The peace deal advances, while the economy slows

Latam in Depth Monday, October, 1 The peace deal advances, while the economy slows The fall of oil prices are reducing economic growth in Colombia, weakening the exchange-rate and worsening external and fiscal accounts. As a result, the central bank raised the policy rate and the government is cutting expenditures. However, because of the buffers accumulated during the commodity-boom, policy tightening will be modest and growth is unlikely to fall much further. Lower terms of trade are reducing investment growth, confidence and national income. The economy is gradually slowing. We expect GDP growth of.7% both this year and next. As the energy trade balance shrinks, the current-account deficit remains wide, leaving the Colombian peso vulnerable. We expect some additional depreciation, to 3, pesos to the dollar by the end of this year and 3,3 by the end of 16. The Colombian peso weakening is increasing both headline inflation and core measures. Inflation expectations for some horizons are also deteriorating. We expect only a gradual convergence of inflation to the target. Our forecasts for inflation are 4.8% for this year and 3.% for 16. In response to the evolution of inflation and expectations, the central bank delivered a rate hike in September, earlier than we were expecting. Comments made by a number of board members after the decision suggest that consecutive additional rate hikes are unlikely. We expect only two additional -bp rate hikes (one in 4Q1 and another in 1Q16). Lower oil revenues and weaker economic growth are reducing fiscal revenues. As a response, the government is cutting expenditures, but the public deficit will rise this year. Colombia s government and leaders of the Revolutionary Armed Forces of Colombia (FARC) announced that they are ready to sign a peace deal within the next six months. While a deal would yield long-term growth dividends, it would also generate short-term fiscal costs at a time of lower revenues (increasing the likelihood of another tax reform). Colombia s terms of trade have deteriorated with the decline in oil prices. As a result, the economy is slowing, albeit moderately. Looking ahead, the weaker currency and infrastructure investment (through the 4G PPP program) will provide support for growth, but not fully offset the negative impact of lower oil prices on investment demand, confidence and national income. Growth is therefore likely to remain below the average rates of the past few years. Lower oil prices have led to a sharp exchange-rate depreciation, but the current-account deficit remains wide. Meanwhile, the weaker Colombian peso has been fueling both inflation and some inflation expectation measures, leading the central bank to raise the policy rate. Given the weak recent growth, the policy rate is unlikely to rise much further. Finally, after considerable delays, a peace deal with the FARC seems likely. Peace would yield long-term growth dividends, but it would also generate shortterm fiscal costs at a time when the government is cutting expenditures to offset lower oil revenues. Another tax reform is likely. Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

Macro Vision Monday, October, 1 Slowing, but moderately The economy is gradually slowing. Colombia s GDP grew by 3.% year over year in Q1, surpassing both our and market consensus estimates, following the.8% growth recorded in the previous quarter. As a result, GDP grew by 3.3% in the rolling four-quarter average, below the 3.6% growth reported in 1Q1 and 4.6% growth in 14. Construction continues to lead growth. Activity in the sector was up by 8.7% year over year (vs. increases of 4.7% in 1Q1 and 9.9% in 14). Both the building (+9.1%) and civil work (+8.4%) segments posted strong gains. The former was boosted by a 19.6% jump in non-residential buildings, while housing contracted by.6% as the momentum from the government housing programs (free social housing and mortgage subsidies) begins to fade. Civil works have been boosted by local government spending funded by past oil royalties. On the other hand, manufacturing continues to underperform. Output in the sector fell by 1.3% year over year (vs. -.% in 1Q1), with oil-refining sector output falling by 6.4% (vs. -1.% in 1Q1), still reflecting the temporary shutdown of the Cartagena refinery. However, higher growth in the U.S. and a weaker currency are expected to boost the remaining manufacturing subsectors. The internal demand breakdown for GDP shows that private consumption is holding up well, while public consumption and gross fixed investment have been weak. Private consumption rose by 3.4% year over year. The labor market has been helping consumers: although the national unemployment rate rose in August (to 9.1%, from 8.9% one year before), there was a.% year-over-year increase in employment. Solid consumer credit has also helped. In contrast, gross fixed investment slowed sharply, to 1.9% (from.9% in 1Q1 and 1.9% in 14). In Colombia, as in other Latin American countries (like Chile, Peru and Brazil), investment is the component of demand that is slowing the fastest; but it is not contracting, as it is in those countries. Capital expenditures by the public sector (highlighted by the growth in civil works) are partly offsetting the lower investment in oil and oil-related sectors. 1 8 %, yoy Investment-led slowdown GDP Gross Fixed Investment (rhs) Private Consumption 6 1 4 1-9 1 11 1 13 14 1 Source: Dane, Itaú - While the hard data available for July brought positive surprises, the recent soft indicators suggest a slowdown ahead. Retail sales grew by 4.% from one year before, and sales excluding fuel and vehicles rose by 6.6%, but consumer confidence declined sharply in August. Confidence among retailers reached its lowest level since 4Q13, while industrial confidence was also low, albeit higher than in the previous month. Page

