## cr17156

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### 1. Recent developments — real sector, prices, and monetary policy
- Growth and output:
  - Economy growing robustly in 2015–16; GDP expanded by 4¾ percent in 2015 and around 4¼ percent in 2016 (¶5, ¶9).
  - Output gap: essentially closed.
  - 2016 growth supported by strong export performance (medical devices, corporate services, agricultural products), lower oil prices, and supportive financial conditions.
  - Intel’s manufacturing withdrawal and adverse agricultural weather in 2015 were offset by large investment schemes (notably a new port terminal).
- Labor market:
  - Unemployment remained elevated; underemployment decreased substantially; labor force participation and employment continued to decline.
- Inflation and monetary policy:
  - Headline and core inflation stayed below the BCCR 2-4 percent target range in the last two years; headline inflation turned negative in H2 2015 and returned to positive in H2 2016.
  - Central bank policy rate set at 1¾ percent since early 2016 after cumulative cuts of 350 basis points.
  - BCCR increased policy rate by 225 basis points since April 2017, to 4 percent (¶4, ¶11).
- External sector and reserves:
  - Current account deficit: 3¼ percent of GDP in 2016 (down from 4¼ percent in 2015).
  - Sustained strong FDI of about 4½ percent of GDP.
  - International reserves fell by about US$260 million to US$7.6 bln in 2016; early 2017 additional reserve loss about US$430 mln and colón depreciation about 6½ percent; overall colón depreciated about 3 percent in 2016.
- Competitiveness and REER:
  - CPI-based REER depreciated 1½ percent in 2016; staff estimates indicate an appreciated equilibrium REER with productivity gains implying some competitiveness improvements (Annex I).
- Financial conditions:
  - Financial conditions broadly neutral after easing in 2016; a broad-based FCI suggests conditions expansionary in 2016, turning neutral toward end-2016.
  - Real lending rates fell in 2016; credit decelerated in late 2016 steered by slowing FX loans.
  - FX lending and high dollarization remain key financial sector vulnerabilities (¶25, ¶27).

### 2. Baseline macroeconomic outlook and staff projections (2016–2022)
- Baseline assumptions and near-term outlook:
  - Baseline does not incorporate fiscal adjustment provisions beyond those already sanctioned; primary fiscal deficit assumed almost 3 percent of GDP over the medium term.
  - 2017 growth anticipated to slow marginally to 4 percent.
  - Financial conditions expected to gradually tighten; inflation projected to return to middle of target range by end-2017.
  - Without additional consolidation, public debt will rise close to 65 percent of GDP by 2022 driven mainly by mounting interest bill (¶18).
- Baseline Scenario (staff estimates — in percent of GDP, unless otherwise indicated):
  - Real GDP growth (percent): 4.3, 4.0, 4.0, 3.9, 3.9, 3.8, 3.8
  - Potential GDP growth (percent): 4.2, 4.1, 4.1, 4.0, 3.9, 3.8, 3.8
  - Output gap (percent of potential GDP): 0.1, 0.0, -0.1, -0.2, -0.2, -0.2, -0.2
  - CPI (percent, end-of-period): 0.8, 3.0, 3.0, 3.0, 3.0, 3.0, 3.0
  - Credit growth (percent): 12.8, 11.1, 10.9, 10.0, 9.2, 8.6, 8.1
  - Current account balance: -3.2, -4.0, -4.0, -4.0, -4.0, -4.0, -4.0
  - Central government fiscal balance: -5.3, -6.1, -6.5, -6.9, -7.3, -7.7, -8.2
  - Structural primary balance: -2.4, -2.8, -2.8, -2.8, -2.7, -2.7, -2.7
  - Central government debt: 44.7, 48.4, 51.7, 55.2, 58.4, 62.1, 66.0

### 3. Alternative (Adjustment) scenario and impacts
- Adjustment required and effects:
  - Staff analysis: additional correction of about 3 percent of GDP would stabilize public debt in the medium term with moderate short-term output costs and higher growth in outer years.
- Adjustment Scenario (includes measures of 3 percent of GDP):
  - Real GDP growth (percent): 4.3, 4.0, 4.1, 3.8, 4.4, 4.4, 4.2
  - Potential GDP growth (percent): 4.2, 4.2, 4.2, 4.2, 4.2, 4.2, 4.2
  - Output gap (percent of potential GDP): 0.1, 0.0, -0.1, -0.4, -0.2, 0.0, 0.0
  - CPI (percent, end-of-period): 0.8, 3.0, 3.0, 3.0, 3.0, 3.0, 3.0
  - Credit growth (percent): 12.8, 11.0, 11.0, 11.2, 11.3, 11.7, 10.9
  - Current account balance: -3.2, -3.8, -3.7, -3.0, -2.9, -2.8, -2.7
  - Central government fiscal balance: -5.3, -5.7, -5.6, -4.1, -3.5, -3.2, -3.2
  - Structural primary balance: -2.4, -2.5, -2.3, -0.5, 0.2, 0.2, 0.3
  - Central government debt: 44.7, 48.0, 50.3, 51.0, 50.6, 50.1, 49.7

### 4. Fiscal sustainability, required adjustment, and scenarios
- Fiscal outlook and risks:
  - Without additional policy action, central government primary deficit would return to around 3 percent of GDP; overall deficit would rise over 8 percent of GDP and debt reach 65 percent of GDP by 2022 (from 45 percent at end-2016).
  - Fiscal sustainability gap has declined by ¾ percent of GDP since last Article IV.
- Recommended adjustment:
  - Mission recommendation: further budget adjustment of 3 percent of GDP to stabilize public debt ratio and keep public debt below levels that weaken macro stability.
  - Authorities’ main plan: full-fledged tax reforms plus administrative steps to contain wage bill would deliver the 3 percent of GDP residual adjustment.
  - Alternative legislative package would yield at most 1½ percent of GDP; removal of VAT rate increases explains much of the shortfall.
- Composition of Fund-endorsed consolidation package (percent of GDP, totals 2017–2022):
  - Total Adjustment: 3.0
  - Revenue (total): -2.3
  - VAT: -1.5
  - Base widening (services): -0.5
  - Tax rate (13 to 15 percent): -0.8
  - Vehicle and real estate sales: -0.2
  - Income tax: -0.8
  - Expenditure: 0.7
  - Wage bill (hiring freeze and salary increases 1 percent below inflation): 0.7
- Distributional implications:
  - Staff estimates: Fund-endorsed package would be distributionally positive due to increased progressivity of income tax and VAT transfers to low-income households offsetting regressive VAT impacts (AN II.A).
- Pension system:
  - Independent actuarial recommendations: raise retirement age to 70 years; cut replacement rate by one fifth; lift contribution rate up to 26 percent by 2055.
  - CCSS announced a 1 percent increase in the employee’s contribution rate (bringing total contribution to 9.5 percent) from June 2017 and commenced a national dialogue on additional reforms.

### 5. Public debt dynamics, DSA highlights, and recommended path (Annex IV)
- DSA summary:
  - Debt projected to rise over 65 percent of GDP by 2022 in the baseline; headline deficit exceeds 8 percent of GDP in 2022; average gross financing needs 12 percent of GDP in 2017–22.
  - Adjustment scenario: additional measures of 3 of GDP, gradual but frontloaded, stabilize debt by 2022 just below 50 percent of GDP assuming tightening in credit spreads.
- Key assumptions:
  - Potential growth assumed to slow from 4.3 percent in 2016 to 3.8 percent by 2022.
  - Baseline assumes additional fiscal adjustment of about ¾ percent of GDP from already approved measures.
- Market spreads and costs:
  - External financing costs currently around 400 basis points; spreads briefly exceeded 600 basis points in late 2015–early 2016.
  - Domestic financing costs declined in prior year due to pass-through of policy rate cuts and greater reliance on floating rate and dollar-denominated bonds, increasing medium-term balance sheet vulnerabilities.

### 6. Financial sector vulnerabilities, indicators, and policy measures
- Structural vulnerabilities:
  - Costa Rica among highest credit dollarization in region.
  - Banking system heavily reliant on foreign funding; about 35 percent of bank liabilities in foreign currency (Annex IV).
  - About 40 percent of credit to non-financial private sector denominated in foreign currency; over 70 percent of such FX credit extended to unhedged borrowers.
  - Banks adequately capitalized and liquid; profitability low by regional standards; NPLs remain low.
- Selected indicators (quarterly series where noted):
  - FX loans % (of total loans): 41.0, 41.2, 41.4, 41.8, 41.8, 42.1, 41.5, 41.0
  - FX liabilities % (of total liabilities): 34.6, 35.1, 33.7, 33.5, 33.9, 33.1, 33.7, 33.5
  - Deposit-to-loan ratio: 100.8, 104.8, 98.4, 96.6, 96.6, 90.4, 93.3, 85.7
  - Leverage ratio (%): 10.0, 9.7, 9.9, 9.7, 9.9, 9.7, 9.5, 9.3
  - ROA: 1.1, 1.0, 1.0, 1.1, 1.2, 1.2, 0.6, 0.6
  - ROE: 8.0, 7.4, 7.3, 7.3, 8.3, 8.7, 4.3, 4.3
  - NPL ratio: 1.6, 1.6, 1.7, 1.7, 1.7, 1.6, 1.6, 1.6
- Stress test and resilience findings:
  - Despite long FX position, a large colón depreciation would indirectly affect capital adequacy via higher NPLs from unhedged borrowers.
  - Significant spike in interest rates would produce mark-to-market losses on domestic government bonds; banks appear sufficiently capitalized to absorb shocks; smallest public bank required a restructuring plan.
- Prudential and macroprudential measures adopted or proposed:
  - Higher risk-weightings on household mortgages with high LTV ratios and penalization for FX mortgages to unhedged borrowers.
  - Additional generic provisioning of 1.5 percent on FX loans to unhedged borrowers.
  - Countercyclical provisional buffers.
  - April 2017 SUGEF proposal: revision of minimum capital requirements for market risk in line with Basel III.
  - Proposed regulation requiring banks to fix net open FX position as a share of capital.
- Staff caution:
  - If banks’ FX exposures do not decline in a reasonable time or FX credit deceleration is temporary, further tightening should be considered: higher reserve and liquidity requirements on FX liabilities; increases in capital buffers and provisioning; stricter LTV ratios on FX loans.

### 7. External stability and REER assessment (Annex I)
- External position:
  - Staff views external position broadly in line with medium-term fundamentals and desirable policies.
  - 2016 REER depreciated about 1½ percent; REER level about 30 percent above 2009 level attributed to relative productivity improvement (Balassa-Samuelson).
- Current account and exports:
  - CA deficit improved to 3¼ percent of GDP in 2016.
  - Exports grew more than 9 percent in 2016; tourism expanded more than 12 percent.
- Financing and reserves:
  - CA largely financed by FDI; Net IIP negative at more than 45 percent of GDP.
  - International reserves: decline of US$260 mln in 2016; stock was 4.9 months of non-maquila imports at end-2016 and within Fund’s adequacy metric.
- External balance assessment results (methodologies):
  - Macro balance (EBA): sustainable CA norm deficit of 4.8 percent of GDP in 2016; actual cyclically-adjusted deficit 3.2 percent; implies REER undervaluation of 3.8 percent.
  - EBA-lite: REER undervaluation of 4.7 percent and sustainable CA norm about 5¼ percent of GDP.
  - External sustainability (ES) approach: slight REER overvaluation of 2 percent; excluding FDI implies moderate undervaluation of 7.9 percent.
  - Staff aggregation: simple average across methodologies implies no over- or undervaluation; conclusion: REER broadly in line with fundamentals.

