Public Information Notice: IMF Concludes 2002 Article IV Consultation with Costa Rica

March 7, 2003

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On March 3, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Costa Rica.1


The Costa Rican economy developed successfully in the 1990s: economic growth averaged about 5 percent annually during the decade, reflecting high domestic investment and progress on structural reforms, large inflows of foreign direct investment, declining inflation, and a stable exchange rate regime.

However, since 2000, economic growth has slowed to around 2 percent, inflation has remained at 10 percent, and unemployment has remained at about 6 percent. The external current account deficit has increased to about 5.5 percent of GDP, reflecting a sharp increase in imports of capital goods by public enterprises, and a loss of dynamism of exports, associated in part with some weakening of international competitiveness. Net official international reserves have remained at about 2-2½ months of imports, covering only the public sector component of short term external debt.

These developments reflected a combination of a weaker domestic policy framework and a deterioration in the external environment. The public sector deficit surged in recent years, reaching almost 6 percent of GDP in 2002 (from 3.8 percent in 2001). Current expenditures, mainly wages and pensions, rose by nearly 2 percentage points of GDP, while investment expenditures by public enterprises increased by about half of 1 percent of GDP. Costa Rica has been able to maintain ample access to capital markets, including the recent placement of two bonds for US$450 million in international capital markets. However, the rise in public debt to 52 percent of GDP in 2002 (two-thirds denominated in foreign currency), from 42 percent in the late 1990s, has contributed to an increase in domestic interest rates.

The rising difference between interest rates in colones and U.S. dollar terms combined with a crawling peg exchange rate regime have fueled large short-term capital inflows. Bank deposits have increased at an annual rate of nearly 20 percent during recent years, allowing rapid growth in credit to the private sector (25 percent annual increase).

There is a need for further steps to strengthen the health of the financial sector, although some progress has already been made in implementing the recommendations of the 2001 FSAP mission, especially in the area of supervision. Public sector banks will need to be kept fully capitalized, weaknesses in prudential regulations as well as risk and liquidity management will need to be eliminated, and bank supervision, especially of the large offshore banking system will need to be strengthened further. Steps also will be needed to minimize the risks arising from the high degree of dollarization of deposits and credit (about half of bank deposits and credit is denominated in foreign currency and about half of dollar credit is extended to non-dollar earners).

Progress in other areas of structural reform has also slowed in recent years. In particular, the privatization process lost dynamism following the failure in 2000 of efforts to open to private initiative the telecommunications sector and key economic sectors remain dominated by large public enterprises. Pension system reforms are also incomplete and there is a need to ensure that it does not become a serious burden on the public finances over the medium term.

The authorities are aware of the need to address potential vulnerabilities, advance structural reforms, and bolster further the health of the financial sector and have begun to take steps to re-orient economic policies. They intend to maintain full ownership of this effort and have not requested financial assistance from the Fund.

In the fiscal area, a number of temporary measures have been introduced since late 2002, including an increase in personal and corporate income tax rates and certain excises and stamp duties. A ceiling has been placed on nominal growth in discretionary government expenditures for 2003, and limits placed on public enterprise wage and investment spending. The authorities are facing strong resistance in implementing some of these measures, but they remain committed to achieving an important reduction of the fiscal deficit in 2003.

In the coming months, the authorities intend to complement these measures with a number of structural fiscal reforms, including a tax reform that aims at broadening the tax base, improvements in tax administration, a rationalization of public expenditure that seeks to limit revenue earmarking and wage indexation, and a strengthening of government control of public enterprises, especially of their wage and investment policies. These steps aim to raise the primary balance of the public sector to at least 2.5 percent of GDP over the medium term, which, together with a resumption of rapid economic growth, would help ensure debt sustainability.

The authorities are also taking steps to bolster the health of the financial system, including measures to reinforce prudential regulation and help level the playing field among private and public banks. Steps are also being taken to strengthen supervision of offshore banks, including through the introduction of consolidated supervision of financial holdings and information-sharing agreements with countries where offshore banks are located. Reforms are also being proposed to increase the operational autonomy of public banks and strengthen risk and liquidity management in the banking system.

At the same time, the authorities intend to continue with their efforts to broaden Costa Rica's export base. The authorities are hopeful that a free trade agreement with the United States (currently being negotiated jointly with the other central American countries) will be concluded soon.

Executive Board Assessment

Directors praised Costa Rica for being at the forefront of economic and social progress in Latin America and the Caribbean over the past few decades, achieving high rates of growth, and witnessing major improvements in its social indicators. They also commended the authorities on their long-standing traditions of democratic accountability, solid institutions, and rule of law and governance. Directors noted, however, that macroeconomic vulnerabilities have increased sharply in recent years, presenting the authorities with major policy challenges. Growth has been disappointing, continuing fiscal deficits have resulted in substantial growth in public debt, and large public sector financing requirements have maintained an upward pressure on domestic interest rates, discouraging private investment and encouraging a rapid dollarization of the banking system. These developments, combined with a sharp increase in the general perception of risk in emerging markets, highlighted the need for a rapid reorientation of economic policies. Directors therefore strongly endorsed the authorities' commitment to address these vulnerabilities through a significant and comprehensive strengthening of the reform process, as well as their desire to retain full ownership of the necessary adjustment effort.

