Document of The World Bank

FOR OFFICIAL USE ONLY

Report No.: 28570

M E M O ~ N D U M OF THE PRESIDENT

OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

COUNTRY ASSISTANCE STRATEGY

FOR THE

REPUBLIC OF COSTA RICA

April 20, 2004

Central America Country Management Unit Latin America and the Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

CURRENCY E Q U I V A L E N T S Currency Unit = Colon (e)

Fiscal Year: January 1 - December 3 1

US $1.0 = 418 (December 2003)

GLOSSARY OF A C R O N Y M S AND ABBREVIATIONS

A A A A&A BCCR C A S CAFTA C A S C R CCSS CABEI CAE C A F CEM CINDE C F A A CPAR CZFA E S W FDI F I A S F I R S T FSAP F S A FSSA F O D E S A F GEF GDP ICA ICE IBRD IDB IDF IFC IMAE I M A S IMF INEC INTEL JBIC LAC MDGs MEP M I G A PCF PER PHDR R A M P R U T A R&D UNDP

Analytical and Advisory Sevices Water and Sanitation Enterprise (Empresa de Acueductos y Alcantarillados) Central Bank o f Costa Rica (Banco Central de Costa Rica) Country Assistance Strategy Central American Free Trade Agreement C A S Completion Review Social Security Institution (Caja Costarricense del Seguro Socil) Central American Bank for Economic Integration Country Assistance Evaluation Andean Development Corporation (Corporacion Andina de Foment0 ) Country Economic Memorandum Costa Rican Investment Board Country Financial Accountability Assessment Country Procurement Assessment Review Americas’ Free Trade Zone (ComitC de Zonas Francas de las AmCricas) Economic and Sector W o r k Foreign Direct Investment Foreign Investment Advisory Service Financial Sector Reform and Strengthening Initiative Financial Sector Assessment Program Financial Sector Assessment Financial System Stability Assessment Social Development Fund (Fondo de Desarrollo y Asistencia Social) Global Environment Facility Gross Domestic Product Investment Climate Assessment State Electricity Company (Instituto Costarricense de Electricidad) International Bank for Reconstruction and Development Inter-American Development Bank Institutional Development Fund International Finance Corporation Monthly Index o f Economic Activity (Indice Mensual de la Actividad Economica) Social Welfare Institute (Instituto Mixto de Asistencia Social) International Monetary Fund National Statistics and Census Bureau (Instituto Nacional de Estadisticas y Censos High Technology Corporation (Corporacion de A k a Tecnologia) Japan Bank for International Cooperation Lat in American Countries Millennium Development Goals Ministry of Public Education (Ministerio de Educacion Publica) Multilateral Investment Guarantee Agency Prototype Carbon Fund Public Expenditure Review Japan Policy and Human Resources Development Fund Reserves Advisory and Management Program Regional Unit for Technical Assistance Research and Development United Nations Development Program

FOR OFFICIAL, USE ONLY MEMORANDUM OF THE PRESIDENT

OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORS

ON A COUNTRY ASSISTANCE STRATEGY

FOR THE REPUBLIC OF COSTA RICA

TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................................................. i I . INTRODUCTION .......................................................................................................... 1 I1 . COUNTRY CONTEXT ................................................................................................ 1 111. RECENT DEVELOPMENTS ...................................................................................... 4

A . Political Context ...................................................................................................... 4 B . Economic Performance ........................................................................................... 5 C . Poverty, Gender and Social Development .............................................................. 9 D . Human Capital Development ................................................................................ 11

IV . COSTA RICA’S DEVELOPMENT CHALLENGES ............................................... 14 A . Maintaining Macroeconomic Stability ................................................................. 14 B . Strengthening Trade and Competitiveness ........................................................... 17 C . Sustaining Social Progress .................................................................................... 19 D .

WORLD BANK GROUP’S COUNTRY RELATIONS .......................................... 23 A . The Last CAS: Impact and Lessons ...................................................................... 23 B . Current Bank Group Program ............................................................................... 24 C . Country Assistance Strategy FY04 - FY07 .......................................................... 27 D . Coordination with Partners ................................................................................... 36 CAS Program Risks ...................................................................................................... 39

CONCLUDING REMARKS ................................................................................ 39

Continuing The Leadership In Environmental Management ................................ 22 V .

V I . TEXT TABLES

Table 1 : Millennium Development Goals ....................................................... 3 Table 2: Selected Economic Indicators ........................................................... 7 Table 3: IBRD Active Portfolio and Proposed Base Case Bank Assistance Program

Table 4: Ongoing Donor Activities ............................................................... 38 FY04 - FY07 ............................................................................. 29

CHARTS Chart 1 : Governance Indicators for 1996-2002 ................................................ 5 Chart 2: Costa Rica Poverty Incidence 1991 -2003 (as o f % o f total households). ....... 11

This document has a restricted distribution and may be used by recipients only in the performance of their official duties . I t s contents may not be otherwise disclosed lwithout W o r l d Bank authorization .

ANNEXES

A I : Country at a glance

B 1 a: Costa Rica CAS Completion Review B 1 b: Country Program MatrixlCAS Results Framework (FY04 - 07) B2: B3: B4: B5: B6: B7: B8: B9:

C:

D:

E:

F:

Selected Indicators o f Bank Portfolio Performance and Management Proposed IBRD Base Case Scenario Lending Program Summary o f Non-lending Activities Costa Rica - Social Indicators Costa Rica - Key Economic Indicators Costa Rica - Key External Debt Exposure Indicators Status o f Bank Group Operations/ Status o f IFC Committed and Disbursed Portfolio CAS Summary and Development Priorities

Social Spending and the Poor

Public Debt Management and Domestic Debt Market Development

Synthesis o f Financial Sector Assessment

Consultations with Civi l Society

IBRD

Vice President: David de Ferranti Country Director: Jane Armitage Country Operations Advisor: Neeta Sirur Task Manager: Ana Lucia Armijos

The team would like to acknowledge the contributions of several colleagues in the LAC region, especially Ricardo Tejada, as well as BCFBD, SFRCR, ISGIA, IFC, IMF and IADB.

EXECUTIVE SUMMARY

1 This Country Assistance Strategy, which covers FYs 04-07, is the f i rst to be prepared for Costa Rica since 1993. Over the last decade, collaboration between Costa Rica and the Bank had been relatively limited, focused primarily on ensuring effective implementation o f a small portfolio o f projects and the provision o f analytical and advisory services. This CAS, prepared at the request o f the Pacheco Administration which took office in 2002, envisages a highly selective program o f lending and non- lending services, focused less on resource transfer objectives and more on knowledge sharing and advisory services in areas o f mutual interest. The aim i s to focus cooperation in areas where (i) lessons from Costa Rica’s successful poverty reduction and economic diversification efforts and pioneering leadership in environmental management would be instructive for other Bank clients; and (ii) the Bank’s global experience could support Costa Rica’s efforts to address second generation problems in key sectors. In its discussion o f this CAS, the Board may wish to consider the following:

D o Executive Directors agree with the primary rationale for Bank engagement in Costa Rica - Le., mutual learning and knowledge sharing rather than significant resource transfer? Are the size o f the program and the specific areaslinstruments chosen for Bank engagement appropriate to further the CAS’S knowledge objectives?

ii Costa Rica i s a development success story in many respects. The country has a long tradition o f political stability, with successive democratically elected governments transitioning peacefully to power since 1949. The political climate i s characterized by well-established processes for consultation and consensus-building on policy reform which, in turn, have engendered social and political stability, contributed to the sustainability o f reforms and helped maintain the credibility and accountability o f public institutions. Since the mid-l980s, Costa Rica has followed a successful strategy o f outward-oriented export-led growth, openness to foreign investment and gradual trade liberalization. As a result, the structure o f the economy has been transformed from one highly dependent on agriculture and agro-industry to one that i s now led by high-tech computer and electronic industries, services, non-traditional agriculture and tourism. The country has successfully attracted foreign direct investment, fueling economic growth, which averaged 5 percent in the 1990s -well above the Latin American average. The combination o f steady economic growth and sustained investment in human development has led to a substantial reduction in head-count poverty, and the country has already met or is well on the way to meeting the Millennium Development Goals. In the future, it is expected that the free trade agreement recently negotiated with the United States will further boost exports and attract new national and foreign investment..

... 111 As the above suggests, Costa Rica is in a strong position vis a vis i ts Latin American neighbors as it enters the new century, but faces new issues and challenges as it strives to achieve continued sustainable growth, further reduce poverty and promote social equity in an increasingly integrated and competitive global economy. To address

these challenges, the Government has identified four main areas o f emphasis for the coming years -- maintaining macroeconomic stability, strengthening trade and competitiveness, sustaining social progress with particular attention to reaching indigenous and Afro-Costa Ricans, and continuing Costa Rica’s leadership on environmental issues.

iv Linked to the above emphases, and taking into account the lessons o f the CAS Completion Review (Annex Bla), the CAS includes a relatively modest lending program o f US$2 18 million for six projects over four years, focused on developing sustainable, innovative solutions to the second-generation challenges being encountered in a number o f sectors. These include: (i) education, where government i s seeking to resolve remaining problems o f inequity and to improve overall system efficiency; (ii) water and sanitation, where with JBIC, the Bank will help establish modernized approaches to improving coverage, quality and sustainability; environment, (iii) regional development in the Puerto Limon area on the Caribbean coast, through an operation aimed at revitalizing the port and related infrastructure as a means o f reducing the region’s relatively high poverty rates and increasing the country’s overall competitiveness; (iv) a possible follow-on environmental project targeted to improving financial sustainability in the sector; (v) a small e-Government learning and innovation loan aimed at improving public sector efficiency; and (vi) an Agriculture Sector project designed to help smallholders fare adequately under the more competitive conditions which will likely result from the CAFTA agreement.

v. In addition to the lending operations described, the CAS includes a substantial program o f knowledge and advisory services and analytical work. For example, capacity-building activities on both a reimbursable and grant basis are foreseen to support reforms in critical areas o f public sector debt management, domestic debt market development, financial sector reform, Central Bank management o f international reserves and management o f private participation in infrastructure. In addition, the Bank will undertake a number o f economic and sector work activities in cooperation with the Government, including the five core diagnostic studies, an investment climate assessment and selected regional studies on key issues for Central America.

v i Specific indicators have been identified for evaluating the results and impact o f the CAS. The results based approach is linked to the development challenges, to which the government and all it’s partners, including the Bank Group, will contribute. The main risk concerns the potential for macro-economic instability, triggered by external factors, deterioration o f the fiscal situation, andor financial system weaknesses. However, this risk i s judged to be modest for the CAS period, given the country’s track record o f successfully weathering regional crises and enacting reforms and attracting funds on the capital markets when needed, the prevailing broad consensus and agreement in the National Assembly on the need for fiscal reform (although details are s t i l l being worked out), and the steps taken in the past two or so years to strengthen the regulatory and prudential framework o f the financial system and recapitalize the Central Bank, thereby significantly lowering the risk o f a banking or financial crisis.

*. 11

M E M O ~ D U M OF THE PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS

ON A COUNTRY ASSISTANCE STRATEGY FOR THE REPUBLIC OF COSTA RICA

I. INTRODUCTION

1. The last Country Assistance Strategy (CAS) for the Republic o f Costa Rica was presented to the Board in March 1993, together with an adjustment operation aimed at continued reform of public sector management, the financial sector and trade. That operation was cancelled two years later and since then, the collaboration between Costa Rica and the Bank has been relatively limited, focused primarily on ensuring effective implementation o f a small portfolio o f projects (in health, education, environmental services and water and sanitation) and the provision o f non-lending analytical and advisory services. Despite the scaling back o f Bank financial support Costa Rica advanced significantly in achieving many o f the objectives laid out in the 1993 CAS. The Pacheco Administration, which took office in mid-2002, has indicated strong interest in forging a closer relationship with the Bank, leading to the development o f this new CAS after a period o f over 10 years. This CAS envisages a highly selective program o f lending and non-lending services, focused less on resource transfer objectives and more on knowledge sharing and advisory services in areas o f mutual interest - Le., areas where lessons from Costa Rica’s successful poverty reduction and economic diversification efforts and pioneering leadership in environmental management would be instructive for other Bank clients, as well as areas in which the Bank’s global experience could benefit Costa Rica’s efforts to address second generation problems in key sectors.

11. COUNTRY CONTEXT

2. Costa Rica i s a development success story in many respects. A middle-income country o f about 3.9 mil l ion people, Costa Rica boasts one o f the most stable democracies in Latin America, with uninterrupted democratically elected governments since 1949. Several factors have contributed to this stability, including the limited presence and power o f land-based oligarchies, the existence o f effective social mobility mechanisms, the abolition o f the army after a brief c iv i l war in 1948, the enactment o f a new constitution in 1949, and the foundation o f one o f the region’s first welfare states. The President and a Legislative Assembly comprised o f 57 legislators are elected for 4 year terms. Two major political parties have generally alternated in power, although the country has seen greater political diversity in recent years, with the rise o f a number o f smaller parties. Costa Rica’s government and politics have long placed a high premium on achievement o f wide socio-political consensus on major policies. While sometimes delaying decisions, this emphasis on consensus has the advantages o f creating a broad social base, enhancing the sustainability o f economic and social reforms and helping to maintain the credibility and accountability o f public institutions.

3. Since the mid-l980s, Costa Rica has followed a successful strategy o f outward- oriented export-led growth, openness to foreign investment and gradual trade liberalization. As a result, the structure o f exports and the economy i tse l f has been transformed from one highly dependent on agriculture and agro-industry - coffee and bananas represented 56 percent o f exports in 1985 vs. only 12 percent in 2003 - to one that i s now led by high-tech computer and electronic industries, services, non-traditional agriculture and tourism. The ratio o f exports to GDP grew from 20.8 percent in 1991 to 36.5 percent in 2000, and greater trade openness contributed greatly to growth during the decade. Costa Rica attracts foreign direct investment at a rate o f about 3 percent o f GDP annually, and has been successful in attracting high-tech investors such as INTEL. As a result, the economy grew by an average 5 percent rate in the 1990s, with factor productivity accounting for two fifths o f this performance, In the future, it i s expected that the free trade agreement recently negotiated with the United States (know as Central America Free Trade Agreement or CAFTA) will further boost exports and attract new national and foreign investment, increasing the country’s development prospects.

4, At least in part, Costa Rica’s rapid productivity growth and attractiveness to investors i s the result o f sustained investment in the education and health o f i ts population over the past two decades. The country’s social indicators are currently closer to those prevailing in developed countries, far above the norm for countries with similar per capita GDP ($4,193 in 2003). Coverage o f basic education and health care services is nearly universal today, although there have been some signs in recent years that the efflciency and effectiveness o f social spending has begun to plateau, or, in some cases (e.g., secondary education), has actually suffered some decline. Continued improvements in social areas w i l l have to rely on better use o f expenditures, as the scope for further increases in social spending is likely to be limited by fiscal and financial constraints.

5. The combination o f respectable economic growth, relatively low inequality along both gender and class lines, and large investments in human development have led to a substantial reduction in head-count poverty in Costa Rica over the past decade. Headcount poverty declined from 3 1.9 percent in 1991 to 20.6 percent in 2000, while the proportion o f the population living in extreme poverty fell from 11.7 percent to 6.1 percent during the same period. After stagnating for several years, during which time the numbers o f poor immigrants entering the country from Nicaragua accelerated, the poverty rate fe l l sharply in 2003, probably due to the pick-up in GDP growth.

6. Table 1, below, shows Costa Rica’s progress with regard to the Millennium Development Goals (MDGs). The indicators measured there clearly reflect the country’s notably strong development performance on a number o f dimensions over the past two or so decades, While continued improvements are necessary in some areas -and these could be more difficult to achieve as “easier” milestones have already past - the Government i s well aware o f the challenges ahead and i s working to bring about the political consensus needed to move forward with needed reforms. Recent developments in Costa Rica and some o f the specific challenges faced by the country in the medium-term are discussed further in Sections I11 and IV o f this document.

2

Table 1: Millennium Development Goals

100%

~

Millennium Development Goals

1. Poverty and Hunger * Reduce extreme poverty by half. * Reduce malnutrition rate by half

1990-2015

Achieved

2. Achieve universal primary education * Increase enrollment ratio in primary school to 100% 3. Promote gender equality * Raise ratio girlslboys in primary and secondary school to 100% 4. Reduce child mortality * Reduce child mortality in children under 5 by two-thirds 5. Improve maternal health * Reduce the rate o f maternal mortality (for each 100,000 live births) by three-fourths. 6. Combat HIVlAIDS and other diseases * Halve the incidence o f tlIV/AIDS by 2015 and begin to reverse propagation. 7. Ensure environmental sustainability I. Halve the proportion of individuals without access to improved water source.

--

_ _

98%

4 1.6% * Halt forest degradation (% o f total land).

_ _ -_

Likely

Surpassed

' Data refers to 1

Present Status

* Extreme poverty declined from 11.7% in 1991 to 5.1 % in 2003.. * Child malnutrition in children under 5 decreased from 6.0% in 1985 to 4.7% in 1996.

* Net enrollment in primary school increased from 86% in 1990 to 91% in 200 1.

* There are no significant differences between the genders in respect of education

* The child mortality rate fell from 17 to 11 per 1,000 live births between 1990 and 2001.

* Consistently among the top 40 countries in the world in terms o f maternal mortality and health systems performance. The maternal mortality rate was 35 per 100,000 in 1995.

* Incidence o f HIVlAIDS in men and women (ages 15-24) i s 0.6% and 0.3% respectively. Slightly below the average for LAC.

* Access to improved water was 95% in 2001, greater than the average for LAC o f 86%. * Annual deforestation rate was 0.06% between 1997 and 2000 and 0.24% between 1987 and 1997. A significant reduction in land use. The CA average for the 1990-2000 period

1990 MDG Benchmark'

11.7% (1991)

6.0% (1985)

86.3%

95.8%

17

_ _

41.6%

Latest Estimates'

5.1% (2003)

4.7% (1 996)

91.0% (200 1)

100.0% (200 1)

11 (2001)

35 (1995)

0.6 (2001) 0.3 (2001)

(200 1) 95%

45.4% (2000)

Likelihood

results MDG of achieving Goals

5.9% + Achieved

6 I Likely

t I -- 9

was 2.4%lsignificantly higher.

Spending and the Poor Report (World Bank 2002) and INEC; Sanchez, Arturo, et al.. 2002. Estudio de cobertura forestal de Costa Rica con imagenes LANDSAT TM7 para e l aiio 2000.

3

7. Costa Rica has also been a world leader on environmental issues, successfully exploiting linkages between environmental protection and poverty reduction. It has set aside about 25 percent o f i ts land to protected areas and has put in place innovative ways to pay its citizens for good environmental practices. Given Costa Rica’s rich biodiversity - about 5 percent o f known species worldwide -- and improving tourist infrastructure, eco-tourism has become, after the INTEL chip plant, the principal foreign exchange earner, and a driver for rural development. In addition, Costa Rica has been a leader in developing markets for global environmental services, such as Carbon Trading Offsets, as well as for local environmental services, where water bills in parts o f the country now include a charge to pay farmers upstream for “producing water”. Studies show payments for these global and local services can be effective ways to reduce rural poverty in a sustainable way.

111. RECENT DEVELOPMENTS

A. Political Context

8. President Abel Pacheco o f the Social Christian Unity Party (PUSC) was sworn into office in May 2002, but his Party does not have a majority in the Legislative Assembly. Congress is currently divided into blocks: Partido Unidad Social Cristiana (PUSC), Partido Liberacion Nacional (PLN), Partido Accicin Ciudadana (PAC), Movimiento Libertario (ML) and a minority block o f independents. While the President continues to enjoy popular support, policymaking has been slow as the Executive can count on only one third o f the seats in the Assembly (19 o f 57 deputies). Between October 2002 and December 2003, there have been a number o f changes in the cabinet, including the Ministries o f Justice, Planning, Finance, Education, Presidency, Science and Technology and Economy, Industry and Commerce. Although the administration began with ambitious promises which raised the expectations o f the population, a more cautious economic policy has prevailed in the cabinet. In the past year or so, Government, jointly with a wide spectrum o f political parties, private sector and civ i l society organizations, has been able to build wide consensus on the importance o f passing a key fiscal reform. This emphasis on consensus-seeking i s a hallmark o f Costa Rican government and politics and helps ensure the sustainability o f economic and social reforms. At the same time, it often makes for slow and complicated policy-making, as it needs the participation o f all four political parties and coalitions. Additionally, key initiatives are often further delayed when opponents refer them to the Constitutional Chamber (or Sala IV) created in 1989 to regulate the relationships between the different branches o f government and guarantee citizen rights.

9. Transparency International ranked Costa Rica 40* in i t s 2002 Perceptions o f Corruption Index (second only to Chile in Latin America). The current Government’s fight against corruption i s one o f the priorities o f the country’s development plan. While Costa Rica i s a clear Leader among Central American countries (and near the top for Latin America) on most governance measures, there has been a deterioration in recent years on several fronts. This trend i s also borne out by WBI’s governance indicators, which show

4

that the country's performance has been declining on measures such as government effectiveness, regulatory quality, and rule o f law. Furthermore, data from the latest firm- level survey place Costa Rica below the 50th percentile among 102 countries on various measures o f governance and institutional capacity. Addressing these issues wi l l be critical if Costa Rica hopes to continue to pursue FDI in high-technology and high value-added service industries (Chart 1)

Chart 1. Governance Indicators for 1996-2002

COSTA RIGA C20023 I I I I

Voice and Accountability

P o l i t i c a l Stabi l i ty

Governnent Effectiveness

Regulatory Quality

Rule o f Lau

Control of Corruption

I I I I I I I

0 25 50 75 I0 Conparison betueen 2002, 2000, 1998, 1996 {top-botton order)

Country's Percentile Rank 10-1001 Source: D. KauCmnnr 1. Kraar and H. tlactruzzir 2903: Governance Hatter5 111: Governance Indicators For 1996-2002 thtfp:/~.worldbank.ors~i/sovernance/pubs/scun;ltterr3.html)

