Costa Rica – Concluding Statement of the 2014 Article IV mission
IMF News, November 10, 2014
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- Published: November 10, 2014
I. Recent Developments
- Growth and output
- Activity rose by 3½ percent in 2013, short of the estimated 4¼ percent trend.
- Growth gained some speed in early 2014 as feeble imports and stronger investment offset sluggish exports.
- Output remains virtually at potential despite deceleration in 2013.
- External sector and exchange rate
- Current account deficit declined slightly to 5 percent of GDP in 2013.
- The colon depreciated about 7 percent in 2014, broadly restoring competitiveness and largely correcting the REER appreciation from the last decade.
- A government Eurobond issuance helped boost reserves, which remain well within the IMF adequacy metric.
- Inflation and monetary policy
- Inflation ended 2013 at 3.7 percent and persisted somewhat above the recently lowered target range of 3-5 percent in 2014 due mainly to high pass-through from depreciation.
- The authorities raised monetary policy rates twice since the beginning of 2014 to contain second-round effects.
- Fiscal position
- Central government deficit increased in 2012−13 to 5½ percent of GDP and debt reached 36 percent of GDP at end-2013.
- Transfers and interest costs rose in 2012−13 while revenues stagnated after the 2012 tax reform was nullified by the Constitutional Court.
- Financial system
- Capital is well above regulatory requirements, liquidity indicators are generally robust, and non-performing loans have remained manageable.
- Dollarization remains a source of vulnerability; banks retain a long FX position and credit risk from dollar loans would be sizable in the event of a large depreciation.
- Financial conditions and credit
- Interest rates started rising from mid-2013.
- Credit growth (adjusted for the devaluation’s impact on the stock of FX loans) moderated to a level consistent with continued benign financial deepening.
II. Outlook and Risks
- Baseline outlook
- Growth is expected to remain at about 3½ percent in 2014−15.
- The output gap is projected to widen through 2016, closing slowly in the medium term as growth converges to its estimated trend.
- The central government deficit is anticipated to stay at about 6 percent of GDP through 2019, reflecting a partial consolidation of around 2 ¼ percent of GDP.
- Given continued prudent monetary policy, inflation would hover around 4 percent in the medium term after finishing 2014 somewhat above the target range.
- The current account deficit is to rise slightly to 5¼ percent of GDP by 2019, still largely financed by FDI.
- Key external and domestic risks
- External: risks related to normalization of U.S. monetary policy viewed as balanced; disorderly exit or extreme volatility could inflict serious damage; deeper-than-expected slowdowns in advanced and emerging economies; commodity market disruptions due to geopolitical tensions; continued oil price declines could have limited positive impact.
- Domestic: persistence of a large fiscal deficit and rising debt ratio could exacerbate vulnerability to sudden changes in financial market sentiment; large government gross financing requirements could crowd out private investment and growth; FDI contraction due to the “signaling effect” from Intel exit could hamper growth.
III. Policy Discussions — Objectives and Priorities
- Overarching priorities
- Reduce vulnerabilities and improve long-term sustainability while boosting potential growth and maintaining financial stability.
- Near-term need for tighter fiscal policy stance and vigilance over inflation.
- Begin fiscal consolidation to place public finances on a sustainable path, strengthen the monetary policy framework, and enhance banking sector supervision and regulation.
- Pursue reforms to foster competition, increase efficiency, and strengthen competitiveness.
A. Near-term Policy Mix
- Fiscal policy
- The government’s proposed fiscal correction for 2015 is suitable; mission urges rapid implementation early in the mandate.
- Government’s fiscal correction target: about 1¼ percent of GDP in 2015 compared to the “passive” budget submitted to Congress.
- Speedy adoption of the VAT reform is crucial to achieve the 2015 adjustment since tax administration improvements and expenditure cuts are likely insufficient.
- Political fragmentation in Congress increases the need for support from other parties and civil society.
- Monetary policy
- With the policy rate at 5.25 percent, the stance allows inflation to re-enter the target band but risks of higher inflation prevail.
- Authorities should stand ready to raise rates if inflation does not decline as anticipated, particularly if it persists above the upper limit of the target range.
