A. Macroeconomic Trends

1. Costa Rica faced a slump in economic activity in 1995-96 following a sharp deterioration in the public finances and higher inflation associated with the 1993-94 political-economic cycle.¹ To avert a balance of payments crisis in early 1995, the authorities increased interest rates, imposed temporary import surcharges² and raised excise taxes, while tightening expenditure and shifting some outlays to 1996. However, legislative approval of an increase in the VAT rate (from 10 percent to 15 percent) was delayed until late in the year. In all, there was a significant strengthening of the public finances in 1995 despite a large hike in interest obligations on domestic debt (to 4.8 percent of GDP, double the 1993 level). At the same time, real GDP growth decelerated sharply, inflation rose further (mainly on account of the increase in indirect taxes), while the external position strengthened significantly in part because of a continued improvement in the terms of trade and strong growth of nontraditional exports.

2. The economy went into a recession in 1996, with private investment declining for a third consecutive year. At the same time, the public finances deteriorated once again as the slowdown in economic activity caused a weakening in tax collections, and because the government relaxed the tight rein over expenditure so as not to deepen the recession, while interest obligations continued to rise. However, there was a marked deceleration in inflation as the retrenchment in private sector spending largely offset the decline in public savings. Also, the external current account widened only slightly despite a loss in the terms of trade, reflecting a continued strong performance of nontraditional exports. By contrast, there was a large loss in net international reserves in 1996 on account of large outflows of short-term private capital as interest rate differentials narrowed from the very high levels attained in the latter part of 1995.

3. On the basis of ongoing trends, the combined public sector deficit was projected to worsen further in 1997. Consequently, in early 1997 the government adopted fiscal measures equivalent to 1.5 percent of GDP and sent to the assembly a fiscal package equivalent to another 1.5 percent of GDP. However, in the run-up to the presidential elections (February 1998) the political support for the latter measures (including the maintenance of the VAT rate at 15 percent instead of allowing it to decline to 13 percent in March 1997 as scheduled) did not materialize. Nevertheless, through continued efforts to contain noninterest current expenditure and strengthen tax collections, the government succeeded in preventing a recurrence of the political-economic cycle in 1997. In contrast to previous cycles, economic growth picked up strongly, inflation decelerated further, while foreign investment continued to increase. Also, notwithstanding a widening of the external current account deficit, there was a substantial accumulation of international reserves as private capital inflows more than doubled, reflecting a continuation of large foreign direct investment flows and a reversal of short-term outflows. At the same time, the external public debt to GDP ratio declined further to 30 percent in 1997 from 36.6 percent of GDP in 1995.

4. The central bank continued to adjust the nominal exchange rate daily in 1996-97, taking into account the relative rates of inflation of Costa Rica and its major trading partners and the international reserve targets, with the basis of adjustment shifted in 1996 from past to targeted inflation.³ However, the colón appreciated by 2.5 percent in real effective terms during 1996-97 because of an appreciation of the U.S. dollar vis-à-vis other major currencies over this period (Figure 1).

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Costa Rica Exchange Rate Developments

(1990=100)

Citation: IMF Staff Country Reports 1998, 045; 10.5089/9781451809589.002.A001

Source: IMF Information Notice System.1/ Trade weighted index of nominal exchange rates deflated by seasonally adjusted relative consumer prices. An increase (decrease) indicates appreciation (depreciation).

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B. Output, Employment, and Prices

5. Real GDP growth, which had slowed from an average of 5.4 percent in 1993-94 to 2.4 percent in 1995, turned negative in 1996. Notwithstanding continued large flows of foreign investment into the Free Trade Zones and in-bond industries, private investment (including changes in inventories) declined further in 1996 mainly as a result of the hike in real interest rates, which impacted adversely highly leveraged firms, and reflecting also uncertainties regarding the sustainability of the stance of the fiscal policy (Statistical Appendix Table 1). Moreover, there was little progress in structural reforms and in steps to increase private sector participation in the economy, while a deteriorated infrastructure and the high cost of public utilities relative to the trading partners continued to affect adversely external competitiveness. Private consumption also declined in 1996 following a small increase in 1995, and there was a slowdown in the growth of public consumption and a decline in inventories. In all, domestic aggregate demand declined by over 5 percent in real terms in 1996 on top of the contraction of almost 1 percent in 1995. By contrast, exports of goods and services grew by more than 8 percent in real terms in 1996, somewhat faster than in 1995. Imports of goods and services increased by 2 percent in real terms in 1996, and the external current account deficit widened only slightly to 1.3 percent of GDP notwithstanding a deterioration in the terms of trade.

