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Costa Rica | Fiscal tests

| April 9, 2021

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.

An upcoming vote in Costa Rica on a public employment reform bill marks the first stress test to what has been a low volatility and high carry trade this year. Normalized Eurobond yields already discount low execution risks, trading inside similar ‘B’ credits that also have an International Monetary Fund program in place and tight to ‘BB’ credits. The vote will be a critical barometer of support for Costa Rica’s IMF program. The bill is making progress with fast-track status and early signs of coalition support for rigorous reform across all public entities.

Current tight levels on Costa Rica’s debt suggest optimism on a successful first-round vote that represents the first steps on a gradual path towards fiscal consolidation. It reinforces the carry trade. The ‘B’-to-‘BB’ convergence trade will require years to reach the fiscal consolidation necessary. Convergence should depend on compliance with the IMF program fiscal rule and management of continuing high debt ratios.

The public employment bill should face its first floor vote this month, representing both a litmus test to IMF relations and broad-based political commitment to fiscal discipline.  The IMF only requires enactment of the bill as a performance criterion without incorporating any specific qualifications or estimates for future savings. This seems unusual since the public employment bill tackles high public wages that impede budget flexibility. It has been on the agenda for the past two years as the next important phase of fiscal adjustment. The bill also contrasts against official government proposals that included potential savings. This may suggest potential for additional savings and flexibility on the fiscal targets and explains why the markets have discounted low execution risks for the IMF program.

The approval of this controversial reform will require a broad coalition sufficient to counter legal threats from the constitutional court. Approval should also require a rigorous version that includes endorsement from PSUC. The reform is under debate in Costa Rica’s Assembly. It involves many motions needing review and is on “fast track” status for a first vote before month end.  There was important progress this week with a two-thirds majority on a motion to include the universities and municipalities.  This suggests broader collation support for a serious reform ahead of a floor vote within the next few weeks. The IMF deadline for enactment is the end of May, though there is potential flexibility for final approval before the first review at the end of July. The approval would represent an important first phase on execution risks and reinforce what has been an attractive carry trade this year.

The public employment bill remains an important test on commitment to fiscal discipline; however, it is still a lengthy and uncertain process to migrate towards the ‘BB’ status that depends on compliance with the fiscal rule.  The fiscal rule triggers specific cutbacks in spending depending on the debt ratio. It is the fiscal rule that represents the backbone of the IMF program.  Although adopted in 2018, there has not yet been any obvious benefits on fiscal performance.  The setback to 2019 was the loophole for higher capex spending while the setback to 2020 was the escape clause to allow for pandemic-related spending.  The authorities assert that this year’s budget of a primary deficit of 1.7% of GDP is broadly in line with the fiscal rule while the serious challenge will be reaching relative primary balance in 2022.

The true test is for next year’s budget. The high 70%-of-GDP debt ratio tightens spending restrictions on both current and capex to 65% of average GDP growth over the previous four years. It also mandates a freeze on the base wages and caps on extra remunerations.

The enforcement mechanism may be somewhat more effective than most fiscal rules for the proposed yet undefined and untested sanctions as well as the rules-based culture of a mature democratic country.  Costa Rica lost credibility with its 2019 fiscal performance when the primary fiscal deficit increased to 2.6% of GDP from 2.2% of GDP in 2018; however, 2020 fiscal performance shows conservative spending through an intense adverse shock with a net 5.7% decline in primary spending.  Or maybe the conservative spending was more forced than voluntary because of the high structural fiscal deficit, the restricted access to credit and the 10.9% decline in total revenues.

The importance of the IMF program is not only the fiscal targets but rather the market confidence that allows for continued access to local markets, lower funding rates and the access to cheap IMF loans. Debt service remains the largest problem and should continue to accumulate through only a gradual adjustment process. This constrains much if any improvement on the overall central government debt ratios that remain above 70% of GDP though the 2026 IMF projections.

The bottom line is that near term carry returns still depend on the first important obstacle of the public employment bill with important progress this week while capital gains still depend on a longer process to comply with the fiscal rule.  Costa Rica trades tight to ‘B’ peers, perhaps already discounting a successful IMF program with low execution risks on the public employment bill.  There is also narrow margin to ‘BB’ credits like the Dominican Republic, which suggests an already favorable outlook for medium-term reform.

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