Costa Rica: Staff Report for the 2001 Article IV Consultation
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International Monetary Fund
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Publication Date:
24 Apr 2002
eISBN:
9781451809602
Language:
English
Keywords:
ISCR; CR; deficit; tax simplification package; staff appraisal; public sector deficit; current account; exchange rate; crawling peg; rate of depreciation; fiscal policy; Public sector; Central America
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This 2001 Article IV Consultation highlights that the economic performance of Costa Rica weakened in 2000. Real GDP growth slowed to 1.7 percent, from more than 8 percent a year in 1998–99, reflecting in part deterioration in terms of trade, the end of the construction phase of a large foreign direct investment project by Intel, and the effect of high real interest rates on domestic demand. Inflation remained at 10 percent during the year. In the structural area, the assembly approved legislation to open up the telecommunications and electricity sectors to private investment.

Abstract

This 2001 Article IV Consultation highlights that the economic performance of Costa Rica weakened in 2000. Real GDP growth slowed to 1.7 percent, from more than 8 percent a year in 1998–99, reflecting in part deterioration in terms of trade, the end of the construction phase of a large foreign direct investment project by Intel, and the effect of high real interest rates on domestic demand. Inflation remained at 10 percent during the year. In the structural area, the assembly approved legislation to open up the telecommunications and electricity sectors to private investment.

I. Introduction

1. A mission visited San Jose in the period March 14–24 and on April 23, 2001 to hold discussions for the 2001 Article IV consultation and to review the Fund’s technical assistance program with Costa Rica.1 The staff team consisted of Messrs. Rennhack (Head), Bailen, Giustiniani, and Martin, and Mmes. Coronel and Frantischeck (all WHD). The mission met with the minister of finance, the president of the central bank, other senior government officials, and representatives of the private sector.

2. At the conclusion of the last Article IV consultation in October 1999, Executive Directors welcomed the strong real GDP growth in 1998–99 and the progress in reducing inflation. However, they emphasized the need for fiscal consolidation to reduce public sector debt, relieve pressures on domestic interest rates, and lower the vulnerability of the economy. They also recommended the strengthening of the financial sector and urged the authorities to build political support for structural reforms. Directors observed that the crawling peg exchange rate had been successful in avoiding an erosion of external competitiveness.

3. Costa Rica’s statistical database is weak in several areas, which interferes with proper surveillance of macroeconomic developments (Appendix IV). In particular, the coverage of the monetary statistics and prudential indicators is incomplete because of sizable unrecorded activity in offshore branches and the off-balance-sheet accounts of domestic banks, although the authorities recently improved reporting requirements in this area. In the fiscal sector, a large statistical discrepancy exists in the measurement of the overall public sector deficit. The measurement of the balance of public enterprises, domestic debt, private sector external debt, and exports of services could also be improved.

II. Background and Recent Developments

A. Background

4. During the previous decade, Costa Rica made significant progress in opening its trade system, and social conditions, especially for education and health, remained among the best in the region (Table 1). These factors, together with a long history of political stability, attracted foreign direct investment, led to more diversified exports, and sustained real GDP growth of 4½ percent a year in the period 1990–99, while inflation declined from 27 percent in 1990 to 10 percent in 1999 (Table 2). However, successive governments met strong political resistance to their efforts to reduce the overall public sector deficit on a sustained basis, and total public debt reached 45 percent of GDP by end-1999, contributing to high real lending interest rates in domestic currency and an external current account deficit of 4½ percent of GDP. Progress in implementing structural reforms, besides trade liberalization, also was limited. According to the reported prudential indicators, the banking system appeared healthy at end-1999, but domestic banks engaged in a significant amount of unreported financial activity in offshore branches and off-balance-sheet accounts.

Table 1.

Costa Rica: Comparative Social Indicators

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Source: UNDP Human Development Report 2000.

Uses the national poverty line of individual countries based on a local basket of basic goods and services.

Table 2.

Costa Rica: Macroeconomic Flows

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

B. Developments in 2000

5. In 2000, economic performance weakened. Real GDP growth slowed to 1.7 percent, from over 8 percent a year in 1998–99, reflecting in part a deterioration in the terms of trade, the end of the construction phase of a large foreign direct investment project by INTEL, and the effect of high real interest rates on domestic demand.2 Inflation remained high at 10 percent during the year, in line with the objectives of credit and exchange rate policy. The decline in the terms of trade contributed to a loss of net international reserves of about US$150 million. At end-2000, gross international reserves amounted to 1.7 months of imports of goods and nonfactor services and 22 percent of broad money, a relatively low level by regional standards (Table 3).

Table 3.

Central America: Indicators of External Vulnerability

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Sources: National authorities; Joint BJS-IMF-OECD-World Bank Statistics on External Debt; and Fund staff estimates.

Includes net maquila exports

Excluding imports of goods for processing.

Debt due within a year.

