Fitch Downgrades Costa Rica to 'B'; Outlook Negative

By Fitch Ratings

New York - 08 May 2020: Fitch Ratings has downgraded Costa Rica's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'B' from 'B+'. The Outlook is Negative. Full announcement available on Fitch website here.

KEY RATING DRIVERS

The downgrade of Costa Rica's Long-Term Foreign-Currency (LT FC) IDR to 'B' reflects increased risks of near-term financing stress due to widening fiscal deficits, a steep amortization schedule and borrowing constraints, against a background of economic contraction caused by the effects of the coronavirus pandemic. The ongoing health crisis comes at a time when Costa Rica's fiscal space is limited and rapidly narrowing, raising risks to post-crisis debt sustainability. The interest bill is climbing rapidly, and the debt burden is on a relatively steep upward trajectory.

The Negative Outlook reflects further downside risks to debt sustainability amid uncertain prospects for post-crisis fiscal consolidation, economic growth and borrowing costs. The government will rely on multilateral loan disbursement this year to secure budget financing. However, uncertain external market access coupled with a domestic capital market that has become costly in past periods of sovereign liquidity stress pose financing risks. Risks from the ongoing health crisis remain tilted to the downside, as Fitch's forecasts are predicated on a three-month period of economic disruption due to the coronavirus. In the event of a second wave of infections and the re-imposition of lockdown measures, economic and fiscal outturns would be weaker for 2020 and 2021.

Fitch expects Costa Rica's economy will contract by 4% in 2020, with risks tilted to the downside. Containment measures will lead to a sharp contraction in households' and firms' disposable income, which will affect domestic demand and unemployment. Domestic demand was already weakening prior to the health crisis due to high unemployment, weak private credit growth and declining consumer confidence. External demand is highly vulnerable given the expected halt in tourism (6% of GDP, 19% of current account receipts) and the expected economic contraction of trading partners, particularly the U.S., which is the destination for 40% of Costa Rica's goods exports. Fitch expects the economy to recover gradually from 2H20, growing by 2.6% in 2021, and while this forecast is subject to unusually high uncertainty, a stronger rebound could be hindered by a lasting negative shock to tourism and policy uncertainty related to fiscal issues.

The economic contraction will lead to a significant loss of government revenues and widen the fiscal deficit to over 9% of GDP, according to Fitch estimates. Fitch expects government revenues to decline by more than 3% yoy given the expected economic contraction. Revenue measures announced by the government to mitigate the economic crisis include a three-month temporary moratorium on tax payments and social security contributions.

The government proposed a fiscal package of CRC260 billion (USD460million, 0.75% of GDP). The bulk of the package represents direct transfers to households vulnerable to the coronavirus that it expects to be funded by budget reallocations, containing the impact on the deficit, as well as new multilateral loans. Expenditure reallocations include the suspension of wage increases for public employees, excluding the police. However, a rapid increase in interest payments continues to widen the overall fiscal deficit.

The fiscal responsibility law approved in 2018 was intended to limit current expenditure growth starting in 2020. The government expects to invoke a temporary activation of the emergency escape clause embedded in the fiscal rule. This would only apply to institutions related to the health crisis at this juncture. The government intends to reinstate the fiscal rule by 2021. Nevertheless, the absence of a track record of compliance with the fiscal rule and some ambiguity over the degree of spending containment it will require in the coming years hinder its credibility as an anchor for medium-term fiscal consolidation. Compliance with the rule would require major cuts to primary current spending to offset a rising interest bill, which would likely face political and social resistance.

Fitch expects the central government debt burden to reach slightly below 70% of GDP by 2020 from 58.5% in 2019 and 53.1% in 2018. This would represent a doubling of the debt ratio over the past decade. Fitch expects general government debt, which nets out social security holdings, to reach 62.5% of GDP in 2020, above the current 'B' median of 58% this year. Central government debt to government revenues is set to reach 471% in 2020, while interest payments accounted for 28% of revenues in 2019. In Fitch's view, debt sustainability risks have increased significantly.

Fitch estimates sovereign financing needs of nearly 13% of GDP for 2020 (3.8% of GDP in debt repayments and 9.0% of GDP for budget financing) and to remain above 12% of GDP in 2021 and 2022 due to increasing amortizations. The main sources of funding will come from multilateral organizations, domestic bond issuances and use of government deposits. The government issued a USD1.5 billion bond in November 2019 that eased the financing pressures over the first quarter of the year. The authorities discussed the possibility of signing a Stand-By Arrangement with the IMF, which could ease Costa Rica's funding stress.

The government plans to use multilateral borrowing of up to USD 3.175 billion (5.2% of GDP) for 2020. These include loans from Inter-American Development Bank (IADB), Banco de Desarrollo de America Latina (CAF), the World Bank and Central American Bank for Economic Integration (CABEI), all of which still require congressional approval, except for a USD500 million loan from CAF already disbursed. These also include the IMF Rapid Financing Instrument of USD508 million for balance of payment support, which can be used for budgetary needs. Failure to secure these external loans would lead to a fiscal financing gap given prohibitive external market borrowing costs and limited domestic market size. Although the government continues to place debt in the local market, recent issuances were short-dated (expiring before year-end), raising potential near-term rollover risks.

