Costa Rica
Recent Economic Developments
Author:
International Monetary Fund
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Publication Date:
04 Jun 1998
eISBN:
9781451960402
Language:
English
Keywords:
ISCR; CR; economic activity; real interest rate; private sector; U.S. dollar; Banco de Costa Rica; stabilization bond
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In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

I. Overview of Economic Developments in 1995-97

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).

Figure 1.
Figure 1.

Costa Rica Exchange Rate Developments

(1990=100)

Citation: IMF Staff Country Reports 1998, 999; 10.5089/9781451960402.002.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).

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.

Table 1.

Costa Rica: National Income Accounts

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Sources: Central Bank of Costa Rica; and Fund staff estimates.

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).

Table 2.

Costa Rica: Gross Domestic Product by Sector

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
Table 3.

Costa Rica: Volume of Agricultural Production

(In thousands of metric tons)

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Source: Central Bank of Costa Rica.

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.

Table 24.

Costa Rica: Changes in Banking System Domestic Credit by Origin, Destination, and Financing

(In billions of colones; end of period)

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Source: Central Bank of Costa Rica.
1/

After payments arrears.

2/

Includes counterpart USAJD grants and counterpart unrequited foreign exchange.

Table 25.

Costa Rica: Classification of Loans by Economic Activity

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Source: Central Bank of Costa Rica.
1/

As of October 1997.

2/

For 1997, annual percentage change corresponds to October 1997-December 1996.

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).

Table 13.

13. Costa Rica: Employment 1/

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Sources: “Multiple Purpose Household Survey, Employment Module,” General Directorate of Statistics and Census; Ministry of Economy, Industry and Commerce.
1/

Data from a survey conducted every year in My.

2/

Basic services include water and gas.

3/

Includes international organizations.

Table 11.

Costa Rica: Average Monthly Wages 1/

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Sources: Social Security Agency; and Central Bank of Costa Rica.
1/

Data for June of each year.

2/

Nominal wages deflated by the consumer price index.

Table 12.

Costa Rica: Minimum Wage Index

(1984=100)

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Sources: Ministry of Labor; and Central Bank of Costa Rica.
1/

Nominal minimum wages deflated by the consumer price index. Minimum wages are increased twice a year in January and July.

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.

Table 8.

Costa Rica: Price Indicators

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Source: Central Bank of Costa Rica.
1/

In January 1995, Costa Rica adopted a new CPI index based on a larger number of goods and on a geographically wider sampling area. For comparison purposes, the 1995 indices reported in this table have been converted into the old basis.

Table 10.

Costa Rica: Energy Prices

(End of period)

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Source: Central Bank of Costa Rica.

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.

Table 14.

Costa Rica: Summary Public Sector Operations

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Sources: Ministry of Finance; and Fund staff estimates.
1/

Excludes transfers to cover the losses ofBanco Anglo Costarricense, a state commercial bank closed in December 1994.

2/

Includes rescheduling.

3/

Includes central bank losses.

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.

Table 15.

Costa Rica: Summary Central Government Operations

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Sources: Ministry of Finance; and Fund staff estimates.
1/

Includes capital revenue.

Table 16.

Costa Rica: Operations of the Central Government

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Sources: Ministry of Finance; and Fund staff estimates.
1/

Pension contributions of government employees are excluded from both revenue and expenditure.

Table 17.

Costa Rica: Central Government Revenue

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Sources: Ministry of Finance; and Fund staff estimates.
1/

Pension contributions of government employees are excluded from both revenue and expenditure.

Table 18.

Costa Rica: Central Government Expenditure

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Sources: Ministry of Finance; and Fund staff estimates.
1/

Includes unpaid interest.

2/

Includes transfers to nonconsolidated public sector and private sector.

3/

Pension contributions of government employees are excluded from both revenue and expenditure.

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).

Table 20.

Costa Rica: Summary Operations of Selected Nonfinancial Public Enterprises and Other Public Institutions 1/ 2/

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Sources: Ministry of Finance; Budgetary Office; and Fund staff estimates.
1/

Includes: RECOPE, ICE, ICAA, CNP, Railway Co. (INCOFER), Public Services of Heredia (ESPH), Social Protection Council (JPSSJ), Liquor Co. (FANAL), Pacific Port Administration (DSTCOP), Council of Medical and Social Assistance (CTAMS), Fertilizers Co. (FERTICA), Social Fund of Family Allowances (FODESAF), Coffee Institute (ICAFE), Costa Rican Tourism Institute (ICT), National Trainning Institute (INA), Institute of Agrarian Development (IDA), and Institute of International Health Cooperation (OCIS).

2/

From 1995 excludes FERTICA privatized in 1994, and from 1996 excludes INCOFER closed in June 1995.

3/

Includes net lending.

Table 19.

Costa Rica: Summary Operations of the Social Security Agency

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Sources: Ministry of Finance; Budgetary Office; and Fund staff estimates.

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).

Table 23.

Costa Rica: Private Sector Financial Assets 1/

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

All instruments denominated in foreign currency are valued at end-of-period exchange rates.

2/

Includes private sector holdings of bonds issued by the central government.

Table 26.

Costa Rica: Legal Reserve Position of the Commercial Banks

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Source: Superintendency of Financial Entities.
1/

As of November 1997.

2/

Excludes remunerated reserves constituted in government and stabilization bonds in 1994 and 1995.

Table 27.

Costa Rica: Six-Month Interest Rates

(JJI percent, annual basis)

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Nominal interest rate at time of issue adjusted by the change in the consumer price index.

2/

Ex-post differential rate of return on colón bonds vis-à-vis the LIBOR interest rate plus devaluation of the exchange rate.

3/

Banco Nacional de Costa Rica (BNCR), the largest state-owned commercial bank.

4/

From June 1996 through March 1997, interest rates correspond to government bonds.

5/

Base lending rate minus deposit rate offered by the BNCR.

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).

Table 5.

Costa Rica: Interest Rates

(In percent, annual basis)

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Source: Central Bank of Costa Rica.
1/

Average interest rate on six-month deposits.

2/

Differences between interest rate on deposits and gross interest on six-month government bonds.

3/

Minimum interest rates reported.

4/

Minimum interest rates reported.

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.

Table 28.

Costa Rica: Summary of Balance of Payments

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Imports by INTEL associated with the building and furbishing of a US$500 million plant to be completed in 1999.

2/

Includes errors and omissions.

3/

Excludes changes in commercial banks’ dollar deposits at the Central Bank and swaps.

4/

Includes overdue obligations to multilateral institutions within grace period.

5/

Considering commercial banks’ dollar deposits at the Central Bank as a reserve liability.

Table 33.

Costa Rica: Terms of Trade Indices 1/

(1991=100)

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Paasche index.

Table 29.

Costa Rica: Merchandise Exports

(In millions of U.S. dollars)

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Sources: Central Bank of Costa Rica; Ministry of Foreign Trade; and Fund staff estimates.
1/

Includes leather products and shoes, excludes in-bond industries (maquila).

2/

Included under services in the balance of payments.

3/

Coffee, bananas, meat and sugar.

4/

All exports other than coffee, bananas, meat and sugar.

Table 30.

Costa Rica: Merchandise Imports

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Sources: Central Bank of Costa Rica; and Fund staff estimates.

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.

II. Progress in Reform of the Public Sector Since the 1980s9

A. Introduction and Summary

32. This chapter describes the origins of the structural imbalances in the public sector in Costa Rica that emerged following the economic crisis of 1980-82, and the efforts of successive governments to address them. Significant progress has been made in improving the tax system and in privatizing state enterprises. However, progress has been more limited in other key areas such as reducing the size of the civil service, relaxing rigidities in government expenditure, and permitting a larger role for the private sector in the public utilities and other state monopolies such as insurance.

33. The main reason for the slow progress has been a lack of consensus between the two major political parties on the priorities and content of structural change, which in turn, has led to delays in the approval of legislation required to implement reforms. Also, even in the presence of some consensus, reform has been delayed repeatedly because of the political-economic cycles that have affected policies in Costa Rica every four years. As a result, the essential tasks of placing the public sector finances on a sound footing, reducing the heavy domestic debt burden, generating adequate levels of saving, and permitting the much needed upgrading of infrastructure have remained unfulfilled.