6. The overall public sector deficit rose from 3.5 percent of GDP in 1999 to 4.2 percent of GDP in 2000, as the primary surplus virtually disappeared (Table 4).3 Net external financing (including a US$250 million Eurobond issue) amounted to about 1½ percent of GDP, with the balance covered through further domestic borrowing; total public debt rose to 48 percent of GDP by end-2000. In the central government, transfers to the private sector declined in relation to GDP, reflecting the policy to phase out the export subsidies on nontraditional exports by 2001 (Table 5). However, while the higher world oil prices raised indirect tax revenues (the import duties and value-added taxes on petroleum products are ad valorem), the earmarking system channeled the additional revenues to public social programs. Central bank operating losses rose to 1.8 percent of GDP, reflecting interest on the large stock of open market instruments that had been issued in recent years (Selected Issues Table 19). In September the government began to absorb some of the central bank’s losses by repaying part of its debt to the central bank, on which it was not paying interest. The overall surplus of the rest of the public sector fell slightly to 0.6 percent of GDP (Table 6). This estimate of the enterprise surplus includes an estimated 0.6 percent of GDP of expenditure by a trust fund set up in early 2000 by the state electricity and telecommunications enterprise (ICE). The authorities believed that this trust fund was a private sector operation, because private investors provided the financing and bore all the risk. After consulting with the Fund’s Fiscal Affairs and Statistics Departments, the staff explained this expenditure should be recorded as public spending, because the trust fund was simply a financing mechanism.

Table 4.

Costa Rica: Summary Public Sector Operations, 1996–2001

(In percent of GDP)

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

Negative sign indicates net revenue.

Excludes accumulation of debt due to capitalization of interest payments on some government debt.

Table 5.

Costa Rica: Operations of the Central Government, 1996–2001

(In percent of GDP)

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

Excludes accumulation of debt due to capitalization of interest payments on some government debt.

Table 6.

Costa Rica: Summary Operations of the Rest of the Nonfinancial Public Sector, 1996–2001

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

7. The central bank sought to hold inflation stable at 10 percent a year. The central bank’s net domestic assets contracted slightly in 2000 (Table 7).4 In March 2000, reserve requirements on domestic currency deposits were lowered by 2 percentage points to 12 percent to try to narrow the intermediation spread (the difference between deposit and lending interest rates) and encourage lower interest rates on domestic currency loans. (The reserve requirement on U.S. dollar deposits stayed at 5 percent.) The central bank held the interest rate on its open market instruments steady at 17 percent (for 6-month paper) through September, and then reduced the rate to 15 percent following the repayment by the central government. Lending interest rates in domestic currency declined from 29 percent at end-1999 to 27.8 percent at end-2000, although the intermediation spread held steady at about 13 percent. Exchange rate policy aimed to depreciate the colon to offset the differential between the domestic inflation target and estimated foreign inflation. During 2000, the central bank slowed the rate of crawl to 6.6 percent, from 9.9 percent during 1999, as it expected higher foreign inflation. However, the colon appreciated by 5 percent in real effective terms during the year, owing largely to the unexpected strength of the U.S. dollar (Figure).

Table 7.

Costa Rica: Summary of Monetary Accounts

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

Includes certificate of deposits in U.S. dollars.

8. Bank credit to the private sector rose by 31 percent during the year, led by a 52 percent rise in foreign currency lending. Moreover, a growing share of the foreign currency loans went to mortgage refinancing, consumer credit and other activities without income in foreign currency. Borrowers were taking advantage of the significantly lower cost of U.S. dollar loans, which carried an interest rate of 12.3 percent on average during 2000 plus expected currency depreciation of about 6½ percent. The rapid credit expansion was financed partly by the use of net foreign assets, as broad money rose by 20 percent during the year. By end-2000, foreign currency loans amounted to 46 percent of total loans, compared with 36 percent at end-1999, while foreign currency deposits rose from 42 percent to 45 percent of broad money. Reported nonperforming loans rose from 2.9 percent of total loans at end-1999 to 3.6 percent of total loans at end-2000, reflecting mostly problem loans at the National Bank (the largest state bank) (Table 8). The risk-weighted capital asset ratio amounted to 19.5 percent at end-2000.

Table 8.

Costa Rica: Key Prudential Indicators of the Banking Sector

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Source: Superintendency of Financial Institutions.

Total assets include: cash, precious metals, deposits at the central bank and other financial institutions: other liquid assets; temporary and permanent investments; loan portfolio; real state assets and other nonfinancial assets.

Figure
Figure

Costa Rica. Exchange Rate Developments

(1990=100)

Citation: IMF Staff Country Reports 2002, 088; 10.5089/9781451809602.002.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).

9. The external current account deficit reached 4.8 percent of GDP, from 4½ percent of GDP in 1999, reflecting lower world coffee and banana prices as well as the surge in world oil prices (Table 9). General merchandise exports in U.S. dollar terms declined for the second consecutive year, as world coffee and banana exports remained weak and the decline in subsidies and the strength of the U.S. dollar affected nontraditional exports. INTEL decided to retool the plant built in 1998–99, which led to almost equal declines in exports of goods for processing and profit remittances. Net capital inflows dropped by over 50 percent, partly because foreign direct investment declined, as the construction of INTEL’S plant ended in 1999. Other private capital inflows also fell sharply, reflecting largely the decline in domestic interest rates, while net borrowing by the public sector remained steady at about 1 percent of GDP.

Table 9.

Costa Rica: Summary Balance of Payments

(In millions of U.S. dollars, unless otherwise indicated)

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

Staff projection based on public sector deficit of 4.5 percent of GDP.

Including errors and omissions.

Excluding imports of goods for processing.

In percent of exports of general merchandise and services.

