Costa Rica: Selected Issues and Analytical Notes

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

VI. Transition to a Flexible Exchange Rate: Lessons from Past Experience1

This note considers the presence in Costa Rica of the basic pre-conditions for a smooth transition to greater exchange rate flexibility and inflation targeting. We conclude that Costa Rica would benefit from further exchange flexibility, which would help foster greater resilience to external shocks, and avoid the build-up of imbalances, in particular, in the face of a deteriorating fiscal position. The experience of other countries suggests that Costa Rica already has some important elements in place to support a successful transition, including a spot foreign exchange market, some components of inflation targeting, a basic prudential framework to monitor FX risks as well as a largely liberalized capital account. However, more could be done to prepare Costa Rica for a smooth exit, including developing foreign exchange derivative markets, strengthening the inflation targeting framework, as well as developing a coherent and transparent intervention strategy.

A. Background

1. The central feature of Costa Rica’s current exchange rate regime has been its fluctuation band.2 Costa Rica has been following different variations of crawling pegs since the mid-80s in the context of an open capital account. The main focus of monetary policy was the real exchange rate with the goal of achieving external sustainability and growth. However, this policy had been accompanied by a persistent double-digit inflation. To combat high inflation, the Central Bank (CB) announced a gradual move towards Inflation Targeting (IT). The single rate crawling peg was replaced with a crawling band in 2006 and the band was widened twice in 2007. Open market operations were streamlined and the central bank established an overnight facility. A law to recapitalize the central bank was submitted to the legislature. But no specific date for IT introduction or a clear transition plan was announced. In 2008, the floor of the band was set flat and its width temporarily narrowed. However, in 2009 the width was increased and the ceiling was allowed to crawl at a higher rate. The lower bound is now fixed at C500.00 per U.S. dollar while the upper bound increases at a rate of C0.2 per U.S. dollar per business day. As a result, the band has progressively widened and currently comprises ±25 percent around a theoretical mid-point.

A06ufig1

Daily Exchange Rate

(Colones per U.S. dollar)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A006

2. The dynamics of the exchange rate within the band changed over time. Initially, the exchange rate tracked the upper bound closely. However, with the onset of the global financial crisis it appreciated and remained at the lower bound with minor deviations during 2010–2013—the period of external inflows. In the wake of U.S. monetary policy normalization at end-2013, external inflows into Costa Rica slowed and domestic residents adjusted their portfolios, resulting in about 10 percent depreciation by March 2014 with partial reversal later in the year. The exchange rate stabilized away from the bottom of the band, but the upper bound still appears non-binding with a potential for depreciation of about 55 percent and one for appreciation of only 8 percent.

3. As the exchange rate depreciated in 2014, the authorities intervened. The Central Bank accumulated sizeable reserves since the beginning of the global financial crisis as capital inflows accelerated and the exchange rate remained at the bottom of the band. Reserves stood at US$7.3 billion at end-2103, equivalent to 5.6 months of non-maquila imports. In the wake of sharp depreciation in 2014, the Central Bank intervened to stabilize the exchange rate, losing about 7 percent of its end-2013 reserve stock. There have been no official reserve sales since July 2014 and reserve coverage remains adequate. Amid the exchange rate volatility of early 2014, the CB announced changes in the intervention rule to allow for larger interventions. However, the parameters of the rule have not been disclosed.

4. The greater exchange rate volatility comes in the context of rising external and domestic risks. Growth faces headwinds from the withdrawal of Intel’s manufacturing enterprise. The possibility of a growth slowdown in emerging and advanced economies as well as a surge in financial market volatility in the context of U.S. monetary policy normalization pose downside risks. Also, Costa Rica has a large fiscal deficit. The Central Government’s overall deficit is expected to continue rising to 53/4 percent of GDP by 2019 with public debt reaching 51 percent of GDP.

B. Dangers of Exchange Rate Inflexibility and the Advantages of Flexibility

5. There is no analytical consensus regarding the optimal exchange rate regime. While as a general matter, the Fund tends to recommend greater exchange rate flexibility, this comes along with recognition that this advice may not be suitable for all countries at all times. Indeed, in as much as a consensus on optimal exchange rate regimes exists, it is that the optimal regime for any country at any given time depends on specific circumstances.

6. However, there is agreement on the danger of a fixed exchange rate coupled with strong macro imbalances, most prominent of these being an unsustainable fiscal position. Unsustainable fiscal deficits create a vicious cycle, as agents demand higher interest rates, which, in turn, worsen the fiscal position. As investor fears of either a monetization of public debt or default increase, pressures mount on the exchange rate. In a fixed exchange rate regime, these pressures can lead to a sharp drop in international reserves. Once reserves are exhausted, a sudden and severe depreciation results, usually along with an overall macroeconomic crisis. Different versions of this scenario played out during the Latin American debt crisis of the 1980s.

