country forecast

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Page 2 Map

Political Risk Services Costa Rica Country ForecastReproduction without written permission of The PRS Group is strictly prohibited.

REV2003

Costa Rica

Nicaragua

Panama

q

q

q

q

q

q

q

C a r i b b e a n S e a

P a c i f i c O c e a n

Liberia

Puntarenas

PuertoLimn

San Isidro

San Jos

q

Golfito

Puerto Quepos

AlajuelaNicoyaq

q

Moin

Caldera


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Political Risk Services1-Oct-2010 Reproduction without written permission of The PRS Group is strictly prohibited.

Highlights 1-Oct-2010 Page 3

Costa RicaCountry ForecastHighlights

MOST LIKELY REGIMES AND THEIR PROBABILITIES

18-Month: Divided Government 60%

Five-Year: Divided Government 65%

FORECASTS OF RISK TO INTERNATIONAL BUSINESS

Turmoil

Financial

Transfer

Direct

Investment

Export

Market18-Month: Low B (B+) A- A-

Five-Year: Moderate (Low) B- (B) B- (B) B-( ) Indicates change in rating. * Indicates forecast of a new regime.

KEY ECONOMIC FORECASTS

YearsReal GDPGrowth % Inflation %

CurrentAccount ($bn)

2005-2009(AVG) 4.9 11.2 -1.39

2010(F) 3.8 5.8 -0.92

2011-2015(F) 4.3 6.8 -1.80

A Strong Start

Key Points To Watch

Like other Costa Rican presidents, Laura Chinchillas party does not havean outright majority in the 57-member Legislative Assembly, but heraccomplishments thus far and her plans for the future seem to be wellsupported by the electorate

Her PLN party holds only about 42% of the seats in the Assembly, and sheis counting on the cooperation of the nine ML lawmakers for a majority, butthe ML is likely to oppose Chinchillas proposed tax hikes (while alsotolerating a larger near-term fiscal deficit)


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Political Risk Services Costa Rica Country Forecast1-Oct-2010 Reproduction without written permission of The PRS Group is strictly prohibited.

Page 4 1-Oct-2010 Highlights

Both Oscar Arias and his predecessor, Abel Pacheco, attempted to winapproval of tax reforms during their tenures as president, but were stymiedby their lack of a reliable legislative majority

Chinchilla is counting on a heightened sense of urgency to produce adifferent result on her watch

Security and Trade Issues

The governments chances of success are directly related to the presidentspopularity, and Chinchillas support is more likely to fall than to rise

The main risk is that she might fail to address the publics concerns aboutthe worsening security situation in Costa Rica, which has long enjoyed a

reputation as a relatively safe haven within Central America

While some progress on trade deals has been made, the outlook for CostaRica to secure ratification of the FTA with China and a regional associationagreement with EU are less than bright.

Economic Forecasts for the Three Alternative Regimes

Divided Government Centrist Coalition PLN-PAC

Growth

(%)Inflation

(%)CACC

($bn)Growth

(%)Inflation

(%)CACC

($bn)Growth

(%)Inflation

(%)CACC

($bn)

2010 3.8 5.8 -0.92 4.3 5.9 -1.35 2.9 5.2 -0.752011-2015 4.3 6.8 -1.80 4.7 6.0 -2.00 3.3 9.5 -2.25


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Current Data 1-Oct-2010 Page 5

Political Fact Sheet

CAPITAL:

San Jos

CONSTITUTION:

November 9, 1949

ADMINISTRATIVE SUBDIVISIONS:7 provinces, 81 cantons

POPULATION:

2009: 4.58 million

AREA:50,900 sq. km.

OFFICIAL LANGUAGE:

Spanish

STATUS OF PRESS:

free

SECTORS OF GOVERNMENT

PARTICIPATION:

petroleum refining, insurance and banking,transportation, communications, publicutilities, agriculture, commerce,development

CURRENCY EXCHANGE SYSTEM:crawling band

EXCHANGE RATE:

9/17/2010 $1=514.38 colnes

ELECTIONS:

Presidential and legislative elections are heldevery four years; last, February 7, 2010; next,scheduled February 2014.

HEAD OF STATE:

President Laura Chinchilla Miranda (2010)

HEAD OF GOVERNMENT:

President Chinchilla (2010)

OFFICIALS:

Alfio Piva, First Vice PresidentLuis Liberman, Second Vice President

Gloria Abraham, AgricultureMayi Antillon, Economy, Industry & TradeLeonardo Garnier, EducationTeofilo de la Torre, Environment & EnergyFernando Herrero, FinanceRene Castro Salazar, Foreign RelationsAnabel Gonzalez, Foreign TradeMaria Luisa Avila, HealthHernando Paris, JusticeSandra Piszk, Labor & Social SecurityLaura Alfaro, Planning & Economic PolicyJose Maria Tijereno, Public Security, Government

& Police

Carlos Ricardo Benavides, Tourism

LEGISLATURE:

Unicameral: 57-member Legislative Assembly.Distribution of seats: National Liberation Party(PLN), 24; Citizen Action Party (PAC), 11;Libertarian Movement (ML), 9; Social ChristianUnity Party (PUSC), 6; Access without ExclusionParty (PAE), 4; other, 3.


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Costa Rica

Databank

Reproduction without written permission of

The PRS Group is strictly prohibited.Political Risk Services1-Oct-2010

2000-2004

Average

2005-2009

Average 2000 2001 2002 2003 2004

Domestic Economic Indicators

GDP (Nominal, $bn) 17.06 25.54 15.95 16.40 16.84 17.52 18.60

Per Capita GDP ($) 4163 5716 4059 4090 4107 4191 4366

Real GDP Growth Rate (%) 3.3 4.9 1.8 1.1 2.9 6.5 4.2

Inflation Rate (%) 10.7 11.2 11.0 11.3 9.2 9.5 12.3

Capital Investment ($bn) 3.17 5.39 2.84 3.00 3.18 3.36 3.46Capital Investment/GDP (%) 18.6 20.9 17.8 18.3 18.9 19.2 18.6

Budget Revenues ($bn) 2.25 3.79 1.94 2.14 2.17 2.46 2.54

Budget Revenues/GDP (%) 13.2 14.8 12.2 13.0 12.9 14.0 13.7

Budget Expenditures ($bn) 2.76 4.06 2.40 2.58 2.84 2.93 3.04

Budget Expenditures/GDP (%) 16.1 15.9 15.0 15.7 16.9 16.7 16.3

Budget Balance ($bn) -0.51 -0.27 -0.46 -0.44 -0.67 -0.47 -0.50

Budget Balance/GDP (%) -3.0 -1.1 -2.9 -2.7 -4.0 -2.7 -2.7

Money Supply (M1, $bn) 1.60 2.47 1.47 1.58 1.64 1.74 1.59

Change in Real Wages (%) 0.4 1.2 1.2 1.0 1.6 1.8 -3.4

Unemployment Rate (%) 6.2 6.0 5.2 6.1 6.4 6.7 6.5

International Economic IndicatorsForeign Direct Investment ($bn) 0.58 1.53 0.41 0.46 0.66 0.58 0.79

Forex Reserves ($bn) 1.55 3.41 1.29 1.30 1.47 1.81 1.89

Gross Reserves (ex gold, $bn) 1.58 3.48 1.32 1.33 1.50 1.84 1.92

Gold Reserves ($bn) 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Gross reserves (inc gold, $bn) 1.58 3.48 1.32 1.33 1.50 1.84 1.92

Total Foreign Debt ($bn) 5.27 7.96 4.59 4.88 5.26 5.89 5.71Total Foreign Debt/GDP (%) 30.8 31.4 28.8 29.8 31.2 33.6 30.7

Debt Service ($bn) 1.03 0.41 0.64 0.91 0.81 1.61 1.18

Debt Service/XGS (%) 12.5 3.5 7.8 12.5 10.7 18.5 12.9

Current Account ($bn) -0.77 -1.39 -0.71 -0.60 -0.86 -0.88 -0.80

Current Account/GDP (%) -4.5 -5.4 -4.5 -3.7 -5.1 -5.0 -4.3

Current Account/XGS (%) -9.4 -10.6 -8.7 -8.2 -11.3 -10.1 -8.8

Exports ($bn) 5.71 8.58 5.81 4.92 5.27 6.16 6.37

Imports ($bn) 6.67 11.56 6.02 5.74 6.55 7.25 7.79Trade Balance ($bn) -0.96 -2.99 -0.21 -0.82 -1.28 -1.09 -1.42

