THE COLOMBIAN MONETARY

AND EXCHANGE REGIME UNDER STRESS

José Dario Uribe1

Let me first thank BCRA for organizing this very interesting seminar and for inviting us to
share our experience in these turbulent times. The mere comparison of the shocks our
economies have undergone and our policy reactions, let alone the insights of the
distinguished economists who join us in this timely event, is of great value for our future
policy making.

After the Lehman Brothers bankruptcy in September 2008, the Colombian financial and
foreign exchange markets came under stress. However, the outcome of the shock was less
severe than for other countries in the region. In what follows, I will briefly describe the
macroeconomic context in which the shock occurred, the effects of the shock and the policy
response by Banco de la Republica. While doing so, I will advance some reasons for the
relatively low impact of the shock on Colombia. Most of them are related to the prevailing
regulatory framework.

By the third quarter of 2008, the Colombian economy was experiencing a deceleration of
growth. Consumption growth was weakening as a result of the previous tight monetary

1
Governor of the Central Bank of Colombia. Money and Banking Conference “Lessons and Challenges
for Emerging Countries during the Crisis”. Central Bank of Argentina, Buenos Aires August 31, 2009
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 2

policy and the effect of the relative price increases of raw materials and foodstuffs on costs
and real household income. Public investment fell drastically due to delays in public works
programs. Nevertheless, according to our estimates, there still remained a positive output
gap inherited from several years of strong aggregate demand growth.

As another consequence of the relative price shocks, inflation was moving well above its
target range for the year (3.5%-4.5%). At the same time, inflation expectations started to
rise which threatened to permanently unleash inflation. Hence, policy was further tightened
in July. The sharp appreciation of the currency observed in the first half of the year was
correcting itself possibly due to changing global risk perceptions and the daily purchases of
fixed amounts of dollars by Banco de la Republica in the foreign exchange market.

Immediately after the Lehman failure, the Colombian sovereign risk premium jumped
around 500 bps, an increase similar to the one which occurred in other countries (Charts 1
and 2). The currency moved along, depreciating by 15% between September 12th and
October 29th. Again, this reaction was comparable to the behavior of other currencies in the
region. Domestic public bond interest rates also rose after the shock and the zero coupon
curve became steeper as in other economies in the region (Charts 4 and 5). Thus, the
heightened risk aversion after the shock produced the usual reaction on the foreign
exchange and local bond markets.

Chart 1
 Bps
Bps. 04
/
09 07/
/ 0

0
100
200
300
400
500
600
700
800
0
100
200
300
400
500
600
700
800

14 07/ 8
01/06/ 08 / 0
19 07/ 8
/ 0
24 07/ 8
15/06/ 08 / 0
29 07/ 8
/ 0
03 07/ 8
29/06/ 08 / 0
08 08/ 8
/ 0 08
13/07/ 08 13 8/
/ 0

CDS 1 YEAR
18 08/ 8
/ 0
27/07/ 08 23 08/ 8
/ 0
28 08/ 8
/ 0
10/08/ 08 02 08/ 8
/ 0
07 09/ 8
24/08/ 08 / 0
12 09/ 8
/ 0
17 09/ 8
07/09/ 08 / 0
22 09/ 8
/ 0
27 09/ 8
21/09/ 08 / 0
02 09/ 8
CDS5 YEARS / 0
07 10/ 8
05/10/ 08
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