### 8. Risks to the outlook and risk assessment matrix
- Risks tilted to the downside:
  - External risks:
    - Markedly tighter global financial conditions (stronger U.S. dollar, faster Fed normalization) could inflict significant damage given weak budgetary situation, bank reliance on foreign funding, and high credit dollarization.
    - Retreat in cross-border integration and protectionism could reduce trade, capital and labor flows, and FDI; adverse U.S. policy scenario could decrease GDP growth by ½ percent over medium term (ANNEX I).
    - Intensification of AML-compliance concerns could exacerbate loss of correspondent banking relationships risk (¶29).
  - Domestic risks:
    - Persistent large fiscal deficits and gross financing requirements increase vulnerability to higher domestic interest rates and adverse global market sentiment.
    - Greater reliance on floating rate and dollar-denominated bonds could exacerbate financing risks (¶7).
    - Financial stability risks from substantial currency depreciation given low profitability and heavy dollarization, via higher NPLs (¶25).
- Risk Assessment Matrix — selected high-concern items (levels preserved as in source):
  - 1. Tighter global financial conditions — Overall level of concern: High/Medium; Relative likelihood: High/Medium; Impact if realized: High/Medium.
  - 2. Retreat in cross-border integration — Overall level of concern: High; Relative likelihood: High; Impact if realized: High/Medium.
  - 3. Slower growth in advanced and/or emerging economies — Overall level of concern: Medium/High; Relative likelihood: Medium/High; Impact if realized: Medium/High.
  - 4. Worse-than-anticipated fiscal deficits or persistence of high deficits — Overall level of concern: High; Relative likelihood: High; Impact if realized: High.

### 9. Policy discussions and IMF staff recommendations
- Overall policy focus:
  - Restore fiscal sustainability; improve monetary policy framework; enhance financial system supervision and regulation; boost potential and inclusive growth.
- Near-term policy mix:
  - Additional fiscal tightening and continued monetary policy normalization.
  - With output essentially at potential, inflation recovering, and a sizeable fiscal sustainability gap, authorities should deepen budgetary consolidation and withdraw monetary stimulus.
- Fiscal policy recommendations:
  - Continued fiscal consolidation in 2017 on a gradual path toward fiscal sustainability.
  - Intensify administrative efforts to curtail expenditure and mobilize revenue to minimize or prevent fiscal deterioration, including seeking Congressional approval of additional legislative measures (¶19–21).
  - Note: Primary deficit expected to widen to 2¾ percent of GDP this year under baseline due to recent Constitutional court rulings (¶8).
- Monetary policy recommendations:
  - Central bank should continue reversing the easing cycle; consider further tightening during second half of 2017, especially if price pressures threaten to push inflation above the mid-point of the target range.
  - Policy rate at 4 percent as of May 2017 still below estimated neutral rate of 5 percent.
- Exchange rate and market development:
  - Mission recommendation: more XR flexibility and enhanced transparency about FX-intervention triggers to strengthen credibility of inflation targeting, make XR a shock absorber, limit reserve loss, reduce FX mismatches, and discourage dollarization.
  - Deepen secondary market for government securities using standardized instruments; BCCR planned single-price FX auction introduction in July 2017.
- Financial sector measures:
  - Continue and, if needed, tighten prudential measures to reduce FX exposures and strengthen resilience (higher reserve and liquidity requirements on FX liabilities; increases in capital buffers and provisioning; stricter LTV ratios on FX loans if FX exposures do not decline).
  - Accelerate implementation of pending 2008 FSAP recommendations and gradually introduce Basel III standards (Net Stable Funding Ratio planned for 2018 in addition to Liquidity Coverage Ratio enacted in 2015).
- Structural reforms to support competitiveness and growth:
  - Address transport infrastructure weaknesses; improve public expenditure efficiency (especially education); strengthen competition policies; amend electricity regulatory framework; expand child-care provision to boost female labor participation; stimulate sectors resilient to climate change.

### 10. Selected social and economic indicators (baseline and historical)
- Population (2016): 4.9 (millions)
- Per capita GDP (2016, U.S. dollars): 11,888
- Unemployment (2016, percent of labor force): 9.5
- Poverty (2016, percent of population): 20.5
- Income share highest 10 percent: 36.9
- Income share lowest 10 percent: 1.5
- Human Development Index Rank (2016): 66 (out of 188)
- Life expectancy (2015, years): 79.6
- Literacy rate (2015, percent ages > 15): 97.6
- Gini coefficient (2014): 48.5
- Real GDP growth (selected years): 2013: 2.3; 2014: 3.7; 2015: 4.7; 2016: 4.3; 2017: 4.0 (proj.); 2018: 4.0 (proj.)
- Consumer prices (end of period): 2013: 3.7; 2014: 5.1; 2015: -0.8; 2016: 0.8; 2017: 3.0 (proj.); 2018: 3.0 (proj.)
- Monetary policy rate (percent; end of period; 2017 data as of May 2017): 2013: 4/3.8; 2014: 5.3; 2015: 2.3; 2016: 1.8; 2017: 4.0

*International Monetary Fund — Costa Rica: IMF staff report excerpts (cr17156).*

### 1.    Recent Developments, Real Sector _____________________________________________________________ 6

### 1.    Recent Developments, Real Sector

### Overview
- The economy is growing robustly boosted by favorable external conditions, but macro vulnerabilities, mainly from the weak fiscal position, remain elevated.
- Good economic performance in 2015-16 aided by continuing low commodity prices and ample liquidity in financial markets.
- Persistence of large fiscal deficits and continued increases in the public-debt-to-GDP ratio make Costa Rica vulnerable to adverse changes in financial market sentiment (¶13).
- Inflation and the current account deficit declined significantly on the back of lower oil prices, but inflation is expected to return to target this year, while the current account is anticipated to widen slightly over the medium-term as international commodity prices recover (¶11).
- FX lending remains the key financial sector vulnerability despite recent deceleration (¶25).

### Real activity and labor market
- Activity fell below potential during 2013-14; slack largely plugged in 2015 when GDP expanded by 4¾ percent.
- In 2016, growth was around 4¼ percent, supported by strong export performance, additional terms-of-trade gains from lower oil prices, and supportive financial conditions (¶5, ¶9).
- Output gap: essentially closed.
- Intel’s manufacturing withdrawal, adverse agricultural weather in 2015, and normalization in investment were offset by large investment schemes, notably for a new port terminal.
- Labor market: unemployment remained elevated, underemployment decreased substantially, labor force participation and employment continued to decline.

### Inflation and monetary policy
- Headline and core inflation stayed below the BCCR target range in the last two years, anchoring inflation expectations within it.
- Sharp decline in imported oil prices pushed headline inflation negative in H2 2015; core inflation fell close to zero by mid-2016 despite a broadly closed output gap.
- Central bank policy rate set at 1¾ percent since early 2016 after cumulative cuts of 350 basis points.
- Headline inflation turned positive again in H2 2016 as the effect of lower oil prices faded.
- Both headline and core indicators still below the 2-4 percent target range; inflation expectations converged inside the range, hovering near its top.
- BCCR increased policy rate by 225 basis points since April 2017, to 4 percent (¶4, ¶11).

### External sector and reserves
- Current account deficit fell to 3¼ percent of GDP in 2016, from 4¼ percent in 2015, amid low oil prices and strong export growth (medical devices, corporate services, agricultural products).
- Sustained strong FDI of about 4½ percent of GDP.
- International reserves fell by about US$260 million to US$7.6 bln in 2016—the largest drop since 2008—but remain well above the Fund’s adequacy metric.
- Drivers of lower net FX supply: decrease in external budget financing; reduced premia on savings in local currency prompting portfolio switches into dollar deposits; expectations of decoupling from the U.S. dollar leading banks to decrease foreign funding and increase deposits abroad in FX.
- Early 2017: additional reserve loss of about US$430 mln and colón depreciation of about 6½ percent; overall colón depreciated about 3 percent in 2016.

### Competitiveness and real exchange rate
- With average headline inflation near zero and modest nominal XR devaluation, CPI-based REER depreciated 1½ percent in 2016.
- Fund’s multilaterally consistent estimates and other methodologies indicate an appreciated equilibrium REER and continued productivity growth, implying some competitiveness gains in 2016 (Annex I).
- Exports and FDI persistent strength confirm improvement; overall external position remains broadly in equilibrium.
- Risks to external stability: continuing large fiscal deficits, inadequate infrastructure, public spending inefficiencies (¶30), and excessive regulatory costs.

### Fiscal developments
- Fiscal deficit remains high; public debt continued to rise rapidly despite consolidation efforts in 2016.
- Primary deficit reduced by about ½ percent of GDP to 2½ percent of GDP in 2016 due to containment of wage bill growth and lower personal income tax evasion—imparting an equivalent negative fiscal impulse.
- Overall deficit dropped to 5¼ percent of GDP; public debt reached 45 percent of GDP at end-2016.
- Decline in cost of domestic financing occurred despite no new Eurobond issuance; government has relied more on floating rate and dollar-denominated bonds, extending average debt maturity but increasing medium-term balance sheet vulnerabilities.
- External bond spreads remained among the highest in Central America; sovereign rating fell deeper into sub-investment grade.
- Measures enacted in 2016 (anti-tax-evasion, containment of transfers to decentralized institutions and pensions paid out of the budget) expected to yield additional consolidation of about ½ percent of GDP in 2017-18.
- Constitutional court rulings mandating stricter enforcement of earmarking for social and education expenditure largely offset those gains.
- Government submitted a comprehensive fiscal package to parliament intended to close the sustainability gap; key tax provisions have not obtained parliamentary approval. Political resistance, trade union calls for a general strike over inclusion of the public employment law, and conflicting opposition statements have complicated adoption prior to early-2018 elections (¶7, ¶8).

### Financial conditions and sector vulnerabilities
- Financial conditions broadly neutral after gradual easing in 2016.
- Real lending rates fell in 2016 as pass-through from policy rate cuts quickened and inflation expectations stabilized; two-thirds of the 350 basis points cuts to 1¾ percent were mirrored in lower lending rates before tightening.
- REER depreciated slightly (¶6); credit decelerated in late 2016 steered by slowing FX loans due to increased XR volatility, reduced gap between domestic and FX lending rates, and macro-prudential measures increasing cost of FX lending to unhedged borrowers (¶27).
- Slower FX credit growth reduced need for banks’ foreign funding (¶5).
- A broad-based Financial Conditions Index (FCI) suggests conditions were expansionary in 2016 and turned neutral toward end-2016.
- Credit risks manageable; banks have adequate capital buffers but profitability low by regional standards.
- High dollarization of credit and bank liabilities creates XR-related credit and funding risks; buffers sufficient to withstand plausible shocks without raising solvency and liquidity concerns.
- Over-reliance on non-deposit liabilities has heightened vulnerability to market volatility and loss of confidence from foreign lenders, compounded by high perceived sovereign risk.

*International Monetary Fund — Costa Rica: 1. Recent Developments, Real Sector*

### 2. Inward

### 2. Inward spillover risks

### Macroeconomic outlook and baseline projections
- With approval of a fiscal package unlikely, baseline projections envisage that economic activity will ease somewhat, while inflation reverts to the target range.
- Assumptions and near-term outlook:
  - The baseline scenario does not incorporate fiscal adjustment provisions beyond those already sanctioned, leading to a stable primary fiscal deficit of almost 3 percent of GDP over the medium term.
  - In 2017, growth is anticipated to slow marginally to 4 percent.
  - Export performance is expected to remain robust, supported by recent real depreciation and accelerating global and especially U.S. growth.
  - Financial conditions should gradually tighten amid incipient monetary policy normalization, persistently high public sector financing needs, and rising international rates.
  - Past monetary stimulus, fading base effects from past oil price declines, and recent moderate depreciation are expected to bring inflation back to the middle of the target range by end-2017.
  - Over the medium-term, potential growth would be visibly eroded due mainly to strain on private investment from higher interest rates and costlier risk premia in the continuation of large budget deficits.
  - Credit is projected to expand modestly faster than nominal GDP, consistent with further healthy financial deepening.
  - The current account deficit will widen slightly to 4 percent of GDP amid gradual recovery of commodity prices.
  - Without additional significant consolidation steps, public debt will rise close to 65 percent of GDP by 2022, driven mainly by a mounting interest bill (¶18).

