Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 46809-CR

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED LOAN

IN THE AMOUNT OF US$500 MILLION

TO

THE REPUBLIC OF COSTA RICA

FOR A

PUBLIC FINANCE AND COMPETITIVENESS DEVELOPMENT POLICY LOAN WITH DEFERRED DRAW-DOWN OPTION

March 31,2009

Poverty Reduction and Economic Management Central America Country Department Latin America and Caribbean Region

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

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REPUBLIC OF COSTA RICA-FISCAL YEAR January 1 - December 3 1

CURRENCY EQUIVALENTS (as o f February 24,2009)

1 USD = 558.4 Colones 1 Col6n = 0.002 USD

WEIGHTS AND MEASURES Metric System

SELECTED ACRONYMS AND ABBREVIATION

CAT-DDO Development Pol icy Loan with Catastrophe Deferred Drawdown Option

C F A A Country Financial Accountability Assessment

CPI Consumer Price Index CPS Country Program Strategy DPL-DDO Development Pol icy Loan with

Drawdown Option DR-CAFTA Trade Agreement for Central

America and Dominican Republic EU European Union FDI Foreign Direct Investment FONABE National Scholarship Fund FONATEL Universal Service Fund

(Telecoms) GDP Gross Domestic Product IDB Inter-American Development

Bank I C E Instituto Costarricense de

Electricidad IFMIS Integrated Financial Management

Information System

I M A S M i x e d Institute for Social Assistance

IMF International Monetary Fund L A C Lat in America and the Caribbean MIDEPLANMinistry o f Planning NGO Non-governmental Organization PER Public Expenditure Review PFM Public Financial Management R&D Research and Development SIGAF Integrated Financial

SUGES Oversight entity for insurance

SUPEN Superintendence o f Pensions SUTEL Regulatory Authority for the

Telecommunications Sector T ICA Information Technology Project

for Customs USD United States Dollar WDI Wor ld Development Indicators

Administration System

sector

Vice President Pamela Cox Country Director Laura Frigenti

Sector Director Marcel0 Giugale Sector Manager Rodrigo A. Chaves Task Managers Rashmi Shankar and

J. Humberto Lopez

FOR OFFICIAL USE ONLY

REPUBLIC OF COSTA RICA DEVELOPMENT POLICY LOAN WITH DEFERRED DRAWDOWN OPTION

TABLE OF CONTENTS

LOAN AND PROGRAM SUMMARY ....................................................................................................................... i

I . INTRODUCTION ..................................................................................................................................................... 1

I I. COUNTRY CONTEXT ........................................................................................................................................... 1

A . RECENT ECONOMIC DEVELOPMENTS IN COSTA RrCA ........................................................................................... 2 B . MACROECONOMIC OUTLOOK ................................................................................................................................ 6

11 I. THE GOVERNMENT PROGRAM AND PARTICIPATORY PROCESSES ..................................................... 9

A . RENDERING PUBLIC FINANCES MORE EFFICIENT AND TRANSPARENT ............................................................... 10

C . BOOSTING COMPETITIVENESS BY FACILITATING MARKET ENTRY ..................................................................... 15 B . IMPROVING COMPETITIVENESS BY REMOVING THE SECONDARY EDUCATION BOTTLENECK ............................. 13

I K BANK SUPPORT TO THE GOVERNMENT’S PROGRAM ............................................................................ 18

A . LINKS TO THE CPS ............................................................................................................................................. 18 B . COLLABORATION WITH THE IMF AND OTHER EXTERNAL PARTNE Rs .................................................................. 19 c . RELATIONSHIP TO OTHER BANK OPERATI~NS ................................................................................................... 19 D . LESSONS LEARNED ............................................................................................................................................. 20 E . ANALYTICAL UNDERPINNINGS ............................................................................................................................ 20

K THE PROPOSED OPERATION .......................................................................................................................... 21

A . OPERATION DESCRIPTION .................................................................................................................................. 21

C . EXPECTED OUTCOMES ....................................................................................................................................... 23 D . PROPOSED LOAN AMOUNT ................................................................................................................................ 24