7. The experience of Costa Rica during its crisis in the 1980s illustrates the point. In the late 1970s, Costa Rica faced a decline in its terms of trade while higher world interest rates made external financing more expensive. Nonetheless, Costa Rica continued following expansionary policies, with the NFPS deficit rising to 11 percent and the current account deficit surging to 14 percent of GDP by 1980. With foreign financing drying up, the country suspended payments on its foreign debt service and abandoned the long-standing peg with exchange rate depreciating sharply. As the crisis unfolded, the real GDP fell by 5 percent, inflation surged to 65 percent and unemployment doubled to almost 9 percent.

8. More generally, while a flexible exchange rate regime cannot correct for fiscal imbalances, it may help avert a crisis. Flexible exchange rate regimes are no panacea in the face of fiscal sustainability problems. Indeed, allowing the exchange rate to depreciate could increase the cost of debt service, as FX debt becomes more expensive. However, allowing pressures on the external position to be absorbed by the exchange rate could help prevent a sudden drop in reserves and a disorderly and abrupt devaluation.

9. In drawing lessons from the 1981 crisis, it is critical not to overstate the parallels to the current state of the Costa Rican economy. The fiscal deficit in 1980 stood at 11.2 percent of GDP, compared to 5.4 in 2013. The external debt-to-GDP ratio alone stood at 56 percent, compared to 42 percent in 2013. The 2013 current account deficit of 5 percent of GDP was only about one third of the level in 1980. The current exchange rate regime also features a much greater degree of flexibility than in the run-up to the 1981 crisis. Nonetheless, both periods do have some commonality in the pairing of worsening fiscal imbalances coupled with less than fully flexible exchange rate regimes.

10. Greater exchange rate flexibility could offer other advantages to Costa Rica. Flexibility can allow for the better absorption of global shocks. With a flexible exchange rate, changes in world prices would be transmitted more directly to economic agents within the country, thereby aligning incentives to prevailing international conditions. Moreover, an expectation of flexibility would lead to the internalization of exchange rate risk by both creditors and debtors, which could facilitate de-dollarization of the financial system.

C. Moving Toward Exchange Rate Flexibility: Experiences and Lessons from Other Countries

Section 1. Orderly transitions3

Chile (1984–99)

11. Chile’s transition to a flexible exchange rate was gradual, lasting 15 years. It occurred through a successive adjustment of the parameters of the band, including gradual step-by-step widening of the band, changes in the rate of crawl, as well as discrete adjustments to its central parity. The move towards flexibility was a response to changing economic conditions and an attempt to resolve conflicts among preserving external competitiveness versus anchoring inflation expectations, in particular, with a surge in capital inflows. The latter was tackled through imposition of capital controls, which were gradually lifted during transition to a float.

12. Several elements facilitated a smooth exit:

  • A relatively low degree of exchange rate pass-through. The pass-through from exchange rate to inflation was ex-post estimated at 0.2–0.3 though the pass-through was estimated as high as 0.6 during the transition due to the available earlier estimates. The estimates of pass-through for Chile are close to staff estimates for Costa Rica (see Analytical Note V).

  • Highly developed FX and financial markets minimized the negative effects and mitigated the fears of floating. Spot and forward markets developed over time as the authorities liberalized the regulations affecting arbitrage operations, authorized swap transactions, eased access to FX market, and allowed greater exchange rate flexibility. Capital markets were also well-developed, in part, due to the emergence of institutional investors (pension funds), which covered a large share of the demand for debt instruments.

  • A low level of dollarization and a prudent attitude of the private sector to exchange rate risk. The financial sector was more exposed than the corporate sector but the banks were also more familiar with risk management strategies and were able to hedge in offshore markets. The liberalization of the currency mismatch regulations was gradual. In the beginning, the banks were required to finish daily with a long cash position in their trading activities and FX operations while derivatives transactions were permitted only to support trade activities or investments abroad. Later the authorities introduced a framework for managing liquidity and interest rate risks and liberalized derivative transactions. Currency mismatches of debtors were incorporated in the credit evaluation of banks after XR was liberalized. Tight prudential rules and a well-functioning and liquid forward market helped manage FX risks in the private sector.

  • Gradual capital account liberalization, which happened in parallel. Controls on the outflows were removed first while retaining the market-based controls on inflows (unremunerated reserve requirements) till the end of the transition. Controls on derivative transactions were relaxed through the transition to facilitate handling of FX risks.

  • Implicit IT framework in place. The changes in XR regime proceeded in parallel with the efforts to establish an alternative monetary policy framework. From 1990 a pre-announced inflation band target co-existed with the crawling band. Most of the IT elements were in place before the exit to a float, including autonomy of the central bank, well-developed and liquid financial markets, an effective capacity to conduct monetary operations, and a reasonable capacity to forecast inflation. A relatively good understanding of the transmission mechanism helped. Over the years, the CB gained credibility through the success in meeting the inflation targets and improved transparency through the publication of regular inflation reports and the release of the minutes of the policy meetings.