10. In the structural area, the assembly approved legislation to open up the telecommunication and electricity sectors to private investment, but subsequently strong popular opposition and an unfavorable supreme court ruling stopped this reform. In early 2000, the superintendent of financial institutions introduced regulations that required banks to place off-balance-sheet operations on their balance sheets, report regularly on their offshore operations, and apply stricter norms for loan classification. Trade liberalization continued, with a reduction in tariffs on imports from outside Central America in January, the abolition of a small tax on trade with Central America, and the approval of a free trade agreement with Chile.

III. Policy Discussions

11. Since taking office in 1998, the authorities have sought to promote more rapid economic growth by adopting structural reforms and maintaining macroeconomic stability. Their economic program for 2001 (which was published in December 2000)5 envisaged a recovery in real GDP growth to 3.2 percent, on the assumption that lower domestic interest rates would stimulate a recovery in investment. Inflation was to be held at 10 percent during the year. The external current account deficit was projected to remain constant in relation to GDP, but with increased net capital inflows, net international reserves would remain constant. The fiscal plan was to reduce the overall public sector deficit in relation to GDP, financed by another international bond issue and domestic borrowing. The government planned to repay the remainder of its debt to the central bank, which would allow the central bank to redeem a significant amount of open market instruments without expanding credit. This policy was expected to permit a reduction in interest rates on open market instruments of about 50 basis points. Consistent with the inflation target, the central bank planned to depreciate the colon by 6.6 percent during the year.

12. So far in 2001, preliminary information suggests that real economic activity declined by about 2 percent (year on year) in the first four months, as INTEL had not yet finished retooling its plant. (Excluding INTEL operations, economic activity rose by an estimated 2 percent year on year in the same period). Price increases in housing and food raised 12-month inflation to 13.3 percent in May. In the first quarter, the central government deficit amounted to 3.2 percent of quarterly GDP. Although the government repaid the remainder of its debt to the central bank, net domestic assets of the central bank contracted through end-May. The central bank lowered interest rates on its open market instruments by 50 basis points to 14.5 percent in late April, much less than the decline in interest rates on U.S. treasury bills since end-2000, and continued to sell open market securities. Owing to stagnant exports, the external current account deficit widened to about 3 percent of quarterly GDP in the first quarter, considerably higher than in the same period in 2000. Through end-May, net international reserves rose by US$32 million, benefiting from the proceeds of a US$250 million bond issue by the government in March.

13. The discussions reviewed the prospects for achieving the objectives of the 2001 economic program. The authorities felt that it would be possible for the economy to grow by 3 percent in 2001, but noted that they might update this projection when they revised their economic program in midyear. The staff commented that inflation for the year might overshoot the target, but the authorities stressed that credit and exchange rate policy would aim to keep inflation close to 10 percent. The staff noted that the overall public sector deficit was likely to be larger than projected by the authorities and that this would generate more public debt than expected. This would lead to higher interest rates and slower economic growth or increased demand pressures which would spillover into a wider external current account deficit and a further loss of net international reserves.

14. Most of the discussions centered on how to improve the mix of economic policies to reduce the economy’s vulnerability over the medium term. The authorities and staff agreed that continued sizable overall public sector deficits and limited progress on structural reform would weaken the economy over time. The authorities explained that, since taking office in May 1998, the current government’s efforts to advance structural reforms and to maintain a strong fiscal policy had frequently been thwarted by strong political resistance, as this government lacks a simple majority in the assembly. Nonetheless, the government intended to continue trying to strengthen fiscal policy and advance structural reforms where possible. For example—while dropping the plans to increase private participation in electricity and telecommunications—it recently introduced legislation to increase the independence of the central bank, strengthen financial supervision, and extend limited deposit insurance to all banks. Also, the authorities have asked to be included in the Financial Sector Assessment Program (FSAP), although they felt that the offshore banks and off-balance-sheet accounts contained few problems. The authorities agreed, however, that the prospects for adopting stronger policies in the remainder of 2001 were limited, because political pressures would probably intensify ahead of the general elections in February 2002.

A. Fiscal Policy

15. The authorities expected the overall public sector deficit to decline to 3.8 percent of GDP in 2001, with an improvement in the primary surplus to 0.6 percent of GDP.6 The central government deficit was expected to widen to 3 ½ percent of GDP, reflecting the absorption of part of the central bank’s losses and a further increase in the wage bill. Central government revenues are projected to decline slightly in relation to GDP, as lower world oil prices reduce the taxes on petroleum products. Part of this revenue loss was to be offset by the tax simplification package expected to be approved in June, which has an estimated revenue yield of 0.3 percent of GDP in 2001.7 Central bank operating losses were to decline to 1.4 percent of GDP, as the central bank redeemed open market securities. The central government projected the surplus of the public enterprises to improve to 1 percent of GDP in 2001, mainly because it assumed that the state electricity and telecommunications enterprise (ICE) was assumed to benefit from strong increases in sales of electricity and cellular telephones.

16. However, the staff projected that the overall public sector deficit would rise to 4½ percent of GDP in 2001, with no primary surplus. While the staff agreed with the projected deficit for the central government, it noted that the central government exercised only indirect control over major public enterprises such as ICE and that the government’s projections of ICE’s revenue and expenditure (besides the trust fund) were too optimistic. On this basis, it estimated that the overall surplus of the public enterprises would fall from 0.6 percent of GDP in 2000 to 0.4 percent of GDP in 2001, instead of rising as expected by the authorities. With an overall public sector deficit of 4 ½ percent of GDP, public debt would rise to over 50 percent of GDP by end-2001. The authorities agreed that they lacked direct control over major public enterprises, but said they would make an effort to secure an increase in the enterprise surplus to limit the overall public sector deficit to 3.8 percent of GDP (including the trust fund spending).

