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More Warnings Over Fiscal Deficit

Lack of fiscal reform continues to erode Costa Rica's public finances, constraining its long-term growth prospects and highlighting its vulnerability to external shocks.

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Standard & Poor’s maintained Costa Rica’s debt rating at BB, but warned that it could lower it this year if the next government (on May 8) does not take measures to resolve the fiscal problem.

In its review of the long-term debt rating and in the short term, the rating agency again pointed out that due to the absence of a fiscal reform, public finances continue to erode, limiting the possibilities of long-term growth and increasing vulnerability to external shocks.

S&P ensures that the probability of a reduction in the debt in the course of this year is 33%, if the new government in May fails to address the problem of public finances.

Persistent and high fiscal deficits could result in lower GDP growth, a higher debt burden and growing external vulnerabilities, leading to a downgrade in the rating.

On the contrary, a prompt approval of a fiscal reform that reduces the deficit and stabilizes in general terms the burden of the government debt, along with a growth in the economy and moderate account deficits could prevent further erosion of the financial profile. This could, the rating agency explains, result in an improvement in the rating outlook, from negative to stable, this year.

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From a press release by Standard & Poor’s

– Lack of fiscal reform continues to erode Costa Rica’s public finances, constraining its long-term growth prospects and highlighting its vulnerability to external shocks.

– We are affirming our ‘BB-‘ long-term foreign and local currency ratings on Costa Rica.

– The outlook remains negative, reflecting the one-in-three chances that we could lower the ratings on Costa Rica this year if the new administration that takes office later this year fails to address the fiscal situation of the country.

RATING ACTION
On Feb. 21, 2018, S&P Global Ratings affirmed its ‘BB-‘ long-term foreign and local currency sovereign credit ratings on the Republic of Costa Rica. The outlook remains negative. At the same time, we affirmed our ‘B’ short-term foreign and local currency sovereign credit ratings and our ‘BB+’ transfer and convertibility assessment.

OUTLOOK
The negative outlook reflects the at least one-in-three chance that we could lower the ratings this year if the new administration that takes office later this year fails to promptly address the fiscal situation of the country. Persistently high fiscal deficits could result in lower GDP growth, a higher debt burden, and increased external vulnerabilities that would lead to a downgrade.

Conversely, early approval of a fiscal reform that reduces the fiscal deficit and stabilizes the general government’s debt burden, along with continued economic growth and moderate current account deficits (CADs), could prevent further erosion of the sovereign’s financial profile. This could lead us to revise the outlook to stable this year.

RATIONALE
The ratings on Costa Rica reflect its stable political system, ample political checks and balances, and higher social indicators than peers’. It also reflects the weak government effectiveness to approve fiscal reform quickly. Many years of large fiscal deficits have raised the government’s debt burden. That, along with a high level of dollarization in the financial system and overall monetary inflexibility, contributes to its external vulnerability.

Institutional and economic profile: New political landscape might increase the chances of fiscal reform, which could benefit economic growth Costa Rica’s stable political system and higher social indicators compare positively with peers. The inability of the outgoing government of President Luis Guillermo Solis to implement fiscal reform has weakened public finances. National elections this year offer the possibility that the new president and Congress might advance quickly with long-discussed fiscal reform. Timely reform that reduces the fiscal deficit would have a positive impact on investors’ confidence and economic growth over the next few years. Costa Rica continues to compare positively with peers in the region and insimilar rating categories because of its strong democratic history, the stability of its political institutions, and higher social standards. Overall low poverty and crime compare positively among most of its Central American peers. We estimate that its GDP per capita would reach US$11,580 in 2018.

However, our assessment of its institutional effectiveness also reflects the inability of several consecutive governments–including Congress–to take measures on revenue and spending to control a persistently large fiscal deficit. A prolonged stalemate in Congress over policies to boost tax revenues and contain government spending has contributed to currently weak public finances, lower investor confidence, and worse debt management.

The results of national elections on Feb. 4, 2018, indicate that the new Congress will be modestly less fragmented than the last one, which could help advance fiscal reform this year. Also, the recent political debate about fiscal issues during the political campaign, along with support from the private sector and international organizations, could encourage the new administration and Congress to take corrective actions soon.

In the presidential race, Fabricio Alvarado from Partido Restauracion Nacional (PRN) got 24.9% of votes, and Carlos Alvarado from the ruling Partido Acción Ciudadana (PAC) got 21.6% of votes. They will face a runoff election on April 1, 2018. These results show an overall vote against the country’s two traditional political parties over the last 30 years, Partido Liberacion Nacional (PLN) and Partido Unidad Social Cristiana (PUSC), neither of which has a candidate in the second round of the presidential elections.

Regardless of the winner, we expect overall continuity in economic policy. Besides the fiscal reform, the new government will also face accelerating public infrastructure investment and improve effectiveness of education spending, among other challenges.

A smooth political transition and early approval of a fiscal reform could help recover economic growth momentum. GDP growth of 3.2% in 2017 was the lowest since 2013. Growth slowed in part because of less dynamic internal demand. Weak demand reflects rising domestic interest rates, a consequence of heavy government borrowing in the country’s limited domestic market.

For 2018 and 2019, we expect broadly similar economic activity in the country, with average real GDP growth of 3.4% and GDP per capita growth of around 2%. Projected higher economic growth in the U.S. should keep the exports increasing, more than likely offsetting higher prices on imports. Nevertheless, current higher local interest rates would continue reflecting slower credit growth and sluggish private consumption and investment.

