Emerging MarketsNov 21 2016

Investors wary after peace deal rejected

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Investors wary after peace deal rejected

There have been significant political developments in Colombia with president Juan Manuel Santos working hard to end the country’s 50-year civil war with the rebels of the Revolutionary Armed Forces of Colombia (Farc).

While Colombia’s political stability is uncertain, market participants have observed that its economy has always performed relatively well. This situation highlights the complexities of investing in emerging markets and, therefore, the need for investors to carry out in-depth, fundamental research to ensure decisions are both informed and considered. 

At the beginning of October, Colombia joined a growing list of countries that have put important strategic decisions to a popular vote, only to find that the people stubbornly refuse to follow the government’s script. In this case, president Santos had spent four years eking out a painstaking peace deal with Farc leaders in a bid to end more than five decades of violent conflict. 

 It is a sad fact that Colombia’s formal economy has long performed well even against a backdrop of conflict in more remote rural areas

Having already held a formal signing ceremony attended by visiting heads of state, the October 2 plebiscite was intended to secure popular approval for the government’s peace negotiations. Instead, and confounding polls suggesting a 20-point margin for the ‘Yes’ camp, opposition spearheaded by former president Álvaro Uribe won 50.2 per cent of the vote.

Just 50,000 votes out of 13 million tipped the balance into defeat for the government. Adding to the frustration, it seems likely that Hurricane Matthew depressed turnout on the Caribbean coast, where support for the Santos administration and peace deal is strong. 

Nevertheless, it is also clear that opposition to the peace deal centred on a perception that Farc leaders stood to escape punishment for their role in driving the conflict and were being rewarded with congressional representation.

However, the plebiscite defeat should not be seen as a make-or-break episode for the peace process in Colombia. While the government was not expected to lose, a resumption of widespread violence appears low. 

The conflict had been winding down for some time and the broad outlines of a peace deal have been agreed between the combatants. Indeed, the government, Farc and the opposition all quickly promised to work together to forge a new agreement. It is possible that moves to further restrict impunity for Farc leaders prompt splits between the different factions, but it is a sad fact that Colombia’s formal economy has long performed well even against a backdrop of conflict in more remote rural areas. 

One interesting new development is that president Santos has been awarded the Nobel Peace Prize for his efforts; it will be interesting to note whether it has any impact on the negotiations. While  he had staked his administration on the peace process, he is expected to stay in office. However, he has used up valuable political capital and will need to deploy more to successfully revive the negotiations with Farc in Havana. 

The government’s game plan was to bounce from euphoria over endorsement of the peace deal straight to submitting an unpopular tax reform to congress, arguing that higher taxes are necessary to shore up funding to extend the state’s presence to all corners of the country.

In practice, a tax reform is necessary anyway to compensate for the impact of falling oil prices and falling oil production on the budget.

Colombia is an investment-grade sovereign, rated BBB or equivalent by all three major rating agencies. However two of them (Standard & Poor’s and Fitch) put their ratings on negative outlook earlier this year, warning that a downgrade was likely if the government’s tax reform proposals fell short of expectations. Moody’s has highlighted similar concerns following the plebiscite. 

Due to fears that the government is now in a weak position to approve an effective fiscal adjustment, it is likely the rating agencies will follow through with downgrades in the coming months, albeit by just one notch, and, therefore, narrowly preserve the country’s investment-grade status.

The plebiscite, tax reform, soft oil prices and rating agency outlooks have increased the country’s risk profile. Since the vote, the currency, local rates and sovereign credit have all sold off, despite support from firmer oil prices. Further weakness is likely as the market’s attention turns from the peace process to the policy agenda, and specifically to the prospects for tax reform and rating downgrades. Therefore, it is likely investors will continue to trade cautiously. 

Graham Stock is head of emerging market sovereign research at BlueBay Asset Management