Country Report Costa Rica
Although Costa Rica’s economic performance is still good, the deterioration of public finances and the inability of the government to implement consolidation measures are reason for concern.
Strengths (+) and weaknesses (-)
(+) Strong institutions
Costa Rica has a long tradition of strong institutions and a stable democracy.
(+) High value added sectors
Partly due to the well-educated labor force, Costa Rica’s economic sectors; manufacturing, transportation, communication and tourism are in the higher value-added segment of their market.
(-) Narrow tax base
The combination of a narrow tax base (14.5% of GDP in 2012) and rigid government expenditures restricts the government’s room to maneuver with regard to economic policies.
(-) Fragmented political landscape
Since the government has no majority and has difficulties to find common ground with the opposition, hardly any progress is made in multiple fronts, including government finances.
1. Economic performance remains strong
Since the economic slowdown in 2009, Costa Rica’s economy has performed relatively well with an average growth rate of almost 5% (figure 1). Looking at the sector composition, main contributors were; manufacturing, transport, financial intermediation and business services. All these sectors are strongly linked to the export sector, whereby the export value of goods grew from USD 8.8bn in 2009 to USD 11.4bn in 2012. The reason behind this trend may be the signed free trade agreements by Costa Rica in 2009 (CAFTA) and 2011 (China). Although economic growth has slowed down recently, Costa Rica’s economy is expected to grow by around 4% a year in the coming years on the back of an improving external environment.
2. Current fiscal trend is unsustainable
Since the economic contraction in 2009, Costa Rica has been coping with a budget deficit of around 4% of GDP (figure 2). The deficits are the result of the implementation of crisis measures in 2009, whereby the structural nature of the measures and the inability of the government to increase revenue to finances these expenditures, has led to a deterioration of the government’s fiscal position. Attempts of the government to raise taxes have failed, as they were blocked by the opposition. In addition, the Supreme Court qualified some proposals as unconstitutional. The alternative, a reduction in government spending – mainly delays in infrastructural investment – did not have the hoped effect.
Although government finances are still in an acceptable state, the need for fiscal consolidation is rising. Public finances will become unsustainable in the medium term without additional measures. The task of fiscal consolidation will, however, not be easy. The necessary extension of the tax base by 4% of GDP is substantial, especially given Costa Rica’s current narrow tax base. In addition, new presidential elections are scheduled for 2014, which makes it unlikely that new tax laws will be implemented shortly.
3. Political trends and the elections in February 2014
As indicated above, Costa Rica’s political landscape is highly fragmented, which is unlikely to change after the presidential elections scheduled for February 2014. The leftist candidate, José María Villalta of the Frente Amplio, led the polls in November with 17%-22% of the votes. Johnny Araya of the ruling Partido Liberación Nacional (PLN) received just 14-19% of the votes. The final outcome of the elections is difficult to predict, as people easily shift their preference. The latter can be linked to the fact that people feel poorly represented by their political parties, due to multiple corruption scandals.
4. Improving external position
In recent years, Costa Rica’s external position has improved considerably. First, to prevent a further appreciation of the Costa Rican currency (colon), the central bank (CB) has been selling colons in exchange for foreign currencies. This has resulted in an accumulation of FX-reserves in recent years. Remarkable is that, even after the announcement by US FED chairman Bernanke in May, that the FED was considering to reduce its quantitative easing program, the colon remained at the lower bound of the exchange rate band (figure 3). This is in contrast with many developing and emerging market countries, which experienced a depreciation of their currency and a rise in bond yields. Second, Costa Rica’s current account deficit is covered by a strong inflow of both FDI and portfolio investments, which strongly relate to the manufacturing and technology sectors. The net position of the financial account has led to an additional accumulation of FX-reserves. All in all, the import cover has risen from 3.8 months in 2010 to an estimated 4.5 months in 2013. The current account deficit has widened in recent years despite increasing exports, as the increase in exports has been off-set by a stronger increase in imports, which is mainly the result of higher oil bills.
Costa Rica is one of the most stable and democratic countries in Central America. The current deadlock between political parties prevents the government to implement the necessary fiscal measures. In addition, Costa Rica’s international relations are quite strong, although the country is having some disputes with Nicaragua regarding its northern border. This is the result of Nicaragua’s plan to build a canal linking the Atlantic and the Pacific, which may include a contested border river. With a homicide rate of 10 people per 100,000 inhabitants Costa Rica is relatively safe compared to other countries in the region. Crime levels have however increased somewhat in recent years, and mostly relate to drug trafficking.
The creation of a free trade zone in 1982 has helped Costa Rica to develop a modern and dynamic export sector. The policy has attracted multiple foreign manufactures, and the manufacturing and transportation sector now make up two-fifths of the economy. In addition, the export oriented sectors generate high-quality jobs. An important downside is, however, that these sectors do not generate job opportunities for all segments of the population. This fuels income inequality, which is relatively high (the country’s Gini coefficient is 51. The combination of high income inequality and the fact that people feel poorly represented by politicians may cause social tensions in the future. The tourism sector is another important sector in Costa Rica’s economy, especially since it brings in foreign currency, compensating for the country’s large trade deficits. The main attractions are nature related, including volcanos, beaches, wildlife and national parks.