Costa Rica
Request for Stand-By Arrangement: Staff Report; Staff Supplement and Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Costa Rica
Author:
International Monetary Fund
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Publication Date:
29 Apr 2009
eISBN:
9781451809695
Language:
English
Keywords:
ISCR; CR; inflation expectation; producer price inflation; expectation; financing; Fund credit; GDP deflator; fund staff estimate; short-term debt; fiscal policy; long-term debt; Currencies; Commercial banks; Global
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This paper discusses the request from Costa Rica for a Stand-By Arrangement (SBA). The program seeks to enable an orderly adjustment of the Costa Rican economy to an adverse external environment, while mitigating its adverse effects on growth and household incomes. To strengthen the external position, the authorities have tightened monetary conditions and increased exchange rate flexibility. Fiscal policy will be geared toward mitigating the impact of the adjustment on domestic activity and the most vulnerable population. IMF financial support is intended to bolster investor confidence in the authorities’ policy framework.

Abstract

This paper discusses the request from Costa Rica for a Stand-By Arrangement (SBA). The program seeks to enable an orderly adjustment of the Costa Rican economy to an adverse external environment, while mitigating its adverse effects on growth and household incomes. To strengthen the external position, the authorities have tightened monetary conditions and increased exchange rate flexibility. Fiscal policy will be geared toward mitigating the impact of the adjustment on domestic activity and the most vulnerable population. IMF financial support is intended to bolster investor confidence in the authorities’ policy framework.

I. Background and Recent Developments

1. Costa Rica benefited from a sustained growth spell during 2003–07. During this period, annual real GDP growth averaged 6.6 percent, helped by the robust expansion of the global economy, sound economic policies, and strong business and consumer confidence. Rising real incomes and higher social transfers reduced poverty to a record low of 16.7 percent of the population in 2007. Fiscal and monetary policies remained generally prudent, which helped reduce vulnerabilities, including through a substantial decline in the public sector debt-to-GDP ratio and a large increase in net international reserves. However, the economy began to overheat by 2007, and pressures on prices and the external accounts started to become evident.

uA01fig01

Net International Reserves

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

2. The effects of the global economic and financial crises hit Costa Rica in 2008.

  • Growth. Economic activity started to slow in the second quarter and declined by 2 percent (q/q-4) in the fourth quarter. Activity weakened particularly in the construction, manufacturing, and financial services sectors. For 2008 as a whole, real GDP growth is estimated at 2.9 percent, five percentage points less than the year before (Table 1 and Figure 1).

  • Inflation. Surging commodity prices and strong demand pressures, fueled by rapid credit expansion, pushed inflation to 16.3 percent (y/y) by November 2008, well above the central bank target of 8 percent. With the decline in world prices for fuel and other commodities, inflation started to fall in December 2008 and in February 2009 (latest available observation), inflation stood at 12.8 percent (y/y).

  • Balance of payments. High commodity prices and still robust import demand during the first half of the year, and a marked slowdown in export growth widened the external current account deficit to 8.9 percent of GDP in 2008, from an average of 5 percent of GDP in 2003–07 (Table 2 and Figure 2). In contrast to previous years, foreign direct investment (FDI) was insufficient to fully cover this deficit and other private net capital flows, which had remained strong until the first quarter, weakened significantly in the latter part of the year. As a result, the exchange rate came under pressure, and net international reserves (NIR) declined by US$315 million (1.1 percent of GDP), lowering the coverage of short-term debt (residual maturity basis) from 143 percent to 97 percent by end year (Box 1 and Table 9).

Table 1.

Costa Rica: Selected Economic Indicators

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

In value terms, excludes maquila.

Combined Public sector = Central government + Central bank + Other public enterprises and entities, excl. ICE.

2007 includes a one-off adjustment of US$159.7 million for reclassification of capital contribution to FLAR.

Figure 1.
Figure 1.

Costa Rica: Real Sector Developments

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: Central Bank of Costa Rica; Fund staff estimates.
Table 2.

Costa Rica: 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.

Includes one-off adjustment in 2007 of US$175 million for reclassification of capital contribution to FLAR.

Public and private sector external debt on remaining maturity. Includes trade credits.

Includes public and private sector debt.

Figure 2.
Figure 2.

Costa Rica: External Sector Developments

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: Central Bank of Costa Rica; and Fund staff estimates.
uA01fig02

Index of Economic Activity

(In percent)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

3. The authorities responded slowly to the rise in inflation and the emerging exchange rate pressures.

  • Although the balance of the combined public sector remained in surplus (0.2 percent of GDP), the structural fiscal balance was mildly expansionary.1 Public spending, especially capital outlays, grew faster than revenues, lowering the primary surplus by almost 2 percent of GDP (Tables 3–6 and Figure 3).

  • Monetary policy changed course mid-year. In early 2008, the central bank (BCCR) lowered interest rates by 300 basis points to discourage capital inflows. When capital inflows ceased, partly as a result of the global crisis, the exchange rate came under pressure and the authorities began to tighten the monetary stance. The BCCR gradually increased its policy rate by 400 basis points, to 10 percent, and its deposit rates by up to 700 basis points.2 In response, market interest rates rose considerably, but high inflation kept the real policy rate negative and private credit growth began to slow only in the second half of the year (Figure 4).

uA01fig03

Key BCCR Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

1/ Deflated by 12-mo average inflation expectations
uA01fig04

Credit to the private sector

(12-month percentage change)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

1/ Excludes effect of incorporation of offshore portfolio.
Table 3.

Costa Rica: Central Government Balance

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates.

TUDES are inflation indexed bonds of the central government. The inflation adjustment of principal is not reflected as interest expenditure in the fiscal accounts of the Costa Rican authorities, but is added here to the Fund presentation of the fiscal deficit and public sector debt.

For 2008, excludes one time expense for recapitalization of commercial banks.

Table 4.

Costa Rica: Central Government Balance

(In billions of colones)

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Sources: Ministry of Finance; and Fund staff estimates.

TUDES are inflation indexed bonds of the central government. The inflation adjustment of principal is not reflected as interest expenditure in the fiscal accounts of the Costa Rican authorities, but is added here to the Fund presentation of the fiscal deficit and public sector debt.

For 2008, excludes one time expense for recapitalization of commercial banks.

Table 5.

Costa Rica: Combined Public Sector Operations 1/

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates.

Combined Public sector = Central government + Central bank + Other public enterprises and entities excl. ICE.

TUDES are inflation indexed bonds of the central government. The inflation adjustment of principal is not reflected as interest expenditure in the fiscal accounts of the Costa Rican authorities, but is added here to the Fund presentation of the fiscal deficit and public sector debt.

Table 6.

Costa Rica: Combined Public Sector Operations 1/

(In billions of colones)

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Sources: Ministry of Finance; and Fund staff estimates.

Combined Public sector = Central government + Central bank + Other public enterprises and entities excl. ICE.

TUDES are inflation indexed bonds of the central government. The inflation adjustment of principal is not reflected as interest expenditure in the fiscal accounts of the Costa Rican authorities, but is added here to the Fund presentation of the fiscal deficit and public sector debt.

Figure 3.
Figure 3.

Costa Rica: Fiscal Developments

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: Ministry of Finance; and Fund staff estimates.
Figure 4.
Figure 4.

