The Big Idea

Costa Rica | Possible upgrade ahead of issuance

Siobhan Morden | February 3, 2023

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. This material does not constitute research.

Costa Rica’s latest full year fiscal performance should set off a much-awaited review from the credit rating agencies and possible upgrade ahead of its imminent Eurobond launch. It’s curious that rating agencies have waited so long to upgrade the country. The fiscal accounts have shifted from a 2018 primary deficit of 2.6% of GDP to a 2022 surplus of 2.1%. And there is already a 4-year track record of strong fiscal performance.

There is no other country in the region that has adjusted its fiscal accounts by nearly 5% of GDP, especially through the Covid shock. If S&P can deliver a one notch upgrade without warning to the Dominican Republic, then there is no reason why Costa Rica also couldn’t benefit from similar treatment. The rating agencies are far behind the curve with already full convergence of Costa Rica spreads to other ‘BB’ credits. The often-heard pushback is that spreads are too tight. But this undermines broad commitment to fiscal discipline may even blunt medium-term efforts to win an investment grade rating.

The cumulative fiscal adjustment of 5% of GDP is strong and may represent a permanent structural shift that restores the fiscal anchor. This fiscal adjustment has occurred through various stress tests of the fiscal rule and the ultimate stress test of the Covid shock itself. There have been attempts but no success on weakening the rigidity of the fiscal rule and no obvious social or political pressures to unwind the fiscal anchor. The IMF and rating agencies alike would probably accept some flexibility on what appears an overly austere fiscal rule. But there has been no cooperation from the legislature or any societal pushback to relax the spending constraints. The fractured legislature and policy paralysis perversely would reinforce fiscal consolidation.

Costa Rica should be able to maintain a 2% of GDP primary fiscal surplus for a few reasons:

Costa Rica is a highly democratic and rules-based country
There is broad support among political establishment and social sectors to reduce structural spending, comply with the IMF program and restore the fiscal anchor necessary for debt sustainability
Public employment reform hasn’t even yet kicked in to provide additional budget flexibility and future savings based on lower public wages (that would offset any potential weakening of the fiscal rule)

The bottom line is that the institutional strengths should reinforce the trend 2% of GDP primary surplus, slowly reduce the debt burden and gradually stabilize debt dynamics into the BB rating category.

The current ‘B’ rating is overdue for upgrade. The bonds spreads trade similar to ‘BB’ peers but, unlike the other credits, Costa Rica could already be on a path for investment grade. There are no other obstacles to regain the investment grade rating other than slowly working down debt ratios. The crux of the problem was temporary stimulus that become permanent after the global financial crisis in 2008/09. This represented over a decade of large fiscal deficits and debt accumulation. The country is now on a firm path to reduce the debt burden. Meanwhile, Costa Rica already benefits from well diversified and solid trend growth, low inflation, high foreign direct investment and a flexible foreign exchange rate. Costa Rica also boasts strong ESG credentials before that was even a concept. The strong institutions and social indicators are favorable metrics that have few if any comparisons in the region outside of Uruguay.

There has also been an important reduction in liquidity and rollover risks. Not only for the lower gross financing needs but also for the broader access to financing options. Costa Rica is unique for its deep local markets, authorization for multi-year (and conditional) Eurobond issuance and unprecedented access to the IMF and multilateral funding. This broad-based funding accessibility looks more in line with BB or investment grade credits than B credits.

If there is debate about a path towards investment grade, then Costa Rica should already be moving closer towards a ‘BB’ credit rating. If the Dominican Republic can benefit from a sudden one-notch upgrade, then so too should Costa Rica. There has already been a 4-year track record on fiscal performance through various stress tests as well as a noticeable reduction in liquidity risks. This is an opportunity for rating agencies to make a bold move. The optionality for positive headlines also errs for even stronger demand for the upcoming Eurobond issuance. If the Dominican Republic 8-year issuance serves as a reference at 10 times oversubscribed, then the pricing should be equally tight for Costa Rica with particularly high demand for an infrequent issuer.

Siobhan Morden
Santander Investment Securities
1 (212) 692-2539
siobhan.morden@santander.us

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Siobhan Morden
siobhan.morden@santander.us
1 (212) 692-2539

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