Costa Rica
2012 Article IV Consultation
Author:
International Monetary Fund. Western Hemisphere Dept.
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Publication Date:
22 Mar 2013
eISBN:
9781484382646
Language:
English
Keywords:
ISCR; CR; headline inflation; core inflation; staff appraisal; output gap; GDP deflator; trade balance; short-term debt; inflation expectation
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This article is an analytical report of the economic developments of Costa Rica. The economy showed rapid growth in the aftermath of the global crisis with low inflation; but for further stable growth, certain policy frameworks and reforms need to be reinforced. The fiscal stance should be made tighter to mitigate risks of inflation and external imbalances. Interest rates and exchange rates must be increased, and monetary policy should be tightened for price stability. The Executive Board welcomes these measures for structural potential growth.

Abstract

This article is an analytical report of the economic developments of Costa Rica. The economy showed rapid growth in the aftermath of the global crisis with low inflation; but for further stable growth, certain policy frameworks and reforms need to be reinforced. The fiscal stance should be made tighter to mitigate risks of inflation and external imbalances. Interest rates and exchange rates must be increased, and monetary policy should be tightened for price stability. The Executive Board welcomes these measures for structural potential growth.

Overview

1. Costa Rica was resilient to the 2008-09 financial crisis and recovered quickly. In response to the downturn, the authorities increased public expenditure and entered in a high-access precautionary Stand-By Arrangement with the Fund (that ended in mid-2010), while depreciation of the colón facilitated external adjustment. Macroeconomic and financial stability were maintained. After falling modestly in 2009, real GDP grew strongly in 2010-12, with low inflation. As global economic conditions improved, private capital inflows resumed and the nominal exchange rate returned to pre-crisis levels, reaching the floor of the exchange rate band by end-2010.

2. However, the fiscal situation deteriorated markedly and attempts to correct it have encountered strong headwinds. The budgetary stimulus imparted in 2009, mainly through a rise in wages and transfers, was not reversed when the economy improved and a new government took office. The increase in public expenditure combined with an endogenous fall in revenue (which was above trend in 2008) pushed the fiscal deficit above 5 percent of GDP by 2010—from near balance in 2008. While the authorities curbed expenditure growth in 2011-12, the budgetary position improved only moderately and public sector debt kept on climbing. A revenue-enhancing tax reform aimed at placing the public sector balance on a sustainable path was voided in 2012.

Recent Economic Developments and Outlook

A. Recent Developments

3. Growth picked up in 2012, with inflation well within the policy limits. Real GDP grew by about 5 percent in 2012 (up from an average of 4½ percent during 2010-11), buoyed by strong investment and exports, especially in manufacturing. As a result, the negative output gap that arose during the downturn is estimated to have almost closed. By year-end, headline inflation stood at 4.6 percent, comfortably within the 4-6 percent official target range, and core and producer price inflation were also subdued. At a historical low of 5.7 percent in December, twelve-month inflation expectations were anchored within the target range.

uA01fig02

Real GDP growth and contributions to growth

(in percentage points)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Central Bank.
uA01fig03

Headline and core inflation

(percent y/y)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Central Bank.

4. A significant rise in capital inflows more than offset a modest increase in the external current account deficit and placed strong appreciating pressure on the colón. Robust foreign direct investment (FDI), higher public and private external borrowing, and, since late August 2012, a rise in net portfolio inflows increased the financial and capital account surplus. The rise in private capital inflows kept the colón at the bottom of the exchange rate band, and prompted the central bank to step up its foreign exchange purchases. As a result, net international reserves (NIR) at end-2012 rose to US$6.9 billion, close to adequacy metrics (Box 1).

uA01fig04

Exchange rate

(colones per US$)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Central Bank.
uA01fig05

Net international reserves and central bank foreign exchange purchases

(millions of US$)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Central Bank.

5. Competitiveness has eroded and may not be adequate to ensure long-term external stability. Since 2005, the real effective exchange rate (REER) has appreciated by over 30 percent, largely due to high inflation differentials. Multilaterally consistent estimates under the EBA and CGER approaches suggest that the current account deficit is above medium-term fundamentals-based levels (Box 1) and point to moderate REER overvaluation. Productivity-enhancing reforms (¶ 27) and wage restraint would help restore competitiveness. Fiscal consolidation (¶ 19) would also support long-term external stability.

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Headline Fiscal Balance, Cyclically-adjusted Balance and Fiscal Stimulus

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: IMF staff estimates.

6. While public expenditure growth was contained, the fiscal deficit remained large and the public debt ratio kept rising. During 2011-2012, the authorities slammed the brakes on the rapid swelling of public expenditure of 2008-10 by freezing public sector vacancies, containing wage growth, rationalizing outlays on goods and services, and postponing non-priority public investment projects. These efforts helped reduce the fiscal deficit to an estimated 4½ percent of GDP in 2011 and 2012, from a peak of 5½ percent of GDP in 2010. However, they did not prevent a further rise in the public debt-to-GDP ratio, which is expected to have reached 38 percent of GDP at end-2012 (including external debt placed in late 2012 to pre-finance 2013 borrowing requirements, ¶ 7).

