Public Information Notice No. 98/34

Press Information Notice: IMF Concludes Article IV Consultation with Costa Rica

May 14, 1998

The IMF Executive Board on March 18, 1998 concluded the Article IV consultation¹ with Costa Rica.

Background

Costa Rica is recovering from a slump in economic activity in 1995–96, following a sharp deterioration in the public finances and higher inflation associated with the 1993–94 political-economic cycle. Led by an expansion in private consumption and investment, and a strong growth in manufactured exports, real GDP grew by 3.2 percent in 1997, while the unemployment rate declined to 5.7 percent from 6.2 percent in 1996. At the same time, inflation decelerated to 11 percent from 14 percent a year earlier.

Regarding the public finances, in early 1997 the government adopted fiscal measures equivalent to 1.5 percentage points of GDP. Moreover, through continued efforts to con tain noninterest current expenditure and strengthen tax collections, and lower interest obligations resulting from a decline in the average interest rate on government domestic debt, the combined public sector deficit declined from 5.3 percent of GDP in 1996 to 3.7 percent of GDP in 1997.

Reflecting the recovery of private domestic investment and increasing inflows of foreign direct investment, import growth accelerated in 1997 and the external current account deficit widened in spite of the continued strong growth of nontraditional exports. Public sector capital flows turned positive for the first time since 1993 reflecting in part disburse ments of balance of payments support loans. This, together with a sharp increase in private capital inflows resulted in an accumulation of net international reserves by US$216 million in 1997, to the equivalent of nearly 3 months of imports of goods and nonfactor services. The external public debt to GDP ratio declined further to 30 percent in 1997 from 36.6 percent in 1995.

Progress also was made in the area of structural reforms in 1996–97, particularly in strengthening tax administration, on public expenditure management, and in increasing private sector participation through concessions, management contracts, and privatization. On financial sector reform, regulations were issued for the functioning of an interbank market and the central bank continued to lower reserve requirements, unifying them at 15 percent in March 1998. The auction mechanism for open market operations, and the payments system were improved. Also, legislation was enacted to strengthen the national commission of securities and the superintendency of pensions, and regulations issued to cover offshore banking operations of financial conglomerates.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities’ efforts to avoid a repetition in 1997 of the usual political-economic cycle, and welcomed the satisfactory macroeconomic performance under the staff-monitored program. In contrast to previous cycles, there had been a strong pickup in the pace of economic activity, inflation had decelerated further, net international reserves had increased, and the social indicators had continued to improve. In addition, the steps taken to put in place legislation to increase private sector participation in the economy were noteworthy, as they are expected to facilitate progress in this area by the new government. Directors stressed the importance of a sustained implementation of sound macroeconomic policies and structural reforms to strengthen private sector confidence.

While welcoming the improvement in the public finances in 1997—through sustained efforts to contain noninterest current expenditure, strengthen tax administration, and lower interest obligations—Directors underscored the need to continue to reduce the public sector deficit, in order to help reduce interest rates and to further the recovery of economic activity. In this respect, Directors urged the new administration to move forcefully in the area of fiscal consolidation and structural reforms, including by selling public assets and applying the proceeds toward a reduction in the public debt. Directors also stressed theimportance of removing existing rigidities in the structure of the public finances and strengthening the weak revenue base.

Directors noted that the conduct of monetary policy had been complicated by short-term capital inflows induced by high domestic interest rates and by segmented financial markets. In this regard, they welcomed the reduction and unification of legal reserve requirements, the plans to privatize one large state commercial bank, and the enactment of legislation to develop the capital markets. However, Directors stressed the importance of allowing market forces to play a greater role in the determination of interest rates by developing the interbank market, and of enhancing competition by permitting foreign banks to open branches in Costa Rica. Directors commended the authorities for the progress made in improving the health of the financial system, but underscored the need to continue the efforts in this area, especially by improving the supervision of the offshore financial groups and of the stock market.

Directors expressed concern about the widening of the external current account deficit in 1997, and while noting that the deficit was financed in part by private direct investment, they stressed the importance of preventing a further deterioration in 1998. They wel comed, in this regard, the authorities’ decision to accelerate the exchange rate crawl to offset the appreciation of the U.S. dollar in the recent past. It was noted that the exchange rate rule had been successful in maintaining external competitiveness over the last several years.

Directors urged the new administration to accelerate and broaden structural reforms to foster strong and sustained growth over the medium term. They stressed the importance of reducing the dominant role of the state in the productive sectors, and noted that policies to raise participation by the private sector—including in the electricity and telecommunications sectors—should be pursued.

It is expected that the next Article IV consultation with Costa Rica will be held on the standard 12-month cycle.