Twenty Years Without a Crisis in Costa Rica: The IMF's View, Speech by Agustín Carstens, Deputy Managing Director, IMF

July 12, 2004

Twenty Years Without a Crisis in Costa Rica:
The IMF's View

Speech by Agustín Carstens
Deputy Managing Director, International Monetary Fund
At the Academy of Central America, Costa Rica
Seminar on Volatility and Vulnerability
July 12, 2004

I am delighted to be able to attend this interesting seminar on the economy of Costa Rica, a country which I was honored to represent on the IMF Executive Board during the period 1999-2000, and whose progress I have followed with keen interest since then. I would like to thank the Academy of Central America—and in particular Eduardo Lizano and Francisco de Paula Gutiérrez, both good friends and central bankers—for providing me with this opportunity to discuss Costa Rica's successes over the past twenty years, and to assess the challenges it must face as it seeks to remain "crisis-free", well into the future. In my presentation, I will review Costa Rica's experience and attempt to pinpoint the key factors that have enabled the country to navigate through troubled waters in a comparatively untroubled fashion over the last two decades, while identifying those strategic adjustments that may be required in order to ensure that the favorable results that have been achieved are sustainable, but can also continue to develop over time. For the IMF this exercise offers an additional incentive; namely, identifying the lessons that can be applied to other countries in the region that have not fared as well as Costa Rica.

A central tenet that has been embraced by Costa Rica is that the ultimate goal of economic policy is to deliver human development. Over the past 20 years, poverty has been reduced from 40 percent of the population to below 20 percent. Extreme poverty has been halved from its level in 1990—thus, Costa Rica has already achieved the first Millennium Development Goal, or MDG; and other MDGs are well in sight. In fact, Costa Rica's social indicators are the best in Latin America and, in some cases, approach levels prevailing in advanced economies. Education levels are high and practically the entire population is literate. Health indicators are strong, with high life expectancy. There is wide access to health services and safe water. Forest degradation has been reversed and, more generally, protection of the environment has been a top priority.

It is all the more remarkable that this success was achieved against the backdrop of considerable regional turbulence. Costa Rica has had a stable democracy since 1949 and a long tradition of ruling by consensus. It was not subject to the kind of political and civil unrest that has tragically set back progress in neighboring countries, nor was its progress impeded by these nearby conflicts. In fact, Costa Rica actively worked for pacification, as evidenced most prominently by the Nobel Prize that was awarded to former president Oscar Arias for his work and success in advancing peace in the region.

Clearly, it is desirable to preserve and build on these achievements. And yet, what is the best way forward? Staying the course is one option. However, the global economy is changing, and Costa Rica must respond accordingly—especially as its integration into the globalized world increases. Accordingly, it is a good time to look back on macroeconomic policymaking over the last twenty years to identify its strengths and the features that have been instrumental in fostering human development and guarding against crisis. Then, we can identify remaining weaknesses and assess how policymaking may need to adjust going forward to reduce vulnerabilities and adapt to the changing external environment.

Costa Rica's economic policy strengths

I believe that one of the most fundamental reasons for Costa Rica's success has been the emphasis of its economic policy on human development and social cohesion. The basic needs of the population have largely been met and standards of living have improved steadily. The labor force is relatively well educated and skilled. There is a strong legal system and levels of corruption are low. Wide socio-political consensus is sought on appropriate responses to major issues; thus, economic reforms tend to be sustained because they have grown out of the widespread support of society. All of these achievements have combined to form the bedrock underpinning economic, political, and social stability in Costa Rica. This tradition of coexistence is a major asset for Costa Rican society.

The second foundation of the strategy is that efforts have been made to maintain reasonable macroeconomic stability. Granted, the last twenty years have not been completely smooth sailing—the recovery from the deep recession of 1982 was slow, and inflation has remained at comparatively high levels. Yet growth has picked up significantly during the last decade, averaging 2.5 percent per annum in per capita terms. The crawling peg exchange rate regime has helped to anchor inflationary expectations. And, of course, Costa Rica has not suffered a major financial crisis—of the kind which in too many other countries has undone the gains from years of prudent macroeconomic management.

