Costa Rica | Tough job

admin | November 1, 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.

Costa Rica has officially tapped Rodrigo Chaves for Finance Minister after a distinguished 27-year career at the World Bank, and he seems willing to face the challenges of fiscal consolidation over the next two years. It hasn’t been an overly friendly reception for an apolitical outsider, however, with possibly more expertise in other emerging market countries like Indonesia and Turkey than in the nuances of Costa Rican finances and domestic politics. But it’s an important start with a $1.5 billion Eurobond issue ahead needed to head off funding pressures.

There are pros and cons to Chaves’ appointment, but the first priority is a roadshow for the delayed Eurobond issuance needed to avoid a year-end funding crisis. The relief rally on Chaves’ confirmation may be short-lived with many challenges ahead including the operational uncertainty of pushing through fiscal adjustment, consistent rollover risk and political pressures. Costa Rica looks likely to target issuance in the 10-year sector of the curve to minimize the cost of a high debt burden and take advantage of a steep Eurobond curve. There should still be sufficient demand for an infrequent high yield issuer; however the turnover of the Finance Ministry will probably require new issuance premium for the uncertainty around policy management and Costa Rica’s vulnerability to domestic and external shocks.

The newly appointed Finance Minister Chavez clearly brings academic credentials and gravitas to the new position after the disappointment of the resignation of Minister Aguilar.  It was a difficult search to replace the well-respected former Finance Minister, especially since scrutiny of Aguilar from the Prosecutor General suggests difficult internal politics and pushback against the consolidation efforts.  Minister Chaves is also seen mostly as an outsider after his career at the World Bank and will likely face operational constraints and perhaps a cool reception from the local business community and political establishment.  The most heard criticism from locals is that “it’s not the same to be Minister of Finance than a high level official at the World Bank.” President Alvarado has asked Costa Ricans to give the new Finance Minister the benefit of the doubt.  It’ll take some time to establish a track record and confidence among the local business and political community while also facing the same pushback against fiscal consolidation.

President Alvarado confirms that the first priority will be the financing program with a roadshow ahead of the $1.5 billion in Eurobond issuance. However, the timeframe looks uncertain since the official transition doesn’t start until the end of November. The investor relations should markedly improve under the new leadership given his expertise communicating with external investors.  The marketing pitch should focus on the commitment to fiscal discipline and pushback against opposition to the fiscal rule rigidities. The 5.3% of GDP 2H19 financing program includes the $1.5 billion Eurobond issuance at 4.1% of GDP and 1.2% of GDP in domestic financing needs. The financing risks remain the primary concern with any domestic or external shocks either restricting market access or raising financing costs.

The 2H19 financing program was on target after reaching 44% completion through early September.  The conditions are not ideal for issuance after the departure of Minister Aguilar; however it’s not clear if there are better alternatives on the increasing risk of saturation in local markets and higher onshore/offshore USD yields.  It’s important to extend the debt maturity profile and lower debt service costs after debt service increased from 2.6% of GDP in January-September 2018 to 3.2% of GDP in January-September 2019.  This faster pace of debt service costs undermined the progress on the primary deficit reduction and still pushed up the fiscal deficit to 4.7% of GDP compared to 4.5% of GDP for the same period last year.

The recent reaffirmation of a negative outlook from Fitch on the ‘B+’ rating reaffirms the challenges of high fiscal deficits, steep amortization schedule and economic slowdown.  It’s going to be difficult to shrug off these repetitive shocks that remind bondholders of the complacency towards the fiscal crisis and the political constraints of a minority government that cannot even control internal threats after the recent recommended sanctions from the Comptroller General.

Financing flexibility remains the primary threat with each setback requiring a higher liquidity-and-rollover risk premium and arguing for a chronic spread premium to ‘B’ peers like El Salvador. The gradual fiscal adjustment suggests a higher debt stock and reaffirmation of high beta status. Despite the gross financing needs of 12% of GDP from 2019-2022, the notional amount remains manageable for the small size of the country, and Costa Rica should be able to muddle through. However, credits spreads will not outperform until there is success on the fiscal rule consolidation process through the repetitive political and social pushback.  It might also be a moving target on debt sustainability if debt accumulation, at a projected 71% of GDP, requires a primary surplus as opposed to primary fiscal balance. The relief rally on the Finance Ministry appointment may reverse on the new issuance premium with the middle of the curve vulnerable to bearish flattening and still a cautious view on the high-risk carry returns.