### Baseline Scenario (staff estimates — in percent of GDP, unless otherwise indicated)
- 2016–2022 key projections:
  - Real GDP growth (percent): 4.3, 4.0, 4.0, 3.9, 3.9, 3.8, 3.8
  - Potential GDP growth (percent): 4.2, 4.1, 4.1, 4.0, 3.9, 3.8, 3.8
  - Output gap (percent of potential GDP): 0.1, 0.0, -0.1, -0.2, -0.2, -0.2, -0.2
  - CPI (percent, end-of-period): 0.8, 3.0, 3.0, 3.0, 3.0, 3.0, 3.0
  - Credit growth (percent): 12.8, 11.1, 10.9, 10.0, 9.2, 8.6, 8.1
  - Current account balance: -3.2, -4.0, -4.0, -4.0, -4.0, -4.0, -4.0
  - Central government fiscal balance: -5.3, -6.1, -6.5, -6.9, -7.3, -7.7, -8.2
  - Structural primary balance: -2.4, -2.8, -2.8, -2.8, -2.7, -2.7, -2.7
  - Structural overall balance: -5.3, -6.1, -6.5, -6.9, -7.3, -7.7, -8.2
  - Central government debt: 44.7, 48.4, 51.7, 55.2, 58.4, 62.1, 66.0

### Alternative (Adjustment) scenario
- Staff analysis indicates an additional correction of about 3 percent of GDP would stabilize public debt in the medium term within safe levels, with only moderate short-term output costs and higher growth in outer years due to confidence effects and a more balanced policy mix.
- Adjustment Scenario (includes measures of 3 percent of GDP needed to stabilize debt):
  - Real GDP growth (percent): 4.3, 4.0, 4.1, 3.8, 4.4, 4.4, 4.2
  - Potential GDP growth (percent): 4.2, 4.2, 4.2, 4.2, 4.2, 4.2, 4.2
  - Output gap (percent of potential GDP): 0.1, 0.0, -0.1, -0.4, -0.2, 0.0, 0.0
  - CPI (percent, end-of-period): 0.8, 3.0, 3.0, 3.0, 3.0, 3.0, 3.0
  - Credit growth (percent): 12.8, 11.0, 11.0, 11.2, 11.3, 11.7, 10.9
  - Current account balance: -3.2, -3.8, -3.7, -3.0, -2.9, -2.8, -2.7
  - Central government fiscal balance: -5.3, -5.7, -5.6, -4.1, -3.5, -3.2, -3.2
  - Structural primary balance: -2.4, -2.5, -2.3, -0.5, 0.2, 0.2, 0.3
  - Structural overall balance: -5.3, -5.7, -5.6, -4.0, -3.4, -3.2, -3.2
  - Central government debt: 44.7, 48.0, 50.3, 51.0, 50.6, 50.1, 49.7

### Risks to the outlook (tilted to the downside)
- External risks:
  - Markedly tighter global financial conditions (stronger U.S. dollar, more rapid Fed normalization, rising risk premia) could inflict significant damage given Costa Rica’s weak budgetary situation, bank reliance on foreign funding, and high credit dollarization.
  - Retreat in cross-border integration and protectionism could reduce trade, capital and labor flows, and FDI; model simulations suggest a more adverse U.S. policy scenario could decrease GDP growth by ½ percent over the medium term (ANNEX I).
  - Weaker-than-expected global growth, especially from structurally lower expansion in key economies, would harm medium-term growth prospects.
  - Intensification of AML-compliance concerns could exacerbate loss of correspondent banking relationships risk (¶29).
- Domestic risks:
  - Persistent large fiscal deficits and large gross financing requirements increase vulnerability to hikes in domestic interest rates and adverse global market sentiment.
  - Greater reliance on floating rate and dollar-denominated bonds could exacerbate financing risks (¶7).
  - Financial stability risks from substantial currency depreciation given low profitability and heavy dollarization of the banking system, mainly through higher NPLs (¶25).

### Financial sector vulnerabilities and indicators
- Structural strengths and vulnerabilities:
  - Costa Rica is among the countries with the highest credit dollarization in the region.
  - The banking system is heavily reliant on foreign funding, though associated rollover risks appear manageable.
  - Exposure to a sovereign with high and rising public debt is a concern; banks hold notable claims on the central government.
  - Banks are adequately capitalized and liquid; NPLs remain low.
  - Profitability has been declining and remains below regional averages.
- Select indicators and trends (as reported):
  - FX loans % (of total loans): 41.0, 41.2, 41.4, 41.8, 41.8, 42.1, 41.5, 41.0 (quarterly series)
  - FX liabilities % (of total liabilities): 34.6, 35.1, 33.7, 33.5, 33.9, 33.1, 33.7, 33.5 (quarterly series)
  - Deposit-to-loan ratio: 100.8, 104.8, 98.4, 96.6, 96.6, 90.4, 93.3, 85.7 (quarterly series)
  - Leverage ratio (%): 10.0, 9.7, 9.9, 9.7, 9.9, 9.7, 9.5, 9.3
  - ROA: 1.1, 1.0, 1.0, 1.1, 1.2, 1.2, 0.6, 0.6
  - ROE: 8.0, 7.4, 7.3, 7.3, 8.3, 8.7, 4.3, 4.3
  - NPL ratio: 1.6, 1.6, 1.7, 1.7, 1.7, 1.6, 1.6, 1.6
  - NPL ratio change (%, annual): -2.0, 0.7, 1.6, 7.2, 4.7, 1.4, -4.8, -4.8
- Financial conditions and credit:
  - Financial conditions gradually eased in 2016 and are now broadly neutral.
  - Credit decelerated somewhat despite sustained economic activity, steered by lower FX loans.
  - Real lending rates started falling in 2016 after hedging up through 2015 despite large monetary loosening; about 2/3 of the policy rate cuts were mirrored in lower lending rates, but bank spreads remain high.

### Risk Assessment Matrix — selected high-concern items
- 1. Tighter global financial conditions
  - Overall level of concern: High/Medium
  - Relative likelihood: High/Medium
  - Impact if realized: High/Medium (significant increases in financing costs, exchange rate and reserve vulnerabilities, curtailment of financial services)
- 2. Retreat in cross-border integration
  - Overall level of concern: High
  - Relative likelihood: High
  - Impact if realized: High/Medium (substantial negative effects on trade, FDI, and investor sentiment)
- 3. Slower growth in advanced and/or emerging economies
  - Overall level of concern: Medium/High
  - Relative likelihood: Medium/High
  - Impact if realized: Medium/High (significant negative impact if U.S. growth weakens)
- 4. Worse-than-anticipated fiscal deficits or persistence of high deficits
  - Overall level of concern: High
  - Relative likelihood: High
  - Impact if realized: High (higher domestic interest rates, reduced investment and growth, exacerbated fiscal sustainability risks)

### Policy discussions and recommendations
- Overall focus of consultation:
  - Appropriate policy mix for current cyclical conditions and mitigation of longer-term economic vulnerabilities, including restoring fiscal sustainability, improving the monetary policy framework, enhancing financial system supervision and regulation, and boosting potential and inclusive growth.
- Near-term policy mix recommendation:
  - Additional fiscal tightening and continued monetary policy normalization.
  - With output essentially at potential, inflation recovering, and a sizeable fiscal sustainability gap, authorities should deepen budgetary consolidation and withdraw monetary stimulus.
- Fiscal policy recommendations:
  - Continued fiscal consolidation in 2017 as part of a gradual path toward fiscal sustainability.
  - Staff stressed intensifying administrative efforts to curtail expenditure and mobilize revenue to minimize or prevent fiscal deterioration.
  - Mission strongly supported authorities’ intention to seek Congressional approval of additional legislative measures in the last year of the Solis administration to make additional gains toward closing the sustainability gap over the medium term (¶19–21).
  - Note: The primary deficit is expected to widen to 2¾ percent of GDP this year under the baseline scenario, owing to recent Constitutional court rulings (¶8).
- Monetary policy recommendations:
  - The central bank should continue reversing the easing cycle.
  - Rationale:
    - Both headline and core inflation remain well below the target range, so the monetary stance has been appropriately expansionary; policy rate was 4 percent, still below the estimated neutral rate of 5 percent.
    - Inflation expectations sit near the upper bound of the target range and headline inflation is projected to return to the center of the range by end-2017.
    - With the output gap virtually closed and considering policy lags, staff advised the central bank should consider further tightening during the second half of 2017, especially if price pressures threaten to drive inflation above the mid-point of the target range.
    - Prospective Fed normalization and U.S. dollar strengthening could prompt colón depreciation and stoke inflation.

*Source: IMF staff report (Costa Rica), chapter "2. Inward spillover risks."*

### 18. Staff observed that, despite recent progress in budgetary consolidation, fiscal trends

### cr17156 - 18. Staff observed that, despite recent progress in budgetary consolidation, fiscal trends remain unsustainable in the long term

### Fiscal sustainability outlook
- Without additional policy action (baseline), the Central Government primary deficit would return to around 3 percent of GDP over the medium term.
- The overall deficit would rise over 8 percent of GDP and debt reach 65 percent of GDP by 2022, steadily growing thereafter, from 45 percent at end-2016, owing to a mounting interest bill and constitutionally-mandated education spending.
- The fiscal sustainability gap has declined by ¾ percent of GDP since the last Article IV.

### Recommended fiscal adjustment and scenarios
- Mission recommendation: further budget adjustment of 3 percent of GDP to stabilize the public debt ratio and keep public debt below levels that weaken macro stability in emerging markets, while accommodating increases in growth-friendly capital spending.
- Authorities’ main plan: full-fledged tax reforms accompanied by administrative steps to contain the wage bill would deliver the needed residual adjustment of 3 percent of GDP.
- Alternative legislative package: even if enacted would yield at most 1½ percent of GDP; the shortfall is mainly due to the removal of the VAT rate increases, partly offset by less generous compensation to lower-income families and taxation of previously exempt education and health services at a reduced rate.
- Alternative adjustment scenario (Fund-endorsed consolidation package):
  - Envisages Congressional approval of VAT and income tax reforms along the lines of the government’s main proposal, giving 2¼ percent of GDP.
  - Includes about ¾ percent of GDP in spending reductions—effected administratively, mostly through a partial hiring freeze and holding base salary increases below inflation.
  - Implementation mix: total adjustment since start of fiscal retrenchment in 2016 would consist for about two-thirds of additional revenues.
  - Political timing: approval could be split across administrations; delays imply consolidation would have to be less gradual than previously proposed to better modulate adverse growth impact.

### Fiscal consolidation composition and path (selected figures)
- Total sustainability gap: main plan vs alternative plan—legislative measures 2.3 and 1.5 (percent of GDP).
- VAT contribution: 1.5 (main plan) and 0.9 (alternative plan) (percent of GDP).
- Base widening (services): 0.5 (both plans) (percent of GDP).
- Tax rate hike (13 to 15 percent): 0.8 (main plan) (percent of GDP).
- Income tax: 0.8 (main plan) and 0.6 (alternative plan) (percent of GDP).
- Administrative expenditure measures: 0.7 (percent of GDP).
- Residual gap under alternative plan: -1.5 (percent of GDP).
- Full Adjustment Scenario, aggregate path (Percent of GDP, 2017–2022 totals):
  - Total Adjustment: 3.0
  - Revenue: -2.3
  - VAT: -1.5
  - Base widening (services): -0.5
  - Tax rate (13 to 15 percent): -0.8
  - Vehicle and real estate sales: -0.2
  - Income tax: -0.8
  - Expenditure: 0.7
  - Wage bill (includes hiring freeze and salary increases 1 percent below inflation): 0.7

### Distributional implications
- Staff estimates: distributional impact of the Fund-endorsed package would be positive, due to increased progressivity of the income tax and VAT transfers to low-income households more than offsetting the regressive impact of the VAT reform (AN II.A).
- Design features discussed: limiting VAT refund to poorer deciles and taxation at reduced rates of previously exempted health and education services.

### Pension system sustainability
- Independent actuarial report: only major parametric changes will resolve imbalances of the main pay-as-you-go scheme facing long-term pressures from system maturation and population aging.
- Main actuarial recommendations:
  - Raise gradually the retirement age to 70 years.
  - Cut the replacement rate by one fifth.
  - Lift the contribution rate up to 26 percent by 2055.
- Stylized staff exercise reaches similar conclusions (AN II.C).
- Social Security response: announced a 1 percent increase in the employee’s contribution rate, bringing the total contribution rate to 9.5 percent from June 2017, and the start of a national dialogue on additional reforms.
- Urgency: reforming the actuarially imbalanced special regime for the judiciary could require budgetary support already in the near future and is especially urgent.

