Publish in Perspectives - Wednesday, November 18, 2015
Costa Rica is the only DR-CAFTA country where fiscal conditions are currently deteriorating, the author points out. Here President Luis Guillermo Solís. (Photo: Costa Rica President's Office)
Fiscal deterioration persists in Costa Rica amid dubious reform prospects.
BY FRANCO UCCELLI
Growth is poised to strengthen following recent slowdown. After decelerating to only 2.5 percent oya in 1H15 from 3.8 percent a year earlier, real GDP growth is projected to strengthen in 2H15, as the agriculture and manufacturing sectors recover from their weather-related and Intel closure-related first-half contractions. While the central bank’s revised macroeconomic program for 2015-16 calls for real GDP to expand 2.8 percent y/y this year and 4.0 percent next, both below estimated growth potential of 4.3 percent, authorities believe the final numbers may actually be a tad lower, as the relatively soft evolution of the monthly index of economic activity would suggest. Private sector analysts agree, forecasting growth of only 2.2-2.4 percent for 2015. They believe a confidence boost is needed to grow at a faster pace, something that is seemingly not in the cards, with recent polls suggesting not only that most people are not pleased with the current economic situation, but also that they do not think it is likely to improve much in the near term.
Fiscal space continues to shrink rapidly. In the absence of a fiscal reform, the deficit has continued to climb steadily and is now expected to print at 6.0 percent of GDP in 2015, before inching up to 6.9 percent in 2016 and 7.9 percent in 2017. The anticipated increase in the shortfall would boost financing needs to 12 percent of GDP next year and 13 percent in 2017. Given the magnitude of the deficit, authorities believe a fiscal adjustment of at least 4 percent of GDP would be needed to stabilize the fast growing public debt burden, which is likely to break the 60 percent of GDP mark this year, up from less than 40 percent in 2008. Interestingly, while most local experts agree that President Solis has finally recognized that there is indeed a fiscal problem in Costa Rica, they argue that his interpretation of the challenge is misguided, as he sees the large deficit as a limiting factor to spend more, rather than as a fiscal sustainability issue. Costa Rica is the only DR-CAFTA country where fiscal conditions are currently deteriorating.
Approval of fiscal reform remains uncertain. The government sent to congress a fiscal reform bill in mid-August, but the proposal is currently not under consideration as approval of the 2016 budget, which has to be done by November 30, has taken precedence. The key features of the reform proposal, which includes modifications to the VAT and income tax, are designed to raise revenues by 2 percent of GDP, 1 percent in the first year, nearly 1 percent in the second year, and the remainder in the third year of its implementation. While most people recognize the need for reform and view the government proposals as sensible, the Solis administration is having a very difficult time convincing opposition politicians that the new tax revenues would not be spent liberally, rather than used to narrow the ballooning deficit. Moreover, locals are not certain whether the government believes it must actually cut spending to contain the shortfall, or even if it has the ability to do so, which is something that is generating resistance to sign off on the tax reforms. The situation is being aggravated by the lack of clear signs that the ongoing political impasse may be nearing resolution, with the government, which only has a minor representation in congress, becoming increasingly isolated. The bottom line is that without a formal guarantee from the part of the government that new taxes will not be used to increase spending, but rather to lower the deficit, and that expenditures will be curbed, most local observers believe that the probability of fiscal reform being approved in the near term remains quite low. This contradicts the government’s belief that the reform is likely to be approved by September of next year, before 2017 budget deliberations get underway. The problem here is that if no reform is approved in 2016, doing it in 2017 will be even more difficult, as it will be the year before the next elections are held in February 2018.
China loan is still on the table. The possibility of Costa Rica getting a $1 billion loan from China has made headlines and captured significant market attention. The China “loan” would be in the form of purchases of USD-denominated domestic debt, which would not require congressional approval, unlike the issuance of external debt, which would. According to current rules, no more than 20 percent of domestic debt issued in a single year can de denominated in USD. This means that in order for the government to sell $1 billion worth of domestic USD securities to China next year, it would have to borrow at least $5 billion domestically. Since the gross financing needs for 2016 amount to 12 percent of GDP, equivalent to $6.6 billion, the $1 billion domestic China “loan” under discussion would leave relatively little room for the government to borrow abroad next year. The transaction is reportedly being evaluated by the Chinese government and as yet there is no indication that it will indeed be executed.
Effects of Fed normalization will likely be muted. While the expected imminent increase in international interest rates has generated uncertainty among most EM countries, Costa Rican authorities seem fairly confident that a Fed rate hike will not hurt the country much at all. In fact, they expect the opposite to be the case. They believe that rate hikes will only happen when the ongoing recovery in the US is deemed to have gathered enough momentum to be sustainable over time, something that, at least in theory, boost demand for Costa Rican exports, and hence growth, in the country. Put differently, the adverse effect of higher international interest rates for Costa Rica, a net borrower of funds, would be more than offset by the positive impact on Costa Rican exports of stronger US demand.
Broad FX stability is set to prevail in the near term. Recent figures show that foreign reserves are now greater than the monetary base, so at the moment there are more dollars than colones (CRC) in the country. While this has resulted in appreciation pressures, the central bank has been in a comfortable position to intervene in the FX market (purchasing dollars) in order to keep the exchange rate fairly stable. While some local pundits are in favor of some CRC weakening to keep up with the recent depreciation of other regional currencies, the central bank is purportedly in favor of maintaining stability, at least for the time being. The February policy decision to move to a more flexible FX regime— to a managed float from a band system—was intended to strengthen monetary policy generally, rather than to influence FX trading levels.
Impact of ample domestic liquidity conditions has been mixed. By most measures, the local financial system is currently quite liquid in both CRC and USD. While this has enabled the authorities to push local interest rates down to support stronger growth, some argue that lower rates have created a disincentive for the government to tackle the rapidly rising fiscal deficit more aggressively, a perverse effect. Moreover, since a highly liquid local market has prevented financing the elevated fiscal shortfall from crowding out the domestic market, the argument follows, the government has been in a comfortable position to keep borrowing costs relatively low and easily fund unsustainable increases in public spending, and by extension the fiscal deficit.
Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on a recent trip report. Republished with permission.