Costa Rica: Monetary and Banking Developments

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: Central Bank of Costa Rica; Fund staff estimates.1/ Excludes the asset transfer from offshore on December 2008.

4. The first round impact of the global financial crisis on the domestic banking system was relatively minor. Banks had no significant exposure to structured financial products originated in the U.S. and had not relied heavily on external borrowing to fund their lending. In addition, capital injections into the six largest institutions in late-2008 boosted capital adequacy.3 Short-term foreign credit lines, amounting to US$1.3 billion (about 7 percent of banks’ total assets), remain available, albeit at a higher cost. However, deposit dollarization increased in response to shifting exchange rate expectations, nonperforming loans (NPLs) have edged up, albeit from low levels, and the cover of provisions has declined. In late 2008, private banks effectively terminated most offshore activities and transferred them onshore, following the tightening of regulations for the sector and increased supervisory scrutiny.

Costa Rica: Soundness Indicators of the Banking System

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Source: Staff calculations based on information from SUGEF

5. Since late 2008, the authorities have stepped up crisis preparedness in the financial sector. The BCCR modified regulations to encourage higher liquidity holdings of the banking system, including through raising the minimum 30-day liquidity requirement and temporarily reducing the thresholds of several financial performance indicators (e.g., on minimum profitability) that trigger deeper supervisory scrutiny. In addition, the BCCR established a temporary collateralized loan facility to provide liquidity in colones to banks, and broadened participation in the interbank money market. The superintendency of banks (SUGEF) intensified monitoring of key financial soundness indicators. At the same time, the government sought to mobilize contingent external financing from international financial institutions (IFIs) to strengthen the system’s liquidity buffers.

Exchange Rate Developments

Costa Rica adopted a currency band in October 2006 and has changed the parameters determining its ceiling and floor several times since then. A major change occurred in November 2007, when the authorities lowered (appreciated) the floor of the band by 4 percent and introduced a negative crawl (thus allowing for further gradual appreciation).

  • Following that move, large capital inflows kept the exchange rate at the most appreciated end of the band (floor) through the first quarter of 2008. However, in mid-2008, as capital inflows reversed and export growth slowed, the colón weakened by about 12 percent against the dollar.

  • From July to November 2008, the exchange rate remained at the most depreciated end of the band, and net international reserves (NIR) fell by almost US$1 billion, despite the gradual tightening of monetary policy. Pressures started to ease in mid-November 2008 through January 2009, helped by a seasonal pick up in demand for local currency and rising domestic interest rates, which allowed the central bank to rebuild some reserves.

  • In January 2009, the authorities increased the rate of crawl of the ceiling of the band from 3 to 9 percent per year. Following this announcement, the exchange rate remained at the most depreciated end of the currency band, triggering intermittent interventions by the central bank. Despite these interventions, NIR rose to US$4.1 billion by mid-March (the same level as of end-2007), reflecting higher deposits of commercial banks and temporary inflows from domestic prefinancing operations by the government.1

uA01bxfig01

Daily Exchange Rate

(Colones per USD)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

uA01bxfig02

Net International Reserves

(In millions of US$)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

1/As of mid-March, the government had accumulated some US$300 million in financing from domestic and foreign sources in anticipation of a Eurobond maturity in mid-May.

II. The Economic Program for 2009

A. Objectives and Strategy

6. The authorities’ economic program for 2009 aims to facilitate orderly adjustment to the adverse external environment, while protecting activity and preserving social cohesion. The authorities expect that the global downturn will produce a substantial drop in FDI inflows and a decline in export and tourism receipts. While the impact of these shocks on the balance of payments will be partially offset by improved terms of trade, a deceleration of non-oil import demand will be necessary to avoid reserve losses and protect the external position. In view of this, the priorities for economic policy during 2009 will be to: (i) facilitate the adjustment in the external current account and mitigate adverse effects on growth; (ii) protect the poor in the face of the economic slowdown; (iii) achieve substantial disinflation with less reliance on the exchange rate anchor; and (iv) increase the resilience of the banking system.

7. Fund support through a SBA would bolster confidence in the authorities’ policy framework, thereby reducing the risk of disruptive capital outflows. In particular, the authorities view the liquidity buffer provided by Fund financial support (and financing from other IFIs) as key to maintaining investor confidence and preventing large private capital outflows if the shocks to exports and foreign direct investment were larger than currently envisaged. The authorities also think that the Fund arrangement would help enhance the credibility of the increasingly flexible exchange rate regime and stabilize expectations.

B. Macroeconomic Framework

8. The global economic downturn is expected to have a larger impact on Costa Rica’s economy in 2009.

  • Real GDP growth is expected to decelerate to 0.5 percent, from 2.9 percent in 2008. Construction, manufacturing, and tourism are expected to exhibit continued weakness, while agriculture could register a small rebound due to improved weather conditions. Private sector demand, particularly investment, is expected to contract strongly and to be only partially offset by public sector stimulus.

  • Inflation is expected to slow to 8 percent by year-end. Lower food and fuel prices, a growing output gap, and tighter monetary conditions would help bring down headline and core inflation. Pass-through effects from the exchange rate and widespread backward price indexation mechanisms, however, would slow the pace of disinflation.

  • The balance of payments will be significantly affected. For the current account, inflows will be lower as a result of weak demand for exports and tourism, while most outflows will decline on account of lower oil prices and subdued domestic activity; the exception will be the repatriation of FDI profits, which is projected to rise substantially. Overall, the deficit on the external current account is expected to narrow to 5.3 percent of GDP, 3.6 percent of GDP lower than in 2008. The financial and capital accounts also are projected to weaken. FDI is projected to fall by more than 30 percent, net inflows of other private capital to trickle to almost zero, and public sector flows to be positive, but small (0.7 percent of GDP).4 5

9. After the crisis subsides, Costa Rica is expected to return to the medium-term growth path outlined during the last Article IV consultation (Table 10). Real GDP growth in 2010 is expected to remain subdued, but as the global environment improves, growth is projected to return gradually to its long-term level of about 4.5 percent per year, supported by a competitive real exchange rate level (Box 2), the implementation of the CAFTA-DR and completion of other trade agreements (including with China), and improved infrastructure. Inflation would be expected to decline as the authorities make progress adopting inflation targeting, albeit somewhat more slowly than previously projected given the inflation spike in 2008. The external current account deficit is expected to stabilize at around 5-5.5 percent of GDP.

Table 7.

Costa Rica: Monetary Survey

(In billions of colones)

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Sources: BCCR; and Fund staff calculations.
Table 8.

External Financing Requirements and Sources

(In millions of U.S. dollars)

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Sources: Authorities; and Fund staff estimates.

Excluding the IMF.

Original maturity of less than 1 year. Stock at the end of the previous period.

Includes both loans and grants.

Includes all other net financial flows, and errors and omissions.

Table 9.

Costa Rica: Indicators of External Vulnerability

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

In value terms, excludes maquila.

Public and private sector external debt on remaining maturity. Includes trade credits.

Table 10.

Costa Rica: Medium-Term Framework

(Annual percentage change; unless otherwise indicated)

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

External current account deficit.

