The Big Idea

Costa Rica | Pivot towards growth

Siobhan Morden | May 17, 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.

The prospects for growth in Costa Rica remain good with global appetite for near-shoring and friend-shoring encouraging foreign direct investment in the country and exports still strong. A successful International Monetary Fund program and the restoration of a fiscal anchor further signal a stable economy that should encourage foreign direct investment. The economic data speaks for itself with the country’s gradual trajectory toward an investment grade rating creating momentum toward lower credit spreads on Costa Rica’s debt.

Costa Rica remains the growth leader in the region even with GDP decelerating from 6% year-over-year in the second half of last year towards 4% this year. The central bank has just revised GDP growth forecast this year down to 3.8%. That reflects the constraints of a strong foreign exchange rate and high real interest rates. A competitive foreign exchange rate is critical to maintaining exports from the manufacturing sector.

The central bank has shifted toward monetary easing, with the strong foreign exchange rate a threat to what has been a dynamic export sector. The real effective foreign exchange rate had reached historic tight levels through March 2024. The International Monetary Fund had encouraged a shift toward a neutral policy rate over the next few months. The central bank accelerated the pace of rate cuts from 25 bp to 50 bp to reach a rate of 4.75% at their last meeting after a pronounced cycle of price deflation. The 24-month inflation expectations dipped to 2.7%, below the 3% inflation target in the latest April survey. Real rates still look restrictive based on 2.75% 24-month forward inflation expectations and very restrictive against -0.52% year-over-year persistent deflation. The accelerated rate cut pace has already translated into a weaker foreign exchange rate this month.

Structural trends still favor strong growth, with commitments to invest in technology to realize long-awaited near-shoring and friend-shoring. The main headline was the Intel partnership with Costa Rica to explore semiconductor supply chain opportunities. Costa Rica is well positioned for high technology investment after a decades-long partnership with Intel and an economy that specializes in non-traditional and high value-added exports, especially medical equipment and electronic components. Costa Rica already benefits from a culture that attract high foreign direct investment at 4.3% of GDP from 2010 through 2023 and the highest in the region. There was an increase from $3 billion in 2022 to $3.8 billion in 2023 with stronger inflows into the businesses outside of the free trade zone. The escalation of near-shoring investment could push GDP growth above 4% with higher synergy for stronger US exports. BCCR projects exports will remain a dominant contributor to growth at 38% to 39% of GDP from 2023 to 2025.

The private sector remains the engine for higher growth. The primary fiscal surplus is targeted at 1.85% of GDP this year. That is a transformation since 2019 from a primary deficit of 2.6% of GDP to a trend primary surplus of around 2% of GDP in 2022 and beyond. Costa Rica is the only country in the region to have restored a fiscal anchor post-pandemic and boasts the highest primary fiscal surplus. The high growth prospects should provide additional support and perhaps relieve some pressure on tight spending constraints under the fiscal rule on capex and social spending.

The economic transformation of growth led by foreign direct investment and a fiscal anchor should keep Costa Rica on a path toward an investment grade rating. Official forecasts project debt ratios below 50% of GDP in 2029. This debt consolidation could occur at a faster pace if foreign direct investment pushes GDP growth above 4% trend. There has been a recent pullback in credit spreads, but this may be more attributed to technicals over fundamentals on the prospects for $1 billion Eurobond issuance in the second half of 2024. This should not be overly disruptive considering still limited supply of $7.5 billion stock outstanding and incremental demand, especially under the prospects for innovative ESG issuance. The periodic criticism of “tight” valuations does not consider the spread discount for the scarcity of bonds relative to liquid ‘BB’ credits like Colombia and the Dominican Republic as well as the clear trajectory toward investment grade.

It’s not the same alpha return profile of the past three years; however, Costa Rica remains a rising angel on a gradual path towards consolidation of yields at 6% closer to investment grade credits like Peru. The relative value assessment should be more dynamic given the improving credit risk. This static analysis is why many investors have missed the relative outperformance validated by the successive credit rating upgrades this past year. The shift towards higher economic growth may offer a faster path towards investment grade convergence and fundamentals should eventually dominate technicals in driving lower credit spreads.

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

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