B . POLICY AREAS ................................................................................................................................................... 22

V I . OPERA TION IMPLEMENTATION .................................................................................................................. 25

A . POVERTY AND SOCIAL IMPACTS ......................................................................................................................... 25

c . MONITORING AND EVALUATION ......................................................................................................................... 27

E . DISBURSEMENT AND AUDITING .......................................................................................................................... 27 F . RrSKS .................................................................................................................................................................. 2 8

B . ENVIRONMENTAL ASPECTS ................................................................................................................................ 26

D . FIDUCIARY ASPECTS ........................................................................................................................................... 27

LIST OF ANNEXES

ANNEX 1 : LETTER OF DEVELOPMENT POLICY .................................................................................. 3 0 ANNEX 2: COSTA RICA: PUBLIC FINANCE AND COMPETITIVENESS DPL.DDO. POLICY MATRIX ....................... 43

ANNEX 4: COSTA RICA AT.A.GLANCE .......................................................................................... 48 ANNEX 5: DEBT SUSTAINABILITY ANALYSIS ................................................................................... 5 1 ANNEX 6: THE PROGRESSIVITY OF SOCIAL EXPENDITURES ................................................................... 5 4

ANNEX 3: COSTA RICA: ASSESSMENT LETTER TO THE WORLD BANK - STATEMENT BY IMF STAFF ................... 46

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties . I t s contents may not be otherwise disclosed without Wor ld Bank authorization .

LIST OF TABLES. BOXES AND FIGURES

TABLE 1: COSTA RICA: KEY MACROCONOMIC INDICATORS AND PROJECTIONS. 2005-2013

TABLE 3: LINKS BETWEEN THE PROPOSED DPL-DDO AND PRIOR ANALYTICAL WORK

......................... 3 TABLE 2: COSTA RICA: CENTRAL GOVERNMENT EXPENDITURES; 2006-2009 ........................................ 4

.............................. 21 TABLE 4: EXPECTED MEDIUM-TERM PROGRAM OUTCOMES .............................................................. 23 TABLE A5.1: MAIN UNDERLYING BASELINE ASSUMPTIONS .................................................................... 51 TABLE A5.2: PUBLIC SECTORDEBT SUSTAINABILITY ANALYSIS .................................................................... 52 TABLE A5.3: DEBT SUSTAINABILITY ANALYSIS: ALTERNATIVE SCENARIOS ........................................................ 53 TABLE A6.1: DISTRIBUTION OF PESP BENEFITS BY SECTOR ..................................................................................... 55

BOX 1:PRIORACTIONS FORBOARDPRESENTATIONOFTHEPROPOSEDDPL.DDO ....................................... 22 Box 2: GOOD PRACTICE PRINCIPLES ON CONDITIONALITY ................................................................... 24 BOX 3: DR-CAFTA: ESTIMATED DISTRIBUTIONAL CONSEQUENCES FOR COSTARICA .................................. 25

FIGURE A6.1: PESP CONCENTRATION COEFFICIENTS (EXCLUDING SOCIAL PROTECTION) .......................................... 54

MAP (IBRD 33392) .............................................................................................................. 56

ACKNOWLEDGEMENTS

T h i s loan was prepared by an IBRD team consisting o f Rashmi Shankar (co.TTL). J . Humberto Lopez (co.TTL). Ulr ich Lachler. Ana Lucia Armijos. Teresa Genta.Fons. Fabiola Altimari. Antonio Blasco. Juan Navas.Sabater. Carlos Sobrado. Chnstel Vermeersch. Maria Lucia Guerra Bradford. Marie Georgiana J . Vidal. Patricia de la Fuente Hoyes. Patricia Holt. Michael Geller. Ricardo Tejada. Sabine Pemssin. Andrea Kucey. Marlene Sims. Sonia C . Molina. Sununta Prasamphanich. Jose R . Lopez Calix (peer reviewer) ahd Mark Roland Thomas (peer reviewer) . We are grateful for the helpful advice received from Francisco Galrao C . (OPCS). Todd Crawford (LCSDE). Rodrigo A . Chaves (LCSPE). Andreas Bauer (IMF). Rodrigo Cubero (IMF) and Nicole LaFramboise (IMF) . Finally. the Bank team also would l ike to express i t s appreciation for the collaboration o f the Government o f Costa Rica in the preparation o f t h i s Development Policy Loan .

