.7 24.3 1.4 2.0 13.3

Exports of goods and services 16.2 20.6 17.4 18.3 7.5 5.3 5.9Impor ts of goods and serv ices 15.6 14.8 18.9 22.0 0.4 9.0 11.2Gross savings 19.6 21.6 13.5 18.7

Note: F igures in ital ics are for years other than those spec ified. 2008 data are preliminary . .. indicates data are not available.a. Aid data are for 2007.

Development Economics , Development D ata Group (DECDG ).

( average annual growth %)

(% of GDP)

10 5 0 5 10

0-4

15-19

30-34

45-49

60-64

75-79

pe rcen t of total p opu lati on

Age distributio n, 2007

Male Female

0

10

20

30

40

50

60

1990 1995 2000 2007

Colombia Latin America & the Ca ri bbean

Under-5 mo rtality rate (per 1,000)

-8-6

-4-202468

10

95 05

GDP GDP pe r capita

Grow th of GDP and G DP p er capita (%)

86

Colombia

Balance of Payments and Trade 2000 2008

(US$ millions)Total merchandise exports ( fob) 13,115 37,095Total merchandise imports (cif) 11,564 39,669Net trade in goods and services 1,185 -2,139

Current account balance 770 -6,761 as a % of GDP 0.8 -2.8

Workers' remittances and

compensation of employees (receipts) 1,610 4,842

Reserves, including gold 9,006 23,670

Central Government Finance

(% of GDP)Current revenue (including grants) 25.4 31.3 Tax revenue 15.4 23.4Current expenditure 22.0 26.3

Technology and Infrastructure 2000 2007Overall surplus/deficit -6.6 -1.0

Paved roads (% of total) 14.4 ..Highest marginal tax rate (%) Fixed line and mobile phone Individual 35 22 subscribers (per 100 people) 24 95 Corporate 35 33 High technology exports

(% of manufactured exports) 7.7 2.9

External Debt and Resource Flows

Environment

(US$ millions)Total debt outstanding and disbursed 33,930 46,053 Agricultural land (% of land area) 40 38Total debt service 5,105 9,028 Forest area (% of land area) 54.9 54.7Debt relief (HIPC, MDRI) – – Nationally protected areas (% of land area) .. 74.4

Total debt (% of GDP) 36.1 22.2 Freshwater resources per capita (cu. meters) 51,402 48,014Total debt service (% of exports) 28.7 22.3 Freshwater withdrawal (billion cubic meters) 10.7 ..

Foreign direct investment (net inflows) 2,395 10,563 CO2 emissions per capita (mt) 1.4 1.4Portfolio equity (net inflows) 17 …

GDP per unit of energy use (2005 PPP $ per kg of oil equivalent) 9.3 11.0

Energy use per capita (kg of oil equivalent) 689 695

World Bank Group portfolio 2000 2007

(US$ millions)

IBRD Total debt outstanding and disbursed 1,920 4,756

Disbursements 266 564 Pr incipal repayments 242 432 Interest payments 126 256

IDA Total debt outstanding and disbursed 7 2 Disbursements 0 0

Private Sector Development 2000 2008 Total debt service 1 1

Time required to start a business (days) – 36 IFC (fiscal year)Cost to start a business (% of GNI per capita) – 14.1 Total disbursed and outstanding portfolio 107 557Time required to register property (days) – 23 of which IFC own account 84 457

Disbursements for IFC own account 26 237Ranked as a major constraint to business 2000 2007 Portfolio sales, prepayments and (% of managers surveyed who agreed) repayments for IFC own account 20 26 Anticompetitive or informal practices .. 34.5 Crime .. 13.0 MIGA

Gross exposure 97 62Stock market capitalization (% of GDP) 10.2 49.1 New guarantees 0 0Bank capital to asset ratio (%) 11.2 11.4

Note: Figures in italics are for years other than those specified. 2008 data are preliminary. 6/22/09.. indicates data are not available. – indicates observation is not applicable.

Development Economics, Development Data Group (DECDG).

