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Costa Rica | Setback to confidence

| October 25, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The resignation of Costa Rica Finance Minister Aguilar is not just the loss of a well-respected technocrat. It also reaffirms weak consensus on fiscal discipline and high dependence on deficit financing for rolling over debt. It is an inopportune setback ahead of the pending roadshow for $1.5 billion Eurobond issuance originally slated for late October or early November. Deputy Finance Minister Rodolfo Cordero will serve as interim Minister, suggesting a longer search for the permanent replacement.  President Alvarado looks likely to designate a competent replacement. But the recent setback may draw new attention to these recurrent negative shocks, creating a stubborn spread premium and adding to the cost of Eurobond financing.

Finance Minister Aguilar unexpectedly resigned after the Comptroller General recommended a 1-month suspension for tapping the central bank for emergency funds last year.  It clearly was an unorthodox source of financing.  However, the suspension seems extreme considering the successful management of  the funding crisis last year and the many other successes on fiscal reform that defined conservative fiscal discipline during Aguilar’s tenure.  Minister Aguilar probably resigned out of protest for the disrespect on what has been a highly respected and stressful tenure at the Finance Ministry.

The censure from the regulators is worrisome on several fronts as it shows again weak consensus among the establishment on prioritizing economic and financial stability and broader complacency about the challenges on sourcing financing for a large fiscal deficit.  It could also reflect a latent pushback from other sectors to defend entitlements for a Finance Minister that reinforces fiscal discipline through the rigidity of the fiscal rule.  It’s also a reminder to investors that Costa Rica remains vulnerable to these unexpected shocks for its high rollover risk and perhaps may force a reassessment of exposure that requires a higher permanent credit spread premium.

There are no updates yet on the permanent replacement candidate with recommendations from the business community to expedite the process.  It would be more efficient if there were an internal promotion for an easier transition.  The more efficient solution is to shift Central Bank Governor Rodrigo Cubero to the Finance Ministry for his credentials and visibility, with a replacement sourced from the competent technocrats of the Central Bank. There is clearly a priority on fiscal versus monetary management.  However, it’s not clear that high profile candidates would be willing to accept the stressful position.  The sudden resignation suggests delays for a minority party that may need to seek an outsider from the business or academic community, someone that would view the challenge as a career opportunity. Or perhaps the Deputy Finance Minister adjusts to the new role for a smoother transition.

There is no doubt of a technocrat replacement with high credentials, but timing is important with cash flow stress requiring access to the Eurobond markets. Perhaps the economic team may still try to quickly access Eurobond markets under interim Minister Cordero. The replacement will probably not have the same gravitas and prestige as Finance Minister Aguilar and  could be politically weak on adopting the controversial fiscal consolidation agenda.  There is the negative shock of a well-respected Finance Minister with a track record of effective crisis management that provided reassurance to bondholders. Minister Aguilar was tested during critical moments, and she was effective at sourcing financing and pushing back against the entrenched entitlement among government institutions. This implies a higher cost of funding under a weaker mandate from the Finance Ministry.

The initial reaction was a knee-jerk 2- to 5-point gap lower on the 30-year bonds that partly adjusted to 1- to 2-points lower intra-day on limited trading volume. The spread premium retraced back to the worst relative to El Salvador of last December rollover stress. The 10-year sector was more vulnerable to underperformance for the relative steepness of the curve and the higher vulnerability to rollover stress on the bearish curve flattening.

The priorities for the turnover at the Finance Ministry should be to minimize the cost of financing for the high budgetary rigidity, where debt service comprises 38% of the budget and the fiscal rule reinforces strict spending constraints on current spending.  The appointment of a new respected and high profile Finance Minister should help reverse the negative shock; perhaps Governor Cubero may be the best replacement candidate.  It’s probably more likely that it’s an alternative candidate—either upgrading an insider from the Finance Ministry team or bringing in an outsider. That could leave a subsequent residual spread premium until there is a proven track record of effective liquidity management.

Uncertainty should linger until there is an adequate replacement and a subsequent roadshow that completes the $1.5 billion Eurobond issuance and avoids relapse of the funding crisis of last December. It’s also not clear if there is more political fallout from the Comptroller across the rest of the economic team with subsequent higher execution risk for funding management.  This merits a more cautious view and stubborn spread premium relative to single B peers like El Salvador.

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