Fitch Affirms Costa Rica's IDR at 'BB'; Outlook Stable

Business Wire, Nov 1, 2007

NEW YORK -- Fitch Ratings today affirmed Costa Rica's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'BB' and 'BB ', respectively, with Stable Outlooks. Fitch also affirmed Costa Rica's Short-term IDR at 'B' and Country Ceiling at 'BB '.

Costa Rica's ratings are supported by its dynamic economy, stable and democratic political system, relatively favorable social indicators, and modest and declining external debt burden. On the other hand, Costa Rica's relatively weak albeit improving monetary and exchange rate policy framework, as well as structural weaknesses in public finances continue to constrain the ratings. Moreover, while international liquidity has improved over the past two years, it remains fragile in the context of Costa Rica's large current account deficit and high level of financial dollarization.

Over the past year, the Central Bank of Costa Rica (BCCR) has moved toward allowing greater exchange rate flexibility with the aim of adopting an inflation targeting regime in the coming years. While viewing this development positively, Fitch notes that monetary policy is fraught with challenges due to the limited exchange rate flexibility. In this context, changes in interest rates have been aimed at discouraging short-term capital inflows rather than fighting inflation more aggressively, resulting in negative real interest rates. While inflation and financial dollarization have come down somewhat in this early phase of the transition, the BCCR is expected to miss its inflation objective of 8% for 2007 and needs to improve its inflation-fighting credentials. 'In the coming months, Fitch will monitor how the central bank chooses to resolve the challenging policy trade-offs it faces in order to contain domestic demand and inflationary pressures,' said Shelly Shetty, Senior Director in Fitch's Sovereign Group.

Although progress on fiscal reforms initiatives, which languished in the presence of the DR-CAFTA debate, has also been protracted, cyclical economic recovery and improved tax administration have kept Costa Rica's fiscal deficits on a declining path. Furthermore, fiscal consolidation, robust economic growth, and a stable currency have resulted in a reduction in general government debt as a proportion of GDP to an estimated 37% in 2007, which is in line with Fitch's 'BB' median. On the other hand, government debt as a proportion of revenue of 209% is much higher than the 'BB' median of 155% and reflects Costa Rica's narrow revenue base.

While the October referendum on DR-CAFTA yielded a positive result, it remains uncertain whether Costa Rica's Congress will be able to approve the enabling legislation required for full implementation of DR-CAFTA in a timely manner. Passage of the agreement could solidify Costa Rica's reputation as one of the most popular destinations for foreign direct investment (FDI) in the region, in turn supporting the country's growth prospects through the continued expansion and diversification of its exports. Increased FDI flows could also sustain more favorable financing of Costa Rica's current account deficits.

Implementation of DR-CAFTA, continued solid fiscal performance, and further progress on reducing inflation would contribute to improving Costa Rica's creditworthiness. At the same time, passage of revenue-enhancing legislation as well as gradual recapitalization of the central bank would be viewed positively. A tax reform remains crucial to bolstering the government's ability to increase social spending and create fiscal space for the recapitalization of the central bank while still firmly entrenching positive debt dynamics. Recapitalization of the central bank could build the scope and credibility of independent monetary policy, and also enhance the Costa Rican economy's ability to cope with external shocks.

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