The Big Idea
Costa Rica | Reform negotiations
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Costa Rica’s structural reform agenda is taking on new importance after recent disappointing economic numbers and conservative fiscal projections. The economic downshift may explain S&P’s neutral outlook on the country’s ‘BB’ rating, which anticipates slower improvement in debt ratios. But S&P sees ratings upside if the legislative package moves forward. Successful implementation also opens a track to an investment-grade rating from Fitch, bridging the gap between Fitch’s “BBB” sovereign model rating and the country’s actual ‘BB’ rating.
The timing is critical to capitalize on Fitch’s positive rating outlook. Reform negotiations focus specifically on a Eurobond bill and the imminent release of ambitious fiscal reform. Progress on one or both of these reforms would be necessary to reduce ‘qualitative overlap’ penalties and get a fast-track Fitch investment grade rating.
Political negotiations for the Eurobond bill are coming to a head. While talks have stalled across previous legislative cycles, the current congressional landscape features less political fragmentation. The ruling PPSO party commands a simple majority capable of passing general fiscal updates. However, authorization for the Eurobond bill requires a qualified two-thirds majority, meaning the administration remains seven votes short of passage. The defining hurdle lies in securing breakaway opposition votes, testing the political finesse of the PPSO to horse-trade for concessions and break legislative paralysis.
While prior legislative coalitions aligned with the FA party on the Eurobond bill, the minority bloc’s narrow presence threatens to disrupt cross-party cooperation. Ideological rifts with PPSO have prompted negotiators to pivot toward the larger opposition faction, the PLN. The PLN has already signaled resistance to the proposed $13.5 billion shelf issuance over nine years. The minority opposition may carry some leverage, but they would quickly become marginalized without any collaboration with the ruling PPSO.
The political strategy seems to focus first on political cooperation on the Eurobond bill before the PPSO approves more controversial fiscal reforms with their own simple majority. Finance Minister Chaves announced 24 separate reform projects that will need legislative approval in phases through next year, including selective elimination of VAT exemptions, new laws to combat tax evasion and restrict spending as well as a new global income tax. There have not been any public estimates of revenues. But the clear intent is to improve budget flexibility and generate higher primary fiscal surpluses.
The progress on the reform agenda would tackle some or all of the rating penalties that separate the Fitch sovereign rating model of ‘BBB’ to the current ‘BB’ rating. Those penalties include restrictions on external borrowing, political fragmentation and high debt-service-to-revenues ratio. Approval of the Eurobond bill would show broader political cooperation under the qualified two-thirds majority and, alongside the recent local law EUR issuance, would show less restrictions on external borrowing.
There is probably a low threshold to lift Costa Rica one-notch to ‘BB+’. Costa Rica has positive momentum since before the elections and encouraging forward guidance. The question is whether Fitch upgrades more than one notch with the options of either sustaining a positive outlook or even shifting two notches to investment grade.
The markets are probably not positioned for a positive rating surprise, especially considering the recent lagging performance to peers like Guatemala. The confirmation of an investment grade track should tighten differentials to peers with potential for Costa Rica to trade inside ‘BB’ comps (Guatemala) and flat to ‘BBB’ comps (Paraguay). There is also maybe more upside on the higher yielding local law EUR-denominated bonds with a steep Costa Rica curve that should align closer to Mexico. This favors bullish curve flattening of the EUR’33 and EUR’36 with closer convergence towards Mexico EUR-denominated bonds.
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