The Big Idea
Costa Rica | Value trade
This material is a Marketing Communication and does not constitute Independent Investment Research.
High oil prices remain a drag on oil importers across Central America, but Costa Rica has economic buffers and policy flexibility going for it. There is also the unique advantage of policy momentum from its recent political transition. This opens the door to activist reform that should encourage positive credit rating action, especially given the biases of the Fitch sovereign rating model. Costa Rica consequently looks attractive as a target for a convergence trade with illiquid investment grade credits like Paraguay.
The near complete reversion of spreads to pre-war levels should bring more attention to higher yielding credits and their value for the carry trade. However, this shouldn’t distract from other select opportunities for ‘BB’ credits with upside credit rating potential. The risk aversion in March also serves as a reminder about potential diversification with a strategy of core exposure to resilient ‘BB’ credits like Costa Rica and Guatemala with positive rating potential.
There has been a full reversion of credit spreads despite stubbornly high oil prices with no quick resolution yet to supply shocks. There has only been one rating adverse action towards Central American credits in response to the oil shock with Fitch shifting the positive outlook on the Dominican ‘BB-‘ rating back to neutral. Costa Rica does not face the same fate for their positive outlook with continuing momentum on shifting from ‘BB’ to ‘BB+’ over the next few months.
There has been no announcement of any fuel subsidy proposals. There is no flexibility under the fiscal rule for counter-cyclical fiscal stimulus or injecting a fuel subsidy shock into the fiscal accounts. This leaves only a passive approach of allowing the economy to fully absorb the fallout. There is room to accommodate slightly higher inflation and slightly lower growth considering months of stubborn deflation and above-trend robust 4% GDP growth expected in 2026-2027. This provides a buffer to adverse shocks. The central bank could also heed the recent advice from the International Monetary Fund for additional stimulus and respond to any secondary threats to growth, similar to Banxico’s preemptive rate cuts. The foreign exchange weakness would also be welcome for the external sector as an adjustment mechanism after protracted period of currency appreciation as well as a huge stockpile of foreign exchange reserves to reduce any unnecessary exchange rate volatility.
Under a more adverse scenario of protracted high oil prices above $100 a barrel, this will require extraordinary policy flexibility. This is where a few countries have a relative advantage. The adverse oil shock coincides with a more activist agenda of the Fernandez administration with a turnover of the legislature for majority PPSO control on May 1. This should allow for a break in legislative gridlock, which has been a penalty weighing on the Fitch sovereign rating model. There is a long list of legislation that requires either simple or absolute majority support including: external credits for a train and route 1 highway to connect the free trade zones, 4×3 labor flexibility law, alliance on public-private partnership law, constitutional reform on flexible financing, Eurobond bill of $1.5 billion for the next eight years, opening up electricity to the private sector, opening up local markets with a Euroclear law on local bonds, law that transfers FCL from the central bank to the federal government and a central bank independence law.
There is a wide difference between the Fitch ‘BBB’ sovereign rating model and the actual ‘BB’ credit rating with the difference explained for the 3-notch subjective deductions for legislative gridlock, restricted external financing, and high interest-to-revenue ratio. If there is an activist legislative agenda, this may warrant removal of the deduction for political gridlock. It wouldn’t be surprising for Fitch to upgrade Costa Rica to ‘BB+’ over the next few months and shift to a positive outlook. This would represent a positive shock that accelerates the prospects and optionality for an investment grade rating.
The next few weeks should open legislative sessions with potential for headlines about an activist reform agenda. The majority congressional leader under former Finance Minister Acosta is well aware of the rating process and the benefits of an investment grade rating. This should factor into the legislative agenda, with a priority to leverage the positive credit rating momentum for economic reform. This should translate into even tighter credit spreads and encourage convergence between Costa Rica and Paraguay. There is still value on the longer end of the curve even after the impressive gains.
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