### Improving monetary and exchange rate policy framework
- Progress noted toward full-fledged inflation targeting: inflation expectations substantially lowered and kept within the 2-4 percent target introduced in January 2016.
- Exchange rate (XR) policy:
  - BCCR accommodated a contained increase in XR flexibility in 2016 and intends to maintain a similar stance.
  - Mission recommendation: more XR flexibility and enhanced transparency about the triggers of the FX-intervention rule to strengthen credibility of inflation targeting, make XR a shock absorber, limit reserve loss, reduce FX mismatches, and discourage dollarization.
- Market development measures:
  - Deepen secondary market for government securities using standardized simple instruments with conventional maturities to boost monetary policy effectiveness and resilience to external shocks.
  - BCCR planned introduction in July 2017 of a single-price FX auction among authorized intermediaries before each Monex trading session to consolidate FX demand and supply, improve liquidity and price discovery, lower uncertainty and volatility at session start, and reduce market concentration.
  - April 2017 proposal: new regulation requiring commercial banks to fix their net open FX position as a share of capital consistent with their business model, with deviations subject to authorization.
  - Complementary prudential measures proposed by SUGEF to protect banks’ capital adequacy against XR losses and reduce incentives for FX speculation.

### Financial stability vulnerabilities and policy measures
- Key vulnerabilities:
  - About 40 percent of credit to the non-financial private sector is denominated in foreign currency.
  - Over 70 percent of such foreign-currency credit is extended to unhedged borrowers, exposing the system to credit risk via XR risk.
  - Brisk increase in household leverage in later years, with a high incidence of credit by non-bank commercial entities.
  - Continuing accumulation of government debt holdings exposes banks to sovereign risk and mounting mark-to-market losses on sovereign exposures, especially with increasing interest rates.
- Stress test findings (summary):
  - Despite the system’s overall long FX position, a large depreciation of the colón would indirectly affect capital adequacy through credit risk due to large unhedged foreign liabilities.
  - A significant spike in interest rates would produce stock effects from repricing of domestic government bonds, compounding capital losses; however, banks appear sufficiently capitalized to absorb these shocks and there is no need for additional buffers.
  - The smallest public bank required a restructuring plan after prolonged losses; staff urged decisive implementation to minimize contingent liabilities.
- Bank balance-sheet exposures:
  - About 35 percent of Costa Rica’s bank liabilities are in foreign currency, posing rollover risk.
  - Staff analysis: current high liquidity provides sufficient cushion for a short-term generalized drain and for a more protracted FX liquidity shock; most banks could withstand a substantial loss of foreign funding (AN III.B).
- Prudential and macroprudential measures adopted or proposed:
  - Higher risk-weightings on household mortgages with high loan-to-value ratios, with further penalization for mortgages in FX to unhedged borrowers.
  - Additional generic provisioning of 1.5 percent on FX loans to unhedged borrowers.
  - Countercyclical provisional buffers.
  - April 2017 SUGEF proposal: revision of minimum capital requirements for market risk in line with Basel III to protect capital adequacy against XR movements.
- Staff caution: if there is no evidence of a reduction in banks’ FX exposures within a reasonable time, or if the deceleration of FX credit proves temporary, further tightening of prudential requirements should be considered. Possible additional measures:
  - Higher reserve and liquidity requirements on FX liabilities.
  - Increases in capital buffers and provisioning.
  - Stricter requirements such as more stringent loan-to-value ratios on FX loans.

*Source: Fund staff estimates.*

### 28. The mission repeated that implementation of pending 2008 FSAP recommendations

### 28. The mission repeated that implementation of pending 2008 FSAP recommendations

### Financial sector resilience and Basel III
- Implementation of pending 2008 FSAP recommendations and adoption of Basel III standards would improve resilience of the financial system.
- Substantial progress has been made in adopting risk-based supervision.
- Advances toward other key FSAP recommendations—notably crisis management and the bank resolution framework—have been slow due to the crowded legislative agenda; most require new legislation, including, in some instances, constitutional reform (Annex II).
- Staff argued regulatory and risk management frameworks would benefit from gradually introducing Basel III capital requirements and liquidity standards.
- Authorities plan to introduce in 2018 a Net Stable Funding Ratio in addition to the Liquidity Coverage Ratio enacted in 2015.
- The credit gap proves to be a robust early warning indicator of future financial distress; activation of countercyclical capital buffers based on it would strengthen banks’ resilience through the financial cycle, although implementation would likely entail non-negligible challenges (AN III.A).
- Progress toward past FSAP advice and the implementation of Basel III standards will be assessed, among other topics, by an imminent Financial Sector Stability Review (FSSR).

### AML/CFT and cross-border consolidated supervision
- The mission urged reinforcement of the AML/CFT regime and the national framework for cross-border consolidated supervision.
- Costa Rica needs to implement recently adopted legislative measures aimed at remedying deficiencies in its AML/CFT regime identified by the GAFILAT.
- Inclusion in the list of jurisdictions with strategic weaknesses in this area would hinder access of domestic financial institutions to the international financial system and increase the risk of losing correspondent banking relationships.
- National implementation of recommendations in the WHD Cluster Surveillance Report on Financial Integration in CAPDR would support cross-border harmonization of prudential norms and promote regulatory and supervisory coordination (Annex III).

### Structural reforms to support competitiveness and inclusive growth
- Structural reforms are needed to further improve competitiveness and foster inclusive growth.
- Costa Rica ranks favorably in many business indicators and remains a regional leader in attracting foreign direct investment, but additional steps are needed to maintain competitive position and mitigate vulnerabilities to adverse international conditions (¶6 and 13, Annex I).
- Key reform areas:
  - Address weaknesses in transport infrastructure.
  - Improve public expenditure efficiency—especially in education.
  - Strengthen competition policies (OECD accession recommendations include giving the competition commission more independence, eliminating anti-trust exemptions, improving corporate governance of SOEs, and reducing barriers to entrepreneurship) (ANs II.B and IV).
  - Amend the electricity regulatory framework, including price-setting procedures to enhance cost discipline and reduce tariffs.
  - Expand child-care provision to promote female labor force participation.
- Environmental policy has supported structural transformation toward high growth services, primarily tourism; legal and regulatory frameworks should stimulate growth of sectors more resilient to climate change (AN V).

### Financial deepening and public debt management
- Measures to increase competition in the banking sector would help reduce comparatively high interest rate spreads, boosting credit, investment and growth.
- Supportive measures for financial development include:
  - More market-friendly public debt management and issuance strategies to promote larger secondary markets for government securities.
  - Refined loan-provisioning rules to prevent high collateral requirements substituting for proper credit-risk analysis.
  - Better protection of investor rights.

### Authorities’ views
- Authorities generally agreed with the outlook and risks highlighted by staff; they concurred that a baseline scenario without additional adjustment would be detrimental to growth due to high financing costs and crowding out of private investment, while an alternative adjustment scenario would yield a more favorable outlook.
- Authorities shared staff’s assessment of downside risks and emphasized the importance of non-tax pull factors for FDI as a key mitigator of vulnerability to changes in U.S. fiscal policies; they expressed greater concern about possible indirect effects through other regional trading partners.
- Authorities broadly concurred with staff policy recommendations while stressing graduality in extending XR flexibility and prudential requirements.
  - Agreed on need for administrative efforts to minimize fiscal deterioration from recent Constitutional court rulings mandating stricter enforcement of revenue earmarking provisions.
  - Reiterated readiness to continue increasing the monetary policy rate as needed to prevent emergence of inflationary pressures.
  - Viewed gradual restoration of the premium on savings in colones as important to contain depreciation pressures with possible second-round effects on inflation.
  - Concurred that full implementation of fiscal reforms broadly in line with staff advice would be critical to place public debt on a sustainable trajectory over the medium term; reiterated commitment to seek parliamentary approval of a comprehensive fiscal package before the elections.
  - Central bank supported in principle a contained increase in XR flexibility and more transparency regarding its intervention rule to strengthen the monetary policy framework, while stressing need to ensure recent measures deepen the FX market and make it more resilient against speculation.
  - Bank supervisors recognized vulnerabilities from large dollarization, currency mismatches in the private sector, and growing household leverage; they underscored benefits of recent prudential measures but cautioned that additional regulations should be introduced cautiously given impact on already low profitability in the banking sector.
  - Authorities reiterated support for a gradual adoption of Basel III standards, implementation of pending FSAP recommendations, and further improvements in cross-border supervision; noted the upcoming FSSR will help identify and fill regulatory gaps.
  - Regarding education expenditure efficiency, authorities emphasized high costs associated with maximizing coverage as a key tool to tackle poverty.

### Staff appraisal and policy recommendations
- Risks to the outlook are rising, increasing urgency to address mounting macro vulnerabilities.
  - Economy is growing at trend; inflation is returning to target; external current account deficit has narrowed.
  - Exchange rate depreciated moderately and international reserves declined due to reduced external budget and bank financing and domestic portfolio switches into FX deposits.
  - External position continues to be close to equilibrium.
  - Weakening domestic fundamentals from large fiscal deficits make the country particularly vulnerable to projected tightening in global financial conditions and other external risks.
  - Growth anticipated to slow only marginally in 2017, but potential growth would be eroded over the medium term reflecting higher risk premia and greater need for monetary tightening in a baseline without additional fiscal reforms.
  - If fiscal vulnerabilities are not addressed, competitiveness and the external position could be negatively affected.
- Near-term policy mix: continuation of fiscal consolidation and monetary policy normalization.
  - With output virtually at potential and a still sizeable fiscal sustainability gap, near-term policy should feature gradual budgetary adjustment and unwinding of monetary easing.
  - Important to administratively contain expenditure and mobilize revenue to minimize short-term deterioration from recent constitutional court rulings expanding revenue earmarking.
  - Central bank should keep tightening monetary stance to maintain inflation around the mid-point of the target range and prevent jeopardizing incipient anchoring of inflation expectations.
- Comprehensive reform strategy needed for long-term fiscal sustainability.
  - Authorities’ main proposal: 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 tax reforms, 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 (XR) flexibility would strengthen credibility of the IT framework and enhance resilience to external shocks.
  - Enhanced transparency of triggers for the FX-intervention rule would firm confidence in subordination of XR management to inflation objectives.
  - Greater XR flexibility would reinforce XR as a shock absorber, ease pressure on international reserves, help internalize XR risks, reduce FX mismatches and discourage dollarization.
- Micro- and macro-prudential tools welcomed, but more may be needed.
  - Further tightening should be considered if no evidence of reduction in banks’ FX exposures, or if deceleration of FX credit proves temporary.
  - Additional measures could include higher reserve and liquidity requirements on FX liabilities, increases in capital buffers and provisioning, and stricter controls on FX loans.
  - Implementation of pending 2008 FSAP recommendations and adoption of Basel III standards would improve resilience of the financial system.
- Structural reforms reiterated as required to maintain competitiveness:
  - Address transport infrastructure weaknesses, improve education expenditure efficiency, and support financial deepening to accelerate potential growth and make it more inclusive.
  - Build on successful environmental policies by providing legal and regulatory environment to stimulate sectors more resilient to climate change.