17. The staff urged the authorities to improve expenditure management by simplifying the complex wage structure and scaling back revenue earmarking. The wage bill of the nonfinancial public sector is expected to reach over 9 percent of GDP in 2001, from 7.7 percent of GDP in 1997, reflecting in part strong growth in teacher’s salaries and additional employment in education and security. While base salaries tended to rise in line with inflation, actual salaries included additional elements—based on the employee’s job, educational level, seniority, and other characteristics—that effectively multiplied the base salary increase by a factor of 1.5 for central government employees and up to 2.5 for employees of the state refinery. The staff commented that revenue earmarking applied to a significant share of the central government’s tax revenues (perhaps on the order of 33 percent), limiting the ability to reduce the deficit through revenue measures. The authorities agreed that the wage structure and revenue earmarking complicated fiscal management, and recently proposed legislation to eliminate all revenue earmarking.

B. Credit Policy

18. An overall public sector deficit of 4 ½ percent of GDP would generate an increase in public debt that is inconsistent with the planned credit policy. The staff estimated that the increased public sector borrowing requirement would put pressure on domestic interest rates as well as the international reserve position. If the central bank were to try to keep its interest rates at 14.5 percent, net domestic assets would expand more than expected, and net international reserves would decline by about US$180 million. With broad money projected to rise somewhat faster than nominal GDP, bank credit to the private sector would rise by 22 percent during the year. Fiscal measures to reduce the overall public sector deficit to 3 ½ percent of GDP would probably eliminate the loss of net international reserves without forcing the central bank to raise domestic interest rates. Alternatively, the central bank could adopt a tighter credit policy, which would drive up domestic interest rates, slow growth in credit to the private sector, and impede the recovery in real economic growth.

19. The authorities agreed that a wider fiscal deficit would force a shift in credit policy and said they would consider whether to modify the economic program to be published in July 2001. They mentioned that—in the past—the central bank has raised interest rates if necessary to protect the reserve position. So far this year, the central bank’s interest rates had declined much less than interest rates in the United States, which had led to an increase in net international reserves so far this year.

20. The authorities viewed the rapid growth in U.S. dollar lending as a potential risk that needed close monitoring. They explained that the private sector preferred U.S. dollar loans because of both the lower interest rates in U.S. dollars as well as confidence in the central bank’s exchange rate policy. The authorities agreed with the staff that reducing public debt was the best way to lower domestic currency interest rates and diminish the advantage to borrow in foreign currency. Nonetheless, with limited prospects for an immediate shift in fiscal policy, they were taking other steps to discourage lending in U.S. dollars. Thus, in January and May 2001, the reserve requirement on local currency deposits was lowered in steps to 9 percent and a further reduction to 5 percent by mid-2002 is planned. Other possible actions might include equalizing the tax treatment on deposits regardless of currency or increasing provisioning or capital requirements on these types of loans. The staff supported these measures.

C. External Sector Policies

21. The staff estimated that—with an overall public sector deficit of 4 ½ percent of GDP and no change in credit policy—the external current account deficit would widen to about 5 ½ percent of GDP in 2001, despite some relief from lower international oil prices. While domestic demand was expected to sustain imports, general merchandise exports are unlikely to recover, owing to slower growth in the United States and other key trading partners and to depressed markets for coffee and banana exports. INTEL was expected to finish retooling its plant and resume exporting at full capacity in the second half of 2001. Profit remittances were projected to decline for the year as a whole, as the INTEL plant was expected to generate lower profits.

22. The staff projected that net capital inflows could rise significantly but could finance only part—not all—of the wider current account imbalance. Reflecting strong investment in the tourism sector, FDI inflows would remain a stable source of financing, amounting to about 2 ½ percent of GDP, while declining international interest rates may attract more portfolio investment inflows. However, net external borrowing by the public sector would fall sharply to 0.3 percent of GDP since the proceeds from the international bond placement and the expected disbursements from multilateral organizations would be offset by significant amortization payments. The public sector’s external debt would decline slightly to 19 percent of GDP at the end of 2001.

23. The staff raised the issue of the appropriateness of the crawling peg exchange rate regime. The authorities noted that the poor performance of nontraditional exports in recent years raised questions about external competitiveness, but felt that wages and the exchange rate were not the source of the problem. Instead they preferred to strengthen competitiveness through structural reforms to improve infrastructure (especially telecommunications, roads, and ports), cut administrative inefficiency and lower the high financial intermediation spread in local currency. The staff supported this assessment, noting that Costa Rica’s relative unit labor costs in manufacturing in U.S. dollars had declined since 1995. However, the staff recommended that the central bank accelerate somewhat the rate of depreciation in 2001, as the WEO projected foreign inflation at 1.4 percent, compared with the central bank’s estimate of 3.2 percent.

24. The staff suggested that Costa Rica consider a move to another exchange rate regime in the medium term, because the crawling peg helped sustain high inflation and could be undermined by swings in private capital inflows, especially with significant macroeconomic imbalances. The authorities agreed that the crawling peg was vulnerable, but noted that this regime had helped protect external competitiveness from the effects of an inflation rate of 10 percent a year. They felt it would be essential for Costa Rica to strengthen its fiscal and external positions, lower inflation and improve financial supervision before considering a move towards a harder peg, such as in the case of El Salvador, or towards a more flexible exchange rate regime.