B. Economic Performance

10. Macro Economic Performance Following a debt crisis in the late 1980s, Costa Rica reestablished relatively stable macroeconomic performance over most o f the 1990s. Real growth averaged about 5 percent for the period 1990-99 and public debt levels were manageable through most of the decade, at a level o f about 50 percent o f GDP. By the end o f the decade, however, real growth slowed to an average o f about 2 percent for 2000-2002 (reflecting both external and domestic factors)', while inflation remained at an annual rate o f about 10 percent over the same period, due mainly to relatively large annual fiscal deficits. The overall public sector deficit increased significantly to 5.7

~~~~

' However, if the contribution of the high-tech industry to GDP i s excluded, the decrease o f real growth during the same period i s lower (from an average o f 4.6 percent during 1990-1999 to an average o f 3 percent between 2000 and 2002), demonstrating that growth volatility did not affect as much the traditional sectors o f growth

5

percent o f GDP in 2002 due to stagnating tax revenues and unchecked growth in expenditures, associated, inter alia, with increases in interest payments, higher-than- planned rises in wages, investments in the state telecom and electricity company (ICE), and Central Bank losses.

11. Debt levels, rose from 44.9 percent o f GDP in 1999 to 51.9 percent o f GDP in 2002 (Table 2). At end-2002, about 60 percent o f the public sector debt was denominated in foreign currency and a growing share i s at floating interest rates, making public finances vulnerable to a real depreciation o f the colon or increases in international interest rates. Moreover, unfavorable terms o f trade and fiscal imbalances have been contributing to an external current account deficit since 1996, which has been financed since the late 1990s by large inflows o f foreign direct investment. The growing external imbalance reflected a decline in the terms o f trade over the last three years, due mostly to low international coffee and banana prices, increased o i l prices, and the downturn in the U.S. technology sector, all o f which resulted in a reduction in Costa Rica’s net exports, highlighting the country’s continued vulnerability to external developments despite great progress in export diversification.

12. In 2003, however, Costa Rica’s economic performance was significantly stronger. According to the latest official information, the annual rate o f growth o f the economy was 5.6 percent, and, if the contribution o f the high-tech industry to GDP is excluded, real growth in 2003 reached 4.4 percent. Exports increased by 16 percent driven by a pick-up in tourism (6.1 %), high technology industries (8.6%), and non-traditional agriculture (4.7%). Consequently GDP growth in 2003 was much higher than originally anticipated, while the external current account deficit remained at 5.7 percent o f GDP (same level o f 2002) and the level o f total public debt increased to 54.7 percent o f GDP (versus 51.9 in 2002). The inflation rate closed at 9.4 percent, slightly higher than in 2002 (9.2 percent).

13. In light o f the unfavorable economic trends over the 2000-2002 period and the structural weaknesses they demonstrated, the newly-installed Pacheco administration launched a formal Economic Recovery Plan through a process o f public debate and consensus building with a wide range o f political actors and civ i l society. The main goals of the Plan are to increase economic growth and reduce poverty by eliminating the fiscal deficit and giving specific support to tourism, agriculture and small and medium enterprises. In the short-term, however, government efforts are focused on two key objectives: fiscal reform and a new free trade agreement with the United States (CAFTA). To address the fiscal deficit, the Government adopted a very tight budget for 2003 aimed at reducing the deficit to 3 percent, via a one year Fiscal Emergency Package (approved in December 2002) and an associated expenditure control plan. However, at end-2003 the overall public sector deficit was 4.1 percent o f GDP, reflecting slippages with respect to both spending and revenues. On the revenue side, a comprehensive tax reform package - aimed at providing Costa Rica with a tax system that would increase revenue, eliminate the distortions created by multiple taxes, reduce tax evasion and contribute to fairness and competitiveness - has been under discussion for over a year and a half, following its presentation to Congress in July 2002. While the package is expected

6

to be approved in the second quarter o f 2004, important changes have been introduced that may dilute i ts revenue generating impact. Progress on CAFTA has been more encouraging, as discussed further in para. 17 below.

Table 2: Selected Economic Indicators (as YO o f GDP, unless otherwise indicated)

1990

Real Growth Rates GDP at market prices (mp) 3.6

Inflation (average, % change) 19.0 GDP per capita 1.4

GDP (mp) excluding High Tech Industry .,.

As percentage o f GDP, unless otherwise noted Gross Domestic Investment (as % o f GDP) Gross National Savings (as % o f GDP) Current account balance N e t reserves (months o f imports o f GNFS) Foreign direct investment Total public sector revenues Total public sector expenditures Public sector primary balance Overall public sector deficit Total public debt

Domestic External

External public debt service (% o f exports o f GNFS) Interest on external debt (% o f exports o f GNFS)

20.8 12.3 -8.0 0.3 2.2 ... ..* ... ...

67.1 17.6 49.5 22.8 8.3

Source: Central Bank of Costa Rica and IMF.

1999 2000 2001 2002 2003*

8.2 1.8 1.0 2.9 5.6 2.8 2.9 3.2 3.0 4.4

10.0 11.0 11.3 9.2 9.4 5.7 -0.5 -1.0 0.9 3.6

17.1 17.1 20.1 22.2 20.6 12.0 12.6 13.3 14.0 14.5 -4.3 -4.4 -4.5 -5.7 -5.7 2.1 2.0 2.3 2.5 2.7 3.9 2.5 2.8 3.9 3.4

19.8 20.7 22.3 22.0 21.7 23.5 25.1 26.1 27.7 25.8 0.6 0.5 1.2 -0.5 0.9

-3.7 -4.4 -3.8 -5.7 -4.1 44.9 45.9 48.3 51.9 54.7 25.6 26.2 28.5 32.0 33.4 19.3 19.8 19.8 19.8 21.4 6.6 7.6 10.4 9.7 13.2 2.4 2.6 3.4 3.3 3.0

* Data for 2003 are ureliminaw estimates. GNFS =goods and non-factor services. See Annex B6 for a complete list o f economic indicators.

14. Financial Sector. At the request o f Government and in close coordination with its economic team, the Bank and the IMF carried out a joint Financial Sector Assessment Program (FSAP) in 2001 -02. That exercise identified several issues, including weak bank supervision, undercapitalized public banks which represent about 75 percent o f total banking deposits; the preferential tax and regulatory status that public banks enjoy over private banks; and lack o f a clear bank resolution framework. At the same time, about 60 percent o f loans o f the consolidated (onshore and offshore) banking system are dollar denominated, increasing the balance sheet risks o f devaluation. Progress has been made in implementing the recommendations following the findings o f the FSAP and the government% aware of, and committed to, implementing further steps to strengthen the financial sector.

7

15. The FSAP also highlighted some potential weaknesses o f the current exchange rate system. Since the early 1980s, Costa Rica has followed a somewhat flexible exchange rate crawl, in the sense that the devaluation rate has been regularly adjusted (usually on a yearly basis) to compensate for differentials o f past inflation between Costa Rica and its main trading partners. In addition, the central bank has adjusted interest rates upwards to defend international reserves in times o f turbulence. The exchange rate regime has considerable credibility in Costa Rica and has avoided large real exchange rate overvaluations and currency crises. However, by trading short-term real certainty against long-term nominal uncertainty, through the systematic targeting o f the real exchange rate, rather than inflation, the current regime has promoted dollarization.

16. bank’s negative net worth and the weak fiscal situation, limit the capacity to reduce and stabilize inflation. Inflation has been around 10 percent for the last five years and lower inflation would facilitate monetary management by reducing uncertainty in real interest rates and limiting incentives for dollarization. However, an essential condition to achieve sustainable inflation stabilization i s that the central bank be recapitalized, so as to eliminate i ts operating losses. Early 2004, the Government announced a strategy for the capitalization o f the Central Bank that will take place over the next three years. To that end, in January 2004, the Government’s external bond issue o f US$250 mil l ion w i l l be used to partly recapitalize the central bank.

The FSAP also signals that the exchange rate crawl, together with the central

17. Trade and Competitiveness. Negotiations on CAFTA were successfully completed in January 2004. Following ratification by the Costa Rican and U S Congresses, the treaty would consolidate Costa Rica’s access to i t s major market for both exports and imports and is expected to further boost trade, foreign direct investment and growth. CAFTA will provide a more permanent framework for trade expansion than that currently available through the Caribbean Basin Initiative, which is temporary and subject to unilateral changes by the US. CAFTA is expected to extend benefits beyond the trade arena, providing disciplines for the non-discriminatory treatment o f investors, dispute resolution, protection o f intellectual property rights and other areas that are likely to strengthen perceptions o f Costa Rica’s commitment to stable rules o f the game and attract further investments. Currently, Costa Rica i s reviewing its regulatory and institutional frameworks for trade and investment, with a view to ensuring that complementary measures are in place to take maximum advantage o f the opportunities afforded by CAFTA.

18. The CAFTA agreement signed by Costa Rica is an important instrument to promote trade expansion. However, it i s also an important indicator o f the national commitment toward modernization o f the economy and the creation o f a more competitive environment. In the past, Costa Rican had been reluctant to entertain privatization and private participation in infrastructure, with certain key sectors - telecommunications, insurance, energy- subject to considerable restrictions andor closed to private participation andlor foreign investment. With the signing o f CAFTA, the Government o f Costa Rica has accepted opening up to private participation, both domestic as well as foreign, the provision o f cellular telephone services, internet, private

8

data networks and the provision o f both voluntary and mandatory insurance services. Opening to private participation wi l l be gradual and results w i l l begin to materialize as early as December 2004, and with sectors fully opened by 2008.

19. By and large, Costa Rica has an open international trade and investment regime and investors have been attracted by i ts political and economic stability and i ts well- educated labor force. The legal framework i s conducive to attracting foreign direct investment as the investment requirements do not discriminate between foreign and national investors. The World Economic Forum Microeconomics Competitiveness Ranking provides a useful starting point to assess the business environment o f a country by conducting qualitative surveys on the state o f factors such as physical infrastructure, logistics, human resources, capital markets and competition policies. Among 80 countries surveyed, Costa Rica ranked 44 in the index for 2003, making it the leader among Central American countries. The Global Competitiveness Report also highlights Costa Rica’s notable strength in areas such as research and development, labor-employer relations and quality o f management schools.

20. In spite o f Costa Rica’s past accomplishments and enviable competitiveness position, the country faces some important challenges that call for attention in the years to come. The Global Competitiveness report identifies three major areas where Costa Rica shows competitive disadvantages: overall infrastructure quality, venture capital availability and administrative burden for startups. Regarding infrastructure provision, investments in this area are carried out by public companies that have and continued to face fiscal constraints, preventing them from undertaking new projects. As a result, coverage has not improved, especially in areas such as water and sanitation, ports, and telecommunications; maintenance has deteriorated in some areas; and quality has suffered.

21. The Doing Business Survey, conducted by the World Bank, provides additional information on the obstacles to growth that firms face in relation to starting a business, labor regulation, contract enforcement, and credit registries and procedures for closing a business. In terms o f business registration costs and procedures, Costa Rica ranks relatively well when compared to other Central American countries, especially with respect to the necessary expenses to start a business. However, there i s s t i l l room for advances to reduce the number o f days needed for registration where Costa Rica ranks lower than some o f i t s Central American neighbors. In terms o f contract enforcement, evidence suggest that many indicators for Costa Rica lag behind other Central American countries. This difference i s especially important in the case o f the duration o f procedures and the costs associated with them. In addition, evidence suggests that Costa Rica has relatively complex procedures for enforcement o f contracts.

C. Poverty, Gender and Social Development

22. As noted earlier, Costa Rica made substantial progress in reducing headcount poverty and improving social sector indicators over the 1990s, driven largely by economic growth and significant public investment in the social sectors. As a

Poverty Trends

9

result, the proportion o f people below the poverty line declined from 3 1.9 percent in 199 1 to 20.6 percent in 2000, while extreme poverty declined from 11.7 percent to 6.1 percent in the same period, as can be seen in Chart 2 below. At end 2003, official data from a survey made by the National Statistics and Census Bureau shows that the number o f families living in poverty decreased to 18.5 percent. This i s the f i rst time in five years that this index shows a significant drop. The survey also found that the percentage o f families living in extreme poverty decreased to 5.1 percent in 2003.

Chart 2. Costa Rica Poverty Incidence 1991-2003 (as o f YO of total households)

3 5 . m

3.0%

25.0Dh

20.oo/o

15.@h

1o.m

5 . m

O.CP/a I I I I I I I I

31Yh 1 294% 1 232% X)Ph 204% 1 216% X)Ph 1 19Ph 1 20699 1 206% 1 20Yh 1 206% 1859

23. Costa Rica has also made significant progress in closing gender disparities. A reduction in the total fer t i l i ty rate from 7 children in the 1950s to 2.8 in 2000 has facilitated women's entry into the labor force, while taking the pressure o f f men as the main family providers. Women now comprise over 30 percent o f the economically active population, compared to 25 percent on average for Central American as a whole. Costa Rica has also successfully closed the education gender gap, although some new disparities are emerging, especially at the secondary level. Currently enrollments levels for males and females are roughly equal at primary and tertiary levels, but girls outnumber boys at secondary level (1 11:lOO). For the population as a whole literacy is higher among women than men. Costa Rica does well in terms o f the gender wage gap. In 2000, women's salaries were 86.3 percent that o f men's salaries, which is a much smaller gap than that prevailing in many OECD countries, L i fe expectancy at birth for females i s about 5 years higher than for males, approximating the difference prevailing in higher-income countries. However, there are gender issues which deserve continuing policy attention: (i) there is an increasing share o f women-led households among families

Gender

10

l iving in extreme poverty; (ii) women, together with young adults (less than 25 years old) show the highest open unemployment rates; and (iii) the adolescent fertility rate o f 85 per 1,000 in women aged 15-19 i s greater than the average for Latin America (75 per 1,000 adolescent women).

24. Social Inclusion Costa Rica’s success in reducing the poverty headcount - an undeniably significant achievement -- has not yet, however, overcome the social exclusion o f indigenous peoples and Costa Ricans o f African descent, who are disproportionately represented among the poorest 5 percent o f Costa Rican households. Indigenous households, which comprise about 1.7 percent o f the Costa Rican population, s t i l l live in conditions o f extreme poverty, about 42 percent in indigenous territories and the remainder in surrounding areas or in urban centers (principally San Jose). In part, this reflects the fact that the National Commission for Indigenous Affairs has not been fully effective in fulfilling i ts mandate o f defending indigenous rights and coordinating across sectors to ensure that development programs are adapted to indigenous needs. The Afro- Costa Rican population, too, continues to be concentrated in the poorest parts o f the country (Limon province and the immediate vicinity). While a small minority has attained social and financial success and some important advances are apparent in education and national political participation, it remains the case that Afro-Costa Ricans, like the country’s indigenous inhabitants, disproportionately experience low human capital development, high unemployment, and limited access to infrastructure services.

25. Over the past decade or so, Costa Rica i s grappling with a new challenge to i ts efforts to reduce poverty and promote social inclusion- namely accelerating immigration from neighboring Nicaragua. Currently, 8.8 percent o f the population i s o f Nicaraguan origin? Thus far, Costa Rica has shown a unique attitude within L A C countries in maintaining a policy o f social inclusion vis a vis Nicaraguan immigrants, including promotion o f respect for diversity and non-discrimination in labor polices and the provision o f social services. Despite these efforts, the welfare o f Nicaraguan migrants i s noticeably below that o f the rest o f the Costa Rican population. Currently 7.1 percent o f Nicaraguan households in Costa Rica live in shanty-towns (versus 1.5 percent o f Costa Rican households), and only 38.8 percent o f children o f Nicaraguan origin aged between 13-19 years attend school (versus 61.3 o f Costa Rican origin). To avert increasing social tension, renewed efforts are needed to develop a coherent policy framework to deal with the formalization o f immigrants and the adoption o f actions to reduce opportunity gaps o f Nicaraguan immigrants in accessing education, housing and qualified employment, and reinforce a culture o f recognition and tolerance.

D. Human Capital Development

26. As discussed at the outset o f this document, Costa Rica’s strong and sustained effort with respect to strengthening social services has had important pay-offs for the welfare o f i ts population. Overall, the main human development indicators are far above those o f neighboring countries and have shown considerable improvement over time: l i fe expectancy at birth i s close to 78 years, the infant mortality rate was 11 per thousand live

FLASCO, based on MEC, July 2002

1 1

births in 2001, access to safe drinking water i s around 80 percent, primary enrollment i s near-universal and illiteracy has dropped to only 5 percent o f the population over 12 years o f age.

27. Currently, Costa Rica spends more on social services, relative to GDP and as a share o f public expenditures, than other countries in Latin America, and considerably more than the average for other countries at similar stages o f development outside the region, Over the last ten years, Costa Rica's total public spending grew seventy percent in real terms, and the share o f public spending allocated to the social sectors increased from 59 percent to 63 percent, with spending in education and pensions growing more rapidly than spending in health and social protection. The level o f spending, and the fact that many social programs are well designed and targeted, will help Costa Rica attain the MDGs. Nonetheless, continued attention to improvements in sector resource use and management is needed in some o f the social sectors, given the country's tight fiscal situation which leaves l i t t le room for continued increases in social spending to address the service gaps and coverage needs. In this context, the Government i s currently developing a strategy to improve the institutional framework to coordinate the implementation o f social programs and to improve coverage for the rural and poorest, most vulnerable population groups. The Bank has assisted in this effort via a study on social expenditures which i s summarized in Annex C. The study highlights priorities for education, health and social protection in meeting the needs o f the poor, and includes policy recommendations aimed at improving the impact o f existing resources.

28, Education Costa Rica has made major advances in the education sector, reaching nearly universal primary coverage and low rates o f illiteracy, and has gone further than most countries in introducing modern technology. There have been some improvements in secondary education enrollment, increasing from 40 percent in 1990 to nearly 50 percent by 1999 and further increasing to 54 percent by 2001. By 2002, 97% o f all children aged 7-12, 61% o f adolescents aged 13-15, and 61% o f youth aged 16-18 were enrolled in different levels o f the education system.

29. Despite increases in spending and in coverage rates, high repetition and dropout rates indicate that system performance has not kept pace over the decade. The problem o f over-age children i s worrisome, parti'cularly in the last years o f secondary school. Twelve percent o f children aged 10 are already behind in terms o f the appropriate grade for age, and the problem increases with age to 30% o f children by age 12, 50% o f adolescents by age 13, and 62% o f youth by age 18. In terms o f school completion, only 78.4% o f children finalize the primary cycle, 53.4% finalize the third cycle (grades 7-9), and 33% the secondary cycle (grades 1 1-12). These indicators are significantly worse for the poor and rural populations.

30. There are concerns regarding equity in education achievements in al l grades and the situation did not improve in the 1990s despite substantial increases in spending. In 1999, 92% o f al l children in the highest income groups but only 62% in the lowest income groups completed primary schooling, and the rate for the latter group was the same as in 1990. Overall, only 15% o f 20 year olds from the lowest income quartile

12

have completed 12 years o f education, whereas the proportion i s 4 times higher for the highest income quartile. During the period 1995-1 999, enrollment in lower secondary increased for the wealthiest quartile from 90.8% to 92.4%, but decreased slightly, from 67.8% to 66.8%, for the lowest income quartile. During the same period, preschool enrollment o f 5 year-olds from the highest income quintile increased by 25%, but only by 18% for the rest o f children in the age group.

31. Health The Constitution o f Costa Rica requires the State to finance and ensure the provision o f far-reaching social services to the people. A result o f this mandate is the establishment o f a universal health system, which gave the State an overwhelming presence in the health sector. Starting in the 60s, efforts to strengthen the health system focused on public sector financing and delivery. However, factors such as the poor organization and the lack o f incentives to use resources efficiently and effectively exposed the health system to significant risks that threatened the attainment o f the Government’s goals. To correct these problems, the authorities put in place a wide- ranging health sector reform at the beginning o f the 90s that received support from key stakeholders as well as from all political parties.

32. As a result, the efficiency o f public resource use increased and outcomes improved. By the end o f the 1990s, health conditions in Costa Rica were among the best in LAC: life expectancy at birth was about 8 years higher than the L A C average; mortality rates in infants and children under five were about 4 times lower; and health insurance coverage reached 65% o f the labor force3. The coverage o f primary healthcare was further expanded and hospital productivity increased. At the same time, public health spending was reduced from 6.7% o f GDP in 1990 to 5.3% o f GDP in 1999. The strong national commitment to the reform and government leadership in promoting dialogue and consensus-building for change underpins the reform effort.

33. Social Assistance Costa Rica has a well-established social assistance network which spends an estimated o f 1.5 - 1.8 percent o f GDP per year to protect vulnerable groups and to deliver a wide variety o f social programs. There are, however, critical gaps in social assistance provided to key vulnerable groups such as inadequate coverage o f programs for poor children under five years o f age and for the elderly poor. The importance o f increasing the effectiveness o f i t s programs is underscored by the fact that Costa Rica spends a much higher percentage o f GDP on social assistance than other similar countries. There have been recent improvements in program coordination and a few programs have been eliminated, but efforts are needed to continue improving the system. Targeting o f most safety net programs has been traditionally weak but it i s anticipated that the introduction o f a new system that selects beneficiaries for a number o f programs, such as the school voucher and scholarship programs, school stipends to poor children, and other direct income support programs operated by the Instituto Mixto de Ayuda Social (IMAS), should improve the situation.

Social Sector Reform to Improve Poverty Outcomes: Lessons from Costa Rica and El Salvador WB Report, October 2003

13

IV. COSTA RICA’S DEVELOPMENT CHALLENGES

34. As the preceding analysis indicates, Costa Rica is in a strong position vis a vis i t s Latin American neighbors as it enters the new century, but faces a number o f challenges in continuing i ts impressive record o f sustainable growth, continued poverty reduction and social equity in an increasingly integrated and competitive global economy. The Costa Rican Government has identified four main challenges: maintaining macroeconomic stability, strengthening trade and competitiveness, sustaining social progress with particular attention to reaching indigenous and Afro-Costa Ricans, and continuing Costa Rica’s leadership on environmental issues. These challenges and the Govemment’s strategy for addressing them are summarized below.

A. Maintaining Macroeconomic Stability

35. Putting the economy back on a sustainable growth path requires dealing with recent deterioration in fiscal accounts and improving monetary and financial policies. The strategy should include actions on four fronts: (i) achieving fiscal sustainability; (ii) strengthening public sector debt management and debt market development; (iii) strengthening monetary policies to address the dollarization risk; and (iv) continuing the reform o f the financial sector to avoid macroeconomic and fiscal risks.

36. Achieving fiscal sustainability. The noticeable deterioration in public finances since 1999 i s fundamentally explained by a combination o f sluggish tax revenues and inflexible public expenditures. While part o f the growing domestic debt is cyclical, stemming from depressed international conditions and slow domestic growth, structural deficiencies on both the revenue and expenditure front require prompt action to avoid longer term sustainability problems,

37. In order to address fiscal imbalances, Costa Rica needs to deepen reform efforts in two key areas. The f i rs t i s the modernization o f the tax structure. The system would benefit from replacement o f the current sales tax with a true value-added tax with fewer exemptions, as well as applying income taxes to al l income, regardless o f whether generated in Costa Rica or abroad. The second is the rationalization o f public expenditures, including the removal o f some o f the rigidities that have been gradually introduced into the budget and that leave l i t t le room for discretionary fiscal policy. In 2001, over 60 percent o f expenditures covered wages, pensions and interest costs, while 47 percent o f tax revenues were earmarked for specific expenditures! Public expenditure reform also requires improved prioritization o f investment expenditures and better targeting o f social protection programs.

38. The Government’s strategy to address the above challenges i s defined in i ts Economic Recovery Plan.’ In relation to fiscal sustainability, the government i s aware

Agenda de Transformacion Fiscal para e l Desarrollo. Report prepared by the Ad-hoc Commission o f Former Finance Ministers in April 2002. * The “Plan de Reactivacibn Economica 2002 - 2006” was prepared by the Economic Counsel and launched by the Govemment in July 2002.

14

that a significant improvement in public finances i s needed and the strategy includes (i) the adoption o f an emergency tax package and o f a strong expenditure reduction program, that took place in 2003; (ii) enhanced efforts in tax administration and the approval o f a comprehensive Fiscal Reform, that wi l l ensure fiscal sustainability in the medium term; (iii) the restructuring o f the Public Sector debt; (iv) the strengthening o f customs administration; and (v) the implementation o f the Public Sector Budget Law aimed at improving the budget administration and promoting transparency and accountability

39 Strengthening Public Debt Management and Domestic Debt Market Development.6 Weak public debt management can contribute to high real interest rates and vulnerability to external interest and exchange rate shocks. Prudent management o f the risks inherent in a debt portfolio and development o f a deep and liquid domestic debt market go hand in hand with assuring short- and long-term funding o f the fiscal deficit. In addition to i ts high level, the structure o f Costa Rica’s domestic public debt also is risky in terms o f i t s exposure to exchange rate and interest rate shocks and i ts relatively short maturity.

40. During the past few years, the authorities have been making important progress in modernizing public debt management. However, this progress has been divided among different government and central bank units. The key reason for this division i s the quasi-fiscal deficit o f the Central Bank (BCCR), which requires that, in addition to the debt issued by Tesoreria, BCCR also issues debt both for open market operations (OMOs) as well as funding i ts deficit. As a result, debt issuance objectives are sometimes conflicting, and this has led to a lack o f an integrated strategy for managing the aggregate public sector debt portfolio and i ts risk implications for the government balance sheet, and for developing the domestic debt markets.

41. To strengthen and modernize public debt management it will be necessary to focus on issues such as governance, strategy and risk management; and institutional capacity building. The government requested participation in the Bank Treasury’s program for public debt management and domestic debt market development, and the Country Assessment has been carried out. The government has begun to develop a reform plan to strengthen debt management as well as the development o f the debt markets. The reform plan will be designed by country officials from the BCCR and Bank staf f from Treasury who are involved in debt management and debt analysis, together with officials from the three key Superintendence in the areas o f Securities, Pensions, and Banking. Annex D summarizes the Costa Rica Country Assessment in Debt Management and Domestic Debt Market Development.

42. Strengthening monetary policy. Dollarization i s on an increasing trend, starting from an already-high level. According to the recent financial sector assessment, 45 percent o f deposits and 50 percent o f loans o f the onshore banking system are dollar- denominated. As al l operations o f offshore banks are in dollars, about 60 percent o f loans o f the consolidated (onshore and offshore) banking system are dollar denominated. The

Based on the joint World Bank-IMF Aide Memoire o f the Public Debt Management and Domestic Debt Market Development Country Assessment.

15

consolidated private banking system i s much more dollarized than the public system. Over 75 percent o f private bank loans are in dollars, compared to 47 percent in the case o f the consolidated public banks; and it is estimated that about half o f onshore dollar loans are to debtors whose incomes are not in dollars, which increases the vulnerability o f the system to exchange rate shocks.