Exports of Services ($bn ) 2.00 3.38 1.94 1.93 1.87 2.02 2.24

Income, credit ($bn) 0.18 0.26 0.24 0.19 0.16 0.15 0.14

Transfers, credit ($bn) 0.30 0.62 0.20 0.27 0.30 0.37 0.37

Exports G&S ($bn) 8.18 12.83 8.19 7.31 7.60 8.70 9.12

Liabilities ($bn) 0.68 0.17 0.95 0.81 0.72 0.62 0.32

Net Reserves ($bn) 0.90 3.31 0.37 0.52 0.78 1.22 1.60

Liquidity (months import cover) 1.5 3.4 0.7 1.1 1.4 2.0 2.5

Currency Exchange Rate 366.696 521.048 308.190 328.870 359.820 398.660 437.940

Currency Change (%) -8.9 -5.6 -7.9 -6.7 -9.4 -10.8 -9.9

Social Indicators

Population (million) 4.10 4.46 3.93 4.01 4.10 4.18 4.26

Population Growth (%) 2.1 1.5 2.3 2.0 2.2 2.0 1.9

Infant Deaths/1000 12 10 13 13 11 11 11

Persons under Age 15 (%) 31 29 32 32 31 31 31Urban Population (%) 54 62 49 51 54 57 60Urban Growth (%) 6.8 2.1 4.9 6.2 7.8 7.7 7.6

Literacy % pop. 95 96 95 95 95 95 96

Agricultural Work Force (%) 20 19 22 20 20 20 20

Industry-Commerce Work Force (%) 23 22 23 25 22 22 22

Services Work Force (%) 57 59 55 55 58 58 58

Unionized Work Force (%) 15 15 15 15 15 15 15

Energy - total consumption (1015 Btu) 0.16 0.18 0.15 0.16 0.16 0.17 0.17

Ener - consumption/head (109 Btu) 0.04 0.04 0.04 0.04 0.04 0.04 0.04

Current Data 1-Oct-2010 ~ Page 6-7


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Costa Rica

Databank

Reproduction without written permission of

The PRS Group is strictly prohibited.Political Risk Services1-Oct-2010

2000-2004

Average

2005-2009

Average

Domestic Economic Indicators

GDP (Nominal, $bn) 17.06 25.54

Per Capita GDP ($) 4163 5716

Real GDP Growth Rate (%) 3.3 4.9

Inflation Rate (%) 10.7 11.2

Capital Investment ($bn) 3.17 5.39Capital Investment/GDP (%) 18.6 20.9

Budget Revenues ($bn) 2.25 3.79

Budget Revenues/GDP (%) 13.2 14.8

Budget Expenditures ($bn) 2.76 4.06

Budget Expenditures/GDP (%) 16.1 15.9

Budget Balance ($bn) -0.51 -0.27

Budget Balance/GDP (%) -3.0 -1.1

Money Supply (M1, $bn) 1.60 2.47

Change in Real Wages (%) 0.4 1.2

Unemployment Rate (%) 6.2 6.0

International Economic IndicatorsForeign Direct Investment ($bn) 0.58 1.53

Forex Reserves ($bn) 1.55 3.41

Gross Reserves (ex gold, $bn) 1.58 3.48

Gold Reserves ($bn) 0.00 0.00

Gross reserves (inc gold, $bn) 1.58 3.48

Total Foreign Debt ($bn) 5.27 7.96Total Foreign Debt/GDP (%) 30.8 31.4

Debt Service ($bn) 1.03 0.41

Debt Service/XGS (%) 12.5 3.5

Current Account ($bn) -0.77 -1.39

Current Account/GDP (%) -4.5 -5.4

Current Account/XGS (%) -9.4 -10.6

Exports ($bn) 5.71 8.58

Imports ($bn) 6.67 11.56Trade Balance ($bn) -0.96 -2.99

Exports of Services ($bn ) 2.00 3.38

Income, credit ($bn) 0.18 0.26

Transfers, credit ($bn) 0.30 0.62

Exports G&S ($bn) 8.18 12.83

Liabilities ($bn) 0.68 0.17

Net Reserves ($bn) 0.90 3.31

Liquidity (months import cover) 1.5 3.4

Currency Exchange Rate 366.696 521.048

Currency Change (%) -8.9 -5.6

Social Indicators

Population (million) 4.10 4.46

Population Growth (%) 2.1 1.5

Infant Deaths/1000 12 10

Persons under Age 15 (%) 31 29Urban Population (%) 54 62Urban Growth (%) 6.8 2.1

Literacy % pop. 95 96

Agricultural Work Force (%) 20 19

Industry-Commerce Work Force (%) 23 22

Services Work Force (%) 57 59

Unionized Work Force (%) 15 15

Energy - total consumption (1015 Btu) 0.16 0.18

Ener - consumption/head (109 Btu) 0.04 0.04

2005 2006 2007 2008 2009

19.96 22.53 26.27 29.66 29.30

4610 5120 5890 6562 6397

5.9 8.8 7.8 2.6 -0.7

13.8 11.5 9.3 13.4 8.0

3.74 4.48 5.72 6.94 6.0918.7 19.9 21.8 23.4 20.8

2.78 3.20 4.07 4.73 4.16

13.9 14.2 15.5 16.0 14.2

3.20 3.40 3.92 4.67 5.12

16.0 15.1 14.9 15.8 17.5

-0.42 -0.20 0.15 0.06 -0.96

-2.1 -0.9 0.6 0.2 -3.3

1.81 2.33 2.82 2.82 2.58

-4.0 0.5 7.6 2.9 -0.8

6.6 6.0 4.6 4.9 7.8

0.86 1.47 1.90 2.08 1.35

2.28 3.08 4.08 3.77 3.83

2.31 3.11 4.11 3.80 4.07

0.00 0.00 0.00 0.00 0.00

2.31 3.11 4.11 3.80 4.07

6.76 7.19 8.44 9.06 8.3333.9 31.9 32.1 30.6 28.4

0.95 0.24 0.22 0.44 0.21

9.2 2.0 1.6 3.0 1.6

-0.98 -1.02 -1.65 -2.75 -0.57

-4.9 -4.5 -6.3 -9.3 -1.9

-9.4 -8.6 -11.9 -18.7 -4.3

7.10 8.10 9.30 9.55 8.84

9.26 10.83 12.28 14.57 10.88-2.16 -2.73 -2.98 -5.02 -2.04

2.62 2.97 3.55 4.15 3.59

0.19 0.25 0.34 0.28 0.24

0.47 0.59 0.73 0.71 0.59

10.38 11.91 13.92 14.69 13.26

0.21 0.13 0.11 0.12 0.30

2.10 2.98 4.00 3.68 3.77

2.7 3.3 3.9 3.0 4.2

477.790 511.300 516.620 526.240 573.290

-9.1 -7.0 -1.0 -1.9 -8.9

4.33 4.40 4.46 4.52 4.58

1.6 1.6 1.4 1.3 1.3

10 10 10 10 9

31 29 28 28 2761 61 62 62 623.1 1.6 3.4 1.3 1.3

96 96 95 95 96

20 20 20 20 14

22 22 22 22 22

58 58 58 58 64

15 15 15 15 15

0.17 0.18 0.18 0.19 0.19

0.04 0.04 0.04 0.04 0.04

Current Data 1-Oct-2010 ~ Page 6-7


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Costa RicaCountry Forecast1-Oct-2010 Comparison: Costa Rica

Page 8 1-Oct-2010 Current DataReproduction without written permission of The PRS Group is strictly prohibited

Regional Real GDP Growth (2009): N&C America

-8 -6 -4 -2 0 2 4

Mexico

El Salvador

Trinidad & Tobago

Jamaica

Canada

United States

Honduras

Nicaragua

Costa Rica

Guatemala

Cuba

Panama

Haiti

Dominican Republic

(percent)

Regional Inflation Rates (2009): N&C America

-4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0

Cuba

United States

Haiti

Canada

El Salvador

Dominican Republic

Guatemala

Panama

Nicaragua

Mexico

Honduras

Trinidad & Tobago

Costa Rica

Jamaica

(percent)


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Costa Rica Country Forecast1-Oct-2010 Comparison: Costa Rica

Current Data 1-Oct-2010 Page 9Reproduction without written permission of The PRS Group is strictly prohibited

Regional Current Account/GDP (2009): N&C America

-15.0 -10.0 -5.0 0.0 5.0 10.0

Nicaragua

Jamaica

Dominican Republic

Haiti

United States

Canada

Honduras

Costa Rica

El Salvador

Guatemala

Mexico

Panama

Cuba

Trinidad & Tobago

(percent)

Economic Performance Profile

Country's Ranking Relative to All Countries

Covered by Political Risk Services

2005-2009

5716

4.9

11.2

6.0

20.9

-1.1

-5.4

3.5

-5.6

BEST 25% NEXT 25% NEXT 25%

GDP Per Capita ($)

Real GDP Growth (%)

Inflation (%)

Unemployment (%)

Capital Investment

(% of GDP)

Budget Balance

(% of GDP)

Current Account

(% of GDP)

Debt Service Ratio

Currency Change (%)

WORST 25%


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Comment & Analysis 1-Oct-2010 Page 11

Costa RicaCountry ForecastComment & Analysis

Chinchilla Making a Strong Start

President Laura Chinchilla marked the end of her first 100 days in office in early Augustwith a speech highlighting the accomplishments of her first few months in office, andlaying out her priorities for the rest of the term. The achievements focused mainly on theearmarking of additional funds for social programs and security. As for her future plans,

Chinchilla affirmed her commitment to maintaining the policy course set by herpredecessor, Oscar Arias, which combined support for economic liberalization with apledge to ensure social justice for all Costa Ricans.

