October 31, 2023
An International Monetary Fund (IMF) staff team, led by Mr. Ding Ding, visited San Jos é during October 18–27. The staff team held discussions on the 2023 Article IV consultation with the Costa Rican authorities. The consultation focused on how to institutionalize the significant progress achieved in the past few years over the medium term. The Costa Rican authorities and IMF staff also reached a staff-level agreement on the policies needed to complete the fifth review of the Extended Fund Facility (EFF) and the second assessment of reform measures under the Resilience and Sustainability Facility (RSF) Arrangement.
Despite strong growth momentum, inflation has declined sharply. Real GDP growth is expected to reach around 5 percent this year, supported by buoyant exports and recovering domestic demand. Growth is expected to moderate to 3½ percent in 2024, which is broadly in line with the medium-term potential growth rate. Headline inflation has been negative over the past four months as global commodity prices fell and a stronger currency helped to reduce goods prices. Inflation is expected to rise back within the Central Bank of Costa Rica (BCCR)’s tolerance band by mid-2024. The value of the colón has stabilized near its long run historical average in real effective terms and international reserves buffers are strong.
The rapid decline in inflation should allow monetary policy to return to a neutral setting by mid-2024, assuming the economy evolves according to staff’s baseline forecast. The BCCR appropriately raised interest rates (to 9 percent) in 2022 to counter the global inflation shock and anchor inflation expectations. As inflation receded, the BCCR appropriately lowered the policy rate and should continue to normalize its policy stance to ensure that inflation converges decisively to the BCCR’s target . Risks to inflation are broadly balanced as those from weak domestic price pressures are offset by the potential for higher global energy or other import prices. Policy decisions should continue to be data-dependent, forward-looking, and supported by clear and transparent communications, with due attention to the two-sided risks to inflation. Going forward, the authorities should persist in their efforts to further strengthen the BCCR’s autonomy, governance, and operational framework.
A deeper and more liquid foreign exchange (FX) market and greater exchange rate flexibility would strengthen the transmission of monetary policy to activity and inflation. Costa Rica has a shallow FX market and faces some degree of currency mismatch arising from dollarization. In principle, this could justify deploying targeted FX intervention to mitigate excessive exchange rate fluctuations. However, in most circumstances, the exchange rate should be allowed to move freely in response to market conditions. The BCCR should explore the reduction of the impact of its operations in the FX market by aligning the timing of BCCR purchases of FX on behalf of the non-financial public sector (NFPS) with the sale of FX to these entities. A more flexible exchange rate and greater transparency in BCCR FX operations would both allow monetary policy to have its full effect on activity and inflation and incentivize the deepening of the FX market (including the use of FX hedging instruments). To complement this more restrained approach to FX intervention, further institutional and technical reforms would be useful to improve the functioning of the FX market and strengthen market participants’ ability to manage currency risks.
The banking system appears resilient to adverse shocks and planned reforms will improve financial oversight. Capital and liquidity metrics are comfortable, and provisioning is adequate, although high dollarization introduces vulnerabilities. Planned amendments to the bank resolution and deposit insurance law will clarify the government’s role in the resolution regime and strengthen crisis management. The approval of regulations to incorporate socioenvironmental and climate change risks into credit portfolio assessments and efforts to incorporate climate effects in stress tests are important steps forward. Legislation should also be passed to align the regulatory treatment of all banks to provide a level playing field. This should include phasing out the public guarantee for state-owned banks’ deposits as the deposit guarantee covering the entire banking sector becomes fully effective. The parafiscal contributions of state-owned banks should be converted into a single budget transfer and private banks should no longer be required to contribute part of their short-term deposits to the Sistema de Banca para el Desarollo (Development Bank System) for lending to underserved sectors. Regulatory limits on credit card fees should be continually set to further promote efficiency and competition while protecting consumers.
