Costa Rica, Falling Angels, and Fair Winds

22 September 2014


Last month, we spoke about the economic data and corporate investment opportunities in Costa Rica. Today we focus once again on that Central American state because on September 16th 2014, Moody’s followed the lead of both Standard & Poor’s and Fitch in downgrading Costa Rica’s government bonds from investment grade to “junk bond” status.

The Costa Rican political system is broadly similar to that of the United States. Since attaining office in May 2014 the administration of President Solis has – like its immediate predecessor – been unsuccessful in brokering an arrangement with a politically unsympathetic congress, to pass fiscal measures that would address the issue of the country’s growing fiscal deficits and increasing debt burden.

The fiscal deficit has averaged 4.5% of Gross Domestic Product (GDP) since 2009, largely driven by unchecked spending growth and poor tax receipts, and is expected to reach 5.8% by the end of 2014. The level of these high annual deficits has materially impacted upon Costa Rica’s debt burden, with debt to GDP expected to rise close to 40% for 2014. Compared to other countries in the region this may not seem high, but measured against the 25% of GDP recorded in 2008 by Costa Rica the climb is significant.

In real terms interest costs on the accumulated government debt consumes over 30% of the government’s annual tax revenues. In the absence of political consensus the government has been unable to pass measures that would introduce value added tax. Nor have they managed to reform an income and corporate tax system that encourages tax evasion and hinders tax collection. In the short to medium term tax revenues may remain relatively stagnant.

Costa Rica has chosen to finance a significant portion of its long term borrowing in Eurobonds.

In April 2014 the Government issued US$1billion in debt on the international market with a 30 year term and a coupon rate of 7% via an issue of Eurobonds. This was significantly above the 5.63% set a year previously for a similar issue (also for $1billion). The additional premium reflects the market’s perception of risk, generated by unchecked and continued fiscal deficits.

In 2015, if the country sticks to its medium term plan, a further $1 billion in Eurobonds will be offered.

What does this mean for investors?

Firstly, the reclassification of existing government bonds to “junk status” does not mean that the existing stock of Eurobonds trading on international markets is worthless.

When the “Angels Fall” and an investment grade bond is reclassified to junk status, all that is effectively happening is that the market is adjusting to reflect the increased risk profile of the borrower.

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In Costa Rica’s case the adjustment is significant in that it takes the country’s risk profile from the lowest rung in the investment grade classification into junk bond status. Since in normal market conditions, the return on the pool of existing bonds is considered to be more “questionable”, its market or trading price falls so that the effective yield the Eurobond pays (measured by dividing the coupon return by the market price) rises.

Secondly, in Costa Rica’s case the general economic indicators remain positive despite some significant internal shocks in 2014. Without question the most painful of these shocks was the announcement by Intel (the international computer processor manufacturer) in April 2014 that it plans to close its Costa Rican factory and move its operations to Malaysia, Vietnam and China. For Costa Rica this is a significant blow, since historically the operations of Intel have amounted to over $2 billion per year, representing approximately 20% of its annual exports.

Thirdly, any Eurobond issue in 2015 is almost certainly going to be at a rate above 7%. For those with appetite for investments in emerging markets that offer high returns, and who are prepared to stomach the risk, any future Eurobond issues may well prove attractive. They are also likely to be oversubscribed. (The 2014 Eurobond issue of $1billion attracted offers in excess of $4billion reflecting the markets willingness to lend to Costa Rica).

Fourthly, if you compare Costa Rica with other emerging countries in the region – such as Chile and Mexico – you find that most are paying more to borrow on international markets.

It is almost an anachronism to state that Costa Rica’s democratic system, which fragments power between the President and Congress, has contributed significantly to its downgrading. In the event that no consensus can be found on the issue of tax reform and addressing the fiscal deficit, its grading is unlikely to improve although its underlying economic markers should remain positive.

Despite recent shocks, Costa Rica remains successful at attracting foreign investors, has made significant inroads at controlling inflation, is politically stable, and has a deep pool of educated and talented workers. In short Costa Rica – which translates literally to “Rich Coast” – remains an attractive investment opportunity despite its investment grading.  Short term shocks and volatility aside, in the medium term the winds are likely to remain more than favourable to Costa Rica.

If you are interested in investing in Costa Rican Eurobonds, or wish to discuss other investment opportunities with a member of our team please contact info@nullfirstlinesecurities.com or call for Mrs. Ihsan Slater at 868.628.1175. We look forward to hearing from you.

Mike Sims FCA, LL.B

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