43. Costa Rican authorities are aware that the high degree o f dollarization i s a major vulnerability and the challenge i s to strengthen the macroeconomic framework to better balance the risks o f the transactions in colones and dollars. Dollarization in Costa Rica also appears to reflect other factors, including increasing international integration and uncertainties about public sector debt sustainability, which undermines the role o f the , colon as a store o f value, fostering deposit dollarization, and raises the domestic real interest rate, contributing to loan dollarization. The authorities are taking steps to reverse this trend, such as: removing distortions that favor lending in U S dollars (eliminating differentiated tax treatment o f deposits in different currencies, increasing provisioning on dollar loans, raising capital requirements on dollar loans) and encouraging banks to build their dollar liquidity.

44. Continuing the Reform of the Financial Sector ’ The Bank-Fund financial sector assessment (FSA) o f Costa Rica, based on information available as o f end-2001, presented an overview o f the country’s financial system, key vulnerabilities and a set o f recommendations. Besides the findings related to weak bank supervision, undercapitalized public banks and preferential regulatory status that public banks enjoy over private banks, the study indicated that the entry o f the private sector into the financial system has not been accompanied by a well-defined bank resolution strategy for public financial entities. Private financial entities, which initially competed among themselves in businesses not dominated by public banks, such as offshore banking and fund management, have been increasingly competing with public banks. At the same time, public banks correctly argue that the elimination o f certain privileges implies a slow death o f public banks under the pressures o f competition, unless the governance and administrative constraints on the public banks’ capacity to compete are simultaneously lifted. In order to increase the performance o f the financial sector in i ts key role o f intermediating resources for investment, the financial assessment also recommended among other things, the elimination o f obstacles to a level playing field for all financial institutions.

45. In 2002 the government launched a comprehensive effort to address financial sector challenges with a series o f reforms aimed at strengthening prudential regulations, bank supervision and the financial system safety net. The government’s strategy also includes the insurance sector, which at present constitutes a state monopoly, preventing the development o f domestic insurance markets, and limiting consumer choice. Regarding anti-money laundering, important progress has been made in strengthening the anti money laundering legislation. Reforms approved by Congress in early 2002 aligned the anti-money laundering law closer with international standards, while the

Based on the Financial Sector Assessment (FSAP) report for Costa Rica that was completed in August 2002 and discussed extensively with the authorities on September and November 2002

16

Superintendency o f Financial Intermediaries (SUGEF) issued new guidelines and rules establishing the minimum standards that are to be complied with by Costa Rican institutions. However, there are some remaining areas for improvement and the Bank i s ready to discuss policy measures to further improve AMLlCFT systems and seek ways to provide necessary assistance. The authorities have incorporated the recommendations of the FSAP into a reform agenda, within a coherent plan that sets out priorities, allocates institutional responsibilities, and provides for coordination mechanisms. Annex E summarizes the main findings and recommendations of the financial sector assessment, as well as the salient measures adopted by the authorities since year 2002.

B. Strengthening Trade and Competitiveness

46. Although overall, Costa Rica’s business environment compares well to the rest o f LAC, there i s s t i l l ground for further gains in order to provide the basis for sustainable growth. To further improve the investment climate and facilitate private-sector led growth, key areas o f attention include: (i) administrative simplification; (ii) continue lowering obstacles to Costa Rican exports through CAFTA and other bilateral, regional and global agreements; (iii) broaden access to financial services; (iv) improve key infrastructure; and (v) invest in innovation and technology.

47. Administrative Simplification As mentioned elsewhere, Costa Rica has a long l i s t o f accomplishments and an enviable position in the area o f competitiveness. However, the country faces some challenges with respect to administrative simplification, where the country has began to lose ground vis a vis i t s main competitors and some o f i ts regional neighbors. Areas that require attention and improvements include: (i) labor markets are over-regulated, (ii) enforcement o f contracts can be cumbersome, time consuming and expensive; (iii) procedures for creation o f new firms are time consuming even though they are low cost; (iv) taxation at central and local level is relatively complex; (v) custom procedures could be streamlined; (vi) business regulations and registration procedures could be improved and Costa Rica could strive for a simpler, streamlined, and digitalized process, making it possible for investors to apply online for company registration.

48. Supporting Trade Costa Rica’s trade openness is high, near the top in LAC, with the ratio of trade to GDP reaching 70 percent in 2002. The high exposure o f the economy to international markets has been a key-driving factor behind the positive growth and diversification record o f recent years. High levels o f trade are due to trade- friendly policies including unilateral trade liberalization since the mid 1980’s, complemented by an aggressive agenda o f bilateral and regional free trade agreements. In January 2004 Costa Rica successfully completed free trade negotiations with the United States. This treaty i s expected to (i) boost exports by making permanent and expanding the Caribbean Basin Initiative trade preferences currently enjoyed by Costa Ricans exporters and (ii) improve perceptions o f the investment climate by locking-in many o f the reforms o f recent years and thus attract new national and foreign investment. In addition, CAFTA is expected to consolidate the Central American Common Market trading block. Key challenges that Costa Rica will face in the implementation o f CAFTA

17

include how to derive the most benefit from new trade opportunities, how to ensure that the benefits o f the treaty spillover to all segments o f the population, and how to cushion the potential negative impact on a few sensitive protected activities (mainly traditional agricultural activities). On the latter, Costa Rica was able to obtain a long tariff phase- out periods (10 - 20 years) for most o f i ts sensitive crops, as well as the exclusion o f tariff reduction commitments for potatoes and onions.

49. government and the country at large, including

In the area o f private participation CAFTA presents important challenges to the

e Designing and adopting new legislation for ICE (Instituto Costarricenese de Electricidad) in 2004. The plan i s to obtain Congress approval o f a new Telecommunications Law in 2004. Creation o f a new regulatory agency for the telecommunication and the insurance industry in 2006. In telecommunications, Costa Rica has a regulatory entity, ARESEP, that mainly reviews tariffs, but it will have to re-engineer it or create a new entity to oversee the telecom sector, as the issues become much more complex in a liberalized and competitive market. Developing the legal and institutional framework for private participation in internet and data networking in 2006, in cellular telephony in 2007, for the purchase o f insurance through foreign private providers as soon as CAFTA enters into effect, and for the creation o f private companies providing voluntary insurance in 2008. Finally, in 201 1, Costa Rica will have to be ready with the legal and institutional framework to allow for the creation o f private companies providing mandatory insurance services. Providing the space and mechanisms to allow for consultation and consensus building in support for the reforms and ensure that private participation i s compatible with the country’s policies o f universal service coverage and social protection.

e

e

e

50. Broadening Access to Financial Services. The financial sector i s increasingly diversified, though centered on banking intermediation. Credit i s allocated on market terms, although the state-owned banks sometimes act as development banks for those activities deemed to be o f public interest, such as SMEs. The four state-owned banks accounted at end 2002 for more than 50 percent o f the banking system, but the 17 private banks have been steadily increasing their share. While banks account for the lion’s share of financial sector assets (77 percent), investment funds (mutual funds and pension funds) have grown rapidly in recent years. While small and medium enterprises s t i l l face constraints in accessing credit, some positive developments are apparent on which Costa Rica hopes to build: first, increased competition in the banking sector - driven by the rise in private banks -- has meant that both private and public banks are seeking to expand their customer base; and, second, a number o f non-governmental foundations have arisen which focus on providing small and medium enterprises with better access to credit through indirect and direct financial assistance.

18

5 1. Improving Key Infrastructure. Given the reduction in public sector investments in the recent past, Costa Rica’s efficiency indicators in the key infrastructure sectors are starting to lag behind other countries, especially compared to countries which compete with Costa Rica in attracting investments, Sustained economic growth requires significant investment in infrastructure that the public sector will continue to face difficulties in undertaking given Costa Rica’s severe fiscal constraints. Consequently, there i s a need for increasing cash generation by service providers and for attracting private sector investment in all infrastructure areas. Although political circumstances in the recent past have not favored privatization, efforts are being made to build support towards a greater participation o f the private sector through management contracts and concessions to encourage private investment in key areas o f the economy, including roads, airports, ports, electricity, telecommunications and water and sanitation infrastructure. In this context, regulatory uncertainty regarding private sector participation in the sector should be addressed. If not addressed, it could raise the level o f regulatory risk perceived by investors, and limit private investment to the sector.

52. Investing in Innovation and Technology. Costa Rica displays an efficient and functional National Innovation System. The amount o f patents produced per dollar invested in R&D i s high for L A C and worldwide standards. This i s due to the higher quality o f research institutions and the strong collaboration between public and private efforts. However, Costa Rica’s indicators o f innovation performance (Le., number o f patents and scientific publications) are not above international norms mainly due to low levels o f R&D expenditure, a characteristic that it shares with most L A C countries. Recent Bank analytical work suggests that Costa Rica should be investing more in R&D than in the 1990s due to the high economic returns to this type o f investment.

C. Sustaining Social Progress

53. The past decade has demonstrated that significant improvements are possible in the socioeconomic condition o f the poor when economic growth is combined with social programs that are well designed to reach the poor. However, progress in poverty reduction and social sector performance has been uneven, and there are important gaps between rich and poor. Sustained progress w i l l have to rely on better use o f expenditures, as further increases in social spending i s likely to be limited by fiscal and financial constraints.

54. The impact o f social spending in Costa Rica could be improved with the creation o f mechanisms that exploit synergies, reduce program overlaps, and improve overall effectiveness of programs in the areas o f education, health, and social protection. The strategy o f the Government is to progressively improve the impact o f social spending and ensure poverty reduction even in periods o f slower growth, through the implementation o f the recommendations o f the Social Spending and the Poor study in education, health and social protection. * ’ Based on the Document ofthe World Bank “Costa Rican Social Spending and the Poor” finalized in October 3 1,2003.

19

55. Despite commitment o f a high share o f public resources to the education sector, outcomes have been mixed. Compared to other middle income countries, Costa Rica has better than average education outcomes (especially so in primary education), but these outcomes are uneven across regions, rural and urban areas, and across income groups. In secondary education, however, outcomes are considerably below average, even when spending outpaces other medium income countries. Evidence shows that education services in Costa Rica are not sufficiently reaching the poor, 65 percent o f whom live in rural areas. In order to redress the situation, the Government expects to achieve improvements in the following areas: (i) quality o f rural education (formal and non-formal modalities); (ii) secondary education access through creative and cost-effective education strategies; (iii) student-centered pedagogical strategies and pertinent curriculum application supported by teacher training, educational materials and technology; (iv) equity o f access, specifically improving targeting and impact o f education demand-side programs managed by the Ministry o f Public Education (MEP) and other institutions such as IMAS (school vouchers, cash transfers to poor families, scholarships, transportation, and school meals); (v) efficiency and synergies among education sector institutions and optimization o f allocated resources; and (vi) collaboration with the productive and corporate sector to increase school-to-work opportunities and develop pertinent skil ls and competences.

Education

56. Health In order to keep the achievement o f health related MDGs by 2015 on track, improve the quality and equity o f health care, and assure financial sustainability o f its almost universal health insurance system, the Costa Rican government i s committed to continue the health reform process started in the early 1990s by: (i) strengthening the stewardship role o f Government on the sector; (ii) improving performance o f the well extended primary health care model, integrating better targeted health education and public health programs; (iii) further developing the separation o f the purchasing and provision functions within the public system and streamlining the corporate structure and procedures o f the Caja Costarricense de Seguro Social; (iv) increasing management and financial autonomy and capacity o f health providers in the public sector; (v) reducing current disparities in expenditures levels by region; (vi) increasing performance o f public facilities by reforming the payment and incentive mechanisms; (vii) substituting unnecessary hospital care with more efficient care modalities; (viii) optimizing the prescription, utilization and procurement o f pharmaceuticals and medical supplies; (ix) strengthening collection o f social security revenues and the financial information system o f the Caja Costarricense de Seguro Social; and finally, (x) developing alternative delivery arrangements through public-private partnerships.

57. UN AIDS estimates the prevalence o f HIV in the adult population o f Costa Rica at 0.6%. At this level o f prevalence, the epidemic i s s t i l l believed to be largely concentrated among high-risk groups. Like many countries, Costa Rica's surveillance system has major problems o f coverage, under-diagnosis and under-reporting o f HIV. A sentinel HIV prevalence survey i s underway in the country which should yield later this year more information about the epidemic. Most funding for HIVIAIDS prevention and treatment comes from domestic public and private spending. Costa Rica's Social Security

20

System finances anti-retroviral treatment for people living with HIVIAIDS. In terms o f external assistance, the Global Fund to Fight AIDS, TB, and Malaria signed a grant agreement in July 2003 for $2.3 million for Costa Rica for a two-year program o f HIV prevention and comprehensive care. As o f January, 2004, only $100,000 had been disbursed.

58. Water and Sanitation Costa Rica has made meaningful progress in expansion o f water services in urban areas over the past decade. In 2000, Approximately 98 percent o f the urban population was connected to water supply. A similar percentage was either connected to public sewerage or individual septic systems. Rural coverage i s lower, with about 75 percent o f the population connected to public water supply and about 97 percent connected to sanitation services, mostly through the use o f septic tanks. Coverage rates in water and sanitation countrywide mask significant shortcomings in the quality o f service. Water systems are operating with high water losses, In addition, only about 70 percent o f the population receives water o f potable quality per estimates o f A and A’s National Water Laboratory. As for sanitation services, 96 percent o f all urban wastewater collected i s discharged into rivers and receiving bodies without any treatment, generating respective public health risks and water resources contamination problems. In the metropolitan area o f San Jose, only 47 percent o f the population is connected to sewerage networks, which discharge raw sewage to the water courses that cross the city. Overall, the country water production capacity is very close to current demand, so the risk o f future water deficits i s high.

59. Going forward, the Government o f Costa Rica envisages maintaining urban water coverage at 98.5 percent and a drastic increase coverage o f urban sewerage from 21 to 89 percent by 2020. It also envisages an increase in rural water supply from 75 to 90 percent over the same period. The total investment required for implementing this program would amount to about US$1.6 billion or approximately US$SO million per year, reflecting the many years o f neglect in the maintenance o f A and A’s assets. This corresponds to four times the average annual investment during 199 1-1 998 and over five times the amount during the eighties. In the past, over 60 percent o f the sector investments came from government resources, half o f which was financed by multilateral loans. However, given the current investment needs o f the sector, the government can no longer continue to provide such a level o f support. The main problems faced by the water and sanitation sector in Costa Rica are: (i) outdated centralized sector model and inadequate sector policy framework; (ii) unsatisfactory performance o f service providers and low quality o f provided services; (iii) large backlog in sanitation infrastructure; (iv) high investment needs in the sector; and (v) low tariffs and poor cost recovery.

60. Social Assistance Although Costa Rica has a well-established social assistance network aimed at protecting vulnerable groups, spending priorities in social assistance need an urgent change. To offer better services, avoid duplications and reduce costs, institutions need to be strengthened and modernized. Priority actions should be taken in the following fronts: (i) improve coordination and reduce program duplication; (ii) introduce legislative changes to the law that governs the Social Development Fund, so that the government may change spending priorities according to needs, allowing a rapid

21

respond to crisis times; (iii) improve targeting mechanisms and apply them to allocate resources and select beneficiaries in social sector agencies, particularly FODESAF, IMAS and the CCSS; (iv) reorganize social assistance programs within IMAS to improve effectiveness, increase coverage, and reach the poorest and more undeserved population; and (v) complete coverage o f the poor by non-contributory assistance pension programs

D. Continuing The Leadership I n Environmental Management

6 1. Costa Rica has in many ways been at the forefront o f sustainable environmental practices: pioneering debt-for-nature swaps in the mid- L980s, putting in place institutional structures and responsibilities for environmental management, and establishing ecological reserves covering close to 25 percent o f the country’s territory. Given Costa Rica’s rich biodiversity - about 5 percent o f known species worldwide - it has been a world leader in environmental issues and has developed markets for global and local environmental services, providing the country with a source o f foreign exchange and contributing to rural development. The country’s progressive environmental policies have fostered the development o f an important eco-tourism industry, the conservation o f biodiversity, the preservation o f important forest ecosystems on privately-owned lands, the promotion o f the sale o f environmental services by private sector forest owners, the valorization o f environmental services by private forest owners, and the production and sale o f certified environmentally friendly products.

62. Despite i ts pioneering leadership and remarkable progress in environmental management and biodiversity conservation the Government faces a major challenge - namely achievement o f financial sustainability in the sector. This is an ongoing issue o f great importance because the conservation and sustainable use o f Costa Rica’s natural wealth is dependent to a large degree on a substantial Government role in maintenance o f the vast national park system, the payments for environmental services, and the many other roles the ministry plays. The budget o f the Ministry o f Environment in Costa Rica i s larger than that o f all other ministries o f environment in Central America combined, and improving the financial sustainability o f i ts programs is critical.

63. Other challenges which could affect Costa Rica’s leadership and image in the environmental sector lie: (i) in the water and sanitation sector, where improvements in management and performance urgently needed (see para 57 above); and (ii) in the exploration o f the nexus between agriculture and the environment. Both the Ministry o f Environment and o f Agriculture are strongly committed to finding solutions that will allow for a productive, sustainable agriculture both reduces poverty among smallholders and incorporates conservation practices that are fully integrated into the rural landscape. Costa Rica has already advanced considerably in this area and has marketed certified environmentally friendly products in many parts o f the world.

22

V. WORLD BANK GROUP’S COUNTRY RELATIONS

A. The Last CAS: Impact and Lessonsg

64. The World Bank’s Board o f Directors discussed the last CAS, in conjunction with SAL I11 o f $100 million, in March 1993. It proposed lending o f about US$280 million for the period 1993-1997, to support a continuation o f the Government’s adjustment efforts in the areas o f public sector reform, financial sector reform, trade and the regulatory framework, and also a selective program o f investment loans in the water and sanitation, urban, health, transport, education and forestry sectors. The adjustment loan straddled two administrations and after a number o f extensions was cancelled two years later under President Figueres’ Administration (1 994-98) following mutual agreement that the tranche release conditions were unlikely to be met in the foreseeable future. The process leading up to the cancellation o f the adjustment loan negatively affected Bank relations with the Figueres Government. In 1995, the Government requested Bank management not to consider new lending, since i ts extremely tight fiscal position would not allow it to provide the necessary counterpart funding. Instead, it was agreed that the Bank would focus on ensuring effective implementation o f the ongoing portfolio and the provision o f non-lending services that could help the country implement i t s reform program.

65. The Government o f President Rodriguez, (1998-2002) appreciated the non- lending support provided by the Bank and was also keen to reestablish a lending relationship, Two new IBRD projects were approved: Ecomarkets (FYOl) and Health Sector Strengthening and Modernization (FY02). During this period, the Bank also continued to support reform efforts through formal sector work, non-reimbursable technical assistance, grants, and analytical and advisory services in the areas o f pension and financial sector reforms, investment o f international reserves, energy environment, forest conservation, bio-diversity, social programs, health, education, gender and information technology. A total o f about US$18.9 mil l ion in grant funding (PHRD, GEF, IDF) was provided between FY98 and FY2002. (see Annex B4)

66, The CAS Completion Review (CASCR) in Annex Bla, analyses the relationship between Costa Rica and the Bank since the last CAS, Drawing both on the FYOO Country Assistance Evaluation (CAE) carried out by OED and the L A C Region’s own assessments o f past experience the CASCR emphasizes the following lessons:

a Given Costa Rica’s institutional environment, a thorough and inclusive process to build wide social support i s needed to get National Assembly approval and to implement reforms, hence Bank lending should focus on areas where a broad consensus has already been forged as to both the need for reform and the general direction o f expected reforms. This i s especially true given the political context

’ See Annex B l a for a fuller discussion ofthe evaluation o f the contribution o f the Bank’s program in Costa Rica and the lessons learned during the previous CAS period (1993-1997).

23

described in paragraph 8 and the potential for delays in key initiatives given the role o f the Constitutional Chamber (Sala IV). In Costa Rica’s case, it may not always be appropriate to link potentially productive individual projects to broad sector-policy reforms. When trade and price policies are crucial for the results of an investment project, the Bank should ensure that the proper environment i s in place before the project i s approved, but not as condition for effectiveness. The Bank can effectively partner with Costa Rica via non-lending activities including well-focused ESW, advisory services and grants in areas o f mutual interest. In several areas, including the social sectors and the financial sector, the Bank’s support for analysis and policy dialogue helped build a consensus on the need for reforms and change. Similarly, IDF, GEF and PHRD grants have contributed, through studies, analyses, capacity building and evaluation o f pilot activities, to build consensus around sectoral policies and programs. Finally, well-focused and structured advisory services (such as the RAMP program) have clearly helped build considerable capacity within the public sector.

e

B. Current Bank Group Program

67. IBRD and GEF Assistance The implementation capacity among the Government and the different entities i s quite strong and the portfolio implementation o f Costa Rica has been good. Over the past three decades 87% o f Bank projects achieved satisfactory development outcomes, compared with 70% for L A C and 74% Bank-wide. The Bank’s current lending portfolio in Costa Rica includes two projects: The Ecomarkets Project ($32.6 million approved in FYOl) and the Health Sector Strengthening and Modernization Project ($17.0 million approved in FY02). The portfolio also contains two GEF grants for Biodiversity and Ecomarkets, with net commitments o f US$15 million. In the absence o f significant new lending over the past decade, analytical and advisory activities became an important vehicle o f Bank assistance, including the Poverty Assessment update (FY97); Pension Reform Strategy (FY99); INTEL’S Plant Report (FY98); Reserves Advisory and Management Program (FY02); Social Spending and the Poor (FY02) and Financial Sector Assessment Program (F Y 02).

68. Ecomarkets Project Costa Rica’s progressive environmental policies have fostered the development o f an important eco-tourism industry and the Bank has been helping Costa Rica to address some cutting edge environmental problems through the Ecomarkets project. This project is financed by a combination o f an IBRD loan, and grants from the GEF and the Prototype Carbon Fund and aims to foster biodiversity conservation and preserve important forest ecosystems on privately owned lands outside o f government protected areas in the Mesoamerican Biological Corridor. The Bank, through the Prototype Carbon Fund (PCF) and related carbon finance vehicles, has taken a leading role in the early implementation o f the Kyoto Protocol and can be help to further develop Costa Rica’s growing carbon trading market by new project development, capacity building and replication o f best practices. Special efforts are undertaken to link

24

carbon finance benefits to community development and poverty reduction. Current efforts are centered on the Renewable Energy Umbrella Project, which replaces fossil- fired electricity generation with a package o f mini-hydro and wind sub-projects. Further potential has been identified for projects that aim to use landfill gas for power generation and thereby further improve sustainable waste management practices, for new renewable electricity projects, and for activities in the forestrylland management and transport sectors.

69. Health Sector ~odernizutjon Project The health reforms in Costa Rica, which have been supported from their inception by the World Bank, have contributed to further reduce poverty in the country, from i ts already low levels by Latin American standards. As a result o f the advances made, the challenges facing Costa Rica’s health sector are now similar to those facing much more advanced countries. As part o f the Health Strengthening and Modernization Project, the Bank is supporting the Government o f Costa Rica to improve health system performance and financial sustainability by supporting the ongoing policy changes in the health sector in Costa Rica. Most o f these changes are part o f second-phase reforms in the Costa Rican Social Security Institute (CCSS). (i) align the organizational and functional structure o f the CCSS with recent changes separating financing, purchasing and provision o f health services at all levels; (ii) promote improvements in quality and fulfillment o f consumer rights, as well as the efficiency and effectiveness o f the Ministry o f Health (MOH) as a regulatory agency, by strengthening the institutional and regulatory framework; (iii) improve the quality and efficiency o f the CCSS health delivery system by supporting decentralization o f decision-making, consolidation o f the primary care delivery network based on a population-based system, and introduction o f performance-based incentives for providers; (iv) reduce inefficiencies in the pharmaceutical sub-sector and promote rational drug use by introducing changes in the planning, purchasing and distribution o f pharmaceuticals and supplies; (v) develop financial mechanisms that will improve the equitable distribution o f resources, improve efficiency in the provider payment mechanisms and strengthen the CCSS’s capacity to collect payroll contributions; and (vi) improve targeting o f public social expenditures by updating and strengthening the current system (SIPO) and improved sectoral coordination among human development actors: CCSS, MOH, MEP, and IMAS.

For the short- to medium-term, these policy changes will:

70. In addition to lending in support o f sector-wide reform in health, the World Bank i s also supporting policy dialogue and analysis on how best to contain and reverse the HIV epidemic in Costa Rica. In 2002 the World Bank developed a tool to help countries better understand which prevention activities should be well funded if the HIV epidemic i s truly to be reversed as soon as possible. The tool is called the Allocation by Cost- effectiveness (ABC) Model and was applied in a participatory workshop in Costa Rica in early February 2004. The model helps policymakers, NGOs, donors, and representatives o f civi l society determine the resource allocation that will prevent the maximum number o f new HIV infections at any given budget level. The model can be used to simulate the effect o f alternative resource allocations and generate consensus around the HIV prevention interventions that have the greatest impact on the epidemic.

25

71. International Finance Corporation IFC’s strategy since the 1993 CAS was to invest in viable manufacturing, education, infrastructure, tourism and financial sector projects to help diversify the economy and support private sector growth. During this period, however, IFC’s activity was limited due in part to a considerable role that has been played by the state sector in the economy, and significant public opposition to reforms, which inhibited further opening o f various sectors to private participation, IFC’s strategy in the infrastructure sector has focused on supporting viable projects that could demonstrate the existence o f attractive private sector opportunities with a high developmental impact. Such i s the case o f the FYOl U S 1 2 0 million (including US$S5 mil l ion from participants) committed investment for the Juan Santamaria International Airport project approved in FYOl -- 1FC’s largest ever investment in Costa Rica. Thus far, this investment has been affected by uncertainties related to the tariff methodology, as the Contraloria issued a report invalidating some o f the costs inputs used by the government. Negotiations between the Government and the sponsors on th is issue are advancing. The outcome o f the negotiations will likely have an impact on future private sector participation in other infrastructure projects.

