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IMF Executive Board Concludes Article IV Consultation with Costa Rica

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
May 2016
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On May 16, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Costa Rica.

Background

Costa Rica bounced back quickly from the 2008–09 global crisis, but growth, despite picking up in the last two years to 3.75 percent, has stayed below trend, while macro vulnerabilities, mainly from the weak fiscal position, have risen. Failure to reverse the counter-cyclical budgetary stimulus imparted in 2009, and a rising interest bill since then have pushed the deficit to about 6 percent of GDP in 2015–16. This has placed the public-debt-to-GDP ratio on an unsustainable path, which is fast approaching levels shown to increase risks of disorderly adjustment for emerging economies. Inflation, on the other hand, has been on a trend decline, and has turned negative in 2015, owing largely to lower oil prices. The current account, benefiting from the positive terms-of trade shock, has shrunk to about 4 percent of GDP and is entirely financed by Foreign Direct Investment. Continuing fast expansion of dollar-denominated credit, facilitated by a stable exchange rate, has exacerbated vulnerabilities in the financial sector, rendering further improvements in regulation and supervision even more important.

Growth is expected to accelerate to 4.25 percent in 2016 supported by the dissipation of the one-off effects arising from a withdrawal of Intel’s manufacturing operations, further terms-of-trade improvement, and current accommodative monetary policy stance. The output gap is anticipated to stabilize in 2016, and then close over the medium term. The baseline scenario contemplates fiscal consolidation measures of 2.25 percent of GDP over the medium term. The central government overall deficit would decline moderately to 5.25 percent of GDP and the public debt ratio would reach almost 55 percent of GDP by 2021. Inflation is expected to return to the center of the new 2–4 percent target range by end-2016 and hover around that value through 2021, buttressed by continued prudent monetary policy. The current account deficit should widen slightly to 4.25 percent of GDP over the medium-term, amid gradual recovery of international commodity prices.

Risks to the outlook are tilted to the downside. Concerning external factors, in the case of faster US monetary policy normalization, slightly upside risks prevail, with a positive impact of higher US growth more than offsetting the negative influence of tighter global financial conditions in the short run. However, extreme bouts of market volatility could inflict serious damage. Continued real exchange rate appreciation can negatively affect external competitiveness. Deeper-than-expected slowdowns in the rest of the world could also hamper Costa Rica’s growth. On the domestic side, the persistent large fiscal deficits could render the economy vulnerable to sudden changes in financial market conditions, necessitating an increase of domestic interest rates, which would weigh on private investment and growth. Financial stability could be jeopardized by substantial currency depreciation, mainly through higher non-performing loans.

Executive Board Assessment2

Executive Directors commended Costa Rica’s rapid recovery from the global financial crisis. However, Directors noted that recent growth rates, while increasing over the last two years, have moderated below trend and macroeconomic vulnerabilities have increased arising mainly from the large fiscal deficits and high dollarization. They stressed the importance of a well-calibrated policy mix and broad political consensus to ensure macroeconomic and financial stability and support inclusive growth.

Directors welcomed the authorities’ fiscal consolidation strategy focusing both on revenue and expenditure measures. They took positive note of the plans to increase tax collections, impose tougher sanctions against evasion, and implement the income tax reform as well as the VAT reform with targeted support to offset the impact on lower-income households. The planned reduction in the growth of current expenditures will also be important. Directors supported phased adjustment over the medium term with significant frontloading to balance the objectives of maintaining growth and lending credibility to the adjustment effort. They emphasized that full implementation of the planned fiscal reforms will be critical to reducing the large budget deficit and stabilize the level of public debt over the medium term.

Directors viewed the current expansionary monetary policy stance to be appropriate and commended the progress made toward the inflation targeting regime. Welcoming the removal of the exchange rate band, they highlighted that gradual steps towards greater exchange rate flexibility would strengthen the credibility of the inflation-targeting framework and protect against shocks. Directors also saw merit in deepening of the foreign exchange market, thereby facilitating greater exchange rate flexibility.

Directors noted that while the financial system is sound, regulatory upgrades aimed at reducing dollarization and strengthening supervision will be important going forward. They encouraged the authorities to fully implement the 2008 FSAP recommendations, gradually adopt Basel III standards, and improve cross-border supervision. Directors observed that greater competition between public and private banks would help lower interest rate spreads and foster further financial deepening.

Directors called for stronger emphasis on structural reforms to boost Costa Rica’s growth potential and competitiveness. They encouraged greater private sector participation in the energy sector, along with a review of the tariff-setting framework, and infrastructure upgrades, notably to ease transportation bottlenecks. They saw scope for efficiency gains and improvement in educational outcomes. Directors stressed that more efficient education and social spending would especially benefit the most vulnerable segments of the population and foster more inclusive growth.