6. The construction sector was the hardest hit with its output declining by 10 percent in 1996, followed by a 4 percent decline in the manufacturing sector and 0.5 percent decline in the agricultural sector (Statistical Appendix Table 2). In manufacturing, output of wood and wood products and textiles fell by 15 percent and 12 percent, respectively, while in the agricultural sector, declines in output were most notable in coffee and bananas, reflecting in part the adverse effects of hurricane Caesar (Statistical Appendix Tables 3 and 6).

7. Led by a recovery in domestic private demand, including for housing, and by manufactured exports, real GDP grew by an estimated 3.2 percent in 1997. The expansion in private consumption was associated with a sharp increase in credit (Statistical Appendix Tables 24 and 25) and the impact on personal disposable income stemming from a significant decline in mortgage rates. The latter, together with a reactivation of the low income housing program by the National Housing Bank, have contributed to the rapid and strong recovery of construction activities.

8. The unemployment rate, which had remained stable at 4 percent during 1992-94 rose to 6.2 percent in 1996 but declined to 5.7 percent in 1997 (Statistical Appendix Table 13). Data through the end of 1996 indicate that since 1994 employment fell in the manufacturing and construction sectors, but remained mostly unchanged in agriculture. Although employment in the public sector fell by about 4 percent, it grew by about 2 percent in the private sector. In line with the fluctuations in economic growth, the average monthly real wage, which had jumped by 22 percent in 1993-94, stagnated in 1995 and declined by almost 5 percent in 1996 (Statistical Appendix Tables 11 and 12).

9. Following a sharp increase over 1994-95, inflation (as measured by consumer prices) fell from 22.5 percent during 1995 to 14 percent during 1996 (Statistical Appendix Table 8). The continued decline in private demand and the increase in the share of imported durable consumption goods in total supply, more than offset the adverse impact on domestic prices of increases in the international prices of oil and cereals and the weakening in the public finances (Statistical Appendix Table 10). This situation reversed in 1997, as the international prices for oil and cereals declined sharply and the public finances strengthened, while at the same time private domestic demand recovered significantly. However, part of the increased demand was channeled to imports which together with no changes in the price of housing services contributed to a further reduction of inflation in 1997 to 11.2 percent.

C. The Public Finances

10. Following a marked improvement in 1995, the combined public sector deficit widened to 5.3 percent of GDP in 1996 due largely to an increase in interest payments on domestic government debt—associated with both a higher stock of debt (from 18 percent of GDP in 1995 to 26 percent in 1996) and continued high interest rates (about 22.5 percent during 1996) (Statistical Appendix Table 14). The weakening of the public finances also reflected higher noninterest current expenditure in the central government—particularly transfers and wages, and a smaller operating surplus of the public enterprises. In addition, the operating losses of the central bank rose further on account of higher interest payments on stabilization bonds. The domestic financing requirement of the nonfinancial public sector amounted to 4.0 percent of GDP in 1996 compared with 2.7 percent in 1995.

11. Concerned about the rapidly rising fiscal deficit, which on the basis of ongoing trends was projected to widen to about 6.5 percent of GDP in 1997, the authorities announced in December 1996 an ambitious fiscal package involving measures equivalent to 3.0 percent of GDP, and plans to increase private sector participation in road construction and management of ports and airports and to privatize public assets of about 8 percent of GDP over 1998–99. In early 1997, the authorities moved swiftly to implement fiscal measures that did not require approval by the assembly. These included (a) an increase of 15 percentage points on the consumption tax on diesel and gasoline (0.6 percent of GDP); (b) doubled the number of large taxpayers subject to close monitoring (0.2 percent of GDP); (c) delayed the reduction of import duties on consumption and intermediate goods to 1998 (0.1 percent of GDP); and (d) cut net lending by the social security agency and investment by public enterprises (0.4 percent of GDP). They also submitted draft legislation to maintain the VAT rate at 15 percent instead of allowing it to decline to 13 percent in March 1997 as scheduled (0.7 percent of GDP), increase the excise tax on luxury cars (0.1 percent of GDP), cut budgeted central government expenditure in goods and services, transfers and capital outlays (0.6 percent of GDP), and cancel debt to nonconsolidated public agencies and enterprises (0.3 percent of GDP). Of the latter, only the excise tax on luxury cars was implemented. Moreover, the privatization proposals were diluted and formulated at a slower pace than planned, with pertinent legislation not submitted to the assembly until October 1997.⁴