C. Monetary and Exchange Rate Policies

10. Tighter monetary conditions and increased exchange rate flexibility are the cornerstone of the 2009 economic program. In late January, the central bank moved on both fronts. It increased the rate of crawl of the ceiling of the currency band (thus increasing the expected width of the exchange rate band to 22 percent by year-end) and raised short-term interest rates of the central bank’s deposit facility by 70–150 basis points. These measures appear to have helped ease pressures in the foreign exchange market.

11. The authorities are strongly committed to keeping interest rates consistent with the goal of maintaining the currency band and lowering inflation. They expect that progressively higher real interest rates would help restrain private credit and domestic demand growth, and reduce pressures on international reserves. Moreover, they intend to undertake timely interest rate responses if unexpected shocks were to build pressures on the foreign exchange market.

12. Increasing exchange rate flexibility and moving toward inflation targeting are viewed as important objectives. The authorities believe that the transition to an inflation targeting regime could be completed by late 2010. To support this objective, they plan to adopt measures to strengthen the transmission mechanism of monetary policy, including relying on a daily liquidity forecasting exercise to guide central bank interventions in the money market, and eliminating the segmentation in the money market through a new integrated platform (both actions are structural benchmarks under the program). The authorities are also committed to working closely with the legislative assembly to secure approval of the draft law to recapitalize the central bank, which would strengthen the independence of monetary policy.

Real Exchange Rate Assessment

Relative to other countries in the region, Costa Rica’s real effective exchange rate has been remarkably stable since the mid 1980s. The real effective exchange rate has fluctuated within a range of about 25 percent around its mean, a variation much lower than that of neighboring countries in the region. At end 2008, the real effective exchange rate was about 10 percent above its historical average.

uA01bxfig03

Real Effective Exchange Rates

(2000=100)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

On balance, Costa Rica’s real exchange rate appears broadly in equilibrium. This assessment is based on results from the three methodologies normally used to assess the level of the real exchange rate, and their results are mutually consistent:

  • According to the macro balance approach, a panel regression of emerging market countries shows that the current account norm for Costa Rica is 4½ percent of GDP. This estimate is within two standard error bands of the current account projection for 2014 at 5¼ percent of GDP, suggesting that the real exchange rate is not misaligned.

  • In terms of external debt dynamics, the ratio of external debt to GDP is projected to rise over the next few years but then stabilize at about 30 percent of GDP. This is slightly below levels normally associated with a sharp rise in crisis probabilities.

  • The third methodology involves estimating the long-run determinants of the real exchange rate. Staff has found that the real exchange rate in Costa Rica is cointegrated with the productivity differential between Costa Rica and partner countries, the terms of trade, and Costa Rica’s net foreign liability position. These variables suggest that, as of end-2008, Costa Rica’s real exchange rate is about 5 percent undervalued, with the 5 percent real appreciation observed in 2008 compensating for the comparable rise in the equilibrium level associated with improvements in Costa Rica’s productivity differential.

Given the current world economic climate, there is a risk that financing sources for the current account deficit may come under pressure. The recent increase in the rate of crawl of the currency band has given some room for the nominal exchange rate to adjust in such a scenario, and also to compensate for expected inflation differentials. This would allow the real exchange rate to remain broadly stable and close to its long-run equilibrium.

D. Fiscal Policy

13. Fiscal policy will be geared toward mitigating the adverse effects of the drop in private demand during 2009. Prudent budget execution and increasing revenues have helped lower combined public sector debt to about 35 percent of GDP, and created some room for counter-cyclical fiscal expansion. The authorities plan to use this fiscal space to increase spending on education and labor-intensive infrastructure projects. In particular, at the level of the central government, they expect to increase the wage bill and central government transfers by about 1 percent of GDP each, including to hire additional teachers and police officers, and to expand the conditional cash transfer program AVANCEMOS and noncontributory pensions. Capital investment is slated to increase by 0.8 percent of GDP, mainly for infrastructure projects. Given the projected cyclical decline in revenues, these spending plans would increase the deficit of the central government to 3.2 percent of GDP by end-2009, while the deficit of the combined public sector would increase to 4.1 percent of GDP.

14. While the fiscal deficit is envisaged to remain broadly unchanged in 2010, fiscal sustainability will not be at risk. The program for 2010, which is indicative at this stage and will be discussed in more depth during the second program review, foresees unchanged headline deficits for the central government and the combined public sector. However, in cyclically adjusted terms, maintaining the same fiscal deficit-to-GDP ratio in 2010 would imply an improvement of the structural overall balance of 0.5 percent of GDP for the central government and about 1 percent of GDP for the combined public sector. Over the medium term, as the output gap closes, the deficit of the combined public sector (and the central government) would be expected to decline to levels that are consistent with the authorities’ goal of keeping the combined public sector debt-to-GDP ratio well below 40 percent of GDP. Attaining this goal, however, may require broadening the revenue base of the central government with tax reform, especially if higher levels of social spending and public sector investment are to be protected.

Costa Rica: Financial Sector Structure 1/

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Source: BCCR.

As of December 2008.

Assets under management.

15. Public sector financing in 2009–10 is expected to come largely from domestic sources, keeping some of the resources secured from IFIs to cover possible shortfalls. Financing needs of the combined public sector are estimated at about US$1 billion in both years. The authorities are confident that Costa Rica’s financial system (with total assets of about US$38 billion as of end-December 2008) is large enough to absorb these net borrowing requirements. In particular, they believe that private pension funds and banks have room to absorb the new public debt, given the expected decline in the demand for private credit. Moreover, if part of the financing were not forthcoming, the authorities’ plan would be to draw on a US$500 million budget support loan that they are negotiating with the World Bank.

E. Financial Sector Policies

16. Addressing remaining weaknesses in the supervisory framework and strengthening crisis preparedness are critical elements of the economic program for 2009. The authorities will seek swift approval of a bill to strengthen consolidated bank supervision, which was submitted to the legislative assembly some time ago.6 The authorities also plan to remedy some key remaining weaknesses in the prudential framework for banks, including the absence of a deposit insurance scheme (public banks’ liabilities are fully guaranteed by the government while private banks’ deposits have no guarantee) and of an adequate framework for bank resolution. The current framework only allows for financial penalties, operational restrictions, or forced liquidation of distressed banks, but does not allow for intermediate corrective measures such as official administration or bank restructuring.

17. The authorities also plan to set up a system to detect early symptoms of stress in banks. They view this system as particularly important given the effect that the economic slowdown is likely to have on banks’ loan portfolios, and the significant presence of foreign-owned banks in the system.7 Accordingly, the superintendency will produce a monthly report to monitor, on a bank-by-bank basis, the structure and quality of assets and liabilities, liquidity positions, and the availability and effective usage of foreign credit lines.

18. Mechanisms to provide systemic liquidity to the financial sector will also be strengthened. The central bank is determined to keep in place, for as long as necessary, the collateralized loan facility in colones established in late-2008. In addition, a US$500 million financial sector loan from the InterAmerican Development Bank (IDB) that could be used by banks to obtain U.S. dollar liquidity has been submitted to the legislative assembly and is awaiting ratification.

