Bogotá — JPMorgan issued a warning last week about the significant decline in liquidity in the Colombian stock market, suggesting that Colombia may face a downgrade from its current status as an emerging market to a frontier market. However, some analysts say there is still a window of opportunity to avoid that scenario if the government sells part of its stake in Ecopetrol, the country’s largest oil and gas company.
In the realm of market classifications, MSCI stipulates that emerging market status is granted to countries with at least three instruments included in their index. Notably, Ecopetrol was removed from this category a year ago, leaving behind only the shares of Preferencial Bancolombia, Ordinaria Bancolombia, and ISA.
According to Daniel Guardiola, Director of Equity at BTG Pactual, there’s a cause for concern. While there are indeed three assets, there are only 2 issuers involved: Bancolombia and ISA. The liquidity of the energy transport company, ISA, has been steadily decreasing, raising the risk of ISA’s exclusion from the index during the November rebalancing.
“In order to retain emerging market status, a country needs to have a minimum of three constituents in the MSCI emerging markets index. Examining the stocks in the index after Ecopetrol’s exit last year, we find PF Bancolombia, the ordinary shares, and ISA. Many investors argue that we lack three constituents; there are three assets, but in reality, there are only two constituents. This becomes the focal point of discussion – whether Colombia meets MSCI’s criteria,” explains Guardiola.
Furthermore, Guardiola underscored the most immediate threat to Colombia in connection with the impending November rebalancing. “ISA represents the weakest link among these two issuers in MSCI due to the gradual erosion of ISA’s liquidity. Investors are apprehensive that ISA might face exclusion from the index during the November rebalancing. Should this occur, MSCI may not even need to seek consultation, as having just two members would render it impossible for Colombia to retain its status as an emerging market index member,” asserted the expert.
He went on to say, “If ISA is removed from the index, Colombia is likely to exit immediately without undergoing a consultation process. This is the challenge we face, and the solution lies in enhancing ISA’s liquidity, boosting its market capitalization, and ideally introducing a new member, preferably Ecopetrol.”
Ecopetrol’s MSCI Path
Guardiola shed light on the factors contributing to Ecopetrol’s exclusion in 2022, primarily attributed to a substantial decline in its market capitalization and liquidity. However, he offered a more positive outlook for the oil company this year compared to 2022.
“What’s required for Ecopetrol’s reentry? Its share price needs to rise, its market capitalization must increase, and it has indeed been on an upward trajectory. The strengthening of the peso has been instrumental in boosting Ecopetrol’s market capitalization, which was the key factor behind its exclusion from the index last year. Yet, it’s essential to note that this is a relative assessment, not solely based on Ecopetrol’s market capitalization. It’s assessed in comparison to other companies within the MSCI index to determine if it meets the minimum criteria for inclusion in the emerging markets index. Ecopetrol holds the potential to be our savior,” asserted BTG’s Equity Director.
A Lengthy Journey for Ecopetrol
Even as the MSCI EM rebalancing looms for November and ISA grapples with diminishing liquidity, there’s a chance that Colombia can maintain its position within the index if ISA can sustain its presence. However, there’s consideration for initiating a consultation process to assess whether investors see merit in Colombia retaining its membership among this group of countries.
In such a scenario, Guardiola proposes an alternative strategy that could secure Ecopetrol’s reintegration into the MSCI basket. However, this path requires a commitment from the government to reduce its stake in the company.
“If exclusion doesn’t happen now, and we initiate a consultation process, one effective measure to ensure Ecopetrol’s inclusion in the index is to increase the company’s float. According to MSCI, the consistent requirement for a stock to enter the index is a float of 15%. Currently, Ecopetrol has a float of 11.5%, meaning that if the Colombian government dilutes its ownership by an additional 4%, Ecopetrol will be obliged to rejoin MSCI EM and maintain its position. When assessed in terms of market capitalization and liquidity, there is no justifiable reason for its exclusion at this juncture. Its absence from the index last year was due to its failure to meet the minimum requirements for companies with a float less than that. This approach represents our nation’s most potent card in preserving our status as an emerging market,” Guardiola elaborated.
It’s worth noting that since 2005, the Colombian Congress has authorized the government to sell up to 20% of the company’s shares. In the final stages of President Duque’s government, the process began to sell the remaining 8.5%, but those plans were abandoned by the current administration of Gustavo Petro.