25. Costa Rica has a generally liberal trade regime, and has no significant restrictions on capital account transactions.8 Average tariffs are relatively low, as the effective weighted average tariff rate fell from 5.9 percent in 1999 to 5.5 percent in 2000, and there are few nontariff barriers. In a recent WTO trade policy review, the authorities were encouraged to reduce the discrepancy between actual import tariffs and the maximum tariff rates (which are 45 percent for most goods except for a few products) with a view to leading to more predictable market access conditions.

26. The authorities reiterated their commitment to provide Costa Rica’s share of debt relief under the HIPC Initiative for Nicaragua. They commented that—depending on the modality—Costa Rica would have to provide relief in net present value terms equivalent to over 2 percent of GDP, which is high compared with other HIPC creditors.9 They added that the relief would most likely require legislative approval. For these reasons, they wanted to find a modality that minimized the financial cost and gained the broadest domestic political support. In their view, it would be important for Costa Rica to participate, preferably as a signatory, in a multilateral debt agreement for Nicaragua. They also wanted to explore the possibility of securing financial support from other bilateral creditors.

D. Structural Reforms

27. The authorities viewed the proposed financial legislation as an important part of their ongoing efforts to strengthen the financial system. The legislation includes several reforms that strengthen the independence of the central bank, including by lengthening the term of the president from four years to eight years and separating the beginning of the term from the change in government. The legislation seeks to improve financial supervision through several changes, including by requiring annual inspections of financial institutions and allowing the supervisor to share information with his counterparts in other countries. The legislation would establish deposit insurance for all financial institutions. Currently, public banks—which together account for about two-thirds of banking system assets—have a full deposit guarantee, while private banks have no deposit insurance. The insurance would cover deposits up to 2.5 times the previous year’s per capita national income per person, and financial institutions would finance the insurance through premia that varied with each bank’s risk. The legislation would also allow foreign banks to set up branches in Costa Rica (the existing law only allows the establishment of fully owned subsidiaries).

28. The staff and the authorities agreed on the need to create incentives to lower the spread between domestic currency deposit and lending interest rates, which was especially high in private banks. The authorities noted that the proposal to extend limited deposit insurance to all banks would help reduce deposit and lending interest rates in private banks. Both public banks pay substantially lower deposit interest rates, because of the full deposit guarantee, and charge lower lending interest rates than private banks. The staff added that efforts to improve the efficiency of the National Bank—which accounts for 40 percent of banking system assets—could reduce its very high financial intermediation spread.10 It would also be useful to remove the other forms of preferential treatment enjoyed by the state banks, such as the requirement that private banks maintain minimum balances with state banks.

29. The staff expressed concern that the existence of unsupervised banking in the offshore branches, as well as the off-balance-sheet activity, created doubts that the banking system was as healthy as indicated by the reported prudential indicators, such as the risk-weighted capital asset ratio. It mentioned that an MAE report prepared in early 2000 pointed to significant departures in the implementation of the Basel Core Principles and serious weaknesses in the state banks. The authorities replied that nonperforming loans were relatively low and almost fully covered by provisions and that banks were well capitalized. They believed that the offshore banks and off-balance-sheet accounts contained few problems. However, they were looking forward to the results of the upcoming financial sector assessment.

IV. Medium-Term Outlook

30. The mission explained that the continuation of current policies would make the economy increasingly vulnerable over time. Wide public sector deficits would sustain upward pressure on domestic real interest rates, keep the international reserve position weak, and curtail real economic growth. Limited progress on structural reforms, together with high interest rates, would not allow the country to reduce its costs and strengthen competitiveness on world markets.

31. The mission discussed with the authorities an active medium-term scenario that illustrated the benefits of tightening fiscal policy starting in 2001 and advancing structural reforms. This scenario assumed a fiscal policy that aimed to reduce public debt by about 10 percentage points of GDP by 2006 (Table 10). To achieve this, the government would need to increase substantially the primary surplus from 0.2 percent of GDP in 2000 to 1.6 percent of GDP in 2001. Subsequently the primary surplus could decline to 1.1 percent of GDP by 2006, as public debt and interest payments decline.11 This would imply a gradual reduction in the overall public sector deficit from 4.2 percent of GDP in 2000 to about 2 percent of GDP in 2006, consistent with a reduction of the central government deficit of about 2 points of GDP over the period. The staff commented that substantial fiscal action would be required under this scenario, in the form of revenue measures, expenditure restraint, and adoption of structural reforms in the areas of telecommunications, electricity and roads. Furthermore, the scenario is consistent with a healthy and well-supervised financial system.

Table 10.

Costa Rica: Medium-Term Macroeconomic Framework

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

Excludes intrapublic sector debt.

32. The fiscal adjustment, together with structural reforms, would encourage a gradual improvement in overall macroeconomic performance. The decline in public debt would help reduce real interest rates, while steps to improve infrastructure would reduce costs. The staff projected that these actions would contribute to a gradual rise in real GDP growth to 5 percent a year by 2005-06, while inflation would fall to 4 percent a year.12 The external current account deficit would decline gradually to 4 percent of GDP by 2006, financed largely by foreign direct investment, and net international reserves would rise to about 2 months of imports of goods and services (Table 11 and 12). Gross domestic investment would rise from 17 to 19 percent of GDP, while the strong increase in public savings will contribute to higher gross national savings.

Table 11.