72. IFC’s portfolio, as at the end o f November 2003, amounted to U S 1 8 2 million (US$97 million for IFC’s own account and US$S5 mil l ion for the account o f participants) by the held balance (including the outstanding and the undisbursed). A large part o f the portfolio consisted o f investments in infrastructure, retail trade, and the financial sector. During the FY99-04 period (through November 2003), six projects have been committed totaling US$212 mil l ion (including US$S5 mil l ion for the account o f participants), in retail trade, finance, health, infrastructure, and agribusiness. This includes the airport investment mentioned above and a FY99 US$40 mil l ion financing to assist a Costa Rican retail operation to expand, not only in Costa Rica but to other Central American countries and the Dominican Republic. In November 2003, IFC also committed US$20 million financing for Banco Interfin, a leading private sector bank in Costa Rica. The investment, which followed IFC’s two previous credit lines primarily for SME on- lending, US$5 mil l ion in FY93 (fully repaid) and US$15 mil l ion in FYOl, would be used for SME on-lending, and the bank’s capital strengthening, among others.

73. Multilateral Investment Guarantee Agency (MIGA) Costa Rica became a member o f MIGA in February 1994. The outstanding portfolio in Costa Rica consists o f 15 contracts o f guarantee, o f which 1 1 are in the tourism sector, two in the infrastructure and two in the manufacturing sectors, with a total gross exposure o f US152.4 million and net exposure o f US$128.3 million. During FY03, one project totaling US$81 mil l ion in the tourism sector was executed in Costa Rica. MIGA has not had any technical assistance engagements in Costa Rica in recent years, however, MIGA’s on-line investment promotion services partner with two organizations who provide investment promotion content: The ComitC de Zonas Francas de las AmCricas (CZFA) - based in Costa Rica - concluded FDI Xchange Content Partner cooperation agreement with MIGA in July 2003; and the Costa Rican Investment Board (CINDE) concluded the F D I Exchange Content Partner cooperation agreement with MIGA in October 2002. MIGA’s on-line investment promotion services feature 1 19 documents on investment opportunities and the related legal and regulatory environment in Costa Rica.

26

C. Country Assistance Strategy FY04 - N O 7

74. This CAS envisages a highly selective program o f lending and non-lending services, focused less on resource transfer objectives and more on knowledge sharing and advisory services in areas o f mutual interest - Le., where Costa Rica’s successful poverty reduction and economic diversification efforts and pioneering leadership in environmental management would be instructive for other Bank clients as well as areas in which the Bank’s global experience could benefit Costa Rica’s efforts to address second generation problems in key sectors. Given the very tight fiscal situation in Costa Rica, the Government has indicated that it i s only interested in projects that “pay for themselves” through efficiency gains leading to cost-savings or revenue generation from tariff increases. The CAS will seek to support the country’s development objectives through: (i) selective priority investment projects in education, water and sanitation, environment, infrastructure, agriculture, and information and communications technologies ; (ii) knowledge and advisory services to support reforms in critical areas o f public sector debt management, domestic debt market development, financial sector reform, Central Bank management o f international reserves and to support greater private participation in infrastructure; and (iii) economic and sector work, including the five core diagnostic studies, an investment climate assessment and regional studies on key issues for Central America. Table 3 below summarizes the Bank’s assistance program for FY 2004-2007.

75. CAS Results Framework The Government of Costa Rica and the Bank have agreed to develop this country strategy as a result-based CAS. The results monitoring framework i s shown in Annex Blb. The approach which w i l l be implemented and refined over time, was constructed on the basis o f Costa Rica’s development challenges outlined in this proposed country strategy. The monitoring indicators were developed jointly with the Government and Government i s fully committed to achieving the results specified. Progress toward the medium-term outcomes, to which the government and al l i ts partners, including the Bank Group, contribute, should be achievable within the CAS period (2004-2007) and will be monitored using intermediate indicators and the Government’s own data collection and monitoring and evaluation systems. The results framework lays out planned lending and non-lending Bank activities which contribute towards specific outcomes during the CAS implementation period. Progress within the framework would be reviewed during periodic joint program reviews between the government and the Bank’s country team. I t should be noted that the indicators to be monitored are already effectively collected on a regular basis by the Ministry o f Finance, the Central Bank, the General Comptroller’s Office and the sectoral line ministries. Bank staff has reviewed the existing systems for data collection and information related to the results identified and found them to be of adequate quality to enable meaningful monitoring o f development progress.

27

76. Lending The CAS envisages a lending program o f about US$218 million, which would involve six operations covering the period 2004-2007. Three areas where the preparation o f new lending operations are relatively advanced are: (i) education, where the Bank is partnering with Government to develop a new approach to tackling remaining inequity and efficiency problems in the sector; (ii) the water and sanitation sector, where the Bank in partnership with the Government o f Japan (JBIC) i s proposing a new approach to tackle problems o f coverage, quality and sustainability; and (iii) Puerto Limon area (one o f the poorest areas o f the country), which aims to transform the city into a regional center o f economic growth, contributing to alleviate poverty and inequalities particularly for the Afro-Costa Rican population, as well as improving the overall competitiveness o f the country. In addition, the CAS envisages a possible follow- on environmental project aimed at improving financial sustainability in the sector, a small e-Government learning and innovation loan aimed at improving public sector efficiency and citizen services through rationalized information technology applications, and an Agriculture Sector project aimed at helping the smallholders, including ethnic minorities, fare adequately under the more competitive conditions which will likely result from the CAFTA agreement.

77. The proposed lending program, albeit quite modest, represents an increase in both the scope and size o f Bank lending compared to the last decade. The Govemment i s clear about the areas where they would l ike Bank support and i s not interested at this stage in discussing additional lending under a high case scenario. As usual, a CAS Progress Report would be prepared in case o f significant changes to the CAS program laid out in this report, for example if during CAS implementation the Government should request additional lending. Conversely, in case o f adverse developments - for example if portfolio implementation were to deteriorate, or continued difficulties on the fiscal side were to lead to problems with counterpart funding - the Bank would review with the Government whether to proceed with the lending operations in the outer years.

78. Education Project (FY04 US830 million) During the development and preparation o f the Education Loan, the Bank has supported the development o f the Ministry o f Education’s “Plan de Relanzamiento Educativo” which aims at closing the quality and equity gaps between rural and urban education, while improving the efficiency o f the education sector institutions and the resources allocated to them. The Project w i l l support Costa Rica’s education policies in the following areas: (i) increasing quality and equity o f rural education; (ii) improving targeting and impact o f the education equity programs (scholarships, school meals, school transportation, and conditional transfers for low income families), and (iii) strengthening the efficiency o f the existing institutional capacity o f the education sector, at the central, regional and school levels. The Project will support an innovative mechanism including targeting and monitoring tools (Sistema de Informacion de Rezago Educativo, SIRE) to identify and support those municipalities with the lowest level o f education indicators (mostly rural). Such targeted support should also take into account those municipalities with a majority o f indigenous people, and would explore possibilities to introduce bilingual/inter-cultural education. The proposed implementation strategy will promote coordination, synergy and efficiency o f the existing capacity o f the Ministry o f Education and i t s operational and technical

29

units. Regional Departments and Schools will be involved in defining strategies and investments to achieve the education policies targeted by the Project. Both institutions administrating the Equity Programs and the school level community participation entities called (Juntas Escolares y Administrativas), which already receive an important share o f the education budget, will be strengthened so that they can be more effective in improving education outcomes

79. ~ o ~ e r n i z a t i o n of the Water and Sanitation Sector (FY0.5 US$70) The development objectives o f the project are: to initiate the modernization process o f the water and sanitation sector in Costa Rica; and to complete the construction o f the sewage collection, conveyance and treatment system o f the metropolitan area o f San JosC. The project would be composed o f the following components: (i) development and implementation o f a Design Built Operate (DBO) contract for collection, treatment and disposal o f the wastewater o f San Jose to be managed by a private operator; (ii) development and implementation o f a contract for hiring a private operator to manage the commercial operations o f the water and sewage public enterprise (AyA); (iii) modernization o f financing mechanisms for water and sanitation services in rural areas; (iv) development and implementation o f a pilot program for incorporating the private sector in the provision o f W&S services in four medium size cities; (v) preparation and implementation o f a program for reduction o f unaccounted for water; (vi) development o f a long term strategy for water supply in the metropolitan area o f San JosC; (vii) implementation o f an institutional reform o f the sector and o f AyA; and (viii) strengthening o f environmental management capacity. The estimated project cost amounts to US$230 million. J3IC demonstrated interest to finance component A, which has an estimated cost o f about US$ 160 million.

80. Port City of Limon (FY05 US$ 70 million) The long-term purpose o f this project i s to collaborate in the transformation o f the Port-City o f L imon into a regional center o f economic growth, thus helping to improve the country’s overall competitiveness and to alleviate the city’s very high poverty rate and social inequalities particularly with respect to the black population. Achieving this would require working both at the national and local level, developing soft skills and capacities, carrying out reforms and upgrading the quality o f infrastructure facilities and services locally. This i s an ambitious agenda, which cannot be fulfilled within the term o f a typical investment project. Under that perspective, the project i s conceived as a f i rs t step towards that direction, with development objectives less ambitious than the one stated before. The key development objective would be to improve the business environment within the port, and revitalizing the urban situation o f the city o f Limon. The project would seek to: (i) improve the port’s business environment and build consensus regarding subsequent and more complex reforms needed to ensure long-term sustainability; (ii) revitalize the urban environment in the conurbation o f Limon; (iii) leverage the interface and synergies between the port and the city; and (iv) reduce poverty and increase social inclusion o f Afro-Costa Rican households in the Province through the provisioning o f increased economic opportunities and their active and informed participation in project related activities

.

30

81. Environment/Ecom~rkets 11 Project (FY06 US$30 million) This loan w i l l be focused on enhancing the financial sustainability and value added o f the country's protected area system (public and private). Having made a major decision on the use o f such a large part o f i ts land, the country could generate much greater returns from i ts protected areas by improving access and making parts accessible to tourists with minimum facilities such as small museums, paths, and other amenities which in turn could generate substantial returns from higher entrance fees. I t is anticipated that the park system would become financially sustainable, rather than a burden on public finances. The same is true for the payments for environmental services, where a more concerted effort to extend the (small) fees to more users could also make this close to se l f sustaining, while protecting the environment and reducing poverty. In addition to the Ecomarkets Loan 11, the proposed GEF grant for the Central-America Indigenous Integrated Ecosystem Management Project would also support the conservation and use o f the rich natural resources by indigenous communities in Costa Rica.

82, E-Government Citizens Services Learning Innovation Loan (LILj (FY06 US3) The key objective o f this loan would be to increase public sector efficiency and improve citizens' access to public services via a coherent and coordinated application o f information technology applications and provision o f web-based services to the general public. The project would support: (i) Government's efforts to devise a coherent strategy and detailed time-bound action plan for how to integrate the different disjointed IT based systems currently operating in the public sector; and (ii) implementation o f key aspects o f the "integrating strategy". This effort would include a critical review o f the Digital Govemment Program (DGP), an assessment o f the steps and resources needed to integrate the already-operational IT based systems with new applications, and a re- formatting o f the DGP, to adjust it to the requirements o f possible inputslsupport from donor agencies. In the course o f project preparation and implementation, the Bank would also help formulate a strategy to help secure the funding necessary to fully implement the "integrating strategy" above. In this regard, the Bank would help facilitate donor coordination and donor financing to leverage grants from different funds and agencies in support o f the different IT components o f the Costa Rican Digital Government Program.

83. Agriculture Project (FY07 US$15) Since the 1980's Costa Rica has made an extraordinary effort to increase and diversity i t s exports. This has been especially important as the world market prices o f most traditional exports, including coffee, have continued to decline. The agricultural sector has been particularly successful at diversifying: basic grains which are noncompetitive have largely been eliminated, and substituted by a number o f nontraditional exports including shrimp, tropical fruit, agro- industrial products, sustainable products (organic, fair trade, etc), root crops, ornamentals and many others. However, there is concern how the smallholders wi l l fare under CAFTA. The Bank will help Costa Rica address this concern with a proposed operation which would better prepare the agricultural smallholder sector for this heightened competition and new opportunities under CAFTA.

31

84. IFC Strategy. In Central America, IFC's support to the countries i s provided at both the country and the regional level. The small economies o f the Central American region would benefit from economies o f scale, through greater integration o f their physical and financial infrastructure. In the case o f IFC, the regional approach has increased investment opportunities in Central America. In the Central American region, IFC i s focusing on: (i) physical infrastructure; (ii) strengthening and deepening the financial sector; (iii) supporting competitive f i rms in agriculture and industry; and (iv) promoting investments into Central America from other Latin American and emerging market economies. The strategy in Costa Rica has focused more on pursuing investment opportunities, when they arise, in (i) regional capital markets development and possible strengthening of local financial institutions, (ii) viable manufacturing and service projects, and (iii) the agricultural sector. These will continue to be IFC's strategy pillars in Costa Rica during this new CAS period.

85. Knowledge and Advisory Services A key focus i s assistance in the area o f public debt management and domestic debt market development, following the completion o f an initial country assessment by the Bank in July 2003. The Bank i s also providing training in reserves management to Central Bank staff. Following the completion of an FSAP for Costa Rica, the government has indicated interest in continued Bank support for the implementation o f financial sector reforms via technical assistance and other advisory services. This will be pursued, possibly with support from a recently established donor supported grant facility (FIRST) to assist the FSAP follow-up. Finally, the Government has requested technical assistance to improve infrastructure through public-private partnerships, with initial priority given to telecommunications.

86. The Public Debt Manag~ment and Debt Market Development Country Assessment and Action Plan The objective o f Bank involvement is to provide support to the Costa Rican authorities to develop an action plan, based on a detailed World Bank assessment, to improve the government's capacity in central government debt and cash management (including management o f financial guarantees), and in the development o f the domestic debt market. This project will require the active participation o f the authorities to support the areas that need strengthening, propose strategies for their resolution and implement the action plan. The Bank has already begun to provide advice and assistance, helping to ensure coherence of the overall process and act as catalyst to coordinate efforts across institutions.

87. Reserves Advisory and Management Program @AMP) Under RAMP, the Treasury i s managing a part o f BCCR's foreign exchange reserves and providing technical advisory services aimed at upgrading the internal and international reserves management capacity. The engagement was initiated in December 200 1 and significant progress has been made in building internal capacity. Over the f i rs t two years, TRE has sent about 10 on-site missions and around 18 staff from BCCR has been to Washington for training. The Central Bank o f Costa Rica entered into the third year o f the asset management and capacity building engagement with the World Bank Treasury. The engagement encompasses governance, investment strategy, portfolio management and analytics and systems support. The BCCR has to date met al l o f the performance

32

objectives set out in the original needs assessment and annual project plans. The term o f such engagements i s limited to three years and BCCR i s on track to "graduate" from the program in December 2004. TRE fully expects, however, to continue a collaborative relationship with the BCCR to sustain the progress made to date. The program has constituted an extremely useful non-lending facility aimed at strengthening the internal and international reserves management capacity o f the Central Bank o f Costa Rica.

88. Financial Sector Assessment and its Implementation The Bank assistance would support the main recommendations o f the FSAP such as the establishment o f effective consolidated supervision; leveling o f the playing field for public and private banks; strengthening o f the system for crisis management; opening up o f the insurance state monopoly to competition; and, modernization o f the pension system. The messages o f the FSA Report, recently published through the World Bank website, particularly the messages regarding public banks and the risks o f unsupervised offshore banking, have generated a healthy public debate on reform options. The World Bank has started to help enrich the debate through recent presentations by Bank members at the Costa Rica's I11 Banking Association Congress (June and August 2003) that have been well received and have created a good environment for further policy dialogue with World Bank participation. Finally, following the signing o f CAFTA, Costa Rica would gradually open up i ts insurance sector and with the help o f the World Bank has started to prepare a diagnostic report that would include a medium-term strategy. The Bank assistance will concentrate on: (i) the preparation o f a draft insurance law; (ii) the report on the observance o f standards and codes (ROSC); (iii) a market evaluation; and (iv) a strategy for the reform taking into consideration the framework o f the free trade agreement.

89. Financial Sector Reform and strengthen in^ Initiative (FIRST) This i s a multi- donor joint venture being undertaken by the World Bank, IMF, the UK, Switzerland, Canada, the Netherlands, and Sweden, and has been set up, among other things, to fund follow-up to FSAPs, covering: banking systems and supervision; capital markets, domestic debt markets and management; financial systems diversification; and all other areas relevant to financial sector integrity and development. The Costa Rican authorities have showed considerable interest in accessing FIRST funds to finance assistance for the financial sector reform and following a FIRST mission to Costa Rica in June 2003, the Bank i s working with the Costa Rican Authorities in a joint identification o f reform priorities and derived TA work programs.

90. Technical Assistance to Improve I n ~ a s ~ u c t u r e through public-private Partnersh~s. As previously mentioned, Costa Rica's capacity to compete in export markets, i t s capacity to maintain i ts competitiveness as a destination for foreign investments and, in general, the business climate is affected by the quality and coverage of i t s infrastructure. New investments to improve coverage and quality have not kept pace with growing needs. Public companies continue to face fiscal constraints, preventing them from undertaking new projects. Bank assistance to Costa Rica will be aimed at facilitating private involvement in the financing, operation, rehabilitation, maintenance, or management o f eligible infrastructure services. Bank involvement in this area will include: (i) developing strategies and measures to tap the full potential o f private

33

involvement in infrastructure in ways compatible with Costa Rica’s traditions and existing legislation, (ii) identifying, disseminating, and promoting relevant best practices; (iii) building consensus for appropriate policy, regulatory, and institutional reforms; (iv) designing and implementing specific policy, regulatory, and institutional reforms in areas identified by the Government; (v) supporting the design and implementation o f pioneering projects and transactions, (vi) building government capacity in the design and execution o f private infrastructure arrangements and in the regulation o f private service providers.

91. The Government o f Costa Rica and the Bank have agreed that during th is CAS period, it will be o f high priority to support the country meet the challenges associated with CAFTA in the area o f telecommunications. Even though the support for private participation will include other sector such as roads and water, the telecommunication sector wil l be the highest priority, specially in areas such as: (i) preparation o f new telecommunications law and regulations; (ii) assistance to the new telecom regulator to grant new licenses for cellular mobile service, internet and data services, international service and private networks; (iii) assistance to develop the new regulator staff and capacity building; (iv) assistance to prepare a strategic plan for the management and monitoring o f the radio frequency spectrum.

92. Tax incentives assistance through Foreign Investment Advisory Service (FUS). The FIAS Program i s considering providing additional assistance to Costa Rica on tax incentives and an acceptable effective tax burden for high-tech industries. The assistance will involve a review of the relative importance o f tax issues for these industries in their international location strategies, with the purpose to inform the parliamentary debates about the planned tax reform, as well as setting the country’s investment strategy with respect to high-tech industries. This work i s a follow-up assistance to the one completed in early 200 1 on the issue o f tax reform.

93. Economic and Sector W o r k In carrying out the core diagnostic ESW required for active Bank Borrowers, the Bank proposes to focus the analysis on specific topics o f particular interest and strategic relevance to Costa Rica. The sources o f growth and competitiveness, with particular attention to addressing the bottlenecks in infrastructure through greater participation o f the private sector, would be covered in a Country Economic Memorandum (CEM) in FYOS. The Poverty Assessment (FY05) w i l l focus on recent poverty and inequality trends and in-depth analysis o f why the growth elasticity o f poverty was low during 1994-2002 , as well as the implications o f migration. A Public Expenditure Review (PER) would further update social spending analysis, including expenditure tracking to support monitoring and evaluation o f specific programs in FY06.

94. Country Financial Accountab j ~ i ~ Assessment and Country Procurement Assessment. The CFAA will analyze and give advice on financial management practices in the public sector, thereby supporting the Government strategy to improve public finances and administrative simplification in key areas: modernization o f tax and customs administration, operational implementation o f the Public Financial Management and Budget Law, effective use o f the integrated financial management system, and sound

34

mechanisms to track public expenditures - particularly in the social sectors. The CFAA will also analyze the implementation o f the internal and external control norms for transparency and accountability, Regarding the country procurement assessment, the Bank has limited direct experience in Costa Rica and has relied upon what i s known from an earlier CPAR prepared by IADB. The new CPAR should highlight a few issues such as: ex-ante as well as ex-post controls by Contraloria, which may cause undue delays in awarding contracts; gaps in the regulatory framework and procurement law not covering semi-autonomous entities such as public utilities that carry out the bulk o f procurement; new e-procurement initiatives; lack o f capacity of executing agencies and Ministr ies to prepare bidding documents; and lack o f experienced procurement staff among civi l servants. Following previous successful experiences in Latin America, the Bank w i l l seek to conduct the CFAA and CPARjointly with the IDB.

95. Regional Studies There are several region-wide initiatives in the Bank's analytical pipeline that w i l l benefit Costa Rica. A planned Central America wide regional study on CAFTA will be completed in FY04, to be followed in FY05 by a regional study on Trade Facilitation and Logistics, both o f which should support the design o f an agenda to obtain maximum benefits from the free trade agreement with the US. ALSO, an analysis o f the Drivers o f Rural Growth in Central America (FY05) i s expected to develop new insights into rural development strategies with a strong emphasis on geographic considerations. Finally, social protection issues related to shocks in the countryside wil l be the subject o f the Central America-wide study on Shocks and Social Protection (FY04).

96. Investment Climate Assessment As mentioned before, Costa Rica has achieved a relatively good competitive position among the CAFTA countries but shows some areas for further improvement. To overcome limitations inherent in qualitative and subjective surveys and to provide a useful tool for policy design, the World Bank has designed the Investment Climate Assessment (ICA) which consists o f a large survey followed by in depth studies o f conditions related to the investment and business environment in which the f i rms operate. To meet this challenges and simplify business registration and operation, the Government o f Costa Rica and the Bank have agreed on the implementation o f an Investment Climate Assessment (FY05), that will collect and analyze information and formulate recommendations on issues such as investment approval and licensing; other authorizations require form private companies; businesslcompany registration; central bank and finance ministry (income tax, VAT) registration or approvals; required registrations with statistical offices, social security, labor, etc.; immigration and expatriate visas, work permits, and residence permits; local and municipal business licenses; access to land and land titles or long-term leases; construction and building permits; environmental permits and approvals; utility hook-ups (including telephone, water, sewerage, and electricity); selected sectoral approvals (from line ministries); general regional or municipal authorizations (if any); and formalities required after firms begin operations, such import'export clearances and licenses, labor, health or safety inspections, tax and customs reporting and reimbursements, etc. The assessment will identify the number o f days required to complete each stage o f the investment process could detail the costs o f each step o f the process. The I C A will provide policymakers with

35

information to make policy decisions that address Costa Rica’s most pressing bottlenecks for businesses. The ICA i s part o f a broader approach to faster private sector competitiveness in Costa Rica and complements other activities in the CAS, including the proposed Water and Sanitation Project, the Puerto-Limon Project, the Financial Sector Assessment and Financial Sector Reform and Strengthening Initiative (FIRST) and the Regional Study o f Trade Facilitation and Logistics. The Bank would be open to discuss avenues for supporting the implementation o f the I C A recommendations.

D. Coordination with Partners

97. There i s no formal aid coordination mechanism in place for Costa Rica (the last CG meeting, chaired by the Bank, was held in 1993), and the Government coordinates assistance programs directly with each o f i t s creditors. The Bank has been coordinating with other partners on specific projects and activities, such as education, environment and financial reform, We will continue to work closely with the Government and i ts creditors to ensure complementarity and coordination o f the respective assistance programs.

98. Inter-American Development Bank (IDB) The short and medium term objective o f the IADB Strategy with Costa Rica i s to accelerate economic growth as a necessary condition to reduce poverty. This objective could be achieved creating a favorable environment for business and improving competitiveness in the production o f goods and services through two strategic axis: (i) consolidate macroeconomic stability, mainly reducing fiscal deficit; and (ii) develop production to facilitate the integration process to the regional and world economy, and take full advantage o f trade liberalization. IDB i s Costa Rica’s largest lender with a total net commitment o f $592 million and an undisbursed portfolio o f US$204 million at end February 2004. The program contains a hybrid operation” o f $350 million that will support fiscal reforms aimed at creating a stable macroeconomic environment, and will fund public sector investments for road improvements, secondary education, modernization o f technology, strengthening o f the capacity o f the public sector to manage foreign trade, development o f a competitiveness strategy, improvement o f the business climate, and helping the adjustment o f the small and medium enterprises to free trade. The program also includes another policy based loan o f $100 mil l ion intended to strengthen public expenditure efficiency. These operations will be coordinated with the Bank’s proposed operations under this CAS . IDB and other donor operations and their links to development challenges are shown in Table 4.

