Fitch Affirms 'BB' Foreign Currency Rating of Costa Rica; Outlook Negative.

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

The Negative Outlook and the ratings reflect Fitch's concerns over Costa Rica's persistently high fiscal deficits and the high level of dollarization of its banking system, which in the context of a crawling peg regime increases the country's financial vulnerability. Since the Negative Outlook was assigned last year, the government has made efforts to prevent a further deterioration of its finances. This, combined with higher GDP growth last year has prevented the government's debt from increasing sharply. These positive developments have forestalled downward pressure on the rating for now. Even so, stabilization of the sovereign rating would require inter alia the passage of fiscal reforms, as these are critical to improving public finances and sustaining a higher level of growth. A tighter fiscal stance would also lead to an eventual reduction of other weaknesses in the economy, such as large current account deficits, widespread dollarization, and relatively high inflation.

Last year the Costa Rican economy rebounded smartly, driven by higher exports and expansion in the telecommunication sector. Its economy grew at 6.5% in 2003 and is expected to grow at nearly 4% this year. In 2003, higher growth, combined with greater revenues from the contingency fiscal package (CFP) helped to rein in the central government fiscal deficit to 2.9% of GDP. In 2004, the government is exercising expenditure restraint to maintain the central government budget deficit at last year's level. Even so, a permanent reduction in the fiscal deficit will require the passage of a revenue-enhancing tax reform. The prospects of passing the comprehensive fiscal reform, which the authorities believe can raise over 2% of GDP, remain unclear, as smaller opposition parties are using delaying tactics to prevent Congress from voting on it.

Costa Rica also needs to consolidate its fiscal accounts to make room for contingent liabilities that could arise from the banking sector. Although private participation has increased in the sector, public sector banks control over 50% of the system's assets and enjoy a blanket state guarantee on their deposits. Moreover, high domestic interest rates, in part driven by persistent fiscal deficits, have led to the widespread dollarization of the banks' balance sheet. Of further concern, a significant proportion of the dollar loans are being made to nondollar earners, exposing banks to significant credit risk.

Due to the low saving rate in the economy, Costa Rica suffers from the 'twin deficit' problem, whereby high fiscal deficits get readily reflected in the large external account deficits. Current account deficits have averaged 5% of GDP over the past five years. Fortunately, foreign direct investment flows have been robust, which have helped in financing over 50% of the current account deficit.

On the positive side, Costa Rica's rating strengths include its modest external debt burden, a successful diversification of its export base, and relatively strong social indicators, distinguishing it from other countries in the region. Costa Rica's vibrant democratic institutions reduce political transition risk, though the high premium that the society places on consensus building has delayed the passage of reforms.

Stabilization in Costa Rica's creditworthiness would depend much on the ability of the government to tackle its fiscal deficits and pass a revenue-enhancing tax reform. Measures to strengthen the banking system, including better scrutiny of off-shore banks, as well as reversal of dollarization would be viewed positively. The implementation of Central America Free Trade Agreement (CAFTA) with the U.S. and passage of laws to improve the regulatory frameworks in the telecom and insurance sectors would also represent positive developments.