Costa Rica Business Commentary
Costa Rica, while still significantly stronger economically than most of its Central American neighbors, still has problems, the largest being the servicing of the national debt currently $10 billion. (February 2005: Source Minister of Hacienda, Federico Carrillo)
The IMF report below, indicates that the ratification of the Central American Free Trade Agreement (CAFCA) and the "comprehensive tax reform" mentioned will solve these problems. While I tend to agree that CAFCA will greatly benefit Costa Rica and its people, the "comprehensive tax reform" put forth by the current administration will, in my opinion, spell disaster for Costa Rica. One of the more odious provisions calls for taxation of foreign earnings of persons living in Costa Rica. There are other equally nasty portions, but this one in particular may and will drive many of the wealthier residents to leave Costa Rica. It will also drive away ex-patriots, many of whom own businesses here and use Tico labor but who maintain taxable assets in other perhaps more secure countries. I can also see a stifling foreign investment, as this will have a profound effect on investors who may not only want to invest here, but to live here as well.
In May 2001, the administration changed and the new president is Nobel Prize winner and past president, Dr. Oscar Arias. He is far more enlightened and far less xenophobic than his predecessor. This spells good news for Costa Rica. He is also in favor of the Free Trade Agreement, another plus.
However, Costa Rica still needs revenue.
Costa Rica is a country of classes, and the moneyed higher classes almost totally control the wealth as they own or control most large business here. It is there that the government should go for its revenue. It should also pass laws taxing real estate while there is still time. This, sadly, may never get accomplished as taxation is controlled by the asemblea, itself composed of many of the moneyed gentry.
There seems to be also a complete lack of understanding of how revenue and costs should track. Example: The roads in Costa Rica are, with some exceptions, in terrible shape. However, the vehicles that do the most damage to the roads (trucks and large vans) remain largely free of any taxation or special charges for the damage they cause. There are a ton of other examples. This country needs revenue, but how that is done will largely affect Costa Rica's future for years to come. Arias has his job cut our for him.
Finally, there appears to me to be something wrong about the annual inflation figures reported by the government. In the USA, a 'market-basket' approach was used (at least when I lived there) to reflect the CPI. Comparing the CPI year to year would give an Inflation rate. That always seemed a reasonable approach to me. But MY personal market basket is sure telling me a far different story than what I read here. Recently, there were published reports of inflation at a rate of about 9-10%. In my opinion, this is wrong by about half for this past year, and I would judge that inflation is running much higher, maybe close to 20%. Costs of just about everything, except housing, have skyrocketed and may be as much as 25% higher than last year. This concerns me greatly as the effect on the average Tico family must be profound.
The Central America Free Trade Agreement was placed before the Costa Rican people and passed by a narrow margin.
Since then the asemblea has passed new laws and has modified current laws in support of the TLC. This will open Costa Rica markets in communication and technology as well as insurance, both heretofore monopolies.
Economic performance improved in 2003. Following several years of slow growth, real GDP rose by 5½ percent, boosted by a recovery of exports and strong private investment. Inflation declined below 10 percent, while unemployment fell to 6 percent. The external current account deficit narrowed to 5.3 percent of GDP in 2003 from 5.7 percent of GDP in 2002. Strong export growth, particularly electronics, largely offset higher imports of oil and capital goods. Gross reserves rose to 2½ months of imports, owing to pre-financing of 2004 fiscal needs and short-term capital inflows.
The public sector deficit was reduced to 5.2 percent of GDP in 2003 from 5.7 percent in 2002, owing to temporary tax measures and expenditure restraint. The primary balance shifted to a surplus of 0.3 percent of GDP, from a deficit of ½ percent of GDP in 2002. However, the public debt continued to rise, reaching 55 percent of GDP by the end of the year.
Monetary policy continued to be heavily constrained by the large quasi-fiscal deficit of the central bank. Broad money rose by 13.6 percent in 2003, reflecting large inflows of private capital, and credit to the private sector increased by about 20 percent in nominal terms. Financial dollarization continued to deepen and, by end-2003, about 60 percent of private sector credit was denominated in foreign currency. Some progress was made in implementing the banking reform recommendations of the 2001 Financial Sector Assessment Program (FSAP), but many reforms remain pending, including to level the playing field between onshore and offshore, as well as public and private banks.
