Wall Street's Dream Colombia Candidate Comes With Health Warning

(Bloomberg) -- As Colombian presidential candidates come, German Vargas is about as good as they get for foreign investors, with proposed plans to slash the corporate tax rate, eliminate levies on dividends and profits for foreign bondholders.  

The only problem is that his proposals put the country’s hard-won investment grade rating at risk.  

Wall Street's Dream Colombia Candidate Comes With Health Warning

Colombia is currently rated two notches above junk, with ratings agencies citing the government’s determination to meet the fiscal rule and narrow the budget deficit as a reason to leave it on hold. That is the same fiscal rule that Vargas wants to make more “flexible,” allowing the government to rack up more debt, while expanding the central bank’s mandate to include targets for economic growth and employment.

“The fiscal rule today is unsustainable,” Vargas said in an interview in Bogota. “We need to make it more flexible, at least during the period of transition, to see if the tax reform like the one we’re proposing is successful.”

Wall Street's Dream Colombia Candidate Comes With Health Warning

To stay within the fiscal rule, which Congress passed in 2011, the government needs to slash the budget deficit to 2.2 percent of gross domestic product by 2019, from an estimated 3.6 percent this year. These targets already looked hard to meet, and will look even less realistic in the context of large tax cuts.

Taking a Risk

Foreign investors led by Franklin Templeton have poured into Colombia’s local peso bond market after a reform five years ago slashed the taxes on foreign bond profits. Foreigners now own about a quarter of the bonds, known as TES, up from 4 percent in 2012.

Vargas, a former Vice President whose grandfather led the country in the 1960s, is proposing to take the tax all the way to zero, from its current level of 14 percent, according to his economic plan published Nov. 14.

The risk is that investors wouldn’t be able to benefit from such a tax cut for long. A loss of investment grade would shrink the pool of investors that consider buying the country’s securities since many institutions such as pension funds forbid investment in assets rated junk.

Fitch Ratings said last week that tweaking the rules governing fiscal policy risks damaging the nation’s credibility.

“If they keep on changing targets and change the rule, you might question a little bit the credibility in terms of fiscal policy,” said Richard Francis, Director of Latin American Sovereigns at Fitch Ratings.

Hang On

The first round of voting will be held in May, with a runoff vote in June. The weakest economy in nearly a decade, corruption scandals and the chaotic reintegration process of demobilized guerrillas are likely to be among the main topics of debate. Other leading contenders include Sergio Fajardo, a mathematician who was Mayor of Medellin, and Gustavo Petro, a leftist former Mayor of Bogota.

A September poll by Invamer placed Vargas second in the election race, with 12.5 percent of voting intentions, behind Fajardo with 21 percent.

Vargas is proposing a bill to reduce taxes on company profits, as well as eliminating sales tax on capital goods. Investors, he says, should hang in there until his tax cuts boost growth and fiscal revenue.

The tax reform will “return competitiveness to companies of all sizes, stimulate investment and contribute to reducing informality,” Vargas said. “We’re probably going to have two or three years of difficulties, but this is the great wager that we have to place.”

To bridge the gap in the short-term, Vargas is proposing a policy as old as the hills -- a crackdown on tax evasion and smuggling. Analysts at Moody’s, Fitch and Nomura Holdings Inc. are unimpressed.

“Many, many countries usually say that one of the measures that they will implement to tackle low revenues or to improve fiscal metrics is to tackle tax evasion and to improve government efficiency,” said Moody’s sovereign analyst Ariane Ortiz-Bollin. “Unfortunately, the evidence shows that that’s very hard to achieve.”

Richard Francis of Fitch said that Colombia is already “relying a lot on formalization and the crackdown on evasion” to meet its fiscal projections, while Mario Castro, a Latin America analyst at Nomura, described the notion as “not very realistic”.

Vargas says Colombia’s central bank should pursue a range of targets, rather than merely focus on consumer price rises. He also wants to reform the royalties system to give regions a greater incentive to back oil and mining projects.

“We have a system which repels domestic and foreign investment and foments capital flight,” Vargas said. The country, “can’t postpone an overhaul of its tax system any longer” he said.

©2017 Bloomberg L.P.