LOAN AND PROGRAM SUMMARY

COSTA RICA PUBLIC FINANCE AND COMPETITIVENESS DPL-DDO

1 Borrower Implementing Agency

Financing Data

1 Operation Type

M a i n Policy Areas

Key Outcome

The Republic o f Costa Rica

The Ministry o f Finance

IBRD Loan Amount: US$500 mi l l ion Terms: Disbursement linked fixed spread loan (FSL), denominated in U S dollars, with level repayment o f principal payable in 30 years (including five years o f grace period). The borrower wishes to maintain al l r isk management options embedded in the loan and to finance the front-end fees out o f the loan proceeds. Single tranche Development Pol icy Loan with Deferred Drawdown OPtion. The proposed operation supports Government efforts aimed at: (i) strengthening public revenue generation capacity and fiscal transparency, and (ii) boosting competitiveness. Key outcomes expected by 2010 under the proposed operation are: (i) maintaining the tax revenue to GDP ratio at the 2007 level or higher in spite o f the global crisis; (ii) advancing the introduction o f a results- based management system; (iii) expanding the beneficiaries o f the conditional cash transfer program, “Avancernos ”; (iv) declining secondary drop-out rates; (v) establishing operational regulatory authorities for the telecommunications and insurance sectors; and (vi) improving the intellectual property rights regime in order to increase interest by foreign investors in technology intensive projects. The Project Development Objectives are to: (i) strengthen public finances and their transparency by enhancing the efficiency o f revenue generation and results-based m’anagement o f expenditures; and (ii) improve competitiveness by enhancing secondary education attainment, facilitating market entry in the telecommunications and insurance sectors, and strengthening the legal framework pertaining to intellectual property rights.

These objectives are fully consistent with the medium-term strategic objectives o f the 2008 CPS, which are: (a) to address emerging challenges to continued growth and competitiveness, in particular with respect to infrastructure shortcomings, skills gaps and excessive red tape; and (b) to sustain and deepen recent gains in poverty reduction, social sector development and the environment.

i

Risks and Risk Mitigation

b e r a t i o n ID

The operation i s subject to three main risks: (i) economic, (ii) lack o f pol icy continuity, and (ii) natural disasters.

On the economic front, the main risk derives f rom the global crisis and more specifically from a deep and prolonged global deceleration. This risk i s mitigated by the design o f the program and by recent steps taken by the authorities to enhance crisis preparedness.

The global crisis could also divert the Government’s attention from its medium term structural reform agenda as it concentrates on crisis management. To manage this risk, the Bank will hold frequent consultations with the Government in the context o f the planned semiannual reviews o f the DPL DDO.

The operation i s also susceptible to risks deriving f rom natural disasters as the country i s highly vulnerable to multiple natural disasters risks that can pose a significant threat to economic growth and fiscal stability and can also delay the Government’s program. This risk i s mitigated by the country’s strong emergency management system and by the CAT-DDO, which became effective March 5,2009. P115173

