March 10, 2008

On February 15, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Costa Rica.¹

Background

Since the last Article IV Consultation, Costa Rica's economy has continued to grow rapidly. Real GDP grew by 8.8 percent in 2006, and economic activity remained strong in 2007 driven by both domestic and external demand. Early estimates suggest that, for the year as a whole, growth was close to 7 percent. Unemployment declined to 4.6 percent, the lowest level since 1994.

Inflation steadily declined between late 2006 and mid-2007, thanks in part to the October 2006 switch to a crawling band regime and the subsequent widening of the exchange rate band. However, inflation rebounded in the second half of 2007, partly because of sharp rises in international oil and food prices, and ended at 10.8 percent in December 2007.

The current account deficit widened to 6.0 percent in 2007, driven by a surge in nonresident income on foreign direct investment. Both exports and imports grew strongly during the year. The current account was more than fully financed by foreign direct investment inflows. Net international reserves reached a historical high of over US$4 billion in December 2007.

Public finances continued to improve in 2007. According to the latest preliminary figures, the central government closed with a surplus of 0.4 percent of GDP, the best performance since 1957, while the overall public sector posted a surplus of 0.6 percent of GDP. In parallel, public debt fell to about 43 percent of GDP at end-2007. These results stemmed mainly from strong revenue growth due to administrative measures and the economic expansion.

Monetary aggregates have kept expanding rapidly. Private sector credit has been growing at over 30 percent (y/y) in 2007, fueled by a construction sector boom and strong consumption demand. Driven in part by sustained capital inflows, lending rates declined sharply, and deposit rates became negative in real terms.

The financial system has become stronger and more diversified, though important vulnerabilities remain. Judging by traditional prudential indicators, banks appear well capitalized, profitable, and highly liquid. Recent acquisitions of domestic private banks by large foreign banks have intensified the process of consolidation in the sector. Vulnerabilities include high dollarization of assets and liabilities, and still large offshore banking activities.

Executive Board Assessment

Directors commended the authorities for the strong performance of the Costa Rican economy in 2007, reflecting the continued implementation of sound economic policies. Directors welcomed the ratification of the Central America-Dominican Republic-United States Free Trade Agreement (CAFTA-DR) and the reduction in the poverty rate to a historical low. The near-term prospects for the Costa Rican economy remain favorable, based on robust domestic demand. At the same time, Directors stressed the need to be vigilant to downside risks, mainly related to the intensity of the slowdown in the U.S. economy.

Directors considered that the main policy challenges will be to lower inflation and take forward the authorities' well-focused structural reform agenda. Reform priorities include fully implementing CAFTA-DR, completing the transition to inflation targeting, passing legislation for a substantial tax reform, and strengthening financial regulation and supervision.

Directors praised the authorities for their impressive fiscal performance, which resulted from effective tax administration efforts and tight control of nonpriority spending. This policy has also contributed to a substantial reduction in public debt. Looking ahead, Directors considered that a prudent fiscal policy will be key to containing demand pressures. They encouraged the authorities to maintain the fiscal stance achieved in 2007—or even improve on it—to support the disinflation objective. Directors supported the authorities' plans for a substantial tax reform, which would permit higher spending in priority areas—including social and infrastructure spending—while preserving a sound overall fiscal stance. They welcomed the authorities' interest in developing a full-fledged medium-term budget framework.

Directors welcomed the steps already taken by the central bank toward greater exchange rate flexibility in the context of a gradual transition to a full-fledged inflation targeting framework. They acknowledged the constraints on monetary policy imposed by continued large capital inflows under the current crawling band exchange rate regime, the appreciation pressures on the colón, and falling U.S. dollar interest rates. However, most Directors stressed that the recent substantial cut in interest rates—which has made interest rates even more negative in real terms—could give further impetus to the already robust level of aggregate demand, and compromise efforts to reduce inflation and subdue inflationary expectations. These Directors encouraged the authorities to put in place institutional conditions for greater exchange rate flexibility, including the adoption of regulations for hedging instruments, which would permit a needed monetary policy tightening. A few other Directors cautioned that raising interest rates could trigger further capital inflows and increase the pressure on the exchange rate.

Directors welcomed the initial step taken in 2007 to recapitalize the central bank, and called for a permanent recapitalization through a one-step stock operation that would also underpin the disinflation strategy.

Directors observed that the current account position is projected to be sustainable over the medium term, and that the real effective exchange rate appears to be in line with fundamentals and within the margins of the staff's estimated equilibrium range. The good performance of nontraditional exports and the diversification of export products and markets suggest that competitiveness is being maintained.

Directors welcomed the strengthening of the financial sector. Nevertheless, vulnerabilities remain, including risks associated with the relatively high level of dollarization and the lack of effective consolidated supervision of financial groups. Directors called on the authorities to move expeditiously to implement the remaining recommendations of the FSAP update. They encouraged the authorities to press ahead with the approval of the consolidated supervision bill and with the introduction of regulations to ensure that banks fully internalize foreign exchange risks. They supported reforms to change the funding arrangements for financial supervision and improve the bank resolution framework.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.