Macro Vision Monday, October, 1 4 3 3 1 1 ma3m The deceleration in private consumption is likely to continue Consumer Confidence Private Consumption (rhs) - 6 7 8 9 1 11 1 13 14 1 Source: Fedesarrollo, DANE and Itaú %, yoy 9 8 7 6 4 3 1-1 We expect the economy to grow by.7% both this year and in 16. This growth rate is below the average rates of the past few years, although it doesn t represent a drastic loss of dynamism. Some factors will serve to partly offset the negative impact of the terms-of-trade deterioration on growth. First, there is the 4G PPP program, through which the government aims to attract private players and thereby narrow Colombia s infrastructure gap. The sale of the utility company Isagen will help the government to fund its share of the necessary capital expenditures. The building phase of the program will start next year, and the estimated investment is 6.% of GDP over a period of six years. The restart of operations at the Cartagena refinery (likely in March 16) will also help the economy. Finally, the depreciation of the peso amid higher growth in the developed economies could also benefit manufacturing exports. On the other hand, as we will discuss below, the room for expansionary fiscal and monetary policies is now much more constrained, so credit expansion and public sector investment are unlikely to help as much as they have before. Lower oil prices limit the room for current-account deficit adjustment The decline in oil prices came at a time when the current-account deficit was already wide. In 14 the deficit was.% of GDP, even though oil prices averaged around USD 1 per barrel (Brent) last year. The combination of the steep decline in oil prices with the wide current-account deficit has made the Colombian peso one of the worst-performing currencies in recent quarters. 4 3 3 1 1 The energy balance continues to shrink Rolling 1-month, USD billion - -1-1 - - -3 Energy balance -3 Non-energy balance (rhs) -4 Jul-8 Jul-9 Jul-1 Jul-11 Jul-1 Jul-13 Jul-14 Jul-1 Source: Haver, Itaú Page 3