99. To the extent that the f i rs t stage objectives are attained, the strategy would continue supporting the strengthening o f fiscal discipline with a second stage o f the program consisting o f a second “hybrid operation” o f an amount to be determined, that would put emphasis on reforms needed to enhance spending efficiency, modernization o f the tax revenue collection o f local governments, and strengthening o f the administration and service delivery systems. The investment program during the second stage would

lo Called “hybrid operation” because it includes a policy based loan (PBL) component and an investment component.

36

include modernization o f government procurement, streamlining o f bureaucracy, and support for financial reform.

100. International Monetary Fund (IMF) Costa Rica does not plan to seek a formal arrangement or a staff-monitored program with the IMF. The Government agrees with the Fund on the need to reduce the fiscal deficit, with the suggestions to move towards a more flexible regime, and specially with the need to eliminate the quasi-fiscal losses o f the Central Bank, however the Government has its own plan and pace. The IMF Board welcomes the govemment commitment to address the vulnerabilities as well as their desire to retain full ownership o f the necessary adjustment effort. In March 2003 the Article I V Consultation was concluded and submitted to the Board, together with the Financial System Stability Assessment (FSSA) based on the work o f the joint IMFlWorld Bank financial sector assessment conducted in October and December 2001. This assessment reflects the state o f the Costa Rican financial system as o f end-2001 and the findings were discussed with the authorities in November 2002 and January 2003, as part o f the 2002 Article IV Consultation. On this occasion Executive Directors praised Costa Rica for being at the forefront o f economic and social progress in Latin America over the past few decades and commended the authorities on their long-standing traditions o f democratic accountability, rule o f law and governance. However, Directors noted that macroeconomic vulnerabilities have increased sharply in recent years, presenting the authorities with major policy challenges.

101. The Central American Bank for Economic Integration (CABEI) This Bank maintains an important lending program in Costa Rica. I t s current portfolio includes eight programs with a total commitment o f $300 mil l ion and an undisbursed amount o f $225 million distributed in loans for the following sectors: infrastructure and energy (66%); health, education, water and sanitation (34%). The loans have been given to the public and private sector. CABEI wil l be involved in 2004 in other specific projects for the roads sector and lines o f credit for financial institutions. Given the active presence o f CABEI in Costa Rica, the World Bank and CABEI should coordinate the areas o f interventions through lending services.

102. Corporacion Andina de Foment0 (CAF) The Andean Development Corporation's efforts in Costa Rica are aimed at supporting infrastructure integration projects and other infrastructure projects that are considered as priorities by the govemment. CAF is currently analyzing a program for Costa Rica, in agreement with the government, o f about US$60 million for the 2003-2006 periods. This financing comprises investment projects for the development o f the areas o f Santa Clara, Puerto Limon and Sixaola. CAF i s also analyzing technical cooperation for the financing o f several required studies (environmental impact, feasibility and engineering) for the infrastructure projects. CAF i s also studying the possibility o f financing the construction o f a pipeline o f 123 Kilometers for the Costa Rican Petroleum Refinery (RECOPE), for an estimated amount o f $72 million. Finally, CAF would lend the Costa Rican Electricity Institute (ICE) in 2004, a $30 million loan for investments that were already assessed in 2003 but were not approved due to debt limits imposed to ICE by the authorities. The

37

World Bank and the CAF are coordinating their lending and non-lending services to avoid duplication.

103. Japan Bank for international Cooperation (JBIC) The Japanese Bank wil l cooperate with the World Bank in financing the proposed Costa Rica Water Sector Modernization Project. The cooperation wi l l be based on parallel financing o f the project. JBIC will finance Component A o f the Project and IBRD wi l l finance the rest o f the project components. JBIC has indicated its interest in financing component A, whose estimated cost i s about US$ 160 million. As part o f the loan processing JBIC has offered to the government “Special Assistance for Project Formation” (SAPROF), which i s basically a comprehensive project preparation study. The study i s expected to start on January 2004 and be completed on August 2004.

104. Regional Unit for Technical Assistance (RUTA)This i s a unique technical assistance project for rural development and environment. Its partners include seven o f the Ministers o f Agriculture o f Central America (including Belize) as well as the main donorsltechnical assistance agencies in the region: DFID, IICA, FAO, IF AD, World Bank, IDB, UNDP and more recently IFPRI. RUTA supports Central American Governments efforts to alleviate poverty and promote competitive sustainable activities in rural areas. It has an office in the Ministry o f Agriculture in each Central American countries, but the headquarters i s in Costa Rica. RUTA has an annual work program o f about 130 activities agreed by all the partners, and it expends about $3 million annually.

Table 4: Ongoing Donor Activities Supporting the four CAS Development Areas

-7 IDB Other Donors I. MAINTAINING MACROECONOMIC STABILITY

* Fiscal sustainability * Government eWciency

i * Structural Reform project ($12.7m) i * Cadastre Modemization proiect

j IMF Financial System Stability Ass. and 1 regular Article IV follow UPS.

* Public debt management , * Domestic debt market I * Monetaly policy

. _ . - 1 ($65m) I * Judicial Modernization project 1 ($22,4m) I

a. The table only includes the Word Bank’s ongoing activities, future activities (lending and non-lending ) are listed in Table 3.

38

CAS Program Risks

105. The risks associated with the modest assistance program proposed in this CAS are relatively low, but could escalate in the absence o f continued progress on economic reforms. The main risk which could materialize concerns the potential for macro- economic instability, which could be triggered by external factors, financial system weaknesses, and deterioration o f the fiscal situation, if the government fails to pass and implement its proposed fiscal reform. However, the risk that macroeconomic stability w i l l be jeopardized in the period covered by this CAS is judged to be modest: firstly, Costa Rica has shown it can take difficult macro decisions when faced with deteriorating economic situation; secondly, there is broad consensus on the need for fiscal reform, which i s expected to be approved by the National Assembly in the second quarter o f 2004; thirdly, Costa Rica weathered well the 2002 South American crisis and moved quickly in securing needed financing (placing $450 million in global bonds in January 2003) and avoiding contagion; and fourthly, since 2002 the Government adopted a number o f measures to strengthen the regulatory and prudential framework o f the financial system, thereby significantly lowering the risk o f a banking or financial crisis. Moreover, a very positive development occurred early 2004 when the Ministry o f Finance announced that the Government’s recent external bond issue o f US$250 million will be used to recapitalize the central bank. Finally, since taking office, the Government has consistently taken a prudent stance vis a vis macroeconomic management and there i s broad support in the Legislature on the need for sound macroeconomic policies. Although Costa Rica exceeds the Bank guideline for preferred creditor debt service to total public debt service, it is well below the other exposure guidelines pertaining to debt and debt service owed IBRD.

VI. CONCLUDING REMARKS

106. The objective o f this World Bank Group assistance strategy i s to support Costa Rica’s efforts to continue its record o f equitable economic growth and improvements in social indicators, and i ts leadership in environmental management. The proposed strategy i s the result o f analytical work, lessons from previous experience and country consultations. It i s focused on mutually beneficial activities that allow the Bank to learn from Costa Rica’s rich and successful experience in areas that are central to the Bank‘s mission, while helping Costa Rica improve the quality and impact o f public programs in key sectors, and enhance i ts competitiveness in an increasingly integrated global economy.

James D. Wolfensohn President

By: Shengman Zhang

Washington DC April 20,2004

39

Costa Rica at a glance 411 5104

27 19

86 90 11 7

130 105 131 106 128 105

9

POVERTY and SOCIAL costa Rica

3 9 4,070

16 1

Average annual gro

2.0 2.5

21 60 78 9 5

95 4

107 I08

Female 105

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 4982 1992

GDP (US$ bilhons) 2.6 8.6 Gross domestic i 24.7 20.2 Exports of goods P 45.1 35.2 Gross domestic saving 27.6 156 Gross national savingslGDP 13.2 15.0

Current account batancelGDP -11.6 4 7 entslGDP 4.2 1.2 debtlGDP $398 38.4

Total external debt servicalexports 21.2 9.5 Present value of debtlGDP Present value of debtlexports

1982-92 1992-02 2001 (average annual growth) GDP 4 4 4.6 11 GDP per capita 1.5 2.5 -06 Exports of goods and services 8.9 9.2 -9.2

Access to improved water source

--Costa Rica Upper~idd/e-jn~me group

Latin Upper- America middle. I

527 331 3,280 5,040 1,727 1,668

Life expectancy

T 1 5 1.2 2 2 Gross

primary nroliment

2001

16.4 20.1 41 6 17.2 13.3

4.5 1.4

19.8 9.9

20.7 47.2

2002

2002

16.8 21.9 42.4 16.8 14.7

-5.6 1.4

19.8 9.2

21.6 48.6

2002-06

Economic ratlos*

Trade

investment Domestic savings

Indebtedness

3.0 4.3 1.2 2.8 5.1 9.2

STRUCTURE of the ECONOMY

(% of GDP) Agriculture industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Private consumption General government consumption Gross domestic investment Imports of goods and services

Manufacturing

1982

27.7 29.1 23.0 43.2

57.8 14.6 42.2

1962-92

4.0 4.4 4.5 4.7

4.7 2.0 9.3

10.6

1992 2001 2002

13.3 8.6 8.4 30.9 29.8 29.1 23.3 22.0 21.6 55.8 61.6 62.4

72.0 68.5 68.4 12.4 14.3 14.7 39.8 44.5 47.4

1992-02 2001 2002

3.4 0.7 -2.0 5.3 4.9 2.3 5.6 -8.4 2.3 4.4 4.5 4.3

3.7 1.3 3.1 1.9 3.5 1.6 5.0 26.4 7.9 6.9 0.0 7.0

Growth of investment and GDP (%) I

0

30

20 10

-10

GDI - I GDP

Growth of exports and imports (%I I

0 I . . .

30

20

10

97 98 99 w 01 02 - Imports

-20

Exports

Note: 2002 data are preliminary estimates. * The diamonds show four key indicators in the country (in bold) compared with its incomegroup average. If data are missing,

the diamond will be incomplete.

Costa Rica

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices 90.1 Implicit GDP deflator 84.2

1982

Overall Public Sector finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeflcit

TRADE

(US$ millions) Total exports (fob)

Coffee Bananas Manufactures

Total imports (ci9 Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=1001 Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

1982

870 237 228 272 868 115 187 166

16 17 91

1982

1,125 1,053

72

-404 30

Current account balance -303

Financing items (net) Changes in net reserves

416 -113

Memo: Reserves including gold (US$ millions) -81 Conversion rate (DEC, locallUS$) 37.4

PUBLIC EXTERNAL DEBT and RESOURCE FLOWS

(US$ millionsJ 1982

3,645 IBRD 200 IDA 5

Total debt outstanding and disbursed

Total debt service IBRD IDA

Official grants Ofticial creditors Private creditors Foreign direct investment Poitfolio equity

World Bank program Commitments Disbursements. Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

245 28 0

5 105 17 29

0

0 20 12 8

16 -9

1992

21.8 20.5

1992

2,386 202 522

1,302 2,974

406 216 610

64 67 95

1992

3,061 3,417 -356

-214 163

-407

495 -88

556 134.5

1992

3,289 372

3

300 77

0

10 63

-52 210 -1 7

41 28 46 -1 9 31

-50

2001

11.3 8.4

22.3 0.2

-3.8

2001

4,923 162 516

3,645 6,569

854 41 1

1,050

176 196 90

2001

6,835 6,927

-92

-793 148

-737

750 -1 3

1,099 328.9

2001

3,243 102

2

709 37 0

14 -119 216 445 39

17 8

27 -19 10

-29

2002

9.2 9.1

22.0 -1.2 -5.7

2002

5,259 165 478

4,011 7,188

915 372

1,277

192 219 88

2002

7,141 7,724 -583

-532 1 69

-946

1,109 -163

1,264 359.8

2002

3,338 91

1

691 33 0

6 -223 226 637 337

0 12 23

-1 1 10

-22

97 9s 99 w 01

DP deflator "O'GPl

Export and import levels (US$ mill.)

8,000 7 7,000 6,000 5,000 4,000 3,000 2,000 1.000

0 96 97 98 99 w 01 02

Exports mlmports

I Current account balance to GDP (%)

I Composition of 2002 debt (US$ mill.)

A91 6 1 I I

I A - IBRD B - IDA D -Other multilateral F -Private C - IMF G -Short-term

E - Bilateral

Development Economics 411 5104

CAS Annex Bla Costa Rica CAS Completion Review 1993-2003’

1. Th is completion review undertakes an assessment o f the relationship between Costa Rica and the Bank in the 1993-2003 period. I t assesses the outcome o f the last CAS, approved by the Board on March 20, 1993 and covering the period 1993-97, as well as more recent cooperation over the period leading to the present CAS. The review draws heavily on the Operations Evaluation Department’s last Country Assistance Evaluation (CAE) which was prepared in late 2000 and covers the Bank’s assistance strategy in Costa Rica in the 1990s.

A. The Country Context

2. Costa Rica i s one o f the most stable democracies in Latin America, with a long standing commitment to inclusive economic growth, social welfare and the environment. I t s economic and social indicators show better results than those in al l other lower- middle-income Latin American countries. Historically, however, the pace o f reform has been slow and driven by a highly democratic process o f achieving consensus. Growth and the absence o f military expenditures allowed the Government to devote a high share o f public funds to social programs and environmental concerns, however high domestic debt and serious fmancial imbalances in the 90s led to the questioning o f the long term viability o f the Costa Rican model.

3. After a strong decline in coffee prices in 1978 and the o i l crisis in 1979, Costa Rica did not adjust public expenditures accordingly and the Government suspended servicing i t s external debt. To deal with the crisis, the Government initiated in 1982-83 a stabilization program supported by the IMF and a structural adjustment program supported by the Bank and IADB. The main objective o f the reform program was to overcome two severe impediments to g r o ~ the anti-export bias o f the trade regime and an overextended and inefficient public sector. The structural reforms during the period 1984-93 were aimed at liberalizing international trade and reducing the role o f the state in productive activities, reducing effective protection, increasing incentives to exporters, and improving the efficiency o f public sector institutions. The Government was committed to reducing export taxes, maintaining a competitive exchange rate and decreasing the level and dispersion o f import taxes.

4. During the period 1994-99 the Government’s program gave priority to re-defining the role o f the state and improving the efficiency o f private markets, while continuing to provide for poverty alleviation and environment’s protection. President Figueres (1 994- 98) was able to continue the trade liberalization program, improve fiscal discipline and managed to attract a significant volume o f foreign direct investment in high-tech industries. The Government o f President Rodriguez (1998-2002) gave high priority to the fmancial sector reform and to open public enterprises to competition with the private sector. Specifically, important areas for reform included changes to the banking and

’ Prepared by Ana Lucia Armijos, Senior Economist, LCSPE

social security systems and to the regulatory framework to allow private participation in public utilities and natural monopolies controlled by the state.

B. Evaluation of the Country Assistance Strategy 1993-1997

5. The Country Assistance Strategy (CAS 93) was presented to the Board on March 10, 1993 in conjunction with a proposal for a Third Structural Adjustment Loan (SAL, 111), which was to be the last quick disbursement lending operation for Costa Rica. The strategy also proposed to focus on a relatively small investment program based upon &e Bank's perceived comparative advantage at the time, The overall program was contingent on the Government maintaining an appropriate macroeconomic framework and on successful implementation o f the structural adjustment program. The reform program, supported by the FY93 CAS, included four pillars: (i) public sector reform, (ii) social sectors and poverty alleviation, (iii) trade and regulatory framework and (iv) financial sector reform aimed at reducing the country's vulnerability to external shocks and the recurrence o f macroeconomic disequilibria prompted by inappropriate fiscal policies equitable society.

6. The proposed lending program also included six sector investment loans in water and sanitation, health, forestry and bio-diversity, transport, education and urban. The economic and sector work (ESW) program was expected to produce a Country Economic Memorandum to focus on public sector reform. An ongoing forestry sector review would support an operation to improve forestry and bio-diversity managemat. An urban sector study would help define policies to be included under a proposed urban project. Finally, a Poverty Assessment study would review progress in poverty alleviation and seek improvements in targeted interventions and the poverty orientation o f social spending.

7. The outcome o f CAS 93 was unsatisfactory. The adjustment loan straddled two administrations, and was cancelled after two years following mutual agreement that the tranche release conditions were unlikely to be met. None o f the other sector investment lending, and only part o f the planned economic and sector work, was delivered during the 1993-1997 period covered by the CAS. Indeed, following the cancellation o f the adjustment operation, the government explicitly requested the Bank to reduce lending and to increase technical advice.

8. OED believes that the authorities were uninterested in Bank lending because of their perception that it would be difficult to reach agreement with the Bank on the political feasibility and a realistic schedule o f policy and institutional reforms. The CAE concluded that the 1993-97 CAS was based on a correct diagnosis o f Costa Rica's long term development problems and included highly relevant objectives. However, it included inappropriate lending instruments, overlooked lessons o f experience and ignored political realities on the feasibility and timing o f some o f the specific measures required. Consequently, the Bank was unable to deliver i t s lending program and the policy dialogue deteriorated. The CAE notes:

2

The CAS included inappropr~ate lending instruments and poorly designed reform programs, in spite of available lessons of experience. The adjustment operation was not appropriate to pursue the proposed objectives since i t included comprehensive institutional reforms in the public, financial and social sectors which required Congress approval o f legislation as conditions for loan effectiveness. The lessons o f experience show that Costa Rica has been a steady, but slow, reformer, with a long process of internal debate and consensus building before major reforms are approved by Congress. However S A L I11 included the passage o f legislation as a condition for loan effectiveness. Consequently, the Bank had to extend the deadline for the loan effectiveness six times while waiting for the authorities to achieve the required passage o f legislation by Congress, and ultimately the loan was cancelled. The CAS ignored political conditions. The Bank assistance strategy was undermined by a poor appreciation o f the political conditions determining ownership o f the reform program. The Project Completion Note o f SAL, I11 concluded that the loan was terminated because the program was designed, negotiated and signed by one Administration while i ts implementation was left to a new Administration that had a markedly different approach to the issues involved.

9. Following the cancellation o f the SAL,, the Bank supported the objectives o f the strategy mainly through supervision o f the small portfolio o f projects already under implementation. According to the Bank's internal performance indicators, Costa Rica has achieved satisfactory development outcomes in implementing the Bank-supported portfolio. The portfolio (total commitments o f US$310 million) evaluated by the Bank during 1994-99 achieved satisfactory development outcomes. The evaluation includes three projects subjected to independent evaluation by OED and four ongoing projects evaluated by the region, not yet subjected to independent evaluation, which the Bank rated as satisfactory. It i s noteworthy that over long evaluation periods, the overall portfolio o f the Bank in Costa Rica has generally achieved better results than in most other clients. Over 1970-1999, about 87 percent o f Costa Rica's portfolio achieved satisfactory development outcomes, which is much higher than the 70 per cent or the 74 per cent satisfactory rating achieved in the same period by LCR or by the Bank, respectively.

10. During the 1993-1997 period, the Bank failed to complete a Country Economic Memorandum that was needed to define the policy agenda for discussions with the Government o f President Figueres in 1994 and failed to produce an urban sector study intended to define policies to be included under a proposed urban project. However, it did prepare an update o f a poverty study (Ey97) to identify the needs o f the poor and an influential study proposing a pension reform strategy.

3

C Post CAS 93 period

1 1. In the last few years, Bank lending to Costa Rica has resumed on a very modest scale, with the Bank Board approving two loans - an Environment Loan for US$ 32 million in 2000 and a second Health Sector Modernization Loan for US$17 million in 2001. Furthermore, during the latter part o f the nineties, the policy dialogue improved and the Bank was instrumental in providing advice to help implement those reforms that had achieved political support and studies to help achieve consensus on those reforms s t i l l under discussion in the Assembly. The Bank supported reform efforts using a variety o f non-lending instruments, including formal sector work, non-reimbursable technical assistance, grants, and analytical and advisory services (See Annex B4 for a surnmary o f non-lending services in recent years). The CAE concluded that non-lending services have provided valuable analysis, advice and technical assistance that have influenced policies and built capacity in many areas, including monetary and fmancial sector policies, international reserves management, public debt management, foreign investment, environment, forest conservation, bio-diversity, health, education, gender, social programs, rural electrification and information technology, Non-lending services have also influenced the discussion o f still unresolved political issues about increasing private participation in key strategic sectors, reforming the pension system, restructuring andor privatizing state banks and strengthening prudential regulations and supervision o f fmancial intermediaries.

12. The experience in the social sectors and in the environmental sector provide good examples where the Bank has maintained a sustained and productive relationship with Costa Rica, over the past decade, providing technical assistance, analysis, advice, grants and some financing in key areas where internal consensus existed about the issues, priorities and future directions.

13. In health, the Bank has been engaged in supporting Costa Rica’s reforms since the first health sector modernization loan was approved more than ten years ago. In 1990, health conditions in Costa Rica were among the best in LAC. However, the demands on the system were becoming more complex, and the health system’s underlying problems were: poor organization, which undermined accountability, and lack o f incentives, affecting the efficiency and effectiveness o f the resources. To correct these problems, Costa Rica outlined a general health sector reform that was intensively debated and received the support from key stakeholders. The Ministry o f Health shifted from fmancier and provider o f services to regulating and policy formulating agency, resulting in an increase o f the efficiency o f public resource use and improved outcomes. By the end o f the 90s, Costa Rica was able to further raise l i f e expectancy, reduce s a n t mortality rates, expand the coverage o f primary health care, increase hospital productivity, while at the same time, reducing public health spending. In addition to the technical advice and finance provided under the fus t and second health sector modernization loan, the Bank’s presence contributed to continuity o f the reform process during three administrations and the corresponding management changes.

4

14. In the social sectors more generally, since 1999 the Bank and Government have pursued joint sector diagnosis and followed up with dialogue and technical support. Key issues include improving equity and effectiveness in education, and improving the targeting o f social assistance programs. Progress has been gradual but sustained, based on diagnostic work which creates awareness o f issues and then fosters consensus about next steps. The Bank has maintained dialogue and presence by engaging with key people in the sectors (health, education, social protection) and the social cabinet, and by carrying out the diagnosticlsector analysis which later became the Social Spending and Poverty Report. Perhaps the most important outcome has been the identification o f areas for improvement in education, such as efficiency and equity in rural schools and steady improvement in institutional effectiveness. Th is work i s now being incorporated into the planned FY04 Education Project.

15. In the environmental sector, the forestry sector review was one o f the f i rst attempts worldwide to value the individual components o f the forest, including the biodiversity, carbon captured, wood and other values, and it greatly influenced Government’s intervention in the sector. The work led to one of the frrst environmental service payment schemes in the world, which i s now being emulated around the globe. This program i s being supported by the Bank in the innovative Ecomarkets project, and a second project has now been requested by Government to make the sector fmancially self-sufficient. In addition, in agriculture, although a planned agricultural sector reform project never became effective, the preparatory analysis and policy dialogue also influenced the sector considerably - for example, Government retired from grain marketing, and implemented market based refoms in technology and other reforms. Finally, in the areas o f indigenous peoples and gender, the Bank supported Government efforts through IDFs, which (although they weren’t implemented in full) helped define policy for indigenous peoples, including the development o f a national indigenous profile and a development plan, and helped mainstream gender analysis into most o f the ministries.

D. Overall Conclusion and Lessons for the new CAS

16. Throughout the past decade, Costa Rica continued to implement reforms at i ts own pace, with financial assistance from other donors, domestic borrowing and, lately, by selling bonds in the international capital market. While reforms have been slow, Costa Rica has achieved better social and economic results than similar countries in Latin America, and i t s political and social stability has been extremely attractive to investors and tourists alike. During and beyond the CAS period, Costa Rica advanced significantly toward many o f the objectives proposed under the CAS 93, in spite o f minimal fmancial support from the Bank. Key areas include:

Progress in implementing structural reforms. Costa Rica has continuously made progress in opening-up trade, diversifying exports and implementing the recommendations o f the fmancial sector assessment, while maintaining political stability and attracting high-tech foreign investment.

5

0 Progress in imp le~ent ing social and environ~entuz reforms. The authorities have also undertaken measures to improve the efficiency, targeting and level o f social expenditures, including rationalization o f govemment agencies and closer cooperation with private providers o f social services. Environmental policies have been strengthened with the passage o f the Environment Law in 1996 and the implementation o f a strategic plan. Progress in gender policies. Costa Rica has been a pioneer in incorporating women in the process o f development. After the approval o f the Law to Promote the Social Equality o f Women in the early 199Os, Costa Rica reached the forefront in sponsoring women’s rights with legislation comparable to the legislation o f many developed countries.

0 Progress in forestry policies. Costa Rica is considered a pioneer in reforestation, forest management and forest protection policies.

0

17, Although the Bank gave very little financial assistance to Costa Rica over the last decade, from the late nineties the Bank made significant efforts to improve the policy dialogue by providing technical advice, mostly financed through grant facilities, and responding quickly b many formal and informal requests for analysis and advice made by the authorities. The Bank’s non-lending assistance became an important source o f advice to the Govemment on the design and implementation o f reforms, and the Bank served as a catalyst in promoting discussion and consensus-building in key policy areas. The key to the effectiveness o f these efforts has been to identify and support areas where there i s internal consensus about issues and direction for reform, and to provide diagnostic and technical advice on demand.

18. Give the lessons from the Bank’s relationship with Costa Rica over the last decade, the future CAS should be highly selective and totally demand-driven, Le. in areas where the Costa Ricans specifically request Bank assistance because there is intemal consensus about the need for and overall direction for reform, and they believe that the Bank’s global experience can add value to the diagnosis, dialogue and implementation o f reforms. Furthermore, given their very tight fiscal situation, the Government has indicated that it i s primarily interested in borrowing for projects that “pay for themselves” through efficiency gains leading to cost-savings or through revenue generation from enhanced cost-recovery from say tariff increases. The Bank in turn has considerable interest in being engaged in areas where the lessons from Costa Rica’s successhl poverty reduction and economic diversification efforts and pioneering leadership in environmental management would be instructive for other Bank clients. Overall, therefore, the country assistance strategy should focus more on knowledge sharing and advisory services and less on resource transfer objectives, and should continue to promote reforms by supporting the policy dialogue through non lending services, including well-focused and properly disseminated ESW, technical assistance and grants. More project-specific lessons include:

Where an appropriate policy and institutional environment is needed for projects to yield expected benefits, the Bank should ensure that the proper environment i s in place before the project is approved, not as condition for effectiveness. In

6

particular, lending to support structural reforms should be considered only if the required legislation i s approved before lending i s committed. Given Costa Rica's institutional environment, wide social support i s needed to get National Assembly approval and to implement reforms, hence conditions agreed with the Executive related to key reforms should be strictly under control o f the Executive and not dependent upon Congress approval.

7

PD .- e ,

. .

. . .

0 . . 0

. 0 .

. .

1 . . . 3 / s a

-. I ~. w

I. . 0 . I.

v1 Y - 5

3

fcl 8 Y V

w

- E 0 Y m u '0 E .- L

3 m

E 8 Y

S 3

-

I .?; .I

.I U

Y

Y d A

cp

0 0

0 0 0

x

0

0 0 . 0

0 0 0

0 0 0

0 0

-0

0 0 0

0 0

0 b 0

0

-0 s

0 0 0

0 0 0 0 b 0

0 0 0

*

e .

0 . .I

../

*

* *

a

* * * .

B

* * a

0 0

0

0 0 0

0 0 0 0

0

0 0

E

2 E PI U z E E 13 0

c 0

3 P L

e

.3 e

.I

U

d u

3 L s

a

8 .I

.3 U L 0 .- 2

a

a a a

B

0 . . . . a

_.

CAS Annex B2

Costa Rica Selected Indicators* of Bank Portfolio Performance and Management

Indicator I By Fiscal Year 2001 2002 2003 2004 Portfolio Assessment Number of Projects Under Implementation Average Implementation Period (years) Percent of Problem Projects by Number a , c

Percent of Problem Projects by Amount Percent of Projects at Risk by Number a,

Percent of Projects at Risk by Amount a,

Disbursement Ratio (%) e

Portfolio Management CPPR during the year (yeslno) Supervision resources (thousands of US$) Average supervision (thousands of US$lproject)

5 5.3 0.0 0.0 0.0 0.0

17.4

No 262.0

52.4

6 5.4 0.0 0.0 0.0 0.0

19.0

No 242

40.3

5 5.9 0.0 0.0 0.0 0.0