13. A coherent and transparent intervention rule. With the crawling band, the authorities intervened in the FX market on discretionary basis. After the adoption of the floating exchange rate the CB announced the possibility of intervening in exceptional situations. The interventions in the foreign exchange market were restricted to cases in which the real exchange rate was deemed to have deviated substantially from its equilibrium level, and the situation might prove damaging to the economy as a whole. Since the move to a floating exchange rate such interventions have taken place four times: in 2001, 2002, 2008, and 2011. The maximum amount and the specific period during which the CB could intervene were announced. However, no specific level of the exchange rate or any other measurable goals were targeted.

  • A well-developed and regulated financial sector. By the time of the float the banking sector was sound with a large capital base, low level of dollarization, and relatively low non-performing loans. A strict regulatory and supervisory framework that limited exposure to credit and FX risk was also in place.

  • Prudent fiscal policy. Fiscal authorities managed to maintain a fiscal surplus during the transition period, which facilitated lower inflation.

14. The main challenge was to determine the timing of the introduction of the floating regime. Assessing the state of preparedness was difficult. The fear of losses from currency mismatches and of the potential pass-through from exchange rate to inflation contributed to a delay in exit. The lack of the reliable and prompt information (outdated pass-through estimates, lack of information on household and corporate balance sheets, uncertainty about the level of derivatives market) contributed to the delay. The mismatches turned out to be less substantial and the availability of hedging better than had been assumed.

Israel (1985–2005)

15. Israel’s transition was more gradual than that of Chile, lasting 20 years. Israel chose a gradual approach, in part as a result of an unsuccessful attempt for a sudden exit in 1977. The transition included: (i) an introduction of a hard peg to the USD, which helped reduce inflation from three-digit to two-digit level; (ii) a move towards a peg to a basket of currencies to smooth the volatility of bilateral rates to USD; (iii) an introduction of horizontal bands in response to persistent inflation differentials (iv) widening of the band in the wake of capital inflows; (v) replacing the horizontal band with the crawling band; (vi) the adoption of a crawling fan in the wake of capital inflows and increased sterilization costs; and finally, (vii) the abolishment of the band when it was essentially irrelevant.4

16. Successful transition to a flexible exchange rate was supported by several elements:

  • Development of foreign exchange and capital markets. The FX market expanded with the entry of interbank brokers, foreign financial institutions, electronic trading, an increase in derivative products, spurred by increased exchange rate flexibility and, in some cases, due to the active involvement of the authorities. To address the fears of speculation with derivative products the authorities established safeguards such as maintaining documentation requirements for underlying transactions, allowing in stages forward transactions of longer maturities, and incorporating banks’ direct and indirect exposures to FX risks associated with derivatives into prudential norms. Efforts were also made to develop the capital markets with the government increasing the issuance of standardized marketable securities.

  • Gradual capital account liberalization. The restrictions on long-term flows were liberalized earlier than those on short-term flows and restrictions for non-residents were lifted before those for residents,

  • Coherent intervention policy. With horizontal and crawling bands, interventions were often used as an ad hoc response to exchange rate developments. Regular interventions by the central bank at times tried to influence the path of the exchange rate to preserve competitiveness, and at times to keep it within an informal “inner band” to preserve its nominal anchor role. The central bank resisted stronger nominal depreciation than appreciation in light of hyperinflationary past, structural rigidities, and the strong pass-through effect to inflation. As markets gained confidence in the commitment and the ability of the central bank to keep exchange rate in a relatively narrow range, capital inflows ensued. The CB reduced and then fully ceased interventions with the move to the crawling fan—a policy maintained until the formal abolition of the fan 8 years later. The credibility of the regime was strengthened in the handling of contagion from the Russian debt crisis and the collapse of Long-Term Capital Management hedge fund, during which the CB did not intervene despite the rapid and sizeable depreciation. The intervention policy became more transparent over time, moving from not announcing the central bank goals other than the formal bands to a policy of nonintervention, which gained considerable credibility. Since the global financial crisis, however, the CB has been intervening in the FX market, first at fixed amounts to increase the level of reserves, and later when sharp fluctuations were deemed not in line with macroeconomic fundamentals.

  • Efforts to ensure financial stability and capability to monitor FX risks. Banks and supervisors gained the necessary capabilities to monitor and manage FX risks by the time of the exit, including explicit policies regarding management of direct and indirect FX exposures (e.g. charges against FX exposures, requirements of additional provisions against FX credit extended to borrowers with no FX income, maintenance of required minimum levels of FX liquidity). Banks’ capital base had also been strengthened and modern market risk management techniques had been put in place.

  • Effective monetary policy and instruments. The introduction of a de facto inflation targeting with a move to the crawling band laid out the foundation for an alternative nominal anchor before the float. Monetary policy instruments to support IT were developed at an early stage. Reserve requirements were reduced, short-term central bank bills were introduced, and the policy interest rate became the primary channel of monetary policy.

17. The exit was also somewhat delayed. The regime was maintained when the bands had already become irrelevant owing to: (i) the difficulty of ascertaining that the band had indeed become irrelevant, (ii) a belief that even if the band was not binding, its existence affected the behavior of the market, and that its abandonment would be destabilizing, (iii) the opposition to abandoning the band since it would give greater freedom of action to the central bank, even if only in principle.