.. 11

COSTA RICA PUBLIC FINANCE AND COMPETITIVENESS DPL-DDO

I. INTRODUCTION

1. This program document describes a single-tranche Development Policy Loan with Deferred Draw-Down Option (DPL-DDO) in an amount of US$500 million. The proposed operation supports the Costa Rican Government’s efforts to: (i) strengthen public finances and their transparency by enhancing the efficiency o f revenue generation and results-based management o f expenditures, and (ii) improve competitiveness by enhancing secondary education attainment, facilitating market entry in the telecommunications and insurance sectors, and strengthening the legal framework pertaining to intellectual property rights. This Public Finance and Competitiveness DPL-DDO, together with a parallel US$500 mi l l ion loan from the Inter-American Development Bank (IDB) approved on December 17, 2008, and a US$720 mi l l ion precautionary Stand-by Arrangement (scheduled to be considered by the IMF Board in early April), are integral to Costa Rica’s strategy to manage financing risks associated with the crisis o n different fronts. For example, the IDB operation seeks to provide liquidity to the private sector by facilitating productive sector access to financial resources. Similarly, the precautionary Stand-by Arrangement provides a contingent l ine o f liquidity to support the Central Bank’s international reserves if needed. Finally, the proposed US$500 mi l l ion DPL-DDO would provide a contingent line o f credit to the Ministry of Finance in case a worsening in the economic environment makes the financing o f the deficit more difficult than anticipated.

II. COUNTRY CONTEXT

2. Costa Rica is an upper middle-income developing country of 4.5 million inhabitants and had a per-capita GDP of US$6,557 in 2008. The country i s wel l known for i ts socio- economic achievements and stable political system. Its l i fe expectancy i s substantially higher than in comparator countries while infant and chi ld mortality rates are significantly lower. Costa Rica’s advantage i s less pronounced in the education indicators however, and may even be lagging behind other regional averages in some areas, such as secondary education.

3. Costa Rica had the second lowest poverty headcount in Latin America in 2004, with just 9 percent of households below the US$2 poverty line and the poverty rate has continued to decline since then. This was hal f the regional average. Using the absolute poverty line o f $1 per person per day, Costa Rica’s poverty rate was only 2 percent, or one-fifth o f the Lat in American average.’ The household surveys carried out by the National Institute o f Statistics and Census, INEC, indicate that progress in poverty reduction had stagnated during the latter part o f the 1990s and early part o f this decade, after having declined from 32 percent in 1989 to 23 percent in 1994. Since 2004, however, the poverty rate resumed i t s downward trend, falling to 17.7 percent in 2008,2 while extreme poverty decreased to 3.5 percent, reflecting both a rapid

See Costa Rica Poverty Assessment: Recapturing Momentum for Poverty Reduction. The World Bank, February

Source: Central Bank o f Costa Rica

1

2007. 2

1

growth rate and increasing social transfer expenditure^.^ A s with poverty, Costa Rica’s income distribution also exhibits very l o w levels o f inequality by Lat in American standards. The Gini coefficient was 0.48 in 2004, compared to the Lat in American average o f 0.52. By this measure, only Uruguay exhibits lower inequality indicators in the Lat in America and the Caribbean Region (LAC).

A. Recent Economic Developments in Costa Xca4

4. Costa Rica’s recent growth performance has been one of the most impressive in Latin America. Gross domestic product (GDP) growth reached 8.8 percent in 2006 and 7.8 percent in 2007 (Table 1) compared to L A C regional averages o f 5 percent and 4.5 percent, respectively. Costa Rica’s strong economic performance is attributable to a combination o f internal and external factors. Internal factors included high business and consumer confidence reflected in robust private consumption and investment, rapid credit expansion at l o w interest rates, and strong growth in the construction, finance, and domestic manufacturing sectors. External factors included strong growth in world demand, receipts from tourism, and foreign direct investment (FDI) inflows. However the food and fuel crisis starting late 2007 followed by the onset o f the global crisis led to growth falling in 2008 to 2.9 percent.

5. Inflation started to increase in the last quarter of 2007, driven by the global surge in food and fuel prices, as well as by easy domestic monetary policy. Economic expansion was accompanied by steadily declining inf lat ion until August 2007, when this trend was reversed. CPI inflation reached 10.8 percent at end-2007 and 13.9 percent by end-December 2008. Food prices have risen twice as fast as headline inflation (26.7 percent as o f October), most importantly affecting the poor, who spend almost ha l f o f their income o n food. The Government used some o f i t s expanded fiscal space to put in place well-targeted transfer programs to cushion the impact o f higher commodity prices o n the poor. Core inflation (headline inflation net o f food and oil) increased from 8.5 percent in January 2008 to 14.8 percent in November 2008, partly reflecting a relaxed monetary stance by the Central Bank during this period. The authorities’ pol icy response at that time was to prioritize growth over the containment o f inflation. Their decision to allow real interest rates to fall, however, led to a sharp increase in the growth o f domestic credit, exacerbating the second-order effects o f food and fuel inflation.

