The Costa Rican authorities appreciate the constructive and transparent dialogue with staff and broadly concur with its assessment and key recommendations.
Costa Rica has continued growing at an accelerating rate during the last three years. As a small open economy, the country is exposed to a variety of shocks such as commodity prices volatility, international financial conditions and main trade partners’ growth, besides its high exposure to natural disasters. Thanks to an increasingly diverse economy, adverse weather conditions for main agricultural exports were compensated by dynamic export of services and lower import commodity prices, especially oil during 2015. Exports supply has widen, medical devices—the main export product—continued to perform strongly while services grew 8.4 percent in 2015 reaching all-time records driven by tourism, IT, information, medical and other business services. FDI also grew in 2015 and is expected to continue financing a sustainable current account deficit. The central bank’s growth projection for 2016 rose to 4.3 percent after closing at 3.7 percent in 2015. The combined effect from improved external demand, stability in main macro variables and lower interest rates have contributed to accelerate the rate of growth which raised to 5.4 percent y-o-y as of February 2016.1
Overall, the economy is expected to continue growing above 4 percent in the medium term in the midst of a fiscal consolidation process and propelled by a loose monetary policy stance, if price pressures do not arise. Even though some risks in the financial sector have build up, the sector remains sound and resilient and the authorities have put in place a number of measures and stand ready to take further actions to keep strengthening the financial system and maintaining it in a growth-friendly development stage.
The government has put in place many administrative measures and a technological revamp to improve tax management. The start up of a new virtual tax administration system eased significantly the administrative cost for taxpayers and digitalized all relevant information to tighten controls. A special strategy to closely monitor large taxpayers was put in place which, combined with other efforts, has helped increase the number of income tax files by 21 percent and income tax revenue by 14.3 percent during 2015. Consequently, the revenue effort climbed to 13.7 percent of GDP in 2015 from 13.2 percent in 2014.
On the spending side, the government has continued working to reduce the growth rate of the wage bill and other current outlays. Latest figures show that the Q1 2016 wage bill grew 3.4 percent compared to the same period last year, while the average growth rate on the first quarter of the last four years was 9.9 percent. In the same vein, purchases of goods and services decreased 28 percent during the first quarter compared to the same period last year. Even though it is too early in the year for conclusions, the government is showing its commitment to hold up current expenditure. In fact, salary increases during the last semesters have been almost negligible for professional central government servants.
With regard to fiscal reform, the government has sent to congress a comprehensive package of law initiatives,2 nine law proposals, to address both the revenue and the expenditure sides of the balance. The broad part of the adjustment is expected to come from the reform to VAT and income tax which were submitted to Congress last year. In the current VAT setup, services—the most dynamic sector of the economy—are exempted. Thus, the proposal amends these leaks while regressivity concerns have been tackled by exonerating the population below the last 4 deciles of the income distribution. The Anti-smuggling law was approved by congress as expected and it is already under execution.
In the case of the Anti-tax evasion initiative,3 its approval has taken longer than expected because the government managed to include the foundation of a business ownership registry, including information of final beneficiaries. This goes in line with OECD, G-20 and G-5 recent initiatives to allow for future automatic exchange of information. In the meantime, the corporate tax law is advancing properly in congress; its final approval is expected soon.
On May 1, 2016 a coalition of parties that control congress directorate agreed on promoting a fiscal reform agenda tilted to the expenditure side. They are proposing to approve a comprehensive set of expenditure measures before approving VAT and income tax reforms. Since many of the coalition measures were already contemplated in the government package (see footnote 2), the authorities have taken this as an opportunity to speed up fiscal reform and negotiations are currently underway.
Monetary Policy, Exchange Rate Policy and Financial Sector
The central bank has continued working on strengthening its monetary policy framework in order to have inflation as the undisputable anchor, including the successfully surrender of the XR band in early 2015. Also, it has succeeded in anchoring inflation expectations, allowing the recent revision of the inflation target range to 2-4 percent (from 3-5 percent), in line with average inflation of main trading partners.