*IMF staff report excerpts (paragraphs 28–39).*

### 40. It is recommended that Costa Rica remain on the standard 12-month consultation

### 40. It is recommended that Costa Rica remain on the standard 12-month consultation cycle.

### Recommendation
- It is recommended that Costa Rica remain on the standard 12-month consultation cycle.

### Selected Social and Economic Indicators (Baseline Scenario)
- Population (2016): 4.9 (millions)
- Per capita GDP (2016, U.S. dollars): 11,888
- Unemployment (2016, percent of labor force): 9.5
- Poverty (2016, percent of population): 20.5
- Income share held by highest 10 percent of households: 36.9
- Income share held by lowest 10 percent of households: 1.5
- Human Development Index Rank (2016): 66 (out of 188)
- Life expectancy (2015, years): 79.6
- Literacy rate (2015, percent of people ages > 15): 97.6
- Ratio of girls to boys in primary and secondary education (2014, percent): 102.0
- Gini coefficient (2014): 48.5

### Output, Prices, and Monetary Aggregates (annual or end‑period unless otherwise indicated)
- Real GDP growth: 2013: 2.3; 2014: 3.7; 2015: 4.7; 2016: 4.3; 2017: 4.0 (proj.); 2018: 4.0 (proj.)
- Output gap (percent of potential GDP): 2013: -0.4; 2014: -0.6; 2015: 0.0; 2016: 0.1; 2017: 0.0; 2018: -0.1
- GDP deflator: 2013: 4.0; 2014: 5.8; 2015: 2.7; 2016: 2.3; 2017: 1.5; 2018: 3.2
- Consumer prices (end of period): 2013: 3.7; 2014: 5.1; 2015: -0.8; 2016: 0.8; 2017: 3.0 (proj.); 2018: 3.0 (proj.)
- Monetary base (annual % change): 2013: 10.2; 2014: 10.4; 2015: 9.2; 2016: 6.4; 2017: 2.8; 2018: 6.5
- Broad money (annual % change): 2013: 7.7; 2014: 15.4; 2015: 4.0; 2016: 2.3; 2017: 6.3; 2018: 7.5
- Credit to private sector (annual % change): 2013: 12.2; 2014: 17.5; 2015: 11.8; 2016: 12.8; 2017: 11.1; 2018: 10.9
- Monetary policy rate (percent; end of period; 2017 data as of May 2017): 2013: 4/3.8; 2014: 5.3; 2015: 2.3; 2016: 1.8; 2017: 4.0

### External Sector (Baseline Scenario)
- Current account balance (US$ millions): 2010: -1,214; 2011: -2,265; 2012: -2,411; 2013: -2,431; 2014: -2,489; 2015: -2,384; 2016: -1,880; 2017: -2,402; 2018: -2,539; 2019: -2,688; 2020: -2,870; 2021: -3,119; 2022: -3,324
- Current Account (percent of GDP): 2010: -3.2; 2011: -5.3; 2012: -5.1; 2013: -4.8; 2014: -4.9; 2015: -4.3; 2016: -3.2; 2017: -4.0; 2018: -4.0; 2019: -4.0; 2020: -4.0; 2021: -4.0; 2022: -4.0
- Trade balance (US$ millions): 2010: -3,548; 2011: -5,027; 2012: -5,348; 2013: -5,559; 2014: -5,329; 2015: -4,977; 2016: -4,508; 2017: -5,103
- Export of goods (f.o.b., US$ millions): 2010: 7,493; 2011: 8,301; 2012: 8,923; 2013: 8,866; 2014: 9,456; 2015: 9,445; 2016: 10,148; 2017: 10,819
- Import of goods (f.o.b., US$ millions): 2010: 11,040; 2011: 13,329; 2012: 14,271; 2013: 14,425; 2014: 14,784; 2015: 14,422; 2016: 14,656; 2017: 15,922
- Services balance (US$ millions): 2010: 3,132; 2011: 3,833; 2012: 3,984; 2013: 4,564; 2014: 4,539; 2015: 4,615; 2016: 5,081; 2017: 5,597
- Travel balance (US$ millions): 2010: 1,828; 2011: 2,023; 2012: 2,107; 2013: 2,503; 2014: 2,546; 2015: 2,732; 2016: 3,063; 2017: 3,315
- Primary income (US$ millions): 2010: -1,186; 2011: -1,418; 2012: -1,456; 2013: -1,828; 2014: -2,150; 2015: -2,484; 2016: -2,926; 2017: -3,388
- Financial account (US$ millions): 2010: -1,642; 2011: -2,873; 2012: -2,034; 2013: -3,084; 2014: -3,042; 2015: -2,751; 2016: -2,234; 2017: -2,316
- Foreign direct investment (US$ millions): 2010: -1,589; 2011: -2,328; 2012: -1,803; 2013: -2,401; 2014: -2,851; 2015: -2,686; 2016: -2,684; 2017: -2,743
- Change in international reserves (increase +, US$ millions): 2010: 561; 2011: 129; 2012: 2,101; 2013: 474; 2014: -119; 2015: 622; 2016: -260; 2017: -325
- Net international reserves (millions of U.S. dollars): 2010: 4,627; 2011: 4,756; 2012: 6,857; 2013: 7,331; 2014: 7,211; 2015: 7,834; 2016: 7,574; 2017: 7,249; 2018: 7,249; 2019: 7,249; 2020: 7,249; 2021: 7,249; 2022: 7,249
- Non-oil current account (percent of GDP, memorandum): 2010: 0.9; 2011: -0.5; 2012: -0.7; 2013: -0.7; 2014: -0.9; 2015: -2.2; 2016: -1.5; 2017: -1.7; 2018: -1.7; 2019: -1.8; 2020: -1.8; 2021: -1.9; 2022: -1.9
- Terms of trade (annual percentage change, memorandum): 2010: -0.3; 2011: -2.4; 2012: 0.6; 2013: -7.8; 2014: 3.1; 2015: 4.8; 2016: 0.6; 2017: -1.7; 2018: 0.0; 2019: 0.1; 2020: 0.0; 2021: -0.1; 2022: -0.2
- External debt (percent of GDP, memorandum): 2010: 25.3; 2011: 26.4; 2012: 32.7; 2013: 39.0; 2014: 42.4; 2015: 43.3; 2016: 45.5; 2017: 39.7; 2018: 36.6; 2019: 33.8; 2020: 31.1; 2021: 28.6; 2022: 26.5

### Central Government Balance (Baseline Scenario)
- Revenue (in billions of colones): 2010: 2,591; 2011: 2,869; 2012: 3,118; 2013: 3,380; 2014: 3,625; 2015: 3,994; 2016: 4,379; 2017: 4,634; 2018: 5,010; 2019: 5,415; 2020: 5,800; 2021: 6,215; 2022: 6,662
- Expenditure (in billions of colones): 2010: 3,623; 2011: 3,762; 2012: 4,178; 2013: 4,765; 2014: 5,231; 2015: 5,647; 2016: 6,024; 2017: 6,638; 2018: 7,315; 2019: 8,037; 2020: 8,773; 2021: 9,581; 2022: 10,526
- Primary balance (in billions of colones): 2010: -580; 2011: -396; 2012: -529; 2013: -704; 2014: -831; 2015: -866; 2016: -758; 2017: -909; 2018: -993; 2019: -1,064; 2020: -1,127; 2021: -1,201; 2022: -1,295
- Overall balance (in billions of colones): 2010: -1,032; 2011: -893; 2012: -1,059; 2013: -1,386; 2014: -1,606; 2015: -1,653; 2016: -1,644; 2017: -2,005; 2018: -2,305; 2019: -2,622; 2020: -2,973; 2021: -3,366; 2022: -3,864
- Central government debt (in billions of colones): 2010: 5,551; 2011: 6,369; 2012: 7,998; 2013: 8,909; 2014: 10,457; 2015: 11,970; 2016: 13,988; 2017: 16,004; 2018: 18,330; 2019: 20,979; 2020: 23,806; 2021: 27,138; 2022: 30,968
- Central government overall balance (percent of GDP): 2010: -5.3; 2011: -4.2; 2012: -4.5; 2013: -5.6; 2014: -5.9; 2015: -5.6; 2016: -5.3; 2017: -6.1; 2018: -6.5; 2019: -6.9; 2020: -7.3; 2021: -7.7; 2022: -8.2
- Interest (in billions of colones): 2010: 452; 2011: 497; 2012: 530; 2013: 681; 2014: 775; 2015: 787; 2016: 886; 2017: 1,096; 2018: 1,312; 2019: 1,558; 2020: 1,846; 2021: 2,164; 2022: 2,569
- Revenue (percent of GDP): 2010: 13.2; 2011: 13.4; 2012: 13.3; 2013: 13.6; 2014: 13.3; 2015: 13.6; 2016: 14.0; 2017: 14.0; 2018: 14.0; 2019: 14.2; 2020: 14.2; 2021: 14.2; 2022: 14.2
- Expenditure (percent of GDP): 2010: 18.5; 2011: 17.6; 2012: 17.9; 2013: 19.2; 2014: 19.2; 2015: 19.3; 2016: 19.3; 2017: 20.1; 2018: 20.6; 2019: 21.1; 2020: 21.5; 2021: 21.9; 2022: 22.4
- Primary balance (percent of GDP): 2010: -3.0; 2011: -1.9; 2012: -2.3; 2013: -2.8; 2014: -3.0; 2015: -3.0; 2016: -2.4; 2017: -2.8; 2018: -2.8; 2019: -2.8; 2020: -2.8; 2021: -2.7; 2022: -2.8
- Central government debt (percent of GDP): 2010: 28.3; 2011: 29.8; 2012: 34.2; 2013: 35.8; 2014: 38.3; 2015: 40.8; 2016: 44.7; 2017: 48.4; 2018: 51.7; 2019: 55.2; 2020: 58.4; 2021: 62.1; 2022: 66.0
- Nominal GDP (in billions of colones): 2010: 19,597; 2011: 21,371; 2012: 23,371; 2013: 24,861; 2014: 27,269; 2015: 29,316; 2016: 31,287; 2017: 33,033; 2018: 35,439; 2019: 38,027; 2020: 40,774; 2021: 43,732; 2022: 46,921
- CPI Inflation (period average): 2010: 5.7; 2011: 4.9; 2012: 4.5; 2013: 5.2; 2014: 4.5; 2015: 0.8; 2016: 0.0; 2017: 1.9; 2018: 3.0; 2019: 3.0; 2020: 3.0; 2021: 3.0; 2022: 3.0

### Consolidated Public Sector (Baseline Scenario)
- Nonfinancial public sector revenue (in billions of colones): 2010: 4,258; 2011: 4,715; 2012: 5,036; 2013: 5,627; 2014: 6,021; 2015: 6,529; 2016: 7,141; 2017: 7,607; 2018: 8,182; 2019: 8,800; 2020: 9,384; 2021: 10,025; 2022: 10,713
- Nonfinancial public sector expenditure (in billions of colones): 2010: 5,209; 2011: 5,482; 2012: 5,941; 2013: 6,770; 2014: 7,344; 2015: 8,001; 2016: 8,496; 2017: 9,280; 2018: 10,128; 2019: 11,031; 2020: 11,952; 2021: 12,954; 2022: 14,101
- Consolidated public sector overall balance (in billions of colones): 2010: -1,039; 2011: -893; 2012: -1,049; 2013: -1,339; 2014: -1,509; 2015: -1,691; 2016: -1,446; 2017: -1,861; 2018: -2,148; 2019: -2,448; 2020: -2,801; 2021: -3,179; 2022: -3,656
- Consolidated public sector debt (in billions of colones): 2010: 5,810; 2011: 6,846; 2012: 8,766; 2013: 10,389; 2014: 11,664; 2015: 13,295; 2016: 15,407; 2017: 17,153; 2018: 19,171; 2019: 21,481; 2020: 23,953; 2021: 26,897; 2022: 30,301
- Consolidated public sector balance (percent of GDP): 2010: -5.3; 2011: -4.2; 2012: -4.5; 2013: -5.4; 2014: -5.5; 2015: -5.8; 2016: -4.6; 2017: -5.6; 2018: -6.1; 2019: -6.4; 2020: -6.9; 2021: -7.3; 2022: -7.8
- Nonfinancial public sector primary balance (percent of GDP): 2010: -2.6; 2011: -1.4; 2012: -1.7; 2013: -1.9; 2014: -2.1; 2015: -2.3; 2016: -1.6; 2017: -1.8; 2018: -1.9; 2019: -1.9; 2020: -2.0; 2021: -2.1; 2022: -2.1