B. The Pre-Reform Period 1969-79

34. During 1966-79, and particularly following the coffee boom of 1976-77, successive governments adopted policies aimed at promoting growth and improving social conditions through heavy involvement of the state in a wide range of economic activities, and industrialization based on import substitution behind high tariff barriers and exports to the Central American Common Market. Public sector investment (in roads, public utilities, health, and education) rose sharply, as did transfers to state enterprises involved in activities ranging from cement production to liquor manufacturing. Initially, this strategy resulted in a rapid acceleration in real GDP and income per capita, and one of the highest levels of social standards in Latin America.

35. Subsequently, however, real GDP growth slowed as a substantial deterioration in the terms of trade (following the decline in coffee prices in 1978 and the second oil crisis of 1979) led to a slowdown in demand and a weakening in government revenue. Faced with these difficulties, the authorities did not adjust government spending levels as warranted, and the fiscal deficit widened from about 4 percent of GDP in 1976-77 to 8 percent in 1980. The weakened fiscal position and the deterioration in the external current account resulted in a serious balance of payments crisis, at the same time as external financing from commercial banks dried up. As a result, the authorities were forced to suspend servicing of the external debt in mid-1981. Also in that year, real GDP fell by 2.5 percent following 20 years of uninterrupted growth, the overall deficit of the nonfinancial public sector widened to 14 percent, inflation rose to 65 percent, and the unemployment rate doubled to 9 percent. The crisis exposed the difficulties of fiscal adjustment and the structural weaknesses in the Costa Rican economy, and made clear the need for a comprehensive reform of the size, scope, and functioning of the public sector.

C. Early Attempts at Reform 1984-93

36. By the second half of 1982 the government had initiated an adjustment program, supported by a Stand-by Arrangement from the Fund. The program aimed at containing inflation by reducing the fiscal imbalance (through temporary import surcharges, increases in the sales tax and public sector tariffs, and measures to reduce the wage bill). Subsequently, beginning in 1983 the government embarked on a program of structural reform (supported by program loans from US AID and the World Bank) aimed at containing employment in the public sector, reducing the deficit of the state enterprises,10 easing rigidities in fiscal policy by, inter alia, limiting the practice of revenue earmarking, and privatizing most of the enterprises under the CODES A umbrella.11

37. The early efforts at fiscal adjustment and restoring macroeconomic stability were broadly successful. By end-1985, following a second Stand-by Arrangement, the fiscal deficit had narrowed to less than 2 percent of GDP, inflation had fallen to 12 percent, and the balance of payments strengthened. Also, the Stand-by Arrangements facilitated reschedulings of Costa Rica’s external debt with official and commercial bank creditors. However, by 1990 financial imbalances, associated in part with another political cycle, had re-emerged. The combined fiscal deficit increased to 5 percent of GDP, inflation accelerated to 27 percent, the external current account deficit widened to 9 percent of GDP, and gross international reserves fell from 4.2 months of imports in 1989 to 2.6 months.

38. Progress in structural reform during this period was mixed. Most significant progress was made in privatizing the state enterprises controlled by CODESA. Despite early delays, by 1991 the sale, merger, or liquidation of about 40 companies (out of a total of 43 companies) had been completed, with the proceeds used to retire CODESA debt with the central bank. A major factor that contributed to this success was the setting up of a trust fund financed by USATD that purchased those enterprises which could not be sold in the public auctions, and later liquidated their assets within a specified time period. Also, the trust fund helped finance severance payments to former employees of the enterprises sold or liquidated.

39. Attempts to implement reforms in other areas were less successful. Initial efforts to reduce public sector employment comprised steps to freeze employment;12 eliminate vacant positions; oblige all civil servants and state enterprise employees at age 65 and eligible to receive a pension to retire; and provide incentives for early retirement.13 Despite these initiatives, and various attempts to set quantitative targets for employment reduction,14 net employment in the public sector increased by about 3 percent in 1985-86, and by about 15 percent between 1987 and 1990. The difficulties in this area resulted mainly from the lack of agreement on the mechanisms for achieving the targeted reductions; difficulties in measurement, which made monitoring and attempts to enforce the freeze almost impossible; successful legal challenges in the constitutional court to mandatory employment reductions; and the lack of political support related to the political campaigns in 1986 and 1990.

40. In the area of expenditure control, key objectives in the World Bank SALs were reorganization, closure, or merger of institutions experiencing chronic financial and operational weaknesses.15 However, little progress was made in reducing the losses of the CNP. Indeed the losses increased sharply during 1984-85 and again during 1989-91, due to the subsidies to producers and consumers of basic grains. There was little progress in containing revenue earmarking, a major source of inflexibility in expenditure, although toward end-1992, some of the inflexibility in fiscal policy had been eased through legislation which provided for the elimination of the export incentive system (CATs) by 1996; and of price subsidies to consumers of basic grains.

41. While pension reform was not explicitly included in the initial reform program, the importance of restructuring the various pension regimes funded from the budget16 became increasingly recognized following studies which showed that without fundamental reform, the schemes would be bankrupt in the long run due to the excessive generosity in benefits, juxtaposed with inadequate contribution rates. Beginning in 1992 steps were taken to rationalize and unify the various pension regimes in the civil service. The objectives have been to reduce the burden on the budget, encourage the transfer of contributors from those regimes to that of the social security system, and make the latter the basic pillar of a restructured pension system. In the first phase of reforms instituted under the 1992 Framework Law on Pensions, the retirement age was raised from 50 to 55 years, the maximum pension lowered, the rate of contribution by employees increased, and the minimum number of years of contribution required for eligibility for a pension increased from 25 to 30 years.

D. Reforms in 1994-97

42. The administration which took office in early 1994 shared the broad objectives of the reforms noted above, except for that related to employment reduction which they regarded as unrealistic. The government’s priorities for structural reform and progress toward achieving them may be summarized as follows:

Tax reform

43. The main priority was to modernize the tax system and its administration. A major step was the approval of a new tax code (Ley de Justicia Tributaria) in September 1995, which was able to improve efficiency and equity in the tax system by eliminating 30 minor taxes; reducing the bias in the corporate income tax in favor of debt financing; authorizing crosschecking between tax returns and other sources of information on income and business activity; and introducing a gross assets tax. Also, the tax code classified some acts of tax evasion as criminal offenses punishable by imprisonment; and strengthened the legal framework for enforcing tax collections including by streamlining procedures for imposing fines and closing businesses. In addition, during 1992-95 exemptions and tax incentives to the tourism, manufacturing, and nontraditional export sectors were gradually phased out.

44. In 1997, the number of large taxpayers subject to close scrutiny by the ministry of finance increased from 280 (representing 60 percent of total income tax collections) to 535 (80 percent); a new computerized information system was installed; and agreement was reached with the banks on revenue collection procedures as well as information to be supplied by them. In the customs area, institutional improvements, comprising mainly seeking a more efficient organizational structure, upgrading professional skills, and automating most customs procedures, were supplemented in 1995 by legislation17 which provides for suffer penalties for customs duty evasion.

45. A Tax Reform Commission was set up in 1996 to review the tax system and propose revisions to the tax structure. Proposals for the next steps in tax reform include completing the elimination of those taxes for which the marginal yield is small relative to collection costs, and reducing the large number of exemptions. Also, they envisage continued progress in decentralizing tax collection, and setting targets and norms to enhance revenue performance.

Budget and expenditure reform

46. Various practices including the increased earmarking of revenue,18 and legislation requiring specific budget allocations to, for example, universities and social programs, have resulted over time in limiting severely the scope for discretionary expenditure policy. Consequently, when faced with the need for adjustment, governments had often to resort to cuts in spending for infrastructure. Capital expenditure of the government has stagnated at about 2 percent of GDP since 1990 (compared with 3 percent in 1986-89), and infrastructure has deteriorated.