Chinchilla declared that her government will focus on four areas: social welfare,economic competitiveness, environmental protection, and domestic security. Each ofthese policy areas claims a strong political constituency, and her specific proposalsconstructing 20,000 new housing units for low-income families and expanding child-careand elder services, reducing the unemployment rate to 5% (from 7.8% in 2009) by the endof her term, generating electricity sufficient to meet national demand using 95%renewable resources, investing in upgrades to transportation, sewage, and otherinfrastructure, and enhancing the effectiveness of law enforcement through increases inmanpower, administrative reforms, and improved technical supportensured that mostof the electorate found something they could like in her program.

The strategy appears to have been effective. An August poll by Unimer showed just 38%of respondents rating Chinchillas performance as good or very good, but another 43%judged it to be acceptable, while only 12% assigned her a failing grade. On the separatequestion of confidence in Chinchillas leadership, she scored a 2.81 on a scale of 15 (thehighest number for a president in seven years), while 58% of respondents believed thatthe president is capable of solving problems given enough time, and 46% felt that her

administration can be trusted to effectively manage public expenditures (also a seven-yearhigh).

But Tax Reform Faces Hurdles

Whether Chinchilla will be able to muster the legislative support needed to put her planinto action is not entirely certain. Her National Liberation Party (PLN) holds just 24 seatsin the 57-member Legislative Assembly, and she is counting on the cooperation of the


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Page 12 1-Oct-2010 Comment & Analysis

nine lawmakers from the Libertarian Movement (ML) for a majority. However,Chinchillas proposal to hike taxes while also tolerating a larger fiscal deficit in the nearterm will likely run into opposition from the ML, which espouses the principles of limitedgovernment and fiscal restraint.

Costa Rica recorded small fiscal surpluses in 2007 and 2008, but last years economiccontraction resulted in a steep decline in revenues that in combination with increasedgovernment spending on stimulus measures produced a fiscal deficit equivalent to 3.3%in 2009. The 2011 budget calls for increases in spending on social programs and securitythat are projected to widen the deficit to 5.3% of GDP next year, but budget performancethrough the first seven months of 2010 suggests that the fiscal gap might be at least thatbig this year.

Finance Minister Fernando Herrero defended the planned larger deficits as necessary tosupport the economy until revenues return to pre-recession levels, but conceded that sucha sizeable shortfall cannot be sustained for an extended period of time. Indeed, theborrowing required to finance the projected deficits will likely increase total public debt tomore than 50% of GDP by 2011 (from less than 40% of GDP at the end of 2008), resultingin a heavier debt-service burden that could produce serious economic strains ifgovernment revenues do not make a strong and fairly rapid recovery.

As a first step, the administration has begun cracking down on tax evasion, which bysome estimates reduces government income by as much as 4% of GDP each year. But

even if that effort is successful, the government will not be able to fully finance itsspending pledges without broader tax reforms. The Finance Ministry has warned that thebudget shortfall could increase to more than 6% of GDP in 2012 if proposed tax reformsare not approved.

Many of the tax measures currently under consideration were first floated by the Ariasadministration. Among the most controversial are a tax on gambling enterprises and aspecial $300 levy on all registered businesses (regardless of size), the proceeds of whichwill be used exclusively for security-related spending. Other proposals include thereplacement of the current 13% sales tax with a value-added tax (VAT), a financial

services tax of 0.5%, and changes to the income-tax structure that would significantlyincrease the tax burden of those at the top of the income ladder. The governmentestimates that if enacted in its entirety, the tax-reform package will boost state income by2.5% of GDP annually.

Both President Arias and his predecessor, Abel Pacheco, attempted to win approval of taxreforms, but were stymied by their lack of a reliable legislative majority. Chinchilla iscounting on a heightened sense of urgency to produce a different result on her watch. In


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that regard, she has gained potentially helpful assistance from Rodrigo Bolaos Zamora,the head of the central bank, who has warned that Costa Rica will be in very deepfinancial trouble if tax reforms are not implemented by the end of 2011.

Despite such forecasts of doom, the tax proposals have encountered resistance from boththe left and the right. Predictably, the ML has voiced objections to any tax increases,arguing that the government should instead focus heavily on ensuring compliance withexisting tax rules. On the left, opponents of the tax proposals have noted the regressivecharacter of the VAT, and have called for the replacement of the flat $300 fee oncorporations with a progressive levy that would require large companies (such as Intel) topay a much larger sum than small family-run businesses.

Even if the Legislative Assembly approves the tax measures, rapid implementation is not

assured. Under Costa Rican law, any single lawmaker (or any private citizen, for thatmatter) can challenge the constitutionality of measures passed by the LegislativeAssembly on either substantive or procedural grounds, thereby forcing a review by thecourts that can take several months to complete, even in cases where the soundness of thelaw is confirmed.

Security Threat a Concern

The governments chances of success are directly related to the presidents popularity,and it is probably safe to assume that Chinchillas support is more likely to fall than torise. The main risk in that regard is that she might fail to address the publics concernsabout the worsening security situation in Costa Rica, which has long enjoyed a reputationas a relatively safe haven within Central America. In addition to rising property crime,Costa Rica has also become a battleground in a spreading war among gangs fighting forcontrol of the illegal drug trade between South and North America.

The threat of crime is emerging as a top issue among all sectors of Costa Rican society, butespecially among wealthier citizens, the most likely targets of criminals, and the businesscommunity, which recognizes the potential for heightened insecurity to deter investmentand discourage tourism, one of the countrys most important industries.

Chinchilla has adopted a two-track approach to addressing crime. On the one hand, thegovernment is pushing for tighter law enforcement. During her first 100 days, sheauthorized the hiring of hundreds of new police officers and established the funding toincrease prison capacity. On the other hand, the president has stressed the need to attendto the social causes of crime. Chinchilla contends that security issues cannot be divorcedfrom the conditions of poverty and inequality that breed crime, and has argued that a


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strong social safety net and an economic program that promotes healthy economicdevelopment are essential elements of an effective anti-crime strategy.

As for the threat posed by drug gangs, Chinchilla declared in an Independence Dayspeech that Costa Rica was no longer immune from the epidemic of deadly violence thathas driven up the murder rates in Guatemala and El Salvador. Warning that Costa Ricansmust not kid ourselves, she stated that the government is at the point of losingmeasures of control over sovereignty, territorial spaces, and the integrity of itsinstitutions.

Critics lambasted the speech as overblown fear-mongering that would unjustifiablystigmatize Costa Rica, and castigated Chinchilla for failing to propose any solutionsbeyond increased spending on social programs. However, just days after the presidents

speech, Costa Rica was for the first time ever identified by the US as a major world transitpoint for drug-trafficking. Officials in Washington were quick to point out that thedesignation was not a criticism, but rather a function of geography, and praisedChinchillas government for granting such high priority to security.

Officials in San Jose are hoping that US recognition of Costa Ricas vulnerability willtranslate into US support (financial and otherwise) that bolsters the governments effortsto improve security. Chinchilla has seized the opportunity, immediately dispatchingSecurity Minister Jose Maria Tijerino to Washington in search of help from the US.

Chinchilla Aims High

Even as her government pursues policies that are consistent with the PLNs socialdemocratic roots, Chinchilla is also planning a major push to boost investment, promoteinnovation, and expand trade ties, with the aim of positioning Costa Rica to become thefirst developed nation in Central America. Toward that end, Chinchillas government islooking to increase exports to $17 billion per year (nearly double the total for 2009) andhas established a goal of attracting $9 billion in new foreign direct investment (FDI) by theend of her term in 2014.

Key elements of the governments development plan include the ratification of free-trade

agreements (FTAs) concluded with the EU, China, and Singapore, the negotiation ofadditional trade treaties with a particular focus on Asia, upgrading the countryshighways and port facilities, and expanding competition in the electric-power market,which is currently controlled by the state-owned Costa Rican Institute of Electricity (ICE).The agenda is extremely ambitious, considering the limited progress made by Chinchillaspredecessors on all of these fronts, and given the similar legislative roadblocksconfronting the current administration, successful implementation is hardly a safe bet.


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Trade Deals Encounter Skepticism

Some progress has already been made on the trade front. Foreign Minister Ren Castrohas already traveled to Seoul, and reached an agreement to begin negotiations on an FTAwith South Korea, and Costa Rica and Canada are preparing to discuss an expansion oftheir bilateral agreement to include investment and trade in services.

