This 2004 Article IV Consultation highlights that Costa Rica’s economic performance improved in 2003. Following several years of slow growth, real GDP rose by 5½ percent, boosted by a recovery of exports and strong private investment. Inflation declined below 10 percent while unemployment fell to 6 percent. Real GDP is expected to expand by 4 percent in 2004, and while inflation has risen to 11 percent recently owing to higher oil prices, core inflation remains stable at about 10 percent, broadly in line with the rate of crawl.
1. The information on recent developments presented below has become available since the staff report was issued. It does not affect the thrust of the staff appraisal.
2. Output growth has slowed somewhat and inflation edged up broadly in line with projections in the staff report. Economic activity grew by 3½ percent in April (y/y; down from over 7 percent a year earlier). The slowdown reflects mainly weaker growth of computer parts exports following the switch to a new production line by a large company and international inventory stockpiling. The 12-month inflation rate rose to 11½ percent in May due to higher oil prices; core inflation has remained under 10 percent. At end-May, the central bank raised its policy interest rate by 57 basis points, to 12.25 percent.
3. The tax reform bill continues to make progress in the National Assembly and is now anticipated to be approved by end-August. The fiscal commission in congress is expected to conclude its discussions of the reform in the coming two weeks. So far, no changes have been introduced and the reform is still expected to yield 2 percent of GDP on an annual basis. To offset any potential delay of the reform beyond August, the authorities have announced contingent expenditure cuts of up to 1 percent of GDP.
4. Costa Rican sovereign bond prices have rebounded slightly after a sizable drop in April–May. The rebound reflects the overall narrowing emerging market spreads and reduced sales of Costa Rican bonds by local investment funds.
5. Outflows from local investment funds have slowed markedly in recent weeks. As a result, the value of these funds has now stabilized at around US$1.5 billion, from about US$3 billion in early 2004. The decline in the funds’ value reflects both a price effect (investments are markedtomarket) and the redemption from the funds. While outflows have halted, there are continuing risks associated with further increases in U.S. interest rates.
6. It appears that most of the outflows from the funds were deposited at domestic commercial banks (deposits increased by over US$700 million in March–May). As noted in the staff report, banks used the resources partly to buy government bonds (banks’ bond holdings increased by around 30 percent since end-2003), and partly to on-lend to the investment funds, taking advantage of a temporary increase in the leverage ceilings for such funds. The funds’ borrowing increased by US$85 million in March–April, but most of this has been already repaid.
7. Monetary stability has been maintained through this episode. The recycling of liquidity minimized the need for central bank intervention to stem a wider collapse of funds (which are managed mainly by banks) and/or a sharp fall in bond prices. Action by the central bank has been limited to small repurchases of bonds (about US$50 million) to help stabilize their prices. Net international reserves have remained stable at US$1.5 billion.
8. The authorities are taking measures to ensure appropriate prudential safeguards against the risks associated with investment funds. Preliminary estimates put the losses arising from lower bond prices at about 1 percent of risk-weighted assets (2 percent for public banks).While the weakening of profitability might complicate some banks’ recapitalization plans, the authorities have instructed them to keep those plans on track; the largest public bank has already announced asset liquidations and expenditure cuts to meet its recapitalization goals. The authorities have also issued guidelines to keep investors appropriately informed about the nature of risks associated with investment funds.