Colombia was one of the best performing emerging markets last year, growing by around 6 percent, and it should continue to do well over the coming years. However, there are three reasons to think that the current pace of growth is unsustainable, according to Capital Economics.

First of all, Capital Economics notes that growth is dependent on rapid capital inflows. While around half of inflows are long-term FDI, which tend to be stable, the other half is shorter-term portfolio and banking flows. These tend to be more volatile, leaving Colombia more vulnerable to a fresh spike in investor risk aversion than in the past.

Going by the report of Capital Economics, the second reason for caution is that a renewed escalation of the euro crisis this year is expected to cause global risk appetite to weaken. At the same time, commodity prices are likely to fall. This would cause a deterioration in Colombia’s terms of trade, further weakening demand. Finally, even if we are wrong on the global backdrop, it seems unlikely that the recent rapid pace of demand growth can be maintained. Credit is expanding at an unsustainable pace, and there are signs of a bubble developing in the property market.

Capital Economics points out that in the near-term, this means that policymakers will stay focused on the threat of overheating. If market-implied inflation expectations move above 4 percent, then interest rates may be hiked again. If strong inflows persist, the authorities could be expected to prevent the peso from appreciating much beyond 1,750/$.

But Capital Economics adds that if the global economy weakens in line with the forecast, Colombia is likely to lose some of its steam. Although a collapse in growth is not envisaged, it is expected to slow from 5 percent this year to around 3.5 percent in 2013. This should ease fears of overheating and may even be sufficient to prompt interest rate cuts.

Emerging markets Investment