Costa Rica 'B+' Sovereign Ratings Affirmed; Outlook Remains Negative

  • Amid the COVID-19 outbreak in Costa Rica and key trading partners, we expect a contraction in Costa Rican GDP and further deterioration of the government's fiscal profile in 2020, with a rise in already high debt and deficits.
  • Access to local market funding, which stabilized in 2019 after coming under pressure in 2018, and access to multilateral funding are critical to forestall deficit-related financing pressures, given instability in global financial markets.
  • We are affirming our 'B+' long-term foreign currency and local currency sovereign credit ratings on Costa Rica.
  • The outlook remains negative, indicating the risk of a downgrade over the coming 12 months if, after the pandemic, the Alvarado Administration and Congress display uneven political commitments to timely adjustment of the country's fiscal profile.

Rating Action

On March 26, 2020, S&P Global Ratings affirmed its 'B+' long-term foreign currency and local currency sovereign credit ratings on Costa Rica. The outlook on the long-term ratings remains negative. At the same time, we affirmed our 'B' short-term sovereign ratings. We also affirmed our 'BB' transfer and convertibility assessment.

Outlook

The negative outlook indicates the possibility of a downgrade over the coming 12 months should Costa Rica's political leadership fail to demonstrate a more concerted, consistent, and timely commitment to reverse projected fiscal deterioration. Such a failure could imply weakness in the country's institutional response, in our view, despite widespread checks and balances and Costa Rica's solid democratic tradition.
We expect Costa Rica's fiscal profile to continue weakening in 2020, given the hit to the economy amid the COVID-19 pandemic. Revenue is set to decline in 2020 given the contraction in growth, besides any near-term, potentially more temporary, hit because of Congress' recent temporary deferral of some taxes until June. We project the general government deficit will rise toward 8% of GDP this year and decline only slowly, toward 6%, over the next two years as the economy recovers from contraction in 2020.
Signs of persistent, unchecked fiscal weakness or unwillingness by the political leadership to implement corrective measures and vigorously implement recent fiscal reform could further weaken public finances. Combined with rigidities in debt management and an already high level of sovereign debt denominated in foreign currency, this would exacerbate the sovereign's vulnerability to external and other shocks, supporting a downgrade.
Conversely, we could revise the outlook to stable over the same period if the government is able to lower its fiscal deficit sufficiently to gradually stabilize its debt burden, contain interest costs, and undertake more flexible debt management to reduce its exposure to potential adverse movements in interest rates and the exchange rate. Such steps, along with a rebound in economic growth, could boost investor confidence, sustain foreign direct investment (FDI), and reduce the country's external vulnerability.

