Costa Rica’s economic model is still in significant ways based on a mercantilist system that is biased in favor of certain sectors of the economy.

Growth without Poverty Reduction: 

The Case of Costa Rica

By Juan Carlos Hidalgo

In the early 1980s, as was the case in much of Latin America, Costa Rica suffered its worst economic crisis in decades. Between 1980 and 1982 the economy contracted by 9.4 percent, and in 1982 average inflation reached 90.1 percent. In two years the proportion of the population living below the poverty line shot up by more than 20 percentage points to 54 percent. Multiple factors caused the crisis, including the exhaustion of the import-substitution model—a protectionist regime that aimed at replacing industrial imports with domestic production. Throughout the years this model encouraged the creation of numerous inefficient state-owned enterprises whose growing financial burden overwhelmed the government. By 1980 total public spending was 54 percent of GDP.

The country also faced a severe deterioration in the terms of trade as the price of oil soared while the price of the handful of products it exported (mainly coffee, sugar, beef, and bananas) plummeted. As foreign direct investment dried up, the current account deficit increased to 12.6 percent of GDP in 1980. Then-president Rodrigo Carazo (1978–1982) decided to resort to foreign financing to maintain the fixed exchange rate. Costa Rica’s external debt quadrupled during his term in office. However, a rise in international interest rates aggravated the situation by increasing the cost of government financing. Instead of cutting public spending and getting rid of onerous state-owned enterprises, Carazo chose to deal with the government’s deteriorating finances by printing money. Eventually the government was forced to devalue the currency. Inflation skyrocketed, sending hundreds of thousands of Costa Ricans into poverty.

Subsequent governments implemented reforms aimed at transitioning Costa Rica from the import-substitution system that had been in place since the 1960s toward an export-oriented model. One of those key policy reforms was the introduction of a crawling peg exchange rate regime based on daily mini-devaluations of the colón, the national currency. The original goal was to provide more certainty to exporters for their investments by stabilizing the real exchange rate. However, since 1999 the crawling peg system increasingly enhanced the competitiveness of the export sector by undervaluing the domestic currency, which lowered the price of the goods being exported. This crawling peg system also boosted the tourism sector, which has become Costa Rica’s most important industry.

In the 1990s Costa Rica implemented further reforms: it established free trade zones where companies would enjoy a tax-free regime as long as their production was solely for export purposes. Thanks to these and other incentives, in 1997 Intel chose Costa Rica as the site for one of its microchip plants. Soon after, semiconductors and computer accessories would replace banana and coffee as the country’s top exports. In the early 2000s other technological, pharmaceutical and service, companies followed suit, investing in Costa Rica’s free-trade zones.

In the mid-1990s Costa Rica also began negotiating free trade agreements whose main goal was to open new markets for its exports. The country now boasts free trade agreements with Mexico, Chile, Peru, Panama, the Central American Common Market (Guatemala, Honduras, El Salvador, and Nicaragua), the Caribbean Community, the Dominican Republic, the United States, Canada, China, Singapore, and the European Union. It will soon implement agreements with Colombia and the European Free Trade Association (Norway, Iceland, Liechtenstein, and Switzerland). As a result of these reforms, the value of exports as a percentage of GDP rose from 27 percent in 1985 to 49 percent in 2007—the year prior to the global financial crisis. (The figure markedly declined after the crisis and was 37 percent of GDP in 2012).1

During the late 1980s and 1990s the Costa Rican economy also underwent significant structural reforms: most state-owned enterprises were privatized, although the government kept its monopolies on electricity, telecommunications, oil refinement and distribution, insurance, and alcohol production.2 Private banks were allowed to operate checking accounts, but the government kept ownership of the four largest banks. Tariffs on many consumer goods were abolished or significantly reduced: while in 1985 the mean tariff rate was 55 percent, by 2000 it was only 5.4 percent—where it remains today.3

These reforms contributed to Costa Rica’s significant improvement in economic freedom. The country went from 62nd in 1985 (among 109 countries) in the Fraser Institute’s Economic Freedom of the World report to 23rd in 2005 (among 123 nations).4 The economy grew an average 4.7 percent per year since 1987, one of the fastest rates in Latin America.

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Conclusion

Costa Rica’s economic transformation of the last 30 years included numerous liberalization measures, but a closer look reveals a strong mercantilist bias. 

Successive administrations adopted monetary, trade, tax, and regulatory regimes that benefited the export-oriented sectors of the economy at the expense of the overall population, particularly the poor. 

As a result, even though the country has enjoyed a healthy growth rate for over 25 years, the proportion of Costa Ricans living below the poverty line remains pretty much the same as it did in 1994 at around 20 percent, while income inequality is on the rise. 

Costa Rica needs genuine market reforms that eliminate the government’s power to pick winners and losers or otherwise bestow favoritism. 

In the areas aforementioned, the country should

• Implement a neutral exchange rate regime either by allowing the colón to freely float against the U.S. dollar or by adopting the latter as the country’s official currency.
• Abolish all tariffs on agricultural products as well as other regulations that provide monopoly powers to conglomerates that produce farm goods such as rice, beef, and sugar, and eliminate price controls on rice.
• Dismantle regulations that stifle domestic entrepreneurship, following the guidelines laid out by the World Bank’s Doing Business project.
• Adopt a neutral and competitive tax regime that taxes all businesses domiciled in the country equally but at a low flat rate.

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