However, the outlook for securing ratification of the FTA with China and a regionalassociation agreement with EU are less than bright. The FTA with China, in particular,has met with strong resistance from elements within Costa Ricas Chamber of Industries,most notably food producers, who have complained that the labor standards imposed bythe US under the Dominican Republic-Central American Free Trade Agreement (DR-

CAFTA) will make it impossible to compete with Chinese goods produced with muchcheaper labor. In late August 2010, the Chamber presented its argument to the LegislativeAssembly, contending that more limited commercial agreements with China would be farmore beneficial for Costa Rica than a comprehensive FTA.

The deal with the EU faces fewer obstacles, and is widely viewed by the business sector asan opportunity to boost investment and jobs without significantly undermining thecompetitiveness of key domestic industries. Nevertheless, as was made evident duringthe prolonged political battle over DR-CAFTA, the main opposition Citizen Action Party(PAC) is unlikely to back either of the deals.

The ML, which favors expanded trade ties, proved during the struggle to secureratification of DR-CAFTA that its support will require concessions in other policy areas,most likely with regard to the governments proposed fiscal reforms. If the ML demandsmore than Chinchilla is willing to concede, ratification of the trade deals will require thesupport of at least two of the smaller parties, a development that would bestow uponthem unexpected leverage that they will undoubtedly exploit to the hilt.

Thus, while Chinchilla is keen to implement the deals, she cannot count on majoritybacking for ratification. The FTA with China is clearly the most controversial, and thecombined opposition of the PAC, environmentalists, and domestic business groups may

be more than the new administration can overcome.

Brighter Prospects for Reform of Power Sector

The proposed liberalization of the electricity market is also a sticky political issue.Previous attempts to break ICEs monopoly have been thwarted by opposition from thecompanys employees and leftist elements in the Legislative Assembly, who have


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characterized such efforts as back-door privatization that would result in job losses,higher costs, and inadequate services for rural communities.

The government argues that private companies would complement the role played byICE with the aim of ensuring that supply keeps pace with demand, and that contracts willbe awarded on the basis of prices and quantities of electricity, with preference alsogranted to bidders making use of renewable resources. The draft legislation also includesrequirements intended to ensure that services are available to all areas, regardless ofpopulation density or income levels.

The safeguards included in the draft legislation might be sufficient to sway reluctantlawmakers. However, there is still some question whether a supermajority is required tosecure approval of the reform, which, if nothing else, means the measure is certain to be

subjected to a court challenge if the government attempts to implement it on the authorityof a simple majority.

Mining Halted

One sector that does not figure to play a prominent role in the administrations economicdevelopment plans is mining. Just hours after taking office on May 8, Chinchilla issued adecree restoring a ban on all new open-pit gold mining in the country that had been liftedby Arias in 2008. The lone active gold mining operation, which is owned by CanadasInfinito Gold, has been embroiled in a two-year court battle.

Chinchillas decree came in response to pressure from local community groups and from

environmental activists who contend that mining operations will destroy the habitat ofendangered species, thereby limiting Costa Ricas potential to become a world leader inthe development of green tourism. The president declared the decree to be consistentwith the publics rejection of extractive industries, which would seem to pretty muchrule out any potential for flexibility.

Weak Demand Will Hinder Recovery

Real GDP growth slowed to 3.7% (year-on-year) in the second quarter of 2010, afterrebounding to 6% in the first quarter of the year. The most recent data for the monthlyindex of economic activity (IMAE) confirmed that the declining trend continued into July,

with the figures for agriculture, manufacturing, hotels, and financial services all slightlylower than in June, while the pace of contraction in the weakest sectors, most notablyconstruction, barely slowed.

The government has raised its forecast for annual real GDP growth in 2010 to 4.5%, andsees the growth rate reaching 5% in 2011. However, these optimistic projections assume acontinued improvement in external conditions, in general, and a solid recovery in the US,in particular. Given the debt troubles in the EU, which point to a stalling of the economic


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recovery in Europe, the uncertain fate of the FTA with China, and the questionablesustainability of the US recovery, the official forecast is probably too optimistic. Althoughgovernment spending will boost the domestic contribution to growth, the pace ofexpansion will be held to less than 4% in 2010.

Chinchillas ability to rely on fiscal tools to spur significantly faster growth in 2011 willdepend on the fate of the administrations tax measures, which remains quite uncertain.Even in a best-case scenario, securing approval of the tax reforms will likely necessitatechanges that reduce the revenue-generating potential of the measures, making it difficultto narrow the large deficit without cuts to spending. On that basis, and assuming thecontinued sluggishness of US and European demand, real GDP growth will be held to3.5%4% once again next year.

Inflation eased to slightly more than 4% (year-on-year) in December 2009, holding theannual average rate to 8%, the lowest figure in decades, but still the highest rate in CentralAmerica last year. Weak domestic demand and the significant appreciation of the localcurrency since July have contributed to lower inflation in recent months. The consumerprice index rose by just 5% (year-on-year) in September, bringing the average for the firstnine months of the year to 5.6%, below the upper end of the central banks target range of4%6%. The inflation rate is expected to trend upward over the remainder of the year,mainly owing to the base effect, but the annual average increase in consumer prices isforecast to remain close to the 6% target. The growth outlook for 2011 suggests thatdemand pressures will remain under control next year, although fairly robust statespending and a weakening of the colon is expected to push the inflation rate above 6%.

The trade deficit narrowed significantly in 2009, as imports fell much more sharply thanexports, reflecting the impact of weaker domestic demand and lower prices for stapleimports. Weaker flows of remittances and income from tourism resulted in somewhatsmaller surpluses in the services and transfers balances that in combination with anexpansion of the income deficit contributed to a less pronounced (but neverthelesssubstantial) narrowing of the current account deficit in 2009.

Exports to China, Costa Ricas second most important trade partner after the US,increased by 13% in 2009, and will continue to grow this year, regardless of the extent ofprogress on ratification of the FTA. However, the continued weakness of US andEuropean demand will dampen overall growth of exports, while higher global prices forcommodities will contribute to a more rapid recovery of imports, resulting in a largertrade deficit that will widen the current account shortfall to $920 million, equivalent toabout 3% of GDP, in 2010. The slow but steady recovery of the economy will beaccompanied by a gradual strengthening of domestic demand that will fuel growth ofimports, resulting in a further increase in the external deficits in 2011.


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Forecast Scenarios 1-Oct-2010 Page 19

Costa RicaCountry ForecastForecast Scenarios

SUMMARY OF 18-MONTH FORECAST

REGIMES & PROBABILITIESDividedGovernment 60%

Centrist Coalition30%

PLN-PAC10%

SUMMARY OF FIVE-YEAR FORECAST



PLN-PAC10%

Most Likely Regime Scenario

18-Month Forecast Period:Divided Government (60% Probability)Five-Year Forecast Period:Divided Government (65% Probability)

It has been a fairly consistent feature of Costa Ricas politics that the party of the victor inthe presidential election falls short of an outright majority in the 57-member LegislativeAssembly, making it incumbent upon each new government to forge alliances withsmaller parties in order to secure the passage of legislation. The power of the presidentialoffice is inherently weak, owing to a constitutional prohibition against immediate re-election, and the characteristic diffusion of legislative power among several parties makesthe task of governing that much more difficult.

The outcome of the 2010 elections was perfectly consistent with that picture. LauraChinchilla, the candidate of the incumbent National Liberation Party (PLN), won adecisive victory at the presidential election held on February 7, 2010, campaigning on apledge to continue the policy course set by her predecessor, Oscar Arias, which combinedsupport for economic liberalization with a pledge to ensure social justice for all CostaRicans. She garnered 46.8% of the vote, compared to just 25.2% for her main rival, OttnSols, the leader of the left-leaning Citizen Action Party (PAC).

DividedGovernment

Growth(%)

Inflation(%)

CACC($bn)

2010 3.8 5.8 -0.92

2011-2015 4.3 6.8 -1.80


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Page 20 1-Oct-2010 Forecast Scenarios

However, the PLN once again fell short of 29 seats, actually suffering a net loss of oneseat that reduced its total to 24, while the PACs seat total dropped by six to 11. TheLibertarian Movement (ML), whose leader, Otto Guevara, finished third in the

presidential balloting, gained three seats for a total of nine, while the Social ChristianUnity Party (PUSC), at one time a major political player, picked up one additional seat toincrease its total to six. The only other party with more than a single seat is the Accesswithout Exclusion Party (PAE), which increased its total by three seats to four.

In a speech marking the end of her first 100 days in office, Chinchilla affirmed hercommitment to honoring her campaign promises, declaring that her government willfocus on four policy areas: social welfare, economic competitiveness, environmentalprotection, and domestic security. Each of these issues claims a strong politicalconstituency, and her specific proposalsconstructing 20,000 new housing units for low-

income families and expanding child-care and elder services, reducing theunemployment rate to 5% (from 7.8% in 2009) by the end of her term, generatingelectricity sufficient to meet national demand using 95% renewable resources, investingin upgrades to transportation, sewage, and other infrastructure, and enhancing theeffectiveness of law enforcement through increases in manpower, administrative reforms,and improved technical supportensured that most of the electorate heard at leastsomething they liked.