III. Program Modalities

A. Access

19. The proposed SBA would involve a frontloaded schedule of purchases and exceptional access. Total Fund resources to be made available to Costa Rica under the 15-month arrangement would amount to SDR 492.3 million (300 percent of quota). Two-thirds of this amount would become available upon approval and the remaining 100 percent of quota phased evenly following quarterly reviews. The proposed SBA falls within the exceptional access category because the annual limit of 200 percent of quota would be exceeded in the first 12 months of the arrangement.8

20. The proposed access and frontloading of purchases are designed to boost confidence in the country’s ability to withstand unanticipated balance of payments shocks and support the increased flexibility of the exchange rate regime. As in other countries, Costa Rica’s quota (SDR 164.1 million or about US$245 million) is small relative to both its “normal” level of capital flows and trade, and to the potential drains on foreign currency liquidity in a scenario of low investor confidence. This implies that relatively high access is needed to provide meaningful protection against shocks. Together with the envisaged contingent financing from the World Bank and the IDB, access equivalent to 300 percent of Costa Rica’s quota (about US$740 million) would boost available foreign currency liquidity buffers by more than one-third. Taken on its own, the proposed access under the SBA would allow to keep NIR coverage above 90 percent of short-term debt in the event of an additional decline in exports of 8 percent, a halving of projected FDI, or a decline in the assumed rollover rate of maturing external debt obligations from 100 to 80 percent.

Costa Rica: Potential Liquidity Drains and Buffers

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Source: Fund staff estimates based on BCCR data.

B. Monitoring and Conditionality

21. Performance under the arrangement will be assessed in four quarterly reviews with test dates for June, September and December 2009, and March 2010. The first review is expected to take place in mid-September 2009, based on end-June 2009 targets, while the last review is expected to take place in mid-June 2010, based on end-March 2010 targets (MEFP Table 1). In addition, the authorities have agreed to keep in close contact and consult with staff on evolving risks and policy adjustments needed to achieve the goals of the program.

22. The proposed SBA contemplates quantitative and structural conditionality.

  • Quantitative performance criteria are being set initially for end-June and end-September 2009 (and indicative targets for end-December 2009) and include: (i) a floor on NIR; (ii) a ceiling on net domestic assets of the central bank; (iii) a floor on the cash balance of the central government; (iv) a ceiling on the stock of central government debt; and (v) a continuous performance criterion on the nonaccumulation of external payments arrears (MEFP Table 2). In addition, the cash balance of the combined public sector will be monitored as an indicative target. The NIR floor is set at a level equivalent to 85 percent of short-term debt for 2009, providing some room for intervention—to be combined with policy adjustment—in the event of renewed foreign exchange market pressures

  • Structural conditionality is parsimonious and focused on strengthening the safety net and the resolution framework for the financial sector, and on advancing preparations for the transition to inflation targeting (MEFP Table 3).

C. Capacity to Repay the Fund and Risks to the Program

23. Costa Rica would be in a strong position to repay the Fund if it were to make all purchases under the proposed SBA. Costa Rica has no debt outstanding to the Fund, and, as of end-2008, had a ratio of total external debt-to-GDP of about 30 percent (less than half of it owed by the public sector). Moreover, the external debt-to-GDP ratio is projected to remain stable in the medium term in most stress test scenarios (Figure 5). Combined public sector debt, at 35.6 percent of GDP, is also moderate. After a temporary increase in 2009–11, the public debt-to-GDP ratio is expected to resume a downward trend as the global economy picks up, and Costa Rica starts reaping the benefits of its trade agreements (including CAFTA-DR), its geographical location, strong institutions, and solid economic fundamentals (Figure 6).

Figure 5.
Figure 5.

Costa Rica: External Debt Sustainability-Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: International Monetary Fund, Country desk data; and Fund staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2008.
Figure 6.
Figure 6.

Costa Rica: Public Debt Sustainability-Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 134; 10.5089/9781451809695.002.A001

Sources: International Monetary Fund, country desk data; and Fund staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

24. Nonetheless, the proposed program is subject to downside risks.

  • The balance of payments could be subject to more severe shocks than built into the baseline scenario. For instance, the global economic outlook could turn out worse than anticipated and depress further Costa Rica’s exports of goods and services. Similarly, global financial conditions could tighten and lead to a withdrawal of cross-border funding for banks and local corporates and/or a larger-than-projected drop in FDI. Regardless of the source of these shocks or the specific channel (i.e., current and/or capital account), a persistent deficit in the balance of payments would put substantial pressure on the currency and the exchange rate band. The associated decline in reserves would tend to erode confidence in the countries’ policy framework and possibly trigger deposit withdrawals and/or other private capital outflows, which could precipitate a disorderly adjustment.

  • Output and/or government revenues could be significantly lower than projected. This would imply larger than envisaged financing needs for the public sector and negative implications for the level and dynamics of public debt.

  • Delays in the approval by the legislative assembly of contingent financing from IFIs would prevent increasing liquidity buffers to comfortable levels.

25. The program contains elements that intend to mitigate those risks. The resources made available under the SBA will help increase liquidity buffers and prevent that a weak balance of payments outturn fuels expectations of disorderly adjustment. The fact that the first purchase under the SBA will be available immediately to the authorities (as the arrangement does not require ratification by the legislative assembly) will strengthen this positive signal. The envisaged budget support and financial sector loans from the World Bank and IDB, when approved by the legislative assembly, would provide additional boosts to confidence and increase liquid reserves to cover unexpected shortfalls in external financing. In addition, the authorities are committed to tightening monetary and fiscal policy, if necessary, to preserve macroeconomic stability.

D. Statistics

26. Costa Rica’s statistics are generally adequate for effective program monitoring. Wage and employment data is only available on an annual basis, which limits somewhat the staff’s ability to assess key factors affecting inflation and economic activity. Data for several public enterprises and government agencies is not available on a timely basis, but these are small and therefore excluded for monitoring purposes from the definition of the combined public sector used in the program. There is room to improve the compilation and dissemination of financing data for the combined public sector.

E. Safeguards Assessment

27. To comply with safeguards policy, a first-time assessment will need to be completed by the time of the first review (June 2009). A FIN mission visited Costa Rica in late March to conduct an on-site assessment, and received full cooperation from the authorities.

Exceptional Access Criteria

The proposed Stand-By Arrangement exceeds the annual normal limit of access to Fund resources. Fund policy allows for access in excess of normal limits (i.e., exceptional access), provided that the following four criteria are met: (i) the member is experiencing or has the potential to experience exceptional balance of payments pressures on the current account or capital account resulting in a need for Fund financing that cannot be met within the normal limits; (ii) a rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term; (iii) the member has prospects of gaining or regaining access to private capital markets within the timeframe when Fund resources are outstanding, and; (iv) the policy program of the member provides a reasonably strong prospect of success, including not only the member’s adjustment plans, but also its institutional and political capacity to deliver that adjustment.

Staff assesses that Costa Rica meets all four criteria for exceptional access:

  • Criterion 1—Potential to experience exceptional balance of payments pressures. Costa Rica experienced sizable capital outflows during May—October 2008, which were broadly similar in magnitude to the inflows it had received in the previous six months. There is a significant risk that exceptional capital account pressures could emerge as a consequence of the global financial crisis and the U.S. recession, including large cuts in credit lines, spillovers from a loss in confidence in the banking sector, and larger-than-expected decline in FDI.