Rationale

The ratings on Costa Rica reflect its long-established democracy, which has brought political stability amid solid checks and balances, and a generally prosperous economy and standards of living compared with regional peers. However, amid persistent fiscal slippage over the past decade--which led to a doubling of government debt as a share of GDP--the political leadership's policy response has not been proactive and timely.
In 2018, passage of long-debated fiscal reform aimed at curtailing expenditure growth and bolstering revenue came on the heels of pronounced financial pressure in the local capital market throughout the year. This also underscored long-standing vulnerabilities in the government's debt management procedures. The government's reliance on external financing (from both commercial and official creditors), given the limited size of local markets, led to a sharp rise in Costa Rica's external indebtedness over the past decade as well.
Despite solid FDI inflows that have generally covered the current account deficit (CAD), vulnerabilities associated with external debt and financing are key ratings weaknesses. Monetary policy credibility and execution, in contrast, have benefited from an inflation targeting regime, more exchange-rate flexibility, and some decline and stabilization in the level of dollarization in the financial system.
Institutional and economic profile: A strong democratic tradition has supported a prosperous economy, but the country's track record of addressing fiscal weakness is not timely
  • Costa Rica's stable political system and higher social indicators compare positively with those of peers.
  • However, mixed signals in implementing the 2018 fiscal reform underscore political challenges in redressing long-standing fiscal weaknesses.
  • After contraction in 2020, we expect GDP growth to average about 3% in 2021-2023.
Our assessment of Costa Rica's institutional effectiveness reflects its strong democratic tradition of stable political institutions, high social indicators, and overall predictable, albeit slow, policymaking. The country's low poverty and low crime compare positively with its Central American peers.
President Carlos Alvarado, from the Partido Accion Ciudadana, presides over a fragmented Congress where his party holds only 10 out of 57 seats. While the passage of fiscal reform at the end of 2018 was an encouraging development, it also highlighted the slow pace of reform in Costa Rica. The two previous administrations had also sought to pass fiscal reform but were unable to do so given the fragmented decision-making process in the country, which gives even small numbers of opponents in Congress the ability to stall approval. Similarly, Congress has repeatedly held back approval for the government to issue external debt at times, forcing it to rely on a small domestic market. Such political obstacles have weakened debt management and reduced the government's financial flexibility.
While the 2018 fiscal reform was an important step toward addressing the country's large fiscal deficit, there have been numerous objections to its coverage across the public sector, as well as mixed signals from within the administration. While the country's comptroller and attorney general have reinforced the need to apply it across the broad public sector, there are likely court cases aiming to undercut its wide-sweeping nature. Furthermore, an unexpectedly poor fiscal outcome in 2019, along with the likely impact of the pandemic in 2020, highlights the need for further politically challenging steps to control the growth of spending, especially on public-sector wages.
In 2020, we expect a 1.5% contraction in real GDP, before a recovery in 2021. This reflects a strong hit to domestic demand amid measures to combat COVID-19 internally and a drop in tourism and goods exports due to the economic contraction in the U.S. and global trading partners. We expect a rebound in 2021 to about 3.7% and growth of 3% in 2022-2023. Persistently large budget deficits will limit the government's ability to make investments, especially in much-needed physical infrastructure, limiting the ability of the economy to expand at a faster pace over the coming years.
A rebound in U.S. growth at the end of 2020 and 2021 should sustain a turnaround in Costa Rican exports and tourism earnings. We expect tourism receipts to contract on balance this year, given the authorities' steps to stem the COVID-19 pandemic within Costa Rica, which have included closing its borders to international travel, in addition to measures taken abroad. We believe the country's overall good business climate will continue to support steady FDI flows of about 3.5% of GDP, especially in life sciences, digital technology, and services.
Flexibility and performance profile: Deteriorating fiscal indicators and high external vulnerability remain prominent credit weaknesses
  • Costa Rica's fiscal profile remains under pressure after deficits and debt rose further in 2019, and it will come under pressure again in 2020 amid economic contraction.
  • High external indebtedness presents a credit vulnerability despite the steady FDI inflows that mostly finance the CAD.
  • The country's monetary policy credibility reflects inflation targeting, more flexibility in the colon exchange-rate regime, and some decline in dollarization.
Given our expectations for fiscal deficits to average over 7% of GDP in 2019-2020, net general government debt to exceed 60% of GDP, and interest to revenue to exceed 15%, Costa Rica's fiscal profile remains challenged. A history of difficult discussions in Congress in authorizing external borrowing--especially from global capital markets--highlights Costa Rica's vulnerabilities in securing deficit financing.
Despite passage of fiscal reform in 2018, which included tax reform effective in July 2019, Costa Rica's fiscal profile has continued to deteriorate. The central government deficit rose to 7% of GDP in 2019, with our estimates for the general government deficit a bit lower. We had projected that the fiscal reform, which introduced a value-added tax in mid-2019 and other taxes, along with measures to control expenditure, would help the sovereign to reduce its general government deficit by approximately 2% of projected GDP from 2019-2021 compared with the prereform scenario. While we did not expect this to stabilize the debt burden, we also did not foresee the jump in the fiscal deficit in 2019 or higher increase in debt. This places the fiscal accounts on an even weaker footing amid the COVID-19 pandemic.
We forecast the general government deficit will decline toward 6% of GDP--still high--in 2023 (our definition of general government includes the central bank, decentralized government agencies, and social security). Accordingly, we project that the change in net general government debt will average 6.8% of GDP--also high--in 2020-2023.
Consistently high fiscal deficits have significantly increased the country's debt burden and interest payments over the past decade. In 2020, we expect the net general government debt will represent about 62% of GDP, up from 27% in 2010, while interest payments will reach 17% of general government revenue, up from 8%. We project net general government debt will reach close to 70% of GDP in 2023.
We expect the CAD to average 3.5% of GDP in 2020-2023, partly reflecting the higher income deficit following projected increases in interest payments on external debt. We expect Costa Rica's trade deficit to average 6.5% of GDP during 2020-2023 and rise toward 8% of GDP by the end of the period as the economy recovers. The services balance is likely to remain in surplus, at about 8% of GDP on average, thanks to a vibrant tourism sector (which we expect will recover after the recent pandemic recedes). Accordingly, we expect the sovereign's gross external financing needs to hover around 103% of current account receipts and usable reserves over the next three years, and for its narrow net external debt to average 64% up to 2023.
Another vulnerability is the rising share of the government's debt that is denominated in foreign currency. Such debt now accounts for more than 40% of general government debt. An abrupt change in the exchange rate could boost the sovereign's interest payments and debt burden.
Dollarization of assets and liabilities in the financial system has declined on balance over the past five to 10 years and poses less of a constraint on the conduct of monetary policy than before. That said, an unexpectedly sharp change in the exchange rate could create asset quality problems in the financial system. Dollarization also limits the central bank's ability to act as a lender of last resort. Dollar-denominated loans from Costa Rica's financial institutions are just below 40% of total loans to the private sector, and some of that lending has gone to borrowers that do not have dollar earnings or other forms of hedging currency risk. The central bank's exchange-rate policy is managed-floating.
Given that the banks' assets-to-GDP ratio is about 100% and that our Banking Industry Country Risk Assessment (BICRA) is '7', we consider Costa Rica's contingent liabilities to be limited. (BICRAs are grouped on a scale from '1' to '10', ranging from what we view as the lowest-risk banking systems [group '1'] to the highest-risk [group '10'].)

