Costa Rica | Auction watch
admin | October 23, 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 suspension of formal talks between Costa Rica and the International Monetary Fund has not yet interrupted local markets. The latest auction of government debt looks status quo in terms of market maturities, size and rates. In the last episode of domestic funding stress, a central bank emergency loan eventually disrupted secondary markets. If current markets prove insensitive to delays in IMF talks, then this could provide breathing room. But there are still heavy maturities through year end, and next year will bring gross financing needs of 15% of GDP that will likely require not only access to IMF funds but also Eurobond issuance only possible with an IMF program. Costa Rica’s liquidity and solvency risks warrant yields closer to 10% and convergence with El Salvador.
Investor communication and data transparency has improved over the past few months with a schedule and posted results for debt auctions. The latest results on October 12 do not yet show any apparent weakness in domestic demand with tenors, size and rates similar to the previous auction on September 28. The size of the rollovers gear up over the next two months, and the question is whether the depth of the local markets will prove sufficient to fund large gross financing needs if IMF talks get delayed. The November and December maturities are the heaviest in terms of rollover this year; however, the July through September issuance has been aggressive with no signs yet of saturation. The next two months should represent an important test for domestic demand. There could be some financing flexibility on the delayed disbursement of $1.1 billion of multilateral funds that still require congressional approval and another $550 million in other potential loans carried over into next year.
There is also the option of central bank support with sufficient liquidity and ability to participate in the secondary markets; however, this may backfire as a sign of saturation or weak demand from voluntary capital markets. There is apparent breathing room near term, but an eventual IMF program is necessary. Costa Rica needs access to external credit. It risks potential saturation of local markets, and debt sustainability would benefit from the discipline of an IMF framework.
It is premature to assume external debt default. Costa Rica has a comfortable external liquidity position, with foreign exchange reserves at 15% of GDP and low external debt service—external debt sitting at 15% of GDP and 23% total debt. It has a low $5.5 billion stock of Eurobonds with administrative barriers (2/3 congressional approval) forcing most debt issues in domestic markets (CRC and USD).The heavy debt service now cannibalizes the budget, making up 5.6% of GDP of the total 8.1% of GDP fiscal deficit for 2021 and 42.4% of total spending. The tradeoff is either fiscal reform or debt relief with the local markets probably not willing to consistently fund what remains an unsustainable funding program until there is clarity on the fiscal adjustment necessary for IMF talks.
The debate still shifts between spending cutbacks and tax hikes; although it is worrisome that academics have introduced measures like debt restructuring and central bank deficit monetization into the debate. The debt relief only typically becomes the alternative if there is no commitment among society for austerity. Although the economic team continues to insist on orthodox policies, austerity measures are inconvenient against the background of stagnant and weak economic recovery. If domestic investors start to believe that forced or distressed debt restructuring is a viable option, then liquidity risks could force solvency risks. Or if the saturation of domestic funding at 11% of GDP next year, or as high as 15% of GDP without the IMF, pushes interest rates higher than this may also backfire on lower domestic demand. This does not suggest or require a restructuring of the New York law bonds; however the external debt may be sensitive to the process on reaching a consensus for domestic debt sustainability with potential funding risks and broader contagion to the real economy. The debate then shifts to what yields would compensate against these risks and a buying opportunity (or short covering) only once market stress forces a solution.