47. With technical assistance provided by Spain, the IDB, and the Fund, the government has developed a set of procedures to better control expenditure and improve its payments and procurement systems. The new procedures were put in place in the 1997 budget, which included for the first time extrabudgetary items such as bank commissions. Other key reforms being implemented include development of a master account system for payments and cash management, training of staff, explicit inclusion of additional extra-budgetary items in the budget, effecting government payments exclusively through the banking system, and computerization of the procurement process. Next steps will include the preparation of an annual report to the assembly on performance relative to fiscal targets, and consolidation of the entire nonfinancial public sector in the budget process.

Pension reform

48. The changes (referred to above) initiated in 1992 were followed in 1995 by actions which obliged all members of the teachers’ regime under age 30 to transfer to another regime, and barred entry in the civil service schemes to new members.19 As a result, with continued efforts to bring benefits and contributions closer in line, it is expected that by about year 2040 the civil service schemes will have been phased out. In the interim period, contribution rates may need to be raised and benefits lowered to maintain the actuarial viability of the schemes.

49. Proposals currently being discussed for further reforms of the pension system comprise:

a. Ensuring the actuarial viability of the basic pension regime administered by the social security agency;

b. Enacting legislation to complete the rationalization of the public sector pension regimes, and regulate the complementary systems; and

c. Complementing the basic pillar with voluntary, individual retirement/savings accounts administered by private sector managers, thereby fostering increased savings and easing pressure on the basic system.

Privatization

50. The process of privatization has slowed considerably since the sale or liquidation of the enterprises covered by CODESA. Since then efforts focused on privatizing the remaining three state enterprises still operating under CODESA (a cement plant, a fertilizer company, and a liquor manufacturing company). The sale of the first two was completed in early 1997, but efforts to sell the liquor manufacturing have been suspended due to lack of political support. 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. The government announced plans in December 1996 to privatize two banks (BICSA—an international bank owned by the state commercial banks—and the Banco de Costa Rica), forty percent of the National Insurance Institute, and RACS A (telecommunications). In line with these plans, the privatization of BICSA is proceeding with an investment bank selected in August 1997, and draft legislation for the privatization of the Banco de Costa Rica was sent to the assembly in October 1997. However, the sale of the other companies did not progress as anticipated due to lack of political support.

51. In addition to outright privatization, the authorities have considered options for increasing private sector involvement in activities previously carried out solely by the state. Mechanisms considered have included subcontracting, leasing, joint ventures, and permitting the private sector to build, own, operate, and transfer projects, especially in the telecommunications and electricity sectors. In 1995 legislation (the Law of Public Works Concessions and the Law of Incorporated Workers’ Companies)20 was approved, allowing private sector participation in areas, including infrastructure and operations of ports, previously reserved for the public sector. However, subsequent examination of the legislation has revealed a number of important flaws. These include the lack of definition of which areas fall under the scope of concessions, and the treatment of monopolies. Revised draft legislation was sent to the assembly in October 1997. Partly reflecting these uncertainties, to date only one concession in infrastructure (for highway repair) was granted, but this was not implemented because of questions related to the legality of the bidding process. However, the concessions to the private sector to operate the Port of Limón have been successful, and have resulted in an improvement in port facilities, and a reduction in handling charges from US$26 per ton to US$6 per ton.

Restructuring the public sector

52. The government reduced the emphasis of past administrations on cutting back employment in the public sector as an end in itself,21 and placed more effort into restructuring and increasing efficiency in the public sector. Efforts in this area since 1993 have focused on the merger of government ministries, the closure of institutions including the national railway (INCOFER) and some specialized agencies,22 the reform of the agricultural sector including eliminating the granting of subsidies to grains by the CNP, and reducing duplication among the various agencies of the ministry of agriculture. In addition, the government has begun to introduce better mechanisms of performance evaluation and reward in the public sector. To this end, in 1996 a national evaluation system was introduced in selected agencies on a pilot basis. It is expected that following the pilot stage, agencies which participate in the system will specify performance objectives and indicate how these would be measured. Also, a unit of administrative efficiency has been established with the objectives of defining the criteria for selecting institutions to be restructured, and determining activities inconsistent with fiscal priorities.

III. Domestic Public Debt and Fiscal Sustainability Issues23

53. This chapter analyzes the sources of the fast increase in the central government domestic debt during 1988-97, describes the structure of the debt, and examines issues related to the sustainability of central government finances.

A. Sources of Debt Growth

54. The central government domestic debt rose from 7.5 percent of GDP in 1988 to

26 percent of GDP in 1997 mainly reflecting a weak primary balance, high real interest rates on domestic debt instruments, and greater reliance on domestic sources of financing. The contribution of each factor to the increase in the domestic debt to GDP ratio has varied over this period.

  • Primary balance: As part of the pohtical-economic cycles experienced over the last 15 years, the central government primary balance shifted from surpluses of 1.0-1.2 percent of GDP to deficits of about 1 percent of GDP within the four-year cycles. In addition to the pressures from the cycle, the behavior in the primary balance reflected structural weaknesses that have made it difficult to broaden the tax base, reduce expenditure because of earmarking of revenue, cut back employment, and eliminate rigidities in other current outlays.24 Consequently, the primary surplus of the government averaged 0.4 percent of GDP a year over 1988-97 and was not sufficient to offset the adverse effect on the debt of a sharp increase in real interest rates in 1994-97.

  • Growth-adjusted interest rate: The dynamics of the domestic debt to GDP ratio have been strongly influenced by the behavior of the growth-adjusted real interest rate, as measured by the difference between the average real interest rate on central government debt (external and domestic) and the rate of growth of real GDP. During 1988-93, the real interest rate remained below real output growth, contributing to limit the increase in the domestic debt-output ratio (Table 1). Conversely, as credit conditions tightened and economic activity slowed markedly in 1994-96, the growth-adjusted interest rate shifted from a negative 1.5 percent in 1988-93 to a positive 3.8 percent in 1994-97, resulting in a sharp increase in the domestic debt ratio (Table 2). As a result of these developments, real interest payments on central government debt rose from 1.1 percent of GDP in 1988 to 2.8 percent of GDP in 1997, while the operational deficit is estimated to have widened from 0.9 percent of GDP to 1.8 percent during the same period. The composition of central government expenditure changed significantly over 1988-97 as the share of nominal interest payments in total expenditure rose steadily from 15 percent in 1988 to 26 percent in 1997, while that of noninterest current expenditure declined by about the same magnitude during this period.25 In terms of GDP, nominal interest payments rose from 2.8 percent to 5.3 percent during the same period, while capital expenditure was held at only 2 percent of GDP per year.26

    Table 1.

    Interest Rates on Central Government Debt

    (In percent per annum)

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    Sources: Central Bank of Costa Rica; Ministry of Finance; and Fund staff estimates.
    1/

    Implicit rates calculated as the ratio of interest payments to the average stock of debt, including valuation adjustments related to consumer prices and exchange rate movements.

    2/

    Calculated as the real interest rate deflated by real output growth.

    3/

    3/ Calculated as the implicit nominal interest rate deflated by the change in the consumer price index.

    Table 2.

    Costa Rica: Domestic Government Debt

    article image
    Sources: Central Bank of Costa Rica; Ministry of Finance; and Fund staff estimates.
    1/

    As of September for debt by instrument and November on debt by maturity.

    2/

    2/Excludes bonds issued for monetary purposes in 1996 and 1997.

    3/

    3/ Includes holdings of state agencies outside the control of the budget authority.

  • Sources of financing: As external disbursements slowed and amortization increased, the government shifted toward domestic financing through the placement of bonds to support its operations. As a result of the low levels of net external financing (net repayments in most years) and debt relief operations from private and official creditors, the outstanding stock of external debt of the central government declined steadily from about 20 percent of GDP in 1988-91 to 12 percent in 1997 (Figure 1). The switch to domestic bond financing was supported by private capital inflows that were prompted by high interest rates (1992-94) as well as increased liquidity abroad (1995-96).

    Figure 1.
    Figure 1.

