IMF Executive Board Concludes 2017 Article IV Consultation with Costa Rica

June 27, 2017

The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Costa Rica on June 14, 2017, and considered and endorsed the staff appraisal without a meeting on a lapse-of-time basis. [2]

Costa Rica’s economy is growing at its estimated trend rate of about 4¼ percent and the output gap is essentially closed. Headline inflation turned positive again in the second half of 2016 and is rising moderately, with both headline and core indicators still below the 2-4 percent target range. The colón has been depreciating moderately since mid-2016, while reserves have declined despite the narrowing in the current account deficit. Considering that inflation is returning to desired levels and that output is at potential, the central bank increased its policy rate by 225 basis points since April 2017, to 4 percent. Financial conditions are now broadly neutral, having gradually eased in 2016, the financial system appears sound, and credit growth continues to be consistent with healthy financial deepening and macroeconomic trends. The fiscal deficit remains high and public debt continues to rise rapidly despite the authorities’ deepened consolidation efforts in 2016. Recent advances in fiscal consolidation have been partly reversed and political consensus on a comprehensive fiscal package remains elusive.

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. In 2017, growth is anticipated to slow marginally to 4 percent, driven by weaker terms-of-trade and more stringent financial conditions. Past monetary stimulus, fading base effects from past oil price declines, and the continuing moderate depreciation since mid-2016, are expected to bring inflation back to the middle of the target range by end-2017. Financial conditions are anticipated to gradually tighten amid the incipient monetary policy normalization, persistently high public sector financial needs, and rising international rates. Consequently, potential growth will also 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 and despite a modest positive effect of the recent depreciation on exports. Key downside risks relate to persistently high fiscal deficits and rising public debt, the heavy dollarization of bank assets and liabilities, and a less favorable external environment, including tighter-than-expected global financial conditions, a retreat in cross-border integration, and weaker-than-projected global growth.

Executive Board Assessment

In concluding the 2017 Article IV Consultation with Costa Rica, Executive Directors endorsed staff’s appraisal as follows:

Risks to the outlook are rising, underscoring the increasing urgency of addressing mounting macro vulnerabilities. The economy is growing at trend, inflation is returning to target, and the external current account deficit has narrowed. The exchange rate depreciated moderately and international reserves declined due to reduced external budget and bank financing, as well as domestic portfolio switches into FX deposits. The external position continues to be close to equilibrium. However, weakening domestic fundamentals stemming from large fiscal deficits make the country particularly vulnerable to the projected tightening in global financial conditions and other external risks. While growth is anticipated to slow only marginally in 2017, potential growth would be eroded over the medium term reflecting higher risk premia and greater need for monetary tightening in a baseline scenario without additional fiscal reforms. If fiscal vulnerabilities are not addressed, competitiveness and the external position could also be negatively affected.

Current economic conditions call for continuation of fiscal consolidation and monetary policy normalization. With the output virtually at potential and a still sizeable fiscal sustainability gap, the near-term policy mix should be characterized by gradual budgetary adjustment and unwinding of monetary easing. Hence, it is important to administratively contain expenditure and mobilize revenue to minimize the short-term deterioration from recent constitutional court rulings expanding revenue earmarking. The central bank should keep tightening the monetary stance to maintain inflation around the mid-point of the target range and prevent jeopardizing the incipient anchoring of inflation expectations to the target band.

A comprehensive reform strategy is needed to achieve long-term fiscal sustainability. The authorities’ main proposal consisting of broadening the bases of the VAT and income tax as well as hikes in their rates, accompanied by sustained administrative steps to contain the wage bill, would be sufficient to stabilize public debt within safe levels in the medium term. Congressional approval before the elections of a balanced package, including the aforementioned tax reforms but also public employment and fiscal responsibility laws, would be important. Parametric reforms are also needed to shore up the pension system over the long term.

Greater exchange rate flexibility would strengthen the credibility of the IT framework, enhance resilience to external shocks. Moreover, enhanced transparency of the triggers for the FX-intervention rule would firm confidence in the full subordination of exchange rate management to the inflation objectives. Greater exchange rate flexibility would also reinforce the role of the exchange rate as a shock absorber while easing pressure on international reserves, and help internalize exchange rate risks, thus reducing FX mismatches and discouraging dollarization.

