1. Stimulating growth, What should be done? The case of Colombia María Teresa Ramírez XXV Meeting of the Latin American Network of Central Banks and Finance Ministries, Washington, May 17-18 2007

2. Outlook Outlook 1. Current Economic Growth 2. Is this rate of growth sustainable? 3. What should be done in the long run?

3. 1. Current Economic Growth The annual growth rate of GDP for 2006 was 6.8%, higher than expected. 6.8%

4. This good performance is explained by a rise in gross fixed capital formation, in particular in machinery, equipment, and construction, which contributed to the increase in productivity. This growth was also driven by household consumption and external demand (favorable terms of trade and the world economy growth).

5. On the supply side, economic growth was explained by the good performance of manufacturing and construction.

6. Two main causes behind the economic growth of 2006: An increase in investment An increase in productivity Both generated by a high level of confidence and a positive macroeconomic performance.

7. Are these sustainable? The potential economic growth in the next year will depend on the possibility of maintaining the current levels of investment and productivity. According to the economic models built by the Banco de la República: Given an investment rate of 18% and an annual rate of productivity growth of 0.8%, the rate of economic growth is estimated at 4.7%. Given an investment rate above 20%, that enhances productivity growth, the rate of economic growth is estimated between 5 and 6%.

8. 2. Is this rate of economic growth sustainable? Historically, the Colombian economy has not been able to maintain investment rates of 20% for more than three years. However, current conditions suggest that the recent rates could last longer than in the past. Why?

9. The actual peak in investment is concentrated on machinery and equipment … 38% … which current destination is targeting export activities.

10. One of the main differences with the last decade was the way in which the rate of investment was financed: Similar rates of investment but financed in a different way 1992-1995: 2003-2006: Fall in domestic savings (1.5%), Increase in domestic savings (5%), with a high current account deficit (6.7% GDP) with a low current account deficit (0.9% GDP) What is the risk? Deterioration in the fiscal balance as well as in the current account balance Approval of TLC (FTA)?

11. … What about the productivity? With the surge of investment, in particular in machinery and equipment and the actual level of confidence as a result of the improvement in security, it is likely that the economy will exhibit productivity rates of growth above 1.5% per year.

12. 3. What should be done in the long run? The question here is: what should be done to maintain high investment rates and productivity growth in the long run? Focus on the following issues 1. Institutions and security 2. Competitiveness' Policy 3. Capital market development 4. Education for growth 5. Infrastructure All of the above plus a stable macroeconomic environment.

13. Two of the most critical areas are Law and Order and Property Rights. One of the main incentives to investors is precisely to have their property rights guarantied. 1. Institutions and Security:

14. The literature (Cárdenas, 2007, Suarez, 2006) identifies the violence as one of the main causes of the low productivity growth in Colombia. Although the indicators have fallen, it is important to continue the reduction of crime and violence to obtain higher levels of economic growth.

15. Colombia obtained the 65 th place in the GCI among 125 countries. 2. Competitiveness' Policy Low Competitiveness 65

16. The indicators of R&D are very low in Colombia, even for Latin American standards.

17. It is only until recently that sectors such as flowers and textiles are playing the dynamic role that the coffee sector had in the past. Low invention

18. Low high technology exports.

19. In summary, Low competitiveness, lack of innovation and research & development could jeopardized growth. The goal is to foster competitiveness, Appropriate rules of the game

20. Informality has increased since the middle of the nineties. Despite good economic performance, informality remains high and stable. Informality Compared with other countries informality is high.

21. This high level of informality could affect the productivity of the country: Technology can only be transferred to the formal sector (Prescott, 2003) Informality could affect the incentives to accumulate human capital Low plant size (sacrifices scale economies) Low physical capital accumulation Low access to financial market.

22. Why is the informal sector large in Colombia? According to Arango et al (2007) the main causes of informality in the country are found in structural and regulatory issues, regarding: High tax rates to labor income and capital income High labor costs The existence of subsidies that promote informality Education costs relatively high (opportunity costs) High search cost Therefore, it is necessary to modify the actual scheme of incentives and to promote law enforcement.

23. Colombia presents low market capitalization relative to GDP. But it is increasing. 3. Capital Markets development:

24. In Colombia the relative increase in market capitalization does not come from new firms. Delisting since the middle of the nineties

25. Colombia also presents a structural low trading value (% of GDP).

26. In summary, The development of the capital market in Colombia is considerably lagged for international standards. To maintain high growth rates it is necessary to deepen the capital market in the country. A profound capital market is important to allocate resources to investment projects and to better firm financing. One way could be to encourage good corporate governance: Promoting good corporate governance is an instrument to enhance investor’s protection which contributes to the development and transparency of capital markets. Linked to the above is the role of private pension funds as the largest institutional investors that need better diversified portfolios.

27. According to the National Planning Department, over 50% of the labor force has not completed secondary school. To obtain higher rates of economic growth it is necessary to have a more qualified labor force. 4. Education for growth:

28. In fact, school enrollments in secondary and tertiary education are relative low in Colombia…

29. …. And also presents less years of schooling than most of the countries in the sample.

30. Although, the current public expenditure on education is high for Latin American standards… This suggests efficiency and quality issues. According to the International Association for the Evaluation of Educational Achievement, that measures education quality, Colombia presents one of the lowest performance in a sample of 41 countries.

31. According to López (2006), in 2004 only 59% of high school graduated students were admitted to college or some form of higher education. For the poorest population this admission rate was 16% while for the richest 95%. In addition, the unemployment rate of high school graduated students that do not attend college, was 45% for the poorest population and 23% for the richest.

32. For instance, Colombia must guarantee the access and permanence of poor students in higher education by granting them financial support that will reduce their opportunity cost. The target of the country should be to enhance tertiary education to qualify the labor force.

33. … Also, tertiary education institutions should encourage their teachers to complete higher degrees by giving the right incentive structure.

34. Colombia presents one of the lowest indicators of transport infrastructure quality. 5. Infrastructure:

35. The deficient transport infrastructure in Colombia constitutes one of the main restrictions to economic growth in the long run. To generate an adequate infrastructure to promote growth it is necessary to consolidate, integrate and modernize the road network and to extend the capacity of the ports as well as modernize them (Ramírez, 2006). These projects are expensive and require many years for their development.