Banco Central de Costa Rica


COSTA RICA: Staff Concluding Statement of the 2017 Article IV Mission


San José, May 15, 2017


A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision. 


This note summarizes preliminary findings and recommendations of the IMF mission that visited Costa Rica during May 2-15 to conduct the 2017 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 and private sector.


I.  Recent Developments


1.  Both output and growth are at potential, while inflation has reemerged and is rising moderately.


  In 2016 activity grew at its estimated trend rate of about 4¼ percent, with the output gap essentially closed. Strong export growth, further terms-of-trade gain from the additional decline in oil prices, and favorable financial conditions supported growth despite moderate fiscal consolidation and a slowdown in investment following the completion of large projects.


  Following the aggressive policy rate cuts of 350 basis points by the central bank in response to the sharp decline in imported oil prices, headline inflation turned positive in the second half of 2016 and attained 1⅔ percent year-on-year in April 2017. Inflation expectations have remained stable within but near the top of the target range since the beginning of 2016. The central bank already started withdrawing monetary stimulus with a 75 basis points increase in the policy rate in April.


2.  The colón depreciated moderately, while reserves declined despite the narrowing in the current account deficit. With average headline inflation near zero and the nominal exchange rate (XR) vis-à-vis the dollar depreciating by about 3 percent, the CPI-based multilateral real exchange rate (REER) depreciated 1½ percent in 2016. At the same time, the REER appreciated slightly, driven by continued productivity growth. Overall, the mission estimates that Costa Rica’s external position was broadly in equilibrium at end-2016. This is confirmed by the persistent strength of exports and FDI. Buoyant exports together with still low oil prices contributed to a further narrowing of the current account deficit to about 3¼ percent of GDP in 2016. However, lower FX supply, owing to a decrease in external budget financing, and increased private sector FX demand, which the central bank partially accommodated, led to a US$260 million decline in reserves to US$7.6 billion, which is still above the Fund’s reserves adequacy metric. The increase in private sector FX demand was prompted by much reduced premia on savings in colones and expectations of colón depreciation. These trends continued in early 2017, with additional reserve loss of about US$300 million and colón depreciation of about 1¾ percent.


3.  The fiscal deficit remains elevated and the public debt-to-GDP ratio continues to increase. In 2016, government efforts to lower personal tax evasion and contain wage bill growth reduced the primary deficit by ½ percent of GDP to 2½ percent of GDP. Lower domestic financing costs and greater reliance on floating and FX-denominated bonds kept the interest bill stable, because of which the overall deficit declined to 5¼ percent of GDP and public debt reached 45 percent of GDP. Measures enacted by Congress in 2016, mainly to fight tax evasion and lower transfers to decentralized institutions are expected to yield additional savings of about ¾ percent of GDP. However, gains from these measures in 2017-18 will be largely offset by recent court rulings mandating enforcement of earmarking provisions raising social and education expenditures.



4.  Financial conditions gradually eased in 2016 and are now broadly neutral. After increasing through 2015, real lending rates fell steadily in 2016 before stabilizing at the end of the year, as pass-through from policy rate cuts continued and inflation expectations remained stable. At the same time, the REER depreciated and credit started to decelerate in late 2016, steered by slowing FX loans. Overall, the combined effect of real interest rates, REER, credit, deposits, and housing prices suggests that financial conditions have neither propped up nor been a drag on economic activity since end-2016.



5.  The financial system appears sound, though dollarization continues to be a source of vulnerability. Credit growth continues to be consistent with healthy financial deepening and there is no evidence of significant financial risk buildup. Capital is well above regulatory requirements and liquidity indicators are robust. The high dollarization of both credit and bank liabilities, however, creates XR-related credit and funding risks. Recently, over-reliance on external borrowing has increased already elevated exposure to market volatility given the high perceived sovereign risk. The authorities, nonetheless, have already adopted measures to address these risks.(16)


II.  Outlook and Risks



6.  With approval of a fiscal package unlikely due to the political cycle, economic activity will ease slightly, while inflation will revert to the target range. Our baseline scenario does not foresee any fiscal adjustment beyond the already sanctioned measures to fight tax evasion and reduce transfers.Growth is expected to slow down slightly to 4 percent in 2017, driven by weaker terms-of-trade and more stringent financial conditions prompted by the large fiscal deficit. Past monetary stimulus, fading base effects from past oil price declines, and recent moderate XR depreciation are expected to lift inflation up to the middle of the 2-4 target range by end-2017. Financial conditions are anticipated to gradually tighten amid persistently high public sector financial needs and rising international rates. Consequently, potential growth will decelerate because rising interest rates weigh on private investment. The current account deficit will widen marginally to about 4 percent of GDP as oil prices recover despite a modest positive effect of the recent depreciation on exports.