Over the next few years, fiscal reform would also contribute to easing
pressure on the local credit market, which could improve credit conditions for the private sector. Sustainable public finances and a more efficient energy sector while keeping crime rates low should keep Costa Rica’s foreign direct investment (FDI) attractive and could boost economic growth.

Flexibility and performance profile: Fiscal deterioration and external vulnerabilities are likely to persist, while inflation could remain within target over the next two years We expect the general government fiscal deficit and debt levels to remain high, and potentially rise if there is not fiscal reform. The CAD would likely remain moderate over the next few years, mostly financed through FDI.

Inflation will likely remain within the central bank’s target despite expected higher commodity prices. The still-high level of dollarization in the financial system exposes Costa Rica to external shocks. The general government deficit continued to increase and reached 5.7% of GDP in 2017 (our definition of general government includes the central bank, decentralized government agencies, and social security). On the expenditure side, the main drivers were increases in central government capital expenditures and interest payments. On the revenue side, the tax and nontax revenue growth rate decelerated to 4% from 9% the previous year, following decelerating GDP growth.

Our base case assumes a slightly worse fiscal deficit this year (above 6% of GDP) and implementation of fiscal reform that starts to show results in 2019, gradually reducing the general government deficit toward 4.5% in 2020. Such a fiscal trajectory should also help reduce the growing debt trend. In 2017, net general government debt reached 44.7% of GDP, more than double the 21% of 2010. A comprehensive fiscal reform would be necessary to stabilize and eventually start reducing the sovereign debt in the following years.

We forecast that Costa Rica’s debt would continue rising to reach close to 52% of GDP in 2020. We expect a similar trend for interest payments that should nevertheless stay below 13% of general government revenues over the same period. In 2017, interest payments reached the highest level over the last 10 years representing 11% of such revenues.

As of December 2017, 21% of general government debt was denominated in foreign currency. Over the last two years, the country has not been able to issue externally because of a lack of Congressional authorization, which is causing a crowding out effect in the local credit market, with a corresponding rise in interest rates and deceleration of private credit.

Given that the banks’ assets-to-GDP ratio is 77% and that our Banking Industry Country Risk Assessment (BICRA) is at ‘7’, we consider Costa Rica’s contingent liabilities as limited. (BICRAs are grouped on a scale from ‘1’ to ’10’, ranging from what we view as the lowest-risk banking systems [group ‘1’] to the highest-risk [group ’10’].) This is also based on the immaterial size of the non-deposit-taking corporations (3% of GDP) relative to the size of the deposit-taking institutions and that the nonfinancial public enterprises have had historically flat balances.

Costa Rica’s external profile has deteriorated in recent years, given a CAD that has averaged close to 4% over the last five years. In 2017, the CAD reached 3.2% of GDP, covered in full by FDI. The CAD rose from the previous year (2.6% of GDP) mainly because of a higher net income deficit following increased interest and dividend payments. The trade deficit stayed at 9% of GDP, balancing increased exports with higher oil prices that in turn increased the import bill, while the service balance continued to post a surplus of 10.5% of GDP with almost half from the tourism sector.

We expect a gradual increase in Costa Rica’s CAD toward 4% of GDP up to 2020, mostly financed by FDI, containing the sovereign’s external debt burden. This should keep the sovereign’s gross external financing needs around 105% of current account receipts and usable reserves, and its narrow net external debt (gross external debt less official reserves, other liquid external assets held by the public sector, and financial-sector external assets) around 52% of CAR in 2018-2020.

Our projection considers higher expected U.S. growth, the main destination of the country’s exports and source of tourism; moderate currency depreciation; and possibly rising commodity prices and increased imports as economic growth recovers.

FDI continues to perform well despite increasing fiscal pressures and political uncertainty. In 2017, FDI reached 5% of GDP, broadly in line with the average of the previous three years. Steady FDI flows could be explained by the overall good business climate, low crime rates, and stronger human capital than its peers in the region.

A high level of dollarization in the financial system exposes Costa Rica to external shocks and, at the same time, constrains its monetary policy. An unexpectedly sharp change in the exchange rate could create asset quality problems in the financial system. Dollarization also limits the central bank’s ability to act as a lender of last resort. In 2017, dollar-denominated loans represented 39% of total loans to the private sector.

Inflation recovered to 2.6% by year-end 2017 from historical lows around 0% in the previous two years following increasing prices in commodities, particularly hydrocarbons. We expect inflation to remain within the central bank’s target over the next two years (3% plus/minus 1) as we expect that private consumption would stay subdued given higher interest rates compared to previous years, which would compensate for higher commodity prices. Our inflation forecast also considers a similar Colon gradual depreciation as in previous years.

The central bank’s exchange-rate policy is managed-floating. Episodes of exchange-rate volatility in 2017 were because of long-lasting low local interest rates, despite increases in the U.S. interest rate, which contributed to local currency depreciation. The central bank acted rapidly by using its foreign exchange reserves and increasing local interest rates to stabilize the currency in the second half of the year. Recurrent central bank intervention would prevent steep local currency depreciation over the next 12 months. In October 2017, the central bank signed a new loan with Fondo Latinoamericano de Reservas (FLAR) for US$1 billion that will be disbursed this year. The bank estimates that reserves will stay around 13% of GDP, a level we consider adequate.

In 2018, credit growth will likely remain slow. We are expecting lower credit demand under the country’s electoral process, which brings uncertainty, coupled with higher interest rates, which could result in a fall of the consumption confidence levels and in credit appetite. As in 2017, we expect this slowdown to continue during the first months of 2018 and then confidence levels could be restored during the second half of 2018, reaching annual credit growth around 8%, supported mainly by corporate and commercial lending.