Costa Rica: External Stability Assessment

Costa Rica’s share in global merchandise trade fell in the last decade, but the export-oriented services sector is growing rapidly. Costa Rica’s share in total world trade has decreased mostly driven by a lower contribution of traditional exports. This decline and the significant widening observed in the merchandise trade deficit, however, were partly offset by a steady increase in the surplus of the real services balance.

uA01fig07

Costa Rica: Export market shares

(percent) 1/

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: International Financial Statistics and Fund staff calculations.1/ Computed as Costa Rica’s exports to the World, the EU and the US in percent of total World, EU and US imports from the World respectively.
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Costa Rica: External current account

(percent)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: Central Bank, Fund staff calculations

Survey-based indicators of competitiveness highlight some key challenges. Costa Rica’s ranking in the 2012-2013 Global Competitiveness Index improved to the 57th position (out of 144 countries), from 61st in the previous survey. However, inadequate infrastructure and excessive government bureaucracy continue to weigh on the country’s competitiveness. The country also stands low in the Doing Business Index, ranking in the 110th position out of 185 countries.

The real effective exchange rate has appreciated significantly in recent years. Driven to a large extent by the inflation differential vis-à-vis trading partners, the real effective exchange rate (REER) has risen by more than 30 percent since 2005. Using unit labor costs, the REER measure rose by about the same magnitude, though at a much slower rate since 2009.

uA01fig09

Costa Rica: Real effective exchange rate

(changes in percent since January 2005) 1,2/

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: National authorities and Fund staff calculations.1/ Increase implies appreciation.2/ The REER based on ULC was calculated with data for 73 percent of the trading partners.

Multilaterally-consistent estimates suggest that Costa Rica’s REER is moderately overvalued, and that a narrower current account deficit would be warranted over the medium term.

External balance assessment (EBA) estimates rely on econometric analysis to gauge the values of key indicators of external sustainability implied by fundamentals and desirable policies:

  • The current account regression-based approach points to a sustainable cyclically-adjusted current account deficit of about 2.7 percent of GDP, which is 2 percentage points below the current cyclically-adjusted level. The gap reflects in part the effect of the large fiscal deficit and generous social protection policies that reduce the need for precautionary saving.

  • Preliminary estimates under the REER regression-based approach point to an overvaluation of about 25 percent. This result, however, should be interpreted with caution. While it is driven in part by identifiable factors—notably, again, by the country’s fiscal policies and high social spending—it is also characterized by a large regression residual.

  • Under the external sustainability approach, the net foreign asset (NFA) position would stabilize at the benchmark level of 26 percent with a current account deficit of 1.9 percent. This suggests that the REER gap is about 23 percent. However, if alternative estimates for the NFA position are used,1 the NFA-stabilizing current account deficit widens to 3.5 percent and the estimated REER overvaluation drops to 12 percent.

Methodologies developed by the IMF’s Consultative Group on Exchange Rate Issues (CGER) also suggest that the real exchange rate is moderately overvalued: three different approaches produce a deviation from fundamentals-based values in the range of 7.9 to 14.6 percent.

Estimates of Competitiveness Using EBA Methodologies 1/

(Deviation from norms implied by fundamentals and desirable policies)

article image
Source: IMF staff estimates

EBA (External Balance Assessment). CA gaps: negative gap implies REER overvaluation.

Estimates of Competitiveness Using CGER Methodologies 1/

(REER deviation from levels implied by medium-term fundamentals)

article image
Source: IMF staff estimates

CGER (Consultative Group on Exchange Rate Issues). Plus indicates overvaluation. International Monetary Fund, 2008, “Exchange Rate Assessments: CGER Methodologies” (available at www.imf.org)

While Costa Rica’s current account deficit appears elevated, its financing structure mitigates risks. The current account deficit is mostly financed by FDI inflows, which have hovered at about 5 percent of GDP per year since 2005. As a result, Costa Rica’s net international investment position is negative, with more than 60 percent of the external liabilities are comprised of FDI liabilities. Such financing structure makes the external accounts less vulnerable to sudden changes in global financial conditions.

The level of net international reserves (NIR) is somewhat below the composite adequacy metric. According to staff’s estimates, Costa Rica’s NIR stand at about 95 percent of the reserve adequacy metric that captures countries’ vulnerabilities based on their exports and asset-liability structure, as well as the risk of related outflows.2

1 Philip R. Lane and Gian Maria Milesi-Ferretti, 2006, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004”, IMF Working Paper 06/69. 2 See “Assessing reserve adequacy”, 2011, Policy Paper, International Monetary Fund.
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Costa Rica’s GDP growth and fiscal deficit are higher than the CAPDR average, while inflation and the current account deficit are lower than the regional average

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

7. The Supreme Court voided a revenue-enhancing tax reform. As discussed in the staff report for the 2011 Article IV consultation, a tax reform aimed at increasing public revenues by 1½-2 percentage points of GDP (by broadening the tax base and turning the sales tax into a full-fledged value-added tax) was the cornerstone of the government’s fiscal consolidation strategy. In March 2012, Congress approved the bill but a month later the Supreme Court nullified it, citing procedural irregularities in its legislative approval. Since then, the authorities’ fiscal policy strategy focused on containing expenditure, strengthening tax administration, and reducing borrowing costs by tapping international capital markets. The government placed US$1 billion Eurobonds in late 2012 and is planning to place an additional US$3 billion in the coming years.

