Negative Outlook Confirmed for Costa Rica

Fitch Ratings kept in B+ with a negative outlook, the sovereign debt rating, arguing that "the weaknesses in public finances are reflected and the political stagnation has prevented the timely approval of reforms that address these problems."

Friday, November 1, 2019

The new fiscal rule has not been approved, and the Congressional authorization requirement for foreign loans periodically restricts Costa Rica's financial flexibility, is another of the risk qualifier's arguments.

From the Fitch Ratings statement:

Fitch Ratings - New York - 30 October 2019: Fitch Ratings has affirmed Costa Rica's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B+' with a Negative Outlook.

Costa Rica's 'B+' rating reflects weaknesses in public finances and political gridlock that has prevented timely passage of reforms addressing these. The new fiscal rule is untested, and the requirement of congressional authorization of foreign borrowings periodically constrains Costa Rica's financing flexibility. This is counterbalanced by structural strengths relative to the 'B' category with strong governance, higher economic development and per capita income. An economic model centered on high-value-added manufacturing and service activities has supported macroeconomic stability and resilience to adverse shocks.

The Negative Outlook reflects downside risks related to high fiscal deficits and a steep amortization schedule, against a background of economic slowdown. A rapidly climbing interest bill will keep the fiscal deficit higher than peers' and the debt burden on a relatively steep upward trajectory. Congress approved an external bond issuance in April, which eased financing pressures in the short-term; an issue is expected in the fourth quarter of 2019. However, restrictions on the amount and timing of the approved issuance will lead to similar government requests over the coming years, posing risks of re-emergence of uncertainty over external financing.

Fitch projects the central government's fiscal deficits will remain above 5% of GDP until 2023, even assuming adherence to the fiscal rule, pushing the central government debt burden higher, albeit at a slower pace, to over 71% of GDP by 2023. General government debt (net of social security holdings) surpassed the 'BB' median of 47% of GDP by year-end 2018 and is expected to converge with the 'B' median of 57% by 2021.

Authorities estimate that the five-year cumulative yield of 3.7% of GDP from the fiscal reform approved in 2018 will be sufficient to stabilize central government debt at 68% of GDP by 2023. This projection comes below initial estimates at year-end 2018 of 4.2% yield from the fiscal reform and a debt burden peaking at 65% of GDP. Growth has been lower and borrowing costs higher than assumed under the plan. The size of the adjustment needed to stabilize debt-to-GDP could prove larger if borrowing costs face upward pressure again or growth slows more than expected.

The bulk of the consolidation expected under the fiscal reform relies on the implementation of a fiscal rule, from which the authorities estimate savings of 1.94% of GDP. The rule caps current spending growth to rates set as percentages of past nominal GDP growth. It will apply for the first time to the 2020 budget. There are risks around compliance with the fiscal (spending) rule. Expenditure reduction has faced political and social resistance, as seen in protest activity in 2018 and 2019 and legal challenges by different autonomous institutions; however, resolutions have so far favored the government's consolidation efforts.

Revenue measures of the fiscal reform were implemented in July 2019. The reform modified the sales tax into new value-added tax (VAT) and expands its coverage to include services. Income taxes now include capital income and new income brackets at higher marginal tax rates. Authorities expect revenue measures will yield to 1.75% of GDP by 2023.

Fitch expects Costa Rica's central government deficit will increase to 6.3% of GDP in 2019 from 5.9% in 2018 due to a rising interest bill. Government revenues benefited from a tax amnesty and strong performance of the new VAT. Proceeds increased by 53% yoy (0.1% of GDP) on the first three months of implementation compared to sales taxes in the same period a year prior. Expenditure growth has offset revenue measures, despite current primary expenditure restraint. Primary spending is estimated to remain flat in terms of GDP in 2019, but interest payments increased by 33% through September and are expected to reach 4.2% of GDP by 2019 (25% of central government revenues).

The government's financing constraints have eased following the passage of the fiscal reform in 2018. Local market yields in colones declined on average by 250 basis points across maturities year-to-date. Borrowing costs, however, could remain high, and continue to increase in effective terms as the government prioritizes local issuance at longer debt maturities. Issuance had become more concentrated at shorter maturities.

