Fitch Affirms 'BB' F-C Rating of Costa Rica; Outlook Negative.

NEW YORK -- Fitch Ratings today affirmed the Republic of Costa Rica's long-term foreign and local currency ratings of 'BB' and 'BB+' respectively. The Rating Outlook is Negative.

The ratings have remained on a Negative Outlook since 2003, reflecting Fitch's continuing concerns that the government is not taking sufficient measures to solidify public finances in order to preserve macroeconomic stability over the medium term. This, combined with the country's crawling peg exchange rate regime, limited 'usable' international reserves as well as a relatively weak banking sector have increased the vulnerability of Costa Rica to external shocks. Finally, Costa Rica is one of the few Central American countries that is delaying the passage of the U.S.-Central American Free Trade Agreement (CAFTA) in its Congress. In Fitch's opinion, the passage of a structural fiscal reform, continued fiscal restraint and the passage of CAFTA in the Costa Rican Congress could help in stabilizing sovereign creditworthiness.

Fiscal performance has improved since 2002, due to higher tax revenues and better control of expenses. Similarly, higher growth and better fiscal performance have stabilized the debt burden. In addition, the authorities passed a social security reform last year, which would increase the life of the state pension system. However, without a tax-enhancing fiscal reform, it is unlikely that further fiscal consolidation can be pursued. The reform under discussion is promising because it could raise revenues by up to 2% of GDP, a part of which could be used by the Treasury to recapitalize the central bank. This in turn, would allow the central bank to implement a more flexible monetary policy to reduce inflation. Despite its obvious benefits, it is still unclear whether the comprehensive fiscal reform that has been in discussion in Congress for more than two years will be passed this year due to the impending presidential and congressional elections in February 2004.

Another vulnerability of Costa Rica is its relatively low level of external liquidity in the context of a crawling peg regime. Furthermore, the exchange rate regime has introduced inertia in inflationary expectations and has also led to widespread dollarization of the financial sector. Fitch also believes that the Costa Rican banking system is weaker than some of the other 'BB' credits due to high incidence of state ownership, widespread dollarization, regulatory and supervisory shortcomings and the presence of an off-shore banking system. Thus, the system represents a contingent liability to the sovereign. As such, it is important for the authorities to pass the financial sector reform that allows better scrutiny and supervision of the off-shore banking system.

Credit strengths include Costa Rica's stable political system as well as good social indicators. Among the 'BB' rated sovereigns, Costa Rica's per capita income is the highest and its democratic institutions have performed relatively well during past economic and political stresses. Additionally, Costa Rica's five year average growth rate of over 4% is in line with the 'BB' median. Costa Rica's political stability and the availability of well-educated labor force have helped in attracting foreign direct investment flows. FDI has been high in the electronics sector (predominantly Intel), medical devices, software services and business processing outsourcing.

The outlook for Costa Rica's balance of payments could improve further if the country is able to pass the CAFTA soon. Potentially higher capital inflows could increase foreign exchange reserves. Passage of CAFTA could also buttress local investor confidence and help improve productivity and overall growth as telecom and insurance sectors are liberalized under CAFTA provisions.

Fitch will continue to monitor the progress of fiscal reform in Congress in the coming months. Its passage will go a long way toward stabilizing sovereign creditworthiness. In addition, Costa Rica's vulnerabilities could be reduced if the authorities are able to maintain control over the fiscal deficit and pass CAFTA in Congress.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.