November 10, 2014

This note summarizes preliminary findings and recommendations of the IMF staff mission that visited Costa Rica during October 28–November 11 to conduct the 2014 Article IV consultation. The mission is grateful for the high quality and openness of the discussions and for the cooperation and hospitality of the Costa Rican authorities.

I. Recent Developments

1. Economic developments since the 2013 Article IV Consultation have been mixed.

• Growth decelerated in 2013, though output remains virtually at potential. Activity rose by 3 percent in 2013, short of the estimated 4 percent trend, largely on account of weaker consumption and net exports. Growth gained some speed in early 2014, as feeble imports and stronger investment offset sluggish exports.
• The exchange rate depreciated markedly in 2014, broadly restoring competitiveness. The current account deficit declined slightly to 5 percent of GDP in 2013. Nevertheless, in the wake of U.S. monetary policy normalization, the colon depreciated about 7 percent in 2014, largely correcting the REER appreciation from the last decade. Although the Central Bank intervened to smooth exchange rate fluctuations, a government Eurobond issuance helped boost reserves—which remain well within the IMF adequacy metric.
• • Inflation remained within the target range in 2013, but breached its upper limit in 2014. Having ended 2013 at 3.7 percent, inflation persists somewhat above the recently lowered target range of 3-5 percent, owing mainly to the high pass-through to domestic prices from depreciation. To contain second-round effects from depreciation, the authorities appropriately raised monetary policy rates twice since the beginning of the year.
• The fiscal deficit has continued to increase and public debt is climbing rapidly. Transfers and interest costs rose in 2012−13, while revenues stagnated, not least because the 2012 tax reform was nullified by the Constitutional Court on procedural grounds. As a result, the central government deficit increased in 2012−13 to 5 percent of GDP and debt reached 36 percent of GDP at end-2013.
• Domestic financial conditions are broadly neutral. Interest rates started rising from mid-2013, as global financial conditions tightened. Nevertheless, according to our estimates, financial conditions in Costa Rica were neither propelling nor dragging GDP growth in early 2014, even before the latest policy rate raise. Credit growth (adjusted for the devaluation’s impact on the stock of FX loans) has moderated somewhat, to a level consistent with continued benign financial deepening.
• The financial system appears sound, though dollarization remains a source of vulnerability. Capital is well above regulatory requirements, liquidity indicators are generally robust, and non-performing loans have remained manageable. Although reliance on foreign funding has increased, banks retain a long FX position. However, in the event of a large depreciation of the colon, credit risk from dollar loans to households and corporations would be sizable

II. Outlook and Risks

2. The economic outlook is subdued amid deteriorating fundamentals. Growth is expected to remain at about 3 percent in 2014−15, as the positive impact of U.S. recovery is offset by the closure of Intel manufacturing and weak public investment. The output gap is projected to widen through 2016, closing slowly in the medium term, as growth converges to its estimated trend. The central government deficit is anticipated to stay at about 6 percent of GDP through 2019, reflecting a partial consolidation of around 2 percent of GDP (9). Given continued prudent monetary policy, inflation would hover around 4 percent in the medium term after finishing 2014 somewhat above the target range due to the colon depreciation. The current account deficit is to rise slightly to 5 percent of GDP by 2019, still largely financed by FDI.

3. External and domestic risks weigh on the outlook. The mission views external risks related to the normalization of U.S. monetary policy as balanced. If exit is orderly, the net impact of faster U.S. growth and tighter global financial conditions should be positive in the short term. Nevertheless, extreme bouts of volatility in world financial markets could still inflict serious damage. External risks include also deeper-than-expected slowdowns in advanced and emerging economies and disruptions in commodity markets due to geopolitical tensions. On the other hand, if the recent decline in oil prices were to continue, this could have a limited positive impact on Costa Rica. On the domestic front, persistence of a large fiscal deficit and rising debt ratio could exacerbate vulnerability to sudden changes in financial market sentiment. Large government gross financing requirements could also crowd out private investment and growth. In addition, FDI contraction due to the “signaling effect” from Intel exit could hamper growth.

III. Policy Discussions

4. Costa Rica must reduce existing vulnerabilities and improve long-term sustainability, while boosting potential growth and maintaining financial stability. In the near term, a tighter fiscal policy stance and vigilance over inflation would buttress macro-economic stability. At the same time, it will be important to begin fiscal consolidation to place public finances on a sustainable path, strengthen the monetary policy framework, and further enhance banking sector supervision and regulation. Reforms to foster competition, increase efficiency, and strengthen competitiveness would help accelerate potential growth.