    Central Government Debt

    Citation: IMF Staff Country Reports 1998, 999; 10.5089/9781451960402.002.A001

B. Debt Structure

55. Currently, the government satisfies most of its domestic financing needs with the issue of eight different types of bonds. The bonds are issued with several maturities (ranging from one month to 15 years), various denominations (domestic currency, inflation-indexed, and U.S. dollar-denominated), and lack adequate standardization.27 This situation complicates the management of government debt in a way as to avoid competition among instruments, coordinate placement of government and central bank stabilization bonds, and minimize the cost of domestic debt.

56. For many years, short-term bonds (up to six months) denominated in colones with fixed interest rates had been the main instrument used by the government. With the advent of institutional investors such as the social security agency and other pension funds, the demand for long-term assets increased after 1991, making it possible to lengthen maturities and introduce variable interest rates. The bond portfolio was further diversified with the creation of a consumer price-indexed bond in 1993, which provided a safe asset against variable inflation, and a U.S. dollar-denominated bond, which was used intensively in the face of balance of payments pressures during 1995-96. These two instruments grew in importance recently with their combined share in the stock of domestic debt rising from 6.7 percent of the total at end-1994 to 50 percent by September 1997. At the same time, the pursuit of a yield structure that broadly favored longer-term maturities contributed to lengthen the maturity of domestic debt. The share of 4-year to 15-year bonds rose from 19 percent at end-1994 to 42 percent by November 1997.

57. Government bonds traditionally had been tailored to meet the needs of specific investors and placed over-the-counter (windows) with amounts determined by investor demand at interest rates set by the government. In the first half of the 1990s steps were taken to reduce the number of maturities, set minimum purchase amounts by investor, and make amounts issued a multiple of this minimum. To move to market-determined interest rates and enhance the effectiveness of monetary policy, the system of windows for placement of government and central bank bonds was replaced by an auction mechanism in April 1996, while inflation-indexed and U.S. dollar bonds have been placed through an electronic system in the stock exchange starting in June 1996 (Chapter IV).

58. With the objective of further improving debt management, a new bond with a one-year maturity and sold at discount was introduced in the auction in September 1997 as a step to standardize government bonds and develop a secondary bond market. The bond was designed to set standards at which existing debt instruments will gradually converge. As the market for the new bond develops, existing bond maturities will be further reduced, while an electronic system for operation of paperless bonds will be introduced.

59. The nonfinancial private sector is the main holder of government bonds, with its share in the stock of domestic debt doubling to 48 percent over the period 1991-97. This development resulted from more attractive interest rates on government bonds relative to bank deposit rates and also mirrored a substantial increase in private financial savings in this period. Access of small investors to government bonds was facilitated with the proliferation of small private financial funds, which offered instruments with high liquidity and return based on the intermediation of government bonds.

60. Although the social security agency intensively used government bonds for the management of pension and other workers’ contributions during this period, its share of bonds declined from 20 percent in 1996 to 11 percent in 1997 reflecting the government’s decision to exchange fixed-interest bonds held by the agency with inflation indexed bonds (with one-to five-year maturities). At the same time, the share of commercial banks and nonbank financial institutions declined from 33 percent of the total in 1991 to 29 percent in 1997. The share of bonds held by the central bank had been small but rose to 9 percent in 1995 as government bonds were exchanged for central bank losses that resulted from the liquidation of a large state-owned bank in 1995. Holdings of nonresidents increased from 3 percent of the total in 1994 to 10 percent in 1997.

C. Sustainability Issues

61. Based on a standard budget constraint for the central government finances in which revenue from seignorage are excluded, the dynamics of the debt to output ratio is governed by the following equation:
bt⋅=(r−n)bt−st

where b is the change of the debt to output ratio over time (f), r is the real interest rate, n is real output growth, and 5 is the primary surplus in terms of GDP. This equation indicates that the debt to output ratio would decline (rise) when the primary surplus exceeds (falls short) growth-adjusted real interest payments, while the debt ratio would be stable when the sustainable primary surplus (s*) is achieved—the surplus that would fully cover growth-adjusted real interest payments, s*= (r-n)b. This equation would also correspond to the definition of the operational balance of the central government if the real output growth argument was omitted.

62. As a measure of fiscal sustainability, the primary surplus gap would indicate the magnitude of the adjustment required to keep the overall debt-output ratio stable over the long term,
Primary surplus gap s*−s=(r−n)b−s

63. Several adjustments to the actual stock of domestic debt outstanding are required to measure accurately the central government domestic debt. The adjustments are related to the anticipated issue of government bonds to recapitalize the central bank, settle obligations with the social security agency, and take over debts from CODESA, a state holding company.28

The envisaged recapitalization of the central bank in 1998 is a key step in the strategy to provide greater autonomy to the bank and enhance the effectiveness of monetary policy. This operation requires the issue of government bonds in an amount equivalent to 12 percent of GDP (C 260 billion) to shift to the central government about 80 percent of the quasi-fiscal losses of the central bank, which amount to some 2 percent of GDP a year.

64. A decree promulgated in June 1997 provides for the issue of government bonds

(2 percent of GDP) to the social security agency to pay overdue contributions by the government as employer and to transfer contributions made by teachers that are expected to shift from the pension regime run by the government to that of the social security agency. Also, an additional government bond issue (1 percent of GDP) to the central bank is envisaged to assume the old debts of CODESA that remained after its liquidation.

65. With these adjustments, the estimated stock of domestic debt in 1997 would amount to 41 percent of GDP and, including outstanding external debt, the overall government debt would be 53 percent of GDP. The primary surplus gap is estimated under two scenarios:

(a) on the basis of the past fiscal stance (past policy scenario); and (b) on the projected fiscal stance over the medium term (projected policy scenario) presented in the staff report.29 The past policy scenario utilizes averages of the primary surplus, real interest rate, and real output growth over the period 1993-97, while the projected policy scenario utilizes averages of the same variables for the period 1998-2002.

66. Under the past policy scenario, the sustainable primary surplus is 1.6 percent of GDP compared with an average primary surplus of only 0.6 percent of GDP a year (Box 1). Thus, the primary surplus would be insufficient to cover growth-adjusted real interest payments, resulting in increasing debt to GDP ratios to finance the fiscal gap. The pursuit of the past fiscal stance in the future would place the central government in an unsustainable path over the medium term (i.e., the overall debt ratio and real interest payments would rise without bound). To achieve fiscal sustainability, the central government would need to adopt measures to raise the primary surplus by about 1 percent of GDP.

Sustainability of the Central Government Finances

(In percent of GDP, unless otherwise noted)

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1/

Variables expressed in actual averages for the period 1993-97.

2/

A positive value for the primary gap indicates that the current primary surplus is not large enough to prevent the debt to GDP rate from rising.

3/

In percent per annum.

4/

Associated with the sustainable primary surplus.

5/

Variables expressed in projected averages for the period 1998-2002.

67. Under the projected policy scenario, a strengthening of the finances of the central government is envisaged to result in a primary surplus of 1.1 percent of GDP a year. On the basis of stronger macroeconomic policies, the medium-term projection envisages higher output expansion and lower real interest rates than those observed in the period 1993-97. Under these assumptions, the growth-adjusted real interest rate would be 0.5 percent compared with 3 percent under the past policy scenario, which in turn implies that a primary surplus of only 0.2 percent of GDP a year would be sufficient to cover the growth-adjusted interest bill and keep the overall debt to GDP ratio stable in the medium term. Consequently, the central government primary surplus envisaged under this scenario would allow for a gradual decline in the overall debt to GDP ratio from 53 percent of GDP in 1997 to 49 percent in 2002.

68. These results are quite sensitive to the underlying assumptions. A rise of200 basis points in the real interest rate (or a decline of similar magnitude in output growth) would raise the growth-adjusted interest payments by 1.2 percent of GDP. Sustainability of the central government finances would then require a primary surplus of 1.4 percent of GDP a year.

D. Policy Implications

69. A comprehensive strategy to reduce the burden of the central government debt should be based on a combination of various actions, including the expected increase in the primary surplus and a faster implementation of structural reforms to improve prospects for higher sustainable output growth. This strategy should also include the use of privatization proceeds to repay government debt and an improved debt management to reduce the cost of domestic debt.