7.  External and domestic risks weigh on the outlook. Markedly tighter global financial conditions owing to more rapid global monetary policy normalization, substantial further strengthening of the US dollar, and rising risk premia because of a weaker fiscal position in the US could be detrimental to Costa Rica, given its weak budgetary situation, bank reliance on foreign funding, and high credit dollarization. Costa Rica’s open economy would also be hurt by a potential reversal in trade integration and more inward looking policies in advanced economies as well as a deeper-than-expected slowdown in trading partners. FDI could suffer from sizable reductions in the US effective corporate tax rate, although the impact is likely to be contained given the importance of investor-friendly pull factors in Costa Rica, notably an educated workforce, sound institutions and respect for law and property rights. Additional downside risks include a substantial currency depreciation which could trigger an increase in NPLs given high credit dollarization of the banking system. Domestically, persistently high fiscal deficits and rising public debt make the economy vulnerable to sudden changes in financial market conditions and investor confidence. Recent greater reliance on floating rate and dollar-denominated bonds could exacerbate these risks.


III.  Policy Discussions



8.  The key challenge is to reduce longer-term economic vulnerabilities while maintaining a policy mix that is appropriate for current cyclical conditions. It is crucial to restore fiscal sustainability as soon as possible to mitigate adverse consequences for macroeconomic stability. The monetary policy framework and financial system supervision should be further enhanced. Finally, structural reforms are needed to boost potential and inclusive growth.


A.      Near-term Policy Mix



9.  The mission advises fiscal tightening accompanied by the unwinding of monetary easing. The primary deficit is expected to widen again to 2¾ percent of GDP in 2017, mainly reflecting recent Constitutional court rulings. In this connection, the authorities should step up administrative efforts to contain expenditure and mobilize revenue to minimize or even eliminate the deterioration. Moreover, the mission strongly commends the authorities’ intention to continue seeking Congressional approval of additional consolidation measures in line with the package submitted to parliament (11). Given the currently expansionary monetary stance—with the policy rate considerably below the estimated neutral rate—and lags in policy transmission, the mission advises the central bank to continue reversing the easing cycle, and do it at a fast clip, especially if inflation accelerates more than projected and inflation expectations rise.


B.  Safeguarding Fiscal Sustainability


10.  A gradual fiscal adjustment of 3 percent of GDP is needed over the medium term to stabilize the public debt ratio within prudent levels. With no additional policy action, the primary deficit would return to almost 3 percent of GDP over the medium term. The overall deficit would rise to 8 percent of GDP owing to a mounting interest bill and constitutionally-mandated education spending. Public debt would reach 65 percent of GDP by 2022, steadily growing thereafter. This could seriously undermine investor confidence. Given this, the mission estimates that fiscal adjustment of 3 percent of GDP, implemented mostly in 2018-20, is needed to stabilize debt below 50 percent of GDP. This is about ¾ percent of GDP lower than the sustainability gap estimated in the last Article IV consultation, reflecting the net effect of gains from already adopted administrative and legislative measures and additional expenditures arising from recent Constitutional Court rulings.


11.  Staff underscores that only the authorities’ more ambitious fiscal adjustment plan can close the sustainability gap. The authorities’ main consolidation proposal accompanied with sustained administrative steps to contain the wage bill would deliver the necessary adjustment of 3 percent of GDP. Key elements of this package are the VAT and income tax reforms, comprising the gradual increase in the VAT rate accompanied by transfers to compensate poorer strata of the population. Moreover, to maintain the balance between revenue and expenditure measures, it is critical to include in the package the public employment and fiscal responsibility laws. This is also needed to gain parliamentary support for the plan. In contrast, an alternative package, which has been informally submitted for discussion to the parliamentary fractions, focused mainly on widening the VAT and income tax base, would yield at most 1½ percent of GDP. The shortfall is mainly due to the removal of the VAT rate increases, even if partly offset by less generous compensation to lower-income families.


12.  Ambitious reforms to ensure long-run financial sustainability of pension systems should be implemented. The mission urges political and social forces to reach agreement on initiatives currently under consideration before Congress to reform the actuarially imbalanced special regime for the judiciary, which is projected to require budgetary support in the near future. The mission also supports the recommendations of a recent independent actuarial report calling for major parametric changes to resolve imbalances of the general pay-as-you-go system subject to long-term pressures from system maturation and population aging. The recommendations include cutting the replacement rate, increasing the contribution rate, and in the longer run increasing the retirement age.


