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Letter From Costa Rica

By Andrew Stanners, Investment Director, Fixed Income, Aberdeen Standard Investments

Do you know the way to San Jose?

Dionne Warwick was, of course, referring to the other San Jose, when she sang about an actress who’d failed to achieve stardom in LA returning to her hometown. San Jose, California and San Jose, Costa Rica do have a few things in common, though. In North America, the Golden State is known for its ecological credentials, progressive politics and for being a huge draw for US tourists. The same could be said for Central America’s ‘Rich Coast’, long viewed as a paragon of high political, economic and environmental standards compared to other countries in the region.

Costa Rica had become almost a victim of its own success. Its democratic system is laudable, but sometimes, when everyone is free to have their say, bureaucracy can weigh on progress. Having travelled there on a due diligence trip earlier this year, I have some personal experience of the effects of extensive red tape. While it’s not particularly difficult to find your way to San Jose, navigating once you have arrived in the capital presents a whole other challenge. Local authorities can’t agree on what to call many of the streets, or where to place signs. As a result, many roads are nameless and directions must be given using local landmarks as reference points, e.g. ‘the building in between the park and the branch of Starbucks’. The issue could be a metaphor for how the country’s budgetary problems developed: everyone knows the problem, everyone knows how to fix it, but no one seems to be able to do it.

At a macro level this inability to take effective action has steadily eroded the fiscal balance. Costa Rica’s constitutional mandate demands high expenditure in fields such as education. Over the years, therefore, there has been little discretionary room left in the budget for the its various administrations. Each government has had only about 10% left to cover interest expenditure and its own economic agenda.

For 20 years, finance ministers from different political parties wrestled with legislatures and the constitutional courts in an attempt to get tax reform through – with no success. Last year’s crisis was the culmination of these failures, with domestic and international investors losing confidence, the currency devaluing by over 10% and international and domestic bonds falling over 20%. Finding itself running out of money, the government was forced to borrow 500 billion colones (around $830 million) from the central bank. While the monetary authority insisted that the crisis was ‘controlled’, I think the government came closer to default than anyone will admit.

Addressing the problem

The moment of truth arrived following last year’s general election. In early 2018, the electorate defied local pollsters by voting for the incumbent Citizens’ Action Party (PAC) to maintain control of the presidency. The PAC had a new leader, Carlos Alvarado Quesada, but it was left with weakened legislative authority. The prospects for tackling the disintegrating fiscal position looked bleak.

In somewhat classic emerging market political behaviour, it took looking into the abyss for the legislature and, crucially, the constitutional court, to finally take action. A breakthrough fiscal reform, the first in over two decades, passed in the fourth quarter of 2018. The reform relies heavily on the constricting power of the fiscal rule and is now forecast to bring a primary surplus to the country over the term of the Alvarado Presidency. The worsening debt-to-GDP ratio will also finally be arrested. As such, there is a newfound optimism in both the political and financial sectors that after decades of gridlock the country has finally found a way to move forward.

These crossroad moments in a country’s economic path can prove to be some of the most fruitful times for bond investors. Costa Rica now appears to be an attractive proposition. Political parties are collaborating across ministries and the legislature and the economic agenda looks like it could improve the trajectory of the fiscal and debt position. Meanwhile, valuations are cheap on the back of an overly pessimistic rating-agency stance and an apparently ineffectual relationship with the International Monetary Fund that had spooked investors.

Delivering change

As regular visitors to Costa Rica, we have built up a comprehensive network of local connections in both financial and political circles. At these pivotal economic and political moments, nothing beats face-to-face discussions with key policy makers.

One of the meetings I had on my trip was with Rocio Aguilar Montoya, the country’s finance minister. She articulated a strong, positive and coherent message and is clearly focused on delivering the fiscal reform. Such an outcome is dependent on three assumptions. First, the current austerity measures must continue unabated into the final years of President Alvarado’s term. Second, economic growth must continue to meet expectations in order to sustain the necessary improvement in tax revenue. Finally, the cost of international financing must remain low.

For 2019, the government has three areas of focus: implementation, financial and reform. Implementation involves putting legislative changes – such as alterations to new public employee contracts – to work. Financial means obtaining approval to issue $5 billion of international bonds over the next six years. In July, the Costa Rican government approved the placement of $1.5 billion worth of bonds, but any future delays to issuance could create another mini-crisis. Finally, reform relates more to conventional promises about cutting down on bureaucracy – things like the merging of various ministries and government departments. Given the current stagnancy, there is potential for material gains to be made in this area.

What’s next for the Rich Coast?

Investing in both Costa Rica's hard currency dollar bonds and the local currency colon debt has worked well for our clients over the year to date. Dollar bonds are up 20%, and local interest rates have fallen 350 basis points, alongside a currency that has appreciated over 6% versus the US dollar.

Will Costa Rica continue to live up to the literal translation of its name for bond investors? The answer is more nuanced than simply assuming that fiscal reform will allow it to do so. Cross-party political co-operation could start to fade and strict austerity discipline will be required to meet the terms of fiscal rule – so only time will tell. Slower-than-hoped-for economic growth will start to test the reformers’ resolve, and legislative challenges for further dollar bond issuance lie in wait.

What our clients can be assured of is that we know the way to San Jose. I, for one, can’t wait for my next visit.

Disclosures:

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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