  • Criterion 2—Sustainable public debt position. Costa Rica’s level of combined public sector debt is moderate (36 percent of GDP). Projections by staff indicate that the debt-to-GDP ratio is sustainable under the baseline scenario of the Fund’s standard DSA analysis and various alternative scenarios, including a sharp real depreciation and a 10 percent of GDP contingent liabilities shock. Currently, there are no indications of any potential contingent liabilities of the government that could arise from private external indebtedness.

  • Criterion 3—Access to private capital markets. While the terms and access to private capital markets by the sovereign and the private sector have worsened as a result of the global financial crisis, credit to banks and large corporates has not been cut off. The country has good prospects of regaining full market access at better terms once global financial conditions improve, given its moderate level of indebtedness, institutional stability, and positive economic outlook.

  • Criterion 4—Strength of the policy program and capacity to deliver. Costa Rica has strong political and economic institutions, and a track record of generally sound macroeconomic policy implementation, as described in recent Article IV staff reports. The economic program to be supported by the Fund has a high degree of ownership and represents an appropriate response to the challenging external environment.

IV. Staff Appraisal

28. Costa Rica’s economy has benefited from robust growth in recent years but is now facing considerable headwinds. Economic activity is decelerating rapidly, reflecting flagging demand from trading partner countries as a result of the global downturn, lower private capital inflows (including FDI), and heightened economic uncertainty.

29. The authorities’ economic program for 2009 seeks to preserve macroeconomic and financial stability in this challenging environment, while limiting negative implications for growth and social cohesion. Tight monetary policy will facilitate orderly adjustment of the balance of payments, including a gradual increase in exchange rate flexibility. Fiscal policy, in turn, will be geared toward mitigating the impact of the adjustment on domestic activity and incomes of the vulnerable population. By protecting public investments in human and physical capital, the program also provides a basis for a gradual return to high and sustained growth rates in the medium term.

30. Monetary policy will have to be geared to strengthening the external position and reducing inflation. Resolute implementation of a tight monetary policy will prevent conflicts between those goals. Staff supports the recent widening of the currency band and increase in central bank deposit interest rates, which should facilitate the required external adjustment without compromising disinflation. Consistency with the currency band regime requires that interest rates continue to be set at levels that ensure attractive returns for colon- denominated financial assets.

31. The authorities’ continued commitment to increasing exchange rate flexibility and moving gradually to an inflation targeting framework is welcome. Staff looks forward to meaningful progress in this direction during the course of the arrangement. Greater exchange rate flexibility will increase the scope for independent monetary policy and facilitate adjustment to external shocks, whereas inflation targeting will provide an operational framework to facilitate convergence of Costa Rica’s inflation to trading-partner levels.

32. The fiscal expansion contemplated for 2009 will need to be managed cautiously. Staff agrees that the prudent fiscal conduct of recent years has created space for temporary stimulus in 2009 and 2010, including to expand the social safety net in response to the substantial contraction of private demand that is already underway. However, the authorities should be prepared to delay or even withhold some of the stimulus if the current account deficit does not converge to a manageable level, financing shortfalls arise, and/or inflation pressures fail to abate.

33. The deterioration of the fiscal position envisaged for 2009 should be partially reversed in subsequent years to maintain public debt at manageable levels. Many of the planned increases in current spending are recurrent in nature and will not automatically reverse, while permanently higher capital expenditures appear desirable. In view of this, the future reduction in the fiscal deficit will likely depend on a substantial strengthening of the revenue base, including through comprehensive tax reform.

34. The banking sector appears generally sound, but the slowing economy and the global financial environment pose risks that should be closely monitored. The recapitalization of public and private banks and the winding down of most offshore operations have been welcome developments in recent months. Going forward, however, the likely increase in NPLs could strain bank balance sheets. There remains room to strengthen the monitoring and forecasting of liquidity, by collecting and processing information on the maturity structure of bank liabilities. In addition, monitoring efforts should be complemented with forward-looking system-wide stress testing to identify vulnerabilities to interest rate, exchange rate, and credit risk, followed by the development of appropriate contingency plans.

35. While important measures to strengthen the prudential framework have been taken, further actions are needed to put in place a strong financial sector safety net. In this regard, prompt approval of the consolidated supervision bill remains important, even if it does not provide legal protection for bank supervisors. Given the importance of supervisory independence, the authorities are encouraged to find alternative means to reintroduce this issue to the legislative assembly. The authorities are also expected to make rapid progress under the program on two other key initiatives: strengthening the framework for bank resolution, and creating a limited deposit insurance scheme.

36. Prompt ratification of loans from the World Bank and the IDB to be used as contingent financing will be highly desirable. The authorities’ crisis prevention strategy hinges importantly on the availability of ample liquidity buffers to provide first lines of defense in case of larger-than-expected external shocks. The IDB loan would help provide additional foreign currency liquidity to the banking sector in the event its funding sources are impaired, while the World Bank budget support loan would allow the authorities to sustain budgeted spending in case of domestic financing shortfalls.

37. The exceptional level of access under the proposed arrangement will provide an additional liquidity cushion, while keeping Fund exposure manageable. Costa Rica would be in a strong position to repay the Fund if it were to make all purchases under the proposed SBA. While there are downside risks to the program, particularly more severe balance of payments shocks, those risks can be contained with resolute implementation of policies and contingent financing that the authorities are mobilizing.

38. In view of the sound strategy and policies proposed by the authorities, staff supports their request for a SBA for SDR492.3 million.

Table 11.

Costa Rica: Indicators of Fund Credit

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Sources: IMF Finance Department; and Fund staff estimates.

End of period

Assumes full drawings

Repayment schedule based on repurchase obligations

Table 12.

Costa Rica: Proposed Access

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Source: Executive Board documents, MONA database, and Fund staff estimates.

High access cases include available data at approval and on augmentation for all the requests to the Board since 1997 which involved the use of the exceptional circumstances clause or SRF resources. Exceptional access augmentations are counted as separate observations. For the purpose of measuring access as a ratio of different metrics, access includes augmentations and previously approved and drawn amounts.

The data used to calculate ratios is the actual value for the year prior to approval for public and short-term debt, and the projection at the time of program approval for the year in which the program was approved for all other variables.

Table 13.

Country: Combined Public Sector Debt Sustainability Framework, 2006-2014

(In percent of GDP, unless otherwise indicated)

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The combined public sector comprises central government, central bank, and other public enterprises and entities (excluding ICE).

The primary deficit (line 4) is the public sector balance minus gross interest expenditure. The traditional measure that uses net interest expenditure is shown in the last line below.

Derived as [(r - π(1 +g) - g + αε(1 +r)]/(1 +g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1 +g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as combined public sector deficit, plus amortization of medium and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Table 14.

Country: External Debt Sustainability Framework

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising GDP deflator inflation.

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Attachment I. Letter of Intent

San José, March 26, 2009

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C.

Dear Mr. Strauss-Kahn:

1. Costa Rica’s strong policy record has greatly increased the economy’s resilience to external shocks. Prudent fiscal policies and high real GDP growth rates have allowed us to lower substantially the public debt burden. We have also made progress in strengthening the monetary and exchange rate policy frameworks, improving financial sector regulation and supervision, and extending the social safety net.