Monetary policy prioritized liquidity and the easing of credit conditions for households and businesses to soften the economic damage from the health crisis. Costa Rica's Central Bank (BCCR) cut its policy rate by a 100bps to a record low of 1.25% since the beginning of the pandemic. Additionally, the BCCR began to purchase government securities in the secondary market to provide liquidity during times of systemic market stress. The BCCR purchases will be limited to local-currency securities issued prior to 2020 with a maximum maturity of 10 years.

Banks have adequate capitalization and liquidity levels. However, banks remain vulnerable to high household indebtedness and high credit dollarization, largely to unhedged borrowers. NPLs have been low, 2.6% of total loans as of March 2020, but gradually increased over the past years. Risks remain tilted to the downside, as the economic shock will weaken asset quality across the banking system. The BCCR has a financial facility available to the banking system of about 5% of GDP in case of liquidity pressures. Other measures include reducing cost of credit, relaxing regulations on loan restructuring and a two-month moratorium on principal payments on loans from affected households and firms, pending congressional approval.

External finances are being supported amid the global crisis by improved terms of trade and the absence of large foreign capital in the local market, as demonstrated by the absence of recent currency depreciation. Nevertheless, portfolio dollarization of domestic agents could pose a risk, as has occurred in the past. Issuance of the USD1.5 billion eurobond and access to multilateral loans reduced the government's FX demand in the near term, but renewed external financing constraints could increase pressure on the exchange rate. Net foreign reserves stood at USD8.5 billion (6.1 months of goods imports) by April 2020.

ESG - Governance: Costa Rica has an ESG Relevance Score (RS) of '5' for both Political Stability and Rights, and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Costa Rica has a high WBGI percentile of 70.7%, reflecting its long track record of stable and peaceful political transitions, well established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Costa Rica a score equivalent to a rating of 'BBB' on the LT FC IDR scale.

In accordance with its rating criteria, Fitch's sovereign rating committee decided to adjust the rating indicated by the SRM by more than the usual maximum range of +/- three notches because of the extent of Costa Rica's sharply rising debt burden, fiscal budget financing constraints and emergence of macroeconomic vulnerabilities.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

--Structural: -2 notches; one negative notch reflects a long track record of institutional gridlock that has hindered progress on necessary reforms, which is not fully captured in the WBGI in the SRM. Fitch added an additional negative notch to highlight the constraints on external financing posed by political gridlock in the context of the current crisis.

--Fiscal: -2 notches; reflects the severe constraints on fiscal financing flexibility, and reflects our expectation that government debt will continue to rise fairly rapidly over the medium term while the appetite to further increase the revenue base is limited.

--External: -1 notch; reflects the institutional gridlock that led to periodic barriers to external bond issuance. Absent authorization for further external bond issuances, the government would be a net buyer of FX rather than a supplier, increasing external vulnerabilities.

--Macro: -1 notch; reflects policy framework weakness, as evidenced by the government's decision to use short-term financing from the central bank, as well as spillover effects from the fiscal imbalances affecting macro stability.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

--Evidence of sovereign funding stress in the event that external and domestic borrowing sources cannot be accessed, or a significant buildup of short-term debt liabilities;

--Increased risks to debt sustainability reflected by difficulty in post-crisis fiscal consolidation, weaker economic recovery prospects and increase in borrowing costs;

--Evidence of external liquidity stress; for example, a significant sharp decline of international reserves.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

--Sustained improvement in government financing flexibility, including sustained access to external funding sources.

--Greater confidence in the political commitment to fiscal consolidation that significantly reduces the steep upward trajectory of the government's debt/GDP ratio.

--Reduction of political fragmentation that supports more cohesive policy making, for example, a significant improvement in the relationship between the executive branch and the legislative assembly.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Public Finance issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

KEY ASSUMPTIONS

Fitch assumes the global economy performs broadly in line with its most recent Global Economic Outlook (GEO) published in April 2020.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Costa Rica has an ESG Relevance Score of '5' for Political Stability and Rights, as WBGIs have the highest weight in Fitch's SRM, are highly relevant to the rating and a key rating driver with a high weight.

Costa Rica has an ESG Relevance Score of '5' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption, as WBGIs have the highest weight in Fitch's SRM, and are therefore highly relevant to the rating and are a key rating driver with a high weight.

Costa Rica has an ESG Relevance Score of '4' for Human Rights and Political Freedoms, as strong social stability and voice and accountability are reflected in the WBGIs that have the highest weight in the SRM. They are relevant to the rating and a rating driver.

Costa Rica has an ESG Relevance Score of '4' for Creditor Rights, as willingness to service and repay debt is relevant to the rating and is a rating driver for Costa Rica, as for all sovereigns.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg..