The Big Idea

Costa Rica | Fiscal rule flexibility

Siobhan Morden | January 5, 2024

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 has been a stellar emerging markets performer for three straight years for good reason. The latest economic data shows a strong combination of high 6% GDP growth, little inflation and a roughly 2% GDP primary fiscal surplus for 2023. It is also one of the only countries in Latin America that is lowering its debt burden. The continuing high 4.4% GDP debt service does remain a burden on the budget and requires continuing commitment to a high primary fiscal surplus. But there are a few institutional checks and balances that should reinforce fiscal discipline through the remainder of the Chaves administration, and Costa Rica should remain on a gradual track for an investment grade rating.

Firstly, fiscal consolidation remains critical. The preview of the 2024 budget reinforces the need to reduce debt payment below 46% of the budget. Debt service at 4.4% of GDP in 2023 remains a rigid component that cannibalizes the majority of the budget. The debt service and public salaries represent the majority of the budget. If there is no popular support for higher taxes, then the budget requires cutbacks across both categories to better allocate spending towards more productive sectors. There remains broad cultural support for fiscal discipline with no social pushback after near 5% of GDP fiscal consolidation from 2019 to 2022. There was also a conservative interpretation of the fiscal rule through the pandemic in 2020 with only minimal flexibility from the escape clause. There is now a track record of near two years of generating a primary fiscal surplus of roughly 2% of GDP and a budgeted 1.88% of GDP primary surplus for 2024.

Secondly, there are a few institutional guardrails. The Eurobond issuance law (10332) requires a high primary fiscal surplus as a pre-requisite for debt issuance at 1.85% of GDP in 2024, 2.25% of GDP in 2025 and 2.45% of GDP in 2026. If these criteria are not met, then the administration needs to again seek authorization prior to Eurobond debt issuance.

It’s equally important to assess the adoption of public employment reform. This represents an important medium-term reform that will provide significant budget flexibility and potential for maximum savings of 0.4%-0.6% of GDP during the first five years (third review IMF estimate). The IMF program target was adjusted to incorporate 90% of the public payrolls to a single wage spine through September 2023 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.

The fiscal rule itself is not that flexible, especially since the debt ratio under reference (2022) for the 2024 budget is still above the 60% of GDP threshold. This remains the highest threshold whereby capital and current expenditures cannot exceed 65% of the average nominal GDP growth over the previous four years. This sets the most stringent parameter for the 2024 budget, especially since the nominal growth still captures the below trend average GDP growth from 2019 to 2022. The 2025 budget would be equally austere on referencing still the higher 60% debt ratio estimated at 61.5% of GDP (2023) and the still below trend average GDP growth from 2020 to 2024.

The downshift to the next parameter (debt ratios 45% to 60%) restricts only current spending and at a slightly higher 75% of average nominal GDP growth. The exclusion of capital spending is less impactful as only a fraction of current spending. The more important transition would occur on the 2026 budget when 3.5% average increase in spending in the 2024-2025 budgets could accelerate to 6.1% on referencing the higher average nominal GDP growth post pandemic (2021-2024). This could reflect a less austere phase of spending growth of 5% to 6%, but still below the pace of nominal GDP. This is when revenues will be important to monitor, especially if there are less cyclical revenues on near-shoring in the tax free trade zones. This fiscal rule only reverts neutral — spending at the same pace of nominal GDP — once debt ratios are below 30% of GDP. The official forecasts are for high primary fiscal surplus above 2% of GDP that would allow for debt ratios to improve towards 52% of GDP through 2028.

The fiscal rule is restrictive based on either the higher (60%) or the lower debt ratios (45%) with spending growing at a lower pace than average nominal GDP. The broader political establishment has shown clear commitment and track record to fiscal discipline with a rules-based approach for lower spending through the fiscal rule, the public employment reform and the debt issuance law. This should reassure for a trajectory of successful fiscal consolidation and still lower overall debt ratios towards the investment grade category. This should allow for gradual divergence from the illiquid BB rating category and convergence with investment grade comps.

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

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