Macro Vision Monday, October, 1 Although the current-account deficit is now narrowing (sequentially) in response to the lower internal demand growth and the weaker currency, it remains wide. The current-account deficit came in at USD 4.3 billion in Q1, up marginally from USD 4. billion one year before. As a result, the four-quarter rolling deficit was broadly stable, at USD.8 billion, with the improvement in both the service and income balances offsetting the further deterioration of the trade balance. As a percentage of GDP, the four-quarter deficit continued to widen (to 6.% of GDP, from.7% in 1Q1), reflecting the 19% year-over-year decline in nominal GDP in dollars. Sequentially, however, the deficit narrowed substantially (to.9% of GDP, from 7.% in 1Q1), according to our own seasonal adjustment. The improvement at the margin came mainly from the non-energy trade balance (which narrowed by 1.9% of GDP between 1Q1 and Q1, according to our calculations). Both foreign direct investment and foreign portfolio investment are falling. Direct investment into Colombia (FDI) totaled USD 14. billion over the past four quarters, down from USD 1. billion in 1Q1 and USD 16. billion in 14. The bulk of the drop in FDI is in the energy sector (oil and carbon), which represents 3% to 4% of total FDI. Foreign portfolio investment accumulated over the last four quarters fell to USD 14.8 billion (vs. USD 18. billion as of 1Q1). The positive news is that the share of foreign participants in the domestic bond market is stable, so far, in spite of global volatility. % GDP The current account deficit is still wide - -4-6 Rolling-4Q Seasonally Adjusted annualized -8 1 3 7 9 11 13 1 Source: Banrep, Itaú. Our exchange-rate forecasts are unchanged. We see the exchange rate ending this year at 3, pesos to the dollar and at 3,3 pesos to the dollar at the end of 16. The global appreciation of the dollar will likely lead to some additional depreciation from the current levels. However, we now expect a wider 1 current-account deficit than we did in our previous scenario (.7% of GDP, instead of.3%). We still see the deficit narrowing to 4.8% next year. As the deficit remains high, the Colombian peso will remain more vulnerable than many other floating EM currencies to shocks in external financial conditions. Inflation expectations deteriorate amid high current inflation Inflation and its core measures continue to rise. In August, the inflation rate reached 4.74% year over year (up from 4.46% in July). Inflation has now been above the center of the target range for 11 months, and above the upper bound of the range for seven months. Supply shocks affecting food prices are partly to blame. However, CPI excluding food (as well as each of the other core measures) was also above the upper bound of the target range and above the previous month s level. Page 4

Macro Vision Monday, October, 1 %, yoy Uncomfortably high inflation 4 3 1 Headline Average Core Measures 11 1 13 14 1 Source: DANE, Banrep and Itaú. The weaker currency explains most of the increase in inflation. Inflation for tradable goods (excluding food and regulated items) climbed to.% in August, up from 4.7% in July and.% at the end of 14. While non-tradable-goods inflation has stabilized at 4.% (in June, July and August), it is at its highest level since November 1. 4 %, yoy Inflation expectations are rising Mar-1 Jun-1 Sep-1 Target 3 1 Yearend 1 1 months ahead Yearend 16 4 months ahead Source: Banrep monthly surveys (median forecast), Itaú As a result of these persistently high inflation rates, inflation expectations are rising. Surveyed expectations for year-end 16 inflation rose to 3.6% from 3.3% one month before. For the next 4 months the increase in inflation expectations was more modest, to 3.% (from 3.1%). We expect inflation to end this year at 4.8%. In 16, slower currency depreciation, the economic slowdown and the fading of the supply shocks affecting food prices will likely bring inflation back into the target range, but not all the way to its midpoint. We see inflation at 3.% in December 16. Rate hikes target inflation expectations The central bank of Colombia increased its reference rate by bps in September, to 4.7%, surprising most market analysts, which were expecting rates to be left on hold. At the previous two meetings the board was split over the question of whether to stay on hold, but the September hike had the Page