70. The fiscal stance envisaged in the medium-term projection is anticipated to reduce the debt to output ratio by some 0.9 percentage point of GDP a year. The projected reduction in the debt ratio would make the central government finances less vulnerable to changes in long-term trends for interest rates and output growth. In addition to sustainability considerations, a reduction in the debt ratio would place the government in a better position to gradually change the composition of expenditure in favor of capital spending and to deal with the risk of maintaining a large portion of the domestic debt in short-term maturities.

71. Privatization plans envisage the sale of two state commercial banks with a possible value of US$400 million. The use of these proceeds to repay debt would reduce the stock of debt by about 4 percent of GDP and would result in savings on interest payments of 0.1-0.2 percent of GDP a year. Additional interest savings may arise from improvements in debt management (i.e., a 100 basis point reduction in the interest rate would reduce interest payments by 0.6 percent of GDP a year). Steps initiated in 1997 to standardize bond instruments and develop a government bond market should be intensified so as to ultimately reduce the cost of domestic debt and contribute to lengthen the average maturity of debt.

Debt Instruments of the Central Government

72. This appendix summarizes the main features of the eight types of central government bonds. An income tax rate of 8 percent is levied on the interest earnings of government bonds, with the exception of earnings on U.S. dollar bonds.

73. The fixed-interest rate bond has been issued for many years. The bond is issued with maturities of 28, 84, and 168 days and with a minimum value of C 250,000 (US$10,000) and in September 1997 represented 19.3 percent of the total outstanding bonds. The 28-day bond is issued at discount, while remaining maturities carry an interest coupon redeemable every 84 days.

74. The variable-interest rate bond was created in November 1990. It is issued with maturities of 270 days, 1, 2, 3, 4, 5, 10, and 15 years, with a minimum value of C 1 million, and six-month interest coupons, with a share of 30 percent of the total bonds outstanding in September 1997. The interest rate is the basic interest rate of the central bank (a weighted average of interest rates in the weekly auction and six-month bank deposits) plus a spread set by the government at the time of issue. The interest rate is adjusted every six-months and was in the range of 19.5 to 21.8 percent depending on maturity at end-1997. Another variable-interest rate bond, TIAB, was created in May 1990. Its share in the stock of domestic debt peaked at 8.3 percent in 1993 but has remained below 1.0 percent thereafter.

75. The inflation-indexed bond, titulo de unidad de desarrollo, was created in May 1993. It is issued with maturities of 1, 2, 3, 4, 5, 10, and 15 years, with a minimum value of US$10,000, and six-month interest coupons. The bond principal is expressed in a special unit of account, unidad de desarrollo, with its value fully indexed to the consumer price index (as calculated by the ministry of commerce and industry) and adjusted monthly by the stock exchange commission. The real interest rate is set by the government on the basis of its financing needs and was in the range of 4.5 to 6.5 percent depending on maturity during 1997. This bond is mostly held by institutional investors such as pension funds and its share in the stock of domestic debt rose from 6 percent at end-1994 to 18 percent in September 1997.

76. The U.S. dollar-denominated bond, DOLEC, was created in December 1993 but its share in the stock of domestic debt has remained very small (below 2 percent). The bond is issued with maturities of 180 and 270 days, 1, 2, 3, 5, and 15 years, with a minimum value of US$5,000, and six-month interest coupons. The bond is purchased with colones at the central bank at the buying exchange rate of the day and redeemed in colones by the central bank at the selling exchange rate of the day, and is offered with fixed or variable interest rate. The variable interest rate is the six-month LIBOR deposit rate plus a spread set by the government for each maturity at the time of issue. Other bond instrument with minor importance is the U.S. dollar indexed bond, TINDEX, which was created in July 1991 and discontinued in 1995.

77. The U.S. dollar bond was created in March 1995. It is issued with maturities of 90 and 180 days, 1, 2, 3, 5, and 15 years, with a minimum value of US$5,000, three-month interest coupons, and is negotiated fully in U.S. dollars. The interest rate is the six-month LIBOR rate plus a spread set by the government for each maturity. Its share in the stock of domestic debt amounted to 20 percent in September 1997.

78. A new inflation-indexed bond, bono de renta real, was created in February 1997 to provide an alternative investment instrument to the social security agency, the state insurance and electricity companies, and other public agencies under the control of the budgetary authority. The bond is issued with maturities of 28, 56, 84, 168, 252, and 336 days, with a minimum value of C 1 million, and 84-day interest coupons. The interest rate is linked to the change in the value of the unidad de desarrollo plus a spread to account for a real return. The real rate of return is set by the government and was in the range of 2-4 percent depending on maturity during 1997. The share of this instrument in the stock of domestic debt amounted to 11 percent in September 1997.

79. A new fixed-interest rate bond denominated in colones was created in September 1997 with the objective to move to standardized and paperless bond instruments that could be operated electronically. The bond is issued at discount with one-year maturity and auctioned every month.

IV. Financial Sector Developments and Issues30

80. During recent years, the authorities have taken measures to strengthen prudential supervision, reduce discrimination against private banks, strengthen the financial situation of the state commercial banks, and improve the regulatory framework of the financial system. However, as discussed below, Costa Rica’s financial system is not well developed and retains a number of inefficiencies and distortions. The banking sector continues to be dominated by inefficient state banks protected by a number of institutional and regulatory controls, which in turn have allowed private banks to prosper shielded by these inefficiencies. The distortions in the regulatory framework have led to the development of off-balance operations and offshore or parallel operations that reduce the effectiveness of monetary policy and complicate effective banking supervision. These distortions and the lack of effective competitiveness have resulted in large interest rate spreads, which have contributed to financial disintermediation. Prompt and corrective measures are required to address the weakness in the institutional and regulatory framework.

81. This chapter describes the financial system in Costa Rica and developments regarding the regulatory and legal framework of the financial market in the context of the conduct of monetary policy. Section A describes the structure of the financial sector, while Section B reviews reforms to the regulatory and institutional framework of the financial system and recent developments. Section C analyzes the factors that affect the efficiency of the banking sector, and Section D suggests possible measures to improve the regulatory and institutional frameworks so as to increase the efficiency of the financial system.

A. Structure of the Financial Sector

82. The financial system in Costa Rica consists of two major groups: a domestic, regulated sector and an offshore sector, which is outside of the scope of the Superintendency of Financial Entities (SUGEF). The leading player in the regulated sector is the banking system, which in turn is dominated by three state-owned banks (Table 1). Legislation that discriminates against private banks, distortionary taxes, and high reserve requirements have stimulated the growth of innovative financial instruments, which constitute close substitutes for sight deposits, and of offshore transactions through affiliates of domestic banks, largely to circumvent these regulations and distortions. There is no official data on the actual size of the private offshore sector, but estimates indicate that it may be as large as the regulated one,31 which makes it difficult to get an accurate assessment of developments in the financial sector and to formulate policy recommendations on the basis of the information prepared by the central bank and SUGEF.

Table 1.

Costa Rica: Structure of the Regulated Financial System

(As of September 30,1997)

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Source: Superintendency of Financial Entities (SUGEF), Financial Bulletin, September 1997.
1/

Net of provisions.

2/

Excludes net worth.

3/

Deposits and obligations with the nonfinancial sector.

83. The financial system under the supervision of SUGEF comprises 3 state commercial banks, 25 private banks (17 of which have a subsidiary abroad that performs offshore operations), 20 nonbank financial firms, 7 savings and loan associations, 34 credit cooperatives, 3 public banks created by special laws (Banco Popular y de Desarrollo Comunal funded through a mandatory 1.5 percent annual revolving deduction from salaries, the Caja de Ahorros y Préstamos from the association of teachers, and the National Housing Bank (BANHVI)).