8. Domestic financial conditions tightened during 2012. Although the monetary policy rate has remained at 5 percent since mid-2011, other interest rates rose significantly, especially during the first half of the year, driven by large government borrowing and buoyant private sector credit demand. Interest rates declined somewhat late in the year, but remained above the previous year’s level. A broader-based index developed by staff (comprising variables such as interest rates, the REER, and house prices) also pointed to tighter financial conditions (Box 2). Despite this tightening, credit expansion to the private sector was slightly higher than nominal GDP growth.

Costa Rica: Financial Conditions

A Financial Conditions Index (FCI) was developed for Costa Rica. Financial conditions can be defined as the current state of financial variables that influence economic activity. The FCI seeks to summarize the information contained in key financial variables and capture the link between them and economic activity. A VAR analysis was used to decompose the contribution of various financial indicators to real GDP growth. The FCI was built as the sum of the cumulative impulse responses of real GDP to each of the relevant financial variables. The financial variables used included a summary measure of interest rates (the basic passive rate or “tasa basica pasiva”), the real effective exchange rate, the stock market index, and a house price index (proxied by rental prices as measured in the consumer price index). The period of estimation was 1991-2012, and the frequency of the data was quarterly. The impulse responses were standardized so that a change in each FCI component by one unit can be interpreted as an (annualized) change in real GDP growth by 1 percentage point. Hence, a change in the value of the overall FCI reflects the total contribution of financial conditions to GDP growth.

uA01fig11

Monetary and Financial Conditions Index

(percentage points of y/y real GDP growth)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Fund staff estimates.

The estimated FCI suggests that financial conditions tightened in 2012. The rise in the basic passive interest rate and a weaker stock market during the first half of the year were the main drivers of the tightening in the FCI. Financial conditions eased somewhat during the second half of the year, partly driven by a decline in the basic passive interest rate in the fourth quarter. However, considering the year as a whole, financial conditions in 2012 were on average tighter than in 2011. Tighter financial conditions may have been a drag on growth, which showed slowing signs in the second half of the year.

9. The financial system remained sound, though dollarization continues to be a source of vulnerability. Capital adequacy stood well above regulatory requirements and liquidity remained robust. Profitability was stable, albeit somewhat below that of regional peers, and non-performing loans are at manageable levels. Reliance on foreign funding is small and exposure to foreign assets modest. Staff analysis suggests that a potential intensification of sovereign and banking strains in advanced countries would not have a large direct impact on credit or the financial system in Costa Rica (Box 3). Stress test exercises conducted by bank supervisors in 2012 yielded similar results. Although the banking sector has a long open foreign exchange position, a large depreciation of the colón may impact asset quality, given large unhedged liability dollarization of households and corporations.

Financial Soundness Indicators

(in percent) 1/

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Source: FSI tables, October 2012, IMF, http://fsi.imf.org/fsitables.aspx.

As of July, 2012 unless otherwise noted.

As of August, 2012;

as of June, 2012.

Comprises Guatemala, El Salvador, Honduras, Panama, and the Dominican Republic.

Comprises Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Costa Rica: Cross-Border Spillovers1

Strong trade and financial linkages make Costa Rica particularly sensitive to shocks emanating from the United States (U.S.). The U.S. is Costa Rica’s main trading partner, the destination of over a third of its merchandise exports and the source of almost 40 percent of its merchandise imports. Financial linkages also are strong, with a large share of external assets and liabilities of Costa Rica’s banks concentrated in the U.S. In addition, the bulk of foreign direct investment flows comes from the U.S. (64 percent of the total FDI stock is of U.S. origin).

Risks stemming from a growth slowdown in the U.S. are significantly higher than those from lower growth in other trading partners. Results from multi-country VAR analysis suggests that an adverse shock of ½ standard deviation in U.S. growth could lower Costa Rican GDP growth by ⅓ percentage points in 2013 and ¾ percentage points in 2014. A U.S. growth shock would propagate to Costa Rica both directly and indirectly through its negative impact on other Central American countries. In comparison, a shock of a similar size in China would lower growth by ⅕ and ⅖ percentage points in 2013 and 2014, respectively, while growth shocks in Europe and the rest of Central America would have very modest effects.

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Costa Rica: Growth Forecast and Simulation, 2008-2014 (percent)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

Fiscal adjustment in the U.S. could have comparatively significant but still limited effects on Costa Rica. Simulations suggest that each percentage point of GDP of fiscal adjustment in the United States would reduce Costa Rican growth by about 0.1 percentage points.

Though the presence of foreign banks is important, the direct effects of banking stress spillovers on the Costa Rican economy do not seem large. As of end-2012, the market share of international banks subsidiaries was about a third of the banking sector’s total assets. The private and public sectors also have been actively involved in direct cross-border borrowing from international banks. The associated rollover risks, however, appear to be moderate, as the upstream exposure of Costa Rica to all BIS reporting banks does not exceed 13 percent of total credit.2

  • The analysis of various stress scenarios based on the RES/MFU Bank Contagion Module suggests that the impact of large haircuts in the sovereign debt of some European countries on international banks lending to Costa Rica would be close to zero. This is due to the limited sovereign exposure of these banks to the euro area periphery countries.

  • The estimates also indicate that the direct impact on lending to Costa Rican residents from a 10-percent decline in value in European assets (both sovereign and non-sovereign) held by international banks lending to Costa Rica would not exceed 3 percent of GDP.

Spillovers to Costa Rica from International Banks’ Exposures as of March 2012

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Source: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of on-balance sheet claims (all borrowing sectors) that lose value.

