Costa Rica | Locals as lenders of last resort
admin | November 6, 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.
Costa Rica continues to see early signs of domestic stress. Efforts to slow the pace of foreign exchange depreciation have taken a toll on foreign exchange reserves. CRC auctions have succeeded despite no appetite for voluntary debt liability management and a failed USD auction. It is unclear how long this fragile equilibrium will last and how long locals will ignore insolvency risks without progress on talks with the International Monetary Fund. This is the risk for Eurobond holders and whether officials embark on an orderly or disorderly domestic debt restructuring. The longer the delay on reaching consensus around a fiscal plan, then the higher the financing risks and the fallout on financial markets and the real economy.
The local headlines continue to discuss the prospects of a domestic debt restructuring while Costa Rica’s Finance Ministry sends out press releases confirming available funds for November domestic debt payments. The distressed debt exchange is not yet on the official menu of options, with the Finance Ministry instead seeking voluntary debt relief. There is typically no clear path towards an isolated distressed debt restructuring, especially if the local investors are not partnering in a solution. The current holders are mostly pension funds, but public banks and non-financial public entities also have significant holdings. It is uncertain whether these public entities will participate.
There are other negative consequences of a distressed exchange. A “selective default” rating could affect both local and external bondholders and perhaps a trigger forced selling from accounts that cannot hold SD-rated Eurobonds. There has been no mention of the “equitable treatment” of debt with most in the market assuming that Costa Rica would avoid a default on the low 10% of GDP stock of Eurobonds. However, there are potential complications such as the treatment of the local law USD bonds issued to foreign investors (contrato de colocacion). This was backdoor access to foreign investors to bypass the restrictive approval process on Eurobond issuance.
The progressive alternatives start to become mainstream alternatives if society continues to reject a cutback in entitlements or paying higher taxes. There has been no apparent progress on building consensus for fiscal adjustment. However, debt relief without a coherent fiscal adjustment is not a recipe for success, highlighted by recent struggles in Argentina. The debt relief in itself would not allow for a solution and may actually backfire if local investors are unwilling to fund large fiscal deficits after restructuring. The base year 2019 was a structural primary deficit of 2.8% of GDP that is programmed to worsen to 4.5% of GDP in 2020. A slow economic recovery suggests a slow convergence back to trend. The domestic debt restructuring would have to be part of a broader fiscal adjustment with “burden sharing” among domestic investors and broader society that includes higher tax revenues and lower entitlements under the credible framework of a formal IMF program.
The worse alternative scenario is that officials are only forced reactively as opposed proactively to restructure after a sudden stop. This may prove the base case scenario if there is not progress on what appear complicated discussions with “multi-sector dialogue of 805 proposals from 35 organizations.” If local investors do not see progress on debt sustainability after this dialogue concludes on November 21 or if the debate shifts more towards a domestic debt relief, then this may morph into a funding crisis. The domestic markets are critical, with delays (even outright rejection of IADB loan on 11/4) from the legislature on multilateral loans, less budget flexibility for high structural spending and large overall gross financing needs. The inaction could be costly if a domestic funding crisis triggers broader financial contagion that further undermines both the economic recovery and potential political and social support for fiscal austerity. The latest risk-on bounce would only be rational if positive contagion spills over to domestic investors; however high rollover risks continue until when or if the Alvarado administration reach consensus on a fiscal adjustment program.