Abstract
The economy recovered quickly from the global crisis of 2008–09, with healthy growth and low inflation. Growth has, however, slowed recently and is expected to remain subdued in the short run, since gains from recovery in the U.S. will be offset by the closure of the Intel manufacturing plant. Inflation is elevated, owing primarily to exchange rate (XR) depreciation triggered by global repricing of emerging market assets in early 2014. Risks to the outlook are tilted to the downside. Absent consolidation, large fiscal deficits would make public debt dynamics unsustainable in the long-run.
The Costa Rican authorities thank staff for a very constructive dialogue during the Article IV consultation and concur with the report’s main findings and recommendations.
A new government took office last May after a second round presidential election, marking a first time win for the Citizens’ Action Party. The government plans to boost economic growth and reduce unemployment by addressing infrastructure bottlenecks, supporting SME, fighting red tape and other reforms. The authorities’ agenda also contemplates reduction of poverty and income inequality, both high for the country’s standards. Since its inception the government has been dealing with a high fiscal deficit and has put in place many measures to tackle it.
Recent Developments
Thanks to the authorities’ efforts the fiscal deficit, previously projected at 6.3 percent of GDP, closed 2014 at 5.6 percent. Upon enactment of a decree to freeze 85 percent of vacancies in July 2014 and other measures, the government has managed to reduce the growth of spending from 14 percent in 2013 to 9.3 percent in 2014. Moreover, as capital spending grew at 16 percent, the burden of the adjustment fell on current spending that grew at 8.71 percent compare with 13.4 percent in 2013.
As stated in the report, authorities and staff concur on the size, pace and composition of the fiscal adjustment. The Finance Minister has presented a 3.8 percent of GDP fiscal consolidation plan that includes reform of current taxes, rates2 and spending measures, as well as a freeze on real salaries.
The macroeconomic context is positive. Inflation, at 5.1 percent, closed near its target range even after a considerable depreciation during the first semester. Growth would be only partially affected by the proposed fiscal consolidation and is expected to return to potential in the medium term. Stronger growth in the U.S., Cost Rica’s main trade partner, and prolonged lower oil prices would improve growth prospects.
Despite the closure of Intel manufacturing plant, external accounts are healthy and FDI remains high. Reserves are within IMF adequacy metric.
Fiscal Policy
Revenues
Tax avoidance and tax evasion accounted for 7.75 percent of GDP3 while exemptions account for 6 percent of GDP. Together they exceed the current tax revenue. Since May 2014, the government has put in place a number of administrative initiatives to fight tax evasion and tax avoidance, one of the most relevant being the obligation by every firm to withhold 2 percent of each sale as a corporate income tax presumption4. The electronic invoice is expected to become mandatory this year and will join the set of tools to fight evasion.
These measures are being complemented by two law initiatives already under congress review, the anti-tax evasion law and the anti-smuggling law5. While the former strengthens tax controls and enforces collection, the latter fights smuggling by overhauling the legal framework and increasing sanctions and penalties.
The authorities are aware that all these measures account for a small portion of the needed fiscal consolidation. The broad part of the adjustment is expected to come from the reform to the VAT and income tax. In the current VAT setup, services, the most dynamic sector of the economy, are exempted. The reform will include them into the taxable base exempting basic goods6, education and health services.
In the case of income tax, the government is working to change the current schedular system for a global determination of the tax liability. At the time of the Article IV mission in November, the VAT reform and the income tax reform were to be sent for Congress approval in December 2014 and February 2015, respectively. However, to compensate some of the regressive effects of the VAT reform some members of Congress opted to approve both reforms together. This makes March the new date to present both initiatives.
During the first semester of 2015, the authorities plan to present another exemptions related reform. It will streamline the current setup, incorporate sanctions and regulate the creation of exemptions, for instance by setting an expiration date.
Expenditure and Financing
On the expenditure side, the government cut the 2015 budget in 0.4 percent of GDP and will maintain the partial hiring freeze. Salaries are going to be frozen in real terms. Those are tangible actions that will impact the 2015 expenditure invoice. A number of law initiatives will be also sent to congress during 2015 and will have a permanent effect on the fiscal accounts, such as a cap on pensions paid out of the budget and a strengthening of the system, a cap on high salaries and the public employment law.