Reduction in foreign banks credit to Costa Rica due to the impact of the analyzed shock on their balance sheets, assuming a uniform deleveraging across domestic and external claims.

Austria, Greece, Ireland, Portugal, Italy, Spain, France, Germany, Netherlands, and UK.

1 See Analytical Note 1 (AN 1). 2 Total credit to the non-bank sectors in Costa Rica is calculated by adding IFS local (both domestic and foreign owned) banks’ claims on non-bank borrowers and BIS reporting banks’ direct cross-border claims on non-bank sectors (BIS Locational Banking Statistics Table 6B).

B. Macroeconomic Outlook and Risks

10. Both authorities and staff project growth to decelerate in 2013, with inflation and the current account deficit remaining broadly stable. Real GDP growth would ease to 4¼ percent largely on account of a lower contribution from net exports and a somewhat slower expansion in domestic demand. On the supply side, the bulk of the slowdown would come from manufacturing after an exceptionally strong performance in 2012. With output still slightly below potential, inflation is projected to stay within the target range and the current account deficit would not change materially. The overall balance of payments would remain strongly in surplus, amid continuing large FDI and portfolio inflows, leading to further substantial NIR rise.

11. Staff’s medium-term baseline scenario envisages continuing growth but a modest deterioration in fundamentals. This central setting contemplates no fiscal consolidation over the forecast period (given uncertainties surrounding passage of the tax reform, ¶ 21), and projects the output gap to close by 2014, after which growth would converge to a steady-state potential rate of 4½ percent. The overall fiscal deficit would increase to about 7½ percent of GDP by 2018, and the public debt ratio would rise steadily to about 50 percent of GDP. With prudent monetary policy, inflation is projected to hover around 5 percent, though the current account deficit increases to about 6 percent of GDP.

Costa Rica. Baseline Scenario

(in percent of GDP, unless otherwise stated)

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Sources: National authorities, and IMF staff estimates

Central government.

The structural fiscal balance in 2010 and 2011 was adjusted taking into consideration the timing of a large public investment project.

12. An alternative scenario that incorporates the authorities’ fiscal consolidation intentions yields a stronger outlook. The authorities aim to start a process of adjustment as well as adopt monetary and exchange rate policies that would keep the economy on a robust growth path, while alleviating lingering vulnerabilities. This scenario would have inflation gradually declining to trade partners’ levels and would improve prospects for long-term external and fiscal sustainability (¶s 5 and 19). According to staff analysis, the authorities’ plans would have only moderate short-term output costs and help lower inflation and the current account deficit over the forecast period.

Costa Rica. Fiscal Consolidation Scenario

(in percent of GDP, unless otherwise stated)

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Sources: National authorities, and IMF staff estimates

Central government.

13. Risks to the outlook are tilted to the downside. Downside risks stem from both external and domestic sources. While deviations from the assumed baseline for each of the risk factors listed below could occur in either direction, the probability of downside occurrences is deemed prevalent.

  • Weaker global growth would reduce the demand for Costa Rican exports and FDI flows, weakening domestic activity. Costa Rica would be particularly sensitive to a worsening in the U.S. growth outlook, given close trade and financial links.

  • Higher global risk aversion would ease the pressures stemming from large capital inflows but, if extreme, could impair access to international capital markets and bank lending, with adverse implications for growth, the balance of payments, and the fiscal accounts.

  • Inflation shocks could stem from an increase in commodity prices, stronger-than-expected price pressures from current policies, or inability to manage large private capital inflows.

  • The persistence of a large fiscal deficit, and the ensuing rise in the public debt ratio, could render the economy vulnerable to sudden changes in financial market conditions, and reduce the authorities’ policy space to respond to adverse shocks. Also, large government financing requirements could raise domestic interest rates, and weigh on private investment and growth.

  • A large depreciation of the colón (in the event of an adverse balance of payments shock) could weaken the balance-sheets of corporate and households, given their negative foreign exchange positions, raising credit risks for banks, hurting economic activity.

Costa Rica: Risk Assessment Matrix1

(Scale—high, medium, or low)

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path discussed in this report (which is the scenario most likely to materialize in the view of the staff). The RAM reflects staff’s views on the source of risks and overall level of concerns as of the time of discussions with the authorities. The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding this baseline.

In case the baseline does not materialize.

Policy Discussions

14. Discussions centered on how to maintain macroeconomic stability and reduce vulnerabilities, while taking actions to spur potential growth and boost competitiveness. In the near term, tighter fiscal and monetary policies may be necessary to maintain macroeconomic stability. In addition, fiscal consolidation is necessary to place public finances on a long-term sustainable path, the monetary policy framework should be further improved to maintain low inflation, financial sector supervision and regulation should be further enhanced, and structural reforms are needed to boost the growth potential of the economy and bolster competitiveness.

A. Near-term Policy Mix

15. Staff cautioned about inflationary risks. Though inflation has stayed subdued since 2009, risks of an uptick stem from: (i) continued capital inflows in the context of a lax global financial environment and a rigid exchange rate system; (ii) potential second round effects from higher global food prices (deserving special attention in light of their elevated pass-through in the past); and (iii) the imminent closure of the output gap. While agreeing with this assessment, the authorities highlighted that inflation expectations have recently fallen and are well-anchored within the target range.

16. There was agreement that a tighter policy stance would help safeguard macro stability, but the authorities indicated that major fiscal adjustment was not possible in 2013.