C.  Upgrading the Monetary and Exchange Rate Framework


13.  The mission advises steady progress toward full-fledged inflation targeting. In 2016 the central bank successfully maintained inflation expectations within the target range while the XR was more flexible. While commending this, and also noting that the real exchange rate is estimated to be currently in line with the economy’s fundamentals (2), the mission argues for continued XR flexibilization and higher transparency about the triggers of the FX-intervention rule, aided by FX market deepening. These steps would increase confidence in the inflation target as the key objective of the central bank, enhance the role of the exchange rate as a shock absorber, limit further reserve losses, and induce market participants to internalize FX risk, thus reducing mismatches and discouraging dollarization.


14.  The central bank is aptly deepening the FX market, thereby propitiating more tolerance for XR flexibility. The authorities will introduce in July 2017 a single-price FX auction among authorized intermediaries before the beginning of each trading session in the continuous market—Monex. The measure aims to consolidate FX demand and supply, thus providing an anchor for Monex. This is expected to improve liquidity and price discovery as well as make the XR less dependent on the operations of a few large entities. In April, the authorities issued new prudential measures to reduce incentives for FX speculation by banks. If successful, these measures should reduce central bank interventions in the FX market.



D.  Financial Stability


15.  The mission considers that currency mismatches, growing household leverage, sovereign exposure, and high net foreign liabilities pose key risks to financial stability. Even though our stress test indicates that the banking system appears resilient, with sufficient capital and liquidity buffers, four vulnerabilities persist. First, the large share of FX-denominated loans and their extension to unhedged borrowers exposes the system to credit risk through XR risk. Second, the continued increase in household leverage, coupled with incomplete information on borrowers’ total debt including to non-bank commercial entities, endanger banks’ asset quality. Third, continuing accumulation of government debt exposes banks to sovereign risk, which could rise in the absence of fiscal adjustment and with the onset of tighter global monetary conditions. Finally, high net foreign bank liabilities can create liquidity risk if global financial conditions worsen or corresponding banking relationships suffer disruptions.


16.  The authorities appropriately introduced several regulations to address these risks, though more may be needed.In 2016, building on previous measures, supervisors instituted higher capital requirements for mortgages with high loan-to-value ratios or in FX to unhedged borrowers, established additional provisioning on all FX loans to unhedged borrowers, and introduced countercyclical provisions. In April 2017, supervisors proposed modifications to the regulation of minimum capital requirements for market risk to protect banks’ capital adequacy against losses from XR movements, in line with Basel III guidelines. Even though credit in FX has slowed, the authorities should consider further risk-mitigating measures, especially if FX credit accelerates again or banks’ FX exposures do not decline sufficiently.



17.  The mission urges implementation of outstanding 2008 FSAP recommendations and Basel III standards to make the financial system more resilient. Although the progress in adopting risk-based supervision has been substantial, other FSAP areas have seen only limited advances, notably crisis management and bank resolution framework. The upcoming Financial Sector Stability Review will assess the situation. We also believe that introduction of Basel III minimum capital requirements and liquidity standards would benefit the regulatory framework, and therefore welcome the authorities’ plan to introduce in 2018 a net stable funding ratio in addition to the liquidity coverage ratio enacted in 2015.



18.  We encourage regional collaboration on cross-border financial supervision and reinforcement of the AML/CFT regime. The mission counsels regional supervision of entities with cross-border operations through the regional association of banks’ supervisors to assess and mitigate common and spillover risks. Harmonization of prudential norms across the region should also promote regulatory and supervisory coordination. Additionally, Costa Rica needs to steadfastly implement recently adopted legislative measures aimed at remedying deficiencies in its AML/CFT regime identified by the Financial Action Task Force. Inclusion in the list of jurisdictions with strategic weakness in this area would significantly hinder access of domestic financial institutions to the international financial system.


E.  Structural Reforms


19.  Structural reforms are needed to maintain competitiveness, boost potential growth and make it more inclusive. Costa Rica ranks better than most of Latin American countries in international competitiveness comparisons, but it should not be complacent.  Enhancing transport infrastructure and public expenditure efficiency―especially in education―and competition policies should accelerate potential growth and foster inclusiveness. Amending the electricity price-setting scheme to enhance cost discipline and thus creating conditions to reduce tariffs would also support economic development. Expanded child-care policy should promote female labor force participation. Continued sectoral transformation towards high growth and higher value added services, supported by adequate public investment and regulatory framework, should make the economy more resilient to climate change and mitigate the latter’s regressive impact on income distribution


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