Macro Vision Monday, October, 1 backing of the entire board. This unanimity was also a surprise, given that recent communications from several board members indicated that some of them were still comfortable with the 4.% policy rate level. With both headline and core inflation on the rise, the central bank highlighted that the one- and twoyear-horizon inflation expectations from surveys are in the upper half of the %-4% target range, while the expectations derived from certain asset prices (for two, three and five years out) are above 4%. The board thus acknowledged that expectations are possibly unanchored. In this context, the board argued that the risk of higher inflation and inflation expectations had increased since the previous meeting, while the risk of lower-than-expected economic growth remained broadly unchanged. After the rate decision, comments made by a number of board members suggested that the rate hike was not necessarily the beginning of a sequence of rate increases (or at least a sequence of consecutive rate increases). These board members are selling the September decision as a signal to economic agents regarding the central bank s commitment to bringing inflation down to the target. In fact, Finance Minister Cardenas (who is also a board member) explicitly said that the rate increase does not indicate the start of a tightening cycle. Meanwhile, co-director Adolfo Meisel said that the hike had an immediate impact on inflation expectations. Ana Maiguashca (another board member) said in an interview that the -bp rate increase was a signal aimed at anchoring inflation expectations and would not necessarily lead to an increase in household borrowing costs. We expect only two additional rate hikes in this cycle, one before the end of this year and another in 1Q16. Evidently, the board is unwilling to hike much in an environment of weak economic growth. The evolution of inflation and (especially) inflation expectations will be key factors determining future policy moves. Living with lower oil revenues On the back of disappointing oil revenues, the authorities adjusted this year s budget. The postponement of expenditures on non-essential items, mainly related to investment, meant an effective reduction of.6% in the budget approved for the year (or.7% of GDP). Even after taking this adjustment into account, however, we estimate the central government s deficit at 3.3% of GDP this year. The authorities are forecasting a slightly lower deficit of 3.% of GDP, although this would still be larger than the.4% deficit recorded in 14. In this adverse scenario, the government expects this year s structural balance to show a slight improvement from the.3% deficit estimated for 14, reaching.%. The low cyclical oil prices would explain close to. percentage points of the difference between the expected nominal deficit and the expected structural deficit. -. -1. % GDP Lower oil and growth widen the public nominal deficit -1. -. -. -3. -3. -4. Structural Balance (Government Forecasts) Oil-price cycle Growth cycle Nominal Balance (Government Forecasts) 14 16 18 4 6 Source: Finance Ministry, Itaú. Page 6

Macro Vision Monday, October, 1 Next year, oil revenue, which includes oil-related rents and income taxes on oil producers, is expected to fall to its lowest level since 1. In nominal terms, oil income of 3.3 trillion Colombian pesos (approximately.4% of GDP) is expected for 16, down from the 9.6 trillion pesos estimated for this year (1.% of GDP) and 19.7 trillion pesos in 14 (.6% of GDP). Besides the negative surprises on oil prices, oil production has also been disappointing. In fact, the government now assumes oil production of 1, tbpd in 16, instead of the 1,94 tbpd forecasted one year ago. 1 Government s oil revenues are falling fast Trillions of COP % of GDP (rhs) 3. 3... 1 1. 1.. 1 11 1 13 14 1 16 Source: Finance Ministry, Itaú.. But the adverse effect of low oil prices will continue to mark the medium-term fiscal outlook. The administration is expecting larger nominal deficits for all years until relative to the estimates it made one year ago, according to the latest multi-year fiscal outlook. For 16 in particular, the authorities are forecasting a nominal deficit of 3.6% of GDP for the central government. As the government s assumption for the long-term price of oil is relatively high, this wide deficit would mean a structural deficit of.1% of GDP. The government expects to reach the 1.% structural deficit target only in. To meet the long-term structural deficit target, the government aims to increase revenues by around 1.4% of GDP over the next decade. Hence another tax reform is possible (perhaps including a VAT rate increase). Peace deal on firmer footing Colombia s government and leaders of the Revolutionary Armed Forces of Colombia (FARC) announced they are ready to sign a peace deal within the next six months. The announcement came three years after the beginning of the negotiations, when the two parties finally agreed on a mechanism to punish those who had committed crimes and on a schedule for the guerrillas disarmament. If successful, the process would put an end to an almost five-decade-long conflict that has exacted significant human and economic costs. This announcement could be a milestone in the peace process, for several reasons. First, both parties have now found common ground on the thorniest issues of transitional justice and disarmament. And second, it proved that discussions have reached a stage where President Santos himself is willing to join the negotiators in Havana (something that he had avoided in the past), which not only gives additional momentum to the process but boosts confidence in the possibility of an agreement (otherwise, his image could suffer from the miscalculation). On the key issue of transitional justice, negotiators found a middle ground between the full amnesty demanded by the FARC and the full application of justice for crimes against humanity pushed by the government. The parties agreed that those who confess to certain types of crimes in a timely manner will serve at least five years of restricted liberty (not necessarily jail time). Those who confess later could serve Page 7