Key Statistics

Table 1

Costa Rica--Selected Indicators
20132014201520162017201820192020f2021f2022f2023f
Economic indicators (%)
Nominal GDP (bil. LC)24,86127,22729,28131,13633,18934,93836,28036,48638,85741,18443,607
Nominal GDP (bil. $)5051555758616462646668
GDP per capita (000s $)10.510.611.311.611.812.112.612.112.412.612.8
Real GDP growth2.33.53.64.23.92.72.1(1.5)3.73.02.9
Real GDP per capita growth1.02.22.43.02.71.51.0(2.6)2.51.81.7
Real investment growth(0.3)3.33.04.8(2.5)3.0(6.4)(1.5)3.73.02.9
Investment/GDP19.018.818.418.419.319.617.916.717.118.618.7
Savings/GDP14.114.014.916.216.416.515.715.814.114.013.4
Exports/GDP31.332.330.832.132.833.533.832.033.133.032.8
Real exports growth3.35.02.69.44.04.72.7(1.5)3.73.02.9
Unemployment rate8.39.79.69.59.312.012.414.012.010.010.0
External indicators (%)
Current account balance/GDP(4.9)(4.9)(3.5)(2.2)(2.9)(3.1)(2.2)(0.9)(2.9)(4.6)(5.4)
Current account balance/CARs(14.4)(13.8)(10.5)(6.3)(8.2)(8.4)(6.3)(2.6)(8.2)(13.0)(15.3)
CARs/GDP34.035.233.434.935.736.534.934.435.535.435.2
Trade balance/GDP(11.2)(10.5)(8.4)(7.7)(7.4)(7.2)(6.6)(4.0)(6.3)(7.3)(8.0)
Net FDI/GDP4.85.64.63.74.43.63.33.63.53.53.6
Net portfolio equity inflow/GDP5.11.61.50.51.0(1.3)0.00.00.00.00.0
Gross external financing needs/CARs plus usable reserves100.2101.499.998.7105.6108.0106.797.9101.6104.0108.0
Narrow net external debt/CARs39.942.958.758.857.361.155.562.660.965.667.2
Narrow net external debt/CAPs34.937.753.155.353.056.352.261.156.358.058.3
Net external liabilities/CARs108.1122.3146.1144.5145.3150.4136.3144.6132.5130.1125.8
Net external liabilities/CAPs94.5107.5132.2135.9134.2138.7128.2141.0122.4115.1109.2
Short-term external debt by remaining maturity/CARs26.529.528.731.235.734.536.336.233.132.231.5
Usable reserves/CAPs (months)4.34.34.34.44.03.63.84.94.34.23.7
Usable reserves (mil. $)7,3337,2147,8367,5767,1537,5048,9408,9409,3088,6028,602
Fiscal indicators (general government; %)
Balance/GDP(5.4)(5.5)(5.7)(4.8)(5.5)(5.0)(6.8)(7.7)(6.8)(6.1)(5.8)
Change in net debt/GDP4.75.25.45.24.38.14.07.77.16.46.1
Primary balance/GDP(2.9)(2.9)(2.9)(2.0)(2.4)(1.5)(2.6)(3.1)(2.2)(1.6)(1.2)
Revenue/GDP25.625.225.626.425.826.226.726.227.127.327.6
Expenditures/GDP31.030.631.231.131.331.233.433.933.933.433.4
Interest/revenues9.910.210.710.611.913.415.717.416.916.316.7
Debt/GDP40.441.344.047.048.753.957.765.168.370.873.0
Debt/revenues157.7164.3171.7178.4188.5205.7216.4248.5251.9259.3264.4
Net debt/GDP38.440.242.945.547.052.854.962.365.668.270.5
Liquid assets/GDP2.01.11.11.51.71.12.82.82.72.62.4
Monetary indicators (%)
CPI growth3.75.1(0.8)0.82.62.01.52.12.72.92.9
GDP deflator growth4.05.83.82.02.62.51.72.12.72.92.9
Exchange rate, year-end (LC/$)501.41539.42538.41554.64569.49608.07573.29596.79612.91630.68648.97
Banks' claims on resident non-gov't sector growth12.117.113.912.99.15.15.20.66.86.46.3
Banks' claims on resident non-gov't sector/GDP57.261.264.868.870.470.371.371.371.571.872.1
Foreign currency share of claims by banks on residentsN/AN/AN/AN/AN/AN/AN/AN/AN/AN/AN/A
Foreign currency share of residents' bank depositsN/AN/AN/AN/AN/AN/AN/AN/AN/AN/AN/A
Real effective exchange rate growth4.5(5.5)7.8(0.7)(4.6)(2.6)(1.3)N/AN/AN/AN/A
Definitions: Savings is defined as investment plus the current account surplus (deficit). Investment is defined as expenditure on capital goods, including plant, equipment, and housing, plus the change in inventories. Banks are other depository corporations other than the central bank, whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within the year. Narrow net external debt is defined as the stock of foreign and local currency public- and private- sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial-sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. N/A--Not applicable. LC--Local currency. CARs--Current account receipts. FDI--Foreign direct investment. CAPs--Current account payments. e--Estimate. f--Forecast. The data and ratios above result from S&P Global Ratings' own calculations, drawing on national as well as international sources, reflecting S&P Global Ratings' independent view on the timeliness, coverage, accuracy, credibility, and usability of available information.