84. There are other important participants in the financial sector that do not fall under the purview of SUGEF, including the state insurance company (INS), the social security agency (CCSS), self-regulated complementary pension funds operating through trust accounts and investment funds, and two stock exchanges. Significant financial intermediation also takes place in the form of off-balance sheet activities offered by banks by setting up trust accounts and services as financial agents (fideicomisos and comisiones de confianza), and through money market funds offered by brokerage firms (OPABs and CAVs) and by mutual funds (investment funds).32

85. The securities market is dominated by government paper and short-term deposit facilities with the central bank, with very little activity in the form of equity transactions. The dominance of government and central bank paper results from the financing of fiscal and quasi-fiscal deficits through the issue of government and stabilization bonds in the domestic financial market (see Chapter III). As of August 1997, the stock of government bonds was the equivalent of about 75 percent of 6-month deposits in the financial system.

86. The quality of the loan portfolio of the regulated banking system has improved since 1995, when it was seriously affected by a combination of high interest rates and the slump in economic activity. Overdue loans have decreased from 28 percent of the total portfolio in June 1995 to 17 percent in August 1997. The state-owned commercial banks reduced loans in arrears from 34 percent to 21 percent, while private banks lowered their loans in arrears from 14 percent to 8 percent over this period (Table 2). Historically, the quality of the loan portfolio of the state-owned commercial banks has been lower than that of the private banks.

Table 2.

Costa Rica: Overdue Loan Portfolio of the Financial System

(As of August 31,1997)

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Source: Superintendency of Financial Entities (SUGEF), Financial Bulletin, September 30,1997.
1/

The amount under judicial collection was included in different categories of overdue loans.

2/

Excluding other nonbank financial institutions.

As of August 1997, the latest month for which data are available, 83 percent of loans overdue by more than 180 days were held by the state banks. These indicators, however, may be biased in favor of private banks since they can transfer nonperforming loans to their offshore branches.

87. The overall structure of the financial system has been strengthened over the past two years through injections of capital, mergers, and acquisitions of private domestic banks by foreign banks. In addition, the elimination of the monopoly by state banks on sight deposits widened and lowered the cost of the resource base of private banks. In part reflecting these developments, the share of bank loans from the state banks has decreased from 40 percent to 36 percent over the past two years.

88. The distribution of credit by economic activity has changed in the 1990s. Despite little change in the participation of agriculture and manufacturing in GDP, their share in credit has declined steadily since 1990 (Statistical Appendix Table 25). By contrast, credit to the tourism, trade, and service sectors has expanded significantly. However, the most marked growth has taken place in credit for consumption and housing, reflecting in part the expansion in retail finance activities by the domestic banking system.

B. Reforms to the Institutional Framework in the Financial Sector

89. There have been several changes in the legislation and regulations of the financial sector in Costa Rica in recent years. Among the most important was the legislation approved in November 1995, which aimed at enhancing competition and efficiency in the financial system and strengthening prudential supervision. The new legislation:

  • Eliminated the monopoly held by the state banks on sight deposits, this by allowing private commercial banks to accept sight deposits subject to certain restrictions. These restrictions are for private banks to (a) maintain a minimum balance with state banks equivalent to 17 percent (after deduction for legal reserve requirements) of deposits with a maturity of 30 days or less, at an interest rate equivalent to 50 percent of the central bank basic deposit rate—a weighted average of interest rates in the weekly auctions and six-month bank deposits—or the one-month LIBOR rate (for dollar deposits); or, alternatively, (b) open four agencies or branches in certain regions of the country, and allocate at least 10 percent (after deduction for legal reserve requirements) of deposits with a maturity of 30 days or less for loans to activities determined by the government, at an interest rate not to exceed the basic deposit rate or the one-month LIBOR rate for loans in foreign currency.

  • Opened access to central bank rediscounts and emergency credits to all the financial institutions to be supervised by SUGEF.33 However, private intermediaries have to comply with additional conditions that are (a) meeting the same conditions established to open sight deposits as described above; or, alternatively, (b) maintaining (for three months prior to having access to the rediscount facility) a minimum balance with state banks equivalent to 12 percent (after deduction for legal reserve requirements) of deposits with a maturity of 30 days or less, at an interest rate equivalent to 50 percent of the basic deposit rate or the one-month LIBOR rate (for dollar deposits). Moreover, the central bank can extend at its discretion the amount of deposits to be maintained at the state banks.

  • Broadened the scope of supervision of SUGEF to include cooperatives, savings and loan associations, the Banco Popular and BANHVI, and entities authorized to participate in the exchange market. However, offshore subsidiaries were left outside the scope of SUGEF.

  • Increased the scope for greater autonomy of the central bank by extending the terms of five of its seven directors from four years to seven years, and rotating directors such that a new director would take office and another leave every eighteen months. The remaining two directors are the president of the central bank and the minister of finance.

  • Increased the autonomy of SUGEF by creating its own board of directors with five members: two from the central bank, two from outside the central bank (named by the board of the central bank), and the superintendent general, who chairs the sessions.

  • Established a ceiling of 15 percent for legal reserve requirements, to be applied to all deposits regardless of maturity or currency. However, in exceptional cases and if economic conditions warrant, the central bank may temporarily raise reserve requirements to 25 percent, but remunerating reserves in excess of 15 percent. In addition, the central bank was allowed to extend reserve requirements to all financial institutions supervised by SUGEF. In March 1996, the central bank initiated the process aimed at unifying, extending the coverage, and establishing a timetable to reduce reserve requirements in steps (to a uniform rate of 15 percent by March 1998) for all financial intermediaries subject to these requirements (Table 3).34 Reserve requirements for savings and loan associations, previously not subject to reserve requirements, will be increased in steps to reach 15 percent by May 1999. Also, in November 1997, the central bank extended reserve requirements to deposits in cooperatives and credit unions (with assets above C 200 millions), comisiones de confianza, fideicomisos, OPABs, and CAVs. For these financial instruments, reserve requirements will be raised in steps to 15 percent by November 1999.

    Table 3.

    Costa Rica: Legal Reserve Requirements

    (In percent)

    article image
    Source: Central Bank of Costa Rica.

90. Other key developments affecting the financial sector have been:

  • In October 1995, the government and the central bank agreed with the three state banks on a set of guidelines and targets to improve their financial performance. To attain these targets, the state banks established action plans to be completed by June 30, 1998, with intermediary targets for every six months. SUGEF was entrusted with the responsibility of monitoring the banks’ progress under the action plans. The guidelines included targets on operating costs, intermediation spreads, and overdue loans. They also dealt with actions to reduce the red tape in the processing of loan applications. Progress under these action plans has been satisfactory to date.

  • To enhance the conduct of monetary policy, develop the market for securities, and move to market-determined interest rates, the authorities introduced in April 1996 an auction mechanism for the placement of government and stabilization bonds. However, shortcomings in the initial design of the auction resulted in limited participation by small investors and a persistent and significant under subscription, little flexibility of interest rates, further segmentation of the financial market, and widening of interest rate differentials among participants in the market. To reduce these shortcomings, the authorities strengthened the auction mechanism in March 1997, by reducing the minimum size of the bids (from C 1 million to C 250,000), allowing private investors to participate with noncompetitive bids through brokerage houses, and reducing the frequency of the auctions to once a week and the maturities to 4, 12, and 24 weeks. However, the switch to discretionary amounts and the elimination of the pre-established rule to determine outliers also adopted at this time, weakened the input of market participants in the determination of the interest rates.

  • In September 1996, the assembly approved legislation allowing private sector participation in the marketing of insurance policies. In this regard, the JOB is supporting a more comprehensive reform of the insurance sector, including the elimination of the public monopoly in the industry.

  • Modifications to the legal instrument of Administration by Judicial Intervention for borrowers in financial distress (a local version of Chapter 11 in the United States) were introduced in October 1996, including stricter eligibility requirements and the accrual of interest on outstanding obligations.35 Before the changes, the Administration by Judicial Intervention had serious repercussions on the quality of the loan portfolio of the banks because the intervention process could linger up to six years, including the period that the court would take to grant it. Following the changes, use of this legal instrument has ail but stopped.

  • In November 1996, regulations were issued 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 of liquidity and as a complement to the open market operations conducted through the weekly auction of stabilization bonds. The interbank market operates through the Bolsa Nacional de Valores (one of the two stock exchanges) through securities held at the central securities depository (CEVAL).