Poland (1990–2000)

18. Poland transition was gradual but faster than that of Chile or Israel, lasting 10 years.

The evolution of the exchange rate regime was largely in response to the introduction of the market economy principles, privatization and restructuring of enterprises, development of the financial system, and increasing openness. The XR regime evolved through 5 main stages: (i) a fixed peg initially vis-a-vis the dollar and then vis-à-vis a currency basket, which helped reduce inflation from four-digit to double-digit level; (ii) a preannounced crawling peg, (iii) a crawling band that was widened in several steps - a compromise between disinflationary and competitiveness goals; (iv) a de facto float with a formal wide crawling band while retaining an eclectic monetary policy framework focusing on both interest rates and exchange rate amidst capital inflows; and, (v) a free float, which was stimulated by the need for faster disinflation, high sterilization costs and as a result of the monetary policy regime change.

19. Structural reforms strengthened sustainability and credibility of the transition:

  • Development of monetary operations, FX, and financial markets. The development of interbank deposit and Treasury bill markets facilitated banks’ management of liquidity and monetary policy conduct. The CB contributed to the financial market development by creating infrastructure and institutions, setting standards, and creating incentives for market participants. The FX market was supported by increased exchange rate flexibility, with spot market being well-developed by the time the CB ceased interventions, while the derivative market developing gradually with the significant pick up only one year before the float.

  • Gradual capital account liberalization. Capital account liberalization was based on careful sequencing. FDI was liberalized first while long-term portfolio and credit flows were liberalized after the significant reduction in interest rate differentials and increased exchange rate flexibility. Inflows were liberalized before outflows. Short-term capital movements and derivative transactions were liberalized only after the introduction of the float.

  • Coherent central bank communication strategy. The intention to switch to a crawling band was announced in advance, which allowed time for banks and real economic agents to prepare for the new regime. Transparency associated with the exit from the crawling band to a free float was more complex. The intention to move towards IT was announced a few months in advance of the move to a float. However, transparency was more limited with respect to operational decisions (e.g. revaluations, crawling rate reductions), which were often announced one day in advance or not announced at all to avoid speculation.

  • Efforts to improve financial stability. At the start of transition the banking sector was undercapitalized, poorly managed, and segmented, with underperforming loans being a threat to financial stability. The authorities took measures to recapitalize the banks, restructure bad loans, strengthen supervision, and introduce more restrictive standards, including tight limits on open FX positions. The result was improved credit quality, increased capital base, and modernized risk-management techniques. Specific capital requirements as well as close monitoring of FX risks were adopted only after the move to a float.

  • Coordination between the central bank and the ministry of finance. It allowed reducing market volatility related to large-scale operations related to public sector debt management and privatizations.

  • Coherent and transparent intervention policy. In the beginning, the CB conducted two types of FX interventions:”direct”, performed by the CB dealers, and “indirect”, the so-called fixing transactions with each domestic commercial bank conducting one FX transaction with the CB at the end of the day. The direct interventions were used to maintain an unofficial (“inner”) intervention range within the band while “fixing” was intended to help small banks to close open positions in a segmented FX market (in practice large banks also used this facility). For two years the CB limited the flexibility of the exchange rate within the “inner” limits to resist strong appreciation pressures but the interventions became more reluctant thereafter. The CB did not intervene in the wake of the 1998 Russian crisis when the currency depreciated sharply. Interventions became more transparent over time. The limits of the “inner” band were discretionary and not public. With the move towards greater flexibility, the CB ceased direct interventions and abolished the fixing arrangement. After the official floating the CB retained the right to intervene in the FX market, should it prove necessary for the achievement of IT. While there is no formal exchange rate goal, discretionary interventions are allowed. However, the CB abstained from interventions until April 2010, with only occasional interventions thereafter.

Section 2. Disorderly transitions include Brazil in 1999, the Czech Republic in 1997 and Uruguay in 20025

20. In disorderly exits the shift to greater exchange rate flexibility came in response to market pressures, which reflected underlying macroeconomic weaknesses. In each of these countries, the catalyst of the disorderly exit was external contagion. For Brazil, the contagion came from the Russian crisis, for the Czech Republic from the Asian crisis, and for Uruguay from the Argentine crisis. The contagion was precipitated by the short-term capital inflows in the context of tight monetary coupled with expansionary fiscal policies. Downward pressures on exchange rates emerged as the flows reversed. In the case of Uruguay, the sudden shift in market confidence was exacerbated by a high degree of dollarization of the banking system.

21. All three countries exited quickly, but the lack of supporting elements hampered credibility and prolonged the period of instability. The exit happened within about six months from the onset of market pressures. FX derivative markets were absent or underdeveloped in all three countries. While Brazil and the Czech Republic had operational monetary policy instruments, the pass-through of interest rates to inflation was weak. In Uruguay basic elements of the effective monetary policy framework were lacking. All of the countries moved toward IT, though the speed of the exit and the lack of sufficient preparation hindered credibility of the policy targets. Partly as a result, all continued to intervene heavily the FX markets until market pressures abated. Nevertheless, the existence of some of the supporting factors helped minimize the negative impact of instability in Brazil and Czech Republic.