16.5

No 334 66.8

4 5.3 0.0 0.0 0.0 0.0

18.5

No 328.7 82.2

Memorandum Item Since FY 80 Last Five FYs Proj Eva1 by OED by Number 23 3 Proj Eva1 by OED by Amt (US$ millions) 591.3 91.4 % of OED Projects Rated U or HU by Number % of OED Projects Rated U or HU by Amt

9.5 0.0 11.0 0.0

a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Bank's country portfolio. c. Percent of projects rated U or HU on development objectives (DO) andlor implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the

beginning of the year: Investment projects only, f. Supervision resources for FYOI to FY03 are actuals, for FY04 budgeted information was used. * All indicators are for projects active in the Portfolio (including GEF grants) with the exception of

Disbursement Ratio, which includes all active projects as well as projects which exited during the fiscal year.

As of 31112004

CAS Annex €33

Costa Rica - Bank Group Program Summary Proposed IBRD Base-Case Lending Program a

Implement ation

Strategic US$(M) Rewardsb Risks

Fiscal Project year

2004 Education Reform Project 2004 2005 Limon Area Development Project 2006 E-government Citizens Services LIL 2006 Ecomarkets II 2007 Agricultural Sector Project

Water and Sanitation Sector Modernization 30.0 H L 70.0 H M 70.0 H H

3.0 H L 30.0 M L 15.0 M M

Total Result 218.0

a. This table presents the proposed program for the next three fiscal years. b, For each project, indicate whether the strategic rewards and implementation risks are expected to be high (H),

moderate (M), or low (L).

Costa Rica - IFC and MlGA Program, FY 2001-2004

Category 2001 2002 2003 2004*

IFC approvals (US$m)" 50.0 7.0 0.0 20.0

Bv Sector (%l Finance L? Insurance 30 0 100 Health Care 0 100 0 Transportation and Warehousing 70 0 0

Total 100 100 n.a. 100

B y Investment instrume~t(%~ Loan Equity Quasi-equity (Equity type) Quasi-equity (Loan type) Risk Management

100 100 75 0 0 0 0 0 0 0 0 25 0 0 0

Total 100 100 n.a. 100

MlGA guarantees issued (US$m) 86.3 108.4 152.4 149.6

""IFC's own account only, excluding Participant's account. *Though February 2004.

As of 311 912004

Annex 84

Costa Rica: Summary of Nonlending Services

Cost or Grant Product FY ~ v s ~ o o o ~ Audience a Objective

Analvtical and Advisow Activities

Recent completions Identifying social needs for the poor (PA update) Costa Rica -A pension reform strategy INTEL'S Costa Rican plant (FIAS paper) Social Spending and the Poor Financial Sector Assessment Program (FSAP)

Underway Public Debt Management and Market Development Shocks and Social Protection (regional) CAFTA Trade Challenges (regional) Drivers of Rural Growth (regional) Financial Sector Stregthening Initiative (FIRST) Trade Facilitation (regional) Reserves Advisory & Management Program (RAMP)

Planned Poverty Assessment Investment Climate Assestment (FIAS) Country Economic Memorandum Country Procurement Assessment Rev. Country Financial Accountability Assess. Public Expenditure Review

Privatization implementation assistance Forest Conservation Public communications on M0C (regional) Strengthning supreme audit instutions (regional) Ecomarkets project grant CAFTA Trade Capacity Building (regional) Strengthening Afro Communities. (regional)

Biodiversity resources development GEF Education Development (PHRD grant) Pension System & Financial Sector Reforms (PHRD) Ecomarkets GEF Poverty Reduction and Social Protection (PHRD)

Completion FY FY97 FY99 FY98 FY02 FY03

FY04 FY04 FY04 FY05 FY05 FY05 FY05

FY05 FY05 FY05 FY05 FY05 FY06

IDF Grants Approval FY

FY99 FY99 FYOl FY02 FY02 FY03 FY03

Other Grants Approval FY

FY98 FY98 FY98 FYOO FYOO

Sustainable Production Indigenous Cacao Farms (GEF) FYOl Ecomarkets (PHRD grant) FY02

...

...

...

...

...

...

...

...

...

...

...

...

1..

...

...

...

... 1..

486.1 500.0 75.0 58.3 300.0 100.0 76.7

7,000.0 530.0 475.9

8,000.0 260.0 725.0 302.3

G, B, PD G, 0, PD

B, PD G, 0, PD

G, 0

G G, 0, PD G, 8, PD G, B, PD

G G, 0

G

G, B, PD G, B, PD G, B, PD

G, B G, 0

G, B, PD

G,PS G,PS G, PS G, PS G, PS G, PS G, PS

G, D, 0 G, B G, 0

G, D, 0 G, B

G, PS G, 13

KG, PD, PS KG, PD, PS

KG, PD KG, PD, PS

KG, PS

KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS

KG, PD, PS KG, PD, PS KG, PD, PS

KG, PS KG, PS

KG, PD, PS

KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS

KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS KG, PS

a. Government, donor, Bank, public dissemination.

~~ ~

b. Knowledge generation, public debate, problem-solving

3/2/2004

CAS Annex B5

Costa Rica Social Indicators

POPULATION Total population, mid-year (millions)

Urban population (% of population) Total fertility rate (births per woman)

POVERTY (“A of population) National headcount index

Urban headcount index Rural headcount index

Growth rate (% annual average for period)

INCOME GNP per capita (US$) Consumer price index (1995=100) Food price index (1995=100)

INCOMEICONSUMPTION DISTRIBUTION Gini index Lowest quintile (% of income or consumption) Highest quintile (% of income or consumption)

SOCIAL INDICATORS Public expenditure

Health (% of GDP) Education (%of GDP) Social security and welfare (% of GDP)

Net primary school enrollment rate (% of age group)

Total Male Female

Access to an improved water source (% of popu/ation)

Urban Rural

Total

Immunization rate (% under 12 months)

Measles DPT

Child malnutrition (% under 5 years) Life expectancy at birth (years)

Total Male Female

Mortality Infant (per 1,000 live births) Under 5 (per 1,000 live births) Adult (15-59)

Male (per 1,000 population) Female (per 1,000 population)

Maternal (modeled, per 100,000 live births)

Latest single year

1970-75

2.0 2.5

42.5 3.9

1,030 3

6.6 5.1

92 92 93

70 68 72

38 55

180 130

1980-85

2.6 2.9

51 .O 3.7

1,280 19 46

4.1 3.2

84 83 84

78 90 6

74 72 77

18 22

159 100

1995-2002

3.9 2.0

60.0 2.3

20.6 16.9 25.2

4,060 202 188

45.9 4.5

51.0

4.4 4.4 5.5

91 91 91

95 99 92

82 88 5

78 75 80

9 11

131 78 35

Same regionl income group

Latin America 8 Upper-middle- Caribbean

523.6 1.5

75.8 2.5

3,580

3.3 4.4

97 98 96

86 94 65

91 89 9

71 67 74

28 34

22 1 124

income

503.6 1.3

77.2 2.3

4,550

3.5 4.4

96 97 95

88 94 69

94 94 9

72 68 75

23 27

218 114

Births attended by skilled health staff (%) 83 98.2 Note: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97; ratios exceeding 100 indicates discrepancies between the estimates of school age population and reported enrollment data. 2003 World Development Indicators, World Bank

31112004

Annex 86 Page 1 of 2

Costa Rica - Key Economic Indicators

Preliminar Projected Indicator 1999 2000 2001 2002 2003 2004 2005 2006

National accounts (as YO of GDP) Gross domestic product a

Net indirect taxes Agriculture Industry Services

100.0 8.3 9.7

32.2 49.8

Total Consumption 77.2 Gross domestic investment 17.1

Government investment 4.3 Private investment (includes inventory changes) 12.8

E X P O ~ ~ S (GNFS)~ Imports (GNFS)

Gross domestic savings Gross national savings

51.6 45.9

22.8 12.0

~ e m o r a n d u m items Gross domestic product (US million) 15,796 GDP per capita (US$) 4,116

Real annual growth rates (%, calculated from 1991 prices) Gross Domestic Product 8.2 Gross Domestic Income 7.9

100.0 100.0 9.0 9.7 8.6 7.8

29.2 26.9 53.2 55.6

80.2 82.8 17.1 20.1 4.2 4.0

12.9 16.1

48.5 41.6 45.7 44.5

19.8 17.2 12.6 13.3

15,946 16,394 4,062 4,090

1.8 1 .o -2.8 -0.4

Real annual per capita growth rates (%, calculated from 1991 prices) Gross domestic product 5.7 -0.5 Total consumption -0.3 -1.2 Private consumption -0.2 -1.2

Balance of Payments (US% millions) Exports (GNFS) 8,192 7,763

Merchandise FOB 6,576 5,813 Imports (GNFS) 7,154 7,310

Merchandise FOB 5,996 6,024 Resource balance 1,038 454 Net income and current transfers -1,719 -1,160

Current account balance -681 -707

Foreign direct investment 615 400 Long-term loans (net) 106 139 Other capital (net, incl. errors & ommissions) 44 1 14 Change in reserves -480 154

~ e m o r a n d u m items Current Account balance (% o f GDP) -4.3 -4.4

-1.0 -0.7 -1.0

6,835 4,923 6,927 5,743

-92 -645

-737

454 40

255 -12

-4.5

100.0 9.6 7.6

26.3 56.4

82.9 22.2 4.5

17.7

42.4 47.4

17.1 14.0

16,818 4,112

2.9 1.8

0.9 1 .o 1.2

7,123 5,259 7,720 6,535 -597 -363

-960

662 67

396 -165

-5.7

100.0 100.0 9.6 10.1 7.8 7.5

26.2 26.1 56.4 56.3

81.6 82.2 20.6 18.7 3.8 4.0

16.8 14.7

46.2 48.5 48.3 49.4

18.4 17.8 14.5 13.4

17,484 18,319 4,193 4,315

5.6 4.4 6.7 4.2

3.6 2.8 0.3 0.7 0.7 0.0

8,062 8,765 6,069 6,636 8,422 8,800 7,221 7,559 -361 -34 -642 -791

-1.003 -825

587 556

434 134 -341 150

323 -15

-5.7 -4.5

100.0 10.0 7.4

26.0 56.6

80.7 20.3 4.3

16.0

50.7 51.7

19.3 15.4

19,025 4,520

3.7 4.0

2.1 0.5 1 .o

9,363 7,108 9,273 7,985

90 -853

-763

550 -9

122 100

100.0 10.2 7.3

25.8 56.6

79.2 21,9 4.5

17.4

53.0 54.1

20.8 17.3

20,634 4,745

4.0 4.1

2.5 0.5 0.5

9,867 7,508 9,772 8,434

95 -921

-825

5 84 121 171 -50

-4.0 -4.0

(Continued)

31112004

Annex 86 Page 2 of 2

Costa Rica - Key Economic Indicators (Continued)

Estimate Projected Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Overall Public sector (as % of GDP at market prices)e Total revenues 19.8

Tax revenue 11.9 Nontax revenue and transfers 7.9

Total expenditures 23.5 Current expenditure 19.2

4.3 Capital expenditure and net lending

Deficit (-) Surplus (+) Net Foreign financing Net Domestic financing

Monetary indicators M2 I GDP (Ya) Growth o f M2 (%) Private sector credit growth (Yo)

Price indices( 1991 -100) Exports o f GNFS price index Imports o f GNFS price index

Terms o f trade index

-3.7 1.6 2.1

33.8 29.0 36.3

306 281

109.2

Annual average exchange rate (C$ I USS) Real exchange rate index (US$ I C$)'

285.7 105.9 10.0

GDP deflator (YO change) 15.0 Consumer price index (YO change, ave.)

20.7 12.4 8.3

25.1 20.9 4.2

-4.4 0.6 3.8

36.8 18.4 29.1

314 313

100.6

308.2 109.3 11.0 7.1

22.3 13.2 9.1

26.1 22.1 4.0

-3.8 0.4 3.4

37.0 10.4 26.6

325 333

97.6

328.9 114.5 11.3 8.4

22.0 13.2 8.8

27.7 23.2 4.5

-5.7 1.3 4.4

39.8 20.9 22.2

355 373

95.1

359.8 112.0

9.2 9.1

21.7 13.2 8.5

25.8 22.0 3.8

-4.1 0.7 3.4

39.8 14.7 18.4

372 388 95.7

398.3 109.0

9.4 9.0

22.2 13.7 8.5

26.3 22.3 4.0

-4.1

0.5 3.6

39.8 15.1 18.0

371 387 96.1

439.3 108.1

9.0 9.9

22.9 14.1 8.8

27.0 22.7 4.3

-4.1

0.8 3.3

39.8 13.4 15.4

377 393 96.1

468.1 108.1

8.5 9.0

23,l 14.3 8.8

27.0 22.5 4.5

-3.9 0.6 3.3

39.8 13.4 13.7

383 399

96.1

498.3 108.1

8.9 9.0

a. GDP at current market prices. b. "GNFS" denotes "goods and nonfactor services." c. Gross Domestic Savings plus net current transfers and net factor income. d. Includes privatization proceeds, if any. e. Includes NFPS and Central Bank operations. Main source: IMF. f. A n increase in the index denotes appreciation.

31112004

Annex 87

Costa Rica - External Debt Exposure Indicators

Actual Preliminary Projection 1999 2000 2001 2002 2003 2004 2005 2006

Total debt outstanding (US$m)a

(mol

Net disbursements (US$m)"

Total debt service (US$m) a

(TDS)

Debt and debt service indicators (%) TDO I Exports o f GNFS TDO I GDP TDS I Exports o f GNFS Preferred creditor debt 1 TDO Preferred creditor DSI TDS (%)

IBRD exposure indicators IBRD DSI TDS IBRD DSI Exports o f GNFS IBRD TDO (US$m) Share o f IBRD portfolio (%)

3,056.5 3,150.6 3,242.5 3,337.7 3,738.1 3,834.1 3,982.8 4,103.3

159.8 152.5 96.8 2.9 400.4 96.0 148.6 120.5

537.9 591.0 708.5 690.5 1068.0 503.7 515.0 512.0

37.3% 40.6% 47.4% 46.9% 46.4% 43.7% 42.5% 41.6% 19.3% 19.8% 19.8% 19.8% 21.4% 20.9% 20.9% 19.9% 6.6% 7.6% 10.4% 9.7% 13.2% 5.7% 5.5% 5.2%

43.0% 40.0% 40.5% 37.2% 33.4% 29.4% 25.1% 21.8% 47.5% 39.4% 41.2% 50.6% 28.9% 52.9% 51.0% 46.4%

8.7% 7.6% 5.3% 4.8% 2.4% 4.3% 4.3% 3.2% 0.6% 0.6% 0.5% 0.5% 0.3% 0.2% 0.2% 0.2%

148.9 121.0 102.2 91.2 80.1 83.5 80.6 83.4 0.12% 0.10% 0.08% 0.07% 0.07% 0.07% 0.07% 0.08%

a. Includes only public and publicly guaranteed debt as private non-guarantee debt represents less than 1% o f GDP. b. "GNFS" denotes exports o f goods and non factor services. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the BIS.

31112004

u) E 0 .- .w !? Q,

4

. . . . . . . .

w m - r ~ b 0 - m a o m a a w - m m m a b 0 0 0 0 a a a a

m 0 0 N a c! N 0 c 0 v) m m m 1

n

c m

v) m al m V c

0 c

rdd

CAS Annex B8 Page 2 o f2

Costa Rica Statement of IFC's Committed and Outstanding Portfolio

(In US Dollars Millions)

Committed Outstanding IFC IFC *. - .. -

FY Approval Company Loan Equity Quasi Participation Loan Equity Quasi Participation 199312001-04 INTERFIN 27.5 0 5.0 0.0 18.3 0 5.0 0.0

1994 Hidrozarcas 0.6 0 0.7 0.0 0.6 0 0.7 0.0 1998 ClMA 0 1.2 0 0.0 0 1.2 0 0.0

199912003 Superunidos 23.6 0 10.0 0.0 10.6 0 10.0 0.0 2001 Aeropuerto IJS 35.0 0 0 85.0 26.3 0 0 63.9 2002 Gutis 7.0 0 0 0.0 0.0 0 0 0.0 2003 Cuscatlan 0 0 5.0 0.0 0 0 5.0 0.0

Total Portfolio: 93.7 1.2 20.7 85.0 55.8 1.2 20.7 63.9

Data as of 2/29/2004

Costa Rica CAS Summary of Development Priorities

Annex B9

Country Major issue Country Bank Reconciliation of Network area performance a priorityc pHorjfyc country and Bank

priorities ' Poverty Reduction & Economic Management

Poverty reduction

Economic policy

Public sector

Gender Social inclusion

Human Development Department Education

Health, nutrition & population

Social protection

Environmentally & Socially Sustainable Development Rural development

Environment

Finance, Private Sector & Infrastructure Financial sector

Private sector

Energy

Infrastructure

Excellent Improve effectiveness and targeting High High

Fair Fiscal sustainability and public debt High High

Fair Improve government efficiency and High High

of social sector spending

management

delivery of public services and technoloav

Excellent Gap in secondary education levels Moderate Low Ongoing dialogue Fair Increase inclusion of indigenous High High

and afro-costa Rican population

Excellent Quality of rural education and High High

Excellent Financial sustainability while High High secondaw education access

maintaining quality and equity aspects of an universal health care svstem

design of social assistance vroarams

Fair Improve targeting, coverage and High High

Good

Excellent

Fair

Good

Good

Fair

Smallholders production High Moderate Other donors have diversification; development of eco- tourism industrv Achieve financial sustainability of Moderate High Ongoing dialogue the sector

the lead

Continue financial sector reform High High and policies to address dollarization risks Domestic debt market High Moderate IADB has the lead development; improve access to and ongoing TA credit and trade facilitation to SMEs policy dialogue

Allow private sector participation in Low Moderate Ongoing dialogue the sector and CABEI has

Modernization of ports, water High High quality and water resource manaaement

the lead

a. Use "excellent," "good," "fair," or "poor." b. Indicate principal country-specific problems (e.g., for poverty reduction, "rural poverty;" for education, "female secondary completion;* for environment, "urban air pollution"). c. To indicate priority, use "low,' "moderate," or "high." d. Give explanation, if priorities do not agree; for example, another MDB may have the lead, or there may be ongoing dialogue.

311 912004

CAS Annex C Executive Summary of Costa Riea

Social Spending and the Poor

Good progress, but a worrying slowdown in poverty reduction- 1. Costa Rica made substantial progress in reducing headcount poverty and improving social sector indicators over the 1990s. Driven by economic growth averaging 4.5 percent o f GDP, and strong investment in the social sectors, the proportion o f people below the poverty line declined from 27 percent in 1990 to 21 percent in 2000 and the proportion o f extremely poor households dropped from 10 percent to 6 percent- although the pace o f reduction in poverty slowed down during the second half o f the nineties. While coverage o f education and health remains nearly universal in the case o f basic education and access to healthcare services, there are worrying signs that social sector indicators and the efficiency and effectiveness o f social spending has begun to plateau or decline in some cases. Between 1990 and 2000, Costa Rica fell from 28th to 48th in the Index of Human Development. In education, there has been increase in gross secondary enrollment to 62.1 percent , but there were also increases in repetition rates. Across the board, education levels are worse for those in the lower income quintiles. In health, performance continues to improve in terms o f life expectancy infant mortality, and health systems performance, but there i s increasing dissatisfaction with the system as waiting l i s ts grow daily and patients requiring more sophisticated treatment for chronic diseases are turned away. However, there i s no consensus as to whether or not this situation represents stagnation in social conditions. For example, while little progress was made in reducing poverty between 1995 and 1999, during this period social indicators that are normally associated with better living conditions-such as reductions in infant mortality and improvements in l i fe expectancy-have shown improvements.

-despite real increases in social services expenditures- 2. Over the last ten years, public spending grew seventy percent in real terms, and the share o f public spending allocated to the social sectors increased from 59 percent to 63 percent, with spending in education and pensions growing more rapidly than spending in health and social protection. Costa Rica spends more relative to GDP, and as a share o f public expenditures, on social services overall than other countries in Latin America, and considerably more than the average for other countries at similar stages o f development outside the region. The level o f spending, and the universal focus o f many o f these programs, mask the true effectiveness o f these programs-in terms o f reaching the poor and vulnerable groups living in rural areas and city slums. Despite recent growth in the economy, many o f the poor and vulnerable do not have access to social programs, which in part reflects the inflexible legal framework that guides social spending budget allocation-distributing resources without considering the changing conditions and needs o f the poor.

3. Current macroeconomic circumstances do not seem likely to provide Costa Rica with an easy solution to these problems. Economic projections do not show signs o f the

consistent growth that has characterized the past ten years, and allowed the government to continue increasing investment in the social sectors. Given the country’s tight fiscal situation and the high level o f public debt, there i s l i t t le room for continued increases in social spending. This underscores a key finding o f this report: that the social sector challenges will not be resolved only by allocating more resources, they wi l l require undertaking reforms to improve management and efficiency in the use o f available resources and to eliminate structural obstacles in most sectors. New instruments and approaches w i l l be required that focus on obtaining value for money in the social programs.

-raising three key questions- 4. There are three key questions which frame our analysis. First: who are the poor and vulnerable groups in Costa Rica-and what are their most important needs? The report addresses this by providing an in-depth, multi-dimensional analysis o f poverty. Second: what has been the impact o f social spending on the welfare for the poor- how are the needs o f the poor being met by existing programs? We answer this by examining the effectiveness o f government policies and spending on the poor in the social sectors. Despite a generally good track record, there are s t i l l some key areas in which the needs o f the poor are not being adequately addressed. Finally, given these problem areas, we ask: how can government spending be used more effectively to reach the poor, improve social indicators and contribute to reducing headcount poverty? The report provides both sector- specific and general policy options. A common theme in the sector specific recommendations i s the need for greater flexibility in the implementation o f existing programs, coupled with more efficient administration. More generally, we advocate the creation o f a policy-making mechanism, charged with setting social policy, exploiting synergies, and reducing program overlap.

-which suggest that structural reforms are needed, not increased funding- 5 . The past decade has demonstrated that significant improvements are possible in the socioeconomic condition o f the poor when economic growth i s combined with cost- effective social programs that are well designed to reach the poor and to contribute to welfare improvements. However, progress in poverty reduction and social sector performance has been uneven, and there are important gaps between rich and poor. Continued improvements will have to rely on better use o f the available resources. If the success of the past is to be replicated, the government o f Costa Rica should undertake structural changes to improve overall effectiveness o f programs in the areas o f education, health, and pensions that offer opportunities for improving the condition o f the poor and ensure that they reach the most vulnerable groups o f the population. One o f the key elements to achieving greater effectiveness o f social spending i s an improved institutional framework to coordinate the implementation o f social programs, and greater flexibility in programs to improve targeting and respond to the needs o f the poor. Each o f these issues is addressed in summary in Part I o f the report, and in greater detail in Part 11.

2

I. Profile o f the Poor

Highlights the priorities for education, health and social protection to meet the needs of th e poor- 6. The report starts with a profile o f the poor, which provides policymakers with key information on who and where the poor are. This overview will lead to more informed decision-making when public policies have to be made regarding how social spending can effectively contribute to alleviate poverty. The rapid poverty assessment shows that the poor have the following general characteristics:

-poverty is not equally dispersed across the population- 7. As in other Latin American countries, poverty in Costa Rica affects more rural than urban residents. Poverty incidence i s highest in families whose heads are working in agriculture, self-employment, micro enterprise and in domestic service-or those unemployed, or under-employed. Women head an estimated 48 percent o f families in extreme poverty compared to only 33 percent in near-poor families. Poor families are younger, and have higher dependency rates than non-poor families, while most have no, or only one, income earner. Poor families are larger than non-poor families and have a higher number o f people younger than 12 years o f age who demand both more expenditures and time from their parents.

-the poor benefit less from educ~tional opportunities- 8. Education levels are much lower for the population in the lowest income quartile group. The percentage o f people in the poorest 25 percent o f the income distribution who completed primary education was only 62 percent in 1999, about the same rate o f 1990, while the percentage o f the richest 25 percent is much higher and has shown some improvement in recent years. In urban areas, only about 15 percent o f the heads o f the poorest income quartile have more than primary education, in contrast to 77 percent o f the heads in the highest 50 percent group. In rural areas, most household heads in al l income groups have only primary education. Regarding children’s human capital, only about 62 out o f 100 children in the lowest income quartile complete primary education, while 82 percent o f children in the richest quartile finish their primary education. And, while only 15 percent o f youngsters in the lowest quartile complete 11 years o f education, 60 percent (st i l l a low number) o f children belonging to the top quartile o f the income distribution do so.

9. For secondary education, the completion rates o f the poorest are less than one fourth o f those in the top 25 percent. Only about 15 percent o f the poorest children complete secondary education, a level considered as a threshold to break intergenerational poverty cycles in countries o f Latin America. The situation i s far worse for children 14-18 years o f age, where 47 percent are out o f school, O f those not attending school, about half o f them v i i work while the rest stays inactive. I t has been estimated that about 33,600 youth 13-18 years o f age are out o f the school system and should be induced to return to school or to receive special training to upgrade their skills for the modernizing Costa Rican economy.

3

-may have trouble accessing healthcare- 10. The poverty profile shows that despite a universal health system, roughly 30 percent o f the poor are having trouble accessing the Caja Costarricense de Seguro Social (CCSS) programs for the uninsured. This reflects problems with knowledge and access. Health conditions also vary considerably between the non-poor and the poor. The results show that more than half o f the poor and extreme poor had a self-declared health condition at the time o f the survey. More importantly, a majority o f the remaining people in extreme poverty indicated having a permanent physical or mental limitation. Over 113 o f the elderly in extreme poverty had a permanent limitation, and another 10 percent a temporary limitation. While the country has made the epidemiological transition, the health system has yet to fully adjust to the changing nature o f health care needs.

-and children younger than five and adults older than 65 years of age are the most vulnerable groups- 11. Despite the relative strength o f the healthcare system and the progress in extending primary education, children 0-5 years o f age are a highly vulnerable population group in Costa Rica. About 84,000 o f them (95 percent o f the poor group) are not attending CEN-CINAI or Hogares Comunitarios centers. Most children stay at home under the care o f mothers, older siblings, or relatives. Over 80 percent o f mothers o f these children have only primary education and may be unable to provide adequate stimulation and the motor and social ski l ls their young children need to start breaking the poverty cycle. The elderly over 65 years o f age in extreme poverty are also a highly vulnerable group because o f their ill health and low incomes. About 46 percent o f extreme poor people older than 65 years o f age reported permanent or temporary physical or mental limitation. About 14,000 elderly in extreme poverty and poor (about 50 percent o f group) are not covered by contributory or assistance pensions.

11. The Impact o f Social Spending

Mixed results, despite a large increase in social expenditures- 12. During the decade o f the 1990’s, Costa Rica made impressive progress in making social spending a priority and increasing the allocations to priority programs. As a result, the main indicators improved significantly: l i f e expectancy at birth is close to 76 years, the infant mortality rate dropped from 15 to 13 for every thousand live births (10.3 in 2001), access to drinking water i s around 80 percent, and illiteracy has dropped to only 5 percent o f the population over 12 years o f age. Despite these accomplishments, analysis indicates that the results have been mixed. In some areas, notably health care, Costa Rica’s striking performance is a sharp contrast to other countries in the Region and even approaches some OECD countries. In other areas, such as secondary education, progress has been uneven. Although access to services for poor groups has improved considerably, there are gaps in outcomes between poor and non-poor students and between urban and rural areas, resulting from a lack o f efficient targeting mechanisms which reduces the cost-effectiveness o f social programs.

4

Education

AccompZishments in primary education and Ziteracy- 13. Costa Rica has made major strides in the education sector, including nearly universal primary coverage and low rates o f illiteracy, and has gone further than most countries in introducing modern technology, mainly at the primary level. There have been some improvements in secondary education enrollment, increasing from 40 percent in 1990 to nearly 50 percent by 1999 and further increasing to 54 percent by 2001'. Increasing spending per student over the decade has contributed to improving coverage rates. Despite the increasing spending and increasing coverage rates, there are signs that performance decreased over the decade. Although secondary coverage improved, little progress was made reducing the gap between rich and poor. During the second half o f the 1990's, enrollment o f 5 year-old children in the lowest income quartile was 50 percent lower than the highest income quartile; furthermore, enrollment shows great differences between urban and rural areas.

-but high rates of drop-out and grade repetition amongst the poor- 14. low secondary completion rates and targeting. Key figures are:

There are particularly alarming results in the areas o f repetition, dropout rates,

0 Overall more than 10 percent o f all students grades lSt-6 th repeat at least one grade, with higher rates for repetition in 1 st- 7 th grades (1 6%). Decreasing repetition has a great impact since cost reduction and resource allocation can be used for improving quality and coverage equity. Each year nearly 23,000 students drop out at the primary school level and 19,000 drop out at high school level. Only 113 o f the Costa Rican youth 20 years old have completed high school education. The differences are even more acute between regions and income quartiles. Only 15% o f the 20 years old from the lowest quartile have completed 12 years o f education, while almost 60% for those in the highest income quartile. There are important weaknesses in the targeting o f education programs aimed at the poor. Four education programs have been developed in an attempt to reduce inequality: School Vouchers, Student Transportation, School-Lunch Programs and Scholarships. There is, however, a problem in resource allocation since beneficiaries in the lowest income quintile receive less than 40% o f the School Voucher Program benefits and 34%of the School Lunch Program benefits. These problems are the result o f the universal concept under which these programs function, and because targeting criteria for the most vulnerable groups have not been applied in allocating resources.

0

0

0

' The total secondary enrollment rises to 62 percent if other Secondary programs such as IPEC are considered in the matriculate

5

Health

Substantial improvements in efficiency of healthcare provision- 15. Over the past decade, Costa Rica has made substantial progress in improving the health o f the population, and has actually decreased spending while extending access and improving productivity. Despite these improvements, the health sector i s starting to feel increasing strain as Costa Rica’s epidemiological and demographic profile changes and the opportunities to use the private sector to generate efficiency, quality and competition have started to expand.

16. From 1996 to 2000, the CCSS introduced key changes aimed at extending access to primary care services, establishing a framework for decentralization, improving community participation, strengthening hospital management and introducing a culture o f performance based evaluation. The management contracts incorporate a clear definition o f objectives for all healthcare providers and establish an evaluation process that motivates performance improvement. By the end o f the decade, results were already evident in lower average length o f stay, lower hospital infection rates, greater user satisfaction, and the introduction o f total quality management programs.

17. Through these efforts the Government addressed the dual objectives -contain spending and focus on allocating resources more efficiently- to improve quality, equity and efficiency o f service delivery. Total public health spending decreased slightly over the decade to just under 5.5 GDP in 99. Despite this fall as a share o f GDP, real per capita public expenditure on health increased 19% during the decade, to almost US$ 210 in 99. Private health expenditure i s among the lowest in the L A C region (20% o f all health expenditure in 98 was carried out in the private sector), but at national level, i t i s significant, as it represents close to 2% o f GDP.

18. The CCSS offers healthcare to al l and has obtained coverage o f nearly 90% o f the population. Nonetheless, nearly 30 percent o f the poor are uninsured, and have problems accessing basic services. For those that do get access, waiting l i s ts are a problem as average waiting times are over 12 months for several services. The pressure o f a free health system i s increasingly evident.

-but medium to long term problems remain- 19. financing in the sector.

The report highlights a number o f important results regarding access, equity, and

The extension o f the PHC model to nearly 90% o f the population had an important impact. Access and utilization o f health service are highly progressive, indicating the pro-poor benefits o f a universal health insurance system and improvements in access through recent strategies o f basic health teams and areas. The data analyzed show a clear trend toward increasing use o f general practitioners and ambulatory services, which will eventually lead to lower costs and shorter waiting times.