### Public Sector Debt (Baseline Scenario)
- Debt issued by NFPS & Central Bank (in billions of colones): 2012: 11,022; 2013: 12,746; 2014: 14,127; 2015: 15,872; 2016: 18,383; 2017: 20,462; 2018: 22,859; 2019: 25,581; 2020: 28,477; 2021: 31,877; 2022: 35,775
- Consolidated public sector debt (in percent of GDP): 2012: 37.5; 2013: 41.8; 2014: 42.8; 2015: 45.4; 2016: 49.2; 2017: 51.9; 2018: 54.1; 2019: 56.5; 2020: 58.7; 2021: 61.5; 2022: 64.6
- External consolidated public sector debt (percent of GDP): 2012: 7.2; 2013: 8.7; 2014: 10.2; 2015: 11.3; 2016: 11.3; 2017: 11.1; 2018: 10.6; 2019: 10.2; 2020: 9.0; 2021: 8.6; 2022: 8.1
- Domestic consolidated public sector debt (percent of GDP): 2012: 30.3; 2013: 33.0; 2014: 32.6; 2015: 34.1; 2016: 38.0; 2017: 40.8; 2018: 43.5; 2019: 46.3; 2020: 49.7; 2021: 52.9; 2022: 56.4
- Memorandum nominal GDP (in billions of colones): 2012: 23,371; 2013: 24,861; 2014: 27,269; 2015: 29,316; 2016: 31,287; 2017: 33,033; 2018: 35,439; 2019: 38,027; 2020: 40,774; 2021: 43,732; 2022: 46,921

### Monetary Survey (Baseline Scenario)
- Net international reserves (millions of U.S. dollars): 2011: 4,756; 2012: 6,857; 2013: 7,331; 2014: 7,211; 2015: 7,834; 2016: 7,574; 2017: 7,249; 2018: 7,249
- Monetary base (in colones): 2011: 1,500; 2012: 1,754; 2013: 1,934; 2014: 2,136; 2015: 2,332; 2016: 2,482; 2017: 2,552; 2018: 2,718
- Broad money (in colones): 2011: 10,415; 2012: 11,530; 2013: 12,424; 2014: 14,334; 2015: 14,911; 2016: 15,251; 2017: 16,211; 2018: 17,422
- Credit to the private sector (colones, levels): 2011: 9,832; 2012: 11,145; 2013: 12,507; 2014: 14,701; 2015: 16,440; 2016: 18,541; 2017: 20,598; 2018: 22,834
- Net foreign assets (in colones): 2011: 2,567; 2012: 3,612; 2013: 3,799; 2014: 4,038; 2015: 4,413; 2016: 4,445; 2017: 4,362; 2018: 4,469

### Banking Sector Indicators (selected)
- Risk-adjusted capital ratio (Dec): 2013: 17.3; 2014: 17.3; 2015: 16.8; 2016: 16.6; 2017: 16.4; Jan 2017: 16.4
- Capital-to-assets ratio (Dec): 2013: 14.8; 2014: 15.0; 2015: 14.8; 2016: 14.5; 2017: 14.1; Jan 2017: 14.1
- Nonperforming loans to total loans (Dec): 2013: 1.8; 2014: 1.7; 2015: 1.7; 2016: 1.7; 2017: 1.5; Jan 2017: 1.6
- Loan loss provisions to total loans (Dec): 2013: 1.8; 2014: 1.8; 2015: 1.7; 2016: 1.6; 2017: 1.6; Jan 2017: 1.9; later Jan: 2.2; later: 2.3
- Return on assets (ROA): 2013: 1.2; 2014: 1.3; 2015: 1.5; 2016: 1.2; 2017: 1.2; Jan 2017: 1.2
- Return on equity (ROE): 2013: 8.3; 2014: 9.1; 2015: 10.3; 2016: 8.2; 2017: 8.5; Jan 2017: 7.3; later Jan: 8.8; later: 9.2
- Loans to deposits (Dec): 2013: 97.8; 2014: 105.2; 2015: 106.3; 2016: 106.6; 2017: 109.5; Jan 2017: 115.5; later Jan: 115.8; later: 113.9
- Liquid assets to total short-term liabilities (Dec): 2013: 90.1; 2014: 85.1; 2015: 92.6; 2016: 101.2; 2017: 98.7; Jan 2017: 97.8; later Jan: 95.8; later: 97.1

*Sources: Central Bank of Costa Rica, Ministry of Finance, Superintendency of Banks (SUGEF), and Fund staff estimates.*

### Annex I. External Stability Assessment

### Annex I. External Stability Assessment

### External position and real exchange rate (REER)
- The external position of Costa Rica is broadly in line with medium-term fundamentals and desirable policies.
- In 2016 the REER depreciated about 1½ percent (headline inflation close to zero and nominal exchange rate vs. the U.S. dollar depreciated about 3 percent). This contrasted with 2015 when the REER appreciated almost 10 percent.
- The 2016 REER level is about 30 percent above the 2009 level; staff estimates attribute this to relative productivity improvement (Balassa-Samuelson effect). REER adjusted for labor productivity differential with the U.S. suggests total appreciation since 2009 reflects changes in the equilibrium value rather than unsustainable developments.

### Current account, exports, and competitiveness
- The current account (CA) deficit improved to 3¼ percent of GDP in 2016.
- Strong exports growth of more than 9 percent in 2016, with tourism expanding more than 12 percent, more than compensated for Intel’s manufacturing exit in 2014.
- Costa Rica’s export share in world markets increased by more than 6 percent relative to 2015, outpacing total LAC exports of services and manufacturing goods.

### Financing structure, external liabilities, and reserves
- The CA continues to be largely financed by FDI inflows.
- Net International Investment Position (IIP) is negative at more than 45 percent of GDP.
- FDI comprises more than 65 percent of total liabilities.
- The U.S. was the largest source of FDI at 25 percent of the total in 2013-15 (down from about 50 percent in 2005-12).
- Sectors attracting high FDI in 2015 include real estate, manufacturing, commerce and agriculture.
- External debt profile: no significant sustainability concerns; external debt-to-GDP ratio set to decline into the medium term; low share of short-term debt.
- International reserves declined by US$260 mln in 2016; the resulting stock was 4.9 months of non-maquila imports of goods and services at end-2016 and within the Fund’s composite reserve adequacy metric.
- Staff note: the ARA float metric (almost 150 percent coverage) is considered more relevant for Costa Rica in 2016 given observed exchange rate dynamics and central bank commitments.

### External balance assessment results (Fund methodologies)
- Macro balance (EBA) approach:
  - Sustainable current account norm deficit of 4.8 percent of GDP in 2016.
  - Actual cyclically-adjusted deficit of 3.2 percent in 2016.
  - Implies a REER undervaluation of 3.8 percent.
  - Overall identified policy gaps are small and negative at -0.2 percent (health expenditures and fiscal gap offset by relative credit gap).
- EBA-lite (larger country sample):
  - Estimates REER undervaluation of 4.7 percent.
  - Sustainable CA norm of about 5¼ percent of GDP (high labor productivity and relatively slow population aging offset high dependency ratio).
  - Implied policy gap small and positive at 0.2 percent.
  - Equilibrium REER approach implied a REER gap of 15 percent (down from 22 percent in 2016); model has historically been a poor fit with large residuals.
- External sustainability (ES) approach:
  - Finds slight REER overvaluation of 2 percent.
  - Excluding FDI from the stock of total liabilities yields a moderate undervaluation of 7.9 percent.
- Staff’s aggregation:
  - Staff views the macro balance approaches as most reliable and the simple average across methodologies implies no over- or undervaluation.
  - Conclusion: Costa Rica’s REER is broadly in line with fundamentals.

### Assessments by other international institutions
- Doing Business Survey (World Bank): Costa Rica maintained its 2016 score in 2017 in almost all categories. Main concerns: high cost of starting a business, weak contract enforcement, poor protection of minority investors.
- Global Competitiveness Report (World Economic Forum, 2017): assessment remained at the same level as previous year. Costa Rica performs better than most Latin American countries, outpaced only by Chile and Panama. Main drags: inefficient government bureaucracy and inadequate (but slightly improved) infrastructure quality.

### Main pending financial sector recommendations (FSAP, 2008 — selected substantive items and status/comments)
- Legal protection for supervisors:
  - Art. 28 of Insurance Law 8653 (August 7, 2008) provides legal protection to insurance supervisors.
  - Draft bank resolution law contemplates protection for bank supervisors participating in resolution; constitutional reform necessary for full legal protection for bank supervisors.
- Consolidated supervision of banking groups:
  - Draft law previously archived by Congress; SUGEF re-drafting new reform bill (strategic orientations defined in 2015).
- Capital adequacy and risk weights:
  - Amendment to capital adequacy regulation effective August 2013 implemented gradual increases to reach final levels of 125% for unhedged borrowers and 62.5% for those with residential mortgages by March 2015.
  - Normative reform approved May 2016 increases generic provision for un-hedged borrowers from 0.5 to 1.5 percent.
- Funding arrangements for supervision:
  - Draft legislation to recapitalize the central bank also addresses increasing the financing share of the industry.
- Prompt remedial powers and corrective framework:
  - With IMF help, SUGEF drafting a new reform bill (strategic orientations defined in 2015) to amend article 155 of the Central Bank law and expand supervisory tools.
  - Plans to amend the rating system for prompt corrective actions once risk-based supervision is fully in place (expected in 2017, with major reforms in 2015 and 2016).
  - SUGEF conducting pilot visits to define rating system focus.
- Lender-of-last-resort and rediscount windows:
  - Emergency line from 2008-09 discontinued; two high-access rediscount windows created in 2011 (using bonds in money market collateral pool; using commercial credit portfolio as collateral with strict rules and haircuts). Rediscount windows activated only when central bank committee considers systemic risk; operational procedures need streamlining; repo operations not yet linked to prudential limits in terms of regulatory capital.
- Deposit insurance and resolution:
  - SUGEF working on a draft law for a deposit insurance scheme with IMF TA.
  - Improvements to bank resolution framework being developed as complement to deposit guarantee scheme.
- Voluntary, extra-judicial corporate restructuring:
  - Law on Execution (October 2007) did not address weaknesses in procedural rules.

### Regional financial integration recommendations (WHD Cluster surveillance summary — selected priorities)
- Regulatory perimeter and supervisory coordination:
  - Designate a Lead Supervisor in each country.
  - Adopt a broad definition of financial conglomerate and economic group; develop and periodically update a map of existing financial conglomerates; empower supervisors to regulate holding corporations.
  - Agree on a common scope of supervision to minimize regulatory arbitrage.
- Capital and consolidation standards:
  - Bridge different capital definitions across countries; adopt common definition of capital consistent with international best practice; harmonize calculation of financial conglomerates’ capital on a consolidated basis.
  - Adopt common loan classification criteria, at least for regional entities.
- Corporate governance and ownership transparency:
  - Regulate conglomerate organization structures to facilitate supervision; reinforce legal authorities for identifying ultimate ownership; harmonize regulations on market entry and participation; establish minimum regional standards on risk management systems.
- Credit limits and related-party exposures:
  - Adopt common thresholds on credit concentration and exposures to related parties; empower supervisors to inquire about ultimate owners beyond financial corporations; grant sufficient legal protection to supervisors.
- Macro-prudential and regional arrangements:
  - Implement a Regional Financial Stability Council with broad mandate; extend principal supervisors’ responsibility for regional conglomerates; harmonize financial data exchange in line with international accounting standards.
  - Ensure integration of systemic risk in regulatory frameworks; develop national and regional frameworks to identify SIFIs; calibrate micro-financial instruments to address macro-prudential risk; agree on a common set of macro-prudential instruments; reinforce regional macro-prudential surveillance.
- Lender-of-last-resort and liquidity policy:
  - Adopt minimum country requirements on LOLR facilities; re-examine ring-fencing regulation to address cross-border liquidity pressures; develop macro-prudential metrics for foreign exchange liquidity; reassess national frameworks on reserve requirements for foreign currency liabilities.
- Remedial actions, resolution, and deposit insurance:
  - Extend regimes for corrective and remedial actions to non-bank financial institutions and SIFIs; adapt resolution frameworks for regional implications; harmonize deposit insurance facilities; establish explicit coverage of deposits in off-shore banks with a specific regime.