  • In April 1997, the central bank introduced regulations to improve the efficiency of the payments system and introduced an electronic check clearing system. The regulations established that daily settlements in the central bank books for net positions of the participants for large value transactions will take place at 8:30 p.m. on the same day and for small transactions at 2:30 p.m. on the following day. However, there is still a need to improve clearing procedures for checks drawn on bank offices outside the capital area.

  • In April 1997, the 27-day deposit facility at the central bank was replaced by a 7-day facility, while the 1-day facility was retained. These facilities are open to all market participants and not just to banks. The 27-day deposit rate (which competed with the 28-day government and stabilization bonds) potentially provided a conflicting signal in contrast with the amount offered in the auction.

  • To improve the management of the domestic public debt, in September 1997 the treasury started placing through monthly auctions a fully standardized one-year bond in denominations of C 1 million (US$4,000). The objectives are to create a deeper market in this bond, promote its trading in the secondary market, lengthen debt maturities (presently concentrated at below 360 days), reduce liquidity premia, and achieve more efficient pricing in the securities market, while providing the market with a reference yield curve. These bond issues will serve also as the base for repos in the interbank market.

  • To continue to improve bank supervision, the central bank issued regulations in November 1997 to cover offshore banking operations of financial conglomerates, including 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 observed within a two-year period starting by April 1998.

  • In December 1997, legislation was enacted to strengthen the national commission of securities and the superintendency of pensions with a view to providing the necessary framework for the development of the capital market.

91. Notwithstanding the marked strengthening in the structure and health of the domestic banking system since mid-1995, further improvement is required, including by reducing market segmentation. There is a need to remove distortions and further competition and efficiency in the sector. Large spreads between lending and borrowing interest rates, large differences in interest rates between public and private financial intermediaries, and the prevailing offshore banking activities are evidence of the need for advancing in regulatory reforms and redefining the role of the public financial intermediaries.

C. Efficiency of the Financial System

92. The efficiency of a financial system in mobilizing and allocating resources is inversely related to the size of the intermediation costs. Traditionally, intermediation costs have been measured by the spreads between borrowing and lending rates prevailing in the financial system. Bank spreads have been historically high in Costa Rica and the spreads of the state banks have been almost double the size of that of the private banks, which is a clear sign of market segmentation.

93. In a comprehensive study, Camacho and Mesalles estimated bank spreads in Costa Rica in the 1987-92 period and examined the main factors behind the high costs of bank intermediation.36 They analyzed the following factors that explain the size of the spreads:37 operating expenses, legal reserve requirements, explicit taxes, implicit costs of holdings low-earning assets, net revenue for other services rendered, and profits (Table 4). They found that operating costs constituted the most important factor in determining the spreads for both the state and private banks. However, the importance of this factor was more significant for the state banks, which could be explained by a higher degree of rigidity in administrative decisions and a larger network of branches. For public banks, the second most important factor in the determination of spreads (but not for private banks) was the cost of other net assets (defined as nonearning assets minus noninterest bearing liabilities and net worth), indicating that state banks were using a larger proportion of liabilities for purposes other than lending. For private banks, the second most important factor determining spreads was profit. By contrast, this factor was not significant for state banks, which would indicate that the lack of competitive pressures was not used by state banks to increase profits but to operate more inefficiently. The third most important factor determining spreads for state banks were legal reserve requirements, which is explained by the monopoly to attract deposits with shorter maturities held by these banks until November 1996, which have higher legal reserve requirements.

Table 4.

Commercial Banks Spreads 1/

(In percent)

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Source: Central Bank of Costa Rica.
1/

Average for 1987-92 data from Camacho and Mesalles (1994). For 1993-97, the central bank staff used the same methodology developed by Camacho and Mesalles.

94. After 1992, Costa Rican commercial banks continued to show high but declining spreads,38 with spreads in state banks still double the size of the spreads in private banks. Operating costs continue to be the major factor behind the spreads for state and private banks, with its importance increasing for private banks. Costs associated with legal reserve requirements have become the second major factor explaining spreads for state banks, instead of costs associated to other net assets as previously. For private banks, the costs associated with legal reserve requirements have become a more important factor than before, but the second most important factor in explaining spreads continues to be profits.

95. These developments point to two important conclusions: (a) the reduction in the spreads in the state banks appears to have prompted a concurrent reduction in private banks’ spreads, supporting the argument that public banks’ inefficiencies have allowed higher profits for private banks than would have been the case in a more competitive market; and (b) a major factor explaining the reduction in state banks’ spread has been the large reduction in the opportunity cost of holding securities and other net assets. This factor does not reflect an increase in the state banks’ efficiency regarding their intermediation function, but a reduction in intermediation activities relative to investment in securities as a share in their portfolio (see Table 1). As of September 1997, the ratio of loans to deposits and net worth was 24 percent in the state commercial banks compared with a ratio of investment in securities to deposits and net worth of 61 percent; the same ratios for the private banks were 90 and 17 percent, respectively.

96. The marked increase in holdings of securities by the state banks was, in part, prompted by a reduction in the legal reserve requirements, which freed previously noninterest earning assets. Furthermore, the opportunity cost of investing in securities relative to extending loans has been reduced for the state banks because of the attractive interest rates offered by government bonds. State banks, in contrast to private banks, can benefit from those rates because they can attract deposits at significantly lower rates due to the explicit and implicit government guarantee on their deposits. State banks have persistently offered lower interest rates on deposits with equivalent maturities of the government bonds, with the costs to attract those deposits representing an upper limit as state banks mobilize sight deposits at even lower rates (Table 5).

D. Conclusions

97. Prompt and corrective measures are required to address the remaining weakness in the institutional and regulatory framework of the financial sector. Reforms should be designed with a view to level the playing field for private financial intermediaries, increase competition in the financial system, and enhance the scope of financial supervision. It would be necessary to:

  • Enforce regulations requiring the supervision by SUGEF of financial groups on a consolidated basis, including offshore activities.

  • Continue to strengthen the finances of the private banks through mergers, consolidation, and increased participation by foreign banks by, inter alia, allowing these banks to establish branches in Costa Rica.

  • Eliminate the government explicit guarantee on 100 percent of the state banks deposits as established in the constitution. Moreover, correct the distorted incentive structure derived from the perception of an implicit government guarantee on state banks’ deposits by introducing a limited, mandatory deposit insurance scheme, funded by premiums levied on all commercial banks, private and state-owned.

  • Remove the conditions imposed on private banks to attract sight deposits and for using the central bank rediscount facilities and emergency windows as they limit their capacity to compete with the state banks.

  • Design a comprehensive strategy to define the role of the state and public banks in the context of the privatization of BICSA and of the Banco de Costa Rica (one of the two major state banks). Actions to level the playing field for the private sector without serious reforms to the structure of the state-owned banking system could result in a rapid deterioration of the finances of these banks and could be a source of quasi-fiscal losses.

  • Allow market forces to play a greater role in the determination of interest rates on central bank and government paper by further improving the auction mechanism and developing the interbank market. This would permit moving faster toward financial deepening, correcting market segmentation, and eliminating unwarranted interest rate differentials.

 

Table 4.

Costa Rica: Output and Prices of Major Agricultural Products

(Annual percentage changes)

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Changes based on export unit values converted at the average annual buying exchange rate.

2/

The CNP ceased to support prices of basic grains in the second half of 1995.

Table 5.

Costa Rica: Average Prices of Basic Grains

(In colones per kilo)

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Sources: National Production Council (CNP); and Fund staff estimates.
1/

The CNP ceased to support prices of basic grains in the second half of 1995.

Table 6.

Costa Rica: Industrial Production

(Index 1991=100)

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Source: Central Bank of Costa Rica.
1/

Refers to the period January-September.

Table 7.

Costa Rica: Comparative Social Indicators

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Sources: International Economics Department, World Bank; and Central Bank of Costa Rica.
1/

In percent of school age population.

2/

In percent of population above 15 years of age.

3/

Per thousand live births.

4/

In percent of age group under five.

