Public Information Notice No.  06/135

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Costa Rica

November 28, 2006

On October 30, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Costa Rica.¹

Background

Since the last Article IV consultation, the economy has strengthened. Real GDP grew 5.9 percent in 2005, driven mainly by exports and private investment, while inflation rose to 14.1 percent, partially explained by higher world oil prices. The current account deficit widened to 4.7 percent of GDP in 2005. Strong export growth, particularly of electronics and tourism services, partially offset higher imports of oil and capital goods. Robust private capital inflows, including a surge in foreign direct investment, led to a substantial accumulation of net international reserves. Unemployment remained constant at 6.6 percent.

In 2006, economic activity has remained strong, supported by large foreign direct investment, improved domestic business confidence, and robust domestic consumption. Inflation is declining, albeit at a low pace. Early economic indicators suggest, for the year as a whole, real GDP growth could reach at least 6½ percent, while inflation would be between 11 and 12 percent at the end of the year.

The overall public sector deficit declined to 3 percent of GDP in 2005, the lowest figure in a decade, owing to improvements in tax and customs administration and expenditure restraint. In parallel, the primary surplus reached a record level of 2.1 percent of GDP and public debt fell to about 52 percent of GDP, still a high level. The central government deficit fell further in the first half of 2006, thanks to buoyant tax receipts and continued capital spending restraint.

Monetary aggregates are expanding rapidly. Currency issue and broad money grew at annual rates of 22 and 20 percent in the year to July 2006, while bank credit to the private sector expanded at a rate of 28 percent. Key contributing factors were the central bank's large operational deficit, sizeable accumulation of reserves, improved consumer confidence, and a rise in investment demand.

On October 17, the central bank replaced the long-standing crawling peg exchange rate regime with a crawling band. The band is defined in terms of colones per U.S. dollar, and has an initial width of 3 percent. It will widen over time, as its floor and ceiling are set to crawl upward, at initial rates of around 3 and 6½ percent per year, respectively.

The health of the financial sector has improved on the back of a favorable macroeconomic environment, though important vulnerabilities remain. Bank profitability reached record levels, in both public and private banks. Reported asset quality indicators have improved markedly, with nonperforming loans falling down to 1.5 percent of all loans. Although the banking sector remains dominated by public banks, recent acquisitions of large private banks by multi-national foreign banks have intensified the process of consolidation and ownership concentration in the sector. Vulnerabilities include high dollarization of assets and liabilities, and large offshore banking activities.

Executive Board Assessment

Directors welcomed Costa Rica's continued strong economic performance, with GDP growth underpinned by robust exports as well as a substantial acceleration in private investment. Private capital inflows, including foreign direct investment, have boosted international reserves, while the fiscal deficit has declined, with an attendant reduction in public debt. Directors noted, however, that the economy continues to face important vulnerabilities, including double-digit inflation, still high public debt, and financial dollarization.

Directors shared the Costa Rican authorities' analysis of the main challenges facing the economy, and commended them for their commitment to a broad reform agenda, including a comprehensive fiscal reform, greater exchange rate flexibility, recapitalization of the central bank, and strengthening of financial regulations and supervision. Implementation of these policies will go a long way toward laying the foundation for faster growth and poverty reduction.

Directors noted that the near-term outlook for the Costa Rican economy remains favorable, with growth expected to stay high and inflation to decline. They considered the risks to the outlook as broadly balanced, while noting the need to deliver on the proposed reform agenda to maintain consumer and business confidence.

Directors emphasized that adoption of a broad tax reform is critical to reduce public debt; allow higher spending on education, infrastructure, and social needs; and provide the needed support to monetary policy to reduce inflation. They endorsed the authorities' efforts to obtain prompt legislative approval of the proposed tax reform. Directors encouraged the authorities to focus the reform on the VAT and the income tax, and advised against introducing a financial transactions tax. Directors underscored the need to complement this reform with measures to further strengthen tax administration and reduce public expenditure rigidities.

Directors praised the authorities for maintaining a prudent fiscal stance in 2006. While they recognized the need to increase spending in priority areas, they urged the authorities to limit expenditure growth until the benefits of the tax reform materialize. Directors observed that tax revenue projections in the draft 2007 budget appear ambitious, and recommended prudence in budget execution to ensure that the fiscal targets are reached.

Directors endorsed the authorities' recent move from the long-standing crawling peg to a crawling band regime. They welcomed the decision to allow for a gradual widening of the band, which will allow market participants to adjust progressively to an environment with greater exchange rate flexibility. The change in exchange regime should gradually enhance the autonomy of monetary policy, help anchor price expectations on target inflation, and enhance the economy's resilience to shocks. Directors generally saw this transition as a first step toward the eventual adoption of an inflation target as a nominal anchor. Several Directors emphasized the importance of the appropriate conditions being in place before such a move.

Directors supported the planned recapitalization of the central bank, which they considered would be an essential complement to a prudent fiscal stance and greater exchange rate flexibility in order to bring inflation gradually down to low-single digits.

Directors observed that the health of the financial sector has improved in recent years. To address the remaining vulnerabilities, Directors urged the authorities to accelerate and broaden financial sector reform, including by strengthening the supervision of offshore banking activities. They also recommended that the supervisory authority continue to enhance the monitoring of banks' asset quality and foreign currency lending to non foreign-currency earners.

Directors welcomed the authorities' determination to press ahead with ratification and implementation of CAFTA-DR. They observed that further trade liberalization, together with a reduction in the regulatory costs of doing business, should add to Costa Rica's growth potential through higher foreign direct investment and trade opportunities.

Directors encouraged the authorities to continue their efforts to foster regional cooperation. In particular, they urged continued efforts to reach consensus on a code of conduct in tax incentives for investment, in order to help forestall harmful tax competition in the region.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.