A. Near-term Policy Mix

5. The government’s proposed fiscal correction for 2015 is suitable, but it is unclear whether the required measures can be implemented in time. The mission urges the government to take advantage of its political capital to push forward reforms early in its mandate. Fiscal reforms aimed at reducing markedly the deficit are a national priority. Given the absence of a government majority and political fragmentation in Congress, the support of other political parties and civil society is crucial for the success of these much needed fiscal reforms. Budgetary adjustment in 2015 would contribute to mitigate risks of higher inflation, widening external imbalances, and possible adverse financial market reactions associated with U.S. monetary policy normalization. It would also represent a first step to reduce the sustainability gap (9). The government’s fiscal correction target of about 1 percent of GDP in 2015 compared to the “passive” budget submitted to Congress is appropriate taking into consideration both fiscal sustainability concerns as well as the cyclical position of the economy. In the mission’s view, speedy adoption of the VAT reform would be crucial to achieve this adjustment since improvements to tax administration and expenditure cuts currently under consideration are likely to prove insufficient.

6. The current monetary policy stance is broadly appropriate, but policy should remain nimble in responding to inflation risks. With the policy rate at 5.25 percent, the mission considers that the monetary stance allows inflation to re-enter the target band. However, risks of higher inflation prevail due to possible: (i) larger-than-estimated pass-through and second round effects from currency depreciation; (ii) faster U.S. growth; (iii) bigger-than-assumed regulated price hikes, though these are now more unlikely given recent declines in oil prices. Thus the authorities should stand ready to raise rates if inflation does not decline as anticipated, particularly if it persists above the upper limit of the target range.

B. Safeguarding Fiscal Sustainability

7. Fiscal trends are unsustainable in the long-term. Under baseline policies, which already incorporate a sizeable adjustment (11), the consolidated public sector deficit is projected to persist around 6 percent of GDP by 2019, amid a mounting interest bill and the constitutionally mandated increase in education spending. Correspondingly, public sector debt would grow to 51 percent of GDP by 2019, further raising vulnerabilities and eroding macroeconomic stability. External financing costs are expected to rise and its availability may decline if market perceptions continue to deteriorate.

8. Moreover, the pension system’s financial position also needs to be strengthened. Retirement plans run by the CCSS, the judiciary, and teachers will turn a cash deficit over the long term due to system maturation and population aging. In addition, the pension plans directly supported by the national budget are very costly for government finances and regressive.

9. Therefore, the mission recommends pursuing ambitious fiscal consolidation. Excluding the pension system imbalance, a permanent improvement in the primary balance of 3 percent of GDP, compared to the level that would prevail in 2015 in the absence of any measures, is required to stabilize the public debt ratio after 2019—which the mission views as an appropriate anchor—and safeguard macroeconomic stability. While the pension system actuarial deficit could be addressed at a later stage through larger contributions, lower replacement rates, and higher retirement age, the mission cautions that the longer the correction is delayed, the larger it will be. The reforms of the pension plans directly supported by the budget undertaken by the government are a step in the right direction but legislative action is needed to deepen the process.

10. The adjustment should strike a balance between lowering the sustainability gap and limiting the adverse impact on growth. Cyclical considerations (output is fairly near potential) and the rapid growth of public debt call for some upfront fiscal tightening. In the mission’s view, the path that achieves the fiscal consolidation objective with the lowest impact on output would be to undertake about a third of the required budget adjustment in 2015 (1 percent of GDP) followed by smaller steps in subsequent 4 years, broadly in line with the authorities’ plans (11). Such a fiscal tightening path would have a modest short-term output cost but a positive impact on output and employment creation over the medium term compared to the baseline scenario. Postponing consolidation would result in larger tightening needs to stabilize debt-to-GDP and increase the probability of disorderly adjustment in the event of an abrupt shift in investor sentiment.

11. In this connection, the mission welcomes the authorities’ medium-term fiscal consolidation plan, but notes that supporting measures still need to be fully specified.

