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Costa Rica | The IMF reveal

| September 11, 2020

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.

The legislative approval of a new loan from the International Monetary Fund has finally kick-started formal talks with Costa Rica’s finance minister, promising an announcement of broad parameters on September 17. The next steps are more challenging. Costa Rica needs legislative approval of austerity measures before the end of the year and then execution of what will probably be difficult multiyear adjustments. The execution risk is important. The large $10 billion in gross funding needs next year will require issuance of new Eurobonds and heavy domestic debt.

Costa Rica faces probably the most ambitious IMF program in the region. It needs to go from a structural primary fiscal deficit of 2.8% of GDP in 2019 to a surplus of 2.4% of GDP in 2024, according to the RFI staff notes on debt sustainability.  The initial proposal for the budget at 2.4% of GDP primary deficit, or slightly larger including state entities, is less ambitious than the initial IMF recommendation of 1.4% of GDP as the deficit has deteriorated throughout this year. The markets may require an upfront commitment to regain confidence after the disappointment throughout 2019 on fiscal performance.  The balance of risk and reward may become increasingly unfavorable in light of relatively low 6.3% to 7.75% yields. There is need for an ambitious IMF program for debt sustainability and a large financing program. The public wage reform could represent an important litmus test and a priori requirement for an IMF program.

A first step is to reach consensus for an IMF program and then move on to execution.  There is some deal risk. Costa Rica has seen active public debate about the need for IMF funding, about the need for an anchor for the 10% of GDP fiscal deficit this year and about deterioration on debt ratios to near 80% of GDP. Costa Rica has now reached a critical turning point on liquidity and solvency risks after years of fiscal deterioration and larger funding needs.  The delayed legislative approval of the Rapid Financing Instrument loan may represent broader complacency with no apparent urgency to approve emergency Covid-19 funding. Finance Minister Villegas suggests legislative approval in December or perhaps even the first quarter of 2021 for the IMF program, depending on a priori actions for other fiscal measures including the public wage reform. The IMF program is critical for facilitating an even more difficult funding program next, and potentially more controversial because it depends on austerity measures, especially if it includes tax hikes. The stakes are now higher.

Costa Rica’s Central Bank President Cubero suggested on a recent investor call that the Alvarado administration would first submit projects on fiscal consolidation to the legislature to seek prior approval of these reforms before seeking approval of the IMF program. The renewed focus on the public wage bill represents an important litmus test. The IMF program may also include more controversial measures such as tax hikes, with Minister Villegas mentioning possible elimination of tax exemptions.  The prospect for front loaded measures such as higher taxes would produce a more efficient shock to confidence after the Alvarado administration failed to deliver on gradual fiscal adjustment.

There is some healthy skepticism about whether the Alvarado administration can deliver any meaningful adjustment after the backtracking in 2019 and many missed opportunities to reign in public spending.  The 2021 budget is austere. It includes broader expansion of the fiscal rule, more rigorous interpretation with a 0.77% year-over-year increase in current spending instead of the maximum of 4.13% year-over-year, and a 9.78% year-over-year decline in revenues. However, the problem is the increasing debt burden that restricts budgetary flexibility with 42.4% of total spending allocated for debt service and 54.9% of the budget financed with debt issuance.

Without having yet seen any details of the formal IMF Extended Fund Facility, the staff notes from the RFI suggests that the structural primary fiscal deficit of 2.8% of GDP in 2019 will have to revert to a primary surplus of 2.4% of GDP in 2024 while the 2021 budget still seems gradual at 2.5% primary deficit. The path for debt sustainability will require not only upfront commitment but persistent commitment for fiscal adjustment for consecutive years.

It will be important to deliver on quarterly IMF targets to retain access to voluntary capital markets.  The 15% of GDP funding program is skewed towards 11.2% of domestic debt issuance, 2.5% of GDP in Eurobond issuance and only 1% of GDP in IMF loans. The domestic debt issuance has been around 7% to 8% of GDP, while the central bank suggests still adequate absorption capacity of the local pension funds for debt issuance at 4% to 5% of GDP per year or USD2.5 billion.  That also depends on investment funds and insurance company investment. However, this does not suggest captive funding. It’ll be important to continue to deliver on quarterly IMF targets and show commitment to fiscal discipline.

The risk for bondholders is the potential mark-to-market volatility with execution risks of legislative approval of a priori measures such as the public wage reform and support for other controversial measures like tax hikes as well as a relatively austere budget and multiyear ambitious fiscal adjustments.  The latent complacency may require market distress to break it, with 2021 a critical year to reset the path towards debt sustainability and with large funding needs requiring follow-through on IMF program targets. The gradual adjustment process is no longer viable with higher debt ratios and a moving target for more fiscal consolidation necessary to stabilize the worse debt dynamics

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