/ 0
12 10/ 8
/ 0

Chart 2
19/10/ 08 17 10/ 8
/ 1 08
22 0/
/ 0
02/11/ 08 27 10/ 8
/ 0
COLOMBIA - RISK PREMIA

01 10/ 8
/ 0

EMBI - SELECTED COUNTRIES

16/11/ 08 06 11/ 8
/ 1 08
11 1/
30/11/ 08 / 0
16 11/ 8
/ 0
21 11/ 8
CDS10 YEARS

14/12/ 08 / 0
26 11/ 8
/ 0
01 11/ 8
28/12/ 08 / 0
06 12/ 8
/ 0
11 12/ 8
/ 0
16 12/ 8
/ 0
21 12/ 8
EMBI

/ 0
26 12/ 8
/ 1 08
31 2/

PERU

CHILE*
/ 1 08

BRAZIL
2/

MEXICO
08

COLOMBIA
3
 90
100
110
120
130
140
150
01/Jul/2008
12/ 09/ 08

17/ 09/ 08
16/Jul/2008

1 Year
22/ 09/ 08

31/Jul/2008 27/ 09/ 08

02/ 10/ 08

5 Years
15/Ago/2008 07/ 10/ 08

COLOMBIA
12/ 10/ 08
30/Ago/2008
17/ 10/ 08

10 Years
22/ 10/ 08
14/Sep/2008

27/ 10/ 08

MEXICO
29/Sep/2008 01/ 11/ 08

06/ 11/ 08
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS

14/Oct/2008

Chart 4
Chart 3

CHILE 11/ 11/ 08

July 2008- December 2008

16/ 11/ 08
29/Oct/2008
21/ 11/ 08

26/ 11/ 08
NOMINAL EXCHANGE INDEX Sept. 12/ 08 = 100

13/Nov/2008
PERU

01/ 12/ 08

Colombian Government Local Bond Zero-Coupon Rates

28/Nov/2008 06/ 12/ 08

11/ 12/ 08

13/Dic/2008
BRAZIL

16/ 12/ 08

21/ 12/ 08
28/Dic/2008
26/ 12/ 08

8%
9%
10%
11%
12%
13%
14%
15%
31/ 12/ 08
4
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 5

Chart 5

10 Year Government Bond Zero Coupon Rates

Latin America*
21%

19%

17%

15%

13%

11%

9%

7%
01-Jul-08

16-Jul-08

31-Jul-08

15-Ago-08

30-Ago-08

14-Sep-08

29-Sep-08

14-Oct-08

29-Oct-08

13-Nov-08

28-Nov-08

13-Dic-08

28-Dic-08
Brazil Mexico Colombia Peru
*7.25 years for Brazil
Fuente: Bloomberg y SEN

However, the shock had more widespread consequences. As key markets in the U.S. were
closed (e.g. the short term commercial paper and the ABS markets), short term external
funding for emerging markets was severely hampered. Those countries in which the
financial system depended significantly on foreign financing suffered stress in both the
foreign exchange and the local short term lending markets as banks and other institutions
scrambled to close their foreign currency liquidity gaps.

However, this was not the case for Colombia, where regulation prevented local banks from
being exposed to maturity mismatches between currency and foreign currency. It also
restricted their non-derivative net foreign asset position to be positive which effectively
inhibited the existence of a foreign currency interbank loan market.

In other countries, pressures on the foreign exchange market and financial stability emerged
from two things: the exposure of the corporate sector to currency risk and the realization of
huge losses after the depreciation of the local currencies against the US dollar. Again, this
was not the case of Colombia where capital controls and exchange rate volatility limited the
corporate sector’s external indebtedness. At the same time, regulation limited the gross
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 6

foreign exchange derivative position of banks to five times their net worth or less. This was
established to curb bank counterparty risk in a period in which there were large speculative
and arbitrage positions against the dollar and had the effect of restricting the currency
exposure of the corporate sector.

As a result, the impact of the Lehman shock on the Colombian foreign exchange and short
term markets was smaller than it was in other countries. The Colombian peso depreciated
less than other currencies in the region during the fourth quarter of 2008 (Chart 1) while
Banco de la República’s intervention in the foreign exchange market to support the
currency was far lower than elsewhere (Table 1). The interbank overnight interest rates
remained close to the policy rate. The spread between the short term deposit interest rates
and the policy rate did not increase and financial system deposits continued to grow faster
than GDP (Charts 6, 7 and 8).

FX Intervention II Semester 2008 (US$ Million)

Supporting the Local

Supporting the Dollar Total
Currency
Colombia 1.347 -235 1.112
Chile* 3.050 -969 2.081
México** -15.178 -15.178
Perú -5.810 -5.810
Brazil 5.343 -25.967 -20.624
*The "sales" of the second semester correspond to the outstanding value of the swaps by the end of the year.
** By December 11th 200 8 the Central Bank had purchased US$ 22.629 million from PEMEX.