The 2018 tax reform and spending restraint have been successful in reducing the public debt burden. The cumulative primary surplus to September was 1.7 percent of GDP and the authorities are on track to exceed their end-2023 target. The ratio of gross debt-to-GDP has continued to decline despite the government’s efforts to build up liquidity buffers. The authorities’ plan to achieve a primary surplus of at least 1.85 percent of GDP in 2024 will help underpin fiscal sustainability. Staff’s baseline medium-term primary surplus forecast of 2 percent of GDP would reduce debt to about 50 percent of GDP by 2035.
Revenue gains achieved through the 2018 tax reform should be restored even as the efficiency and progressivity of the tax system is improved. After exceeding expectations for much of the past few years, revenue growth has started to slow, and tax revenues as a share of GDP continue to be below those of Costa Rica’s peers. Recently approved tax laws, for example, 10.381 and 10.390, will unfortunately erode revenues and reduce the progressivity, equity, and efficiency of the tax system. Broadening the corporate and personal income tax bases, introducing a dual personal income tax, and eliminating VAT exemptions would help arrest this trend. The implementation of the global minimum tax under the G20/OECD two-pillar solution provides an opportunity to target tax incentives for the special regimes to ensure that Costa Rica is not ceding tax revenues to other jurisdictions. The automatic exchange of information for tax purposes will support international efforts to reduce tax evasion and safeguard the integrity of the global tax system. Implementing a feebate scheme would help to further decarbonize the economy by incentivizing a reduction in vehicle greenhouse gas emissions. Finally, income tax exemptions of the salario escolar and aguinaldo should be reconsidered since they are inefficient, inequitable, and costly.
Ongoing spending restraint is expected to continue to drive fiscal consolidation and reduce interest burdens. Continued spending restraint in compliance with the fiscal rule ceilings is a critical part of efforts to reduce debt. Recent revisions to the fiscal rule appropriately preserve the broad coverage of spending categories and exclude entities that produce under market conditions or without government control. However, some exclusions have an unclear rationale and, by further reducing the institutional coverage of the rule, weaken the institutional framework for fiscal policy. Spending ceilings are expected to increase in the coming years, especially as debt falls, which will create some room for more public investment and social assistance spending. Ongoing reforms to make public investment more efficient and climate resilient and to improve the effectiveness of social spending are being implemented in anticipation of the scaling up of these spending programs. Passing a bill to unify the debt management office and granting the executive more flexibility to issue external debt would help lower fiscal financing costs.
The public employment bill modernizes the wage structure, improves performance incentives, and is expected to reduce wage expenditures over the medium term. This important law has been implemented for the executive branch already. All other institutions covered by the law should implement its provisions expeditiously.
Free trade zones are an important driver of growth but supply side reforms should foster more broad-based improvements in productivity. To further develop linkages to the domestic economy and leverage these zones as a broader growth engine, it will be important to improve the business environment outside of the zones. This could involve increasing digital connectivity, reducing electricity costs, and strengthening educational outcomes. Such reforms would further enhance Costa Rica’s standing as an attractive investment destination and reduce the need for tax incentives for foreign direct investment. Increasing the participation of women and migrants in the formal labor market would increase fairness, productivity, and long-term growth.
We welcome the staff-level agreement that has been reached on the policies needed to complete the fifth review under the EFF and the second review under the RSF. Subject to approval by the IMF Executive Board, the completion of the fifth review under the EFF will make available about SDR 206 (US$ 271 million), while the expected completion of programmed reform measures under the first and second RSF assessments will make available about SDR 369 million (US$ 485 million). The authorities have published guidelines to assess the impact of public projects on climate change, prepared legislation to introduce a feebate scheme for vehicles, and approved regulations to assess climate change-related risks to bank credit quality. The authorities are expanding their climate transition fiscal risk analysis and intensifying efforts to attract climate financing from both official lenders and from the private sector.
The IMF team is grateful to the Costa Rican authorities and other counterparts for the productive discussions and hospitality during the mission.