The third foundation of Costa Rica's economic policy is its outward orientation. Trade liberalization has progressed through a unilateral lowering of tariffs, as well as the negotiation of trade arrangements. Exports now represent around 50 percent of GDP, compared to 30 percent of GDP in 1980. Action has been taken to implement an explicit policy of encouraging foreign direct investment (FDI), which typically accounts for more than half of all net capital inflows. The large size of trade and the continuing long-term capital inflows have clearly reduced the Costa Rican economy's vulnerability to capital account shocks.

Trade liberalization has been accompanied by structural adjustment—notably the dismantling of industrialization policies aimed at import substitution—which has spurred investment, growth in total factor productivity, and significant economic diversification. It is highly significant that agricultural production now accounts for a little over 8 percent of GDP, compared to more than a quarter of GDP in the early 1980s. Furthermore, the service sector's share of GDP has increased by 50 percent. High-tech exports account for a fourth of total exports, and tourism—encouraged by the country's great respect for the environment—accounts for a sixth of total exports. Greater diversification has supported more stable terms of trade and made the economy less vulnerable to adverse weather, commodity price movements, and other shocks. These efforts will culminate in implementation of the Free Trade Treaty between Central America and the United States—the Central American Free Trade Agreement, or CAFTA—which will deepen Costa Rica's integration into the global economy, while offering new trade opportunities and catalyzing further structural reforms.

The challenges ahead

Going forward, these firm foundations must be maintained to ensure success, but the policy approach must also be enhanced and adjusted in order to meet the challenges posed by a changing global economy—CAFTA included. Moreover, it will be important in the near future to address certain imbalances that have emerged in recent years, making the Costa Rican economy more vulnerable to external shocks.

I know that you and the Costa Rican authorities are well aware of these challenges—indeed, several important reforms have already been initiated to address them. Even so, let me outline what I think are the most critical macroeconomic policy priorities in the near future.

First, it is important to strengthen government finance, bring inflation down to the levels recorded by Costa Rica's main trading partners, and reverse the dollarization of the financial system. Let me touch on each of these briefly, in turn.

Strengthening government finance: Although public external debt has declined significantly since the early 1980s, total public debt has been rising in recent years, and now stands at 55 percent of GDP, which is very high for Costa Rica. A stronger fiscal position is needed to ensure medium-term fiscal sustainability and to provide the requisite scope for pursuing counter-cyclical fiscal policies to cushion shocks that harm growth. Progress on this front is encouraging. The tax reform package currently before congress would broaden the tax base and eliminate tax loopholes, thereby enhancing government revenue collection. Steps are also being taken to contain expenditure growth by reducing the degree of indexation of civil service wages and strengthening procurement procedures. These efforts should be complemented by additional measures to strengthen tax administration, roll back revenue earmarking, reform the pension system, and improve the performance of public enterprises.

Reducing inflation on a sustained basis: Inflation in Costa Rica has typically ranged between 10 and 30 percent per annum over the last two decades. As international experience has shown, inflation on such a scale distorts decisions by economic transactors and can lead to slower growth. Moreover, the costs of inflation are borne most heavily by the poor, who lack the wealth needed to diversify into inflation-proof assets. The fact that the colón is a less than perfect store of value encourages local currency disintermediation and shortens the maturities of claims denominated in local currency, which limits the financial system's capacity to contribute to economic growth. Bringing down inflation to low single-digit levels—and keeping it there—could therefore help improve welfare in Costa Rica. Now, bringing down inflation will require a higher degree of consistency between fiscal and monetary policies. Fiscal consolidation would decisively support monetary policy and allow it to be more narrowly focused on the inflation objective. The authorities' intention to recapitalize the central bank is also critical for achieving price stability, as such action would cancel out one of the main factors underlying monetary expansion in recent years.