- Inflation upside risks include: (i) larger-than-estimated pass-through and second round effects from depreciation; (ii) faster U.S. growth; (iii) bigger-than-assumed regulated price hikes (though less likely given recent oil price declines).
B. Safeguarding Fiscal Sustainability
- Fiscal trajectory and risks
- Under baseline policies (which already incorporate a sizeable adjustment), the consolidated public sector deficit is projected to persist around 6 percent of GDP by 2019.
- Public sector debt would grow to 51 percent of GDP by 2019 under baseline policies.
- External financing costs are expected to rise and availability may decline if market perceptions deteriorate.
- Pensions
- Retirement plans run by the CCSS, the judiciary, and teachers will turn cash negative over the long term due to system maturation and population aging.
- Pension plans directly supported by the national budget are very costly and regressive.
- Recommended consolidation
- Excluding the pension system imbalance, a permanent improvement in the primary balance of 3¾ percent of GDP, compared to the level that would prevail in 2015 in the absence of any measures, is required to stabilize the public debt ratio after 2019.
- Pension actuarial deficits could be addressed later through larger contributions, lower replacement rates, and higher retirement age; delay increases the eventual correction required.
- The government’s medium-term fiscal consolidation plan to strengthen public finances by about 4 percent of GDP is appropriate, with emphasis on revenue enhancement.
- The mission assesses that proposals at an advanced stage are likely to yield only some 2¼ percent of GDP; additional measures (income tax and expenditure reforms) need specification to reach the 1½ percent of GDP remainder to close the sustainability gap.
- The mission recommends raising the VAT rate from 13 to 15 percent gradually and increasing marginal tax rates on higher brackets as part of a global income tax, addressing distributional concerns.
- The government has confirmed willingness to raise VAT rates in steps starting in 2016 consistent with the mission’s recommended consolidation.
- Contain growth of current expenditure, particularly the wage bill and transfers, including modifying indexation and improving public employment efficiency.
- Caution to contain contingent liabilities and pressures from new off-budget investment vehicles.
- Recommended sequencing and magnitude
- Undertake about a third of the required budget adjustment in 2015 (1¼ percent of GDP) followed by smaller steps in subsequent 4 years, broadly in line with the authorities’ plans.
- This path would have a modest short-term output cost but a positive impact on output and employment over the medium term relative to baseline; postponing consolidation would increase the probability of disorderly adjustment.
C. Upgrading the Monetary and Exchange Rate Policy Framework
- Weaknesses and reforms
- Monetary policy framework still presents important weaknesses despite success in keeping inflation relatively low and reducing the target range to 3-5 percent in 2014.
- Inflation expectations are not yet well-anchored; perceived exchange rate stability has encouraged dollarization and foreign currency mismatches.
- Mission recommendations
- Complete the transition to inflation targeting.
- Eliminate the exchange rate band to establish the inflation target as the undisputed anchor of monetary policy.
- Further improve communication regarding foreign exchange intervention; interventions may smooth volatility and strengthen NIR as long as they do not undermine the inflation target.
- Encourage higher exchange rate flexibility to lower pass-through to inflation and promote reduction of foreign currency mismatches.
- Resist expanding the central bank’s mandate to include growth to preserve clarity and credibility of monetary policy.
- Welcome stipulations allowing more thorough assessment of foreign exchange exposures and higher provisioning requirements.
- Foster further development of the secondary market for government securities.
D. Financial Stability
- Regulatory and supervisory reforms
- Enact pending recommendations from the last FSAP with greater urgency: empower the Superintendence of Financial Institutions to conduct consolidated supervision, provide adequate protection to bank supervisors, and strengthen bank resolution procedures—requiring passage of new legislation.
- Progress welcomed towards full implementation of risk-based supervision; stepped up efforts needed to reach best practices.
- Support gradual adoption of Basel III standards: introduce Basel III definitions of capital, a capital conservation buffer, and a leverage ratio.
- Enhance transnational consolidated supervision given gaps in the definition of a financial group and a narrow supervisory and enforcement perimeter.