So far three particular characteristics of the economy have shaped the current FX intervention rule aiming at countering deviations from medium-term fundamentals as well as from excessive volatility. First, the high level of dollarization is making the bank more vigilant of financial sector vulnerabilities. Second, the FX market lags competition since it is dominated by few large players. Finally, since the inception of the new XR regime, the FX market has been largely on surplus which would have induced even larger real exchange rate appreciation in the short run.4 The staff has seen merit on this explanation and the central bank is working on a new set of rules that would increase competition and deepen the FX market. More XR flexibility and communication on the intervention policy would flow as these measures are put in place.
The authorities concur with staff that the dollar-denominated credit has been growing faster than desirable and, as recognized in the report, they have come up with a series of measures to address this common concern. They already increased capital risk-weightings for dollar denominated credit to unhedged borrowers and set up a 15 percent reserve requirement to medium- and long-term new foreign bank borrowing (this requirement on short-term foreign borrowing was already in place). However, the authorities’ efforts have not stopped there. They are also working on a new proposal to further increase capital provisions for dollar denominated credit and preparing a law proposal to allow increases above 15 percent to the reserve requirements on FX bank borrowing. The authorities are determined to end up this trend and do not rule out additional measures, if required.
The authorities recognize the importance of improving the business climate and competitiveness overall. Last year relevant reforms were approved on access to credit, easiness to pay taxes and access to electricity, which allowed the country to gain 21 positions in the 2016 World Bank Doing Business report.5
In order to address infrastructure gaps, large projects are under execution and many more are in the pipeline thanks to a wide variety of financing sources. The construction of a mega-port in the Caribbean coast awarded to the Dutch based, APM Terminals,6 advances as programmed and is expected to be operational in 2018. A new highway—in the north part of the Inter-American highway, key for trade and tourism—is almost ready and will come into operation next month. Major projects to revamp the capital beltway are currently under execution with some sections projected to open this year. Other key routes, including connections to the new port, will begin major overhauling next year using already secured funding from China, multilaterals and a novel figure through bank trusts.7
Costa Rica’s environmental friendly policies are deeply entrenched in the population. Electricity generation is an example where 97 percent was produced from renewable sources during 2016 first quarter, following the same pattern of 2015. Most of them, 65 percent, came from hydroelectric power plants, while 16 percent from wind, 14 percent from geothermal and two percent from biomass. Solar energy represents a fraction but its participation would probably increase. The system delivers a high quality service and network coverage is very high compared to regional standards. In line with its ambitious environmental goals a wastewater treatment plant, financed through Japan’s cooperation agency, was inaugurated last year which would duplicate the percentage of treated water in the short-run and, as the sewerage network is developed, it would initially take the water treated percentage up to 27 percent of the population.
The authorities are committed to further strengthening the policy mix to preserve macroeconomic and financial stability as these are key to maintain Costa Rica’s strong structural features such as high income per capita, social development and governance indicators, which are also supporting the process to become an OECD member.
Measured by the monthly index of economic activity (IMAE).
The package presented by the government is composed by the following law proposals: reforms to the VAT and income tax, anti-evasion, anti-smuggling (already approved), corporate tax, reforms to improve the treasury single account, reform to improve public servants evaluation, reforms to control pensions paid out of the budget and the fiscal rule (to be sent in the next days).
This law proposal is intended to strengthen tax controls and enforce collection.
Even though REER has appreciated recently, as confirmed by staff, there is no evidence that it has deviated from fundamentals so far.
The main reforms were: a new secured transaction law that broadens the kind of assets that could be used as collateral on financial transactions, the implementation of an electronic filing system for income and sales taxes and the reduction of the time that takes a business to get electricity.
APM Terminals is an independent business unit within the Danish-based Maersk Group.
There is one project using this financial model already approved by congress. Predefine future tolls would be securitized to finance the road construction.