Businessman paying in dollarsCOSTA RICA NEWS (Fitch Ratings, Feb. 12) – The move by Costa Rica’s central bank to adopt a managed floating foreign exchange rate regime along with the Superintendence of Financial Entities’ (SUGEF) efforts to curb high dollarization in the banking system are likely to reduce overall foreign currency lending, says Fitch Ratings.

The SUGEF’s aim is to trim the Costa Rican banking system’s exposure to foreign exchange risk. Fitch views any reduction in bank balance sheet dollarization as positive. However, Fitch also expects any reduction in foreign currency loan growth to mainly affect the private banking sector, as these banks are more dollarized than public sector banks. One risk in the policy move is that local currency loans could replace US dollar denominated loans at different speeds than dollar deposit exchanges. Fitch believes that US denominated loan portfolios may be reduced at only modest levels over the short to medium term, which could give rise to greater balance sheet imbalances.

The central bank’s measures, announced on Jan. 31, follow several moves by the SUGEF aimed at limiting the risk that local bank borrowers with dollar denominated loans could increasingly find difficulty repaying their obligations using local currency sources. The high proportion of dollar denominated loans in Costa Rica is a major form of credit risk for financial institutions. A significant increase in the U.S. dollar-to-Costa Rican colon exchange rate would likely deteriorate foreign-currency loan portfolios.

The Costa Rican Banking system is one of the most highly dollarized in Latin America, with 47.6% of assets and 50.5% of liabilities dollar denominated as of year-end 2014, according to Fitch.

The central bank’s measures also include the intention to implement a 15% mandatory cash reserves requirement on medium- and long-term foreign currency funding. In 2014, the SUGEF implemented additional liquidity and capital requirements for foreign-currency assets and more conservative origination standards for loans to non-foreign currency generators.

The mandatory reserves requirement would increase banks’ funding costs and reduce the differential between local and foreign currency interest rates. In Fitch’s opinion, each of the measures can hold down loan growth on dollar denominated loans. At the same time, lower foreign-currency exposure may also limit foreign exchange gains or losses. One offsetting impact is that the higher cost of long term foreign funding may limit the ability of banks to provide long term loans, given that long term local currency funding is scarce.

Fitch expects that the Costa Rican central bank will ultimately move to a free floating exchange rate at some point in the future. Under both free float and managed float foreign exchange regimes, supply and demand forces in foreign exchange markets determine currency valuations. However, the managed float regime essentially establishes a higher expectation that the central bank could intervene to protect against extreme currency fluctuations.

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