1. Notwithstanding these achievements, and reflecting its integration into the global economy, Costa Rica has not been immune to the present global financial turmoil and economic slowdown. Real GDP growth has slowed markedly in recent months, financial conditions have tightened, and the exchange rate has moved to the upper end of the currency band. Looking ahead, global economic forces pose downside risks to the real economy and balance of payments. Against this backdrop, the government of Costa Rica is determined to continue implementing macroeconomic policies that will mitigate the adverse effects of the downturn on growth and employment, and safeguard domestic financial stability.

2. The attached Memorandum of Economic and Financial Policies (MEFP) describes the plans and policies of the government of Costa Rica for 2009. Prudent monetary policy and increased exchange rate flexibility will support the needed external adjustment and target a gradual decline in inflation. Fiscal policy will be geared toward cushioning the effects of a rapidly slowing economy, including by providing protection to the most vulnerable groups. Financial sector policies seek to further increase the resilience of the system while enhancing monitoring and allowing for contingency planning. The plans and policies of the government for 2010 will be defined at the time of the second program review

3. In support of Costa Rica’s economic program, we request a Stand-By Arrangement (SBA) from the International Monetary Fund totaling SDR 492.3 million (300 percent of quota), covering the period to July 10, 2010. Our intention is to treat the arrangement as precautionary. Together with contingency funds from other international financial institutions, the SBA will provide an important signal and a critical liquidity cushion against worse-than-expected balance of payments outcomes, thereby bolstering investor and depositor confidence, and supporting a smooth transition to a more flexible exchange rate regime.

4. Program implementation will be monitored through quarterly reviews, quantitative performance criteria and indicative targets, and structural benchmarks, as described in the attached MEFP and Technical Memorandum of Understanding (TMU). We expect the first purchase in the amount of SDR 328.2 million (200 percent of quota) to become available upon approval of the program by the IMF Executive Board. The schedule for the availability of subsequent purchases is set out in Table 1 of the MEFP. The first review will be completed on or after September 16, 2009, and the second review on or after December 11, 2009.

5. We believe that the policies described in the attached MEFP are adequate to meet the objectives of our program. However, if needed, the government stands ready to take additional measures. In accordance with the Fund’s policies, we will be in continuous communication with the Fund with regard to policy actions related to this program.

Sincerely yours,

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Attachments

Attachment II. Memorandum of Economic and Financial Policies

March 26, 2009

I. Introduction

1. In the wake of the global downturn and financial crisis, Costa Rica is confronting increasingly challenging external and domestic economic conditions. After several years of strong growth, activity cooled off in 2008. Despite this slowdown, inflation exceeded the central bank’s target, reflecting high commodity prices and domestic demand pressures, and the external current account deficit rose to almost 9 percent of GDP. These developments put pressure on the exchange rate, which depreciated by almost 12 percent in 2008 and remains close to the ceiling of the currency band. With foreign direct investment (FDI) and exports of goods and services expected to decline in 2009, the adverse external environment poses downside risks to Costa Rica’s balance of payments and the real economy.

2. In view of the deteriorating external environment and growing risks, the government of Costa Rica is implementing a broad strategy to strengthen the economic policy framework and bolster confidence. Our objective is to increase the economy’s resilience to the adverse external environment, mitigating its negative effects on growth, employment, and vulnerable segments of the population, and maintaining macroeconomic stability with policies that facilitate an orderly reduction of the current account deficit and a lasting decline in inflation. A tighter monetary stance and greater exchange rate flexibility will be key instruments to attaining these goals. Fiscal policy is starting from a position of relative strength and can therefore provide some countercyclical support, including by strengthening the social safety net. In addition, we are taking measures to increase the resilience of the financial system. While our policy response focuses primarily on addressing the immediate challenges faced by the Costa Rican economy, it remains consistent with the government’s broader strategy to foster high and sustainable medium-term growth.

II. Economic Program for 2009

A. Program Objectives and Risks

3. External conditions are expected to weaken further during 2009. We anticipate a decline in exports and tourism receipts owing to the sharp deceleration in global demand. External financing will also be constrained, as FDI is expected to drop significantly and private sector access to external credit lines will be more limited. Although improving terms of trade should partially offset the effect of these shocks on the balance of payments, a moderation of non-oil import demand will also be necessary to reduce the current account deficit and avoid reserve losses.

4. Under these circumstances, our policy strategy aims to mitigate the adverse effects of the external environment on growth and employment. Our policy objectives include: (i) protecting vulnerable groups of the population from the negative effects of the economic slowdown; (ii) facilitating an orderly reduction in the external current account that minimizes adverse effects on activity; (iii) reducing inflation, while gradually allowing greater exchange rate flexibility; (iv) reducing the reliance on the exchange rate as a nominal anchor for monetary policy, and making progress toward the adoption of an inflation targeting regime; and (v) increasing the resilience of the financial system.

5. The uncertainty surrounding the severity and duration of the global slowdown and financial turmoil and their impact on Costa Rica’s balance of payments pose the greatest downside risks to the economic outlook. While we believe that the resilience of our economy and the existing liquidity buffers are sufficient to withstand a substantial deterioration in the external environment, we recognize that more extreme shocks to global growth and financial markets are possible. Against this background, we view a precautionary arrangement with the IMF as key to bolstering investor confidence and helping insure against downside risks. Access to financial support from the IMF, together with complementary financing from other international financial institutions, will provide a substantial liquidity cushion to help absorb unanticipated shortfalls in external inflows and enhance the credibility of our policy framework, including the transition to a more flexible exchange rate regime. As the external environment improves, growth would be expected to return gradually to potential, supported by factors such as the implementation of the CAFTA-DR; the liberalization of the telecommunications and insurance markets; the conclusion of other trade agreements; and higher infrastructure investment, particularly in the road network and ports.

B. Monetary and Exchange Rate Policy

6. Monetary and exchange rate policy will focus on reducing inflation and the current account deficit, and on supporting the normal operation of the domestic financial system. We remain committed to moving gradually to greater exchange rate flexibility. In line with this commitment, we have recently increased the rate of crawl of the ceiling of our exchange rate band to an annual rate of about 9 percent, from 3 percent previously. With the faster rate of crawl the width of the currency band is projected to widen to about 22 percent by the end of 2009 and about 30 percent by the end of 2010. In addition, we are undertaking steps to improve operations in the foreign exchange market, broadening access to the wholesale foreign exchange market to foster competition and reduce intermediation spreads.

7. We will keep interest rates consistent with the goals of attaining the inflation target and maintaining the exchange rate within the currency band. For 2009, we aim to reduce inflation to 9 percent (plus/minus one percent) by year-end, while our medium term goal remains to achieve inflation rates comparable to those observed in our trading partners. We expect inflationary pressures to subside in the coming months as the recent decline in commodity prices continues to feed through. At the same time, higher interest rates and lower money supply growth should ensure that private credit and domestic demand growth converge to levels that are consistent with the inflation target, and help reduce pressures on foreign exchange reserves. In this context, we increased in mid-January short term interest rates of the Central Bank’s deposit window by 70-150bps, and we expect central bank and market interest rates for deposits with maturities above 6 months to become positive in real terms as inflation declines. We will monitor closely liquidity conditions and the appropriateness of our interest rate levels throughout the program period, and are fully committed to adjusting them as necessary to achieve our inflation target, keep the exchange rate within the currency band, and maintain orderly conditions in the foreign exchange market.

