Fitch Affirms Costa Rica’s Foreign Currency IDRs at ‘BB+’; Outlook Negative
By Business Wire News
Fitch Ratings has affirmed Costa Rica’s Long-term foreign- and local-currency IDRs at ‘BB+’. The Rating Outlook is Negative. 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-‘.
KEY RATING DRIVERS
Costa Rica’s ratings are underpinned by its strong structural features relative to peers in terms of high per-capita income, social development indicators and governance, as well as the continued success of its economic model centered around high value-added service and manufacturing activities, which are boosted by strong foreign direct investment inflows. Costa Rica also benefits from favorable U.S. demand growth and low oil prices.
The Negative Outlook reflects adverse public debt dynamics, driven by large fiscal deficits, and legislative gridlock preventing progress on reforms to correct fiscal imbalances in a timely manner.
The central government deficit inched upward to an estimated 5.9% of GDP in 2015, driven by higher interest costs as efforts to improve tax collections and contain salaries and discretionary spending helped arrest growth in the primary deficit. The 2016 budget envisions a higher deficit of 6.9% of GDP, although budget under-execution could bring it closer to 6%. A growing interest bill and rigid spending commitments on salaries and legally-protected social transfers will maintain pressure on public finances.
The administration has outlined a series of fiscal reforms to produce 3pp of GDP in savings over a three-year period, but progress on these initiatives has been slow in a highly fragmented congress. Some less controversial tax administration bills have advanced, but the outlook is less certain for two key reforms to hike direct and indirect taxes. There is greater willingness among political actors to address fiscal imbalances, but consensus over the sequencing and relative weight of tax-enhancing versus spending-side reforms could be difficult to achieve. Political and procedural obstacles could block or delay reforms, or dilute their yields, as evidenced by multiple unsuccessful fiscal reform attempts under past administrations.
Fitch’s baseline forecast assumes some progress on revenue-enhancing measures to narrow the deficit, but fiscal consolidation will be insufficient to stabilize the debt-to-GDP ratio. General government debt-to-GDP has risen nearly 15pp since 2010 to nearly 40% of GDP in 2015, and officials estimate a fiscal adjustment of 3.8% of GDP is necessary to stabilize debt by 2018. The ratio of interest payments to fiscal revenues is high relative to ‘BB’ peers.
A captive local investor base dominated by publicly-administered funds has supported fiscal financing flexibility. However, financing challenges could increase in 2016 given the absence of congressional authorization for Eurobond issuance or an alternative external financing source. Additional sovereign reliance on the local debt market could put upward pressure on borrowing costs. While recent policy rate cuts have helped hold down borrowing costs, the trend could revert as favorable inflation dynamics unwind.
Fitch estimates that growth slowed to 2.8% in 2015 from an average of 4.3% during 2010-14 as the country absorbed the effects of two shocks to the export sector (closure of a microchip plant and the impact of El Nino on agricultural output), while domestic demand has been strong. Fitch expects growth will recover to 3.6% in 2016 and 4% in 2017, supported by diversified investment in high value-added service and manufacturing activities, lower oil prices, and firm US economic activity.
Lower oil prices have represented a favorable external shock for Costa Rica, bringing the current account deficit below 4% of GDP in 2015 compared to 5% on average during 2011 – 2013, and supporting the accumulation of official reserves. A well-diversified export base and strong foreign direct investment inflows support the economy’s capacity to absorb external shocks in the context of limited exchange rate flexibility given financial dollarization.
Inflation fell sharply in 2015 due to the impact of lower energy prices and the relative strength of the local currency, while inflation expectations have moderated to the official target. This has prompted substantial cuts in the policy rate by the central bank, as well as a reduction in the inflation target from 4% to 3% (+/-1pp) in early 2016. The impact on deposit and lending rates has been somewhat muted, however, and the authorities have unveiled changes in the calculation of a key interest rate benchmark aimed at improving monetary transmission channels. High fiscal deficits, limited exchange rate flexibility, financial dollarization and quasi-fiscal losses at the central bank continue to constrain monetary policy.
The dollarization of credit remains an important source of risk in the financial system, and growth in foreign-currency borrowing gained speed in 2015 on an attractive interest rate differential and the perceived stability in the exchange rate. Banks maintain a long FX position, but are exposed to credit risk from the high shares of foreign-currency loans that are extended to borrowers without foreign-currency earnings and with variable rates linked to US benchmarks.
The following risk factors individually, or collectively, could trigger a negative rating action:
–Inadequate progress on fiscal reforms that support a reduction in the primary deficit consistent with improvement in the debt trajectory;
–Evidence of sovereign financing constraints;
–A deterioration in prospects for foreign investment and growth.
The Outlook is Negative. Consequently, Fitch’s sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change. Future developments that could individually, or collectively, result in a stabilization of the Outlook include:
–Progress on a fiscal consolidation strategy that improves the prospects for debt stabilization;
–Higher growth that improves fiscal and government debt dynamics.
Fitch assumes that in the absence of authorization for a Eurobond issuance, Costa Rica will be able to meet high deficit financing needs in 2016 – 2017 through alternative external financing sources and/or reliance on the local market.
Fitch forecasts that US growth and persistence of lower fuel prices will be supportive of economic growth in Costa Rica in 2016 – 2017.
Additional information is available on www.fitchratings.com
Country Ceilings (pub. 20 Aug 2015)
Sovereign Rating Criteria (pub. 12 Aug 2014)
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Todd Martinez, +1-212-908-0897
Fitch Ratings, Inc.
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New York, NY 10004
Shelly Shetty, +1-212-908-9165
Charles Seville, +1-212-908-0277
Elizabeth Fogerty, +1-212-908-0526