• The plan to strengthen public finances by about 4 percent of GDP is appropriate, as is the emphasis on revenue enhancement given Costa Rica’s low revenue effort compared to other upper-middle-income countries. In particular, we support broadening the VAT base to include services and basic goods, the latter accompanied by actions to mitigate the impact on lower income households, as well as the move to a global income tax. If implemented, the plan will greatly enhance macro stability, thus stimulating growth.
• However, in our view, the proposals at a more advanced stage of elaboration are likely to yield only some 2 percent of GDP. Others, notably parts of the income tax and expenditure side reforms, need to be fleshed out to obtain sufficiently refined estimates of their impact, which should amount to 1 percent of GDP to close the sustainability gap (9). Moreover, while recent actions to strengthen tax compliance, including the draft anti-tax evasion law submitted to Congress, are appropriate, the mission cautions that yields from such initiatives are generally uncertain and far from immediate.
• Although significant revenue gains may be accrued by reducing tax exemptions and other special treatments, the substantial budget consolidation required will likely demand increases in tax rates in the future. Thus the mission recommends raising the VAT rate from 13 to 15 percent gradually and increasing marginal tax rates on higher brackets as part of the introduction of a global income tax, thereby addressing also distributional concerns. The government has confirmed its willingness to raise VAT rates in steps starting in 2016 consistent with the consolidation recommended by the mission.
• The mission also advises stepping up efforts to contain growth of current expenditure, particularly the wage bill and transfers, notably through modifying indexation to prevent automatic real salary increases and improving efficiency of employment in the public sector. This is also important to support desirable increases in growth-friendly capital spending, in line with the efforts of the government to improve project execution. At the same time, caution is needed to contain risks of contingent liabilities and additional pressures on domestic financing resulting from new off-budget investment vehicles.

12. The monetary policy framework still presents important weaknesses. The mission commends the authorities for their success in maintaining inflation relatively low and reducing the target range to 3-5 percent in 2014. However, inflation expectations are not yet well-anchored and perceived exchange rate stability in the past few years has encouraged dollarization, building up vulnerabilities in balance sheets of banks and private sector.

13. The mission urges the authorities to complete the transition to inflation targeting.

• The mission encourages elimination of the exchange rate band, thereby establishing the inflation target as the undisputed anchor of monetary policy, and further improving communication regarding foreign exchange intervention. This would still allow to smooth out exchange rate volatility and to strengthen the NIR position as long as interventions do not undermine the inflation target. An environment of higher exchange rate flexibility would also help lower the exchange rate pass-through to inflation and force market participants to internalize two-way risks in exchange markets, thus promoting the reduction of foreign currency mismatches on balance sheets. Finally, the authorities should resist pressures to expand the central bank’s mandate to include growth, which could generate confusion as to the true target of monetary policy, thereby undermining its credibility.
• The experience of countries that have successfully transitioned to more flexible exchange rate regimes suggests that strong and effective systems for reviewing and managing exposures to exchange rate risk are important. In this regard, the mission welcomes recently adopted stipulations which allow for a more thorough assessment of foreign exchange exposures and associated higher provisioning requirements. Fostering further development of the secondary market for government securities is also desirable.

14. The mission advises enactment of pending recommendations from the last FSAP. In particular, greater urgency is required in empowering the Superintendence of Financial Institutions to conduct consolidated supervision, providing adequate protection to bank supervisors, strengthening bank resolution procedures, all of which require passage of new legislation. We welcome progress made towards full implementation of risk-based supervision, but encourage stepped up efforts to bring it up to best practices.

15. The mission supports gradual adoption of Basel III standards and backs additional improvements in cross-country supervision. In our view, the regulatory and risk management frameworks would greatly benefit from introducing Basel III definitions of capital, a capital conservation buffer, and a leverage ratio. The mission also recommends enhancing further transnational consolidated supervision, given significant gaps in the definition of a financial group as well as a narrow supervisory and enforcement perimeter.

E. Structural Reforms

16. Structural reforms should be pursued to boost potential growth and competitiveness. While Costa Rica has been the regional leader in attracting foreign direct investment, the recent withdrawal of Intel suggests that further steps are needed to maintain the country’s competitive edge. The mission recommends increasing private sector participation in the energy sector and reviewing tariff setting procedures to better reflect changes in costs. Improving the quality of education spending with emphasis on quality child care, early childhood and lower levels of education would help facilitate female return to the labor force, foster productivity improvements, and lower inequality in the long run. Stimulating competition in the banking sector, fostering capital market development, addressing infrastructure bottlenecks, and streamlining business regulations will also help strengthen competitiveness and accelerate potential growth.