Fitch estimates sovereign financing needs of 10.3% of GDP in 2020 (4.9% of GDP in debt repayments and 5.4% of GDP for budget financing) and 13% of GDP 2021 and 2022 due to increasing amortizations. Costa Rica's legislative assembly approved an external bond issuance of USD1.5 billion expected to be disbursed in late 2019, which will ease financing pressures in the short term. The authorities had initially requested a USD6 billion Eurobond authorization over six years. Authorization of external bonds and loans requires a two-thirds congressional supermajority. The government will make greater use of multilateral borrowing, including USD850 million from CAF and IADB in 2019, and a similar amount expected in 2020.

Real GDP growth slowed to 2.6% in 2018 from 3.4% in 2017 and further declined to 1.4% average year over year in first-half 2019. Economic activity has been dragged by transition costs from implementation of the new VAT tax and its extension to services, which Fitch expects to be transitory, weakening business and consumer confidence and adverse external conditions. Private consumption growth has waned due to high levels of unemployment, adverse real wage trends, private credit growth that has weakened amid high household leverage and declining consumer confidence. Political unrest in Nicaragua (Costa Rica's 6th largest export destination) has disrupted Costa Rica's exports to Central America. Fitch forecasts growth will slow down further to 2% in 2019 and continue below 3% over 2020-2021.

Banks have adequate capitalization and liquidity levels, but credit dollarization is high and largely to unhedged borrowers. Loans to non-FX generators were 66% of foreign-currency-denominated loans. Asset quality has been resilient through 2019. Non-performing loans (including write-offs and foreclosed assets) stood at 4.1% in June 2019, down from 4.7% at end-2018.

Government demand for foreign currency put pressure on the exchange rate in 2018, which prompted significant FX intervention by the BCCR. Passage of the fiscal reform has improved the government financing capacity and reduced pressures on the exchange rate. The exchange rate has strengthened throughout the year as a result. Issuance of the USD1.5 billion Eurobond increases FX supply and reduce government FX demand. Net foreign reserves reached USD7.5 billion, or an estimated 5.5 months of goods imports, as of mid-October 2019.

Fitch's proprietary SRM assigns Costa Rica a score equivalent to a rating of 'BBB' on the Long-Term Foreign-Currency (LT FC) IDR scale.

In accordance with its rating criteria, Fitch's sovereign rating committee decided to adjust the rating indicated by the SRM by more than the usual maximum range of +/- three notches because of the extent of Costa Rica's sharply rising debt burden, fiscal budget financing constraints and emergence of macroeconomic vulnerabilities.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

--Structural: -1 notch, to reflect a long track record of institutional gridlock that has hindered progress on necessary reforms, which is not fully captured in the World Bank Governance Indicators in the SRM;

--Fiscal: -2 notches, to reflect the severe constraints on fiscal financing flexibility and also reflecting our expectation that government debt will continue to rise fairly rapidly over the medium term while the appetite to further increase the revenue base is limited;

-External: -1 notch, to reflect the institutional gridlock that has led to intermittent external bond issuances. Absent authorization for further external bond issuances, the government would be a net buyer of FX rather than a supplier, increasing external vulnerabilities;

--Macro: -1 notch, reflecting policy framework weakness as evidenced by the government's decision to use short-term financing from the central bank, as well as spill-over effects from the fiscal imbalances affecting macro stability.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

The following risk factors may individually or collectively result in a downgrade of the ratings:

- Emergence of sovereign financing pressures, particularly in relation to external financing;

- Wider fiscal deficits and acceleration of the increasing debt trend, for example caused by incomplete fiscal reform implementation;

- Signs of deterioration in macroeconomic stability and rising external vulnerabilities.

As the Outlook is Negative, Fitch's sensitivity analysis does not anticipate developments with a high likelihood of leading to a positive rating action. However, the main factors that could individually or collectively lead to the Outlook being revised to Stable include:

-A significant reduction of the fiscal deficit for example supported by implementation of the fiscal reform;

-Sustained improvement in government financing flexibility, including external funding sources.

The global economy performs largely in line with Fitch's Global Economic Outlook.

Costa Rica has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as World Bank Governance Indicators have the highest weight in the SRM and are relevant to the rating and a rating driver.

Costa Rica has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are relevant to the rating and a key rating driver with a high weight. Institutional gridlock has hindered progress on fiscal reforms impacting Costa Rica's sovereign rating.

Costa Rica has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.

Costa Rica has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver.

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In line with recent warnings issued by other credit rating agencies regarding the country's bleak fiscal outlook, Fitch has reduced the debt rating from B + to B, and changed the outlook to negative.

From a press release issued by Fitch Ratings:

Fitch Ratings-New York-01 February 2017: Fitch Ratings has downgraded El Salvador's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to 'B' from 'B+'.