Chart 6
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 7

Spread between the Interbank Overnight Rate and the Policy Rate
2008
20

-20
Basis Points

-40

-60

-80

-100
02-Mar-08

02-May-08

02-Jun-08

02-Jul-08

02-Nov-08
02-Ene-08

02-Feb-08

02-Abr-08

02-Ago-08

02-Sep-08

02-Oct-08

02-Dic-08

Chart 7
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 8

Spread between the Average Deposit Interest Rate and the Policy Rate
2008
-140

-160

-180
Basis Points

-200

-220

-240

-260

-280

-300

07-Nov-08
21-Nov-08
06-Jun-08
20-Jun-08
04-Jul-08
18-Jul-08
04-Ene-08
18-Ene-08
01-Feb-08
15-Feb-08
29-Feb-08
14-Mar-08
28-Mar-08
11-Abr-08
25-Abr-08
09-May-08
23-May-08

01-Ago-08
15-Ago-08
29-Ago-08
12-Sep-08
26-Sep-08
10-Oct-08
24-Oct-08

05-Dic-08
19-Dic-08
Chart 8

Deposit Real Growth Rates

Real Growth of the Deposits in the Financial System *

17,0%

16,0%

15,0%

14,0%

13,0%

12,0%

11,0%

10,0%

9,0%

8,0%

7,0%
20080104

20080125

20080215

20080307

20080328

20080418

20080509

20080530

20080620

20080711

20080801

20080822

20080912

20081003

20081024

20081114

20081205

20081226

* Deflated by CPI ex - food

Credit growth remained strong even for foreign-owned banks (Chart 9), which work as
subsidiaries in Colombia and are subject to the same regulatory framework as domestic
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 9

banks. However, lending interest rate spreads did rise in October 2008 thus reflecting a
larger risk premium, especially for prime and corporate treasury loans (Chart 10). Our
financial system survey showed tightening local credit conditions in the fourth quarter
(Chart 11) and both firms and banks reported anecdotal evidence regarding more expensive
credit with shorter maturities. Interestingly, throughout 2009 the behavior of foreign and
domestic banks in the local loan market has diverged. Foreign banks have drastically cut
their exposure to consumer credit while domestic banks have kept high rates of growth of
loans (Chart 9).

At the same time the external credit lines available to the Colombian Banks were reduced
and their cost raised (Chart 12). Nonetheless, the use of those lines remained below the
approved amounts and declined along with them (Chart 13). This reflected, among other
things, a dramatic fall in the demand for funding linked to international trade (Chart 14).

Chart 9

Real Growth of the Colombian Financial System Loans

25,0%

20,0%

15,0%
%

10,0%

5,0%

0,0%

-5,0%
4/01/2008

4/02/2008

4/03/2008

4/04/2008

4/05/2008

4/06/2008

4/07/2008

4/08/2008

4/09/2008

4/10/2008

4/11/2008

4/12/2008

4/01/2009

4/02/2009

4/03/2009

4/04/2009

4/05/2009

4/06/2009

4/07/2009

4/08/2009

Local Banks Foreign Banks Total

* Deflated by CPI ex - food

Chart 10
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 10

Lending-Deposit Interest Rate Spreads

2008
900

850

800
Basis Points

750

700

650

600

550

500

07-Nov-08
21-Nov-08
06-Jun-08
20-Jun-08
04-Jul-08
18-Jul-08
04-Ene-08
18-Ene-08
01-Feb-08
15-Feb-08
29-Feb-08
14-Mar-08
28-Mar-08
11-Abr-08
25-Abr-08
09-May-08
23-May-08

01-Ago-08
15-Ago-08
29-Ago-08
12-Sep-08
26-Sep-08
10-Oct-08
24-Oct-08

05-Dic-08
19-Dic-08
Average Lending Rate - Deposit Rate Corporate Treasury Rate - Deposit Rate
Prime Lending Rate - Deposit Rate

Chart 11

Observed and Expected Tightening of Requirements for New Bank

Commercial Loans Approval (Survey)
(% of Respondents)

80,0%

70,0%

60,0%

50,0%

40,0%

30,0%

20,0%

10,0%

0,0%
Abr-08

Ago-08

Abr-09

Ago-09
Jun-08

Sep-08

Oct-08

Nov-08

Ene-09

Feb-09

Jun-09

Sep-09
May-08

Jul-08

Dic-08

Mar-09

May-09

Jul-09

Observed Expected (previous quarter survey)

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 11

Chart 12

External Indebtedness through the Financial System: Stock and interest Rate
3.500,0 6,50

3.300,0 6,00

3.100,0
5,50

2.900,0
5,00
Stock (US$ Million)

Interest Rate (%)

2.700,0
4,50
2.500,0
4,00
2.300,0
3,50
2.100,0

3,00
1.900,0

1.700,0 2,50

1.500,0 2,00
Ene Feb Mar Abr May Jun Jul Ago Sep Oct Nov Dic Ene Feb Mar Abr May Jun