Costa Rica: Balance of Payments Medium-Term Projections, 2000–2006

(In millions of U.S. dollars, unless otherwise indicated)

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

Including errors and omissions.

Excludes imports of goods for processing.

In percent of exports of general merchandise and services.

Table 12.

Costa Rica: Medium-Term Public External Debt and Debt-Service Indicators

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

Consistent with stall’s active scenario.

Exports of general merchandise and services.

V. Technical Consultation

33. The discussions also covered the strategy for the Fund’s technical assistance in the coming years (Appendix V). The authorities felt that past technical assistance, particularly to improve economic statistics, had been useful. The staff and the authorities agreed that a lack of transparency complicated the design and implementation of economic policy. In the coming years, the Fund’s technical assistance should focus on improving transparency, with an emphasis on strengthening fiscal transparency and continuing to improve economic statistics. The upcoming financial sector assessment would likely generate recommendations for technical assistance to improve transparency in the financial sector.

VI. Staff Appraisal

34. Looking at the past decade, Costa Rica made good progress in trade liberalization and maintained social indicators, especially in education and health, which compared favorably with the rest of the region. It experienced a reasonable economic performance, with steady growth and declining inflation, even though political factors prevented a sustained improvement in the fiscal position and limited progress on structural reforms.

35. In 2000 the weak fiscal and structural policies appeared to take their toll on economic performance. The decline in the terms of trade widened the external current account deficit, yet economic policies could not adjust to stem the loss in net international reserves, which were relatively low at end-1999. Facing strong political resistance, it was difficult for the authorities to turn to a tighter fiscal policy. With the overhang of public debt, a tighter credit policy would have driven domestic real interest rates even higher, and added to the incentive to borrow in U.S. dollars. Moreover, the central bank probably trimmed the rate of currency depreciation to limit inflation, which contributed to the moderate erosion of competitiveness. In the end, the international reserve position weakened further, inflation remained relatively high and real economic growth slowed to less than 2 percent.

36. Looking forward, the economy is likely to become increasingly vulnerable over time if the fiscal imbalances persist and structural reforms remain stalled. Real economic growth will probably remain slow, as continued growth in public debt will sustain the upward pressure on domestic interest rates. The external position is likely to remain weak, with wide external current account deficits and relatively low international reserves. Moreover, economic policies seem to be losing their ability to respond to the effects of an adverse external shock.

37. The most urgent policy requirement is to increase in the public sector’s primary surplus to reduce the public sector’s debt burden significantly over the next five years. A significant fiscal adjustment would support faster economic growth by helping to achieve a significant reduction in inflation to single digit levels and by lowering real interest rates. The best approach would be to implement a significant up-front fiscal adjustment, which could allow for a gradual decline in the primary surplus over time, as public debt and interest payments decline. A delay in the fiscal adjustment would probably require a larger primary surplus over time simply to cover the higher interest payments. Steps to increase the primary surplus would include measures to raise revenues, cut unproductive expenditure and improve expenditure management by scaling back revenue earmarking and adopting a more transparent wage structure. In this regard the staff welcomes the tax simplification package, the phasing out of the export subsidies, and the proposed legislation to remove revenue earmarking as steps in the right direction. The government’s decision to repay its debt to the central bank is an important step that makes fiscal policy more transparent. Structural reforms to modernize the public sector would help strengthen the fiscal position. It will be important to continue to try to open up the electricity generation and telecommunications sectors to private sector participation to reduce costs and satisfy the projected increase in demand for these services.

38. A stronger fiscal position would enable credit policy to protect net international reserves and limit inflation, without having to crowd out the private sector and put economic growth at risk. The rapid growth in U.S. dollar lending presents a serious risk that underscores the need for a lower overall public sector deficit. In the meantime, it would be useful to remove distortions that favored lending in U.S. dollars, such as differential tax treatment of deposits in different currencies, or to increase provisioning or capital requirements on these types of loans.

39. For the time being, the crawling peg exchange rate regime appears adequate, until fiscal reforms are more firmly in place. A faster rate of depreciation in 2001 seems warranted, based on the WEO projection of foreign inflation for Costa Rica. Nonetheless, weaknesses in external competitiveness are probably best addressed through structural reforms to improve infrastructure, cut administrative inefficiency, and lower the high financial intermediation spread in local currency. Over time, the authorities should improve the fiscal and external positions and reduce inflation and then give serious consideration to adopting a less vulnerable exchange rate regime.

40. The staff welcomes the authoritie’s commitment to provide debt relief to Nicaragua under the HIPC Initiative and notes their interest in finding a modality that minimizes the financial cost of this relief and that gains broad domestic political support.

41. The financial legislation recently introduced to the assembly contains important reforms that will strengthen the financial system. The measures will strengthen the central bank’s independence from political interference and improve supervision of domestic financial institutions, especially by authorizing information sharing with supervisors in other countries. The proposed limited deposit insurance will help reduce the intermediation spread in domestic currency by leveling the playing field for private and public banks. It will be important to make the National Bank operate more efficiently. The staff welcomes the authoritie’s strong interest in the upcoming financial sector assessment, which should help clarify whether the offshore branches and off-balance-sheet accounts pose any risks.

42. In the coming years, the Fund’s technical assistance to Costa Rica should focus on improving transparency, with an emphasis on continuing the efforts to improve economic statistics. Efforts to strengthen fiscal transparency, especially to include all public spending in the fiscal accounts, is key to improve the surveillance of macroeconomic developments.