6. Good macroeconomic management has also contributed to Costa Rica ’s positive economic performance in recent years. Macroeconomic pol icy has been oriented towards containing inflation while facilitating continued growth and poverty reduction. I t i s based o n the following key elements: (i) stimulation o f private sector-led growth through further integration with the rest o f the world; (ii) introduction o f greater fiscal discipline and reduction in public debt; (iii) improved debt management, with a view to reducing the reliance on foreign

T h i s represents an increase from a record l o w o f 16.7 percent in 2007 attributable to the impact o f the food and fue l crisis.

Macroeconomic data i s consistent wi th the agreement between the Government and the IMF. Discrepancies wi th official numbers, if any, are due to differences in exchange rate assumptions. IMF includes debt issued in inflation- indexed and dollar bonds (TUDES - Titulos de Deuda Emitidos en Dolares y en Unidades Constantes) in calculation of fiscal balances.

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borrowing; (iv) a redistribution o f public spending towards education, health, security and public infrastructure; and (v) an improved quality o f public spending through better expenditure budgeting and planning, including the introduction o f the medium term expenditure framework. The monetary and exchange rate pol icy framework i s based o n a crawling exchange rate band.

Table 1 Costa Rica: K e y Macroeconomic Indicators and Projections* (As percentage o f GDP, unless indicated otherwise)

2005 2006 2007 2008 2009 2010 2011 2012 2013 --I- Actual---- Est. ---- Projected-------

Output and Prices Real GDP growth (% A) Inflation (eop, % A in CPI) REER (?! A, + = appreciation) Savings and Investment Gross Domestic Investment Gross Domestic Savings Balance of Payments Current Account Balance

Trade Balance Exports (merchandise fob) Imports (merchandise cif)

Foreign Direct Investment Public Sector Finances Central government

Total revenues o/w tax revenues

Total expenditure o/w capital expenditure Primary balance

Overall balance Overall public sector I / Primary balance Overall balance Total Public Debt o/w foreign currency denominated Memorandum item:

5.9 14.1 4.0

26.4 21.8

-4.9 -10.8 35.6 46.4

4.3

13.9 13.6 16.6 1.1 2.0

-2.8

1.5 -2.6 52.7 27.0

8.8 9.4 0.0

26.4 21.8

-4.5 -12.1 36.0 48.1 6.5

14.2 14.0 15.7 1 .o 2.7

-1.4

1.5 -0.7 47.8 22.5

7.8 10.8 7.5

26.4 21.8

-6.3 -11.4 35.4 46.8 7.2

15.5 15.2 15.2 1.4 3.7 0.3

2.6 1.2

43.2 17.3

2.9 13.9 6.8

27.4 18.1

-8.9 -16.4 32.1 48.5

6.7

15.9 15.7 16.1 1.8 2.4

-0.3

0.1 0.1

35.6 11.5

0.5 8.0

n.a.

21.8 16.1

-5.3 -10.7 28.4 39.1 4.4

15.7 15.4 18.9 2.6

-0.6 -3.2

-3.4 -4.1 36.9 11.9

1.5 7.0 n.a.

22.0 16.0

-5.3 -11.0 29.2 40.2 4.4

15.8 15.6 19.0 2.3

-0.3 -3.2

-3.3 -4.2 38.4 12.4

3.5 5.0 n.a.

22.3 16.9

-5.4 -12.1 31.4 43.5 4.6

16.0 15.7 18.4 2.1

-0.1 -2.4

-2.9 -3.5 38.8 12.5

4.5 4.0 n.a.

22.9 17.5

-5.5 -12.5 31.6 44.0 4.8

15.9 15.7 18.0 1.8 0.2

-2.0

-2.3 -2.9 38.6 12.4

5.2 4.0 n.a.