12. In addition to the measures implemented earlier in the year, the improvement of the public finances in 1997 (the combined public sector deficit was reduced to 3.7 percent of GDP) was achieved mainly through sustained efforts to reduce central government noninterest current expenditure, and to strengthen tax administration to offset for the loss of revenue from the reduction in the VAT rate. Also, across-the-board wage increases were kept in line with targeted inflation, and central government interest obligations on domestic debt and central bank losses declined, reflecting a sharp drop in the average interest rates on government paper (to about 18 percent) which stemmed in part from changes to the auction mechanism implemented in March 1997 (see below, subsection D). In addition, there were delays in the implementation of the investment program of the electricity and telephone company (ICE) on account of administrative red tape.

13. During 1994-96 the overall deficit of the central government has ranged from 4.5-5.3 percent of GDP, compared with deficits averaging 1.9 percent of GDP in 1992-93 (Statistical Appendix Tables 15, 16, 17, and 18). The widening in the deficit in recent years has been due almost entirely to increases in interest payments on the domestic debt which rose steadily from an average of 2.6 percent a year in 1992-93 to 5.4 percent in 1996 (see Chapter III). Over the same period, noninterest current expenditure rose from about 12 percent of GDP to 13.4 percent, with most of the increase accounted for in wages, pension payments, and transfers to the private sector. Fixed capital outlays have remained largely unchanged at less than 1 percent of GDP since 1992, with the result that the quality of the country’s infrastructure has deteriorated markedly. Despite the weakening of tax collections resulting from the slowdown in economic activity, revenue performance strengthened by more than 1.5 percentage points of GDP in 1995-96 owing to the increase in the VAT rate (September 1995) and excise taxes on fuels, which more than offset for a decrease in import duties resulting from a lowering in import tariffs and a sharp deceleration of imports.

14. The overall deficit of the central government narrowed to 4.2 percent of GDP in 1997 reflecting a strengthening in tax collections (from the pickup in economic activity and a large increase in imports), reduced outlays on domestic interest payments on account of lower interest rates, and smaller current transfers. These more than offset some increase in capital outlays in infrastructure which had been kept under tight control in 1995–96.

15. Following a marked improvement in 1995, the finances of the rest of the nonfinancial public sector⁵ weakened in 1996 reflecting slow growth in the operating revenues of the public enterprises, in particular the oil refinery, from the decline in economic activity, adjustments in tariffs by less than inflation, higher international oil prices, and an increase of the consumption tax on fuels and lubricants (Statistical Appendix Table 20). By contrast, the current surplus of the social security agency remained at 1.3 percent of GDP in 1996 reflecting the effect of measures adopted in 1995 to increase contributions and streamline benefits (Chapter II and Statistical Appendix Table 19).

16. The overall surplus of the public corporations improved in 1997 mainly as a result of the overall pickup in economic activity together with strengthened expenditure controls. While the operations of ICE improved, the financial situation of the water and sewage corporation deteriorated in 1997 because of higher investments as new wells had to be drilled to offset the adverse effects of “El Niño.” At the same time, revenues of the water company stagnated because the regulatory authority decided not to adjust tariffs based on the improved financial outcome for the company in 1996. Also, the Institute of Agrarian Development was forced to effect a transfer to a farmers’ cooperative to repay external debt.

D. The Financial Sector

17. The main objectives of the monetary policy in 1996-97 were to contain the growth of net domestic assets of the banking system to levels consistent with declining inflation rates and a stronger net international reserves position. In Costa Rica, the effectiveness of the monetary policy is constrained by the openness of the capital account and the targeted inflation-based crawling peg. The authorities attempt to control liquidity through open market operations in stabilization bonds, which began to be conducted through an auction mechanism since April 1996, short-term deposit facilities at the central bank, and an interbank market which initiated operations in 1997 (Chapter IV).

