Negative Outlook for Costa Rica's Debt

Fitch Ratings has changed the outlook from stable to negative, due to "diminished flexibility to finance its rising budget deficits and public debt burden, as well as persistent institutional gridlock preventing progress on reforms to correct the fiscal imbalance."

Thursday, January 18, 2018

EDITORIAL

Costa Rica is running out of time. The decision taken by Fitch Ratings to reduce from the outlook for the sovereign debt rating from stable to negative reflects a serious problem that the country faces and shows us that, in the not very long term, the rating agency could lower this rating, currently in the BB category.  

If this happens, the cost of financing, both external and internal, will become even more expensive, as has been happening in the last two years, due to the pressure that the government has exerted with its search for resources in the local market.  
See: "Fiscal deficit, interest rates and poor management"

In the view of the Chamber of Industries, the announcement by Fitch Ratings is "... worrisome. We have been warning of this situation and presenting solutions for a long time and nothing has been done. Our economy has not been well managed. It should be a priority for the President and the deputies who take office in May, to reorganize the Government's finances with a comprehensive vision that tackles the subject of expenses bravely as well as the issue of modernization of taxes."

From a statement issued by Fitch Ratings:

Fitch Ratings-New York-18 January 2018: Fitch Ratings has affirmed Costa Rica's Long-Term Foreign and Local Currency Issuer Default Rating (IDRs) at 'BB'. The Rating Outlooks have been revised to Negative from Stable. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

The Negative Outlook reflects Costa Rica's diminished flexibility to finance its rising budget deficits and public debt burden, as well as persistent institutional gridlock preventing progress on reforms to correct the fiscal imbalance. Incipient signs of crowding out of private investment have increased risks to Fitch's prior expectations that the economy will remain insulated from fiscal stress, while the sovereign's reliance on the local capital market to meet its high financing needs is facing greater strain. Uncertain prospects for fiscal reform imply continued large deficits and a rapidly rising debt burden.

After shrinking in 2016 for the first time in five years to 5.2% of GDP, the central government's budget deficit increased to an estimated 5.9% in 2017. Inertial spending pressures coupled with a cyclical slowdown in revenues largely negated the marginal improvements in tax collection and cost containment achieved in 2015-2016. Fitch expects these trends to continue in 2018 and for the deficit to rise to 6.2% of GDP. Assuming no significant consolidation measures in 2018, the general government deficit (i.e. including the social security fund surplus) is forecast to reach 5.2% of GDP in 2018, above the 'BB' median of 3.4%.

Fitch's projections assume some fiscal adjustment after the 2018 election through a combination of spending cuts and tax hikes, though the timing and scope of the measures remain uncertain. Past attempts at comprehensive fiscal reform have foundered in the gridlock-prone Congress or in the Constitutional Court. Prolonged delays in addressing Costa Rica's fiscal imbalance will amplify the costs of future adjustments and raise the risks to growth. Costa Rica's general government debt burden, at 44% of GDP in 2017 (net of debt holdings by the social security fund), is projected to surpass the 'BB' median of 46% this year and continue to climb steeply over the medium term.

The government has relied heavily on the local market to finance its deficits, the more so since congressional authorization for external bond issuance expired in 2015. A favorable backdrop for domestic borrowing began to unwind in mid-2017 when an abrupt tightening of monetary policy put upward pressure on local interest rates. As a result, the National Treasury faced difficulties raising funds mid-year, as evidenced by unsuccessful auctions and tightening liquidity, but has since validated higher interest rates demanded by the market.

Additionally, the sovereign has sought alternative mechanisms to tap into foreign funds that would bypass the requirement for congressional approval of an external bond issuance. Fitch expects the sovereign will be able to manage its liquidity situation, but tightening market conditions and persistent institutional obstacles point to growing funding challenges.

Domestic borrowing costs have increased as currency depreciation and rising inflationary pressures led to a sharp tightening of monetary policy in 2017. A 300bps hike in the policy interest rate was swiftly transmitted to lending rates in the banking sector, leading to a sharp deceleration in credit growth. Proactive tightening should keep headline inflation within the 2%-4% target range, in Fitch's view.

Also adding to upward pressure on local interest rates is high government borrowing, which could restrain investment and growth. Real GDP growth is projected to have slowed from 4.5% in 2016 to 3.4% in 2017, driven in part by a sharp fall in fixed investment (-1.9% yoy in the first three quarters of the year). The economy should remain broadly resilient to the deteriorating fiscal situation, in Fitch's view, although fiscal imbalances pose risks of crowding out, and constrain the scope for counter-cyclical policies. Growth is forecast to average 3.9% in 2018-2019, broadly in line with potential.

Costa Rica's 'BB' ratings are supported by structural indicators that are strong relative to peers, including high per capita income, social development and governance standards. The ratings are also underpinned by the country's successful economic model centered around high value-added service and manufacturing activities, which supports robust growth and foreign direct investment inflows. FDI inflows still cover a current account deficit estimated at 3.2% of GDP in 2017 comfortably. Fitch expects FDI inflows to remain relatively firm during the forecast period and for the current account deficit to widen slightly owing to weaker terms of trade.

The likely winner of the presidential elections on Feb. 4, 2018 (and a potential run-off in April) is highly uncertain. Fitch's base case scenario assumes the winner will have another minority government and face challenges from a highly fragmented legislature. This could complicate coalition building and add to legislative gridlock and reform inertia, especially on controversial fiscal issues.

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From a statement issued by Fitch Ratings:

Fitch Ratings-New York-22 January 2015: Fitch Ratings has revised the Rating Outlook on Costa Rica's Long-term foreign and local currency Issuer Default Ratings (IDRs) to Negative from Stable and affirmed the IDRs at 'BB+'. The issue ratings on Costa Rica's senior unsecured foreign and local currency bonds have been affirmed at 'BB+'. The Short-term foreign currency IDR has been affirmed at 'B' and the Country Ceiling at 'BBB-'.