23.3 18.1

-5.2 -12.7 31.8 44.5 4.8

15.9 15.7 17.7 1.8 0.4

-1.8

-2.0 -2.5 37.9 12.1

Nominal GDP (billions o f US$) 20.0 22.5 26.3 29.8 30.2 31.0 32.9 35.1 37.5 1/ Combined public sector includes Central Government, Central Bank, and non-financial public sector excluding the Costa Rican Institute o f Electricity (ICE). Source: Ministry o f Finance, Central Bank o f Costa Rica, and IMF & World Bank estimates. Note: REER denotes Real Effective Exchange Rate.

7. Fiscal discipline has been a key component of Costa Rica’s macroeconomic framework. An improved fiscal performance in 2006 and 2007, and the maintenance o f a slight public sector surplus in 2008, permitted increased social spending as wel l as a reduction in public debt. The central government posted a surplus o f 0.3 percent o f GDP in 2007 (its best performance since the mid-1950s) and a slight deficit in 2008, while the overall public sector closed with an overall surplus o f 1.2 percent o f GDP and 0.1 percent o f GDP in 2008. The combination o f high growth rates and fiscal reforms introduced by the Government raised tax

3

collection5 from 13.6 percent o f GDP in 2005 to 15.7 percent in 2008. These higher tax revenues, together with lower public debt servicing costs, have permitted higher public spending o n priori ty social expenditures. As indicated in Table 2, central government spending on education, social protection, and health increased from 7.9 percent o f GDP in 2006 to 9 percent o f GDP in 2008. The substantial increase in priority spending was achieved without an increase in public debt. In fact, the total public debt dropped considerably, from 56 percent in 2005 to under 36 percent by the end o f 2008.

Table 2 Costa Nca: Central Government Expenditures; 2006 - 2009

Percent of GDP 2006 2007 2008 2009

Economic classification Est. Proj. Total Expenditures 15.7 15.2 16.1 18.9

Current expenditures 14.7 13.8 13.9 16.3 Wages and salaries 4.6 4.4 4.6 5.6 Pensions and social security 2.4 2.4 2.4 2.6 Transfers and other 3.4 3.7 4.3 5.5 Interest 4.2 3.3 2.6 2.6 N e t Capital Expenditures 0.9 1.3 1.8 1.7

Social Spending 7.9 8.5 9.0 10.0

Health 0.4 0.3 0.4 0.5 Education 4.7 5.0 5.1 6.0 Social Protection 2.5 3.0 3.0 3.2

Functional classification

Housing 0.1 0.1 0.4 0.1

Source: IMF (Economic Classification) and Ministry o f Finance, Government o f Costa Rica (Functional Classification).

8. I n addition to disciplined fiscal management, sound debt management also contributed to thepublic debt decline. Several important initiatives carried out by the Finance Ministry in this context included the creation o f a consolidated debt and cash management office, the development o f a coordinated exchange and interest rate pol icy with the Central Bank, and the implementation o f a debt management strategy. Two key elements o f the debt management strategy have been to reduce the share o f foreign currency debt and to increase the share o f debt at fixed interest rates as part o f efforts to extend the col6n yield curve. As a result, the share o f variable interest debt in central government public debt fe l l from over 58 percent in 2000 to 17.5 percent in 2008. This has reduced exposure to interest rate r isk and resulted in a more stable and predictable yield curve in short- and medium-term securities. Another component o f the debt management strategy has been to extend the average maturity o f central government debt, thereby mitigating rollover risk. Between 2000 and 2008, short-term debt (maturing in less than one year) fel l from 41.2 percent to 25 percent o f domestic debt.

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9. Costa Rica's external position remained stable between 2005 and 2007, before the onset of the global crisis started affecting export growth in 2008. Between 2005 and 2007, the high import bill was being paid for by growing exports and robust capital inflows, especially

Non-tax revenues f e l l slightly f i om 0.3 percent o f GDP to 0.2 percent o f GDP over the same period, while contributions to social security increased slightly f iom 6.3 percent to 6.6 percent o f GDP, also between 2007 and 2008.