22. In all of the cases of disorderly exit, the authorities continued interventions in the FX market, though the countries followed different approaches. In Brazil, the central bank announced that interventions would be occasional and limited, but didn’t specify a rule. Interventions subsequently picked up 2001–2002 in the wake of the Argentine crisis. In the Czech Republic, the central bank also did not adopt a rule, but did intervene in order to stabilize fluctuations, especially resulting from capital inflows. Intervention volumes were announced ex post. By contrast, immediately after floating Uruguay introduced daily FX auctions governed by a specific rule, namely that interventions were limited to fulfilling the central banks pre-announced FX liquidity needs. However, once the credibility of the new regime became better-grounded, the rule was dropped and interventions became less transparent.

Section 3. Summary of the historical experiences and lessons from orderly and disorderly transitions

  • Greater flexibility was introduced when multiple monetary policy objectives became incompatible: growing emphasis on reducing inflation, compared to other goals e.g., competitiveness. Exits were accelerated by the surge in capital inflows. In disorderly cases, the transitions were the result of market pressures highlighting weak fundamentals, in particular, fiscal imbalances, which could undermine the credibility of the monetary and exchange rate policies.

  • Orderly transitions were gradual and lengthy (between 10 and 20 years) while disorderly transitions were quick (about 6 months).

  • Slow transition process in the case of orderly exits allowed establishing elements that are needed to mitigate concerns about floating, namely, undermining policy credibility, loss of competitiveness, pass-through to inflation and the effects on the balance sheets.

The key ingredients for a successful transition to a float included:

  • A deep and liquid foreign exchange market and financial markets supported by a stable financial system;

  • Effective systems for reviewing and managing the exposure of both the public and private sectors to exchange rate risk;

  • An appropriate alternative nominal anchor and, more generally, an effective monetary policy framework

  • A coherent and transparent intervention strategy

  • Advanced preparation paid off: having the main ingredients of flexibility in place before the transition as well as agreeing on the principles of the transition and characteristics of the new regime facilitated transitions.

  • In orderly transitions, establishing the individual supporting elements was mutually reinforcing in that increased flexibility helped build the capacity for a float (e.g. the development of hedging instruments was stimulated by the introduction of the higher degree of flexibility). Hence, it is important to strike a balance: a premature introduction of exchange rate flexibility can be damaging, however, too much emphasis on meeting all preconditions may unduly prolong the move.

  • Having good understanding of the transmission mechanism as well as the dynamics between the exchange rate and inflation could facilitate the transition.

  • Consistent decision making and coordination between the central bank and the government is important. Policy reversals could be damaging to the credibility of the central bank with large costs to the economy.

  • Both orderly and disorderly transitions were durable, i.e. no major reversals though in case of disorderly exits establishing monetary policy credibility turned out to be more difficult,

  • Inflation and its volatility declined after both orderly and disorderly transitions (Figure 1). Nominal exchange rates became more volatile after orderly transitions, but the average annual depreciation declined in both cases. In both cases, the real effective exchange rate depreciated after transitions, thereby, improving competitiveness and reducing the current account deficits. FDI flows improved slightly while more risky portfolio flows declined. The degree of FX market intervention declined in both orderly and disorderly transitions.

Figure 1.
Figure 1.

Costa Rica: Historical Experiences with Transitions to Exchange Rate Flexibility

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A006

Source: Fund staff estimates.
A06ufig2

Exchange Intervention Index for Selected Countries that Switch from Fixed to Floating Exchange Rate 1,2/

(Percent)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A006

Sources: WEO and Fund staff estimates.1/ Five-year window before and after the change in regime, excluding data from 2008 onwards.2/ The Exchange intervention index is calculated according to Barajas, A., L. Erickson and R. Steiner, 2008.

Section 4. Peru’s recent experience with exchange rate flexibility (2002–14)

23. Peru has undergone a slow transition towards more exchange rate flexibility. After experiencing a hyperinflation during 1988–90, the economy went through a long period of stabilization, which started at the end of 1990. It took the authorities 10 years to bring inflation down to a level around the current long-run target of 2.0 percent. During the disinflation process, the central bank established targets for monetary aggregates. In the new low inflation environment, demand for base money became unstable and the central bank adopted IT in 2002 (with the interest rate as operational target), as a more efficient way of communicating the monetary policy stance to the public. IT is also seen as a way of credibly committing to price stability, which helps enhance the effectiveness of monetary policy and restore the use of the domestic currency to store value and reduce dollarization (Armas, Grippa 2005).

24. Peru’s IT regime departs from a pure IT framework, which, according to the central bank, is the consequence of the high degree of financial dollarization. Such differences are related to the inflation target, the operational target, the inflation forecasting model, and the central bank’s strategy to deal with the risks associated with dollarization.

  • The target for inflation in Peru is lower than in any other Latin American country using IT. The low target was chosen because the domestic currency would be in better position to compete with the U.S. dollar.