The introduction of micro- and macro-prudential tools to contain systemic financial risks is welcomed, but more may be needed. Further tightening of regulatory requirements should be considered if there is no evidence of a reduction in banks’ FX exposures, or if the deceleration of FX credit proves temporary. Additional measures could include higher reserve and liquidity requirements on FX liabilities, complemented by increases in capital buffers and provisioning, and stricter controls on FX loans. In addition, implementation of pending 2008 FSAP recommendations and adoption of Basel III standards would improve resilience of the financial system.

Structural reforms are required to maintain the country’s competitive position. Addressing weaknesses in transport infrastructure, education expenditure efficiency, and taking steps to support financial deepening would be critical to help accelerate potential growth and make it more inclusive. The successful implementation of environmental policies has buttressed the economy’s structural transformation towards higher growth services. The authorities also need to build on this by providing a legal and regulatory environment that stimulates those sectors that are more resilient to climate change.



Table 1. Costa Rica: Selected Social and Economic Indicators, Baseline Scenario 1/

Population (2016, millions) 4.9

Human Development Index Rank (2016) 66 (out of 188)

Per capita GDP (2016, U.S. dollars) 11,888

Life expectancy (2015, years) 79.6

Unemployment (2016, percent of labor force) 9.5

Literacy rate (2015, percent of people ages > 15) 97.6

Poverty (2016, percent of population) 20.5

Ratio of girls to boys in primary and secondary

Income share held by highest 10 percent of households 36.9

education (2014, percent) 102.0

Income share held by lowest 10 percent of households 1.5

Gini coefficient (2014) 48.5

Proj.

2013

2014

2015

2016

2017

2018

(Annual percentage change, unless otherwise indicated)

Output and Prices

Real GDP growth

2.3

3.7

4.7

4.3

4.0

4.0

Output gap (percent of potential GDP)

-0.4

-0.6

0.0

0.1

0.0

-0.1

GDP deflator

4.0

5.8

2.7

2.3

1.5

3.2

Consumer prices (end of period)

3.7

5.1

-0.8

0.8

3.0

3.0

Money and Credit

Monetary base

10.2

10.4

9.2

6.4

2.8

6.5

Broad money

7.7

15.4

4.0

2.3

6.3

7.5

Credit to private sector

12.2

17.5

11.8

12.8

11.1

10.9

Monetary policy rate (percent; end of period) 4/

3.8

5.3

2.3

1.8

2.5

…

(In percent of GDP, unless otherwise indicated)

Savings and Investment

Gross domestic investment

19.0

18.8

20.2

19.7

19.6

19.5

Gross domestic savings

14.1

13.9

15.9

16.5

15.6

15.6

External Sector

Current account balance

-4.8

-4.9

-4.3

-3.2

-4.0

-4.0

Of which: Trade balance

-11.0

-10.4

-9.0

-7.8

-8.5

-8.5

Financial and capital account balance

-6.1

-6.0

-4.9

-3.7

-3.7

-3.7

Of which: Foreign direct investment

-4.8

-5.6

-4.8

-4.6

-4.6

-4.5

Change in net international reserves (increase +)

474

-119

622

-260

-325

0

Net international reserves (millions of U.S. dollars)

7,331

7,211

7,834

7,574

7,249

7,249

Public Finances

Central government primary balance

-2.8

-3.0

-3.0

-2.4

-2.8

-2.8

Central government overall balance

-5.6

-5.9

-5.6

-5.3

-6.1

-6.5

Central government debt

35.8

38.3

40.8

44.7

48.4

51.7

Consolidated public sector overall balance 2/

-5.4

-5.5

-5.8

-4.6

-5.6

-6.1

Consolidated public sector debt 3/

41.8

42.8

45.4

49.2

51.9

54.1

Of which: External public debt

8.7

10.2

11.3

11.3

11.1

10.6

Memorandum Item:

GDP (US$ billions)

50.3

51.3

55.5

58.1

60.0

63.7

Sources: Central Bank of Costa Rica, Ministry of Finance, and Fund staff estimates.

1/ The baseline scenario includes additional consolidation deriving from already adopted legislative measures, mainly to combat tax evasion and curtail unspent budgetary allocations of decentralized government entities. It includes increases in education and social expenditures broadly consistent with constitutional mandates, as well as limited increases in investments.

2/ The consolidated public sector balance comprises the central government, decentralized government entities, public enterprises, and the central bank, but excludes the Instituto Costarricense de Electricidad (ICE).

3/ The consolidated public debt nets out central government and central bank debt held by the Caja Costarricense del Seguro Social (social security agency) and other entities of the nonfinancial public sector.

4/ The 2017 data is as of April 2017.


[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 prepares a report, which forms the basis for discussion by the Executive Board.

[2] The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.

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