For the most part, people get extremely concerned when they hear the words recession, inflation or devaluation. Do not panic, all of these are natural stages of the economic cycle that every country has to go through over time.
While it is important to have some knowledge in macroeconomics to understand what is currently going on in Costa Rica, I will make my best effort elaborate an analysis of the current situation without getting too academic.
The Price of the Colon
Paired to the US Dollar, the Colon has been losing value. The currency has devalued 11.98% over the past two years (between January 1st, 2016 and November 16th, 2018). This year, the currency opened on January first at ¢569, and as the close on Friday it was ¢613 which represents 7.73% change. Nevertheless, these fluctuations are not unusual for the local currency. Take a look at the chart below and you can see that on September 14th, 2009 it reached a value of 589.70 and on December 9th, 2013 the value as ¢491.60.
How Are Exchange Rates Determined?
Floating rates are determined by the market forces of supply and demand. How much demand there is in relation to supply of a currency will determine that currency’s value in relation to another currency. In the case of the colon, the Costa Rican Central Bank (BCCR) has influenced the supply and demand by either selling or buying currency in the local market. While the value of the currency should be affected by economic factors, the Costa Rican government has intervened in order to give it a stable price and avoid devaluation. I disagree with this practice, as it creates a bubble due to the fictional price.
You can see that over the past 10 years the Colon has remained within the range of 490 and 588. As noted, this is due to the intervention of the BCCR, and thus the price of the colon is the result of manipulation and not the result of natural economic forces. To learn more about the factors that affect exchange rates click here.
The Real Value of the Colon
Since the colon has been manipulated by the BCCR, it is difficult to ascertain what the real value should be other than to stop any interventions from the BCCR and allow the currency price to be determined by the market conditions. There is a correlation between the devaluation of the currency and inflation, and since the currency has not devalued much over the past decade, we can use inflation as a reference and therefore with a value of ¢511 colones per US dollar in 2008 the value should have been ¢814 colones per USD by January 2018.
Having the colon at around ¢500 is not a reflection of the reality. In the past months, the BCCR has allowed the currency to fluctuate more freely resulting in an increase in prices. Over the past days, the BCCR has intervened to stabilize the currency price as the public is getting concerned of the possibility of exacerbated devaluation.
China has been manipulating its currency to keep their products at a competitive price in the world market. Costa Rica has manipulated the currency (in my opinion) to give a false sense of stability to the Ticos. The average Tico believes that a currency that does not devalue is a sign of a strong economy. The Ticos are as adverse to the devaluation as Americans are to a rescission, while both phenomena are intrinsic to the economic cycles.
Benefits of Devaluation and Inflation
Allowing the currency to devalue has its advantages. If the Costa Rican Currency devalues, the costs of products and services in Costa Rica will cost less in the global market and thus creates an incentive to acquire products and services produced in Costa Rica due to their relatively low value as a result of the devaluation of the currency. Conversely, having a currency highly priced makes Costa Rican unattractive.
Let’s take tourists as an example. If renting a hotel room cost ¢50,000 colones in January 2018 at an exchange rate of ¢570 colones per USD, the cost for a tourist will be $87.71.
If the actual exchange would be ¢814 colones per USD (as calculated above) then the cost for a tourist will be $61.48 USD.
When you apply this to the cost of production in Costa Rica, then it will become more attractive for foreign companies to invest in Costa Rica and for local companies, it will allow them to have more competitive prices which will boost production.
Adverse Effects of the Devaluation and Responsible Fiscal Policy
The main issue with the devaluation of the colon is the increased cost for Costa Ricans to acquire products and services from abroad. Costa Rica imports a lot of goods and services. As many of you know, we need to import items such as clothing, electronic devices, food, healthcare equipment, fuel, vehicles.
The devaluation of the currency will naturally result in inflation and thus it will cost more money for Costa Ricans to acquire these products. In addition, roughly 40% of the local bank loans (for mortgages, auto loans, etc) are in USD Dollars. Of all of the loans in USD dollars, 68% of the people make a salary in Colones, and thus, the cost for their loans increased.
So, if a person has a mortgage on USD Dollars but receives a salary in colones, the natural result of a devalued currency is that their mortgage payments will go up.
At a macro level, the main issue is with the debt service. Most of Costa Rican debt is foreign currency (US Dollars). Currently, the balance of the Costa Rican foreign debt is $28 Billion USD. The government receives income in colones from the taxes that it collects locally, and therefore, the cost of the debt is going to increase as a result of the devaluation of the currency.
Appropriate Course of Action
As the government has wrongfully taken steps to manipulate the currency, it has also taken other actions adverse to the economy, one of them is the taxation. The Costa Rican tax policy exacerbates the problems. Currently, the amount of taxes and the number of tax impositions in Costa Rica creates an imbalance preventing economic growth. In my opinion, one of the most damaging taxes is on the importation of goods. As noted, Costa Rica depends on a lot of imports not only for industry but for day to day needs of the local population. Heavy duties on imports result in the higher costs of living and less competitiveness.
If the government is going to allow the currency to roam free and therefore resulting in a decreased value, which results in the higher costs for foreign goods and services, the reduction on importation tax will offset the increased value of goods caused by the devaluation.
But, if Costa Rica does not have the capacity to cover a pothole on the street, how is it going to have the intellectual capacity to develop a responsible economic policy?
Fiscal Crisis and the Worst Scenario
Is Costa Rica going to turn in to an Argentina or Venezuela? It is certainly possible, but how likely will it be?