While fiscal measures begin to yield, the government will use external financing in order to avoid crowding out domestic market and pressure interest rates. It is expected to place one billion dollars in international markets during 2015 and contingent credit lines with World Bank and IADB for 2016 are being negotiated.
Monetary and Exchange Rate Policy
Inflation ended 2014 close to the target range despite an important depreciation of the Colon during the first semester. The authorities agree with the importance of allowing for more XR flexibility and concur that the elimination of the band could be the next step. However, we would like to provide more details regarding the FX market in Costa Rica and the Central Bank’s (BCCR) rational behind maintaining veiled some aspects of the intervention rule. As the report states, the main objective of the rules is to avoid excessive short-term fluctuations without interfering with the medium-term trends. BCCR intervention is framed into a robust set of regulations approved by the Board of Directors and a special committee7. Daily when market closes BCCR publishes the balance negotiated in the market as well as the amount of the intervention, if any. The intervention trigger, the amounts allowed and other elements were approved by the Board based on technical advice. BCCR’s staff is in charge of the execution with no discretion allowed and under the constant scrutiny of the audit department. The BCCR’s Board of directors has decided to maintain specific intervention criteria private since Costa Rica FX market is small and dominated by few banks, thus disclosure of those specific details would facilitate speculation against small agents. The system works in a very transparent way.
Financial system
The financial system is sound and as the report recognizes “…only a few banks are not yet in full compliance with Basel III standards…” The pending reforms have been delayed by an overwhelming fiscal and trade agenda in congress over the last years. Notwithstanding, the authorities have requested the IMF for TA on conglomerate supervision in order to expedite the reform process.
Structural reforms
We concur competitiveness needs to be improved. The country ranks 51th (third in Latin-American region) in the Global Competitiveness Index 2014-2015. Infrastructure bottlenecks, excessive regulatory environment, ease of doing business and concerns on the efficiency and efficacy of education spending are among the diagnosed problems being addressed by the authorities. The government has secured more than USD 1.5 billion coming from multilateral and bilateral sources to overhaul road infrastructure and a comprehensive strategy has been put into place to launch execution. The environmental agency has just granted final approval to begin the construction of a USD 1 billion mega-port in the Caribbean coast by APM Terminals8.
With regard to electricity tariffs, they are relatively well-positioned against different benchmarks, more so taking into account that 80 percent of the electricity comes from renewable sources.
The recent withdrawal of Intel, more than signaling competitiveness problems in Costa Rica, was the result of changes in the personal computers global market. Due to this fact the company is closing or downsizing microprocessor chip manufacturing lines, also in other markets. But it is not exiting the country; an important division of R&D is going to be upgraded.
Thanks to its well- educated work force, the country continues attracting foreign corporations from the technology and services sectors. In fact, FDI was in line with the authorities’ projection, totaling USD 2.2 billion in 2014. The medical sector, mainly manufacturing technological devices, is booming with 63 firms already operating and new investments in the pipeline. This technology industry is less sensitive to economic downturns than other sectors.
With regard to trade integration, Costa Rica began the process of joining the Pacific Alliance9 on February 10, 2014. This bloc not only will boost trade among members but also may serve as a platform toward the Asia-Pacific region. The authorities are also fully committed with the action plan to become a member of OECD.
This is the lowest current spending growth rate in 6 years.
Gradually from 2016 onwards.
2012 estimations.
This measure was initially appealed in the administrative court but it has been recently affirmed.
These law initiatives were sent to congress in July and November 2014 respectively.
In the case of basic goods the authorities plan to eliminate the exoneration as soon as the subsidy system works. They will subsidize the first 3 deciles.
The Financial Stability Committee is formed by the central bank’s president, manager and relevant directors.
APM Terminals is part of the MAERSK Group.
The founding members are Chile, Colombia, Peru and Mexico. If counted as a single country this group of nations would be the sixth largest economy in the world