Statement by Ramon Guzmán, Executive Director for Costa Rica and Alvaro Umaña, Senior Advisor April 8, 2009

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.

We would like to thank Staff for a comprehensive and well-written set of papers. Our Costa Rican authorities broadly agree with the Staff’s assessment and fully support its recommendations. After five years of robust growth, averaging 6.6 percent per year, the Costa Rican economy experienced a considerable slowdown during the final months of 2008 as the United States, its main trading partner, and the rest of the world entered the present recession. The current account deficit reached almost 9 percent and inflation shot up into double digit territory, although it is expected to decelerate substantially over the next months.

Costa Rica’s strong policy record has increased its resilience to the severe external shocks that it is now experiencing and which are expected to continue throughout 2009. The transmission mechanisms of the crisis are primarily declining exports, diminished tourism receipts and reduced foreign direct investment (FDI). External financing will also be constrained and credit lines will likely be more limited and more expensive. However, imports have also dropped by almost one third, due to lower oil imports and reduced demand. This should contribute to reducing pressure on the current account.

In light of the weaknesses in the external environment and increased risks derived from the crisis, the Costa Rican government is focused on strengthening the economy policy framework and increasing confidence. Their main objectives are to increase resilience to the external shocks, mitigate its negative effects on growth and employment, protect vulnerable groups, and maintain macroeconomic stability with policies that facilitate an orderly reduction of the current account deficit and bring a lasting decline in inflation.

Prudent fiscal policies in the boom years allowed the country to post surpluses in both 2007 and 2008 and to substantially lower its debt burden to below 36 percent, as well as to reduce poverty, which reached a record low of 16.7 percent in 2007. A fundamental concern for our authorities is to protect the most vulnerable groups from the economic downturn and to avoid permanent or longer-term damage to groups such as low-income students. Fiscal policy is fortunately starting from a position of relative strength and can therefore provide some countercyclical support, including strengthening the social safety net. In addition to increases in education expenditures and cash transfers, labor-intensive public investments in infrastructure and human capital are also preserved and will provide a basis for a gradual return to high and sustained growth rates over the medium term.

Monetary and exchange rate policy will focus on reducing inflation and the current account deficit, and on supporting the operation of the domestic financial system. Our authorities remain committed to moving gradually to greater exchange rate flexibility, and the rate of crawl of the ceiling of the exchange rate band was recently increased to an annual rate of about 9 percent, from 3 percent previously. This will widen the band to about 22 percent by the end of 2009 and 30 percent by the end of 2010. There are also planned improvements in the operations of the foreign exchange market, broadening access to the wholesale foreign exchange market to foster competition and reduce intermediation rates.

Interest rates will be kept consistent with the goals of attaining the inflation target and maintaining the exchange rate within the currency band. For 2009 the inflation target is to reach 9 percent (plus or minus one percentage point) by the end of the year, with a medium-term objective of achieving rates comparable to those of Costa Rica’s trading partners. We expect central bank and market interest rates with maturities above 6 months to become positive in real terms as inflation declines. Our authorities will continue to strengthen the interest rate transmission mechanism in order to prepare for the inflation targeting regime. The transition to this regime is expected to take place in 2010. Efforts will also be made to obtain legislative approval of the draft law to recapitalize the central bank.

Costa Rica’s financial system is fundamentally sound and continued progress is being made to strengthen financial regulation and supervision. Public and private banks have been recapitalized and offshore operations have been almost completely wound down in recent months. A rise in NPLs could nonetheless put pressure on balance sheets and we are strengthening our monitoring and liquidity forecasting capabilities, as well as introducing a forward looking system-wide stress testing. A draft bill to establish consolidated supervision of financial conglomerates is presently under consideration by Congress. In addition, draft laws to establish a bank resolution framework and a deposit insurance scheme will be introduced by end September and end December 2009 respectively.

Costa Rica was recently named in an OECD report as a jurisdiction that had not yet committed to the internationally agreed tax standards sponsored by the OECD. The OECD has subsequently removed Costa Rica from this list on April 6, 2009. Our authorities would like to reassure the Executive Board that they will shortly introduce amendments to the present legislation to be in line with OECD standards.

These improvements in our monetary and financial policies are taking place in a context of increased risks and uncertainty. Our authorities believe that it is critical to have access to contingent financing for the turbulent period ahead. The availability of ample liquidity buffers to provide for first lines of defense in case of larger-than-expected external shocks is key in this context, and Costa Rica has negotiated a $500 million loan with the IADB to provide additional foreign currency liquidity to the banking sector in the event that its funding sources could become impaired, while a similar budget support loan from the World Bank would allow authorities to sustain budgeted spending in case of domestic financing shortfalls.

Against all this background, our authorities view the precautionary arrangement with the Fund as a suitable complement to the support of the other IFI’s and a key to bolstering investor confidence, as well as helping insure against downside risks. We therefore seek your support for the staff’s recommendation of and SBA for SDR 492.3 million for the period between April 11, 2009 and July 10, 2010.

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