Whether Chinchilla will be able to muster the legislative support needed to put her planinto action is debatable. She is counting on the cooperation of the nine lawmakers fromthe Libertarian Movement (ML) for a majority in the Legislative Assembly. However, thegovernments plan to rely on continued deficit spending in the near term and proposedtax increases that will be essential if the PLN is to have any hope of fulfilling its promiseswithout a dangerous run-up of the public debt over the medium term will almostcertainly encounter opposition from the ML, which espouses the principles of limitedgovernment and fiscal restraint.

Other elements of Chinchillas program, including plans to move aggressively toconclude new free-trade agreements (FTAs), are expected to encounter strong oppositionfrom the PAC and other left-leaning parties, as well as environmental groups andbusiness groups representing the industries most vulnerable to increased foreign

competition, and the PLN will need to strike bargains with smaller parties on an ad-hocbasis to win backing for ratification. Efforts to introduce greater competition in keymarketsincluding electricity generation and telecommunicationswill similarlyrequire drawn out negotiations, and concessions made to obtain the necessary legislativevotes will limit the extent of such liberalization as does take place.


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In most respects, the trajectory of Chinchillas tenure is expected to follow the pattern ofher two most recent predecessors, with the stalling or dilution of key parts of thegovernments agenda producing disappointment among the electorate, and the resulting

decline in the presidents popular support reducing her leverage in negotiations withessential allies in the Legislative Assembly. In short, the most likely scenario for the five-year forecast period is the continuation of the political gridlock that has prevailedthrough most of the last decade.

Legislative Obstacles Will Impede Liberalization

Even as her government pursues policies that are consistent with the PLNs socialdemocratic roots, Chinchilla is also planning a major push to boost investment, promoteinnovation, and expand trade ties, with the aim of positioning Costa Rica to become thefirst developed nation in Central America. Toward the end, Chinchillas government is

looking to increase exports to $17 billion per year (nearly double the total for 2009) andhas established a goal of attracting $9 billion in new foreign direct investment (FDI) bythe end of her term in 2014.

Key elements of the governments development plan include the ratification of free-tradeagreements (FTAs) concluded with the EU, China, and Singapore, the negotiation ofadditional trade treaties with a particular focus on Asia, upgrading the countryshighways and port facilities, and expanding competition in the electric-power market,which is currently controlled by the state-owned Costa Rican Institute of Electricity (ICE).The agenda is extremely ambitious, considering the limited progress made by

Chinchillas predecessors on all of these fronts, and given the similar legislativeroadblocks confronting the current administration, successful implementation is hardly asafe bet.

Beyond the obvious impediments posed by divisions within the legislature, the prospectsfor fully realizing the potential of trade and investment opportunities are furtherdampened by the organized resistance of environmental groups to increased investmentin extractive sectors. The license issued to Canadas Infinito Gold to clear some 262hectares of forest, including some protected species of trees, as part of a plan to developthe Las Crucitas gold mine, has been suspended for nearly two years, as environmental

activists have challenged the legality of the procedures by which the license and otherpermits were issued. Within hours of being sworn into office, Chinchilla issued a decreerestoring a ban on all new open-pit gold mining, which had been lifted by Arias in 2008.Environmentalists contend that mining operations will destroy the habitat of endangeredspecies, thereby undermining the countrys potential as a preferred destination for greentourists. The president declared the decree to be consistent with the publics rejectionof extractive industries, which would seem to pretty much rule out any potential for


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flexibility. In any case, the dispute over Las Crucitas will likely warn off other potentialinvestors operating in environmentally sensitive sectors.

Despite the handicaps arising from PACs aggressive opposition strategy and the activistposture of the courts, the Arias administration succeeded in implementing policies thatwill contribute to an improved climate for business and trade going forward. Theprevious government took the first steps toward opening up the countrystelecommunications market under legislation that was approved as part of the process ofimplementing DR-CAFTA. In October 2008, the Public Services Regulatory Agency(ARSP) published new rules for companies in the sector that, among other things, requirecarriers to service all areas of the country, regardless of profitability, with resulting lossesto be covered in part by a 1.5%3% tax on services. In addition, telecom companies willbe required to ensure interconnectivity of their networks, and prohibitions on monopolies

and other forms of unfair competition will be enforced by a new agency established tosupervise the sector.

Managers of the state-owned Costa Rican Electricity Institute (ICE), which was forced tosurrender its monopoly over both telecommunications and electricity services as a resultof DR-CAFTA-related reforms, expect that foreign firms will seek to partner with thedomestic giant, rather than trying to compete head-to-head. Opportunities in theinsurance sector will similarly expand as a result of legislation related to DR-CAFTA.

The government has adopted a similar position in its efforts to secure legislative backingfor reforms that would similarly enhance competition in the generation and distributionof electricity. Chinchilla argues that private companies would complement the roleplayed by ICE, with the aim of ensuring that supply keeps pace with demand, and thatcontracts will be awarded on the basis of prices and quantities of electricity, withpreference also granted to bidders making use of renewable resources. As in the case ofthe revised telecommunications law, the draft legislation requires the delivery of servicesto all areas, regardless of population density or income levels.

The safeguards included in the draft legislation might be sufficient to sway reluctantlawmakers. However, there is still some question whether a supermajority is required tosecure approval of the reform, which, if nothing else, means the measure is certain to be

subjected to a court challenge if the government attempts to implement it on theauthority of a simple majority.

Efforts to implement tax reforms have been impeded not only by PAC, but also by theML, which insists that a crackdown on tax evasionwhich by some estimates reducesgovernment income by as much as 4% of GDP each yearis all that is needed to restorefiscal balance. That approach was the governments policy by default under both Arias


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and his predecessor, Abel Pacheco. However, Chinchillas government will not be able tofully finance its spending pledges without broader tax reforms. The Finance Ministry haswarned that the budget shortfall could increase to more than 6% of GDP in 2012 if

proposed tax reforms are not approved.

Many of the tax measures currently under consideration were first floated by the Ariasadministration. Among the most controversial are a tax on gambling enterprises and aspecial $300 levy on all registered businesses (regardless of size), the proceeds of whichwill be used exclusively for security-related spending. Other proposals include thereplacement of the current 13% sales tax with a value-added tax (VAT), a financialservices tax of 0.5%, and changes to the income-tax structure that would significantlyincrease the tax burden of those at the top of the income ladder. The governmentestimates that if enacted in its entirety, the tax-reform package will boost state income by

2.5% of GDP annually.

Chinchilla is counting on a heightened sense of urgency to ensure that she succeedswhere her predecessors failed. In that regard, she has gained potentially helpfulassistance from Rodrigo Bolaos Zamora, the head of the Central Bank of Costa Rica(BCCR), who has warned that Costa Rica will be in very deep financial trouble if taxreforms are not implemented by the end of 2011.

Despite such forecasts of doom, the tax proposals have encountered resistance from boththe left and the right. Even if the Legislative Assembly approves the tax measures, rapidimplementation is not assured. Under Costa Rican law, any single lawmaker (or anyprivate citizen, for that matter) can challenge the constitutionality of measures passed bythe Legislative Assembly on either substantive or procedural grounds, thereby forcing areview by the courts that can take several months to complete, even in cases where thesoundness of the law is confirmed.

Given the uncertain outlook for the tax reforms, no significant improvement in fiscalstability can be expected until DR-CAFTA begins to yield the promised benefits, whichseems unlikely before 2012 under the best-case scenario. The near-term rise in the public-debt burden poses some danger of currency volatility, but the BCCRs ample supply ofreserves will limit the danger of even a temporary tightening of exchange controls.

Much Resistance to Free Trade

Not all recent efforts to expand trade ties have been as frustrating as the battle to winratification of DR-CAFTA. In October 2008, Costa Rica ratified a free-trade agreement(FTA) with Panama, its most important regional trading partner, under which tariffs on


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80% of agricultural products and 93% of industrial goods were lifted immediately, withthe phased elimination of all remaining tariffs to be completed by 2025.

Chinchillas foreign minister, Ren Castro, has already traveled to Seoul, and reached anagreement to begin negotiations on an FTA with South Korea, and Costa Rica andCanada are preparing to discuss an expansion of their bilateral agreement to includeinvestment and trade in services.

However, the outlook for securing ratification of the FTA with China and a regionalassociation agreement with EU are less than bright. The potential benefits for China areenormous, in that it would provide the country with an investment and trade platformwithin the DR-CAFTA structure. For its part, Costa Rica could expect a significant boostin FDI, as Chinese firms sought to exploit that advantage. However, the trade benefits for

Costa Rica are less clear-cut. China is Costa Ricas second most important internationalcustomer after the US, with electronics components accounting for the lions share ofexports to China. Agricultural exporters are keen to gain increased access to the Chinesemarket, where demand has been much more stable than in the US during the recentglobal downturn. However, many small manufacturers in Costa Rica are rightlyconcerned that they will be driven out of business if Chinese goods are granted duty-freeentry to the country.