  • Staff argued that a tighter fiscal stance in 2013 would contribute to mitigate risks of inflation and a wider external imbalance. It would also represent a step towards ensuring long-term sustainability (¶ 19). In staff’s assessment, a fiscal correction of about 1-1½ percent of GDP in 2013 would be appropriate, taking into consideration inflation and fiscal sustainability concerns as well as the cyclical position of the economy (¶ 20 and AN 3). The authorities noted that, while administrative efforts to contain expenditure and improve tax collections would continue and result in some decline of the fiscal deficit, a correction of the magnitude recommended by staff would require passage of fiscal measures, notably tax reform, through Congress, which the authorities considered unlikely to be enacted before 2014 owing to the parliamentary calendar.

  • The authorities indicated readiness to tighten monetary policy if signs of inflationary pressure emerge. Staff highlighted that, in the absence of fiscal adjustment, actions may be required to keep inflation within the target range. The central bank indicated that, to prevent a resurgence of inflation, it would consider raising the policy rate and allowing greater exchange rate flexibility, probably coupled with adoption of capital flows management measures.

B. Safeguarding Fiscal Sustainability

17. The authorities concurred that current fiscal trends are unsustainable in the long-term. While efforts made in 2011-12 to contain expenditure yielded important results (¶ 6), the fiscal deficit remains well above debt-stabilizing levels. Moreover, in the absence of measures, the consolidated public sector deficit would rise to about 7½ percent of GDP by 2018, driven by higher education and investment spending and a mounting interest bill. This would increase public sector debt to about 50 percent of GDP by 2018 (from 33 percent of GDP at end-2011). The authorities acknowledged that a rise in debt of that magnitude would raise vulnerabilities and erode the underpinnings of macroeconomic stability.

18. The authorities also acknowledged that the pension system’s financial position has to be strengthened. The Old Age, Disability and Survivor insurance plan run by the Social Security agency (Caja Costarricense de Seguro Social or CCSS) as well as the pension funds of the judicial system and teachers are actuarially imbalanced. They are projected to turn a cash deficit over the medium and long term due to system maturation and population aging (AN 3). Preliminary projections suggest that an adjustment equivalent to about 1½ percent of GDP would be required to ensure actuarial equilibrium of all pension systems for the next 100 years. The authorities indicated that a joint study (by the CCSS and the Superintendence of Pensions) would allow determining more precisely the size of the imbalance. Based on the results from the study, gradual corrective measures (in the form of higher contributions, lower replacement rates, an increase in the retirement age, or a combination of measures) would be considered.

19. The authorities agreed that substantial improvement in the primary balance was necessary to attain fiscal sustainability. Staff noted that a permanent improvement in the primary balance of 2½-3 percent of GDP was necessary to stabilize the public debt ratio, and that the improvement would have to be 1½ percentage points of GDP higher to remedy the actuarial imbalance of the pension system (¶ 18), with the long-term fiscal sustainability gap thus totaling 4-4½ percentage points of GDP. Staff also argued that, beyond stabilizing the public debt ratio, it might be prudent to rebuild the budgetary buffers heavily eroded during 2009-10, considering the high sensitivity of public debt dynamics to shocks and the substantial risks to the outlook. Attaining this goal would require an additional improvement in the primary balance of about 1 percent of GDP.

uA01fig13

Costa Rica: Long-Term Fiscal Sustainability, 2011-2070

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: IMF staff estimates.

20. It was recognized that the pace of fiscal consolidation had to strike a balance between lowering the sustainability gap and limiting the adverse impact on growth. While cyclical considerations (output is close to potential) and the rapid pace at which public debt is growing call for significant upfront fiscal tightening, the overall adjustment needed to achieve sustainability should be adopted gradually. Staff analysis suggests that a reasonable balance would be attained by undertaking about one third of the fiscal consolidation in 2013 (or at the latest in 2014) followed by smaller steps in subsequent years (AN 3). With a fiscal multiplier of about 0.3 (multipliers tend to be small when the output gap is virtually closed), consistent with the authorities’ own estimates, the proposed adjustment path would be expected to have a small output cost over the forecast period. At the same time, staff cautioned against further postponing fiscal adjustment, emphasizing that the longer the delay, the larger will be the improvement in the primary balance required to stabilize the public debt ratio. Postponing fiscal consolidation would also increase the risk that currently favorable financial conditions reverse, which would precipitate a disorderly adjustment.

21. The authorities favor a fiscal consolidation strategy with both revenue and expenditure components.

  • Recognizing Costa Rica’s low tax effort, the authorities saw significant scope to increase public revenues. They remained convinced that a tax reform similar to the one they had proposed in 2011-12 had to be the cornerstone of the fiscal consolidation strategy. For this reason, the authorities considered that their plan to resubmit a tax reform proposal to Congress was an important step, as it would allow consensus to be built before a new administration takes office in May 2014. Staff agreed and welcomed new legislation approved in 2012 to strengthen revenue administration.

  • Efforts to contain the growth of current expenditure, particularly wages and transfers, should continue. In this connection, staff welcomed the bill submitted by the government to make the rigid public wage adjustment system more flexible as well as decisions to freeze vacancies and prioritize operational spending.

uA01fig14

Tax Effort in the Region

(Actual/Potential Tax Revenues), 2010 (percent)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Country authorities; and IMF staff estimates.