18. Shortcomings in the technical design of the auction which discriminated against small investors,⁶ together with excessive discretion in determining the cutoff rates undermined the functioning of the auction in 1996, leading to persistent and significant under subscriptions, limited flexibility of interest rates, further segmentation of the financial market, and widening of interest rate differentials among participants in the market. As a result, the central bank was unable to sterilize the amounts required to achieve its monetary policy objectives in 1996, which led to a deterioration in the position of net international reserves and to a more modest deceleration of inflation than originally targeted.

19. After remaining at around 43 percent of GDP over 1992-95, private sector holdings of financial savings (including government and stabilization bonds, and private capital) increased to 49 percent of GDP in 1996 (Statistical Appendix Table 23). While holdings of money declined significantly, time deposits, government bonds, and deposits in foreign currency experienced the largest increases. The increased availability of financial savings permitted an acceleration in bank credit to the private sector that was directed to housing and consumption loans, while financing to other sectors declined (see Statistical Appendix Table 25). Reflecting these developments, also of lower legal reserve requirements—from an average of 28.3 percent in December 1995 to 16.9 percent in December 1996 (Statistical Appendix Table 26)—state commercial banks lowered the prime lending rate from 37 percent at end-1995 to 29 percent at end-1996 and rates on six-month deposits from 24.5 percent to 16.5 percent over the same period (Statistical Appendix Table 27).

20. The state commercial banks benefitted from a large increase in deposits from small investors that shifted their funds from government bonds which, together with the lower reserve requirements, increased their profitability as excess funds were placed in government bonds at significantly higher interest rates. At end-1996, the interest rate on six-month government bonds exceeded the rate on time deposits in the state banks by 1,000 basis points, compared with 490 basis points at end-1995 (see Chapter IV, Table 5).

21. In March 1997, the authorities introduced several changes to the design and rules of the auction mechanism aimed, inter alia, at reducing market segmentation. As a result, the direct placement of bonds through the auction increased sharply and the intermediation by the state commercial banks was reduced, resulting in a decline in interest rates on 6-month government and stabilization bonds by 730 basis points to 19.3 percent at end-1997, with the spreads relative to interest rates on deposits narrowing to 440 basis points for the state banks and to 300 basis points for the private banks.

22. In 1997, broad money increased at a faster pace than anticipated in the monetary program, in part reflecting large short-term private capital inflows toward the end of the year, which in turn allowed to exceed the net international reserves accumulation target. Private sector financial savings and credit to the private sector continued to grow strongly in 1997, expanding by 21 percent and 24 percent, respectively. Nominal interest rates continued to fall in 1997, reflecting also a further reduction in legal reserve requirements, with the prime lending rate falling 300 basis points and the deposit rates dropping by 190 basis points.

E. External Sector

23. Despite a marked deterioration in the terms of trade, the external current account deficit widened slightly to 1.3 percent of GDP in 1996 (Statistical Appendix Tables 28 and 33). The effect of the decline in the terms of trade (by 6.3 percent) was felt mainly on the rate of growth of traditional exports which fell by about 9 percent in value terms (Statistical Appendix Table 29). However, the performance of nontraditional exports (mostly manufactured food products, seafood, horticultural products, and tropical fruit and vegetables) continued to strengthen, with the rate of growth in the value of those exports accelerating to 20 percent, from an average of 16 percent in 1994-95. The growth in non-oil imports remained largely unchanged in value terms as a marked recovery in the demand for consumer goods offset a slowdown in raw material imports and a fall in capital goods, which mirrored the depressed investment climate (Statistical Appendix Table 30). The slight deterioration in the trade account was offset by an improvement in the services balance that reflected an increase in tourism receipts as well as a decline in net factor payments.

24. Notwithstanding the continued large flows of foreign direct investment (4.4 percent of GDP in 1996), there was a sharp deterioration in the capital account in 1996, as the public sector continued to repay debt and there was a large outflow of private short-term capital. This compares with a net inflow in 1995 when investors were attracted by large interest rate differentials, particularly on government and stabilization bonds, while at the same time there were expectations of a decline in nominal rates following the implementation of the fiscal adjustment program. At the end of the year, net international reserves of the central bank had fallen to 2.7 months of imports of goods and nonfactor services, from 3 months at end-1995.