If the Costa Rican government fails to keep the budget deficit under control, it can result in default and then we can have an Argentina. Failing to pay the debt will affect the creditworthiness of Costa Rica and therefore the interest rates for the debt will increase and the currency will be worth less and will spike inflation. In situations like this, the government and the population will panic. Bank accounts get frozen to prevent people from withdrawing their money for fears of losing their life savings due to the devaluation. It is havoc.
While it will turn the country into a crisis, it will not be the end of the world. In the case of Argentina, they had a crisis between 1998 and 2002. One of the causes of the crisis was the controlled fixed exchange rate. Once it was liberated the Argentinean peso lost a low of value (the dollar increased four times to the peso) resulting in inflation of 80% (considered low under the circumstances).
They were able to recover, just to later fall back into trouble as result of irresponsible practices by the Government of Cristina Kirchner. The governments of the Kirchners were populist and tried to obtain support from the Argentinians by lowering the unemployment rate by increasing government jobs which have become unsustainable for the Government budget. In addition, they nationalized some of the local industries keeping much needed foreign investors away.
Can Costa Rica go in the same direction? Absolutely, but it will depend on the policies adopted by the government, which I am not very hopeful for. I think it will take a lot for Costa Rica to become a Venezuela where the government simply decided to print more money (idiots!). But it can certainly get into a similar crisis such as the one in Argentina.
In my opinion, if Costa Rica gets into such a debacle, the least of my concerns will be a loss of value of the currency itself but the policies implemented by the government to stabilize the economy as it can result in higher unemployment rates which will result in a spike in crime.
Costa Rica has some dualities, one of them being the currency. Countries like Panama and El Salvador have decided to use the US Dollar as their local currency, but Costa Rica on the other hand has haphazardly introduced the US Dollar into the local economy. While the official currency is the Colon, it is possible to obtain loans in Dollars, some people make salaries in Dollars, some prices for services and goods are set in US Dollars (for instance, the fees in our firm are in Dollars).
As the saying goes, you cannot ride two horses with one ass, and thus Costa Rica needs to decide if they want to dollarize the currency or just to keep it in colones. For people like me, among so many other businesses in Costa Rica, the devaluation of the currency does not affect me, instead, it is advantageous as we make money in US Dollars, however, that is not the case for most Costa Ricans.
While it is a benefit for me personally, it is not good for the overall economy. In my opinion, the government should implement a one currency only system in order to level the playing field for the local economy.
What Does This Mean For Expats?
Expats depending on foreign income should not be concerned by the devaluation of the Colon, as their foreign dollars will go farther in the local Costa Rican economy. However, expats depending on the local economy such as people with a local job, or with a local business such as restaurant or hotel can be affected by the devaluation, particularly if they have expenses in US Dollars such as loans. A suggestion for local expats is to try to stay away from any debts in US Dollars, especially if they earn income in colones.
The devaluation of the currency will make it more attractive for foreigners to either invest in Costa Rica or to relocate to Costa Rica.
When it comes to Real Estate, people who are looking to purchase real estate should look to properties priced in colones and not in Dollars. Most real estate agents in Costa Rica price their properties in Dollars, and therefore the price of the property does not change. However, if you look for properties priced in colones, you will be able to get more bang for your buck.
If you are selling real estate, then it becomes difficult to ascertain what to do. Naturally, you would like to keep your prices in dollars in order to avoid losing equity, but the problem is that your prices will be too high compared to the properties sold in colones. Thus, you should either hold your property until the market corrects itself and prices are more stable, or you may need to sell at a loss depending on your urgency to sell and the time when you acquired.
Try To Keep Your Money Abroad
Expats with foreign income and accounts should keep most of their assets abroad. The situation is delicate, but not critical. We need to wait and see if the fiscal plan passes in Congress, and if so, it will allow some more room for breathing and maintain the status quo, but if Congress does not pass the bill, the situation can get worse.
Failing to pass the bill in Congress is a cue to reduce your risk in Costa Rica by keeping most of your assets abroad, particularly cash. Not passing the fiscal plan puts the country at risk of defaulting and banks may freeze accounts for a period of time.
Often, I hear clients and expats in general expressing an interest to invest in local Certificates of Deposit as the interest rates in colones are very attractive, ranging from 8% to 12%. However, they overlook the devaluation rate which will offset any gains obtained by the local interest rates. My advice is to stay away from investing in cColones. If you are a seasoned Forex trader, then knock your socks off as you will be able to make some money with the fluctuation, otherwise stick to what you know and keep your money in USD.
The Fiscal Plan
I do not support the current fiscal plan in Congress as it attempts to increase taxes. The issue in Costa Rica is not little taxes, rather it is compliance. The government should invest more resources in collecting taxes instead of creating new taxes. Quite the opposite, I advise to reduce the tax burden, particularly on imports, and enhance the tax collection capabilities on individuals.
Unfortunately, if Costa Ricans do not have the culture to drive safely on the roads and the capacity to enforce transit laws, I doubt it that they will have the culture to pay taxes and absolutely do not have the capability to enforce tax laws. The Costa Rican government likes to charge easy taxes such as the one on imports, fuel, and corporations but does not make the slightest attempt to muscle the collection system for income taxes.
The Last Word
If you are an expat, you are ok. There is no reason to panic. Devaluation of the currency is normal.
Article originally appeared at Outlierlegal.com. Read the original here.