Real GDP is expected to expand by 4 percent in 2004, and while inflation has risen to 11 percent recently owing to higher oil prices, core inflation remains stable at around 10 percent, broadly in line with the rate of crawl. The fiscal deficit is projected to remain at about 5.3 percent of GDP in 2004, as a comprehensive tax reform currently before Congress is expected to compensate for the temporary revenue measures that expired at end-2003. The successful conclusion in early 2004 of negotiations for a trade agreement with the United States (CAFTA) will make permanent the preferential access to the U.S. market hitherto granted under the Caribbean Basin Initiative.
Executive Board Assessment
Executive Directors welcomed the improvement in Costa Rica's economic situation since the last Article IV consultation, and commended the country's long-standing democratic tradition, solid institutions, and strong record of social development. They noted the favorable medium-term outlook, which should provide a good environment to make rapid progress on structural reforms. At the same time, Directors observed that significant vulnerabilities remain. Fiscal and external current account deficits continue to be large, the public debt has risen to 55 percent of GDP, the banking system suffers from growing dollarization and other weaknesses, and international reserves should be strengthened given the currency peg and the banking system's dollar liabilities.
Against this background, Directors endorsed several important reforms launched by the authorities, including a tax reform and trade agreements with the United States and CARICOM, and they were encouraged by the broad-based political support that these reforms are receiving. However, Directors called for a more comprehensive agenda of well-sequenced reforms to address remaining vulnerabilities, with special focus on tax administration, government spending, state enterprises, monetary management, and the prudential regulation and supervision of the financial sector. In light of the consensus-based character of the political system in Costa Rica, Directors emphasized that greater attention should be directed toward building the necessary political support for the reform agenda.
Directors stressed that strengthening the fiscal position is crucial for medium-term fiscal sustainability. They supported the authorities' efforts to obtain prompt legislative approval of the proposed tax reform, and stressed the need to underpin this reform with measures to strengthen tax administration. Directors also urged expenditure reform as a key priority, in particular by rolling back tax revenue earmarking, strengthening the finances of the pension system, keeping the wage bill under control, and improving the performance of the public enterprises.
Directors welcomed the authorities' plans to strengthen debt management, and agreed that fiscal consolidation would make an important contribution in this regard. They supported efforts to lengthen debt maturities and to develop the market for colón instruments in order to reduce the need for foreign-currency instruments.
Directors endorsed the authorities' intention to focus monetary policy on the objective of reducing inflation, and encouraged them to create the conditions for an eventual shift toward inflation targeting. They welcomed the authorities' plans to strengthen monetary management and instruments, make monetary policy more forward looking, and strengthen the analysis of monetary transmission channels. Directors also supported the planned recapitalization of the central bank. They noted that shifting the central bank's quasi-fiscal deficit to the government will improve fiscal transparency, as well as strengthen monetary policy and efforts to reduce inflation, provided that overall public borrowing declines. Some Directors considered that greater exchange rate flexibility could help reduce the economy's vulnerability to external shocks and facilitate adjustment to structural change. Directors noted that a move toward more flexibility should be well sequenced and supported by fiscal and financial reforms, and by the development of exchange market infrastructure.
Directors urged further progress toward strengthening the financial sector. They welcomed the steps taken so far to implement the recommendations of the 2001 Financial Sector Assessment Program (FSAP) report and follow-up technical assistance missions. However, Directors stressed that additional efforts are needed to strengthen the prudential and supervisory system. In particular, they stressed the need to ensure equal treatment of public and private banks and of offshore and onshore banks, implement consolidated supervision, strengthen sanctions and the bank resolution framework, and upgrade liquidity and risk management. They recommended the centralization of credit risk data for banks. The authorities also need to make sure that the investment funds market operates in accordance with relevant norms and transparency standards. Directors noted the authorities' efforts to further improve the already strong framework for combating money laundering and terrorism financing in a regional context.
Directors considered the rising trend of dollarization to be a significant vulnerability. They agreed that, to halt and reverse this trend, a broad strategy centered on reinforcing confidence in the colón and the onshore banking system as well as ensuring that the risks of dollar intermediation are fully internalized would be required.
Directors welcomed the progress made by Costa Rica in opening new markets for its exports. They commended the successful completion of negotiations on the Central American Free Trade Agreement with the United States, and supported the authorities' efforts to secure its early congressional approval. Directors pointed to the positive impact this agreement would have on export growth, foreign direct investment, and economic growth, and urged early approval of the associated structural reforms.
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