IMF Executive Board Concludes 2007 Article IV Consultation With Costa Rica

by Carla Johnson, Investors Offshore.com, London

12 March 2008

On February 15th, 2008, the Executive Board of the International Monetary Fund (IMF) concluded its Article IV consultation with Costa Rica, the results of which were published this week.

Since the last Article IV Consultation, Costa Rica's economy has continued to grow rapidly, according to the IMF.

Real GDP grew by 8.8% in 2006, and economic activity remained strong in 2007, driven by both domestic and external demand. Early estimates suggest that, for the year as a whole, growth was close to 7%. Unemployment declined to 4.6%, the lowest level since 1994.

Inflation steadily declined between late 2006 and mid-2007, thanks in part to the October 2006 switch to a crawling band regime, and the subsequent widening of the exchange rate band.

The IMF went on to reveal that the current account deficit widened to 6.0% in 2007, driven by a surge in non-resident income on foreign direct investment. Both exports and imports grew strongly during the year.

Upon the completion of their assessment, the Directors commended the authorities for the strong performance of the Costa Rican economy in 2007, reflecting what they observed was the continued implementation of sound economic policies.

Directors welcomed the ratification of the Central America-Dominican Republic-United States Free Trade Agreement (CAFTA-DR) and the reduction in the poverty rate to a historical low. The near-term prospects for the Costa Rican economy remain favorable, based on robust domestic demand. At the same time, Directors stressed the need to be vigilant to downside risks, mainly related to the intensity of the slowdown in the US economy.

The Directors praised the authorities for their impressive fiscal performance, which resulted from effective tax administration efforts and tight control of nonpriority spending. This policy has also contributed to a substantial reduction in public debt.

Looking ahead, Directors considered that a prudent fiscal policy will be key to containing demand pressures. They encouraged the authorities to maintain the fiscal stance achieved in 2007 — or even improve on it — to support the disinflation objective.

Directors further supported the authorities' plans for a substantial tax reform, which would permit higher spending in priority areas — including social and infrastructure spending — while preserving a sound overall fiscal stance. They welcomed the authorities' interest in developing a full-fledged medium-term budget framework.

Additionally, Directors welcomed the steps already taken by the central bank toward greater exchange rate flexibility in the context of a gradual transition to a full-fledged inflation targeting framework. They acknowledged the constraints on monetary policy imposed by continued large capital inflows under the current crawling band exchange rate regime, the appreciation pressures on the colón, and falling US dollar interest rates.

However, most Directors stressed that the recent substantial cut in interest rates — which has made interest rates even more negative in real terms — could give further impetus to the already robust level of aggregate demand, and compromise efforts to reduce inflation and subdue inflationary expectations.

These Directors encouraged the authorities to put in place institutional conditions for greater exchange rate flexibility, including the adoption of regulations for hedging instruments, which would permit a needed monetary policy tightening. A few other Directors cautioned that raising interest rates could trigger further capital inflows and increase the pressure on the exchange rate.

On a positive note, Directors welcomed the initial step taken in 2007 to recapitalize the central bank, and called for a permanent recapitalization through a one-step stock operation that would also underpin the disinflation strategy.

Finally, the Directors welcomed the strengthening of the financial sector. Nevertheless, vulnerabilities remain, according to the IMF, including risks associated with the relatively high level of dollarization and the lack of effective consolidated supervision of financial groups.

Directors called on the authorities to move expeditiously to implement the remaining recommendations of the FSAP update. They also encouraged the authorities to press ahead with the approval of the consolidated supervision bill and with the introduction of regulations to ensure that banks fully internalize foreign exchange risks.

They additionally lent their support to reforms to change the funding arrangements for financial supervision and improve the bank resolution framework.

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