Table 9.

Costa Rica: Producer Price Index Components

(1991 = 100)

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Source: Central Bank of Costa Rica.
Table 21.

Costa Rica: Central Bank Quasi-Fiscal Operations

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Source: Central Bank of Costa Rica.
1/

1-day and 27-day deposit facilities at the central bank.

2/

In 1996 includes government bonds used for sterilization purposes.

Table 22.

Costa Rica: Detailed Accounts of the Banking System 1/

(End of period stocks; in billions of colones)

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article image
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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Since 1995 stocks (valued at C$207.7=US$1) include Banco Popular as part of the banking system.

2/

Preliminary data.

3/

Short-term deposit facilities (1-day and 27-day) at the central bank.

Table 31.

Costa Rica: Petroleum Imports

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Source: Central Bank of Costa Rica.
Table 32.

Costa Rica: Direction of Trade

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Sources: Central Bank of Costa Rica.
1/

Excludes maquila exports.

2/

Includes adjustment for consistency with balance of payments data.

Table 34.

Costa Rica: Tourism Indicators

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Source: Costa Rican Tourism Institute.
Table 35.

Costa Rica: External Public Debt by Creditor

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Includes principal in arrears, as well as rescheduled principal and capitalized interest; excludes interest arrears.

2/

Includes the bonds resulting from the commercial bank debt restmcturing in 1989.

3/

Short-term liabilities of the central bank.

Table 36.

Costa Rica: External Public Debt by Debtor

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Includes principal in arrears, as well as rescheduled principal and capitalized interest; excludes interest in arrears.

2/

Short-term liabilities of the central bank.

Table 37.

Costa Rica: External Debt Payments Arrears

(In millions of U.S. dollars)

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Sources: Central Bank of Costa Rica; and Fund staff estimates.
1/

Arrears to multilaterals within grace period or rescheduled on regular basis.

Table 38.

Costa Rica: Effective Exchange Rates

(Indices: 1990=100)

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Source: IMF Information Notice System.
1/

Increase denotes appreciation.
1

Presidential and parliamentary elections are held every four years. Fiscal fragility associated with pre-election year spending has been a dominant macroeconomic shock in Costa Rica since the early 1980s. Over 1993-94, the combined public sector deficit widened from 0.9 percent of GDP to 6.2 percent (excluding losses of 1.8 percent of GDP from the closing of one of the state commercial banks), real GDP growth slowed from 6.3 percent to 4.5 percent, and inflation accelerated from 9 percent to 20 percent.

2

A surcharge of 8 percent on all imports, which was eliminated in steps between July and September 1995.

3

Costa Rica has followed a real exchange rule since the mid-1980s, without adhering to any pre-announced formula. In the event, the devaluation rate has followed closely the inflation differential between Costa Rica and the United States (destination of about half of Costa Rica’s exports). The central bank intervenes in the exchange market by buying or selling at the set rate. Participants in the exchange market are authorized to maintain a net position in foreign exchange of up to 100 percent of capital, with daily changes restricted to 1 percent of the previous day’s position.

4

The government announced plans to privatize BICSA (an international bank owned by the state commercial banks), a state commercial bank (Banco de Costa Rica), RACS A (telecommunications), and the National Insurance Institute (40 percent), and to sell land along the coastal area under concession to hotels and tourism spots. Of these, only the privatization of BICSA and the Banco de Costa Rica continued to be pursued as noted above.

5

The rest of the nonfinancial public sector comprises the utilities, the oil refinery, a number of smaller enterprises and agencies, and the Social Security Agency.

6

The minimum bid was set at the equivalent of US$4,000 dollars, all bids had to be placed through the stock exchange, and small investors were not allowed to place noncompetitive bids.

7

INTEL, a multinational firm that produces computer parts, is building a US$500 million plant in Costa Rica, to be completed in 1999.

8

By January 2000, import tariffs will be reduced in steps to 5 and 10 percent on intermediate goods, and to 15 percent on consumption goods.

9

Prepared by Michael DaCosta.

10

Efforts focused on reducing the losses of the state marketing agency (CNP—responsible for setting producer prices of corn and other basic grains and international trade in these grains). The overall balance of the agency swung from a small surplus in 1982 to a deficit equivalent to about 1 percent of GDP in 1984.

11

CODESA was the holding company for most state enterprises.

12

For example, the budgets for 1985-86 incorporated guidelines for freezing staff in all public sector agencies at the January 1984 level.

13

These included loans from the Banco Popular (at subsidized interest rates) to establish companies that could supply services to the government.

14

The most ambitious target was a reduction in public sector employment by 25,000 (19 percent of total public sector employment) over the period 1991-94. The target was not met.

15

Institutions included under this category included the CNP, the railway company (INCOFER), the ministry of public works, and the cement and fertilizer companies which were sold.

16

These regimes include those covering teachers, members of the assembly, and judicial workers.

17

Codigo Aduanero Uniforme Centroamericano and Ley General de Aduanas.

18

In 1994 about 25 percent of current expenditure comprised transfers (including mainly pensions, family allowances, export subsidies, support for universities) linked to earmarked revenue. Wages, pension payments, and interest accounted for about 70 percent of current expenditure.

19

Related reforms in the pension scheme of the social security agency (CCSS) in 1995-96 raised the retirement age, and tightened eligibility requirements for disability benefits. These changes will help maintain the pension system of the CCSS in good standing until about 2015.

20

Under this law, former public sector workers are encouraged to establish businesses that would provide services to the public sector in areas such as law, accounting, engineering, secretarial services, transportation, and maintenance and security services.

21

Employment remained unchanged during 1993-96.

22

These included IFAM, CONICIT, and DINADECO.

23

Prepared by Marco Rossi.

24

See Chapter II for a discussion of the structural imbalances in the public sector during this period and actions that have been adopted to address them.

25

When the revaluation of principal related to changes in consumer prices and the exchange rate is added to the interest paid on inflation-indexed and dollar-denominated bonds, interest payments account for one-third of total expenditure during this period.

26

Adding principal revaluation of inflation-indexed and dollar-denominated bonds, interest payments rose from 5.4 percent of GDP in 1988 to 7.8 percent of GDP in 1997.

27

Appendix I summarizes the main features of current debt instruments.

28

CODESA was a holding company for a number of state-owned agricultural, industrial, and mining firms. A program to sell and liquidate its 43 firms started in 1985 and after the program was virtually completed, the company was shut down in 1993.

29

See SM/98/63 (3/3/98).

30

Prepared by Florencia Frantischek.

31

The state commercial banks own an offshore affiliate (BICSA).

32

The investor chooses the portfolio in OPABs (Operaciones de Administration Bursdtit) and a share of a fixed portfolio in CAVs (Cuentas de Administration de Valores). The investment funds are similar to the CAVs but are managed by investment companies, which charge a fee for the administration of the fund.

33

Prior to this change, only state commercial banks had access to these facilities.

34

Except for time deposits above 180 days, for which the reserve requirements will be raised from 10 to 15 percent. Another exception is reserve requirements for foreign currency deposits above 30 days, which in July 1996 was reduced to 5 percent.

35

Previously, enterprises protected by this legal procedure were allowed to stop paying their debts, and creditors did not accrue interest.

36

Camacho, E. and Mesalles, L., 1994, “Margen de Intermediation y Eficiencia en la Banca,” in Regulation, Competentiay Efitiencia en laBanca Costarricense, ed. Academia Centroamericana.

37

Spreads measured as the difference between the average cost of funds relative to the average lending rates.

38

Reduction in state banks’ intermediation spreads was one of the targets to be achieved in the agreement signed between the government and the state commercial banks.

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Cover IMF Staff Country Reports
Costa Rica: Recent Economic Developments
Author:
International Monetary Fund
Volume/Issue:
Volume 1998: Issue 999
Publisher:
International Monetary Fund
ISBN:
9781451960402
ISSN:
1934-7685
Pages:
90
DOI:
https://doi.org/10.5089/9781451960402.002
Figure 1.

Costa Rica Exchange Rate Developments

(1990=100)
Figure 1.

Central Government Debt