Statement by José Rojas, Executive Director for Costa Rica and Alvaro Umaña, Senior Advisor to Executive Director

The Costa Rican economy has grown at rapid rates in the last three years, underpinned by a robust world expansion, sound economic policies, and strong business and consumer confidence. Economic policies have been well oriented. The fiscal position has substantially improved. The exchange rate level and policies are consistent with the maintenance of external stability. IMF staff supports the neutral policy stance envisaged in the 2008 central government budget and plans for a substantive tax reform. The authorities should push ahead with financial system reforms.

Abstract

The Costa Rican economy has grown at rapid rates in the last three years, underpinned by a robust world expansion, sound economic policies, and strong business and consumer confidence. Economic policies have been well oriented. The fiscal position has substantially improved. The exchange rate level and policies are consistent with the maintenance of external stability. IMF staff supports the neutral policy stance envisaged in the 2008 central government budget and plans for a substantive tax reform. The authorities should push ahead with financial system reforms.

On behalf of the Costa Rican authorities we would like to convey our deep appreciation to the IMF staff and management for the constructive policy dialogue and valuable technical assistance that were provided by the Fund during last year. The discussions of the Article IV consultations were held in the first half of December of 2007. Since then, important decisions taken by the Federal Reserve of the United States, Costa Rica’s main economic partner, have had a significant impact on capital inflows and this has required policy responses by the authorities that were not foreseen at the time of the Article IV discussions.

The authorities agree with staff that sound economic policies, as well as strong business and consumer confidence have allowed Costa Rica to benefit from world economic expansion and grow at its highest rate for a decade. During 2006 and 2007, the economy grew by 8.8 and 6.8 percent, respectively, while unemployment decreased to 4.6 percent, the lowest in a decade. Real wages and incomes rose significantly to levels above the Latin American average and poverty was reduced to a record low of 16.7 percent. This was achieved through economic growth and well targeted social transfers, including pensions and subsidies to poor families with children enrolled in secondary school. Inequality remains the lowest in Central America and well below the Latin American average. Costa Rica ranks well in the Human Development Index and life expectancy at birth has reached 79 years, a level comparable to developed nations.

Growth has been fueled by both internal demand and net exports, which are well diversified in terms of composition and destination, although the United States is by far its most important trading partner and source of FDI. Tourism continued its upward trend, and domestic demand in services such as construction and finance supported growth, in addition to strong external demand in agro industrial goods and electronics. The economic slowdown in the US is expected to generate an almost one-to-one decrease in Costa Rica’s growth rate. The authorities agree with the staff that this slowdown in the US economy is the most important short-term risk.

The economy has been growing beyond its potential during the last two years and inflation rose above 10 percent in 2007. External factors such as rising food and fuel prices were significant in this increase but domestic factors also contributed. Private sector credit grew considerably and foreign direct investment (FDI) continued its upward trend, surpassing 7 percent of GDP in 2007. Although the current account deficit rose in 2007, it remains fully financed by FDI flows. International reserves have more than doubled during the last two years and presently stand at close to $4.5 billion.

Fiscal performance has been particularly strong in 2007 and tax revenues rose by over 25 percent in the last two years. The central government generated a surplus for the first time in fifty years. Public debt has dropped considerably and is expected to continue in this downward trend over the medium-term, reaching 37 percent in 2012. Given that the fiscal performance was even stronger than expected, as explained in the staff report’s supplement, the authorities agree with the need to maintain a responsible fiscal policy in 2008. A substantive tax reform, including income tax and VAT will be pursued by the government during 2008. Also, a medium-term budget framework is being introduced this year.

We agree with the staff’s assessment that the real effective exchange rate and exchange rate policies are consistent with external stability. Costa Rica has been moving towards a more flexible exchange rate system since 2006 when an exchange rate band was introduced. In the medium-term the country is moving to an inflation targeting regime. In 2007 the exchange rate band was widened twice, but capital inflows have continued to keep the exchange rate pegged to the band’s floor and forcing the central bank to intervene.

The authorities are committed to move to an inflation targeting regime, but they recognize the existence of several prerequisites that need to be met before the central bank can do it. These include, among others, adoption of derivative regulations, hedging instruments, rules for forex market intervention and enhanced supervision of risks in the financial system. In the short term, given the current exchange rate regime, the quasi-fiscal problem of the central bank and the recent decision by the Federal Reserve to lower interest rates, the possibility of monetary tightening is limited.

The authorities agree with the outlook for 2008 and the medium-term. Growth is expected to be under 5 percent with an inflation target of 8 percent, and growth will remain near that level until 2010, while inflation decreases to 6 percent in 2009 and below that level in 2010. The current account deficit is expected to fall below 6 percent and FDI levels inflows are expected to remain near 5 percent of GDP

The authorities agree that the financial system has become stronger and more diversified and will move to start implementing the recommendations of the recently completed FSAP, some of which require legislative approval, like passage of a consolidated supervision bill. Other remaining tasks include issuing regulations to encourage banks to fully internalize foreign exchange risks and offer hedging instruments, providing the supervisor (SUGEF) with the capabilities and funding to take carry out the expanded responsibilities, and revamping the bank intervention and resolution framework.

The medium-term risks are associated with the passage of structural reforms and key legislation including substantive tax reform and financial sector reform. Efforts to increase competitiveness and reduce red tape are also important. CAFTA was approved by the first referendum in Costa Rica’s history in October of 2007, but some of the legislation required to implement CAFTA is still under discussion in Congress. The legislation under discussion includes, among others, new laws opening the insurance and telecommunications sectors. It is expected that the Executive will request an extension from CAFTA signatories before the deadline expires on February 29, 2008. After approval of CAFTA related legislation, the government intends to seek a program of capitalization of the central bank.

Costa Rica: 2007 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Costa Rica
Author: International Monetary Fund