25. Despite the continued strong growth of nontraditional exports and a recovery in maquila and net tourism receipts, the external current account deficit (excluding imports by INTEL)⁷ widened to 4.2 percent of GDP in 1997 as imports increased at a rate that was more than double that in 1996. Also, proceeds from traditional exports (coffee, banana, sugar and meat) declined despite an increase in coffee prices of more than 50 percent, due to the impact of bad weather on production. Part of the expansion in imports was associated with increased inflows of foreign direct investment (5 percent of GDP), and the recovery in domestic private investment. Imports of capital goods, which declined by 5 percent in 1996, increased by about 24 percent in 1997, while the rate of growth of imports of consumption goods slowed from 23 percent in 1996 to 2 percent in 1997. Maquila exports experienced a strong recovery in 1997 following the resolution of the issue of textile quotas to the United States.

26. Net capital inflows were more than ten times larger in 1997 than in 1996. Despite an increase in amortization payments, public sector flows turned positive for the first time since 1990 reflecting disbursements of balance of payments support under two IDB program loans, significantly larger disbursements of project loans, and bridge financing toward the placement of bonds with foreign commercial banks originally planned for 1997. The bond placement was not effected as anticipated on account of the turmoil in the international markets following the currency crisis in Asia. Also, there was a sharp increase in private capital flows despite the convergence of domestic and external interest rates, apparently the result of more bullish expectations by foreign investors after the decision of INTEL to invest in Costa Rica. Costa Rica received a Bal rating from Moody’s in April 1997. Net international reserves increased by US$216 million in 1997, reaching the equivalent of 2.8 months of imports of goods and nonfactor services.

27. In line with agreements under the Central American Common Market, import tariffs were reduced (a) on capital goods from 5 percent to 3 percent in January 1996, and to 2 percent in January 1998, and will be lowered to 1 percent in July 1998 and to zero in January 1999; (b) on raw materials from 5 percent to 1 percent in June 1996, and to zero in January 1998; (c) on intermediate goods from 10 and 15 percent to 9 and 14 percent, respectively, in January 1998, and to 8 and 13 percent in July 1998; and (d) on consumption goods from 20 percent to 19 percent in January 1998, and to 18 percent in July 1998.⁸ Regarding incentives to nontraditional exports, income tax exemptions to nontraditional exports were eliminated in 1996, and tax exemption certificates (CATS) will be phased out by 1999.

F. Structural Reforms

28. Regarding public sector reforms, progress was made in strengthening tax administration in 1997 by tightening control over large taxpayers and introducing a new computerized information system. Also, the government is preparing a reform of the tax structure, with technical assistance from the Fund. On public expenditure management, the focus has been on training of staff, inclusion of formerly extra-budgetary items in the budget, and effecting government payments exclusively through the banking system (see Chapter II). As regards privatization efforts, in June 1997 the government created a commission to be in charge of privatization, attached to the president’s office and consisting of representatives from the ministries of finance and planning. Also, in August 1997 the government selected an investment bank for the sale of BICSA, and legislation to privatize the Banco de Costa Rica and to improve the legal basis for public works concessions for road construction and the management and construction of ports and airports was submitted to the assembly in October 1997.

29. The government has taken measures to strengthen the financial position of the pension system, including by raising pension contributions and the minimum period of work to qualify for pension benefits, and transferring contributors from more generous pension regimes under the government budget to that of the social security system. The objective is to make the latter the basic pillar of a restructured pension system that will be complemented by voluntary, individual capitalization accounts administered by private sector managers.

30. On financial sector reform, regulations were issued in 1996 for the functioning of an interbank market with a view that the central bank would switch gradually to this market as the main instrument for controlling liquidity, and as a complement to the open market operations conducted through the auction. The central bank also improved monetary programming and has been lowering reserve requirements since 1996, with a view to unifying them at 15 percent in March 1998, while extending reserve requirements to short-term financial instruments in November 1997. In addition, an electronic system for the clearance of checks was put in place. The Fund provided technical assistance in these areas, with four MAE missions during 1996-97.

31. Legislation to strengthen the national commission of securities and the superintendency of pensions was approved in December 1997. Also, to improve banking supervision the central bank issued regulations in November 1997 to cover offshore banking operations of financial conglomerates. The regulations require the provision of consolidated information about the operations and rules for transactions among members of the group (including the offshore affiliates), and with their nonrelated borrowers with a view to reduce risk. A minimum capital of US$3 million was established for offshore bank members of registered conglomerates, while that for local private banks was raised from US$1.2 million to US$4 million, to be complied within a two-year period starting in April 1998.