8. To prepare for the adoption of an inflation targeting regime, which we hope to complete by late 2010, we will continue our efforts to strengthen the transmission mechanism of interest rates. To this end, we will implement a daily liquidity forecasting exercise to estimate the required interventions of the Central Bank in the money market, and will proceed to integrate the currently segmented money market through a new integrated platform (both benchmarks for end-June 2009). We will also work toward obtaining legislative approval of the draft law to recapitalize the Central Bank, which is key for the independent conduct of monetary policy.

C. Financial System Policy

9. Costa Rica’s financial system is fundamentally sound, and important progress has been made in recent years to strengthen bank regulation and supervision. We will continue to improve the regulatory framework and bolster the safety net for the financial sector. In this context, we are committed to working closely with our Legislative Assembly to obtain swift passage of the draft bill to establish consolidated supervision of financial conglomerates and to strengthen the sanctions regime. In addition, we intend to address the remaining gaps of the financial sector safety net. This will involve submission to Congress of draft laws to establish a bank resolution framework in line with international best practice (benchmark for end-September 2009) and create a deposit insurance scheme (benchmark for end-December 2009).

10. In view of the continued dislocations and volatility in global financial markets, the Superintendency of Financial Entities (SUGEF) is in the process of setting up, as a preventive measure, a system to detect early symptoms of liquidity pressure in the banking system. To this effect, SUGEF will produce a monthly report to monitor, on a bank-by-bank basis, the liquidity position, including compliance of legal reserve requirements, levels of cash in vault and securities, outstanding balances of sight and term deposits, and the availability and effective usage of foreign credit lines, among others (benchmark for end-June 2009). With respect to liquidity provision for the financial sector, we are committed to keep in place for as long as necessary the recently established mechanisms to provide exceptional liquidity assistance in colones. In addition, we have signed an agreement with the Interamerican Development Bank (IDB) for a $500 million credit line, which has already been submitted to our Legislative Assembly for approval. The credit line will be made available to the banking sector, and could be used—among other things—in case funding sources from abroad are cut off.

D. Fiscal Policy

11. Fiscal policy will be aimed at mitigating the effects of the economic slowdown and maintaining the nation’s efforts to foster human development and strengthen systemic competitiveness over the medium term. This includes a strong focus on investing in education, health, infrastructure, and science and technology, among others. Fiscal policy in recent years has been very prudent, with the central government posting a surplus in both 2007 and 2008 (excluding the capitalized inflation component of inflation-indexed bonds (TUDES)). Our moderate combined public sector debt level of under 36 percent of GDP leaves us room to use countercyclical fiscal policy to try to offset the downturn. In particular, we intend to increase spending on education, to raise coverage levels; on labor-intensive infrastructure projects, to improve our network of roads, ports, and airports; and on broadening the social safety net, including by expanding the coverage of our conditional cash transfer program AVANCEMOS and noncontributory pensions. With the expected cyclical decline in revenues, this higher spending will raise the deficits of the Central Government and the combined public sector to 3.2 percent and 4.1 percent of GDP, respectively, during 2009.

12. The borrowing needs of the public sector will be mostly financed from domestic sources, and the remainder from external sources that have already been secured. This will result in a moderate, transitory increase in the public debt-to-GDP ratio. However, over the medium term, as the output gap closes, the borrowing needs of the Central Government and the overall public sector are expected to decline and reverse the increase in public indebtedness.

13. In light of the challenging balance of payments outlook and the uncertainties surrounding the government revenue projections we are committed to a prudent execution of the budget. In this context, further fiscal measures would be taken if inflation and/or the current account deficit do not decline at the expected pace. In addition, we are in the process of securing a $500 million contingent budget support loan from the World Bank, which we could use to finance the budget in case revenues and the planned domestic financing cannot be mobilized as envisaged.

III. Safeguards Assessment

14. We recognize the importance of completing a safeguards assessment of the central bank of Costa Rica (BCCR) before the first review of the Stand-By Arrangement. To facilitate this, the central bank auditors will hold discussions directly with IMF staff. An IMF mission to conduct the safeguards assessment is scheduled for late March 2009, and we will provide Fund staff promptly with all necessary information, including information related to correspondent banks and foreign reserve placements.

IV. Program Monitoring

15. The program will be monitored on a quarterly basis, by quantitative performance criteria and indicative targets, and structural benchmarks. The phasing of access under the arrangement and the review schedule are set out in Table 1 of this memorandum; the quantitative performance criteria and indicative targets for end-June 2009 and end-September 2009, and indicative targets for end-December 2009, are set out in Table 2 (targets for March 2010 will be identified at the time of the second program review). Structural benchmarks are set out in Table 3. Program conditionality is further specified in the accompanying TMU.

Table 1.

Proposed Schedule of Disbursements

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Table 2.

Quantitative Performance Criteria and Indicative Targets

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Table 3.

Structural Benchmarks

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Attachment III. Technical Memorandum of Understanding

This Technical Memorandum of Understanding (TMU) sets out the understandings between the government of Costa Rica and IMF staff regarding the definitions of quantitative and structural performance criteria and reporting requirements under the Precautionary Stand-By Arrangement (SBA).

I. Definitions

A. Program Exchange Rates

For the purposes of the program (and not as a target rate), the average exchange rate is set at 576.3 Costa Rican colones per U.S. dollar. The exchange rates against the SDR and Euro are provided in Table 1. The program rate for the inflation indexed unit (UDES) is set at 683.4 colones.

Table 1.

Program Exchange Rates in 2009

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B. Central Government

Numbers referring to the central government include the Central Government budget and extra budgetary funds. If the government establishes new extra budgetary funds, they will be consolidated within the Central Government system.

C. Combined Public Sector

For program purposes, the combined public sector includes the Central Government, the Central Bank, public enterprises (excluding the Instituto Costarricense de Electricidad (ICE)) and a number of decentralized institutions (Table 2).

Table 2.

List of Public Agencies in the Combined Public Sector

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II. Quantitative Performance Criteria, Indicative Targets, and Continuous Performance Criteria: Definitions and Reporting Standards

A. Floor on the Cash Balance of the Central Government

The cash balance is defined as the difference between total revenues and expenditures. The floor on the cash balance of the Central Government will be monitored from above the line on a cash basis. The interest component of expenditures excludes the capitalized inflation component of inflation-indexed zero coupon bonds (TUDES).

B. Floor on the Cash Balance of the Combined Public Sector

The cash balance is defined as the difference between total revenues and expenditures. The floor on the cash balance of the combined public sector will be monitored from above the line on a cash basis. The balance of the Central Bank will be measured on an accrual basis. The interest component of expenditures excludes the capitalized inflation component of inflation-indexed zero coupon bonds (TUDES) held outside of the combined public sector.

C. Floor on Net International Reserves of the Central Bank of Costa Rica

Net international reserves (NIR) of the Central Bank of Costa Rica (BCCR) are defined as the U.S. dollar value of gross foreign assets minus gross foreign liabilities of the BCCR.

