Fiscal Panorama is Still Uncertain

According to Fitch Ratings, the fiscal outlook still faces considerable uncertainty in Costa Rica, despite the promise of President-elect Carlos Alvarado to carry out comprehensive reforms to reduce the deficit significantly.

Tuesday, April 3, 2018

In the view of the ratings agency, "... President-elect Carlos Alvarado's strategy for the future is not yet clear. Pressing the smaller 'fast track' bill might be politically easier, but it could reduce the urgency around additional reforms; Supporting a larger package could be more politically difficult."

From a statement issued by Fitch Ratings:

Fitch Ratings-New York-03 April 2018: Costa Rica's fiscal outlook still faces considerable uncertainty despite President-elect Carlos Alvarado's pledge for comprehensive reforms to reduce the deficit significantly, says Fitch Ratings. Political challenges facing the ruling PAC party's fiscal reform attempts persist despite a greater sense of urgency to address the country's large fiscal imbalance.

Costa Rica's fiscal deficit grew to 6.2% of GDP in 2017 due to structural spending pressures unaccompanied by revenue increases. The outgoing Solis administration enacted tax administration measures but was unable to advance bigger reforms needed for greater fiscal improvement. A fragmented congress and disagreement over the sequencing and relative weight of tax hikes versus spending cuts have hindered progress, despite recognition across the political spectrum on the need for fiscal reforms.

Urgency around the fiscal issue has grown in the past year due to growing pressures on local interest rates and signs of tight government liquidity. In February, lawmakers voted to give a fiscal reform package "fast track" authorization, which improves its prospects in the gridlock-prone congress by protecting it from procedural hurdles. The authorities estimate the package would yield around 1.9% of GDP in savings via conversion of the 13% sales tax into a VAT, higher capital gains taxes and spending restraint imposed by a fiscal rule. Another fiscal rule has been proposed at the constitutional level that could better impose budget discipline given that much spending growth is legally or constitutionally mandated. However, this would involve a separate and more difficult legislative path.

Alvarado called the bill "insufficient" and supports greater efforts to reduce the deficit to 3% of GDP during his term. This will be difficult given the PAC's smaller minority in the next congress (10 out of 57 seats). He has already made progress in negotiating support from opposition lawmakers, which led him to back off of a proposal to raise the VAT rate to 15%. However, members of his own party could resist greater spending reductions. His strategy going forward is not yet clear. Pushing the smaller "fast track" bill could be politically easier but may reduce urgency around additional reforms; supporting a bigger package could be more politically difficult.

The deficit will remain high in the near term under any reform scenario (6.9% of GDP in 2018 in Fitch's base case), implying heavy borrowing needs. Progress on fiscal reforms may unlock budget support loans from multilaterals or congressional authorization for a Eurobond issuance, but this is not certain. Without greater access to external financing, the government will have to borrow heavily from the local capital market, pressuring local rates and raising risks of macroeconomic spillovers.

A government plan to sell USD1.5 billion in bonds in the local market to non-residents appears to be on hold due to technical and legal issues. However, this may no longer be as urgent given a sizable inflow of foreign funds into regular treasury auctions, including one for USD514 million in March. This helps alleviate near-term financing constraints and is in line with our expectation that the sovereign will be able to manage its liquidity situation, but financing conditions could be sensitive to uncertainties on the fiscal reform front and global context.

Fitch revised the Rating Outlook on Costa Rica's 'BB' ratings to Negative from Stable in January due to the sovereign's deteriorating fiscal position and signs of diminished financing flexibility. Fitch will monitor fiscal reform progress and financing conditions to determine how the Negative Rating Outlook is resolved. Failure to deliver a fiscal reform package that reduces the deficit, improves medium-term debt dynamics and relieves financing pressures could result in a downgrade.

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