Public Information Notice No. 02/47

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Costa Rica

April 24, 2002

On July 30, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Costa Rica.¹

Background

During the 1990s, Costa Rica made significant progress in opening its trade system, and social conditions, especially for education and health, remained among the best in the region. These factors, together with a long history of political stability, attracted foreign direct investment, led to more diversified exports, and sustained real GDP growth of 4½ percent a year in the period 1990-99, while inflation declined to 10 percent in 1999. However, successive governments met strong political resistance to their efforts to reduce the overall public sector deficit on a sustained basis, and total public debt reached 45 percent of GDP by end-1999, contributing to high domestic interest rates and a weak net international reserve position.

In 2000, economic performance weakened. Real GDP growth slowed to 1.7 percent, from over 8 percent a year in 1998-99, reflecting in part a deterioration in the terms of trade, the end of the construction phase of a large foreign direct investment project by INTEL, and the effect of high real interest rates on domestic demand. Inflation remained at 10 percent during the year. Net international reserves declined by about US$150 million, leaving gross international reserves at end-2000 at a relatively low level by regional standards. The external current account deficit reached almost 5 percent of GDP, reflecting lower world coffee and banana prices as well as the surge in world oil prices.

The overall public sector deficit rose from 3.5 percent of GDP in 1999 to 4.2 percent of GDP in 2000, as the primary surplus virtually disappeared. Net external financing amounted to about 1½ percent of GDP, with the balance covered through further domestic borrowing, and total public debt rose to 48 percent of GDP by end-2000.

The central bank's net domestic assets contracted slightly in 2000. In March 2000, reserve requirements on domestic currency deposits were lowered by 2 percentage points to 12 percent to try to narrow the intermediation spread (the difference between deposit and lending interest rates) and encourage lower interest rates on domestic currency loans. (The reserve requirement on U.S. dollar deposits stayed at 5 percent.) Exchange rate policy aimed to depreciate the colón to offset the differential between the domestic inflation target and estimated foreign inflation. During 2000, the central bank slowed the rate of crawl to 6.6 percent, from 9.9 percent during 1999, as it expected higher foreign inflation.

Bank credit to the private sector rose by 31 percent during the year, led by a 52 percent rise in foreign currency lending. Moreover, a growing share of the foreign currency loans went to mortgage refinancing, consumer credit and other activities without income in foreign currency. The rapid credit expansion was financed partly by the use of net foreign assets, as broad money rose by 20 percent during the year. By end-2000, foreign currency loans amounted to 46 percent of total loans, compared with 36 percent at end-1999, while foreign currency deposits rose to 45 percent of broad money.

In the structural area, the assembly approved legislation to open up the telecommunications and electricity sectors to private investment, but subsequently strong political opposition stopped this reform. In early 2000, the superintendent of financial institutions introduced regulations that, inter alia, required banks to place off-balance sheet operations on their balance sheets and to report regularly on their offshore operations. Trade liberalization continued, with a reduction in tariffs on imports from outside Central America and the approval of a free trade agreement with Chile.

In the first four months of 2001, preliminary information suggested that real economic activity declined by about 2 percent (year on year) as exports by INTEL remained low. (Excluding INTEL operations, economic activity rose by an estimated 2 percent year on year in the same period.) Price increases in housing and food raised 12-month inflation to 13.3 percent in May. In the first quarter, the central government deficit amounted to 3.2 percent of quarterly GDP. The central bank lowered interest rates on its open market instruments by 50 basis points to 14.5 percent in late April, much less than the decline in interest rates on U.S. treasury bills since end-2000, and continued to sell open market securities. Owing to stagnant exports, the external current account deficit widened to about 3 percent of quarterly GDP in the first quarter. Through end-May, net international reserves rose by US$32 million, benefiting from the proceeds of a US$250 million bond issue by the government. In March 2001, the authorities introduced legislation to improve the independence of the central bank, strengthen financial supervision and introduce partial deposit insurance for both public and private banks.

Executive Board Assessment

Executive Directors noted that Costa Rica had experienced steady economic growth and declining inflation in the 1990s, reflecting in part advances in trade liberalization and resulting in favorable social indicators. Nonetheless, Directors commented that the authorities have encountered difficulties in securing a sustained reduction in the overall public sector deficit, and that this has led to high domestic real interest rates and, in conjunction with a reduction in technology-related exports given the slowdown in the world economy, to a weak international reserve position. They cautioned that the economy is likely to become increasingly vulnerable over time if the fiscal imbalances persist and structural reforms remain stalled.

Directors emphasized that the most urgent policy requirement is to increase the public sector's primary surplus in a sustained manner in order to reduce the public sector's debt burden significantly over the next five years. The best approach would be to implement a sizable up-front fiscal adjustment through increasing revenues, cutting unproductive expenditure, scaling back revenue earmarking, and adopting a more prudent and transparent wage policy. In this regard, Directors welcomed the tax simplification package, the phasing out of the export subsidies, and the proposed legislation to remove revenue earmarking as steps in the right direction. They saw the government's decision to repay its debt to the central bank as an important step that makes fiscal policy more transparent.

Directors viewed the rapid increase in bank lending in U.S. dollars as a serious risk, and encouraged the authorities to remove distortions that favored this type of lending, such as differential tax treatment of deposits in different currencies, and to increase provisioning or capital requirements on these types of loans.

Directors observed that the crawling peg exchange rate regime appeared adequate for the time being, while inflation remained high. They felt that serious consideration should be given to adopting a more flexible exchange rate regime, once fiscal and external imbalances are reduced and inflation is brought down further.

Directors noted that the financial legislation recently introduced to the assembly contains important reforms to strengthen the central bank's independence, improve supervision of domestic financial institutions, and introduce limited deposit insurance. It will also be important to make the state-owned banks operate more efficiently and help reduce high intermediation costs in the economy. Directors welcomed the authorities' strong interest in the upcoming financial sector assessment, which should help clarify whether the offshore branches and off-balance sheet accounts pose any risks.

Directors stressed the importance of making progress on other key structural reforms, especially to improve infrastructure, cut administrative inefficiency, and lower the high financial intermediation spread in local currency. In addition, they thought that high priority should be given to opening up the electricity generation and telecommunications sectors to private sector participation in order to reduce costs and satisfy the projected increase in demand for these services. These steps would help reduce the overall public sector deficit and strengthen external competitiveness.

Directors very much welcomed the authorities' commitment to provide debt relief to Nicaragua under the Initiative for Heavily Indebted Poor Countries. They took note of the authorities' conversations with relevant parties to find a modality that reduces the financial cost of this relief and gains broad domestic political support.

Directors agreed that the Fund's technical assistance in the coming years to Costa Rica should focus on improving transparency, with an emphasis on continuing the efforts to improve economic statistics. Better fiscal transparency, especially to include all public spending in the fiscal accounts, is key to improve the surveillance of macroeconomic developments.