Financial Crime World

Costa Rica Shifts Toward Greater Exchange Rate Flexibility

In a move to reduce systemic risks and improve financial stability, Costa Rica has been shifting its exchange rate regime toward greater flexibility since the second half of 2018.

Impact on Credit Market

The country’s credit market has responded accordingly, with:

  • Local currency-denominated loans growing at a rate of 1% year-on-year
  • Foreign currency-denominated loans seeing a decline of 1%

Reducing Systemic Risks

The shift away from high dollarization in Costa Rica’s banking system is a welcome development. Dollarization previously generated significant risks for the financial sector, including:

  • Systemic risks: Limited capacity of the country’s central bank to provide dollar liquidity as a lender of last resort
  • Solvency risks: Potential for unhedged borrowers who do not generate dollars to struggle to repay their debt in the event of a sudden depreciation of the colón
  • Liquidity risks: Potential for difficulties in rolling over foreign currency-denominated debt

Improving Financial Stability

The move toward greater exchange rate flexibility is expected to reduce these risks and improve financial stability. The Costa Rican authorities are monitoring:

  • Proportion of foreign currency credit extended to the private sector
  • Growth rate of foreign currency credit as potential risks

Increased Foreign Exchange Reserves

The shift away from dollarization has also led to an increase in foreign exchange reserves, which now stand at USD 3.5 billion, up from USD 2.8 billion in 2015. This increased stability is expected to benefit both domestic and international investors, making Costa Rica a more attractive destination for investment.

Challenges Ahead

However, the country’s financial sector still faces some vulnerabilities:

  • High net foreign liabilities of banks
  • Growing household leverage
  • Sovereign exposures all represent potential risks that need to be addressed. The IMF has warned that reduced foreign bank funding could lead to a significant reduction in credit availability in Costa Rica.

Conclusion

Despite these challenges, the shift toward greater exchange rate flexibility is an important step forward for Costa Rica’s financial sector. As the country continues to evolve its monetary policy framework, it will be crucial to monitor closely the impact of this change on financial stability and overall economic performance.