6

During the last decade the CCSS has maintained financial equilibrium, even producing an operational surplus in most years, due to faster increases in real contributions per direct insured person than the real cost per direct insured person. Reducing levels o f evasion and late payment-focused mainly on salary under- reporting and non-insurance-is critical to making further improvements in CCSS financing and equity. There are two obstacles to reducing evasion levels: first, the limited development o f systems for monitoring and measuring evasion; second, contribution control systems for small and middle-sized companies do not comply with the minimum requirements o f technical support. In the next f i f ty years, the population pyramid will show a large expansion among the elderly population. This, together with changes in the epidemiological profile, wil l increase the more costly and complex causes o f medical visits and hospital expenditures, and lead to escalating costs and real expenditure. The report indicates that financial sustainability in the medium and long term w i l l be strongly determined by real wage levels, the ability to reduce evasion and by the possibility o f controlling the expenditures and improving results-or, in other words, increasing “value for money”.

e

e

e

Social Protection

Significant reforms to pensions- 20. In pensions, Costa Rica has made some significant reforms in the past decade. The majority o f the reforms addressed the most pressing financial problems posed by the diversity o f benefits among the many different pension schemes. Under the 1992 and 1995 reforms, most o f the special pensions programs were eliminated, benefit schemes were unified, and requirements and benefits were rationalized to make some progress to uniformity. The reforms achieved a significant reduction in the actuarial liabilities financed by the Central Government Budget and in the government subsidy needed to cover expenses, even though in the short-term it increased fiscal expenditures to meet acquired rights due to existing beneficiaries.

21. At the end o f the last decade, approximately 59% o f the Economically Active Population (EAP) were covered by the National Pensions System (SNP). This represents a decrease in coverage from 66% at the beginning o f the decade; however, the coverage o f self-employed workers increased to 27% (99). As a consequence o f the maturity level o f the IVM Plan, the coverage o f beneficiaries by non-contributory programs is much less than coverage by contributory programs, protecting 36% o f the population aged 60 years or older in the year 2000. The report finds that approximately 35% o f the population over 65 years o f age i s not covered by any benefit.

-with l i m i t e ~ ~ s c a ~ impact- 22. The approval o f the Ley de Proteccibn a1 Trabajador was an important step towards establishing a capitalization based pension system, as a second pillar, under the supervision o f the recently created Pension Superintendence. While this latter reform could be criticized for not going deep enough in reforming the existing pension system, it has the advantage that, compared to reforms in other countries, it has a limited fiscal

7

impact, Part o f the fiscal impact o f the reform wi l l be the strengthening o f expenses, including information campaigns, strengthening the Superintendence o f Pensions, and establishing the centralized collection system in the CCSS. Another fiscal impact could arise from the implementation o f the new rules for the means-tested old age pensions.

-a well-established and well-flnanced social assistance network- 23. In social assistance, Costa Rica has a well-established social assistance network which spends an estimated o f US$250 million per year to protect vulnerable groups and to deliver a wide gamut o f social programs. There are, however, critical gaps in social assistance provided to key vulnerable groups, as many o f the benefits do not reach the poorest individuals. Among the critical gaps in social assistance are the inadequate coverage o f programs for poor children under five years o f age, who may lack adequate education and stimulation, and assistance for the elderly poor not covered by the formal pension system. Institutional strengthening and modernization would help to avoid duplications, reduce costs, and offer better services and they could be complemented by delivery systems involving communities and NGOs.

-but funds are inflexibly allocated- 24. The importance o f increasing the effectiveness o f social assistance programs is underscored by the fact that Costa Rica spends between 1.5-1.8'70 o f GDP in social assistance (a much higher percentage than that o f other similar countries). There have been recent improvements in program coordination and a few programs have been eliminated, but efforts are needed to change the inflexible system, often resulting from outdated laws and institutional arrangements. For example, the Costa Rican government has invested an annual average o f $39 mil l ion in i ts two main nutrition programs over the last decade, equivalent to 0.3% o f GDP-although malnutrition in Costa Rica i s quite low, even in poor families.

-and are not well targeted- 25. Targeting o f most safety net programs has been weak. According to household surveys statistics for 99, only about 24% o f subsidies involved in the public provision o f early child education have gone to the poorest 25% o f the population, and about 25% o f housing subsidies have gone to the poorest 25% o f the population. Overall, the share o f social assistance programs resources received by the poorest 25% just approximates their share in the population, implying little or no re-distributive impact o f spending. Targeting o f assistance programs has improved recently with the introduction o f the SIP0 system to select beneficiaries for a number o f programs, including the school voucher and scholarship programs, school stipends to poor children and other direct income support programs operated by IMAS. Considerable work will be required to ensure that the most needy are targeted and that more transparent mechanisms are used to assign benefits.

8

111. The Way Forward: Policy Recommendations

Education

26. The recommended measures for primary education include, among others: (i) strengthening the teaching and learning of reading, writing and math skills in first through sixth grades; (ii) making more effective use o f learning assessment findings; (iii) improving in-service teacher training; and (iv) strengthening community and parental participation in school-related matters.

27. If improvements in value for money are to be obtained, structural changes will have to be made in the following directions: (i) update the existing curriculum; (ii) improve teacher training; (iii) increase secondary education supply through a menu o f options, including traditionat schools, distance learning, open-access education, virtual schools and vocational training; (iv) promote the collaboration with the private sector to strengthen the relevance o f secondary education; and (v) help parents and students, especially in rural areas, to finance part o f opportunity costs o f studying through scholarships, conditional cash transfers, and other supplemental financing schemes.

28. Progress among the poor has been limited over the past five years as compared with the top income groups. Consequently, in addition to efforts to improve coverage and quality described above, the Ministry o f Education needs to improve the targeting and equity o f programs, such as school feeding, transportation and scholarships.

29. The cost implications o f the recommended primary and secondary education measures are relatively modest when compared with existing resources for education. In total, it is estimated that the cost increases o f the suggested measures would sum to between 6 and 7% o f current expenditures. These increases could be financed by improving internal efficiency, through reduction in repetition rates, for example; and by reducing poorly targeted programs, which distribute resources to less needy populations. Crude estimates show that repetition in primary school costs about $2 1.2 mil l ion per year or about 10% o f the education budget for primary education, while the costs for secondary education repetition are equivalent to $14.8 million per year.

Health

30. Costa Rica needs to continue the reform process started in the early 90s to reduce waste and improve services by: (i) consolidating the Ministry o f Health role as steward and policy maker and strengthening health education and public health programs; (ii) consolidating the EBAIS model and further extending access to the estimated 12% o f the population that i s not covered by this model; (iii) improving administrative and budgeting procedures in the CCSS and consolidating the culture o f performance agreements with hospitalslother health providers to increase coverage o f primary health care and improve efficiency; (iv) promoting changes in the system to increase management and financial autonomy o f health providers in the context o f the 99 Law on Deconcentration; (v) reducing current disparities in expenditures levels by region; (vi) introducing changes in

9

the pharmaceutical procurement system to produce savings in storage and procurement; (vii) strengthening the CCSS’ collections system and promoting changes in the financial information systems; and (viii) developing alternative delivery arrangements through public-private partnerships that complement public services and gradually introduce managed competition in the healthcare market.

31. The cost implications o f the continued reform process have been estimated at about US$70 million over 5 years, but these costs are about half the savings that can be obtained from the reforms over the same period. The Costa Rica Health Sector Project will produce substantial savings for the sector, primarily through reductions in hospitalization costs resulting from ambulatory surgery, pharmaceutical management, and reduced overhead from increasing decentralization ($12 million per year). Improvements in pharmaceutical supply chain management alone could save over $30 mil l ion per year by reducing unnecessary inventory costs. Even under conservative assumptions, direct benefits would exceed $24 mil l ion per year.

Social Protection

32. Pensions: There are important issues remaining for the future. These include: (i) reduce replacement rates and future costs o f the public plans and introduce incentives for contributing a greater share o f actual earnings in the earlier years o f the earnings cycle, in order to guarantee their financial sustainability; (ii) expand coverage, improve membership management and control o f contributions; (iii) extending coverage and improving targeting of the non-contributory pensions; and (iv) consolidating reforms that w i l l guarantee the long-term sustainability o f the pension schemes for Government workers. If reforms are not undertaken, as the population ages sharply over the next 30 years the increasing financial imbalance could lead to pension fund insolvency.

33. Spending priorities in social assistance need an urgent change. Priority actions are in three fronts: (i) introduce legislative changes to FODESAF’s law, so that the government can change spending priorities according to needs and direct more resources to priority vulnerable groups; (ii) consolidate efforts to improve coordination o f programs and eliminate duplications; and (iii) improve targeting, coverage and design social assistance programs; and (iv) complete coverage o f the poor by non-contributory assistance pension programs.

34. The cost implications o f expanding ECD programs for poor children and non- contributory pensions for the elderly poor are also relatively modest and appear to be affordable within the current social assistance budget. It has been estimated that increasing ECD coverage to all children in a mix o f center-based care and community and parental care, would cost about US$26 mil l ion per year. The current budget o f the CEN-CINAI program i s about US$19 mil l ion per year, and it i s estimated that an additional US$l 1 mil l ion would be required to cover all poor children. These are rough estimates that assume that non-poor children are not attended in the public programs. Costs could be reduced further if the CEN-CINAI programs are changed to reduce food subsidies and health care provided by the CCSS. In relation to covering the estimated

10

7,000 elderly poor still not covered, the annual cost could amount to about US$3.1 mil l ion which can be financed by shifting resources from non-poor pensioners that currently receive a public pension.

Program Coordination and Evaluation

3 5 . Improving InstitutionaZ Coordination, The impact o f social spending in Costa Rica could be improved, particularly i ts impact on the poor, with the creation o f a policy- making mechanism charged with setting social policy, exploiting synergies, and reducing programs overlaps. The government should consider possibilities for improving coordination o f social policies by exploring the creation o f a Council for Social Policy Coordination under the direction o f the President, with a technical secretariat to define priorities and regularly evaluate the impact and targeting o f social programs. Such an entity would define programs and their goals, beneficiary populations, and the institutional arrangements to carry out key strategies, Efforts in this direction have been undertaken in recent administrations, but they have been hampered by institutional rigidities and laws which have undermined coordination efforts and the reform or elimination o f ineffective programs or institutions. In this regard, allowing FODESAF greater flexibility to channel resources to vulnerable groups and to respond to changing conditions, particularly during crisis, will greatly contribute to improving the effectiveness o f social spending.

36. Strengthening, monitoring and evaluation systems. The lack o f an effective monitoring and evaluation systems system for the social sectors i s an impediment to ensuring value for money in social spending. This i s most evident in programs such as the CEN-CINAI where-had a good evaluation program existed-resources could have been saved by finding the most cost effective alternative for child care. Different modalities o f child care, some including only parental education, others-including center-based stimulation and early child education4ould have been evaluated to determine their impacts and relative costs. Monitoring and evaluation i s key to evaluate progress, evaluate impact o f programs and make more efficient decisions on programs to improve social indicators o f the poor. The practice o f establishing base-lines and measuring the impact o f specific programs should be implemented routinely in order to draw lessons from experience-which can be used to modify programs and improve their impact. In addition, instruments such as Liv ing Standards and Measurement Surveys and improved household surveys provide valuable information on key target groups and on the outcomes o f the main social programs, complementing the annual household surveys currently carried out by the Statistical Institute. At the same time, evaluation should include ex-ante and ex-post evaluation o f social sector programs using cost-effectiveness and cost-benefit analysis to assess programs.

37. The collective impact o f the actions presented in this report would contribute to progressive improvements in the impact o f social spending and to ensuring that poverty reduction i s not tied exclusively to rapid economic growth. Clearly, improvements should focus on how to improve the impact o f existing resources and ensuring that any additional resources that may be allocated to the social sectors are targeted to the poor.

11

CAS Annex D Costa Rica Public Debt Management and

Domestic Debt Market Development Assessment Report

summary

Costa Rica’s public debt has significant exposure due to its relatively high level (over 50% o f debt-to-GDP) and i ts vulnerabilities to exchange rate, interest rate and refinancing risk. The Costa Rican authorities are aware o f these risks and wish to better manage them, which includes a further development o f the domestic debt market. The authorities have requested participation in the Bank’s Program o f Country Assessment and Reform Plan in Debt Management and Domestic Debt Market Development, and have already hosted the Assessment mission. The corresponding Assessment Report i s the base for discussion o f the reform plan design, a stage which is being initiated with the full support and active participation o f the authorities. However, as developing capacity in debt management and debt markets i s a lengthy process, the Bank will also help the country develop appropriate forms o f continued assistance beyond the scope o f the Program.

I. Background

Public debt management and domestic ’debt market development in Costa Rica should be evaluated within a context o f macroeconomic vulnerability. While widely considered to have the most stable political environment and highest social indicators in i ts region, Costa Rica has suffered recently in terms o f lower economic growth, and significant public sector and current account deficits.

With a relatively high debt-to-GDP ratio (over %YO), debt sustainability i s becoming an issue, according to a recent debt sustainability analysis (DSA) made by the Banco Central de Costa Rica (BCCR). The government’s continued ability to service i ts debt is considered vulnerable to external shocks, even moderate, that could diminish economic growth rates, cause a real currency devaluation or lead to an increase in real interest rates.

The government has made it a key priority to pass fiscal measures that would address growing imbalances, but the riskiness o f the debt structure itself could cause the necessary fiscal adjustment to be much larger should these r isks materialize. Costa Rica’s public debt - o f which almost 70% corresponds to the central government- i s potentially risky not only because o f its relatively high level, but also because its structure i s exposed to exchange rate, interest rate and refinancing risk.

Currently, close to 45% o f central government (CG) debt has exposure to currency risk , 30% has exposure to floating interest rates, and refinancing r i sk for the next year i s fairly significant, with 23% o f debt coming due; in particular, the central government’s domestic debt has significant refinancing risk, as 32% matures in less than 1 year and an

’ Source of data i s detailed in Costa Rica Country Assessment Report

additional 29% has maturities between 1 and 5 years. These exposures could result in significant increases in the budget’s debt servicing load.

As for BCCR debt, although almost 80% o f it i s domestic, 63% o f total debt i s exposed to currency risk largely because more than half o f i t s domestic debt i s issued in time deposits in U S dollars (CERTD$). Duration i s relatively short ( O S years). Financial losses materializing from BCCR debt (i.e., the quasi fiscal deficit) would eventually be covered by the central govemment, so ultimately the latter bears the risk o f the public debt portfolio,

These financial risks could be better managed with sound public debt management practices and successful development o f the domestic debt market. The Costa Rican authorities are well aware o f the vulnerabilities associated with their country’s public debt, and have indicated their desire to move to a more technical and efficient management o f these risks. As a result, they requested that their country be included n the joint World Bank - IMF Program o f Country Assessment and Reform Plan in Public Debt Management and Domestic Debt Market Development. Th is program was developed as a follow-up to the best practice guidelines on public debt management and domestic debt market development2.

The Program’s main objective i s to design a set o f reforms and capacity building initiatives, based on a diagnostic, to improve a country’s capacity in sovereign debt management and in the development and maintenance o f the domestic debt market. A second objective is the provision o f m important demonstration project that can show how principles for sound public debt management and the function o f debt markets can be translated into practical reform programs.

Th is brief annex summarizes a more detailed joint Bank-IMF Country Debt management and Debt Market Development Assessment rq30rt.~ Developing capacity in debt management and in developing local debt markets i s a lengthy process. Hence, the remaining sections summarize the main fmdings o f this work with the important proviso that this will be a continuing process.

II. Key issues

Public debt management

In recent years the Costa Rican authorities have made important progress in modernizing public debt management, including: the merging within the Ministerio de Hacienda (MH) o f Credit0 Publico into the Tesoreria to create one consolidated debt management office with a front, middle and back office structure; the creation o f an Asset and Liability ~

“Guidelines for Public Lkbt Management”, IMF and The World Bank, 2001. Following the request by the Government to participate in the Program, a joint World Bank-IMF mission visited San

Jose in July 2003, and left in the fiekl an Aide Memoire summarizing the main findings. Subsequently, a more detailed Country Assessment report was produced and provided to the authorities for their review. A Memorandum of Understanding i s being discussed to confirm the authorities’ interest in pursuing the second phase, i.e. design o f the reform plan.

2

Management Department in the central bank, also with a front, middle and back office structure; progress in developing the domestic debt market, particularly at the short end o f the yield curve and promotion o f the creation o f a standardized regional debt market; and work on analysis o f the debt’s costs and risks, and with this, preliminary proposals for a debt management strategy, both by MH and BCCR.

However, public debt management i s compartmentalized in different institutions: MH issues debt to meet central government funding requirements, while BCCR issues debt for open market operations (OMOs) and for funding. its own quasi-fiscal deficit4. As a result, the debt issuance objectives o f the two entities are to a degree uncoordinated and at times even conflicting, resulting in the lack o f an integrated strategy for managing the aggregate public sector debt portfolio and its r isk implications for the government’s balance sheet, and for developing the domestic debt markets.

Also missing i s a more formal set o f responsibilities for the authorities involved in debt management, as for example, explicit strategic objectives related to managing the cost- r isk trade-off inherent in debt portfolios, a formal decision making apparatus that coordinates the two entities, periodic reports to top policy-makers with strategic recommendations for managing the debt and developing the domestic debt market, and in tum, reports to Congress on strategy choice and implementation.

This may be related to the institutional fragmentation o f debt management responsibilities; there are many advantages to having these responsibilities consolidated in one entity, which in many countries tends to be the Ministry o f Finance. In the case o f Costa Rica, such a proposal would require a M e r strengthening o f the institutional capacity o f the Tesoreria in MH, in order that it take on the debt management responsibilities currently being carried out by BCCR. Such a project would include strengthening the areas o f staffing, training and information technology.

Until this transference i s completed, hwever, greater coordination is required between Tesoreria and BCCR in order to develop an integrated strategy for managing the cost and r isk o f debt and for developing the domestic debt market. A top political commitment and leadership are required, as there i s a tendency for each institution to focus on their own more narrowly defined objectives.

An important area o f work would be the development o f cash-flow model for quantifjmg debt-servicing risk for al l BCCR and MH debt, which would feed into the development o f an integrated debt management strategy, with reference to risk and cost trade-offs and development o f the domestic debt market.

Eventually debt management should be removed from BCCR’s functions by recapitaliming the latter, or through transfer of annual quasi-fiscal deficit onto government’s budget.

3

Monetary policy and debt management I domestic debt market interface

There i s also progress and remaining issues for the interface between monetary policy and debt management. On the one hand, progress has been made with the introduction o f competitive joint auctions for central government and central bank securities and with the standardization o f new issues to improve their liquidity and marketability, There are however, remaining issues:

. growing fiscal deficits together with heavy quasi-fiscal losses and a negative capital position o f the BCCR are obstructing the conduct o f monetary policy; . the need to strengthen BCCR balance sheet by restoring positive capital and eliminating operating losses; concomitantly, the absence o f assets with which to undertake repurchase agreements and remove liquidity has induced the BCCR to use auctions o f primary securities as the principal instrument o f OMOs; . the increased dollarization trend, high level o f ksintermediation (off-balance sheet operations) and interest rates volatility on assets denominated in domestic cunency reduce the scope o f monetary policy, thus aggravating the complexity o f monetary programming and the short term implementation o f liquidity management; . the introduction o f an explicit Lombard facility -at a preannounce interest rate- would not only serve as a proper signal for monetary policy, but would also provide necessary liquidity. The latter, together with a concomitant deposit facility to absorb liquidity, would help develop a corridor to smooth interest rate fluctuations; . sound monetary policy should be complemented with an appropriate cash management policy to improve the overall liquidity management and to develop the money market. Nevertheless, there seems to be an inadequate information base and capacity for assessing, projecting and updating short-term liquidity, thereby making cash flows uncertain and volatile.

Many o f these issues highlight the need to re-capitalize the BCCR, as also recommended in the Financial Sector Assessment.’ The authorities are committed to such a process and are well aware of the problems that are arising for debt management, debt market development, and implementation o f monetary policy.

Domestic debt market development

Overall Costa Rica’s debt market development i s limited by structural features o f the market that include the prominence o f public sector as a key demander o f such securities, a limited true private investor base, and limitations in the basic infrastructure for custody clearing and settlement o f government securities. In addition, development i s also hindered by important institutional limitations, the most prominent o f which i s the lack o f an explicit written debt issuance strategy agreed upon by MH and BCCR.

Debt Issuance Strategy: As mentioned, Costa Rica’s domestic debt market development i s hindered by the lack o f an explicit, written debt issuance strategy between MH and BCCR. While improvements in coordination have been made for sub-one year issuance,

Costa Rica FSAP

4

the tendency to be reactive and sometimes arbitrary in terms o f the auction calendar, security choice and characteristics, and issuance quantities, has damaged the credibility o f the authorities. A reduction in this uncertainty would likely lead to a lowering of the government’s fmancing costs. In addition, improving the systems for forecasting and accounting in the case o f M H ’ s cash needs and BCCR’s liquidity needs would help set the stage for a better auction process.

The concentration in the distribution channels, and the unique role o f the Puestos in the auctioning process for public debt has negative implications for transparency and competition in the market. Competition issues are fiuther clouded as the Puestos often form part o f larger financial conglomerates, and have an intrinsic relationship to the public institutions. Other methods of government security distribution should be investigated, with the caveat that the structure o f the financial system at large in terms o f fmancial conglomerates may limit the options.

M a r k e t Structure Considerations: The current high paced growth o f assets managed by mutual funds along with specific features o f CRs securities markets can place the fmancial system at r isk should the market suffer any type o f price shock. The high concentration in the portfolio composition (in government securities), flawed capital and liquidity requirements, along with a valuation methodology which relies on marking to model in an illiquid market exacerbates systemic risk. Mutual funds with longer term and relatively illiquid assets are susceptible to a vicious cycle where sudden redemptions cause fund managers to sel l assets quickly, which in an illiquid market causes large drops in asset prices and correspondingly large drops in portfolio valuation. Th is in turn fuels M e r redemptions. Furthermore, since the largest o f mutual funds are also part o f state- owned financial conglomerates, the fmancial system at large can be pulled into such a crisis. In order to avoid such an occurrence, the supervisory bodies should study alternatives to the current capital requirements and monitor liquidity mismatches more closely. Th is should include the development o f a reporting framework that will enable such monitoring.6

The Superintendencia de Valores should consider implementing M e r incentives, including a redefinition o f the “liquidity coefficient”, for the Fondos de Invers ih to properly insure against such risks. The coefficient, used to calculate the amount of liquidity the funds must maintain, does a poor, one-dimensional job at measuring potential r isk, as it does not analyze the underlying nature o f the fund portfolios, and i s backward looking. The amount o f liquidity the fund must maintain should be inversely proportional to the liquidity o f the assets it holds, and should consider the riskiness o f the assets as well, at a minimum. The liquidity requirements should consider the cwerall possibility o f illiquidity o f the market as a whole, in addition to the difficulty in asset valuation.

The significant negative duration gap in obligatory pension funds makes them a natural buyer o f long term colon denominated issues, and a natural participant in the

Several other Latin American countries are more carefdly addressing this problem (e.g. Mexico, Colombia, and Brazil.

5

government’s intention to establish a longer dated yield curve in colones. Currently, the pension fimd’s appetite to match duration i s hindered by the existing mark to market requirement for their long dated government securities. Since the longer dated securities tend to be more illiquid, their mark-to-market value tends to suffer more volatility. A more carefid study o f the liability structure would help the government understand the types o f instruments these pension funds would most naturally require to ameliorate their risk structure.

As is typical in many developing markets, the secondary market in CR i s illiquid, dominated by government securities and with trading concentrated in the short end o f the curve. There have been too many issuers o f public debt with different characteristics., although in recent years the fragmentation has been somewhat reduced, via actions to undertake more effective fiscal planning and via more coordination in issuance processes, However, there are s t i l l problems in the area o f the different types o f outstanding securities, particularly for the TUDES and Tasa Basica. The outstanding issues o f Tasa Basica number over 20,000, with maturities ranging from 2003 to 2015, with 26 different interest rate margins (determining coupons). With this amount o f non-standardized issues outstanding, it i s nearly impossible to expect liquidity. Along with new regular issuance, the authorities should examine how to use exchange offers or debt buybacks to try and reduce the fragmentation in instruments in the medium to longer end o f the curve.

Valuation o f portfolios o f government securities remains complex in Costa Rica except in the very short end o f the curve, due to illiquidity and the various structural problems mentioned elsewhere. Current methods o f marking to model and interpolation cannot substitute for the fiu-ther development o f a local colones curve with sufficiently liquid benchmarks. In part, this i s explained by lack o f sufficient standardization o f long dated colon denominated debt. However, fixther review o f the methods now deployed by the Bolsa for determining the vector o f prices, in light o f both intemational experience and o f the trading system design, i s in order.

