Costa Rica: Selected Issues and Analytical Notes


Costa Rica: Selected Issues and Analytical Notes

Financial Deepening in Costa Rica1

This note examines the current state of financial development in Costa Rica, as well as implications for potential growth and stability from further financial deepening. Costa Rica’s financial system continues to lag behind those of other emerging markets as well as the country’s macroeconomic fundamentals. In the short run, Costa Rica should aim at removing distortions that prevent the country from reaching its full financial development potential given the current state of macroeconomic fundamentals. This includes following through on the modernization of its collateral framework, ensuring a level playing field for private and public banks, following market-friendly debt management and issuance strategies, and taking steps to support the development of the stock market. In the longer term, as fundamentals continue to evolve, Costa Rica would benefit from further financial development in terms of growth and stability, provided there is adequate regulatory oversight to prevent excesses.

A. Financial Development: Where Does Costa Rica Stand?

1. Costa Rica’s financial development was assessed using a comprehensive index. Financial development has proven difficult to measure. Typical proxies in the literature such as the ratio of private credit to GDP and, to a lesser extent, stock market capitalization are too narrow to capture the broad spectrum of financial sector activities. To better capture different facets of financial development, we employ a comprehensive and broad-based index covering 123 countries for the period 1995-2013 (see Appendix and Heng and others, 2015). The index contains two major components: financial institutions and financial markets. Each component is broken down into access, depth, and efficiency sub-components. These sub-components, in turn, are constructed based on a number of underlying variables that track development in each area.

2. Costa Rica’s financial system deepened notably in the past decade but continues to lag behind those of other emerging markets. The improvements came from growth in financial institutions, in particular, better institutional access and improved efficiency. In contrast, market development stagnated. Despite the recent progress, Costa Rica continues to lag behind other emerging markets on many dimensions. In particular, it lags other EM groups on all of the subcomponents of financial market development. It is also behind other EMs on some aspects of institutional development, though performance varies by component. In fact, Costa Rica compares favorably on institutional access, outperforming all other EM country groupings. Good access reflects a wide network of ATMs and bank branches per 100,000 adults. However, the country lags behind other EMs on institutional efficiency, though it slightly exceeds the LAC average on this component. Low efficiency reflects high interest rate spreads, high overhead costs, and high net interest margins. Finally, Costa Rica is behind all other country groupings on institutional depth due to the low level of credit and deposits to GDP as well as small mutual fund and insurance industries.

Figure 1.
Figure 1.

Costa Rica: Financial Sector Development

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A004

Figure 2.
Figure 2.

Costa Rica: Financial Development Gaps

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A004

3. Costa Rica’s financial development is also below the levels predicted by country’s fundamentals (Panel 2). A simple cross-country comparison above does not account for differences in the underlying macroeconomic conditions. Financial development gaps—the deviation of the financial development index from a prediction based on economic fundamentals, such as income per capita, government size, and macroeconomic stability—can help identify potential under or overdevelopment of Costa Rica, compared to countries with similar fundamentals. These gaps suggest that Costa Rica’s financial development is below the levels predicted by its macroeconomic fundamentals on all but two subcomponents. The exceptions are two narrow measures of institutional efficiency, namely, 3-bank asset concentration and non-interest income. Other measures, however, including lending-deposit spread, bank interest margin, and overhead cost, point to inefficiencies in the banking sector. To the extent that the negative gaps reflect distortions or market frictions, they need to be addressed. For example, high interest rate spreads are likely a reflection of the substantial presence of public banks, which lack strong incentives to improve efficiency. The relatively low credit-to-GDP ratio at least to some extent reflects a weak legal collateral framework, which was in place before 2015, and was probably one of the causes of the high collateral-to-loan ratio.

B. The Potential for Raising Growth and Stability through Further Financial Deepening in Costa Rica

4. There is a non-linear relationship between growth and stability on the one hand and financial development on the other hand. Financial development gaps do not address the question of the optimal level of financial development in terms of growth and stability. To explore this question, we examine the relationships between financial development and growth as well as financial development and stability (see Heng and others, 2015). We find that these relationships are nonlinear. In other words, the benefits from financial development are rising at the early stages of development as resources are increasingly channeled into productive uses. However, there is a turning point beyond which the positive growth benefits diminish. Similarly, at the early stages, financial development can help reduce instability, for example, by providing insurance services, but these benefits also start to diminish after a certain point. The turning points likely reflect the fact that large financial systems can eventually divert resources from more productive activities, while excessive borrowing and risk-taking by financial institutions can lead to increased instability and lower long-term growth. Indeed, the inverted U-shaped relationship with growth is driven by the depth of financial institutions, or a measure of size. Access and efficiency, on the other hand, yield unambiguously increasing benefits to growth, although with potential stability costs as reduced bank profitability may encourage risk-taking. Lastly, too much market development at the early stages of institutional development may have negative implications for stability. One reason for this could be increased market volatility, which may more easily set in when financial institutions are not strong enough to help guard against shocks. For similar levels of development, however, institutions and markets are complementary for growth and stability.