Reducing financial dollarization: Foreign currency deposits of private banks have grown substantially in recent years, and now account for half of all bank deposits. This trend has dramatically increased the economy's vulnerability to exchange rate shocks. Reversing this trend will require a comprehensive strategy to restore confidence in the colón and ensure that the risks of dollar intermediation are fully internalized. Key elements of such a strategy would include fiscal consolidation and sustained low inflation. Banking sector reform is also important, and I will touch on this in a minute.

Individually, each of these macroeconomic reforms would yield specific benefits. Yet, the reforms are tightly linked to one another and really must be undertaken in tandem. For example, lowering the inflation rate is not possible without fiscal consolidation. And reversing the trend toward increased dollarization requires a stable inflation rate and confidence in the currency which, in turn, requires a sustainable public debt position.

Second, the authorities' proposed strategy for reforming the banking system is a priority. The uneven regulatory environment has inhibited competition, contributed to the growth of financial dollarization, and encouraged the development of offshore banks. IMF analysis suggests that Costa Rican banks are especially vulnerable to interest and exchange rate risks. While the authorities have made substantial progress in improving bank regulation and supervision since 2001, implementation of reforms has met some obstacles and a number of deficiencies still need to be addressed. Strengthening the banking sector requires a more ambitious pace of reforms to prudential and consolidated supervisory systems, upgrading liquidity and risk management practices, as well as strengthening the crisis resolution framework. In short, Costa Rica's financial system requires a more level playing-field in three areas: private sector versus public sector, intermediation in dollars versus intermediation in colones, and on-shore versus off-shore transactions.

Third, over the medium term, there would be merit in shifting toward greater exchange rate flexibility. Although the crawling peg has served Costa Rica well in the past, it is vulnerable in the face of external shocks, especially in light of the high level of financial dollarization. Greater flexibility could also facilitate the structural change that is anticipated to accompany further trade liberalization. Of course, such a shift would have to be gradual. The foundation must first be laid by developing the necessary exchange market infrastructure, and by undertaking supporting macroeconomic reforms: the fiscal imbalance must be reduced, inflation brought down, and the focus of monetary policy shifted toward inflation targeting, becoming the nominal anchor for the economy. Again, the reforms are all interlinked.

These vulnerabilities—macroeconomic imbalances, financial sector weaknesses, and exchange rate rigidity—have contributed to financial crises in other countries in recent years. Addressing them, soon and in a coordinated and properly sequenced manner, will help to ensure that Costa Rica can continue to enjoy stability and improving living standards for its people. While the tradition of consensus building is important for building ownership and social cohesion, it must be managed carefully so that important legislative or executive decisions do not take too long to materialize. In too many other countries, crisis has been the impetus for further reform. I am sure that we would all agree that this should not happen here in Costa Rica. True, some reforms may impinge on the interests of some special interests. But, together, they will ultimately enhance the Costa Rican economy's capacity to grow and provide for its population. Gaining the acceptance for an ambitious and comprehensive reform package, and the consensus to push forward quickly, is the most urgent priority of all.

It would be remiss of me not to mention the fact that there are certain structural reforms in the real sector of the economy that are still pending, but which, if implemented, would be a trigger for economic growth, at no fiscal cost. These include opening up the telecommunications sector, the electric power sector, and insurance to competition.


Finally, I would like to say a few words about the IMF's role in Costa Rica. I believe—and I think we are of like mind on this—that the Fund and Costa Rica have had a tradition of very constructive discussions on economic developments, policy priorities and implementation. During the most recent Article IV consultation, which was concluded with the Board discussion on July 2, there was considerable agreement on Costa Rica's strengths and the challenges it faces, and a fruitful exchange of views on the scope and pace of needed reforms. In recent years, Costa Rica has also been the recipient of a wide range of technical assistance. Our goal is to be a key partner in discussing your priorities and in implementing your plans to ensure sustainable growth, capitalize on your remarkable record of social progress, and take full advantage of the benefits of your integration to the global economy.

Thank you.


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