Costa Rica | A likely lift from an IMF program review

Siobhan Morden | October 13, 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.

Costa Rica is set to undergo its fifth program review with the International Monetary Fund (IMF) in the next week, and the review carries high expectations as the country emerges as the poster child of successful IMF support. The review follows a significant fiscal transformation that unfolded between 2019 and 2022. The IMF noted in its last review in March that Costa Rica exceeded targets on its primary balance, government debt and net international reserves by substantial margins. The review should strengthen investors’ positive perception of the country’s credit risk with opportune timing ahead of the next Eurobond issuance.

Costa Rica’s fiscal performance stands out regionally due to the balanced tradeoff between growth and inflation, with foreign exchange reserves consistently accumulating above target levels. This upcoming program review is poised to provide transparency on various policy initiatives, including revisions to the fiscal rule, the adoption of the public employment reform, and a slew of ESG-related reforms. As Costa Rica continues to thrive under the IMF program, this reaffirmation of its success could have significant implications for investors, particularly as it aligns with the timing of the next Eurobond issuance.

The IMF review, in Costa Rica’s case, do not create a specific event risk but instead offers a valuable opportunity to assess progress on structural reforms and medium-term policy initiatives. The Costa Rica IMF program is unique in its fiscal adjustment, which continues to surpass the quantitative performance criteria. Recent fiscal data until August showcases a primary surplus of CRC650 billion, equivalent to 1.4% of GDP, against a full-year target of CRC609 billion, or 1.3% of GDP. Authorities are well on track to meet this year’s target, making it an easily achievable threshold given the remaining months in the year.

Perhaps more interesting, observers are focusing on how this fiscal performance deviates from the 2.1% of GDP primary surplus achieved in 2022 and whether Costa Rica’s fiscal accounts will remain in line with IMF projections of a consistent 2% of GDP primary surplus through 2028. This long-term outlook is crucial for anchoring debt ratios closer to 50% of GDP, which could pave the way for further credit rating upgrades, potentially reaching investment-grade status.

The IMF’s insights into the revisions of the fiscal rule and the execution of the public employment reform are key in understanding the integrity of these medium-term fiscal targets. The proposed “watering down” of the fiscal rule has raised concerns, but it’s worth noting that these revisions have been carried out in collaboration with the IMF, which provided specific technical recommendations. The intent behind these revisions is to exclude public entities that are not part of the central government’s balance sheet, providing them with financial autonomy and budget management flexibility. While the scope of the rule’s coverage is narrowed, it would maintain its applicability to various types of spending and spending growth formulas. The next program review will be an opportunity to gauge the proposed revisions in the current legislative draft and assess any potential slippage on fiscal targets.

Another significant aspect to consider is the adoption of the public employment reform. This medium-term reform holds the potential for substantial budget flexibility and the possibility of savings amounting to 0.4% to 0.6% of GDP during the first five years, according to the IMF’s estimates during the third review. These savings could serve as a buffer against any risks related to the fiscal rule or challenges in reaching legislative consensus on a broader equity and efficiency tax system, which could potentially yield 0.17% of GDP in positive revenues by 2025. The program target was adjusted to incorporate 90% of the public payrolls to a single wage spine through September after some initial delays.  This gradual multi-year adjustment would provide some budget flexibility and potential savings that could strengthen the medium-term fiscal targets.

Costa Rica’s Eurobonds have already converted with illiquid ‘BB’ peers like Paraguay and Guatemala, reflecting expectations that positive rating actions are on the horizon, likely approaching Fitch’s ‘BB-‘ rating rather than Moody’s ‘B2’. The limited supply of outstanding bonds positions them to benefit from their scarcity value, especially as credit ratings shift from the ‘B’ to ‘BB’ rating category. Costa Rica remains one of the top Latin American performers, with 10% total returns YTD (as of 10/9) within the EMUSTRUU index, despite this convergence with ‘BB’ illiquid comparables. This performance, coupled with the expected positive endorsement from the imminent IMF mission, promises to strengthen Costa Rica’s credit outlook, provided that medium-term fiscal expectations remain solid.