E. Structural Reforms
- Priorities to boost potential growth and competitiveness
- Increase private sector participation in the energy sector and review tariff setting procedures to better reflect cost changes.
- Improve quality of education spending with emphasis on quality child care, early childhood, and lower levels of education to facilitate female return to the labor force, foster productivity, and lower inequality.
- Stimulate competition in the banking sector, foster capital market development, address infrastructure bottlenecks, and streamline business regulations.
- Strengthen measures to maintain foreign direct investment attractiveness in light of Intel’s withdrawal.
Key Statistics and Tables (selected figures preserved verbatim)
- Social indicators
- Population (2011, millions): 4.7
- Human Development Index Rank (2011): 70 (out of 187)
- Per capita GDP (2013, U.S. dollars): 10,558
- Life expectancy (2009, years): 79.1
- Unemployment (2011, percent of labor force): 7.7
- Literacy rate (2009, percent of people ages > 15): 96.0
- Poverty (2010, percent of population): 24.2
- Ratio of girls to boys in primary and secondary education (2010, percent): 102.0
- Income share held by highest 10 percent of households: 39.4
- Income share held by lowest 10 percent of households: 1.7
- Gini coefficient (2009): 51.0
- Selected macro projections and historicals (annual percentage change unless otherwise indicated)
- Real GDP growth: 2008: 2.7; 2009: -1.0; 2010: 5.0; 2011: 4.5; 2012: 5.2; 2013: 3.5; 2014: 3.6; 2015 (Proj.): 3.4
- Output gap (percent of potential GDP): 2008: 2.8; 2009: -1.9; 2010: -0.3; 2011: 0.6; 2012: 0.0; 2013: -0.4; 2014: -0.9
- Consumer prices (end of period): 2008: 13.9; 2009: 4.0; 2010: 5.8; 2011: 4.6; 2012: 3.7; 2013: 3.7
- Money, credit, and reserves
- Monetary base (annual % change): 2008: 11.9; 2009: 5.1; 2010: 11.2; 2011: 11.6; 2012: 16.9; 2013: 10.2; 2014: 9.3; 2015 (Proj.): 11.0
- Broad money (annual % change): 2008: 15.8; 2009: 10.0; 2010: -0.2; 2011: 10.7; 2012: 12.8; 2013: 9.2
- Credit to private sector (annual % change): 2008: 31.8; 2009: 4.4; 2010: 13.7; 2011: 13.4; 2012: 12.2; 2013: 14.8; 2014: 11.4
- Change in net international reserves (increase -): 2008: 348; 2009: -51; 2010: -561; 2011: -132; 2012: -2,110; 2013: -461; 2014: 466; 2015 (Proj.): -345
- Net international reserves (millions of U.S. dollars): 2008: 3,799; 2009: 4,066; 2010: 4,627; 2011: 4,756; 2012: 6,857; 2013: 7,331; 2014: 6,865; 2015 (Proj.): 7,210
- Public finances (percent of GDP)
- Central government primary balance: 2008: 2.4; 2009: -1.3; 2010: -3.0; 2011: -2.3; 2012: -2.8; 2013: -3.1; 2014 (Proj.): -2.5
- Central government overall balance: 2008: -3.6; 2009: -4.3; 2010: -4.6; 2011: -5.6; 2012: -6.2; 2013: -6.0
- Central government debt: 2008: 24.8; 2009: 27.2; 2010: 29.1; 2011: 30.6; 2012: 35.1; 2013: 36.0; 2014 (Proj.): 42.3
- Consolidated public sector overall balance (selected years): 0.2; -4.0; -6.3
- Consolidated public sector debt (selected years): 27.3; 29.2; 30.5; 32.9; 38.5; 41.9; 44.0; 45.8
- Memorandum
- GDP (millions of U.S. dollars): 2008: 29,838; 2009: 29,383; 2010: 36,298; 2011: 41,237; 2012: 45,375; 2013: 49,621; 2014 (Proj.): 50,185; 2015 (Proj.): 54,057
Concluding Statement of the IMF staff mission to Costa Rica, November 10, 2014.