Costa Rica. Main Elements of the Authorities Fiscal Consolidation Plan

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Source: IMF staff based on national authorities.

C. Upgrading the Monetary and Exchange Rate Policy Framework

22. Staff commended the authorities for having lowered inflation to single digits. Having posted double-digit inflation for almost 30 years, Costa Rica has managed to lower it to 4-6 percent since 2009. This achievement has been underpinned by continued efforts by the central bank to improve monetary control and strengthen its monetary operations framework, notably through the establishment of a corridor for short-term interest rates and the launch of a policy interest rate in 2011. Inflation, nonetheless, remains above that of trading partners. The authorities reaffirmed their goal to reduce inflation to trading partners’ levels (about 3 percent) over the medium term.

23. However, the monetary policy framework still presents weaknesses. Staff argued that the continued adherence to the exchange rate band was undermining the hard-won gains in lowering inflation, and the central bank’s ability to anchor inflation expectations. With the exchange rate at the bottom of the band and persistent appreciating pressures, the central bank has thus far reconciled monetary and exchange rate policy objectives by sterilizing foreign exchange purchases. However, the risk is high that sterilization costs will increase, widening the central banks’ deficit, particularly if capital inflows rise further. Clinging to the rigidity of the current exchange rate band could then lead to higher inflation. The central bank recognized these risks and indicated that, should conflicts arise, the inflation target would take precedence over other objectives.

24. The authorities reiterated their commitment to adopt full inflation targeting, but are concerned that removal of the band would result in abrupt colón appreciation. To protect macroeconomic stability, staff repeated the advice given in past Article IV consultations of eliminating the exchange rate band and establishing the inflation target as the undisputed anchor of monetary policy. This would allow greater use of the exchange rate as a shock absorber. A more flexible exchange rate regime would also make market participants more cognizant of two-way risks in exchange markets, promoting the development and use of hedging facilities and the reduction of foreign currency mismatches. The authorities concurred in principle, but they saw a serious risk of a large appreciation of the colón at the present juncture. To mitigate the latter, the authorities noted that they may consider the adoption of capital flow management measures (CFMs). Staff noted that the elimination of the band would not preclude the central bank from engaging in foreign exchange market interventions to smooth out exchange rate fluctuations as long as these do not undermine the inflation target. At the same time, it stressed that CFMs cannot replace fiscal and monetary policies as the key levers for preventing excessive REER appreciation over the medium term.

D. Financial Stability

25. The authorities are working to implement pending recommendations from the 2008 FSAP update. Progress in implementation has been slow, largely due to a crowded legislative agenda. Key pending steps include empowering the Superintendence of Financial Institutions to conduct consolidated supervision, providing adequate protection to bank supervisors, strengthening bank resolution procedures, and broadening the supervisory perimeter to non-bank financial institutions, all of which require passage of new legislation. On the supervisory front, staff welcomed progress in establishing risk-based supervision, and advised the authorities to step up efforts for its full implementation.

Costa Rica. Financial System Assessment Program (FSAP) Main Recommendations (2008)

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FI: fully implemented; PI: partially implemented; PL: pending legislation; NI: Not implemented.

Source: Superintendence of Financial Institutions.

26. Staff supported the gradual adoption of Basel III standards to improve further the resilience of the financial system. It noted that implementation of Basel III standards should be tailored to the characteristics of the Costa Rican financial system. Staff argued that the regulatory and risk management frameworks would benefit from firming up capital quality and increasing liquidity and capital requirements in line with Basel III standards. In particular, it advised introducing Basel III definitions of capital, a capital conservation buffer, and a leverage ratio. Supervisors agreed and confirmed that a coverage ratio conforming to Basel III will be introduced shortly. Staff estimates that adopting Basel III capital requirements would have a negligible negative growth impact (AN 4).

E. Structural Reforms

27. There was agreement that Costa Rica needs structural reforms to boost potential growth and buttress competitiveness. Staff recommended lifting competition in the banking sector (including by removing legal and regulatory differences between private and public banks), fostering the development of the domestic capital market, addressing infrastructure bottlenecks, and streamlining business regulations. According to staff estimates, efficiency gains from these measures could increase potential growth by up to 2 percentage points over the long run, although these are subject to a considerable degree of uncertainty. The authorities underlined the need to increase investment in infrastructure and noted ongoing projects in this area. They also pointed out progress in increasing competition in the insurance sector, which is expected to contribute to financial deepening.

Reforms to Boost Long-term Growth and Bolster Competitiveness

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Source: World Bank; and Fund staff.

Staff Appraisal

28. Having recovered fast from the global crisis of 2008-09, Costa Rica is well placed to maintain vigorous growth, but external and domestic strains loom large. The output gap that emerged during 2008-09 has almost closed, while inflation is well within the target range and projected to remain stable. However, risks to the outlook are tilted to the downside. On the external front an adverse shock in the U.S. would have a significant impact on growth. As for domestic risks, the current policy mix may not be conducive to lasting macroeconomic stability, and may result in overheating. Surging capital inflows, amidst lax global financial conditions, increase this risk. At the same time, continuing sizable fiscal deficit could hurt confidence and raise borrowing costs.

