Moody’s has removed the country’s rating of “investment grade”, citing the increase in public spending and political inability to implement fiscal reform.

From a statement by Moody’s:

New York, September 16, 2014 — Moody’s Investors Service has today downgraded Costa Rica’s government bond rating to Ba1 from Baa3. Moody’s has also changed the outlook to stable from negative.

Today’s rating action was prompted by the following factors:

1. Institutional weakness, as evidenced by continued political obstacles to comprehensive fiscal reform. Several attempts in recent years to address Costa Rica’s growing fiscal deficits and debt have not brought these levels lower. The new Solis administration, which took office in May of this year, has indicated it will only gradually introduce fiscal consolidation.

2. As a consequence of inaction, we expect the current large fiscal deficits and increasing debt burden are likely to continue for the next few years. The fiscal deficit has averaged 4.5% of GDP since 2009, largely driven by spending growth, and is expected to reach 5.8% of GDP in 2014 and 6% next year. The high deficits have materially worsened Costa Rica’s debt burden, with debt to GDP expected to rise close to 40% this year, compared to 25% of GDP in 2008.

The outlook assigned to Costa Rica’s Ba1 government bond rating is stable indicating further rating changes are unlikely in the next 12 to 18 months.

RATING RATIONALE

CONTINUED POLITICAL OBSTACLES TO FISCAL REFORM

Today’s downgrade reflects our expectations that material fiscal improvements are unlikely in the next one to two years. A negative consequence of Costa Rica’s entrenched democratic tradition has been the cumbersome process of consensus-building. For the past few administrations, the government’s weak position in Congress has delayed approval of legislation because of the need to forge ad-hoc alliances. Consequently, efforts to approve significant fiscal reforms have been impeded.

We expect continued political obstacles to comprehensive fiscal reform during the Solis administration, in office since May 2014. The government aims to introduce new revenue measures by early 2015, but successful implementation will be difficult and the impact on the fiscal deficit insufficient to undo the rise in the debt burden. We expect that the current government will only gradually introduce fiscal reforms going forward.

CONTINUED WEAKNESS IN FISCAL POSITION, DRIVEN BY EXPENDITURE GROWTH

The second driver of today’s rating action is continued weakness in Costa Rica’s main fiscal and debt metrics as the country has been unable to bring its deficit back to pre-2009 levels. The central government deficit, which averaged a 0.9% of GDP from 2004 to 2008, rose significantly to an average of 4.5% of GDP from 2009 to 2013. We expect a fiscal deficit of 5.8% of GDP for 2014, which will be almost double the 3.0% median for the ‘Ba’ category. Absent any change fiscal deficits will average 6%-7% in 2015 and 2016.

The higher deficits are mostly the result of the steady rise of current expenditures, which have increased 4.5% of GDP since 2008 reaching over 18% of GDP in 2014. Expenditure growth was mainly due to increases in wages and transfers that Costa Rica has found difficult to constrain. Years of high current expenditures create structural rigidities through greater public-sector hiring and increased dependence on fiscal transfers. This in turn increases the political difficulty of expenditure cuts, and places the burden of fiscal consolidation on increased revenues. As a result of high fiscal deficits Costa Rica’s debt burden, which had fallen to 25% of GDP in 2008, will reach close to 40% in 2014 according to Moody’s estimates , and will continue rising in 2015 and 2016.

WHAT COULD CHANGE THE RATING DOWN/UP

Structural budgetary adjustments, such as increased tax revenues, spending cuts or a combination of both, could lead to a positive rating action if such actions successfully limit, and eventually arrest, the rise in the debt burden.

A continued deterioration of the fiscal accounts and further increases in the main debt metrics will likely lead to further negative rating actions. Evidence of stress in the banking system or a significant increase in the level of financial dollarization could also place downwards pressure on the rating.

COUNTRY CEILINGS

Moody’s has today affirmed the A3 country ceilings for local-currency debt and deposits. The ceilings for long-term and short-term foreign-currency bonds have also been affirmed at Baa2/P-3. Finally, the ceiling for foreign-currency deposits was downgraded to Ba2/NP from Baa3/P-3.

Moody’s Local Currency Country Risk Ceilings determine the maximum credit rating achievable in local currency for a debt issuer domiciled in that country or for a structured note whose cash flows are generated from domestic assets or residents. Moody’s foreign-currency country ceilings generally set the highest rating possible in a given country by denoting the risk that a government would interfere with a domiciled debtor’s repayment of its foreign-currency-denominated bonds (the Foreign Currency Bond Ceiling) or the risk that the government would impose a foreign currency deposit freeze (the Foreign Currency Deposit Ceiling).

The principal methodology used in these ratings was Sovereign Bond Ratings published in September 2013. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody’s rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider’s credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this rating action, and whose ratings may change as a result of this rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody’s legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.