Not surprising, the treaty with China has met with strong resistance from elementswithin Costa Ricas Chamber of Industries, most notably food producers, who havecomplained that the labor standards imposed by the US under DR-CAFTA will make itimpossible to compete with Chinese goods produced with much cheaper labor. In lateAugust 2010, the Chamber presented its argument to the Legislative Assembly,contending that more limited commercial agreements with China would be far morebeneficial for Costa Rica than a comprehensive FTA.

The deal with the EU faces fewer obstacles, and is widely viewed by the business sectoras an opportunity to boost investment and jobs without significantly undermining thecompetitiveness of key domestic industries. Nevertheless, as was made evident duringthe prolonged political battle over DR-CAFTA, the PAC is unlikely to back either of thedeals.

The ML, which favors expanded trade ties, proved during the struggle to secureratification of DR-CAFTA that its support will require concessions in other policy areas,most likely with regard to the governments proposed fiscal reforms. If the ML demandsmore than Chinchilla is willing to concede, ratification of the trade deals will require thesupport of at least two of the smaller parties, a development that would bestow uponthem unexpected leverage that they will undoubtedly exploit to the hilt.


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Thus, while Chinchilla is keen to implement the deals, she cannot count on majoritybacking for ratification. The FTA with China is clearly the most controversial, and the

combined opposition of the PAC, environmentalists, and domestic business groups maybe more than the new administration can overcome.

Drug Violence a Serious Concern

Potential threats to domestic stability include the potential for dangerous tensions arisingfrom increased unemployment, wide income inequalities, and the increasing number ofCosta Ricans living in conditions of poverty. Arias was prepared to grant higher priorityto social policy even before the fallout from the global economic downturn pushed thegovernment to unveil its so-called Shield Plan in January 2009, and significant increasesin social spending were included in the 2010, as well, and will be maintained in 2011.

Reflecting Arias position that education is the only proven antidote to poverty, thecurrent years budget includes substantial increases in funding for a secondary schoolgrants program, school construction, and new teachers.

The governments social welfare policies have taken on added importance under the newadministration, as they are an essential component of her security strategy, an issue ofgrowing concern among all sectors of Costa Rican society, but especially among thebusiness community, which recognizes the potential for heightened insecurity to deterinvestment and discourage tourism, one of the countrys most important industries.Although property-crime numbers are rising, the more troubling element of the problem

is that Costa Rica has become a battleground in a spreading war among gangs fightingfor control of the illegal drug trade between South and North America.

Chinchilla has adopted a two-track approach to addressing crime. On the one hand, thegovernment is pushing for tighter law enforcement. During her first 100 days, sheauthorized the hiring of hundreds of new police officers and established the funding toincrease prison capacity. On the other hand, the president has stressed the need to attendto the social causes of crime. Chinchilla contends that security issues cannot be divorcedfrom the conditions of poverty and inequality that breed crime, and has argued that astrong social safety net and an economic program that promotes healthy economic

development are essential elements of an effective anti-crime strategy.

As for the threat posed by drug-related violence, Chinchilla declared in an IndependenceDay speech that Costa Rica was no longer immune from the epidemic of deadly violencethat has driven up the murder rates in Guatemala and El Salvador. Warning that CostaRicans must not kid ourselves, she stated that the government is at the point of losing


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measures of control over sovereignty, territorial spaces, and the integrity of itsinstitutions.

Critics lambasted the speech as overblown fear-mongering that would unjustifiablystigmatize Costa Rica, and castigated Chinchilla for failing to propose any solutionsbeyond increased spending on social programs. However, just days after the presidentsspeech, Costa Rica was for the first time ever identified by the US as a major world transitpoint for drug-trafficking. Officials in Washington were quick to point out that thedesignation was not a criticism, but rather a function of geography, and praisedChinchillas government for granting such high priority to security.

Officials in San Jose are hoping that US recognition of Costa Ricas vulnerability willtranslate into US support (financial and otherwise) that bolsters the governments efforts

to improve security. Chinchilla has seized the opportunity, immediately dispatchingSecurity Minister Jose Maria Tijerino to Washington in search of help from the US.

Costa Rican police have established a more visible presence on the northern border withNicaragua, following kidnappings and ransom demands emanating from armed groupsin Nicaraguan territory. Separatist rebels in the Nicaraguan territory of Airrecoccasionally clash with both Nicaraguan and Costa Rican police forces. The Costa Ricangovernment has downplayed the political component of the violence in the region,characterizing the armed bands in Airrec as smugglers. The rebels contend that policeprovoke clashes by harassing Airrec farmers seeking to carry out legal trade, byconfiscating their goods as contraband. The danger that a conflict with the rebels maytouch off disruptive turmoil appears to be quite small.

The risk of conflict with Nicaragua over Costa Ricas use of the San Juan River, whichforms the boundary between the two countries but is entirely in Nicaraguan territory, hasdiminished since July 2009, when the International Court of Justice (ICJ) ruled that CostaRicans (with the exception of police personnel or those transporting supplies for policeposts) are free to navigate the waterway, while acknowledging that Nicaragua is withinits rights to regulate and monitor traffic along the river. However, Ortega is currentlydealing with the controversy over his effort to run for re-election in 2011, and thepossibility that he might attempt to deflect popular hostility by manufacturing a dispute

with Costa Rica cannot be ruled out. Although such a development could negativelyaffect internal commerce, the chances of an outbreak of armed conflict would be remote.

Economy Will Perform below Potential

The wide swings in growth in recent years underscore the massive impact of onecompanyIntelon the countrys economy. The vulnerability of the economy to Intels


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performance has reinforced the desire to expand the scope of foreign investment, butpolitical impediments will limit the opportunities available to investors.

Real GDP growth slowed to 3.7% (year-on-year) in the second quarter of 2010, afterrebounding to 6% in the first quarter of the year. The most recent data for the monthlyindex of economic activity (IMAE) confirmed that the declining trend continued into July,with the figures for agriculture, manufacturing, hotels, and financial services all slightlylower than in June, while the pace of contraction in the weakest sectors, most notablyconstruction, barely slowed.

The government has raised its forecast for annual real GDP growth in 2010 to 4.5%, andsees the growth rate reaching 5% in 2011. However, these optimistic projections assume acontinued improvement in external conditions, in general, and a solid recovery in the US,

in particular. Given the debt troubles in the EU, which point to a stalling of the economicrecovery in Europe, the uncertain fate of the FTA with China, and the questionablesustainability of the US recovery, the official forecast is probably too optimistic.Although government spending will boost the domestic contribution to growth, the paceof expansion will be held to less than 4% in 2010.

Chinchillas ability to rely on fiscal tools to spur significantly faster growth in 2011 willdepend on the fate of the administrations tax measures, which remains quite uncertain.Even in a best-case scenario, securing approval of the tax reforms will likely necessitatechanges that reduce the revenue-generating potential of the measures, making it difficultto narrow the large deficit without cuts to spending. On that basis, and assuming thecontinued sluggishness of US and European demand, real GDP growth will be held to3.5%4% once again next year.

Inflation eased to slightly more than 4% (year-on-year) in December 2009, holding theannual average rate to 8%, the lowest figure in decades, but still the highest rate inCentral America last year. Weak domestic demand and the significant appreciation of thelocal currency since July have contributed to lower inflation in recent months. Theconsumer price index rose by just 5% (year-on-year) in September, bringing the averagefor the first nine months of the year to 5.6%, below the upper end of the central bankstarget range of 4%6%. The inflation rate is expected to trend upward over the remainder

of the year, mainly owing to the base effect, but the annual average increase in consumerprices is forecast to remain close to the 6% target. The growth outlook for 2011 suggeststhat demand pressures will remain under control next year, although fairly robust statespending and a weakening of the colon is expected to push the inflation rate above 6%.

The implementation of DR-CAFTA will encourage increased investment in sectorsliberalized under the terms of the treaty (notably telecoms and insurance) once the global


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economic and financial turmoil subsides, creating the potential for a stronger recoveryover the medium term. However, progress on this front will be delayed in the event thatthe US economy slows again in 2011. The unevenness of economic expansion, the

governments reluctance to pursue privatization, environmental restrictions that deterdevelopment of extractive industries, and the wariness of investors amid political andfiscal uncertainty will create impediments to robust growth. Nevertheless, the countryspolitical stability and relatively skilled labor force will attract some foreign investment,putting a floor under the risks of a prolonged downturn. Even if growth rates accelerateto 5% later in the forecast period, the weak performance in 20102011 will hold theaverage rate of expansion to 4.3% per year through 2015, a far cry from the 6.6% averagefor 20032007, and well short of the level necessary to make a significant positive impacton living standards.

A rising debt burden will generate pressure to re-establish fiscal discipline, which willbecome necessary to stave off destabilizing currency volatility. The increased flexibilityenjoyed by monetary authorities following the adoption of a crawling band in October2006 will facilitate efforts to control inflation over the medium term, but the decline willbe gradual, with the average rate for the five-year forecast period coming in at 6.8%.