29. To lessen risks for macroeconomic stability, the fiscal deficit should be reduced and monetary policy prepared for tightening. While spending growth has been contained in the last two years, the fiscal deficit remains large, and public sector debt is rising. With a closing output gap, an early fiscal correction of about 1-1½ percent of GDP would contain the risk of an acceleration of domestic demand, which could stir up price pressures and external imbalances. Such an adjustment would also make an important contribution toward stabilizing the public debt-to-GDP ratio. The monetary policy stance appears conducive to stable inflation. However, risks that inflation may turn higher than anticipated persist. Accordingly, interest rates should be raised and greater exchange rate flexibility allowed, if there is evidence on an inflation uptick.

30. Ambitious fiscal consolidation should be sustained over the medium term. The current fiscal path, with continuously rising government debt, is untenable in the long-term and exacerbates macroeconomic fragilities. The authorities should thus seek to stabilize the public-debt-to-GDP ratio, which would require a permanent improvement in the primary balance of about 2½-3 percentage points of GDP. Additional adjustment (of about 1½ percentage points of GDP) would be necessary to bring the pension system to actuarial equilibrium. The pace of fiscal consolidation should balance the objectives of lowering the sustainability gap and limiting the adverse short-term impact on growth, which is quite feasible, since fiscal multipliers are low when the output gap is small. Reducing gradually the public debt ratio is also desirable to increase fiscal policy buffers.

31. Fiscal consolidation should include both revenue and expenditure measures. The size of the fiscal adjustment required to ensure sustainability calls for a multi-pronged strategy. There is significant scope to increase public revenues, since Costa Rica’s tax effort is low for an upper-middle-income country. In this connection, the intention of the government to seek parliamentary approval of a new version of the tax reform is welcome. In addition, revenue administration should be further strengthened. At the same time, current expenditure growth, which greatly outstripped nominal GDP growth during 2008-10, should be restrained, including through efficiency gains, as planned by the authorities.

32. The monetary policy framework should be strengthened by moving to inflation targeting and allowing greater exchange rate flexibility. Continued adherence to the exchange rate band system may imperil the low inflation achieved in recent years, in light of the strong appreciating pressures exacerbated by the large capital inflows. Sterilization of foreign exchange purchases will become increasingly costly and ultimately compel the central bank to allow higher inflation. To protect macroeconomic stability, the authorities should phase out the exchange rate band and establish the inflation target as the sole nominal anchor of the economy. Foreign exchange market interventions by the central bank to smooth out exchange rate fluctuations and strengthen the NIR position would still be possible insofar as these do not undermine the inflation target. If necessary, these policies, along with appropriate fiscal and monetary policies, could be complemented for a limited period by macro-prudential and other capital flow management measures.

33. Further improvements in regulation and supervision of the financial system are desirable. The risk of a sharp deterioration of the bank loan portfolio following a large depreciation of the colon (given that a sizable share of dollar-borrowers does not generate significant earnings in foreign currency) is of particular concern. To mitigate this and other vulnerabilities, measures recommended in the 2008 FSAP update but still not implemented should be adopted. On the supervisory front, full-fledged introduction of risk-based supervision should be a priority. In addition, the regulatory and risk management frameworks would benefit from firming up the existing capital quality and increasing liquidity and capital requirements in line with Basel III standards.

34. Structural reforms should be pursued to boost potential growth. Measures to lift competition in the banking sector (including by promoting higher private sector participation), foster the development of the domestic capital market, reduce infrastructure bottlenecks, and streamline business regulations are especially important.

35. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Figure 1.
Figure 1.

Costa Rica: Growth & Inflation

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: Country authorities and IMF staff calculations.1/ CAPDR excluding Costa Rica comprises Dominican Rep, El Salvador, Guatemala, Honduras and Panama.2/ LA-6 comprises Brazil, Chile, Colombia, Mexico, Peru and Uruguay.
Figure 2.
Figure 2.

Costa Rica: External Sector

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: Country authorities and IMF staff calculations.
Figure 3.
Figure 3.

Costa Rica: Fiscal Developments

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Country authorities and IMF staff calculations.
Figure 4.
Figure 4.

Costa Rica: Money and Credit

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Source: Country authorities and IMF staff calculations.
Table 1.

Costa Rica: Selected Social and Economic Indicators

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

The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises, and the central bank, but excludes the Instituto Costarricense de Electricidad (ICE).

The consolidated public debt nets out central government and central bank debt held by the Caja Costarricense del Seguro Social (social security agency) and other entities of the nonfinancial public sector.

Table 2.

Costa Rica: Balance of Payments

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

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

Includes public and private sector debt.

Table 3.

Costa Rica: Central Government Balance

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Sources: Ministry of Finance; and Fund staff estimates.

Transfers to the Social development and Family Transfers Fund (FODESAF) are recorded in net terms.

The inflation adjustment of the principal of TUDES (inflation indexed bonds) was recorded as interest expenditure.

Table 4.

Costa Rica: Summary Operations of the Central Government, GFSM 2001 Classification

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Sources: Ministry of Finance; and Fund staff estimates.

Transfers to the Social development and Family Transfers Fund (FODESAF) are recorded in net terms.

The inflation adjustment of the principal of TUDES (inflation indexed bonds) was recorded as interest expenditure.

Includes subsidies, transfers and other expense.

Table 5.

Costa Rica: Consolidated Public Sector Operations 1/

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Sources: Ministry of Finance; and Fund staff estimates.

The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises and the Central Bank, but excludes the Instituto Costarricense de Electricidad (ICE).

