Washington, USA — On January 30, the executive board of the International Monetary Fund (IMF) concluded the 2014 Article IV consultation with Costa Rica.
Costa Rica bounced back quickly from the 2008–09 global crisis, but growth momentum is now slowing and macro vulnerabilities, mainly from the weak fiscal position, are rising. After falling modestly in 2009, real GDP surged in 2010–12. Since then, however, growth has moderated below potential, with the latter also on a declining trend. The counter-cyclical budgetary stimulus imparted in 2009 pushed the deficit above 5 percent of GDP in 2010 (mainly through a rise in wages and transfers). The deficit has been creeping up further since then, placing the public-debt-to-GDP ratio on an unsustainable upward trajectory, which is fast approaching levels shown to increase risks of disorderly adjustment for emerging economies. A fairly inflexible exchange rate has contributed to vulnerabilities associated with dollarization in the financial sector.
The outlook for 2015 and beyond remains subdued amid deteriorating fundamentals. Growth in 2015 is expected to stay virtually unchanged, as the positive influence of U.S. recovery offsets the negative impact of a gradual Intel withdrawal. The output gap is projected to widen through 2016, then mostly closing over the medium term, with growth also converging to potential. The baseline scenario contemplates fiscal consolidation of 2.2percent of GDP over the medium term. In this case, the central government fiscal deficit would stay at about 5.75 percent of GDP, and the public debt ratio would approach 51 percent of GDP by 2019. Thanks to continued prudent monetary policy, inflation is projected to hover around 4 percent after returning within the Central Bank’s announced band in early 2015, while the current account deficit rises to 5.25percent of GDP by 2019.
Risks to the outlook are tilted to the downside. Concerning external factors, in the case of faster U.S. monetary policy normalization, slightly upside risks prevail, with a positive impact of higher U.S. growth more than offsetting the negative influence of tighter global financial conditions in the short run. However, extreme bouts of market volatility could inflict serious damage, especially given Costa Rica’s weak fiscal position, as interest rates may rise abruptly. On the other hand, further sustained declines in energy prices could have a modest positive effect on Costa Rica. On the domestic side, the persistence of a large fiscal deficit and the ensuing rise in the public debt ratio could render the economy vulnerable to sudden changes in financial market conditions.
Executive Board Assessment
While commending Costa Rica’s resilience in the aftermath of the global financial crisis, Executive Directors called for reinvigorated efforts to preserve macroeconomic stability in the wake of waning growth and rising unemployment and vulnerabilities. They recommended an ambitious but phased budget consolidation to arrest the deterioration in the fiscal accounts and put the public debt on a sustainable trajectory, along with a strengthening of the monetary policy framework and structural reforms to boost competitiveness and inclusive growth.
Directors welcomed the authorities’ intention to implement a total fiscal adjustment of about 4 percent of GDP, with a front-loaded adjustment in 2015 followed by more incremental steps in subsequent years. Noting Costa Rica’s low revenue effort relative to peer countries, they supported the emphasis on boosting revenue mobilization through a mix of administrative and policy reforms—including broadening the tax base, and raising the VAT rate and marginal rates on higher-income brackets. Directors also encouraged efforts to contain the growth of current outlays, particularly the wage bill and transfers, thus creating space for much-needed infrastructure spending. They looked forward to Parliamentary approval of outstanding legislative reforms and encouraged consensus building for a comprehensive package of measures to underpin deficit reduction. Over the longer run, measures are also needed to address the social security actuarial deficit.
Directors considered the current monetary policy stance to be appropriate, while calling on the Banco Central de Costa Rica (BCCR) to stand ready to increase its policy rate should inflationary pressure persist. They recommended strengthening the monetary policy framework, including further steps towards inflation targeting and enhanced exchange rate flexibility. In this regard, most Directors supported the elimination of the exchange rate band. Directors also recommended the development of tools to underpin greater exchange rate flexibility, including hedging instruments.
Directors encouraged implementation of pending FSAP recommendations, to help strengthen financial sector supervision and resilience. They advised a gradual move towards Basel III standards, and strengthening cross-border supervision. Priority should also be given to empowering the Financial Institutions Superintendence to conduct consolidated and transnational supervision, providing adequate protection to supervisors, and enhancing bank resolution procedures.
Directors called for continued progress in structural reforms to boost productivity, enhance external competitiveness, and foster long-run inclusive growth. Efforts are needed to streamline the regulatory environment, increase private sector participation in the energy sector, alleviate infrastructure bottlenecks, and promote capital market development. Directors also recommended ameliorating the efficiency of education spending, with a view to increasing women’s labor force participation, stimulating productivity, and reducing inequality in the long term.