More Manageable External Deficits

The trade deficit narrowed significantly in 2009, as imports fell much more sharply thanexports, reflecting the impact of weaker domestic demand and lower prices for stapleimports. Weaker flows of remittances and income from tourism resulted in somewhat

smaller surpluses in the services and transfers balances that in combination with anexpansion of the income deficit contributed to a less pronounced (but neverthelesssubstantial) reduction of the current account deficit in 2009.

Exports to China, Costa Ricas second most important trade partner after the US,increased by 13% in 2009, and will continue to grow this year, regardless of the extent ofprogress on ratification of the FTA. However, the continued weakness of US andEuropean demand will dampen overall growth of exports, while higher global prices forcommodities will contribute to a more rapid recovery of imports, resulting in a largertrade deficit that will widen the current account shortfall to $920 million, equivalent to

about 3% of GDP, in 2010. The slow but steady recovery of the economy will beaccompanied by a gradual strengthening of domestic demand that will fuel growth ofimports, resulting in a further increase in the external deficits in 2011.Over the medium term, the eventual implementation of an FTA with China and thereturn of sustained moderate growth in the US will boost exports, but strengtheningdomestic demand, the increased access of cheaper foreign goods, and higher external


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interest rates (which will add to the debt-service burden) will contribute to themaintenance of a sizeable current account deficit averaging $1.8 billion, equivalent tosomewhat more than 4% of GDP.

Assistance from international financial organizations and others will be needed to helpfinance the governments investment program. A serious retreat from the pursuit ofmarket reforms could damage relations with bilateral foreign donors, the IMF, the WorldBank, and the IDB. The government will take advantage of a recent upgrade in thecountrys credit rating to swap some of its large domestic debt for cheaper externalfinancing, a strategy that will ease pressure in the near term, but could create problemsover the medium term in the absence of fiscal reform.

Second Most Likely Regime Scenario

18-Month Forecast Period:Centrist Coalition (30% Probability)Five-Year Forecast Period:Centrist Coalition (25% Probability)

Chinchillas assumption of the liberal economic policy stance adopted by Arias hascreated a basis for cooperation with the ML, which has displayed greater flexibility on thematter of state intervention following a 2005 split that resulted in the departure of itshard-line libertarian faction. During Arias term, the PLN, the ML, and the PUSC onoccasion came together to provide the government with a two-thirds legislative majority,and a similar combination could provide the basis for winning approval of controversialreform legislation under Chinchilla.

Although the formation of a long-term partnership among the PLN, the ML, and thePUSC would enable the government to win passage of most measures, some dilution oflegislation would be inevitable. In any event, the relationship would be far fromharmonious, and the alliance would face the constant threat of collapse, particularlygiven the likelihood that the PAC would seek to mobilize organized labor and otherpressure groups to assist in its efforts to thwart the governments agenda.

Barriers to Foreign Investment and Trade

Although Arias was a firm believer in liberal reforms, and Chinchilla has pledged tomaintain the policy course he set, the commitment of the broader PLN membership tothat agenda is a matter of some doubt. The PLN has advocated protective tariffs for thecountrys farmers and restrictive environmental standards for foreign investors. It has

CentristCoalition

Growth(%)

Inflation(%)

CACC($bn)

2010 4.3 5.9 -1.352011-2015 4.7 6.0 -2.00


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been a driving force behind efforts to bar foreign companies from undertakingexploration projects for oil and gas. Likewise, although the PLN has shown a willingnessto open some state enterprises to competition, it is opposed to privatization of state-

owned utilities.

Thus, although there is the potential for the PLN to find common ground with the ML onpolicies related to foreign investment and trade, differences between the parties (andamong factions within the PLN) over the details of economic policies would give rise tofrequent battles that would require compromise. Moreover, intense public opposition(encouraged no doubt by the PAC) would make the government wary of movingaggressively even in cases where broad consensus existed.

Economic Performance Would Be Better, but Still Disappointing

Economic prospects would be moderately more positive under this regime (although notin the early part of the forecast period), particularly if the government succeeded inimplementing fiscal reforms that eased debt pressures and provided the government withgreater flexibility to make investments that might help to make the business climate moreattractive to foreign investors. However, the ambivalent stance of the PLN towardforeign investment and the advocacy of some members for protectionist trade policieswould limit the investment opportunities in the country and would contribute tocontinued wariness on the part of investors.

As a result, growth rates, although higher under this regime, would remain belowpotential, as the economy expanded by an annual average of 4.7% through 2015. Higher

taxes and controls on government spending would dampen price pressures, contributingto a reduction of inflation to an annual average of 6% over the forecast period. Thehealthier performance of the economy would boost domestic demand, giving rise topersistently large trade deficits. Although receipts from tourism would partially offsetthe impact on the current account balance, the exchange of domestic debt for lower-interest foreign debt would increase external debt service requirements later in theforecast period, contributing to deficits averaging $2 billion annually through 2015.

Third Most Likely Regime Scenario

18-Month Forecast Period:PLN-PAC (10% Probability)Five-Year Forecast Period:PLN-PAC (10% Probability)

The PLN and the PAC are in general agreement on many issues. In fact, Sols pledged hispartys support for several of the governments proposed initiatives early in Arias term,and the successful implementation of DR-CAFTA has eliminated the most prominent

PLN-PAC Growth(%)

Inflation(%)

CACC($bn)

2010 2.9 5.2 -0.75

2011-2015 3.3 9.5 -2.25


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obstacle to such an alliance. But even as a medium-term strategy, the potential for a PLN-PAC coalition would be limited by disagreements over privatization, investmentliberalization, and fiscal reform. To the extent that a partnership with the PAC would

raise serious doubts about Chinchillas willingness and ability to fulfill her more liberalcampaign pledges, the move could seriously undermine her credibility. However, if sheconfronted a hopelessly gridlocked legislature, she might be willing to take that chance,seeing a coalition with the PAC as the least bad alternative.

A Wary Attitude toward Foreign Investment

The inclusion of PAC within the government would discourage any bold moves in thedirection of investment and trade liberalization, reducing the prospects of any significantimprovement in the climate for business under this scenario. Foreign investment wouldbe promoted only within narrow limits, and progress toward free-trade agreements

would be slowed, if not stalled altogether.

At the same time, this government would work to reduce the chronic corruption thatthwarts more substantial economic development. It is generally accepted that corruptionis directly related to the countrys debt difficulties. If implemented effectively, aclampdown on corruption could help put more money in the government coffers.However, demands from PAC and the PLNs left wing for increased social expenditureswould contribute to persistent budget pressures that would offset gains that might berealized from a closer watch over public funds. Moreover, the failure of this regime toimplement encompassing fiscal reforms would limit the governments ability to increase

spending without creating a significant expansion of the fiscal deficit, compounding theproblems stemming from the high level of public-sector borrowing.

Slow Steps on Trade Liberalization

A substantial trade deficit, the need to increase government revenues, and the policyleanings of many PLN and PAC members would impose powerful constraints on tradeliberalization. The government might reduce some tariffs as part of its drive to rein ininflation. On the other hand, it would try to curtail imports of luxury goods andautomobiles and to reduce the trade imbalance. It would pursue both goals in order tomaintain the countrys creditworthiness, and limit the risk of any increase in payment

delays.

Lackluster Growth, Higher Inflation

The composition of this regime would dampen the prospects for bold new measures thatmight build a foundation for sustained economic growth. Although the PACs inclusionin the government might lead to improved cooperation on some issues, frequent battleswould be the norm, and the governments majority would not count for much in cases of


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disagreement between the PLN and the PAC over issues of importance to Sols. Thus,while the administration would be able to move graduallyand gentlyin the directionof easing investment and trade restrictions, major reforms required to bolster the

economic base would be unlikely.

Real GDP growth would average 3.3% annually through 2015. Inflation would averageclose to double digits as the government failed to address the source of chronic fiscalstrains. Although the slow pace of trade liberalization and efforts to use tariffs to curtailsome imports would prevent the rapid expansion of the trade deficit, the disappointingperformance of the export sector and a relatively larger debt-service burden wouldcontribute to current account deficits averaging $2.25 billion annually.