  • Gross foreign assets are defined in conformity with the Special Data Dissemination Standard as readily available claims on nonresidents denominated in foreign convertible currencies. They include the BCCR’s holdings of monetary gold, SDRs, foreign currency cash, foreign currency securities, deposits abroad, and the country’s reserve position at the Fund. Excluded from reserve assets are any assets that are pledged, collateralized, or otherwise encumbered, claims on residents, claims in foreign exchange arising from derivatives in foreign currencies vis-à-vis domestic currency (such as futures, forwards, swaps, and options), precious metals other than gold, assets in nonconvertible currencies, and illiquid assets.

  • Gross foreign liabilities are defined as all short-term foreign exchange liabilities to nonresidents, including commitments to sell foreign exchange arising from derivatives (such as futures, forwards, swaps, and options) and all credit outstanding from the Fund.

D. Ceiling on Net Domestic Assets of the Central Bank of Costa Rica

Net domestic assets of the BCCR are defined as the difference between base money and the NIR of the BCCR converted at program exchange rates, where base money is defined as the sum of currency issued and domestic currency reserve deposits of deposit-taking financial intermediaries at the Central Bank.

E. Ceiling on the Debt Stock of the Central Government

The ceiling on the stock of Central Government debt shall apply to all debt defined as set forth in point no. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-00/85).9 Excluded from this performance criterion are normal short-term import credits. All foreign currency denominated debt will be converted into colones using the program exchange rates set out in Table 1. All domestic debt denominated in inflation indexed units (TUDES) will be converted into colones using the program rate set out in Table 1.

F. Continuous Performance Criteria on Nonaccumulation of External Arrears

The Central Government will accumulate no external debt arrears during the program period. For the purposes of this performance criterion, an external debt payment arrear will be defined as a payment by the Central Government system which has not been made within seven days after falling due under the contractual agreement, unless specified otherwise. The performance criterion will apply on a continuous basis.

G. Adjustors

The floor on the NIR will be adjusted upward and the ceiling on NDA downward by the amount of external financing contracted by the Central Bank, excluding funding used to provide liquidity support to the financial sector and IMF disbursements.

III. Clarification of Structural Conditions

Benchmark for end-June 2009 on the establishment of a monthly monitoring report for the banking system: Preparation of a monthly report to monitor the liquidity position of the banking system on a bank-by-bank basis.

Benchmark for end-June 2009 on establishing a system of daily forecasting of systemic liquidity in the money market: Establish a daily liquidity forecasting exercise, containing a comprehensive assessment of liquidity supply and demand based on the compilation and consolidation of information on liquidity needs, a forecasting methodology, close communication with market participants and relevant parties, real-time monitoring of money market transactions, and an assessment of the size and scope of BCCR’s market intervention and its effectiveness.

Benchmark for end-June 2009 on unification of the money market under a single platform: Establishment of an integrated liquidity market (MIL) that will include the following: (i) the introduction of a short-term lending facility that sets an interest rate ceiling to guide the market rate, (ii) the BCCR’s withdrawal from the interbank money market (MIB), and (iii) disallowing access for financial entities to the Central Bank’s deposit facility (Central Director) for maturities of 30 days or less, except for deposits with maturities that mirror the maturities offered by the MIL lending facility.

Benchmark for end-September 2009 on submission to the Legislative Assembly of a draft law to strengthen the bank resolution framework: The draft law should provide for a more robust bank resolution framework. This framework should allow for the orderly transfer of assets and liabilities of an insolvent bank to another institution, while imposing first losses on shareholders and subordinated creditors before any of the general creditors, the deposit insurance scheme, or the government incur costs.

Benchmark for end-December 2009 on submission to the Legislative Assembly of a draft law to create a limited deposit insurance scheme: The draft law should establish a deposit insurance scheme, which includes the following elements: contain a clear ex ante funding mechanism, provide for rules to allow for the swift compensation of depositors in the event of a bank failure, and describe the linkages to the bank resolution framework.

IV. Program Reporting Requirements

The following information will be provided to the Western Hemisphere Department of the IMF within the time frame indicated.

  • Data on the cash balance of the Central Government will be provided within 6 weeks of the end of the month to which the cash balance is calculated.

  • Data on the cash balance of the nonfinancial public sector will be provided within 8 weeks of the end of the month to which the cash balance is calculated.

  • NIR will be provided on a daily basis

  • NDA will be provided on a daily basis.

  • Data on the total stock of debt of the Central Government system will be provided on a quarterly basis within one month of the end of each quarter.
1

The combined public sector comprises the central government, the main public sector enterprises and other decentralized entities, and the central bank. It excludes the state electricity and telephone company ICE, which operates as a private enterprise (see www.imf.org/external/np/pp/eng/2009/031309A.pdf).

2

In May 2008, the BCCR stopped using the overnight deposit rate as its policy rate and switched to the rate at which it lends money overnight in the interbank market through repo operations.

3

In late 2008, the government recapitalized three public commercial banks through a transfer of US$ 117.5 million (0.4 percent of GDP) in inflation-indexed bonds. Subsequently, several major private banks announced capital injections of US$142 million (0.5 percent of GDP) in total.

4

The projected decline in FDI would imply that investments in real estate revert to historical levels and that there are no new corporate cross-border acquisitions.

5

These projections assume that the authorities do not draw on the contingent financing from IFIs that they are in the process of securing.

6

The draft law would provide the bank supervisor with legal powers to perform effective consolidated supervision and strengthen the sanctions regime. Provisions to grant legal protection to bank supervisors had to be dropped from the bill, however, owing to concerns about their constitutionality.

7

About 30 percent of the banking system (90 percent of private banks) is foreign-owned and thus susceptible to dislocations caused by the global deleveraging process.

8

See http://www.imf.org/external/np/pp/eng/2009/031309a.pdf. The Executive Board was informed of negotiations involving exceptional access for Costa Rica in an informal Board session held on January 26, 2009.

9

The definition of debt set forth in point No. 9 of the IMF’s guidelines reads as follows: “(a) For the purpose of this guideline, the term “debt” will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers’ credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers’ credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the leaser retains the title to the property. For the purpose of the Guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair, or maintenance of the property. (b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.”

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Costa Rica: Request for Stand-By Arrangement: Staff Report; Staff Supplement and Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Costa Rica
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 134
Publisher:
International Monetary Fund
ISBN:
9781451809695
ISSN:
1934-7685
Pages:
82
DOI:
https://doi.org/10.5089/9781451809695.002

Net International Reserves
Figure 1.

Costa Rica: Real Sector Developments
Figure 2.

Costa Rica: External Sector Developments

Index of Economic Activity

(In percent)

Key BCCR Interest Rates

(In percent)

Credit to the private sector

(12-month percentage change)
Figure 3.

Costa Rica: Fiscal Developments

(Percent of GDP)
Figure 4.

Costa Rica: Monetary and Banking Developments

Daily Exchange Rate

(Colones per USD)

Net International Reserves

(In millions of US$)

Real Effective Exchange Rates

(2000=100)
Figure 5.

Costa Rica: External Debt Sustainability-Bound Tests 1/

(External debt in percent of GDP)
Figure 6.

Costa Rica: Public Debt Sustainability-Bound Tests 1/

(Public debt in percent of GDP)