  • The use of the interbank interest rate as the operational target was particularly relevant for Peru: it reduced interest rate and macroeconomic volatility; enhanced the monetary policy transmission; contributed to build the yield curve in domestic currency working as the benchmark, thus helping the development of the local financial market and de-dollarization. The adoption of IT increased interest rate pass-through. However, the effect of the interest rate on the output gap is generally smaller in dollarized economies.

  • The forecasting model, in particular the aggregate demand equation includes the real exchange rate, as well as both domestic and foreign interest rates, among other variables. Given that there is financial dollarization, changes in the interest rate in foreign currency affect consumption and investment. On the other hand, the parity condition implies inertia, meaning that due to dollarization, the central bank smoothes the trajectory of the exchange rate through interventions.

  • The central bank has dealt with the risks associated with financial dollarization by emphasizing financial stability (macro-prudential policies) to avoid large swings in bank credit; promoting financial de-dollarization; inducing agents to internalize the risks of financial dollarization; and intervening in the foreign exchange market to reduce volatility and prevent balance sheet effects and accumulate enough foreign reserves to ensure the availability of liquidity in foreign currency.

  • Inflation targeting in Peru is still very similar to how it is practiced in other countries. The central bank publically states that the inflation target should be perceived as the most important target for it to be credible. However, the authorities argue that this is not incompatible with foreign exchange interventions to avoid balance sheet effects of large exchange rate movements (Armas and Grippa, 2005).

25. Several elements have facilitated increasing exchange rate flexibility:

  • IT framework in place. Establishing inflation targeting as the monetary policy framework sent the message to the public that the most important goal for the central bank is the level of inflation. This step enhanced credibility to the point that inflation expectations have been anchored around the inflation target for most years since 2002. This is crucial for the development of financial and capital markets in domestic currency.

  • A decreasing level of dollarization. Various factors have fostered this process: 1) Inflation targeting contributed significantly to the de-dollarization process by stabilizing the inflation rate as well as the interest rate. Less volatility and more predictability of the real return of assets denominated in domestic currency facilitated the development of long-term financial instruments in local currency; 2) Allowing the exchange rate to fluctuate (not excessively) helped financial de-dollarization because agents internalize better the risks of dollarization. Less dollarization, in turn, reduces the risks of high exchange rate volatility; 3) Congress contributed to the de-dollarization trend with a 2004 law, according to which all prices should be listed in domestic currency. Credit and deposit dollarization has come down from 82 and 70 percent respectively in 2000 to 43 and 38 percent respectively in 2012 (Armas and Grippa 2005; Rossini et al., 2013).

  • Active use of macro prudential policies to guarantee financial stability. Credit and liquidity risks associated to dollarization come from currency and maturity mismatches of financial intermediaries, in an environment where the central bank cannot issue foreign currency. To counteract these risks, the central bank accumulated a high level of foreign reserves so it can intervene and smooth excessive exchange rate volatility and act as lender of last resort in foreign currency should banks do not have enough of it. In addition, the authorities imposed prudential measures to prevent credit expansions (in particular in foreign currency) financed with sharp rises in capital inflows (Rossini, et al 2013). For instance, there is a higher level of reserve requirements on bank’s foreign-currency liabilities, as well as limits to the long net foreign position for banks. Regulatory capital requirements are defined according to the type of credit and currency of the loan. Finally, there are limits to short and long positions as percentages of regulatory capital as well as net positions in financial products denominated in foreign currency. Also, there is a limit to long-term foreign liabilities of 2.2 times a bank’s capital (Armas et al 2014; Choy and Chang, 2014; Rossini et al 2013).

  • Interventions. Interventions are discretionary, daily, not pre-announced, and have the objective of reducing exchange rate volatility without committing to or signaling any desired level (ceiling/floor) of it. So, the authorities try to avoid one-sided bets by speculators. Interventions are carried out purchasing or selling dollars mostly in the spot market but also using swaps and reverse swaps to counteract pressures in the forward market. Interventions, specifically purchases of FX, were sterilized using to a great extent treasury deposits and reserve requirements, although the central bank also issues debt instruments. Authorities also introduced incentives for banks and pension funds to invest abroad (Rossini et al 2011, 2013).6

  • Prudent fiscal policy. The fiscal authorities maintained fiscal surpluses for many years, which facilitated the handling of monetary policy. Gross public debt decreased from 47 percent of GDP in 2002 to 20 percent in 2012. The fiscal authorities have contributed significantly to sterilization of foreign exchange interventions by depositing substantial amounts of their financial surpluses at the central bank. In addition, the fiscal authorities have contributed to the development of a market for long-term financial instruments in domestic currency through the management of government liabilities aimed at building a yield curve. There is a high degree of policy coordination between the government and the central bank, even though the constitution guarantees independence to the central bank. The central bank has the ability to establish its goals and instruments. The constitution also forbids the central bank to extend loans to the public sector or buy government securities (Rossini et al., 2012).