Ratings Score Snapshot

Table 2


Costa Rica--Ratings Score Snapshot
Key rating factorsScoreExplanation
Institutional assessment4A fragmented decision-making process in Congress, with minority groups able to stymie timely passage of controversial reform, underpins a comparatively slow policy response to support sustainable public finances. Fiscal reform in 2018 came only after the prior two administrations failed to pass long-debated reform despite persistent fiscal slippage. Solid checks and balances and an active judiciary underpin a favorable investment and growth climate on one hand, but also weigh on timely and predictable policy execution.
Economic assessment4Based on GDP per capita ($) as per Selected Indicators in table 1.
External assessment5Based on narrow net external debt and gross external financing needs as per Selected Indicators in Table 1.
Risk of deterioration in cost of or access to external financing reflects the government's debt management practices, including periodic delay in securing congressional authorization for budget financing from global markets and at times MLIs. This has, at times, created significant liquidity shortages and raised the cost of foreign currency debt.
Fiscal assessment: flexibility and performance6Based on the change in net general government debt (% of GDP) as per Selected Indicators in table 1.
Track record of limited ability to raise general government revenue.
Fiscal assessment: debt burden6Based on net general government debt (% of GDP) and general government interest expenditures (% of general government revenue) as per Selected Indicators in table 1.
Over 40% of gross government debt is denominated in foreign currency.
Monetary assessment4Low inflation, inflation-targeting regime with a growing track record, and a managed float with more exchange-rate flexibility. Some moderation in the level of dollarization (about 40% of loans with financial institutions).
Indicative ratingb+As per table 1 of "Sovereign Rating Methodology."
Notches of supplemental adjustments and flexibility0Not applicable
Final rating
Foreign currencyB+
Notches of uplift0Default risks do not apply differently to foreign currency and local currency debt.
Local currencyB+
S&P Global Ratings' analysis of sovereign creditworthiness rests on its assessment and scoring of five key rating factors: (i) institutional assessment; (ii) economic assessment; (iii) external assessment; (iv) the average of fiscal flexibility and performance, and debt burden; and (v) monetary assessment. Each of the factors is assessed on a continuum spanning from 1 (strongest) to 6 (weakest). S&P Global Ratings' "Sovereign Rating Methodology," published on Dec. 18, 2017, details how we derive and combine the scores and then derive the sovereign foreign currency rating. In accordance with S&P Global Ratings' sovereign ratings methodology, a change in score does not in all cases lead to a change in the rating, nor is a change in the rating necessarily predicated on changes in one or more of the scores. In determining the final rating the committee can make use of the flexibility afforded by §15 and §§126-128 of the rating methodology.
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