Expenditure was adjusted downward in 2010 and upward in 2011 by ½ percent of GDP to reflect a capital project recorded in 2010 but undertaken in 2011.

The inflation adjustment of the principal of TUDES (inflation indexed bonds) was recorded as interest expenditure.

Table 6.

Costa Rica: Summary Operations of the Consolidated Public Sector, GFSM 2001 Classification 1/

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Sources: Ministry of Finance; and Fund staff estimates.

The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises and the Central Bank, but excludes the Instituto Costarricense de Electricidad (ICE).

The inflation adjustment of the principal of TUDES (inflation indexed bonds) was recorded as interest expenditure.

Includes subsidies, transfers and other expense.

Table 7.

Costa Rica: Public Sector Debt

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Sources: Ministry of Finance; and Fund staff estimates.

Excludes the debt issued by the Instituto Costarricense de Electricidad (ICE).

Caja Costarricense del Seguro Social (social security agency).

Table 8.

Costa Rica: Monetary Survey

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Sources: Central bank of Costa Rica; and Fund staff estimates.
Table 9.

Costa Rica: Medium-Term Framework

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

External current account deficit.

Table 10.

Costa Rica: Banking Sector Indicators

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Source: Superintendency of Banks (SUGEF).

Difference between implicit loan and deposit rates.

Table 11.

Costa Rica: Medium-Term Framework Under Fiscal Consolidation Scenario

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

External current account deficit.

Table 12.

Costa Rica: Central Government Debt Sustainability Framework, 2010-2018

(In percent of GDP, unless otherwise indicated)

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Source:

Central government debt.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g + p + gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = 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 ae(1+r).

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

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.

Figure 5.
Figure 5.

Costa Rica: Central Government Debt Sustainability: Bound Tests 1/

(debt in percent of GDP)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: International Monetary Fund, country desk data, and Fund staff estimates.1/ Shaded are as 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/ Ten percent of GDP shock to contingent liabilities occurs in 2009.
Table 13.

Costa Rica: Consolidated Public Sector Debt Sustainability Framework, 2010-2018

(In percent of GDP, unless otherwise indicated)

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Source:

Consolidated public sector debt.

Derived as [(r - p(1 + g) - g + ae(1 + r)]/(1 + g + p + gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = 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 ae(1+r).

Comprises pre-financing, net purchases of private sector assets by the social security agency and issuance of monetary sterilization bonds.

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

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

Figure 6.
Figure 6.

Costa Rica: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: International Monetary Fund, country desk data, and Fund staff estimates.1/ Shaded are as 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/ Ten percent of GDP shock to contingent liabilities occurs in 2009.
Table 14.

Costa Rica: Consolidated Public Sector Debt Sustainability Framework (Under Fiscal Consolidation Scenario), 2010-2018

(In percent of GDP, unless otherwise indicated)

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Source:

Consolidated public sector debt.

Derived as [(r - p(1 + g) - g + ae(1 + r)]/(1 + g + p + gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = 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 ae(1+r).

Comprises pre-financing, net purchases of private sector assets by the social security agency and issuance of monetary sterilization bonds.

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

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

Table 15.

Costa Rica: External Debt Sustainability Framework, 2010-2018

(In percent of GDP, unless otherwise indicated)

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Source:

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 US 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 inflation (based on GDP deflator).

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.

Figure 7.
Figure 7.

Costa Rica: External Debt Sustainability: Bound Tests 1/ 2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2013, 079; 10.5089/9781484382646.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded are as 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/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

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Cover IMF Staff Country Reports
Costa Rica: 2012 Article IV Consultation
Author:
International Monetary Fund. Western Hemisphere Dept.
Volume/Issue:
Volume 2013: Issue 079
Publisher:
International Monetary Fund
ISBN:
9781484382646
ISSN:
1934-7685
Pages:
75
DOI:
https://doi.org/10.5089/9781484382646.002

Real GDP growth and contributions to growth

(in percentage points)

Headline and core inflation

(percent y/y)

Exchange rate

(colones per US$)

Net international reserves and central bank foreign exchange purchases

(millions of US$)

Headline Fiscal Balance, Cyclically-adjusted Balance and Fiscal Stimulus

(percent of GDP)

Costa Rica: Export market shares

(percent) 1/

Costa Rica: External current account

(percent)

Costa Rica: Real effective exchange rate

(changes in percent since January 2005) 1,2/

Costa Rica’s GDP growth and fiscal deficit are higher than the CAPDR average, while inflation and the current account deficit are lower than the regional average

Monetary and Financial Conditions Index

(percentage points of y/y real GDP growth)

Costa Rica: Growth Forecast and Simulation, 2008-2014 (percent)

Costa Rica: Long-Term Fiscal Sustainability, 2011-2070

(Percent of GDP)

Tax Effort in the Region

(Actual/Potential Tax Revenues), 2010 (percent)
Figure 1.

Costa Rica: Growth & Inflation
Figure 2.

Costa Rica: External Sector
Figure 3.

Costa Rica: Fiscal Developments
Figure 4.

Costa Rica: Money and Credit
Figure 5.

Costa Rica: Central Government Debt Sustainability: Bound Tests 1/

(debt in percent of GDP)
Figure 6.

Costa Rica: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)
Figure 7.

Costa Rica: External Debt Sustainability: Bound Tests 1/ 2/

(External debt in percent of GDP)