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Forecast Summary

SUMMARY OF 18-MONTH FORECAST



PLN-PAC10%

RISK FACTORS CURRENT

Turmoil Low SLIGHTLY MORE SLIGHTLY MORE SLIGHTLY MORE

Investment

Equity Moderate Same Same Same

Operations Moderate Same SLIGHTLY LESS SLIGHTLY MORE

Taxation Moderate Same Same SLIGHTLY MORE

Repatriation Low Same Same SameExchange Low Same Same SLIGHTLY MORE

Trade

Tariffs Moderate SLIGHTLY LESS SLIGHTLY LESS Same

Other Barriers Moderate SLIGHTLY LESS SLIGHTLY LESS SLIGHTLY MORE

Payment Delays Moderate Same Same SLIGHTLY MORE

Economic Policy

Expansion Moderate MORE SLIGHTLY MORE MORE

Labor Costs Moderate SLIGHTLY MORE SLIGHTLY MORE SLIGHTLY MORE

Foreign Debt Moderate SLIGHTLY MORE Same SLIGHTLY MORE

SUMMARY OF FIVE-YEAR FORECAST



PLN-PAC10%

RISK FACTORS BASE

Turmoil Moderate Same Same Same

Restrictions

Investment Moderate Same Same Same

Trade Moderate Same SLIGHTLY LESS Same

Economic Problems

Domestic High SLIGHTLY MORE SLIGHTLY MORE MORE

International High Same Same SLIGHTLY MORE

* When present, indicates forecast of a new regime


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Costa Rica

Real GDP Growth Under Alternative Regimes

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

2005 2006 2007 2008 2009e 2010f 2011-

2015f

(percent)


Costa Rica

Inflation Under Alternative Regimes

56

7

8

9

10

11

12

13

14

2005 2006 2007 2008 2009e 2010f 2011-

2015f

(percent)


Costa Rica

Current Account Under Alternative Regimes

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

2005 2006 2007 2008 2009e 2010f 2011-

2015f

($billio

ns)



33/41

Political Risk Services

1-Oct-2010 Reproduction without written permission of The PRS Group is strictly prohibited.

Political Framework 1-Oct-2010 Page 35

Costa Rica

Country Forecast

Political Framework

Players To Watch

Laura Chinchilla Miranda: A former vice president and minister of justice, Chinchilla wonthe 2010 presidential election in the first round, taking slightly less than 47% of the vote. Shebased her entire campaign on a promise of continuity with the policies of the outgoingadministration headed by Oscar Arias, which in the main sought to create a more attractiveand competitive environment for private business, while affirming the governmentsresponsibility to pursue policies aimed at reducing poverty and ameliorating the hardship ofthose that remain poor. Chinchilla has pledged to implement fiscal and labor-marketreforms, but like Arias and his predecessor, Abel Pacheco, she will not be able to count on thereliable support of a majority in the legislature, a fact that dims her prospects for success

National Liberation Party: The center-left PLN retained its status as the largest party in theLegislative Assembly at the February 2010 elections, but lost one seat, reducing its total to 24,five short of a majority in the 57-member chamber. Not all of the PLNs lawmakers are ascommitted to investment and trade liberalization as Chinchilla, a factor that createddifficulties for Arias throughout his term, and will likely cause headaches for the newadministration, as well

Libertarian Movement: The party has moderated its hard-line libertarian stance since a

factional split in 2005, and won nine seats in the Legislative Assembly at the February 2010elections. The government is counting on the backing of the ML to secure approval of itsagenda, but a proposal to hike taxes while also tolerating a near-term expansion of the fiscaldeficit has run into strong opposition from the ML, which espouses the principles of limitedgovernment and fiscal restraint. In general, the ML can be expected to bargain hard for itssupport on a case-by-case basis, resulting in prolonged delays in implementing policy

Citizen Action Party: The PAC remains the second largest party and the leader of theopposition, despite a loss of six seats at the 2010 elections that reduced its total to 11.Although the similar positions of the PLN and the PAC on government spending prioritiesprovide some basis for cooperation between the two parties, their differences on the issues of

investment and trade liberalization will limit the potential for such an alliance during thecurrent term

Social Christian Unity Party: The PUSC represents the more conservative elements in CostaRica and in general supports free-market policies. The PUSC won six seats at the 2010elections, enough to provide the government with a simple majority, and might exert someinfluence over the direction of policy if Chinchilla cannot gain the cooperation of the ML

more on these and other Players in the Political Players section


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Page 36 1-Oct-2010 Political Framework

Political Players

Business Groups

The Union of Costa Rican Private-Sector Chambers and Associations (UCCAEP)represents a wide variety of business interests. Its president, Samuel Yankelewitz, is aprominent businessman who wields considerable political influence. The chambersactively bargain with government and labor over public policy and wage and contractdisputes. They also attempt to influence public opinion through vigorous public relationscampaigns. Additionally, they serve as forums for local business leaders. The growth ofthe Solidarity Movement has led labor and business to unite in their demands on thegovernment.

The chambers sometimes differ, depending on each associations primary interest, onissues such as higher taxes and import limits, but there is general agreement on issues ofprivatization, reduction of government employment, structural adjustment programs,and trade liberalization. Business leaders responded to Pachecos Cabinet appointments,which included prominent members of the business community and advocates of liberalreforms, with enthusiasm, and applauded his inclusion of two members of the PLN in thegovernment.

The Chamber of Commerce has long been an important interest group, seeking toinfluence domestic policy rather than foreign trade, investment, or financing. Thechamber is the principal organization advancing the interests of San Jos merchants and

other domestic commercial enterprises, increasing prices and restricting clientele in theFree Zone of Golfito, which was considered a major competitor to traditional merchants.

Most of the larger exporting companies belong to the Chamber of Exporters (Cadexco),founded in 1982 and currently headed by Antonio Burgues Teran. This chamberpromotes exports, working directly with the government on export policy. It employs athree-fold strategy: direct lobbying, campaigning to influence public opinion, and servingon mixed commissions of government and private sector personnel. These commissionshelp to set tariffs and devise policies on the transfer of technology, as well as lobbyingand negotiating with key trade partners. The chamber produced most of the technical

reports the government has used in regional and global trade negotiations. Membershave been active in their efforts to obtain concessions from the EU on imports of bananasfrom Latin America.

The Chamber of Industries (CICR), founded in 1943 and currently headed by JackLiberman, advises and promotes more than 750 companies. It advocates industrialdevelopment and lobbies for industrial interests. The association lobbies government and


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Political Framework 1-Oct-2010 Page 37

participates directly in advisory bodies formulating government policies.Representatives of the chamber took part in WTO negotiations. The chamber maintains alibrary for members and publishes reports, a monthly magazine, and a weekly full-page

editorial in the leading San Jos newspapers. It also works with the Coalition forDevelopment Initiatives, the University of Costa Rica, and the National Institute ofAdministration in initiating management-training programs.

The economic importance of tourism enhances the influence of the Chamber of Tourism(Canatur), currently headed by Eduardo Villafranca. The chamber has worked toimprove infrastructure, enhance security for tourists, and create more efficientmanagement of the national parks. In the wake of soaring cancellation and vacancy ratesafter two tourists were kidnapped in early 1996, the chamber urgently soughtgovernment assistance to rehabilitate the countrys reputation for security. Canatur has

been an active participant in the successful campaign to restrict exploratory drilling byforeign oil companies, claiming that the detrimental environmental impact willundermine the countrys ability to market itself as an attractive site for ecotourists.

Laura Chinchilla Miranda (President)

A former vice president and minister of justice, Chinchilla won the 2010 presidentialelection in the first round, taking slightly less than 47% of the vote. She based her entirecampaign on a promise of continuity with the policies of the outgoing administrationheaded by Oscar Arias, which in the main sought to create a more attractive andcompetitive environment for private business, while affirming the governmentsresponsibility to pursue policies aimed at reducing poverty and ameliorating thehardship of those that remain poor. Chinchilla has pledged to implement fiscal andlabor-market reforms, but like Arias and his predecessor, Abel Pacheco, she will not beable to count on the reliable support of a majority in the legislature, a fact that dims herprospects for success.

Chinchilla was born on May 28, 1959. After graduating from the University of Costa Rica,she attended Georgetown University, where she earned a masters degree in public policyin 1989. In 1994, Chincilla was appointed deputy minister of public security, and waslater promoted to the top post at the ministry. She contested and won a seat in Congressfor the first time in 2002, and in 2006 was chosen by Arias as his first vice president, a

position she held until late 2008, when she stepped down in preparation for herpresidential run. Helped by the presidents endorsement, Chinchilla defeated San JosMayor Johnny Araya in a primary election held in June 2009.

Citizen Action Party (PAC)

Partido Accin Ciudadana remains the second largest party and the leader of theopposition, despite a loss of six seats at the 2010 elections that reduced its total to 11.


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Page 38 1-Oct-2010 Political Framework

Although the similar positions of the PLN and the PAC on government spendingpriorities provide some basis for cooperation between the two parties, their differences onthe issues of investment and trade liberalization will limit the potential for such an

alliance during the current term.

Formed in January 2001, the Partido Accin Ciudadana was in many respects the realwinner at the February 2002 elections, as the strong showing of its founder andpresidential candidate, Ottn Sols, forced the first presidential run-off in the countryshistory, and the party won 14 of the 57 seats in the Legislative Assembly, creating a fairlyequal three-way division of power that ensured it would wield influence over thedirection of the governments policies. Purportedly representing a third way betweenthe center-right PUSC and the center-left PLN, there was more than a hint of populism inthe partys platform. Pledging to put people before profit, the PAC came out in favor

of higher import tariffs and stiffer environmental regulations for foreign investors.Although the party called for a reassessment of plans for a free-trade agreement withCanada, PAC members gave their appro

country forecast

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