*Source: Annex I. External Stability Assessment (cr17156 - Annex I. External Stability Assessment).*

### Annex IV. Public Debt Sustainability Analysis

### Annex IV. Public Debt Sustainability Analysis (Higher Scrutiny Case)

### Summary
- The DSA highlights Costa Rica’s unsustainable public debt dynamics.
- The debt stock is projected to rise over 65 percent of GDP by 2022 under the baseline scenario, driven mostly by high fiscal deficits.
- There are substantial upside risks to the projected debt path from plausible macro shocks.
- Risks from relatively high financing needs are somewhat mitigated by the existence of a stable domestic investor base.

### Key assumptions
- Debt definition
  - The public debt sustainability analysis focuses on the central government.
  - The rest of the consolidated public sector has been broadly in balance in recent years.
- Growth and fiscal policy assumptions
  - Potential growth is assumed to slow from an estimated 4.3 percent in 2016 to 3.8 percent by 2022.
  - The slowdown reflects strain on private investment from higher interest rates and costlier risk premia owing to continued large budget deficits and a tighter monetary stance.
  - The baseline scenario assumes additional fiscal adjustment of about ¾ percent of GDP based on staff’s assessment of already approved legislative measures.
  - The primary balance is nevertheless projected to deteriorate by almost ½ percent of GDP, driven mostly by projected increases in expenditure arising from recent Constitutional Court rulings and other planned small increases in public investment.
- Debt target
  - The 2003 WEO operational guidance is noted: sustaining a debt-to-GDP ratio above 50 percent of GDP may worsen risks significantly for emerging markets.
  - The WEO (2003) finding that the median public debt-to-GDP ratio for emerging markets in the year before a default was about 50 percent of GDP is cited.
  - Targeting an upper bound to the public debt ratio below 50 percent of GDP is presented as justifiable for Costa Rica.

### Results and assessment
- Baseline outcomes and financing needs
  - The headline deficit exceeds 8 percent of GDP in 2022.
  - Public debt exceeds 65 percent of GDP in 2022 and stays on an upward trajectory thereafter.
  - The average gross financing needs would be 12 percent of GDP in 2017-22.
  - In the adjustment scenario, additional measures of 3 of GDP as part of a gradual but frontloaded consolidation plan suffice to stabilize debt by 2022 at a level just below 50 percent of GDP. This assumes tightening in credit spreads due to favorable market reaction.
- Heat-map and risk assessments
  - Most standard indicators are not at “danger” levels, but:
    - Debt and gross financing needs approach benchmarks for medium-risk assessment under stressed scenarios.
    - Market perception indicators are approaching the high-risk assessment.
  - Specific metric observations:
    - Debt levels are just 2-4 percentage points of GDP short of the 70 percent debt threshold for medium-risk assessment under all other specific shocks.
    - Debt levels have particularly high sensitivity to growth shocks.
    - Gross financing needs are just 2-3 percentage points of GDP below the 15 percent threshold for medium-risk under all other specific shocks.
    - Market perception indicators have at times been above the benchmark for the high-risk assessment.
    - Vulnerabilities to interest rate and exchange rate shocks are increasing.
- Market spreads and costs
  - Costa Rica’s external bond spreads are broadly consistent with market average perceptions of countries with similar projected debt-to-GDP ratios in the medium-term.
  - Costa Rica’s external financing costs are currently around 400 basis points.
  - Spreads briefly exceeded the 600 basis points threshold for high-risk assessment during late 2015-early 2016.
  - Domestic financing costs declined last year due to pass-through of policy rate cuts to domestic market rates and greater reliance on floating rate and dollar-denominated bonds, which increase vulnerability to interest rate and exchange rate shocks.

### Mitigating factors
- Investor base and debt composition
  - External and FX debt represent 23 and 38 percent of total debt respectively.
  - About 60 percent of total domestic debt is held by captive local institutional investors, including the social security system, nonfinancial public sector institutions, and banks.

### Recommended adjustment path
- Policy prescription
  - A gradual but frontloaded fiscal consolidation is recommended to balance lowering the sustainability gap and limiting adverse impacts on growth.
  - A model of quadratic preferences is used to gauge the optimal path, with the optimal consolidation more frontloaded than in the 2016 Article IV because the output gap is now essentially closed while the fiscal sustainability gap remains sizeable.
- Scenarios and outcomes
  - Baseline: debt rising to over 65 percent of GDP by 2022; headline deficit exceeds 8 percent of GDP in 2022; average gross financing needs 12 percent of GDP in 2017-22.
  - Adjustment scenario: additional measures of 3 of GDP, gradual but frontloaded, stabilize debt by 2022 just below 50 percent of GDP assuming tightening in credit spreads.

### Baseline projections and stress tests (selected underlying assumptions and shock outcomes)
- Growth and inflation assumptions
  - Real GDP growth: 4.3 percent in 2016, projected 3.8 percent by 2022.
  - Inflation (GDP deflator): 7.8 percent in 2015, 2.7 percent in 2016, 2.3 percent in 2017, 1.5 percent in 2018, 3.2 percent in 2019, 3.3 percent in 2020, 3.2 percent in 2021, 3.3 percent in 2022.
- Fiscal and interest assumptions (selected)
  - Primary Balance: projected deterioration; baseline primary balance around -2.8 percent of GDP in multiple years.
  - Effective interest rate: shown rising from 7.8 to 9.4 (percent) over projection horizon in baseline table.
- Stress test highlights
  - Primary Balance Shock scenario: primary balance deteriorates to -4.0 in 2018-2019 in the shock path presented.
  - Real GDP Growth Shock scenario: real GDP growth falls to 1.7 and 1.6 in early shock years in the table.
  - Real Interest Rate Shock: effective interest rate rises (e.g., to 9.5 and 10.0 in some projection years).
  - Contingent Liability Shock: primary balance shown as -9.1 in 2018 in contingent liability table entry.
  - Across shocks, gross nominal public debt and public gross financing needs rise materially and approach or breach medium- and high-risk benchmarks in several scenarios.

*Source: Fund staff estimates and projections, Annex IV. Public Debt Sustainability Analysis (Higher Scrutiny Case), Costa Rica.*

### Annex V. Costa Rica: External Debt Sustainability Assessment

### Annex V. Costa Rica: External Debt Sustainability Assessment

### Debt Sustainability: Baseline and Scenario Bound Tests
- Baseline external debt: 26.5 (external debt in percent of GDP).
- Interest rate shock scenario: 27.4.
- Non-interest current account (CA) shock scenario: 32.3.
- Growth shock scenario: 28.2.
- Combined shock (permanent 1/4 standard deviation shocks to real interest rate, growth rate, and current account balance): 30.8.
- Combined shock with one-time real depreciation of 30 percent (real depreciation shock 4/): 37.9.
- Historical and baseline series: shaded areas represent actual data; figures in boxes represent average projections for the respective variables in the baseline and scenario; ten-year historical average also shown.

Notes on scenario construction (as presented):
- Individual shocks are permanent one-half standard deviation shocks.
- For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.
- Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
- One-time real depreciation of 30 percent occurs in 2016.
- Gross financing need under baseline is shown on the right scale in the figures.

### Key Numeric Projections and Historical Averages (as shown)
- Growth shock (in percent per year): Baseline: 6.0; Scenario: 6.3; Historical: 4.1.
- [Additional series shown in charts—preserve displayed values:]
  - Baseline: 4.0; Scenario: 2.7; Historical: 4.3.
  - Baseline: -1.8; Scenario: -2.7; Historical: -3.6.

### Fiscal Policy: Staff Recommendations and Implementation
- Staff recommendation (2016 Article IV): Fiscal adjustment of 3¾ percent of GDP is needed to stabilize the debt-to-GDP ratio over the medium term below levels shown to pose risks for macro stability in emerging markets.
- Recommended sequencing: Start gradual fiscal adjustment in 2016 to close sustainability gap while minimizing impact on growth and mitigating risks of higher inflation, widening external imbalances, and adverse financial market reactions.
- Pension system: Parametric adjustments needed to remedy actuarial imbalance of the pension system.
- Implementation developments:
  - The government achieved a reduction of ½ percent of GDP in the primary surplus in 2016 through administrative measures to contain wage bill growth and reduce personal income tax evasion.
  - Congressional approval of legislative measures—including on anti-tax evasion, transfers to decentralized institutions, and pensions paid out of the budget—expected to deliver about ½ percent of GDP of additional adjustment; recent Constitutional Court rulings offset some of these gains.
  - Authorities announced in early 2017 the start of Congressional discussions of a fiscal reform package intended to largely close the remaining fiscal sustainability gap estimated at 3 percent of GDP. Proposed measures included VAT reform (broadening the base and increasing rates), income tax reform (additional marginal rates on higher-income brackets), and a law to reform public employment. Political opposition prompted exploration of alternative plans that focus mainly on tax base widening.
  - CCSS responded to an actuarial report by announcing a 1 percent increase in the employee’s contribution rate, effective from June 2017, and the start of a national dialogue to discuss additional reforms.

### Monetary and Exchange Rate Policy
- Policy stance recommendation: Maintain current expansionary monetary stance, but stand ready to raise rates if price pressures threaten to drive inflation above the mid-point of the new target range.
- Exchange rate flexibility: Allow more exchange rate flexibility to help establish inflation as the undisputed monetary anchor and to discourage dollarization.
- Implementation developments:
  - In light of normalization of inflation and a closed output gap, the BCCR increased its policy rate by 225 basis points since April 2017, to 4 percent, still below the estimated neutral rate of 5 percent.
  - Starting from June 8, 2016, the exchange rate stayed within a 2 percent band of a 3½ depreciation trend against the U.S. dollar, mostly because the Central Bank maintained an active role in exchange rate management to avert excessive volatility.
  - Authorities have made progress in passing measures to deepen the FX market to facilitate greater exchange rate flexibility and complete the transition to full-fledged inflation targeting.

### Financial Sector: Vulnerabilities and Reforms
- Staff recommendations:
  - Accelerate implementation of pending 2008 FSAP recommendations.
  - Reduce vulnerabilities from currency mismatches in the private sector and high bank net foreign liabilities.
- Implementation developments and prudential measures:
  - Progress on implementing FSAP recommendations remains slow; authorities decided to participate in a Fund-conducted Financial Sector Stability Review.
  - New regulations introduced (in addition to earlier measures):
    - Higher risk-weightings on household mortgages with high loan-to-value ratios, with further penalization for mortgages in FX to unhedged borrowers.
    - Additional generic provisioning of 1.5 percent on FX loans to unhedged borrowers.
    - Countercyclical provisions.
  - In April 2017, SUGEF proposed a revision of minimum capital requirements for market risk to protect banks’ capital adequacy against losses from exchange rate movements, in line with Basel III guidelines.
- Recommended legislative priorities: Approval of legislation on consolidated supervision, deposit insurance, and banking resolution to bring the regulatory framework up to international best practices.

### Bank-Fund Collaboration and Macro-Critical Structural Reforms (JMAP)
- Shared assessment: Main macroeconomic challenges are to safeguard fiscal sustainability, increase effectiveness of monetary policy, maintain financial sector stability, and enhance competitiveness.
- Four macro-critical structural reform areas identified:
  - Fiscal consolidation: Strategy should include revenue and expenditure components, with a slant towards revenue enhancement (broadening VAT base, increasing VAT rates, raising marginal income tax rates on high earners, plus administratively-determined measures to gradually reduce expenditures).
  - Monetary policy framework: Accelerate transition to inflation targeting and greater exchange rate flexibility.
  - Financial sector stability: Continue progress in risk-based supervision; critical to approve legislation on consolidated supervision, deposit insurance, and banking resolution.
  - Productivity: Improve secondary education coverage and quality, develop scientific and technological capabilities, improve the business environment and reduce red tape, and create institutional conditions for private sector participation in infrastructure (public-private partnerships) while guarding against undue contingent liabilities.
- Division of labor:
  - IMF: Policy recommendations on macro-fiscal issues, transition to inflation targeting and flexible exchange rate, and technical assistance areas (listed in work program).
  - World Bank: Technical assistance for public-private partnerships, support on productivity and human capital projects, and lending projects (Higher Education Improvement Project, Catastrophe Deferred Draw Down Option, Strengthening Universal Health Insurance).
- Information sharing requests: Fund team to be kept informed of progress in macro-critical structural reform areas; Bank team to be kept informed of the Fund’s assessments of macroeconomic policies and prospects; timing when milestones are reached and at least semi-annually.

