Fighting gravity: S&P downgraded Colombia to High Yield

S&P cut the sovereign rating of Colombia from BBB- to BB+, outlook stable, in line with our long-held scenario of a 70% of probability of Colombia losing the Investment Grade status after the hit of the pandemic.

The failure of the original tax reform presented a month ago, the social protests and the low possibilities of a structural fiscal adjustment in the coming years triggered the rating cut. Although a reform is expected in the upcoming months, its quality will be low, a key factor for rating agencies at this point, in our view.

Future economic growth will be critical for assessing rating actions in the coming years, while a stability of institutions that allows to reach social and economic consensus will be a key factor to monitor.

We recently updated our ⦁ analysis about the potential impact of a downgrade on the local debt market, which pointed towards a potential impact of ~100bp under said scenario. Since then, the long end of the curve has risen by ~60bp amid a high volatility, so we expect an initial impact in the 30-40bp range after the S&P’s move, meaning that the downgrade has been already priced in a non-negligible proportion.

In any case, volatility is set to remain high in the short term as the market is likely to start pricing in that Fitch will follow the move of S&P (in fact, a large share of the consensus expected Fitch to be the first mover), triggering outflows in the US$1,4-2,6bn range, according to our estimates.

In any case, the final effect on sovereign rates (and the FX) will be a function on the prospects of fiscal adjustment and economic growth. For now, a thinner tax reform has a high likelihood of being approved in the coming months, which should buy some medium-term stability for fiscal accounts and the social heat. In fact, the MoF, Jose Manuel Restrepo, and some members of Congress expect that a tax bill for 1,2%-1,4% of GDP in gross revenues will be approved in the next months (the tax collection net of social spending would be in the 0,7%- 1,0% of GDP, in our opinion). Should this materialize, the market can start to find a gradual calm.

S&P cut today the sovereign rating of Colombia from BBB- to BB+, outlook stable, a move that came as a surprise given that the agency reaffirmed the BBB- note just a few weeks ago. Thus, after 10 years of maintaining the Investment Grade status by all the 3 major rating agencies, Colombia becomes the new sovereign fallen angel, following a process of fiscal deterioration that began in ~2014 and that was marked by lower oil prices, a deceleration of local economic activity, tough political and economic environments to achieve structural reforms, and the hit of the covid-19 pandemic. The move by S&P is aligned with the expectation we set at the beginning of the ongoing shock of a 70% probability of Colombia losing the Investment Grade in the next 12-months from at least one rating agency. Now, expectations will be built around the possibility of Fitch following suit in the short term, considering that this agency also has a negative outlook on the BBB- and has been the more vocal regarding the steep challenges that Colombia currently faces.

S&P argued that the failure of the ‘ambitious’ tax reform presented by the government in Apr-21 leaves a scenario marked by a net public debt standing above 60% of GDP in the coming years, still-high fiscal deficits amid strong spending needs for the economic recovery, lingering external vulnerabilities, and modest growth capacities, a set-up that is no longer “consistent with an investment-grade foreign currency rating”. On its part, the stable outlook was set as S&P expects a fiscal reform to be approved in the coming months, that activity should continue to recover from last year’s hit, and that an institutional solution to the ongoing social protests would be achieved.

For future, potential rating actions, S&P assigns strong weight to the economic growth capacities the country will show in the coming years, given its effect on fiscal accounts and local social conditions. The agency outlined that a weak recovery of activity and employment, along with permanent deterioration on institutional institutions that constrain the ability to reach economic and social consensus, would put additional pressure on the sovereign rating. Conversely, a scenario of accelerating growth beyond what is expected, structural fiscal adjustments (a low probability event given the upcoming elections) and a deeper and more diverse exports basket will put Colombia back in contention for the Investment Grade status, as per S&P.

Pressures are expected on sovereign rates in the short term, beyond the observed so far this year, which has been indeed strong. We recently estimated that the forced outflows of foreign investors from the local public debt market under the event of Colombia being downgraded to High Yield would be between US$1,4bn and US$2,6bn, equivalent to 2% and 4,1% of the current TES COP total outstanding (see report). These flows will materialize with more strength if Fitch follows suit with a rating cut in the near term, and/or if the Investment Grade in local-currency is also lost in the future (S&P cut this note to BBB-, stable), as this would force out positions indexed to the Bloomberg Barclays Global Aggregate Bonds Index (which has a condition on Investment Grade of the securities included).

The recent performance of the local public debt market amid the failure of the tax reform and the social protests suggests that the rating downgrade has been partially priced. Since the beginning of the social uprising, the TES COP curve rates have increased, on average, by 50bp (+59bp in the long end), which in fact is a moderation from the peak observed on 4-May (+88bp). In our analysis we reach to the result of a ~100bp shock on 10-year local rates in the event of Colombia losing the Investment Grade, given the potential forced outflows and the possible pricing of further rating actions, which means that another ~40bp increase could be observed in the wake of this news.

That said, the final effect on interest rates (and the FX) will depend on the scenario for the fiscal adjustment of the coming years. For now, a discussion of a reform of a 1,2%-1,4% of GDP gross size (a target mentioned recently by the new MoF) will stabilize the pressures on the public debt burden in the medium term and ease the current social heat. The likelihood of such a reform being approved is high given that it will lean on surcharges to the corporate income tax, a wealth tax on individuals and higher charges on dividends, among other, which should not face much resistance in Congress and from the public, specially considering that the intention is to permanently fund social programs. Future, more structural measures will be required while being highly sensitive to the result of the looming presidential elections of 2022.