  • Capital account liberalization. While there are no controls on capital outflows, there are high reserve requirements on foreign liabilities and even higher reserve requirements on foreign short term credit. There are also other mechanisms that reduce the return of foreign capital flowing into the country. For instance, there is a reserve requirement of 120 percent on deposits in local currency held by non-residents. There is a 4 percent fee on transfers of central bank instruments (sterilization certificates). There is a limit equivalent to 2.2 times a bank’s capital to the long-term credit in foreign currency that it can obtain (Rossini et al., 2011, 2013).

D. Assessing Costa Rica’s Preparedness to Float

26. Costa Rica has a spot foreign exchange market, though rather thin, while the derivative and complementary markets are underdeveloped. The main spot market is run on an electronic platform, with participation by both the BCCR and banks (daily turnover of about US$95 million). A smaller spot market operates with participation from both banks and retail operations—mainly exchange houses—has a daily turnover of about US$25 million. The central bank does not comprehensively collect information on spot transactions outside the MONEX platform, which captures only transactions among the banks. There is currently also no organized derivatives market. Banks do offer some forward contracts and interest-rate swaps on a limited basis. The derivatives market is unregulated. Hence, while there are no restrictions on derivatives transactions, it is not clear how the associated risks are assessed by the supervisor and how the derivatives market functions or could function. The prime constraint, however, appears to be a lack of interest by FX market participants in purchasing derivatives in the face of exchange rate stability. The interbank market is also underdeveloped, with banks’ excess liquidity being absorbed by the BCCR. The securities market is largely limited to primary market in government securities, secondary market in repos of government securities, and a very thin stock market.

27. The authorities would need to strengthen their capacity to monitor and contain exchange rate risk. This is particularly important in light of the high dollarization of the Costa Rican banking system. While the prudential framework to control the overall FX risk exposure of the banks, including stress tests with FX shocks, as well as the measures to reduce FX risks is in place, it is somewhat obsolete. The BCCR also has a credit facility in foreign currency, but has expressed concerns about potential moral hazard, which could ensue from the existence of this facility. However, the private sector does not use derivatives to hedge their exposures on routine basis, and market participants are not accustomed to assessing the FX risks posed by regular market volatility. The authorities would need to continue strengthening the technical tools for tracking foreign exchange exposures and related credit risks, including the development of, forward-looking indicators of currency risk. In addition, measures to reduce FX risks, such as differential reserve requirements for FX deposits may help.

28. The Costa Rican authorities would need to deepen their commitment to inflation as the sole nominal anchor. While the BCCR already has a target range for inflation in place, nonetheless, inflation expectations are not well-anchored. The transmission mechanism from monetary policy is not well understood and the available estimates suggest a rather weak transmission. There are still some indexation mechanisms in place and the long-term domestic currency bond market remains underdeveloped. While the central bank has significantly improved its inflation forecasting methodologies, the models could be strengthened; particularly through the development of general equilibrium models. Monetary operations could also be streamlined by the establishment of weekly auctions and more vigorous intervention by the BCCR to fortify transmission from the policy interest rate to market interest rates. Clearer communication of the inflation targeting policy would be facilitated by establishing and announcing a regular schedule for monetary policy meetings, which are currently held on an ad-hoc basis, and monetary policy reports. Enhancing regulation and supervision of the financial sector would further fortify the monetary policy framework. Finally, addressing large fiscal deficits could help strengthen monetary policy credibility and reduce the potential for fiscal dominance.

29. A policy for CB intervention would need to be developed and transparently communicated. With the exchange rate currently fluctuating between the widening bands, the BCCR has announced that it is following an intervention rule to reduce volatility. However, the rule has not been disclosed publically. Given that many countries, including inflation targeters such as Peru, intervene in the foreign exchange markets after a move to a float, the CB in Costa Rica would presumably continue intervening as well, at least to some degree. To that end, it would be desirable to establish a transparent rule governing interventions. Such a rule should allow smoothing XR volatility but not counteracting established market trends.

30. While capital account openness has been an issue in some countries’ transitions to exchange rate flexibility, Costa Rica’s capital account is already largely liberalized. The country has no restrictions on short-term capital inflows or on capital outflows. As noted above, the lack of a developed foreign exchange derivatives market is largely due to the absence of market interest in such instruments rather than regulatory restraints. However, a recently adopted law empowers the executive, upon consultation with the Central Bank, to impose temporary restrictions on inflows of short-term capital through taxation and compulsory deposits with the Central Bank, though no measures have been imposed so far.

Costa Rica Table 1.

Costa Rica: Extent of Preparedness for Transitioning to Greater Flexibility: Before the Full Float1

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Source: Otker-Robe and others (2007) and staff analysisNote: FX = foreign exchange.

The years in parentheses refer to the period of transition to a full float

Major boom one year before the float.

Lagged behind compared to the foreign exchange markets.

For maturities less than 270 days.

The prudential framework was not in place to control the overall risk exposure of banks, with identified shortcomings mainly regarding the prudential regulation of banks’ exposure to FX risk. Corporates in general (and banks) were making active use of the futures markets to hedge their exposures or to take speculative positions. Market participants were not accustomed to assessing, as a matter of routine, the FX risks posed by regular market volatility.

