The Big Idea
Costa Rica | Waiting for cooperation
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The debate continues over whether Costa Rica can cross the threshold to an investment grade rating and see spreads compress to split-rated investment grade credits like Paraguay. The markets are not overly optimistic, with Costa Rica recently underperforming Guatemala. However, there is room for optimism. The fiscal performance remains strong despite a slowing economy, and rating agencies appreciate the country’s strong external position. Costa Rica would also benefit from Eurobond scarcity with no recent supply and only six bonds outstanding. Current relative valuations also underappreciate the potential for upside surprise over the next few weeks if there is final approval of Eurobond legislation.
There are only a few weeks left for the legislature’s extraordinary sessions. These sessions offer an opportunity for the executive to control the agenda and focus on legislation necessary for credit rating upgrades. The first on the agenda is the Eurobond bill that would allow “shelf” multi-year issuance. The challenge is seeking some revisions to the pre-requisite requirements for annual issuance and the possibility of upsizing from $2 billion through 2026 to $4 billion through 2028 or longer. The recent support from the National Liberation Party could provide the two-thirds legislative majority needed for final approval. It would require a last-minute push to comply with the month-end deadline.
The recent report from Fitch may provide the necessary motivation. Fitch discusses the “strong endorsement of the country’s macroeconomic policies and institutional framework” as one of the few elite countries to have access to the IMF Flexible Credit Line. This is particularly relevant considering the recent suspension of Colombia’s access to the FCL, leaving Costa Rica as the only speculative grade credit with access. “The IMF approved the two-year arrangement under the Flexible Credit Line (FCL) on June 2, noting that it will ‘provide valuable insurance’ against increased external risks and that the Costa Rican authorities ‘intend to treat the FCL arrangement as precautionary.’” Fitch later reaffirmed its positive outlook and the country’s improving external position, with foreign exchange reserve accumulation as well as the financing flexibility of their debt local markets. This allowed for the payment of the April 30 Eurobond amortization without having to tap external capital markets. “Current yields on colon-denominated sovereign debt are roughly in line with external funding costs.”
However, the report comes with a critical caveat. “The scope for political gridlock to hinder external financing flexibility is a long-standing sovereign credit weakness.” Fitch later comments on the uncertainty around approval of the Eurobond bill and constitutional reform for flexible financing. These reforms are critical for both reducing legislative gridlock and improving access to external credit, and ultimately for attaining the fast-track investment grade rating. Fitch then explicitly states that “Passage of a constitutional amendment that permanently addresses this constraint would therefore likely be necessary for the sovereign to reach investment-grade status.” Eurobond reform is the litmus test on whether the Chaves administration can next seek legislative support for the constitutional amendment for flexible financing that eliminates over regulation on external issuance. This should hopefully spur progress over the next few weeks toward an investment grade rating.
Solid macro performance is probably enough for Fitch to follow-through on the positive outlook with a full upgrade to ‘BB+’. The strong external position also benefits from fiscal support with gradually lower debt ratios. The primary fiscal accounts are no longer posting the high 2%-of-GDP surpluses with the deflation of tax revenues from sub-trend inflation. However, the commitment to the fiscal rule and lower debt service allows for still sustaining the primary surplus while also lowering the nominal fiscal deficit. The nominal fiscal deficit through May 2025 shows an improvement at 1.3% of GDP, compared to 1.1% of GDP for the same period last year, with the debt ratio declining to 57.7% of GDP. The formula of spending restraint and lower debt service is probably sufficient to sustain the slow improvement on debt ratios but under a much slower path towards an investment grade rating similar to the Dominican Republic.
Costa Rica remains a low beta option and maybe now a more defensive alternative after the extended phase of risk rally across the high yielders. Costa Rica should also be less sensitive to any pullback in risk appetite with still favorable technicals on the low stock of Eurobonds outstanding. The wider relative valuations should also offer some technical support at near parity on the longer tenors to other ‘BB’ credits like Guatemala and the Dominican Republic. However, the divergence from illiquid ‘BB’ peers like Guatemala and convergence with investment grade credits like Paraguay will require progress on the reform agenda. There is no fast track (yet) for an investment grade rating until the Chaves administration can break the legislative gridlock. The other alternative is the slow track with a gradual reduction in debt ratios towards 40% of GDP after many years of conservative fiscal and financial management.
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