Public Information Notice No. 04/94

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Costa Rica

August 19, 2004

On July 2, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Costa Rica.

Background

Economic performance improved in 2003. Following several years of slow growth, real GDP rose by 5½ percent, boosted by a recovery of exports and strong private investment. Inflation declined below 10 percent, while unemployment fell to 6 percent. The external current account deficit narrowed to 5.3 percent of GDP in 2003 from 5.7 percent of GDP in 2002. Strong export growth, particularly electronics, largely offset higher imports of oil and capital goods. Gross reserves rose to 2½ months of imports, owing to pre-financing of 2004 fiscal needs and short-term capital inflows.

The public sector deficit was reduced to 5.2 percent of GDP in 2003 from 5.7 percent in 2002, owing to temporary tax measures and expenditure restraint. The primary balance shifted to a surplus of 0.3 percent of GDP, from a deficit of ½ percent of GDP in 2002. However, the public debt continued to rise, reaching 55 percent of GDP by the end of the year.

Monetary policy continued to be heavily constrained by the large quasi-fiscal deficit of the central bank. Broad money rose by 13.6 percent in 2003, reflecting large inflows of private capital, and credit to the private sector increased by about 20 percent in nominal terms. Financial dollarization continued to deepen and, by end-2003, about 60 percent of private sector credit was denominated in foreign currency. Some progress was made in implementing the banking reform recommendations of the 2001 Financial Sector Assessment Program (FSAP), but many reforms remain pending, including to level the playing field between onshore and offshore, as well as public and private banks.

Real GDP is expected to expand by 4 percent in 2004, and while inflation has risen to 11 percent recently owing to higher oil prices, core inflation remains stable at around 10 percent, broadly in line with the rate of crawl. The fiscal deficit is projected to remain at about 5.3 percent of GDP in 2004, as a comprehensive tax reform currently before Congress is expected to compensate for the temporary revenue measures that expired at end-2003. The successful conclusion in early 2004 of negotiations for a trade agreement with the United States (CAFTA) will make permanent the preferential access to the U.S. market hitherto granted under the Caribbean Basin Initiative.

Executive Board Assessment

Executive Directors welcomed the improvement in Costa Rica's economic situation since the last Article IV consultation, and commended the country's long-standing democratic tradition, solid institutions, and strong record of social development. They noted the favorable medium-term outlook, which should provide a good environment to make rapid progress on structural reforms. At the same time, Directors observed that significant vulnerabilities remain. Fiscal and external current account deficits continue to be large, the public debt has risen to 55 percent of GDP, the banking system suffers from growing dollarization and other weaknesses, and international reserves should be strengthened given the currency peg and the banking system's dollar liabilities.

Against this background, Directors endorsed several important reforms launched by the authorities, including a tax reform and trade agreements with the United States and CARICOM, and they were encouraged by the broad-based political support that these reforms are receiving. However, Directors called for a more comprehensive agenda of well-sequenced reforms to address remaining vulnerabilities, with special focus on tax administration, government spending, state enterprises, monetary management, and the prudential regulation and supervision of the financial sector. In light of the consensus-based character of the political system in Costa Rica, Directors emphasized that greater attention should be directed toward building the necessary political support for the reform agenda.

Directors stressed that strengthening the fiscal position is crucial for medium-term fiscal sustainability. They supported the authorities' efforts to obtain prompt legislative approval of the proposed tax reform, and stressed the need to underpin this reform with measures to strengthen tax administration. Directors also urged expenditure reform as a key priority, in particular by rolling back tax revenue earmarking, strengthening the finances of the pension system, keeping the wage bill under control, and improving the performance of the public enterprises.

Directors welcomed the authorities' plans to strengthen debt management, and agreed that fiscal consolidation would make an important contribution in this regard. They supported efforts to lengthen debt maturities and to develop the market for colón instruments in order to reduce the need for foreign-currency instruments.

Directors endorsed the authorities' intention to focus monetary policy on the objective of reducing inflation, and encouraged them to create the conditions for an eventual shift toward inflation targeting. They welcomed the authorities' plans to strengthen monetary management and instruments, make monetary policy more forward looking, and strengthen the analysis of monetary transmission channels. Directors also supported the planned recapitalization of the central bank. They noted that shifting the central bank's quasi-fiscal deficit to the government will improve fiscal transparency, as well as strengthen monetary policy and efforts to reduce inflation, provided that overall public borrowing declines. Some Directors considered that greater exchange rate flexibility could help reduce the economy's vulnerability to external shocks and facilitate adjustment to structural change. Directors noted that a move toward more flexibility should be well sequenced and supported by fiscal and financial reforms, and by the development of exchange market infrastructure.

Directors urged further progress toward strengthening the financial sector. They welcomed the steps taken so far to implement the recommendations of the 2001 Financial Sector Assessment Program (FSAP) report and follow-up technical assistance missions. However, Directors stressed that additional efforts are needed to strengthen the prudential and supervisory system. In particular, they stressed the need to ensure equal treatment of public and private banks and of offshore and onshore banks, implement consolidated supervision, strengthen sanctions and the bank resolution framework, and upgrade liquidity and risk management. They recommended the centralization of credit risk data for banks. The authorities also need to make sure that the investment funds market operates in accordance with relevant norms and transparency standards. Directors noted the authorities' efforts to further improve the already strong framework for combating money laundering and terrorism financing in a regional context.

Directors considered the rising trend of dollarization to be a significant vulnerability. They agreed that, to halt and reverse this trend, a broad strategy centered on reinforcing confidence in the colón and the onshore banking system as well as ensuring that the risks of dollar intermediation are fully internalized would be required.

Directors welcomed the progress made by Costa Rica in opening new markets for its exports. They commended the successful completion of negotiations on the Central American Free Trade Agreement with the United States, and supported the authorities' efforts to secure its early congressional approval. Directors pointed to the positive impact this agreement would have on export growth, foreign direct investment, and economic growth, and urged early approval of the associated structural reforms.