5. Costa Rica has not yet reached the levels of institutional and market development that yield maximum benefits to growth and stability. In Latin America and the Caribbean, Brazil and Chile are closest to reaping those benefits, whereas the Dominican Republic, Paraguay, and Honduras lag behind (Panel 3). Costa Rica is still far away from reaping the maximum benefits to growth and stability, in particular, in terms of financial market development. Note that these estimates stem from a partial analysis that assumes that all other growth determinants (such as income level, inflation, government size etc.) are held constant while financial development is consistent with the level of macroeconomic fundamentals. Thus, in the longer term, reaping maximum benefits from financial development for growth and stability would also require improving Costa Rica’s macroeconomic fundamentals, which in turn would support further development of the financial systems. This is an interactive process whereby financial systems are shaped by fundamentals, and fundamentals evolve partly as a function of more developed financial systems. Estimates should, however, be interpreted with caution since it is difficult to disentangle causality in econometric terms, even though instrumental variables were used to address potential endogeneity issues.2

Figure 3.
Figure 3.

Costa Rica: Financial Institutions, Market Development, and Economic Growth

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A004

Source: IMF staff calculations.Note: surface shows the predicted effect in growth for each level of the indices, holding fixed other sets of controls.

C. Conclusions and Policy Recommendations

  • Costa Rica’s financial system deepened notably in the past decade, but continues to lag behind those of other emerging markets as well as the level of development implied by its macroeconomic fundamentals.

  • Given that the fundamentals are sticky in the short term, Costa Rica should aim at removing distortions that prevent the country from reaching its full financial development potential given the current state of macroeconomic fundamentals.

    • To facilitate deepening on the side of financial institutions, Costa Rica should follow through on the modernization of its collateral framework while balancing it with proper regulation and supervision. In 2015, the country adopted a new secured transactions law that establishes a functional secured transactions system and a modern, centralized, notice-based collateral registry. The law also broadened the range of assets that can be used as collateral, including intangibles such as intellectual property rights, allowed a general description of assets granted as collateral and permitted out-of-court enforcement of collateral. Nevertheless, careful monitoring is warranted at this stage to hinder abuse as the new system is being tested.

    • To improve efficiency of financial intermediation it should ensure a level playing field for private banks compared to public banks. An important first step would be to remove the explicit guarantee currently given by the state to all colon-denominated deposits in state banks.

    • Costa Rica could benefit from following market-friendly debt management and issuance strategies to help foster secondary markets for government securities, such as the use of standardized simple instruments with conventional maturities, as well as strengthening legal and regulatory frameworks.

    • To promote the development of the stock market Costa Rica would certainly gain from a more robust macroeconomic environment, as well as stronger institutional and legal frameworks, which promote investor rights, information disclosure, as well as policies that increase market size, in particular, those supporting the development of an institutional investor base In recent years, an important step has been taken by allowing private participation into the insurance sector where it used to be a state monopoly but more could be done to encourage further entry. Strengthening protection of minority investors - an area where Costa Rica does not score well in Doing Business indictors -could also help. Finally, reviewing tax treatment of securities issuance and investment to make the tax system more attractive to issuers may be warranted as long as it does not jeopardize fiscal sustainability objectives.

  • In the longer term, as fundamentals continue to evolve, including toward a higher income per capita, further financial development would be advantageous for Costa Rica in terms of growth and stability, provided there is adequate regulatory oversight to prevent excesses. The process, however, is likely to be gradual and iterative with income growth supporting financial development and vice versa. In the process, care should be taken not to promote excessive market development when financial institutions are underdeveloped.

