IMF Executive Board Concludes 2016 Article IV Consultation with Costa Rica
Costa Rica bounced back quickly from the 2008–09 global crisis, but growth, despite picking up in the last two years to 3.75 percent, has stayed below trend, while macro vulnerabilities, mainly from the weak fiscal position, have risen. Failure to reverse the counter-cyclical budgetary stimulus imparted in 2009, and a rising interest bill since then have pushed the deficit to about 6 percent of GDP in 2015–16. This has placed the public-debt-to-GDP ratio on an unsustainable path, which is fast approaching levels shown to increase risks of disorderly adjustment for emerging economies. Inflation, on the other hand, has been on a trend decline, and has turned negative in 2015, owing largely to lower oil prices. The current account, benefiting from the positive terms-of trade shock, has shrunk to about 4 percent of GDP and is entirely financed by Foreign Direct Investment. Continuing fast expansion of dollar-denominated credit, facilitated by a stable exchange rate, has exacerbated vulnerabilities in the financial sector, rendering further improvements in regulation and supervision even more important.
Growth is expected to accelerate to 4.25 percent in 2016 supported by the dissipation of the one-off effects arising from a withdrawal of Intel’s manufacturing operations, further terms-of-trade improvement, and current accommodative monetary policy stance. The output gap is anticipated to stabilize in 2016, and then close over the medium term. The baseline scenario contemplates fiscal consolidation measures of 2.25 percent of GDP over the medium term. The central government overall deficit would decline moderately to 5.25 percent of GDP and the public debt ratio would reach almost 55 percent of GDP by 2021. Inflation is expected to return to the center of the new 2–4 percent target range by end-2016 and hover around that value through 2021, buttressed by continued prudent monetary policy. The current account deficit should widen slightly to 4.25 percent of GDP over the medium-term, amid gradual recovery of international commodity prices.
Risks to the outlook are tilted to the downside. Concerning external factors, in the case of faster US monetary policy normalization, slightly upside risks prevail, with a positive impact of higher US growth more than offsetting the negative influence of tighter global financial conditions in the short run. However, extreme bouts of market volatility could inflict serious damage. Continued real exchange rate appreciation can negatively affect external competitiveness. Deeper-than-expected slowdowns in the rest of the world could also hamper Costa Rica’s growth. On the domestic side, the persistent large fiscal deficits could render the economy vulnerable to sudden changes in financial market conditions, necessitating an increase of domestic interest rates, which would weigh on private investment and growth. Financial stability could be jeopardized by substantial currency depreciation, mainly through higher non-performing loans.
Executive Board Assessment2
Executive Directors commended Costa Rica’s rapid recovery from the global financial crisis. However, Directors noted that recent growth rates, while increasing over the last two years, have moderated below trend and macroeconomic vulnerabilities have increased arising mainly from the large fiscal deficits and high dollarization. They stressed the importance of a well-calibrated policy mix and broad political consensus to ensure macroeconomic and financial stability and support inclusive growth.
Directors welcomed the authorities’ fiscal consolidation strategy focusing both on revenue and expenditure measures. They took positive note of the plans to increase tax collections, impose tougher sanctions against evasion, and implement the income tax reform as well as the VAT reform with targeted support to offset the impact on lower-income households. The planned reduction in the growth of current expenditures will also be important. Directors supported phased adjustment over the medium term with significant frontloading to balance the objectives of maintaining growth and lending credibility to the adjustment effort. They emphasized that full implementation of the planned fiscal reforms will be critical to reducing the large budget deficit and stabilize the level of public debt over the medium term.
Directors viewed the current expansionary monetary policy stance to be appropriate and commended the progress made toward the inflation targeting regime. Welcoming the removal of the exchange rate band, they highlighted that gradual steps towards greater exchange rate flexibility would strengthen the credibility of the inflation-targeting framework and protect against shocks. Directors also saw merit in deepening of the foreign exchange market, thereby facilitating greater exchange rate flexibility.
Directors noted that while the financial system is sound, regulatory upgrades aimed at reducing dollarization and strengthening supervision will be important going forward. They encouraged the authorities to fully implement the 2008 FSAP recommendations, gradually adopt Basel III standards, and improve cross-border supervision. Directors observed that greater competition between public and private banks would help lower interest rate spreads and foster further financial deepening.
Directors called for stronger emphasis on structural reforms to boost Costa Rica’s growth potential and competitiveness. They encouraged greater private sector participation in the energy sector, along with a review of the tariff-setting framework, and infrastructure upgrades, notably to ease transportation bottlenecks. They saw scope for efficiency gains and improvement in educational outcomes. Directors stressed that more efficient education and social spending would especially benefit the most vulnerable segments of the population and foster more inclusive growth.