Directors noted that the most urgent policy challenge was to bring about a significant and sustained increase in the primary fiscal balance, and thus to ensure medium-term debt sustainability. They welcomed the authorities' intention to reduce the fiscal deficit in 2003 in order to stop the growth of its public debt, and the measures implemented since end-2002 to achieve this objective, including increases in tax rates, a strengthening of tax administration, and limits on expenditures. However, some of these measures are temporary in nature, and would not suffice to produce a lasting turnaround in the public finances. Hence, Directors supported the authorities' intention to seek legislative approval for, and put in place, a number of fiscal reforms recommended by several high-level commissions, namely, broadening the tax base, further strengthening tax administration, and rationalizing expenditures through reducing revenue earmarking and wage indexation. These measures are designed to achieve a permanent increase in the primary surplus of the public sector over the medium term, to a level well above the average in the 1990s.

A strengthening of the finances of the public enterprises will also be essential to achieve the targeted increase in the primary surplus over the medium term. Directors agreed with the authorities' decision to strengthen government control over public enterprise operations, especially with regard to wage and investment spending, and their indebtedness. Directors noted the strong resistance faced by the authorities and urged them to persevere with their efforts in this area.

For medium-term fiscal sustainability, Directors also noted the need to strengthen the financial viability of the pension system through increasing minimum retirement ages and lowering replacement ratios, and encouraged the authorities to start building the national consensus necessary for these actions. They equally stressed the need for further progress in privatization to ease pressures on the public sector for providing much-needed improvements in the country's infrastructure. In this context, they encouraged the authorities to adopt a more ambitious privatization program, going beyond planned concessions in the areas of road works, ports, and airports.

Directors noted that improved debt management would help reduce the vulnerabilities stemming from current debt levels. They encouraged the authorities to keep markets well informed of developments in the country, improve risk management techniques, and rely more on domestic capital markets to cover the financing needs of the government.

Directors urged the authorities to decisively address the weaknesses of the financial sector. They welcomed efforts under way to recapitalize a large public bank, to level the playing field between public and private banks, and to strengthen prudential regulation and supervision. Directors noted, however, that additional measures had been recommended by the 2001 FSAP mission. In this context, they urged the authorities to enhance the operational autonomy of public banks with a clearer separation between their commercial and development banking operations; remove the deposit requirements of private banks in public banks; establish a broadly-based but limited deposit insurance scheme; and sharply strengthen supervision of offshore banks. They also encouraged the authorities to strengthen risk and liquidity management. As regards the anti-money laundering regime, Directors noted that enforcement procedures on suspicious transactions have been improved, and encouraged the authorities to continue their efforts in this area.

Directors noted the adverse impact of the high degree of dollarization on the banking system and the public finances. They urged the authorities to take steps to address dollarization by strengthening the macroeconomic framework and by introducing appropriate changes in prudential bank regulations and removing distortions that favor lending in dollars.

In discussing the crawling peg exchange rate regime, Directors considered that progress in reducing fiscal and financial sector vulnerabilities would present a window of opportunity to explore more flexibility in exchange rate determination. The authorities were encouraged to start the preparations towards a monetary policy framework consistent with inflation targeting and an increasingly flexible exchange rate regime. In this connection, Directors recommended that attention be paid to a careful sequencing of the proposed reforms of the exchange system with reforms in the fiscal and financial sectors. More generally, Directors also considered it essential to strengthen the central bank's autonomy in the conduct of monetary policy, and to recapitalize the Bank and eliminate the source of its quasi-fiscal losses.

Directors noted the progress made by Costa Rica in opening new markets for its exports. They welcomed the start of the negotiations for a free trade agreement between the Central American countries and the United States, and pointed to the positive impact this agreement would have on export development, foreign direct investment, and economic growth. However, Directors stressed that Costa Rica's ability to take full advantage of the new foreign trade opportunities will depend largely on the progress made in addressing current vulnerabilities.

Costa Rica: Selected Economic and Financial Indicators











Real economy (change in percent)


Real GDP






Consumer prices (end of period)






National savings (in percent of GDP)






Gross domestic investment (in percent of GDP)







Public finance (in percent of GDP)


Combined public sector deficit






Central government deficit







Money and credit (end-year, percent change)


Net domestic assets






Of which:


Net claims on nonfinancial


public sector






Credit to private sector






Liabilities to private sector







Interest rates (end of period)


Deposit rate (time deposits)






Lending rate







External sector (in percent of GDP)


Trade balance






Current account






Change in net international reserves (in millions of U.S. dollars, increase -)






Net international reserves (in millions of U.S. dollars) 1/






Gross reserves (in months of next year's imports of goods and services) 1/






External public debt (as percentage of GDP)






Real effective exchange rate (percent change, end-period; appreciation +)






Sources: Central bank; Ministry of Finance; and IMF staff estimates.


1/ Excludes bilateral claims under negotiations with neighboring countries, which in the official statistics are classified as part of

international reserves.


1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepared a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of the Executive Directors, and this summary is transmitted to the country's authorities.


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