Table 1.Costa Rica: Selected Social and Economic Indicators, Baseline Scenario 1/2/
Population (2014, millions)4.8Human Development Index Rank (2013)68 (out of 187)
Per capita GDP (2014, U.S. dollars)10,425Life expectancy (2013, years)80.0
Unemployment (2014, percent of labor force)9.7Literacy rate (2014, percent of people ages > 15)98.0
Poverty (2014, percent of population)22.0Ratio of girls to boys in primary and secondary
Income share held by highest 10 percent of households39.4education (2013, percent)103.0
Income share held by lowest 10 percent of households1.7Gini coefficient (2012)48.6
Est.Proj.
201220132014201520162017
(Annual percentage change, unless otherwise indicated)
Output and Prices
Real GDP growth5.21.83.03.74.24.3
Output gap (percent of potential GDP)2.80.4−0.8−1.1−0.9−0.6
GDP deflator3.94.24.72.23.43.2
Consumer prices (end of period)4.63.75.1−0.83.03.0
Money and Credit
Monetary base16.910.210.49.29.19.0
Broad money10.77.715.46.68.68.3
Credit to private sector13.412.217.511.812.112.0
Monetary policy rate (percent; end of period)5.03.85.32.3
(In percent of GDP, unless otherwise indicated)
Savings and Investment
Gross domestic investment20.518.819.619.119.119.3
Gross domestic savings15.313.814.915.114.915.0
External Sector
Current account balance−5.2−5.0−4.7−4.0−4.2−4.3
Of which: Trade balance−11.6−11.3−10.5−10.2−10.2−10.4
Financial and capital account balance9.56.44.66.25.15.1
Of which: Foreign direct investment4.14.84.04.14.34.3
Change in net international reserves (increase -)−2,110−461113−622−500−500
Net international reserves (millions of U.S. dollars)6,8577,3317,2117,8348,3348,834
Public Finances
Central government primary balance−2.3−2.8−3.1−3.0−2.4−1.5
Central government overall balance−4.5−5.6−6.0−5.8−5.8−5.4
Central government debt34.336.039.342.445.047.3
Consolidated public sector overall balance 3/−4.5−5.4−5.6−6.0−6.2−5.7
Consolidated public sector debt 4/37.642.043.246.047.949.6
Of which: External public debt7.38.910.511.712.212.7
Memorandum Item:
GDP (US$ billions)46.549.649.652.956.960.8
Sources: Central Bank of Costa Rica, Ministry of Finance, and Fund staff estimates.

Includes cuts in transfers of about 0.4 percent of GDP, another 0.2 percent of GDP of expenditure cuts in a 2016 supplementary budget, broadening of the VAT base and higher taxes on sales of vehicles and real estate from the last quarter of 2016, increase in marginal income tax rates on higher-income brackets from 2017, as well as further amendments to the corporate income tax and moderate gains from improved tax administration.

Data for 2012-15 reflect new nominal and real GDP data released by the authorities under new statistical standards and new base year 2012. The methodological changes resulted in an upward revision in nominal GDP of about 2V2 percent in the base year, as a result mainly of a higher share of the rapidly growing services sector. Pending the release of the full new historical GDP series, nominal and real GDP prior to 2012 are staff estimates using new 2012 GDP data by component, and available past growth rates of components under the old standards.

The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises, and the central bank, but excludes the Instituto Costarricense de Electricidad (ICE).

The consolidated public debt nets out central government and central bank debt held by the Caja Costarricense del Seguro Social (social security agency) and other entities of the nonfinancial public sector.

Sources: Central Bank of Costa Rica, Ministry of Finance, and Fund staff estimates.

Includes cuts in transfers of about 0.4 percent of GDP, another 0.2 percent of GDP of expenditure cuts in a 2016 supplementary budget, broadening of the VAT base and higher taxes on sales of vehicles and real estate from the last quarter of 2016, increase in marginal income tax rates on higher-income brackets from 2017, as well as further amendments to the corporate income tax and moderate gains from improved tax administration.

Data for 2012-15 reflect new nominal and real GDP data released by the authorities under new statistical standards and new base year 2012. The methodological changes resulted in an upward revision in nominal GDP of about 2V2 percent in the base year, as a result mainly of a higher share of the rapidly growing services sector. Pending the release of the full new historical GDP series, nominal and real GDP prior to 2012 are staff estimates using new 2012 GDP data by component, and available past growth rates of components under the old standards.

The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises, and the central bank, but excludes the Instituto Costarricense de Electricidad (ICE).

The consolidated public debt nets out central government and central bank debt held by the Caja Costarricense del Seguro Social (social security agency) and other entities of the nonfinancial public sector.

Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.

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