43. It is recommended that the next Article IV consultation with Costa Rica be held on the standard 12-month cycle.

APPENDIX I Costa Rica: Fund Relations

(As of April 30, 2001)

I. Membership Status:

Joined: January 8, 1946

Status: Article VII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Latest Financial Arrangements:

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VI. Projected Obligations to the Fund (SDR million): Based on existing use of resources and present holdings of SDRs):

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The estimates of amounts of charges and their due dates are estimates and subject to change.

VII. Exchange Rate Arrangements:

Costa Rica has accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Articles of Agreement and maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions. The central bank adjusts the exchange rate daily on the basis of the differential between inflation in Costa Rica and its main trading partners. Buying and selling exchange rates were 322.88 and 323.45, respectively, for April 30, 2001.

VIII. Last Article IV Consultation:

The 1999 Article IV consultation was concluded by the Executive Board on October 6, 1999 (SM/99/224). Costa Rica is on the standard 12-month Article IV consultation cycle.

APPENDIX II Costa Rica: Relations with the World Bank Group

I. Financial Relations

(In millions of U.S. dollars)

A. IBRD/IDA/IFC Operations (as of April 30, 2001)1
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Net of cancellations.

Includes one IDA project (US$6.4 million).

B. IBRD/IDA/IFC Loan Disbursements
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II. Recent IBRD Activities

The Bank has four active projects in Costa Rica (ecomarkets, health, water supply, and transportation), with about US$41 million undisbursed. All projects are rated satisfactory in both development objective and implementation progress. The last loan approved was the Ecomarkets project (US$33 million), which aims to increase the production of environmental services by supporting the development of markets and services supplied by privately owned forests. It became effective on February 20, 2001. Also, preparation of the Costa Rica Health project is underway and should be ready for Board approval by end-2001.

The Bank has also provided grants for technical assistance on pension reform, public sector reform, privatization, and environmental issues, including innovative work on joint implementation and Costa Rica’s carbon bond initiative. The last Costa Rican Country Assistance Strategy Report (CAS) was in 1993. In FY 2002 a new CAS will be prepared, in which the new assistance program for Costa Rica will be defined. The Regional Unit for Technical Assistance office (RUTA) remains located in San Jose.

APPENDIX III Costa Rica: Relations with the Inter-American Development Bank

I. Financial relations

(In millions of U.S. dollars)

A. Operations (as of May 28, 2001)
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B. Loan Disbursements
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Projected.

C. Lending Program for 2001–2003
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II. Recent Activities

The third and last tranche of the Public Sector Reform Loan, as well as the third and last tranche of the Investment Sector Loan, were disbursed in 2000. In addition, during 2000 the IDB approved a new loan for US$65 million to finance a reform to the official land register.

III. Future Plans

The government has been working with IDB staff on the design of a large Competitiveness Support Program, but the nature of structural reforms is still being discussed by the authorities with the opposition. A mission is programmed for the second semester of 2001 to produce a dialogue policy paper, that will be used as a framework for discussing with the main presidential candidates’ teams needed structural reforms for Costa Rica.

APPENDIX IV Costa Rica: Statistical Issues

General

Although some progress has been made with the money and banking and balance of payments statistics, the overall quality of macroeconomic statistics needs improvement. Areas of concern include the consistency of data on the financing of the public sector, statistics on public and private sectors debt, timeliness and coverage of the national accounts by use, delays in the availability of commercial bank accounts, and weaknesses in the compilation of some components of the balance of payments. The authorities are cooperating fully in providing available data to the Fund through electronic means. The authorities also aim at subscribing to the SDDS.

Real sector

New series of national accounts compiled in accordance with the SNA 1993 and based on a 1991 benchmark year have been published in 2000, thus replacing the old series with a 1966 base year. Although the new series represent and important improvement in the quality of the national accounts estimates, a STA mission that visited the country in November 1999 found that weaknesses remain in the source data. That mission also noted weaknesses in private consumption, gross fixed capital formation, and changes in inventories components of GDP estimates by expenditure. Further improvements of the national accounts require improved source data by strengthening the statistical system, establishing and maintaining a statistical register, and regularly conducting economic surveys and censuses. Further developments of the national accounts include the compilation of quarterly GDP estimates, which the authorities have reported to be available in their latest communication with STA expressing their interest and readiness to subscribe to the SDDS.

Government finance statistics

The staff has noted some problems in the compilation of data on the operations of the central government, which derived from combining inappropriately information on a cash and an accrual basis. Moreover, there are significant discrepancies between the above-the-line fiscal figures and estimates of the deficit from the financing side. Costa Rica reports data for publication in IFS and the GFS yearbook. The ministry of finance has requested technical assistance to improve fiscal accounts either on cash or accrual basis.

Monetary statistics

After assistance provided by STA in 1996 and 1998, improvements were made to the classification, coverage, and timeliness of the money and banking statistics, in particular those pertaining to the Central Bank of Costa Rica. However, problems remain regarding the reports of other depository corporations, which lack the degree of detail to clearly identify the sources of deposits and users of loans to facilitate the sectorization of accounts of banks. There is also a need to collect information on offshore operations of bank conglomerates. A recent STA mission compiled enhanced monetary data, which include balance sheets of cooperatives, savings and loans institutions, and private financing corporations for publication in IFS. The mission also noted inconsistencies in the sectorization principles applied in the compilation of data for the central bank, other depository corporations, and other macroeconomic statistics. The mission made several recommendations, including the standardized sectorization of institutional units, and the development of a unified reporting system for monetary data that would meet the needs of STA and WHD. There are some advances in this direction that could improve the state of monetary accounting in the short term.