For Chile, all controls were removed shortly before or with the float. For Brazil, controls were liberalized gradually during the 1990s (inflow controls of 1993-96 liberalized by 1999), with further liberalization for nonresident investments after the float.

In the Czech Republic, most inflows and outflows had been liberalized by 1997, but certain inflow transactions (including financial derivatives) were liberalized in early 1999, following a transition period to phase out the remaining controls under the agreement with the Organization for Economic Cooperation and Development (OECD), with full liberalization taking place in 2002, until which time certain transactions (including some selective derivatives operations and short-term portfolio and deposit transactions) had remained controlled.

Spot market is relatively shallow and the central bank does not comprehensively collect information on spot transactions on regular basis.

Derivatives market is unregulated. Hence, while there are no restrictions on derivatives transactions, it is not clear how the associated risks are assessed by the supervisor and how the derivatives market functions in practice.

The interbank market is underdeveloped with low degree of market depth.

The securities market is largely limited to primary market in government securities, secondary market in repos of government securities, and a very thin stock market.

While the prudential framework to control the overall FX risk exposure of the banks as well as the measures to reduce FX risks is in place, it is somewhat obsolete. The private sector does not use derivatives to hedge their exposures on routine basis and market participants in general are not accustomed to assessing the FX risks posed by regular market volatility. After the depreciation episode in 2014, the CB introduced some measures to smooth volatility in the FX market, including new requisitions for the buying/selling of FX by public sector entities. Specifically, before June 2014, the CB participated in the FX market in order to replenish NIR that was withdrawn by the public sector. Now, the CB can decide discretionally when and how to do this replenishment.

While monetary framework is largely in place, the transmission mechnism from policy rates to the market rates is rather weak.

While there are no capital controls currently in place, a recently adopted law empowers the executive, upon consultation with the Central Bank, to impose temporary restrictions on inflows of short-term capital through taxation and compulsory deposits with the Central Bank.

References

  • Annual Report on Exchange Rate Arrangements and Exchange Rate Restrictions, International Monetary Fund, 2013.

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  • Choy, M. and G. Chang.Medidas Macroprudenciales Aplicadas en el Peru,” Banco Central de Reserva del Peru, Working Paper Series 2014-007.

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  • Duttagupta, R., Fernandez, G., and C. Karacadag,From Fixed to Float: Operational Aspects of Moving Toward Exchange Rate Flexibility,” IMF Working Paper, 04/126, International Monetary Fund, 2004.

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  • Duttagupta, R.; G. Fernandez, and C. Karacadag, 2005, “Moving to a Flexible Exchange Rate: How, When and How Fast,” Economic Issues, 38 (Washington: International Monetary Fund).

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  • Otker-Robe, I., D. Vavra, and others, 2007, “Moving to Greater Exchange Rate Flexibility: operational Aspects Based on Lessons from Detailed Country Experiences,” IMF Occasional Paper 25 6.

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  • Rossini, R, Z. Quispe, and D. Rodriguez, 2011, “Capital Flows, Monetary Policy and FOREX interventions in Peru.Banco Central de Reserva del Peru, Working Paper Series 2011-008.

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  • Rossini, R, Z. Quispe, and J. Loyola, 2012, “Fiscal Policy Considerations in the Design of Monetary Policy in Peru.Banco Central de Reserva del Peru, Working Paper Series 2012-022.

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  • Rossini, R, Z. Quispe, and E. SerranoForeign Exchange Interventions in Peru.Banco Central de Reserva del Peru, Working Paper Series 2013-016.

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  • Tashu, M., 2014, Motives and Effectiveness of Forex Interventions: Evidence from Peru IMF Working Paper WP/14/217 (Washington: International Monetary Fund)..

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1

Prepared by Lennart Erickson, Anna Ivanova and Jorge Restrepo. We gratefully acknowledge useful comments from Antonieta del Cid-Bonilla and Fernando Delgado. Rodrigo Mariscal provided excellent research assistance.

2

The 2013 Annual Report on Exchange Rate Arrangements and Exchange Rate Restrictions classifies Costa Rica’s exchange rate regime as “Stabilized Arrangement”.

3

A summary based on Otker-Robe and others (2007).

4

The band was abandoned when its width reached 62.5 percent around a theoretical mid-point.

5

A summary based on Otker-Robe and others (2007).

6

Tashu, M. (2014) analyzes the motives and effectiveness of foreign exchange interventions in Peru and states that the pattern of interventions suggests that ‘leaning against the wind’ could also be another objective of the intervention.

Costa Rica: Selected Issues and Analytical Notes
Author: International Monetary Fund. Western Hemisphere Dept.
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    Daily Exchange Rate

    (Colones per U.S. dollar)

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    Costa Rica: Historical Experiences with Transitions to Exchange Rate Flexibility

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    Exchange Intervention Index for Selected Countries that Switch from Fixed to Floating Exchange Rate 1,2/

    (Percent)