Macro Vision Monday, October, 1 up to eight years in jail. Moreover, individuals who do not confess but are later found guilty would face an even lengthier sentence. Disarmament would come within 6 days of the peace treaty signing. This would constitute the last formal step in de-escalating the violence, following the recent unilateral ceasefire declared by FARC and the government s response of suspending aerial strikes against FARC camps. A fully-fledged bilateral ceasefire could be declared within the next six months. The focus of the negotiations will now shift to implementation, with ongoing discussions over the mechanism for popular consultation. Although not legally required, Mr. Santos has promised to submit the agreement for popular approval. This is a key concern, given how volatile public support for the peace process has been. However, as there is now a concrete deadline (March 3, 16) to present a peace agreement, popular support for a deal may increase (until recently, as negotiations were taking longer than initially expected, support for a deal had been dropping). While a peace deal would have long-term benefits for Colombia, in the short term it could add pressure to the fiscal accounts. While there is a high degree of uncertainty over the fiscal costs of implementing a peace agreement, estimates place the yearly cost at around.% of GDP for a number of years. So far, the political climate is not favorable for further tax increases (given that the government already had a hard time approving a tax reform by the end of last year), but there could be enough political will to debate the matter, given the need for funds if a peace agreement materializes. On the positive side, the peace process will benefit growth (by leading to less infrastructure damage, increased agricultural and mining-related output and a more productive allocation of resources through less spending on security). Moreover, once a deal has materialized, it would provide a clear incentive for the second largest guerrilla group, the ELN, to engage in a peace process as well. João Pedro Resende Miguel Ricaurte Vittorio Peretti Forecast: Colombia 9 1 11 1 13 14 1F 16F Economic Activity Real GDP growth - % 1.7 4. 6.6 4. 4.9 4.6.7.7 Nominal GDP - USD bn 36 87 336 37 38 378 9 66 Population (millions) 4. 4. 46. 46.6 47.1 47.7 48. 48.8 Per Capita GDP - USD,38 6,311 7,86 7,939 8,6 7,96 6,3,47 Unemployment Rate - year avg 1. 11.8 1.8 1.4 9.6 9.1 9. 9. Inflation CPI - %. 3. 3.7.4 1.9 3.7 4.8 3. Interest Rate Monetary Policy Rate - eop - % 3. 3. 4.7 4. 3. 4... Balance of Payments COP / USD - eop,44 1,98 1,939 1,767 1,93,377 3, 3,3 Trade Balance - USD bn 1.7 1.6.4 4.. -6.3-9.7 -.6 Current Account - % GDP -. -3. -.9-3.1-3.3 -. -.7-4.8 Foreign Direct Investment - % GDP 3.4. 4.4 4.1 4.3 4. 3. 3. International Reserves - USD bn.4 8. 3.3 37. 43.6 47.3 46. 46. Public Finances Nominal Central Govt Balance - % GDP -4.1-3.9 -.8 -.3 -.4 -.4-3.3-3.6 Central Govt Gross Public Debt - % GDP 37.7 38.6 36. 34. 37.3 4. 4. 41.7.%.%.%.%.%.%.%.%.% Source: IMF, Bloomberg, Dane, Banrep, Haver and Itaú Page 8

Macro Vision Monday, October, 1 Macro Research Itaú Ilan Goldfajn Chief Economist Click here to visit our digital research library. Relevant Information 1. This report has been prepared and issued by the Macro Research Department of Banco Itaú Unibanco S.A. ( Itaú Unibanco ). This report is not a product of the Equity Research Department of Itaú Unibanco or Itaú Corretora de Valores S.A. and should not be construed as a research report ( relatório de análise ) for the purposes of the article 1 of the CVM Instruction NR. 483, dated July 6, 1.. This report aims at providing macroeconomics information, and does not constitute, and should not be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell any financial instrument, or to participate in any particular trading strategy in any jurisdiction. The information herein is believed to be reliable as of the date on which this report was issued and has been obtained from public sources believed to be reliable. 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