Costa Rica steps up the credit ladder

Siobhan Morden | November 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.

Costa Rica has recently taken another step up the credit rating ladder with an upgrade to ‘BB-‘ by S&P, the country’s second notch up this year. It is the only credit across the region this year with two notch upgrades. And the upgrades broaden the debate about a potential investment grade rating. This is unique for a region where several countries have lost their investment grade status, including recent threats to Panama. These upgrades quiet criticisms about “tight” valuations and shift the focus to relative value. Credit spreads should continue to compress with Costa Rica on a trajectory towards investment grade and a gradual shift to a new peer group.

Not to oversimplify, but fiscal laxity is typically the main rating constraint for speculative grade credits in Latin America. This is absolutely the case for Costa Rica with temporary fiscal stimulus turning permanent after the global financial crisis in 2008 and a buildup in the debt stock after more than a decade of running fiscal deficits at around 4% of GDP.  The shock to this fiscal complacency was the 2018 funding crisis and the approval of a new fiscal rule and public employment reform.

The strength of the institutions is what defines Costa Rica and legitimizes its fiscal rule compared to other countries in the region. This should lower the execution risk of adjusting the fiscal accounts and perhaps encourage a proactive rating assessment from the rating agencies. This validates the proactive rating action from S&P and Fitch and leaves the B2 rating from Moody’s misaligned in comparison. There is no other country in the region that has shifted the primary fiscal account for a cumulative 5% of GDP adjustment from 2019 to 2022 and more surprisingly exerting fiscal discipline through the pandemic shock.

The S&P report also references a new potential development with references to near-shoring foreign direct investment-led growth.  This would explain the outbreak for higher GDP growth this year with Costa Rica the growth leader in the region this year at a gain of 6% in year-over-year GDP growth from May through July and upgrades on growth forecast this year at 5% year-over-year There has been much debate but little evidence of near-shoring investment across the region, so these recent trends are encouraging on the optionality of a positive shock for higher growth.  “In addition, growth is led by export-oriented goods and service sectors,” S&P writes, “including export zones with the potential to attract more nearshoring and friendshoring, and tourism.”

The fifth review summary statement from the IMF on the last staff mission could also provide a preview on monitoring the execution risks. There was some mention to the slowing tax revenue and recent tax exemptions (vehicle tax); however, this paragraph is the most relevant. “The cumulative primary surplus to September was 1.7 percent of GDP and the authorities are on track to exceed their end-2023 target,” according to the IMF report. “The ratio of gross debt-to-GDP has continued to decline despite the government’s efforts to build up liquidity buffers. The authorities’ plan to achieve a primary surplus of at least 1.85 percent of GDP in 2024 will help underpin fiscal sustainability. Staff’s baseline medium-term primary surplus forecast of 2 percent of GDP would reduce debt to about 50 percent of GDP by 2035.” The IMF assumes a more conservative say 10-year trajectory on investment grade debt levels; however, the markets should continue to anticipate positive rating action if the fiscal performance remains on track. Meanwhile, Costa Ricans assumes a more aggressive track for debt sustainability on reaching 50% of GDP debt ratios in 2028 under higher primary surplus targets of 2.7% of GDP in 2028.

There is no fast track to reduce the 60% of GDP debt burden; however the high 2% of GDP primary fiscal surplus provides a favorable leading indicator. Policy paralysis is ok, and, in fact encouraged if it means the rigidity of maintaining the high primary fiscal surplus under the IMF base case scenario. There has been some minor proposal revisions to the fiscal rule but these are not intended to weaken the spending rigidity while the employment reform should reinforce additional spending restraint. The institutions are stronger than the individuals with a unique consensus across social sectors and the political establishment to restore fiscal discipline. Costa Rica may stabilize within the ‘BB’ rating category for the next few years.  S&P qualifies that higher ratings over the next 12 months would require a lower fiscal deficit. That’s probably not a realistic near-term outcome under already the aggressive cumulative adjustment of 5% of GDP and 2% of GDP primary fiscal target necessary for medium-term debt sustainability.  The next shift towards an investment grade rating will require a gradual reduction in the debt stock and subsequent improvement on debt service/revenues ratio on the consistency of the roughly 2% of GDP trend primary fiscal surplus.