2008 2009
Stock Interest Rate

Chart 13

External Credit Lines of the Colombian Financial System

Approved Amounts and Use
9.000

8.000

7.000

6.000
US$ Million

5.000

4.000

3.000

2.000

1.000
Ene

Ago

Ene

Ago

Ene
Nov

Nov
Abr

Abr

Abr
Feb

Jun

Sep

Feb

Jun

Sep

Feb

Jun
Oct

Oct
May

Dic

May

Dic

May
Jul

Jul
Mar

Mar

Mar

2007 2008 2009

Approved Amount Use (Stock)

THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 12

Chart 14

Total Trade (X+M) Subject to Foreign Finance and External Indebtedness through
the Financial System (US$ Million)

5.000 3.500,0
4.800 3.300,0
4.600 3.100,0

E xte rn al In d e b te d n es s
4.400 2.900,0
4.200 2.700,0
T ra d e

4.000 2.500,0
3.800 2.300,0
3.600 2.100,0
3.400 1.900,0
3.200 1.700,0
3.000 1.500,0
20 07 -0 1
20 07 -0 2
20 07 -0 3
20 07 -0 4
20 07 -0 5
20 07 -0 6
20 07 -0 7
20 07 -0 8
20 07 -0 9
20 07 -1 0
20 07 -1 1
20 07 -1 2
20 08 -0 1
20 08 -0 2
20 08 -0 3
20 08 -0 4
20 08 -0 5
20 08 -0 6
20 08 -0 7
20 08 -0 8
20 08 -0 9
20 08 -1 0
20 08 -1 1
20 08 -1 2
20 09 -0 1
20 09 -0 2
20 09 -0 3
20 09 -0 4
20 09 -0 5
20 09 -0 6
Trade External Indebtedness

Meanwhile, the global economy slumped, terms of trade dropped and the external demand
for Colombian products slowed down. Consumer and business confidence indicators
collapsed thus driving domestic spending down. Policy makers were then left facing the
dilemma of high and increasing inflation on the one hand and a growing deterioration of
both the external and domestic economic outlook on the other. Thus, while the picture
became clearer, monetary authorities started to relax policy gradually. Capital controls were
lifted in October and domestic reserve requirements were reduced in November. Liquidity
provision was increased substantially as reflected by the negative and decreasing spread
between the overnight interbank interest rate and the policy rate as the end of the year
approached (Chart 6). Finally, policy rates were lowered by 50 bps in December, the first
such move among emerging economies. A rapid sequence of cuts ensued, dropping the
policy rate from 10% in November 2008 to 4.5% in June 2009.

A key component of the policy reaction was the flexibility of the exchange rate. This was
possible because currency mismatches were small and inflation expectations remained
partially anchored despite the large shocks to the price of food, energy and raw materials.
THE COLOMBIAN MONETARY AND EXCHANGE REGIME UNDER STRESS 13

Exchange rate flexibility was fundamental in many senses. First, it enabled us to avoid the
need to follow the pro-cyclical monetary policies of the past. Second, it worked as an
absorber of the shocks hitting the current account of the balance of payments (terms of
trade, export demand and workers’ remittances). And third, it prevented dollar demand
pressures that liquidity-thirsty global financial institutions would have exerted under a peg
regime.

In summary, in the last quarter of 2008 our economies underwent a rapid transition from a
supply shock situation to a global financial crisis and a world recession. My take from the
Colombian experience is that, as a regime, the inflation targeting framework with financial
stability complements has fared well and done the best possible job of withstanding the
storm. This was mostly due to the fact that the financial stability measures taken before the
crisis, when the economy was booming, enabled us to avoid large mismatches and to
moderate leverage. The results were:

-The financial system was strong enough to absorb a large external shock and policy makers
could focus on dealing with its macroeconomic consequences.

-The regime was flexible enough to accommodate a gradual path of disinflation under a
preannounced path after the relative price shocks pushed inflation far above target.

-At the same time, this flexibility allowed the central bank to maintain the liquidity of the
financial system in a period of stress.

Our challenge ahead consists of carefully examining our financial regulatory framework to
shore up some aspects such as countercyclical provisioning and bank capital requirements.
Simultaneously, we must strive to enhance financial deepening and enlarge the set of
financial instruments available to Colombian firms and households. However, we must do
so without significantly increasing systemic risk or depriving policymakers of the tools they
need to face shocks. In such a task, difficult tradeoffs must be made, most importantly,
perhaps, the one between the financial integration of the Colombian economy and the scope
for systemic risk and macroeconomic management.