Appendix I. Measuring Financial Development

To measure financial development we employ the same framework as in Heng and others, 2015. 1


Sources and Data Processing

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A004

Source: IMF staff calculations.1 Stock of debt by local firms is based on residency concept.
  • The data generally cover the period 1995 to 2013 with gaps, in particular, for countries in the Middle East, Sub-Sahara Africa and Latin America. For some variables, e.g., ATMs per thousands of adults, the data were only available starting in 2004. Our data came from numerous sources: World Bank’s World Development Indicators (WDI), FinStats, Non-Bank Financial Institutions database (NBFI), Global Financial Development database (GFD); International Monetary Fund’s International Financial Statistics (IFS); Bureau van Dijk, Bankscope; Dealogic’s debt capital markets statistics; World Federation of Exchanges (WFE); and Bank for International Settlements’ debt securities statistics.

  • After a gap filling process to generate a balanced panel, all variables were normalized using the following formula:

  • where Ix, it is the normalized variable x of country i on year t, min(xit) is the lowest value of variable xit over all i-t; and max(xit) is the highest value of xit. For variables capturing lack of financial development, such as interest rate spread, bank asset concentration, overhead costs, net interest margin, and non-interest income, one minus the formula above was used.

  • The weights were estimated with principal component analysis in levels and differences, factor analysis in levels and differences, as well as equal weights within a subcomponent of the index. For most of the methods the weights were not very different from equal weights and econometric results were robust to the method of aggregation. For simplicity, we use an index with equal weights.

Regression Frameworks

  • Regressions use 5-year averages in order to abstract from cyclical fluctuations, and estimated using dynamic panel techniques common in the growth literature.

  • Financial Development Gaps

  • The benchmarking regressions link financial development (FD), institutions (FI) and markets (FM) development indices to fundamentals. Following the literature on benchmarking financial development (Beck and others 2008) fundamentals (XitFI) included initial income per capita, government consumption to GDP, inflation, trade openness, educational attainment proxied by the average number of years of secondary schooling for people 25+, population growth, capital account openness, the size of the shadow economy (given its importance for the LAC region) and the rule of law. Instruments (Zit) for financial development such as the rule of law and legal origin dummies were also used. Predicted norms were computed using the following equation:

  • FIit=δ1XitFI+δ2Zit+hFIt+eFIit

  • where FIit stands for one of the financial indices (FD, FI or FM). Gaps shown are the difference between the actual values of the index and the calculated norms.

  • Financial Development, Growth, and Stability

  • The link between financial development, growth and stability was examined using a dynamic panel regression framework. Real GDP growth (DYit) is linked to financial development allowing for a potential non-linearity by adding a square of financial development while controlling for other factors that are likely to affect growth (below). In the case of individual sub-components of FI and FM, the interaction term between these two indices is included. The controls for the growth regression XitFI were the same as in the benchmarking regression (XitFI) with two additional variables: ratio of FDI to GDP and capital account openness.

  • The impact of financial development on financial and macroeconomic instability used a similar framework. Financial instability (FSit) is measured by the first principal component of the inverse of the distance to distress (z-score),2 real credit growth volatility, and real and nominal interest rate volatility. This combined variable allows capturing different facets of financial instability, thus improving over previous research which typically focused on a single variable. Growth volatility (GVit) is measured by the standard deviation of GDP growth. The controls included initial income per capita, government consumption to GDP, trade openness, changes in terms of trade, growth in per capita income, capital flows to GDP, exchange rate regime, a measure of political stability, and an indicator for whether a country is an offshore financial center.

  • The following three equations were estimated using the Arellano-Bond approach:


    Where f(FinDevit) have two forms, one with the aggregated index: f(FDit)=b1FDit+b2FD2it and one with the subcomponents: f(FIit,FMit)=b1FIit+b2FI2it+b3FMit+b4FM2it+b5FIit×FMit

    Table below shows the results of the estimated equations for growth and instability.

Costa Rica: Estimated Equations

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Source: IMF staff calculations.Note: Standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

Prepared by Anna Ivanova, Rodrigo Mariscal, and Joyce Wong.


We use system GMM estimation (Arellano and Bover, 1995; Blundell and Bond, 1998) to address the dynamic dependence of our variables of interest and potential endogeneity of control variables. We also employ additional instrumental variables used in the literature, namely, rule of law (Kaufmann, Kraay and Mastruzzi 2010) and a set of dummies for the country’s legal origin (La Porta, Lopez-de-Silanes and Shleifer 2008).


The framework in Heng and others, 2015, in turn, follows Sahay and others (2015). For further details see “Advancing Financial Development in Latin America and the Caribbean,” forthcoming, IMF working paper.


Z-score is a measure of financial health. Z-score compares the buffer of a country’s commercial banking system (capitalization and returns) with the volatility of those returns.

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