Policy continuity virtually assured, but fiscal challenges set to linger.

BY FRANCO UCCELLI

Costa Rican voters will go to the polls to elect a new president and a new congress in February 2014, with the elected officials scheduled to be inaugurated in May. According to most observers, the candidate of the ruling PLN party, current San Jose Mayor Johnny Araya, is a virtual shoo-in to win the election, as a deeply fragmented opposition is unlikely to get organized in time to put on a good political fight. Should Araya win, it would be the first time in Costa Rica's political history that the same party wins the presidential election three consecutive times. It is widely believed that the ruling party's considerable lead in the electoral race should keep fiscal slippage related to the election at a minimum, as the government does not need to overspend for electoral gain. Araya's victory would generally guarantee that policy continuity will be maintained, with locals speculating that Finance Minister Edgar Ayales, a strong advocate of fiscal reform, will be kept in the post supported by a solid team of proficient technocrats.

FISCAL PERFORMANCE DETERIORATED

Between 2004 and 2008, the government undertook a consolidation process that enabled it to turn a 3.6 percent of GDP global fiscal deficit into a 0.5 percent of GDP surplus and reduce the total public debt burden from 56 percent of GDP to 37 percent. However, since 2009 when the government implemented an expansionary policy to mitigate the effects of the global recession, the fiscal balance has swung back to a deficit of 5.1 percent of GDP and the debt burden has risen to 50.5 percent of GDP. The most recent numbers would be even worse if not for the fact that the government introduced in 2011 an aggressive program to limit current expenditure growth after the global deficit ballooned to 6.0 percent of GDP in 2010. While income measures designed to reduce tax evasion and tight expenditure policies have allowed the government to contain the size of the deficit (albeit at a high level) and limit excessive pressure on macroeconomic fundamentals, no meaningful fiscal improvement is expected in 2013 when the consolidated deficit is officially projected to close at 5.3 percent of GDP, boosted by an increase in the interest bill and election related spending.

Given Costa Rica's weak fiscal performance, it has become increasingly clear that only a sizable adjustment is capable of putting the country's fiscal accounts on a sustainable path. To that end, the government is working on a comprehensive fiscal reform proposal that would increase tax collections to 15 percent of GDP from the current 13 percent level, helping to boost total revenues by 2.5 percent of GDP while reducing expenditures by 1 percent of GDP, for a total fiscal adjustment equivalent to 3.5 percent of GDP that would lower the global deficit to around 2 percent of GDP. As far as the timeline for the reform, the government is hoping to get all the major political forces to agree on the basic tenets of the proposal before the February 2014 elections, so it can submit the bill to congress immediately after the elections and get it sanctioned before the new administration is inaugurated in May. While the Chinchilla administration believes it can capitalize on the widespread consensus for the need to fix the fiscal situation and secure approval of the reform as envisaged, most local observers believe the prospects of getting a reform approved before a new administration is inaugurated are bleak, pointing to likely congressional inactivity ahead of the elections and continued fragmentation during the transition period.

CAPITAL INFLOWS

The government recently submitted to congress a bill designed to curb foreign capital inflows attracted to Costa Rica by sizable interest rate differentials. The bill contains provisions to boost the tax on interest paid abroad and assess special reserve requirements on inflows, which purportedly were mostly from Costa Ricans bringing their money back to the country in search of higher yields. Most locals believe the bill will be approved, but not implemented, as its submission to congress appears to have been enough to deter further inflows and put downward pressure on interest rates, rendering the application of the law unnecessary. If approved as expected, the law would not be binding, meaning that the central bank would have the authority to apply it, but would not be legally mandated to do so. Meanwhile, the central bank has continued to aggressively intervene in the FX market (USD purchases have totaled US$440 million so far this year) and has cut rates at regular bond auctions to help lower average interest rates in order to limit the appreciation of the colon (CRC).

FX band will probably not be modified in the near term. Despite heavy appreciation forces resulting from massive foreign capital inflows, not one person we met, either in the private or public sector, believes the FX band, specifically the bottom of the band, which is currently set at 500 colones per USD, will be adjusted anytime soon. In fact, locals believe the relaxation of the bottom of the band would spark unnecessary imbalances, as the CRC would quickly appreciate and negatively impact exports, which have been a key driver of economic activity in the country. Most observers argue that the next step should be to liberalize, rather than adjust, the FX regime altogether, letting the CRC float freely according to market forces. If the CRC were to be liberalized today, the argument follows, the CRC would probably not trade too far (perhaps +/- 5 percent) from current levels following a brief period of uncertainty-induced volatility.

Franco Uccelli is an analyst with JP Morgan Chase. This column is based on a recent trip report. Republished with permission.