Market Infrastructure: The infrastructure for clearing, custody and settlement o f securities in the secondary market in Costa Rica has fragmented liquidity until recently. In large part the specific requirements associated with the “locking in o f collateral” within three different trading regimes (the Bolsa, the MIB, and the Mercado de Liquidez for Puestos only) have resulted in a situation o f segmented local markets in which liquidity i s dispersed. In effect it is impossible to free collateral locked into one platform to trade in another because there i s not one true centralized depository, nor fungibility o f the securities. Similar problems o f a lack o f interoperability and lack o f consistency o f the current custody arrangements with international standards also hurt liquidity. M e n combined with the non-standardization o f securities and the relative disincentives to trade long dated securities (more than 180 days) due to current valuation guidelines, these factors help to explain the lack o f liquidity in the secondary market.

The BCCR in conjunction with other agencies i s now developing the new Sistema de Anotacion en Cuenta (SAC) that will effectively create one centralized depository for all government debt. At first th is entity will be operated by the BCCR but will likely be

6

divested (this i s allowed for in the new LRMV) to be managed by a special entity with wide ownership (investors, banks, brokers, the exchange etc.) and professional management. The new depository will allow for the effective linkage between the public debt markets traded on the Bolsa o f OTC with the inter-bank and repurchase agreement markets. This new system wi l l allow for much greater flexibility in the types of transactions that can be undertaken by all market participants across these markets (e.g. electronic negotiation o f securities based on bilateral or multilateral netting, exchange traded or OTC etc.). I t wi l l also allow for fungibility o f securities on deposit and is essential to support any effort to promote regional trading o f dollar denominated money market instruments or ~ecurities.~

In going forward the authorities wi l l need to pay special attention to the risks inherent in implementing this more complex system especially in the area o f securities clearing and in light o f the growing offshore trading and cross-border trading o f money market and debt instruments among different Central American countries that will be facilitated over time.

The attached matrix, extracted from the Country Assessement Report, provides a s m a r y o f issues and recommendations, with a preliminary indication o f their priority and period o f implementation.

IJI. Costa Rica Second Stage Projected Output: Reform Program

The scope and timing o f the second stage o f the Program will depend upon the Costa Rican authorities’ commitment and on the. level and nature o f resources needed to implement the reform plan and specific follow-up technical assistance projects. The output o f the second stage would be the design o f a detailed program o f reforms and institution and capacity building in the areas mentioned, to be developed in close co- operation with officials. The focus o f the program w i l l be practical solutions to the problems identified and a sequencing o f interventions.

Based on the experience o f other countries, a program o f this type can take some time, and should be viewed as a major project, with a project manager, the involvement o f key technical staf f from both institutions, and a high level steering committee to provide guidance.

Note that the new system will allow for new issues o f securities to be dematerialized and registered by the number of the operation o f the title and will allow for fhgibility. Custody accounts will now be independent o f the specific front end trading mechanism to trade the contracts e.g., the MIB or Bolsa. There i s also the beginning o f a market in dollar denominated repos trading cross border among Central American countries and this will be fostered if there i s a more modern and flexible framework for custody and settlement (liquidation) o f all forms o f securities contracts.

7

6 G (11

2 2 m 0 s

b (11 c (li

E

T

s

E z

a E

4 ' P

i 5 F;;

z E 3:

3 z

E

- E

3

0 5 5

z el A

iz el E

z 2 E

E

a

E

L

2:

E

z

P

E 2:

E 2:

$1

CAS Annex E Synthesis of Costa Rica

Financial Sector Assessment

Background

The Financial Sector Assessment (FSA) i s based on the work o f the joint WBlIMF mission that visited Costa Rica as part o f the Financial Sector Assessment Program (FSAP) during October 22-29 and December 5-13,2001. The FSA results were discussed in September 2002 with relevant authorities o f the new administration during a World Bank visit to San Jost. They were also discussed extensively with the authorities in November 2002 and January 2003 in the context o f the IMF Article IV Consultation. This summary mostly reflects the state o f the Costa Rican financial system and the supervisory oversight based on information available as o f end-2001. During 2002 the Costa Rican authorities have taken relevant measures to address some o f the key issues identified in the FSA, particularly as regards the strengthening o f the bank supervision framework.

A. Overall Assessment

The financial sector i s deep relative to other countries in the region and increasingly diversified. It i s organized around financial groups that often include, in addition to an onshore bank, an offshore bank , a stock broker, an investment fund, an insurance commercialization firm, a pension fund, and a mortgage company. Gross assets o f financial institutions reached 72 percent o f GDP in June 2001, which is high by Latin American standards. While banks account for 77 percent o f the financial system assets and investment funds (mutual funds and pension funds) have grown rapidly in recent years to 10.4 percent o f financial sector, the capital market remains narrow and mainly centered on public securities.

The public sector has an important presence in Costa Rica’s highly concentrated financial system, limiting competition. The onshore banking system continues to be dominated by public banks, which include three state-owned commercial banks (Banco Nacional, Banco de Costa Rica, and Banco Nacional de Cartago), and a special-charter bank (Banco Popular) in principle owned by al l Costa Rican workers. They account for about 75 percent o f total banking deposits. Consequently, banking concentration, albeit declining, continues to be high, even by Latin American standards. The public sector has a monopoly o f the insurance sector, through the INS, and dominates the pension and mutual fund industry

The banking system has become more diversified in recent years, with private banks continuing to gain market share. Onshore private banks include 17 banks, 10 o f which have at least a 50 percent share o f foreign capital (from the U.S. and Central American countries). They have expanded their share in onshore banking, following the authorization, in 1996, to open sight deposits. Notwithstanding their higher cost o f

funding, due to their more limited presence in the retail market and lack o f deposit guarantee, in contrast with the state guarantee enjoyed by all public bank deposits, the private banks’ share o f onshore bank lending rose from 33 percent in early 1998 to 42 percent in August 2001, as they countered their local funding handicaps with more aggressive lending in dollars, a rapid increase in funding through external lines o f credit, better service, and quicker product innovation. As a result, the contrast between the asset structure o f public and private banks, while s t i l l sharp has tended to become less pronounced. Public banks concentrate in c o b lending to small borrowers and col6n- denominated public securities while private banks focus on dollar operations with the larger and more sophisticated customers

Offshore banking is unusually large in Costa Rica. Offshore banks account for about 24 percent total banking system assets. They are licensed in foreign (mainly Caribbean) jurisdictions but conduct most o f their deposit-taking and lending activities with Costa Rican residents and are, therefore, fully woven into the country’s domestic financial and economic activity. The assets o f private offshore banks are equivalent to 40 percent o f the assets o f private onshore banks and to 100 percent o f the assets o f their corresponding onshore banks, as against 11 percent for public banks. Offshore banks grew rapidly in the initial stages o f private banking, in response to high unremunerated reserve requirements (over 28 percent in 1995) and reflecting private banks’ search for a competitive edge against public banks. Offshore banks’ growth i s tapering o f f following a substantial reduction in reserve requirements (to 9 percent at end-2001), concerns about the negative connotations o f offshore banking, and aggressive competition in the dollar funding market by mutual funds and public banks.

The already high degree of financial dollarization is on an increasing trend. At present, 45 percent o f deposits and 50 percent o f loans o f the onshore banking system i s dollar-denominated. The share o f dollar loans in the onshore loan portfolio o f private banks is, at 60 percent, higher than in public banks (40 percent). The authorities estimate that about half o f onshore dollar loans are to debtors whose incomes are not in dollars, which understates the problem. Financial dollarization may be generally fostered by ongoing international financial integration, but it i s accentuated by the exchange rate regime. The rapid increase in dollar funding has enabled dollar loans to grow faster than dollar deposits, while deposit dollarization has grown despite a shift in interest rate differentials in favor o f colon deposits caused in part by the relative abundance o f local dollars. The increase in the funding cost o f colon loans, together with high intermediation spreads in local currency has raised the cost o f colon loans, inducing dollar loans to expand across the board, including to consumer loans and mortgages.

The capital market i s narrow and centered on public securities and rep0 operations. The dominant security in the market i s domestic public debt paper issued by the Treasury and Central Bank, o f short duration (less than one year). Partly due to the small size o f the country and concentrated ownership patterns, the market for private securities i s undeveloped. There i s only a handful o f private debt securities, mainly issued by the financial sector, with limited trading. The equity market is nearly non-existent. The capital market has performed basically two functions: orthodox finance o f the public sector and money market activity.

2

The intermediation spreads are high. High spreads between col6n deposit and lending interest rates (at about 12 percentage points, on average) in the onshore banking system partly reflect uneven regulatory and tax treatment, and market segmentation. They also reflect a crowding out o f col6n credit by the predominantly col6n-denominated domestic public debt. Finally, they reflect the use o f currency denomination as a vehicle for price discrimination, as col6n customers are generally less sophisticated than dollar customers and have less access to alternative financial outlays, The notable differences between the average size o f col6n deposits and loans clearly illustrate such market segmentation.

Banks are exposed to interest rate risk and to exchange rate risk. Banks are not directly exposed to interest rate risk, due to the widespread use o f floating lending rates. However, this shifts risk to borrowers and increases banks’ indirect exposure to interest rate risk by accentuating their exposure to credit risk. Similarly, banks’ direct exposure to the risk o f currency depreciation i s not significant, as the scope for holding short open dollar positions i s limited by regulation. However, banks are indirectly exposed through their borrowers. Banks are aware o f the risks associated with lending in foreign currency to borrowers who do not receive dollar incomes and have taken some steps to mitigate such risks..

Liquidity in the onshore banking system has been declining and i s unevenly distributed. Liquidity has declined in recent years as the monetary authorities reduced reserve requirements and banks expanded their lending operations. Also, liquidity i s unevenly distributed across banks. While public banks are generally quite liquid, reflecting their large holdings o f Costa Rican government securities, the liquidity o f some private banks lies much below the average for the system. The short average maturity o f .bank deposits (75 percent o f deposits have a less than three-month maturity), some shortcomings o f the inter-bank money market, and the lack of deposit insurance for private banks increase the risk that some banks may encounter in a situation o f turbulence.

Competition between private and public commercial banks has increased, but significant regulatory and tax asymmetries remain. The privileges o f public banks include the state guarantee on all their liabilities while no explicit deposit insurance exists for private banks. The tax exemption o f their dollar deposits, and the requirement on private banks to deposit at least 17 percent o f their short-term deposits in state banks in order to be entitled to take demand deposits. On the other hand, the capacity o f state banks to compete i s hindered by their legal status as public entities, which makes them akin to a government ministry. As a result, they have difficulties in adopting profit maximization as the objective and they face cumbersome public sector procurement guidelines and inflexible personnel and salary policies. These asymmetries are mostly grounded in the law and create an uneven playing field that complicates prudential oversight.

3

B. Main Recommendations o f the FSA . The FSA recommended the authorities to devise a comprehensive and coordinated medium-term strategy that addresses the problems and promotes financial deepening. The main elements o f the strategy included:

Reforms of the prudential regulatory framework aimed at leveling the playing field between public and private banks and on-shore and offshore banks, strengthening the legal mandate o f supervisory agencies, allowing the creation o f buffers against systemic risks, allowing Costa Rican prudential norms to apply uniformly across all banks.

Reforms of the supervisory framework, including o f on-shore banks and offshore banks through the introduction o f fully consolidated supervision o f financial conglomerates, a strengthening o f the capabilities o f SUGEF and steps to foster improvements in banks’ own risk management system and greater market discipline.

Reforms of the safety net, including the introduction o f prudential buffers, the introduction of a comprehensive deposit insurance scheme in conjunction with an effective bank failure resolution framework.

Improvements in crisis management, including strengthening operational managements o f the lender o f last resort facility, improvements in procedures for intervening troubled banks, and changes in legislation to prevent excessive protection o f debtors and disincentives for creditor participation.

Improvements in liquidity management, including steeps to promote a deepening o f the interbank money market, a recapitalization o f the Central Bank, the development o f a active open market intervention capacity, and improvements in the payments system.

Additionally, reforms to ensure viability o f the pension system, while not pressing in the short-run, need to be introduced to keep public debt under control, Reforms to improve the functioning o f securities, pensions, and insurance markets carry relatively less urgency, but are essential for development. Over the medium-term, reforms should aim not only at financial stability and depth, but also at broadening access to financial services. This requires continuous strengthening o f the enabling environment through improvements in the legal, accounting, informational, and contract-enforcement infrastructure, and in tax treatment.

C. Measures Adopted

In response to the recommendations o f the FSA the authorities have undertaken relevant reforms, which include the following:

On Bank Supervision

Joint Supervision of Offshore Banks. During 2002 SUGEF made considerable progress in signing Memoranda o f Understanding (MOU) with the supervisory authorities o f

4

countries where Costa Rican offshore banks are incorporated. To date, MOUs have been signed with Panama, Colombia, El Salvador, Honduras, and Dominican Republic. (For a description o f offshore banking in the case o f Costa Rica, see text paragraph 7.) Costa Rican offshore banks are required eventually to move to jurisdictions with which an M O U has been signed. Per the MOUs, SUGEF can conduct on-site inspections o f Costa Rican offshore banks, jointly with the local supervisors. SUGEF can do the same with respect to Costa Rica offshore banks incorporated in the US., even though a formal M O U has not yet been signed with the U.S. A joint on-site inspection o f a Costa Rican offshore bank incorporated in Panama was conducted in 2002.

Capital Requirements. In mid-2002, CONASSIF approved a Capital Adequacy Norm that details the manner in which financial groups, included public bank based groups, are to calculate capital adequacy on a solo and a consolidated basis. SUGEF does not have legal power directly to regulate and supervise offshore banks and certain onshore non- bank financial intermediaries (e.g., leasing, factoring, and credit card companies). However, the Capital Adequacy Norm addresses part o f this limitation indirectly. It requires the holding company o f a financial group to hold capital equivalent to at least 20 percent o f the assets in the mentioned onshore non-bank intermediaries. Such capital requirement can be reduced to 10 percent, at the discretion o f SUGEF, if the intermediaries voluntarily accept to be subject to SUGEF’s onsite inspection.

Risk Management. The Federal Reserve o f Atlanta and the Office o f the Comptroller o f the Currency provided technical assistance to SUGEF to strengthen i ts capacity to assess risk management and other internal systems in financial institutions (including strategic planning and management information systems). In addition, a new regulation on credit risk deriving from dollar lending to non-dollar earners has been prepared and i s expected to be approved soon by CONASSIF.

Information Requirements and Accounting Standards. On January lSt, 2003, a new chart o f accounts, that generally follows International Accounting Standards, came into effect.

Anti-Money Laundering. On December 2001, the SUGEF issued new guidelines for “Know Your Customer” rules establishing the minimum standards that are to be complied with by Costa Rican institutions.

On Securities Markets

Money market development. Procedures for the transfer o f securities used in repos were simplified and improvements were introduced to facilitate information availability. The Stock Exchange i s in the process o f changing the technological platform to facilitate the integration o f the Mercado de Liquidez and the MIB.

Regulation. The supervisory roles o f SUGEVAL and the Stock Exchange were clarified. Disclosure requirements for broker-dealers were enhanced and mark-to-market valuation of investment funds introduced.

5

CAS Annex F Costa Rica Consultations with Civil Society

Consultation Workshop

On 27 January 2004, a consultation workshop, attended by about 50 representatives o f a broad spectrum o f Costa Rican civil society organizations, was carried out to discuss the proposed World Bank’s Country Assistance Strategy (CAS) for Costa Rica. The Bank team was led by Ms. Jane Arrnitage, Country Director, Central America and included staff and managers representing each o f the key sectors. A small Government team, led by the Vice-Minister o f Finance, also attended the workshop. Workshop participants discussed the analysis that the Bank o f Costa Rica’s socio-economic development context as well as the objectives and priorities considered in the draft o f the CAS. The Costa Rican Academic Program o f the Latin American Faculty o f Social Sciences (FLACSO), and the Central American Institute o f Business Administration (INCAE) facilitated the workshop and played a key role in identifying Costa Rican participants. Taking into account the main emphases o f the CAS, the participant list included representatives from a range o f institutions such as trade unions, business chambers, NGOs, research centers, academic institutions, churches, community organizations, environmental organizati ons, as well as indigenous and afro-descendant organizations. Representatives from the municipal governments o f San Jose and Puerto Limon were also invited to participate. Prior to attending the workshop, participants were provided a document outlining the main analytical conclusions and proposed program o f activities contained in the draft CAS. Other analytical documents prepared by the Bank on the current economic and social situation o f the Central American Region were also distributed, together with background information on the World Bank, its institutional priorities and its various support instruments. This was a set o f highly relevant information to bring the participant’s perception on the World Bank up to date, in view o f the Bank’s low profile in Costa Rica over the past decade or so.

The consultation workshop was divided into five sessions: a) an opening session with welcoming remarks from representatives o f the Government o f Costa Rica, the facilitating institutions, and the World Bank; b) a plenary session, where World Bank representatives presented the main transformations in its institutional mission (poverty reduction and achievement o f the MDGs), along with analytical considerations and the main objectives and strategy envisioned in the CAS for Costa Rica; c) a thematic break- out session during which the Bank’s sector leaders for FPSI, PREM, HD and ESSD presented and discussed the specific issues and proposed assistance activities for each sector with civi l society representatives; d) a plenary session where rapporteurs presented and discussed comments and recommendations o f the thematic workgroups; and e) a closing session, where World Bank representatives addressed the comments and recommendations resulting f iom the workshop, and where the Vice-Minister o f Finance, on behalf o f the Government o f Costa Rica, thanked participants for their feedback and inputs. Also, during the closing session Jane Armitage, the World Bank’s Country Director, reiterated the institution’s commitment to study with special interest the recommendations made at the consultation, share with participants the report o f the workshop, which will be annexed to the CAS document prior to submission to the Bank’s Board o f Executive Directors, and to publish the final CAS document approved by the Board on the Bank’s external web-site for full public disclosure.

The three thematic workgroups were organized according to the three main focus areas envisioned in the draft document o f the CAS, which respond to the needs and interest for support expressed by the Government o f Costa Rica. These were as follows: 1. Business Climate and Macroeconomic Framework; 2. Human Development: Health, Education, and Social Protection; and 3. the Environment and Agriculture’.

Main Comments and General Recommendations of the Consultation

Rapporteurs o f the three groups raised a number o f general concerns with respect to institutional, fiscal, socioeconomic and environmental as well as territorial issues for consideration by the Government and the Bank‘s CAS team:

Institutional aspects: These involve issues relating to the administrative environment and immediate context o f the proposed actions. Within this area, participants stressed the importance o f increasing the Bank’s support for institutional building to enhance cross-sectoral coordination within government and beyond and to strengthen the capacity o f key public institutions to assume strong leadership roles. Within this sphere o f inter-institutional relations, participants proposed that the Bank consider supporting the Government’s capacity to convene and build consensus across different stakeholders directly or indirectly involved in designing and implementing the country’s development strategy. In addition, participants highlighted the importance o f building solid societal consensus on reform directions to foster the adoption of public policies which would continue to be implemented despite changes in government. Participants also emphasized, in different ways, their view that the Bank could play a stronger role in facilitating donor coordination, in order to contribute to more coherent and effective action within the public sector.

Fiscal aspects. Overall, participants were very mindful o f the gap between available public revenues and legitimate demands for spending to address critical socio- economic needs. In this context, participants stressed the importance o f identifying areas in which scarce economic resources particularly hinder the government’s capacity to deliver and manage public services and goods. The participants also emphasized the need to achieve a workable balance between prudent and efficient use o f public resources, and the allocation o f appropriate levels o f fknding to address core social needs, especially in areas such as education, health and social security. They highlighted the need for creation o f incentives and supportive regulatory and institutional frameworks for more innovative use o f available resources -for instance those deriving from pension funds- to finance poverty reducing activities. For example, establishment o f credit lines for small producers andlor small-scale environmental conservation efforts were pointed out as possible innovative solutions to increasing funding demands, without increasing the pressure on the country’s fiscal deficit.

Socioeconomic and environmental aspects. The various groups highlighted the importance o f human capital formation and the creation o f institutional capabilities as key elements in the future development o f Costa Rica. The issue o f how to support micro, small and medium size enterprises in the light o f the impacts of free-trade agreements, and how to take advantage o f the opportunities for deepening vertical

’ See Box with the main specific recommendations made by the three groups.

linkages was o f interest to all participants, who approached the issue from their individual vantage points.

Participants also considered it important for the Bank to support new environmental sustainability initiatives, as a complement to the now well-established pioneering conservation practices which have earned Costa Rica wide international recognition and had a galvanizing effect on tourism to the country. These include paying special attention to the problems deriving from the secalled gray agenda, associated with the problem o f environmental contamination and its attendant economic and social issues. In this regard, the participants strongly stressed the need for financial sustainability o f environmental efforts.

Participants agreed that equity - both socio-economic and geographic - should be a key hctor in the assessment o f investment priorities. Multiple calls were made to acknowledge the existence o f major differences in welfare and livelihoods in Costa Rica, requiring differentiated and selective actions to address diverse needs. Overall, participants agreed that while Costa Rica's human development and poverty indicators are more equitable than those o f most countries, households at the bottom o f the distribution have significantly diminished access to social services and worse human development indicators. In th is context, several participants made references to the "average CR" and to the "other CR", indicating that it should be a priority for the CAS to highlight the gaps and the diversity observed in the indicators. Further, they felt that the CAS should emphasize the situation o f excluded groups, give priority to the need to collect more and better information to reflect CR realities, and systematically monitor the relevant indicators. The strong view, therefore, was that, within Costa Rica's successful emphasis on universal program coverage, which accounts for many o f the social achievements o f the country, targeted efforts are needed, tailored to the needs o f the excluded groups.

3

In line with the above concerns, participants strongly emphasized the need to introduce territorial selectivity mechanisms to facilitate closing the development gaps between different regions. They indicated that this requires recognizing the different dynamics at local, sub-regional, regional, and national level in order to appropriately design interventions and institutional building initiatives. Furthermore, in view o f the central role o f such issues as international labor migration, participants stressed the need to connect national local processes with trans-national dynamics that may have significant influence on the success or failure o f investment projects and public policies.

Lastly, participants in the various groups raised the central role that should be granted to participatory practices. In their view, this will facilitate maintaining an adequate link between actors and development processes, and will also activate permanent and transparent mechanisms for monitoring and ensuring the accountability o f projects and public policies.

SPECIFIC THEMAnc ~E~~~~~

Business Climate and Macro-Economic Environment Explain at greater length the scope and achievements of the National Development Plan, and its

relation to the Country Assistance Strategy. 4 Provide more examples to substantiate how trade reduces poverty and generates employment.

Provide participants with information on the initiatives the World Bank is already involved in with other multi-national institutions (IDB, CAF, CABEI).

The water and sanitation project envisioned to be developed in San Jose’s Great Metropolitan Area has more bearing on the social sphere than merely on the field of infrastructure.

Human Development General Recommendations

Expressly consider the situation of afro-descendant, indigenous, and disabled populations in the strategy and operations supported by the World Bank. This implies keeping statisti= and creating specific indicators with sufficient levels of desegregation, as well as sensitizing officials tasked with working with these populations.

Include a component of communications for cultural change in the human development project. Discuss, not only the efficiency but also the volume of resources allocated to social investment,

and even consider the possibility of programmatic lending to create an enabling environment for lonpterm investment programs in the social sector.

Education Examine in greater depth the reasons conditioning student drop-out and low educational

performance problems, thereby questioning the premise about the homogeneity of the Costa Rican educational model.

Efforts to close the educational gaps should be emphatic in overcoming the backwardness of secondary education with respect to developed countries, while also considering the deficit in quality dragged on from previous year-levels.

Health Assign high priority to regulation of the health sector given the growing presence of the private

sector on these matters, and the existing separation of functions between the Costa Rican Social Security System (Caja Costamcense del Seguro Social) and the Ministry of Health. Regulation should be linked to social participation on health -an aspect not clearly reflected in the documents presented by the World Bank during this consultation.

Give a major boost to information systems and to improve accountability toward users and toward civil society in general.

Establish policy guidelines to attend to higbrisk groups, in orderto optimize use of scant resources. Consider the possibility of providing World Bank support to review the overall model of allocation

of human and financial resources for the social sector. Ultimately management problems are considered to be affecting the performance of services and the optimum use of resources.

Social Protection In terms of social assistance, emphasis should be placed on supporting the poor with

comprehensive intervention models -rather than through “poor programs for the poor people.” Encourage a discussion on the possible creation of a Ministry of Social Development in the face of

current inter-institutional coordination problems. At any rate, the Bank will necessarily have to support a dialogue aimed at rethinking the “Social Authority.”

The Environment Pay greater attention to providing specific support for the management of marinelcoastal

resources. Loans aimed at the environmental sector should benefit not only the private sector, but also

protected public areas. Support the creation of sustainable act Enhance coordination and information about programs and projects supported by the Bank

through the Ministry of the Environment (MINAE). Favor the realization of more consultations on the Bank‘s support on environmental matters, with

participation of a broader group of key players that did not take part in the CAS consultation. Coordinate with other multilateral and bilateral cooperation agencies, the support for implementing

the National Environmental Strategy.

es that create alternative employment (ecotourism)

,