Statement by Moises Schwartz, Executive Director for Costa Rica and Nina Conrado, Senior Advisor to Executive Director

Despite the oil price shock, growth has been high. Discussions focused on the policies needed to reduce Costa Rica’s vulnerabilities, enhance growth, and reduce poverty in a lasting way. Passage of a substantial tax reform is essential. To bring inflation down to low single digits, the authorities plan to recapitalize the central bank and move gradually to a more flexible exchange rate regime. This Article IV Consultation provides an important opportunity to take stock of Costa Rica’s achievements and the challenges ahead.

Abstract

Despite the oil price shock, growth has been high. Discussions focused on the policies needed to reduce Costa Rica’s vulnerabilities, enhance growth, and reduce poverty in a lasting way. Passage of a substantial tax reform is essential. To bring inflation down to low single digits, the authorities plan to recapitalize the central bank and move gradually to a more flexible exchange rate regime. This Article IV Consultation provides an important opportunity to take stock of Costa Rica’s achievements and the challenges ahead.

On behalf of the authorities of Costa Rica we would like to convey their appreciation to IMF staff and management for a constructive policy dialogue and valuable technical assistance. The discussions of the 2006 article IV consultation were held a couple of months after President Arias took office, providing for an excellent opportunity to discuss medium-term objectives and policies to be carried out by the new administration.

Economic activity in Costa Rica continues to be strong. Even in a context of a negative oil shock, the economy continues a broad base growth trend, supported by dynamism in investment and exports. Increases in FDI, exports and tourism have strengthen international reserves, compensating the expansion in the current account deficit resulting from a higher oil bill. High international oil prices have also affected inflation, which, although still in double digits, has started to decline. Credit growth has accelerated, in part reflecting an improvement in confidence and positive expectations.

To continue with this positive macroeconomic context and to further advance in addressing Costa Rica’s medium-term challenges, the authorities intend to carry out a broad reform agenda, to continue with fiscal consolidation to reduce public debt, to fight persistent inflation, to strengthen the financial sector, and to continue to boost private sector led growth through further integration with the rest of the world.

Fiscal Policy

One of the main elements in the authorities’ medium-term agenda is to further advance towards fiscal consolidation. The dynamism in economic activity, as well as improvements in tax and custom administration have resulted in a buoyant revenue performance. This has been coupled with a better control of expenditures and an improved debt management to strengthen the fiscal balance. In 2005, the fiscal deficit declined to its lowest level in a decade, resulting in a reduction in public debt. For 2006, initial estimates based on information up to September, suggest that the primary balance of the Central Government will be higher and its financial deficit will be lower than previously anticipated.

The government plans to lower the public debt level to about 40 percent in the medium term and, at the same time, allow for additional resources to capitalize the Central Bank and increase priority expenditures in the social sector and in infrastructure. To achieve these objectives, the fiscal consolidation strategy has been centered on a comprehensive tax reform. Taking into account Costa Rica’s legislative procedures, instead of sending one tax package, the authorities have sent to the National Assembly three tax bills, which include reforms to the value added tax, real estate tax, and business registration tax. The income tax bill is still being negotiated and will be sent to the Assembly before the end of the year. The authorities agree with staff that the core elements of this reform rely on the VAT and income tax, and that, depending on the congressional agenda, the approval of these bills will be fully observed as additional revenues in 2008. However, if the VAT and the real state tax are approved in 2007, as it is expected, part of these revenues will be collected next year.

A draft 2007 budget has been submitted to Congress, in line with the objective of strengthening fiscal discipline and consistent with the medium-term objective of bringing down inflation. The proposal incorporates a prudent wage policy, additional efforts in terms of tax administration and a redistribution of resources towards education, health, security and public infrastructure.

Monetary Policy

As a first major step towards exchange rate flexibility, last week the Central Bank introduced a system of bands for the exchange rate. After more than two decades with a crawling peg regime, the new exchange rate system is oriented to regain control of monetary policy, with the main objective of reducing inflation. This reform is part of the medium-term strategy to move to a system of inflation targeting, for which the authorities are engaging in important reforms in Costa Rica’s monetary policy framework.

In the context of a strong position of international reserves, fiscal discipline, and financial stability, the Central Bank’s strategy has been based on two important blocks: gradualism and transparency. During last year, in order to allow for greater degrees of freedom in monetary policy, and to improve the transmission mechanism, monetary instruments have been modified, incorporating changes in policy interest rate and reserve requirements, and introducing an electronic window for direct investment in the Central Bank. In the foreign exchange market, to allow for an orderly move to the system of a narrow band, the Central Bank has issued new regulations, and a new electronic platform for foreign exchange market transactions is being launched. Additionally, important efforts are being made to enhance the Central Bank’s communication strategy.

The behavior of the foreign exchange market after the change in the system reflects a smooth transition. The Central Bank has decided to maintain a crawling band using expected inflation, and plans to gradually broaden the band. In the medium term, the Central Bank expects that this measure will also help reduce financial dollarization. The authorities recognize the presence of vulnerabilities in the financial sector, and are planning to continue to make the necessary reforms to change the regulatory and supervisory framework to strengthen banking supervision. They are also working on norms to allow for instruments to cover exchange rate risk. Important efforts are also being made to strengthen supervision of off-shore banking, including through regional initiatives.

The authorities believe that, in the medium term, the reforms being taken will allow them to better deal with the main challenges in terms of monetary policy, including persistent inflation and financial dollarization. These measures, coupled with the government’s intention to capitalize the central bank and the resulting reduction of quasifiscal losses will enhance the credibility of the new system and reduce inflationary expectations.

Structural reforms

Regarding the structural reform agenda, the authorities of Costa Rica plan to enhance the country’s integration with the rest of the world. High in the government’s agenda is to support the ratification of the US-Central American Free Trade Agreement, and to promote other bilateral agreements such as the one being negotiated with Panama and the one that is under discussion with the UE.

To complement this policy, the authorities are carrying out reforms to strengthen the insurance sector and the public electric and telecommunications utility company (ICE). Last week, the President signed a decree giving more flexibility in financial and investments procedures of the enterprise, allowing it to invest up to US$ 435 millions in additional resources. This effort will allow for the needed investment to modernize this sector and make it more competitive.

Additionally, other efforts are being carried out to improve competitiveness and making the economy more resilient to shocks, such as the recently approved law providing incentives to organic agriculture.

Looking Forward

The authorities are aware of the challenges ahead, especially regarding gathering the necessary consensus for important reforms. Nevertheless, the authorities are committed to their reform agenda, which was clearly presented in their political platform and is now perceived as a public mandate. The authorities believe that carrying out the expected reforms will allow Costa Rica to continue growing at a steady rate, enhance macroeconomic stability through fiscal consolidation and reduce inflationary inertia and, more importantly, improve social indicators and allow for a reduction in poverty.