Balance of payments statistics

Substantial progress in the application of appropriate methodology and procedures in the compilation of balance of payments statistics has been achieved after the two technical assistance missions on balance of payments statistics (1999 and 2000), including the estimation of quarterly balance of payments statistics and the preparation of a provisional statement on international investment position. However, shortcomings relating to incomplete coverage of direct investment, other investment and services transactions, and insufficient validation of data from surveys remain to be addressed in the near future. There are no reliable data on the external debt of the private sector.

Costa Rica: Core Statistical Indicators

(As of mid-June 2001)

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APPENDIX IV Costa Rica—Technical Assistance Consultation

The consultation aimed to assess effectiveness of past technical assistance (TA) with the authorities, and identify priorities for future assistance. In the past, technical assistance provided to Costa Rica has been in the Fund’s core areas of specialization (Table). However, the assistance requests have been ad hoc and have not formed part of a strategy linked to economic policies. The track record of implementation has been good in statistics and payments systems, but weaker in other areas, such as tax reform, monetary operations and bank soundness. The authorities asked for future technical assistance to strengthen transparency and are particularly interested in participating in the financial sector assessment program.

Past technical assistance

Fiscal Affairs Department

In recent years, Costa Rica has resorted only sparingly to technical assistance from FAD. FAD has provided advice on tax reform (1997), draft laws on tax policy and administration (1998), tax reform (1999), and public expenditure management (1999).

Monetary and Exchange Affairs Department

In recent years MAE has sent nine technical assistance missions to Costa Rica to give advice on monetary policy and operations, payment system modernization, reserve and debt management and, most recently, bank soundness issues. Recommendations to improve the payments system, especially to strengthen the check clearance process and to introduce Real Gross Time Settlement, have been largely followed, although there are a few remaining issues. The authorities accepted the advice on monetary policy and monetary operations, including public debt management, but little progress in implementation has been observed. The mission on bank soundness presented its report in July 2000.

Statistics Department

The Statistics Department has provided technical assistance missions to review the macroeconomic statistical systems, balance of payments statistics, government finance statistics, money and banking statistics, and real sector statistics. The central bank made substantial progress in implementing many of the recommendations to improve balance of payments statistics, but several areas still need to be addressed. The advice on money and banking statistics improved several aspects of the analytical accounts for the CBCR and helped update the definition of different monetary aggregates. Most of the real sector recommendations have been implemented.

Future technical assistance needs

The staff and the authorities agreed that better transparency would improve the implementation of fiscal policy and strengthen financial supervision. A ROSC data dissemination module will be prepared for Costa Rica in FY2001. Continuing to improve the dissemination practices and the quality of economic statistics, especially in the fiscal area, will also be important to improve surveillance and allow Costa Rica to subscribe to the Special Data Dissemination Standard (SDDS).

Table. Costa Rica: Technical Assistance

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1

Costa Rica has no outstanding obligations to the Fund. Details of Costa Rica’s relations with the Fund are provided in Appendix I and with the World Bank and the Inter-American Development Bank in Appendices II and III.

2

A wide gap has emerged between GDP and GNP, because the foreign direct investment in the 1990s has led to profit remittances equivalent to 8 percent of GDP. The growth in real GNP rose to 9 percent in 1998 and showed no growth in 1999 and 2000 as profit remittances picked up.

3

Measured from the financing side, the overall deficit rose to 5.3 percent of GDP. The authorities are trying to clarify the sources of this discrepancy.

4

Currency issue declined during 2000, as the demand for currency picked up at end-1999, owing to concerns about Y2K.

5

By law, the authorities must publish their monetary program in December and July.

6

This includes an estimated 0.7 percent of GDP of spending by the ICE trust fund.

7

The main elements of the tax simplification package are: (i) creation of an adjustable specific tax on oil products to replace the sales, excise, consumption, and import taxes currently in force; (ii) elimination of some exemptions to the VAT tax; (iii) elimination or reduction of selective consumption taxes applied to a variety of goods; (iv) minor reforms to the income tax system; and (v) reduction in the time period to present income and sales tax declarations.

8

Costa Rica has a rating of 4 on the Fund’s trade restrictiveness index (on a scale ranging from 1 for the most open trade regime to 10 for the most restrictive regime).

9

At end-2000 Costa Rica’s claims on Nicaragua amounted to over US$500 million, and the staff estimated that Costa Rica would have to provide relief in net present value terms of US$350 million to US$400 million.

10

The spread of the National Bank is 450 basis points higher than the spread of the other public bank, the Bank of Costa Rica.

11

These projections are sensitive to the assumptions about the pace and size of the decline in public debt in relation to GDP and interest rates.

12

The scenario assumes that the current exchange rate regime would remain in effect and that the currency would depreciate to offset the inflation differential.

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Cover IMF Staff Country Reports
Costa Rica: Staff Report for the 2001 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2002: Issue 088
Publisher:
International Monetary Fund
ISBN:
9781451809602
ISSN:
1934-7685
Pages:
52
DOI:
https://doi.org/10.5089/9781451809602.002
Figure

Costa Rica. Exchange Rate Developments

(1990=100)