0 25 50 75 100

Contro l o f corruption

Rule of law

Regulatory quality

Poli tical stabil ity

Voice and accountabi lity

Country's percentile rank (0-100)higher values imply bet ter rat ings

2007

2000

Governance indicators, 2000 and 2007

Source: Kaufmann-Kraay-Mastruzzi , World Bank

IBRD, 4756

IDA, 2IMF, 0

Other m ulti-lateral, 6513

Bilateral, 686

Private, 26341

Short-term, 7755

Composition of total external debt, 2007

US$ mi ll ions

87

Millennium Development Goals Colombia

With selected targets to achieve between 1990 and 2015(estimate closest to date shown, + /- 2 years)

Goal 1: halve the rates for extreme poverty and malnutrition 1990 1995 2000 2007 Poverty headcount ratio at $1.25 a day (PPP, % of population) .. 13.5 16.8 16.0 Poverty headcount ratio at national poverty line (% of population) .. 60.0 64.0 .. Share of income or consumption to the poorest qunitile (%) 3.4 3.2 2.6 2.9 Prevalence of malnutrition (% of children under 5) .. 6.3 4.9 5.1

Goal 2: ensure that children are able to complete primary schooling Pr imary school enrollment (net, %) 68 .. 90 88 Pr imary completion rate (% of relevant age group) 71 84 92 107 Secondary school enrollment (gross, %) 50 61 69 85 Youth literacy rate (% of people ages 15-24) 95 96 97 97

Goal 3: eliminate gender disparity in education and empower women Ratio of girls to boys in pr imary and secondary education (%) 108 .. 104 104 Women employed in the nonagricultural sector (% of nonagricultural employment) 44 45 49 48 Proportion of seats held by women in national parliament (%) 5 12 12 8

Goal 4: reduce under-5 mortality by two-thirds Under-5 mortality rate (per 1,000) 35 31 26 21 Infant mortality rate (per 1,000 live births) 26 24 20 17 Measles immunization (proportion of one-year olds immunized, %) 82 95 75 88

Goal 5: reduce maternal mortality by three-fourths Maternal mortality ratio (modeled estimate, per 100,000 live births) .. .. .. 130 Births attended by skilled health staff (% of total) 82 86 86 96 Contraceptive prevalence (% of women ages 15-49) 66 72 77 78

Goal 6: halt and begin to reverse the spread of HIV/AIDS and other major diseases Prevalence of HIV (% of population ages 15-49) 0.1 0.3 0.5 0.6 Incidence of tuberculosis (per 100,000 people) 63 57 51 45 Tuberculosis cases detected under DOTS (%) .. .. 87 83

Goal 7: halve the proportion of people without sustainable access to basic needs Access to an improved water source (% of population) 89 90 91 93 Access to improved sanitation facilities (% of population) 68 71 74 78 Forest area (% of total land area) 55.4 .. 54.9 54.7 Nationally protected areas (% of total land area) .. .. .. 74.4 CO2 emissions (metric tons per capita) 1.7 1.6 1.4 1.4 GDP per unit of energy use (constant 2005 PPP $ per kg of oil equivalent) 8.1 8.4 9.3 11.0

Goal 8: develop a global partnership for development Telephone mainlines (per 100 people) 7.3 10.6 18.1 18.0 Mobile phone subscribers (per 100 people) 0.0 0.8 5.7 77.2 Internet users (per 100 people) 0.0 0.2 2.2 27.5 Personal computers (per 100 people) 0.9 1.7 3.8 8.0

Note: Figures in italics are for years other than those specified. .. indicates data are not available. 6/22/09

Development Economics, Development Data Group (DECDG).

Colombia

0

25

50

75

100

125

2000 2002 2004 2006 2007

Primary net enrollment ratio

Ratio of girls to boys in primary & secondary education

Education indicators (%)

0102030405060708090

100

2000 2002 2004 2006 2007

Fixed + mobi le subscribers In ternet users

ICT indicators (per 100 people)

0

25

50

75

100

1990 1995 2000 2007

Colombia Latin America & the Caribbean

Measles immunization (% of 1-year olds)

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