### Planned Activities (2017–18)
- IMF work program items (selected): Staff visit October, 2017; Regional Conference July, 2018; Technical assistance on National Accounts and Price Statistics, Monetary and FX Operations, Banking Supervision and Regulation, Fiscal Revenue and Expenditure Management (2017).
- World Bank work program item (selected): Public Expenditure Review, provisional timing March 2018.

*Annex V. Costa Rica: External Debt Sustainability Assessment — IMF staff report content as presented.*

### 8.      Other analytical or advisory services:

### 8.      Other analytical or advisory services:

### Task deliveries and advisory activities
- Task Name — Delivery
  - PMR MRP Implementation Costa Rica — 28-Mar-2019
  - PMR Domestic C-Market Infrastructure — 28-Mar-2019
  - PMR Costa Rica: carbon offset demand — 29-Mar-2019
  - PMR: carbon offset supply (P3) — 29-Mar-2019
  - Hydropower Sustainability Support — 23-Jul-2018
  - Regional Financial Integration Approach — 30-May-2018

### Relations with the Inter-American Development Bank (IDB)
- Recent portfolio and disbursement statistics:
  - IDB loan portfolio in Costa Rica: 9 sovereign guaranteed operations in execution and two programs pending ratification, with an approved amount of US$1,.787.0 million.
  - Available amount for disbursements: US$1,139.1 million (64% of the approved).
  - Sector concentration of available funds: Transportation (49.2%), Energy (27.4%), Education (12.4%), Water and Sanitation (6.0%).
  - Average age of operations: 2.1 years.
  - Disbursements of sovereign guaranteed operations during 2017 are expected to reach US$135.7 million, concentrated in Education (25.8%), Transportation (22.6%), Reform and Modernization of the State (22.5%), and Energy (17.3%).

- IDB Disbursements, amortization and net flows — Sovereign Guaranteed Operations (In millions of U.S. dollars)
  - Disbursements by year: 2009: 41.3; 2010: 55.7; 2011: 121.0; 2012: 86.9; 2013: 131.3; 2014: 209.9; 2015: 173.4; 2016: 154.4; 2017*: 135.7
  - Amortization by year: 2009: 46.0; 2010: 45.3; 2011: 47.0; 2012: 45.2; 2013: 36.9; 2014: 32.5; 2015: 39.1; 2016: 53.8; 2017: 56.9
  - Interest and charges by year: 2009: 12.2; 2010: 11.9; 2011: 10.9; 2012: 9.9; 2013: 10.3; 2014: 10.7; 2015: 13.2; 2016: 22.2; 2017: 26.6
  - Net cash flow by year: 2009: 18.9; 2010: 1.5; 2011: -60.9; 2012: -29.9; 2013: -82.6; 2014: -164.6; 2015: -119.5; 2016: -76.7; 2017: -50.4
  - Note: * Projections (March 2017)

- Sovereign Guaranteed Operations (as of April 21, 2017) — (In millions of U.S. dollars)
  - Summary totals for loans in execution: Approved: 1,787.0; Disbursed: 641.5; Committed: 6.4; Available: 1,139.1
  - Selected individual programs (Approved / Disbursed / Committed / Available):
    - Tourism Program in Protected Areas — 19.0 / 19.0 / 0.0 / 0.0
    - First Road Infrastructure Program — 300.0 / 300.0 / 0.0 / 0.0
    - Cantonal Road Network Program — 60.0 / 44.3 / 0.0 / 15.7
    - Water and Sanitation Program — 73.0 / 5.1 / 0.0 / 67.9
    - Violence Prevention and Social Inclusion Promotion Program — 132.4 / 101.9 / 0.0 / 30.5
    - Power Sector Development Program 2012-16 (Reventazón Hydroelectric Project) — 250.0 / 131.3 / 6.4 / 112.3
    - Building and Equipping of Education Infrastructure — 167.5 / 25.9 / 0.0 / 141.6
    - Innovation and Human Capital for Competitiveness Program — 35.0 / 9.0 / 0.0 / 26.0
    - Infrastructure Transport Program (PIT) — 450.0 / 5.0 / 0.0 / 445.0
    - Border Integration Program of Costa Rica* — 100.0 / 0.0 / 0.0 / 100.0
    - First Renewable Energy, Transmission and Distribution of Electricity Program* — 200.0 / 0.0 / 0.0 / 200.0
    - Non-reimbursable Technical Cooperations — 11.5 / 6.2 / 1.7 / 3.6
  - Total: Approved: 1,799.8; Disbursed: 647.6; Committed: 6.4; Available: 1,145.8
  - *Pending ratification

### Statistical issues (As of May 2017)
- General assessment:
  - Data provision is broadly adequate for surveillance.
  - Quality of macroeconomic data has continued to improve in recent years; reassessment of the Data Module Report on the Observance of Standards and Codes (ROSC) published in February 2010 confirmed improvements.
  - Further statistical improvements are being pursued in real, monetary, fiscal and balance of payments sectors.
  - The Central Bank, the Ministry of Finance, and the National Institute of Statistics and Census make data available to the public through regular official publications on their websites (www.bccr.fi.cr, www.hacienda.go.cr, and www.inec.go.cr).

- National accounts:
  - Compiled generally in accordance with the System of National Accounts 2008 (SNA 2008).
  - Annual national accounts data disseminated for 1991-2016, with 2012 as the new base year.
  - Improvements: estimation of real estate housing including owner-occupied housing; housing stock of base year (2012) estimated at detailed levels per the 2011 Census.
  - Methods and sources: rental item of the CPI used as price indicator for subsequent years; volume extrapolated from statistics of houses built for residential purposes; accounting depreciation used instead of estimating consumption of fixed capital.
  - Deflation and benchmarking: double deflation applied for annual value added in constant prices; single extrapolation used for quarterly volume estimates using output volume indicators; proportional Denton method applied for benchmarking quarterly national accounts to annual counterparts.
  - Informal household production included in GDP level (but not separately estimated) via employment and remuneration matrices.
  - Changes in inventories obtained following 2008 SNA recommendations for products with sufficient information, including major agricultural and livestock products.

- Price statistics:
  - CPI compiled using concepts and definitions from the last international CPI manual; structure, scope, and coverage recently updated.
  - CPI weights based on the 2012/2013 Income and Expenditure Survey; index covers national urban and mixed households, approximately 73 percent of the total population and 82 percent of total consumption expenditures of Costa Rica.
  - Atypical movements investigated and corrected when necessary.
  - PPI compiled based on concepts and definitions from the 1993 SNA and the international PPI Manual; calculated by product and economic activity (manufacture and services).
  - PPI base years and approaches: base year for domestic manufacture, transportation, tourism services and professional services is 2012; PPI for electricity and sales hydrocarbons, and the export and import price index (not yet available) calculated following a moving-base approach.

- Government Finance Statistics (GFS):
  - Concepts and definitions generally follow GFSM 1986.
  - Financing data and government debt use national concepts that combine instruments and holders and are not in accordance with international standards.
  - Monthly fiscal statistics compiled and disseminated only for budgetary central government; annual statistics compiled and disseminated for the entire public sector and subsectors.
  - Annual data for the GFS Yearbook reported on a regular basis, most recently for 2015.
  - Classification issue: place of issue (Costa Rica or abroad) used to classify domestic vs. foreign debt instead of the recommended residency criterion.
  - Fiscal data discrepancies among national compilers on particular items are not regularly reconciled, although large fluctuations or discrepancies are investigated.
  - Fiscal statistics are not regularly reconciled with monetary statistics or other macroeconomic statistics.

- Monetary and Financial Statistics:
  - Central Bank of Costa Rica (CBCR) reports SRFs: 1SR for CBCR, 2SR for other depository corporations (ODCs), and 5SR for monetary aggregates for publication in the IMF's International Financial Statistics (IFS) on a monthly basis with a lag of two months.
  - Reported monetary statistics broadly in line with the Monetary and Financial Statistics Manual (MFSM), with some exceptions.
  - Classification exceptions: accrued interest not classified together with underlying instruments as recommended.
  - CBCR working to expand coverage of monetary statistics to include short term funds as ODCs and investment funds and pension funds as other financial corporations, in line with IMF technical assistance.

- Financial sector surveillance:
  - Costa Rica reports all core financial soundness indicators (FSIs) and one of the 13 encouraged FSIs for deposit takers on a monthly basis for posting on the IMF’s FSI website with less than one quarter lag.
  - Authorities plan to expand reported FSIs of the encouraged set for deposit takers.

- External sector statistics:
  - BCCR compiles and disseminates quarterly balance of payments and international investment position (IIP) statistics on a BPM6 basis.
  - Source data generally adequate; ongoing work to improve coverage of financial transactions of the nonfinancial private sector (e.g., trade credit and advances) and remuneration of employees.
  - Transfer prices in some cases are not converted to market prices.
  - BCCR also compiles and disseminates monthly the Data Template on International Reserves and Foreign Currency Liquidity, reports semi-annual data to the Coordinated Portfolio Investment Survey (CPIS) and annual data to the Coordinated Direct Investment Survey (CDIS), and submits quarterly external debt statistics to the Quarterly External Debt Statistics (QEDS) database.

- Data Standards and Quality:
  - Costa Rica is in observance with the Special Data Dissemination Standards (SDDS).
  - Data Module Report on the Observance of Standards and Codes (ROSC) published in February 2010.

### Table of Common Indicators Required for Surveillance (As of March 24, 2016)
- Metadata columns: Date of latest observation; Date received; Frequency of Data; Frequency of Reporting; Frequency of Publication; Memo Items: Data Quality – Methodological soundness; Data Quality – Accuracy and reliability.
- Selected entries (Date of latest observation / Date received / Frequency of Data / Frequency of Reporting / Frequency of Publication / Methodological soundness / Accuracy and reliability):
  - Exchange Rates — Apr 17 / Apr 17 / D / D / D
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities — Apr 17 / Apr 17 / D / D / D
  - Reserve/Base Money — Apr 17 / Apr 17 / D / D / D / O, LO, LO, LO / O, O, O, LO, O
  - Broad Money — Apr 17 / May 17 / M / M / M
  - Central Bank Balance Sheet — Apr 17 / May 17 / M / M / M
  - Consolidated Balance Sheet of the Banking System — Apr 17 / May 17 / M / M / M
  - Interest Rates2 — Apr 17 / May 17 / D / D / D
  - Consumer Price Index — Mar 17 / Apr 17 / M / M / M / O, LO, O, O / LO, O, LO, LO,O
  - Revenue, Expenditure, Balance, and Composition of Financing3 – Central Government — Apr 17 / May 17 / M / M / M / LO, LNO, LO, LO / LO, O, O, LO, O
  - Stocks of Central Government and Central Government-Guaranteed Debt4 — Apr 17 / May 17 / M / M / M
  - External Current Account Balance — Dec 16 / Mar 17 / Q / Q / Q / O, LO, O, LO / LO, O, LO, O, LNO
  - Exports and Imports of Goods and Services — Dec 16 / Mar 17 / Q / Q / Q
  - GDP/GNP — Dec 16 / Mar 17 / Q / Q / Q / O, LO, LNO, O / LO, O, LNO, O, LO
  - Gross External Debt — Dec 16 / Mar 17 / Q / Q / Q
  - International Investment Position — Dec 16 / Mar 17 / Q / Q / Q

- Footnotes and coding:
  - Frequency codes: Daily (D); weekly (W); monthly (M); quarterly (Q); annually (A); irregular (I); and not available (NA).
  - Data quality assessment coding drawn from ROSC (February 2010) with indicators: fully observed (O); largely observed (LO); largely not observed (LNO); not observed (NO); and not available (NA).
  - Footnotes clarify coverage and methodology for several items (e.g., reserve assets include pledged assets and net derivative positions; interest rate coverage; GFS institutional coverage differences; last year reported for some GFS series was 2015).

*International Monetary Fund — Costa Rica: Selected sections from CR17156*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17156.pdf_