The Role of the Industry
While Ecopetrol’s return to MSCI EM would uphold Colombia’s emerging market status, Guardiola believes that for improving liquidity indicators in the Colombian market, the government needs to take a more proactive role.
“I think brokerage firms have already done a very thorough job seeking clients and markets, and to address the current problem, the solution doesn’t lie solely with brokerage firms. They serve as a channel, a mechanism, but what’s needed is a catalyst, and that necessitates regulatory incentives for both demand and supply. Over the past decade, Colombia has, in fact, generated regulatory disincentives,” he said.
To tackle this, Guardiola argued, “we need to unlock the float in Colombia because we have a float that doesn’t circulate, doesn’t move. This requires regulatory action; we need someone to take the first step to identify what the market lacks, be it supply or demand. Something akin to what happened in 2017 could be achieved by the Colombian government by listing new companies on the stock exchange or increasing the float of existing companies. In my view, a significant portion of the solutions comes from government action,” Guardiola asserted.
He also underscored that beyond attracting new players and investors, messages promoting participation in the capital market are required, with one of those messages relating to the tax treatment of stocks.
“I believe incentives are necessary, and there are no fiscal incentives at present. Fiscal incentives need to be established for companies to list and for investors to view the stock market as an appealing market. In reality, it has gone in the opposite direction; owning stocks has become more expensive over time,” he remarked.
In 2022, a bill proposing a major reform to the capital market was shelved in Congress. However, Guardiola believes that there are aspects where the government can make progress without the need for legislative action.
“Another regulatory matter concerns the requirements for a company to list on the BVC, which should not be uniform for all companies. It’s not the same to demand certain requirements from Ecopetrol as it is for a startup. There should be varying levels of requirements to encourage more companies to list. Currently, if a company doesn’t have a market cap of US$500 million, it can’t list. Additionally, more safeguards for minority investors are required, and the regulator should spearhead campaigns or projects to revitalize the market,” Guardiola maintained.
Guardiola attributes the Colombian Stock Exchange’s negative returns as the only one in Latin America with this trend to uncontrolled inflation. He notes that the lack of clear evidence of inflation converging to the central bank’s target is a major factor.
“I believe the reason why the stock market has negative returns this year, and it’s the only one in Latin America losing money, is inflation and the lack of clear evidence that inflation is really converging to the central bank’s target. Especially when you compare it to all of Colombia’s neighbors, if you look at the average inflation in Brazil, Peru, Chile, it’s below 6%, so there is very high visibility that inflation is under control. Therefore, interest rates will fall, and incentives to invest in stocks will be created again. Here, inflation is stickier than expected, and its convergence to the central bank’s target is not very visible yet; it’s still in the double digits, and I believe the central bank will start cutting rates until 2024, which will remove visibility from inflation convergence to the target, and therefore, it removes incentives to be invested in stocks,” Guardiola explained.
However, he assured that the conditions offered by the Colombian market today, with high interest rates, do not appear attractive. But once inflation is on track and interest rates start to fall, it will become an attractive option for market participants.
“If you look at very low-risk products like CDTs or fixed income, they are yielding 13%, 14%, so many investors don’t see incentives to enter stocks. Now, when the rates on these products drop to around 4%, the opposite will happen, but more so because of dividends than stock price appreciation. Today, the average dividend yield is 10%, very attractive, but not when interest rates are high,” he said.
Memories of Past Discussions
Guardiola recalled that the discussion about becoming a frontier market had previously been present in the region, as Peru faced a similar process in 2015 and ultimately managed to stay classified as an emerging market.
“In October-November 2015, the MSCI index announced a consultation process to ask investors from around the world whether they believed Peru deserved to remain an emerging market or be reclassified as a frontier market.”
Guardiola also pointed out that the Peruvian economic team took ownership of the issue and started a campaign to promote their market and avoid reclassification as a frontier market.
“That process lasted about six months until April 2016. What Peru did, with the leadership of its president and its financial superintendent, along with the president of the stock exchange and the issuers, was to launch a massive lobbying effort to avoid being reclassified as a frontier market. Their problem at that time was low liquidity, very similar to ours. What they did was regulatory changes to improve the liquidity of the Peruvian market, but above all, they conducted an immense lobbying effort among investors because at the end of the day, they are the ones who decide whether reclassification should happen or not,” Guardiola concluded.