4

FDI. Export performance has been driven by an increase in industrial exports, especially computer components and microchips. Import growth has been the result o f high consumer and business confidence reflected in rapid growth in domestic demand that has outpaced supply. While the current account deficit had been hovering around 5 to 6 percent o f GDP in 2005-2007, foreign direct investment (FDI) inf lows alone averaged around 6 percent o f GDP in this period, leading to an increase in international reserves to over US$4 bi l l ion by the end o f 2007. The external balance deteriorated significantly in 2008 with the onset o f the U S economic downturn, as the total demand for Costa Rica’s exports fe l l by an estimated 3.3 percentage points o f GDP in 2008 and the current account deficit jumped to almost 9 percent o f GDP.

10. The surge in food and fuel prices that peaked in the second quarter of 2008 led to a deterioration of external balances, rapid increases of inflation, and fears of a growth slowdown. This was followed by a deepening o f the financial crisis in the United States and Europe, which compounded the challenges faced by macroeconomic policy. Over the past 12 months, Costa Rica’s external environment has changed from one o f abundant capital inf lows that prompted the appreciation o f the currency and forced the Central Bank to intervene (buying dollars), to one o f short-term capital outflows that put the colon on a devaluation path since M a y 2008, driving the Central Bank to intervene (selling dollars) in support o f the col6n. The crawling exchange rate band, introduced in October 2006, was widened twice in 2007 to create more room for monetary pol icy action. Currency speculation in mid-July 2008, however, led the monetary authorities to narrow the band from 17 percent to 11 percents6 Although the authorities allowed the exchange rate to depreciate to the highest part o f the crawling band and interest rates were hiked up significantly, the Central Bank suffered a significant loss o f reserves between April and November 2008 (about US$1,300 million). Capital outflows abated in November and the exchange rate has returned toward the middle o f the exchange rate band.7

1 1. The banking system in Costa Rica is healthier and more diversified than in the past, but vulnerabilities remain. In recent years, the banking system has seen healthy growth in deposits and credit, a declining share o f non-performing loans, and robust liquidity indicators. Additionally, progress has been made in strengthening risk management and supervision. However, weaknesses in consolidated and cross-border supervision limit effectiveness o f regulatory institutions. Currency mismatches in household and corporate balance sheets imply that a potential risk facing the banking sector i s credit risk induced by sharp currency movements. This r isk was exacerbated by the rapid growth in credit during 2007-2008. However the recent increase in interest rates on colones-denominated assets i s a positive move in this context, and exchange rate expectations are stabilizing with the easing o f inf lat ion expectations. An area o f concern is that public sector banks benefit from regulatory asymmetries that complicate prudential oversight and distort incentives for private sector development. L imited lending between public and private banks would normally be a bottleneck o n liquidity recycling, becoming an additional source o f risk in the context o f the ongoing credit tightening, but banks

Although the lower limit o f the band w i l l remain anchored at 500 colones, the upper band was moved to 555 colones and w i l l continue to increase daily by six cents o f CR colones. ’ The pattern in capital flows also i s reflected in the evolution o f EMBI Global spreads: after remaining steady at around 250 bps during the f i r s t hal f o f 2008, the EMBI spread grew steadily to reach around 650 bps in late November 2008, before declining again to fall 600 bps by midJanuary 2009.

5

are currently carrying considerable surplus liquidity in their balance sheets, partly to mitigate this risk, and partly because o f declining loan creation.

B. Macroeconomic Outlook

12. small. in the

The direct impact of the global financial crisis on the domestic banking sector has been Costa Rican banks had no significant exposure to structured financial products originating United States and their lending was financed to a large extent with domestic resources.

Moreover, external lines o f credit to banks, amounting to US$1.3 b i l l ion or 7 percent o f banking assets, have been maintained even though at a considerably higher cost. In addition, capital injections into the six largest institutions in late-ZOO8 boosted capital adequacy.

13. The outlook for 2009-2010 is one of slower growth. The growth rate is projected to fa l l to 0.5 percent in 2009 recovering slightly to 1.5 percent in 2010. On the external front, the global economic crisis i s negatively affecting exports and tourism receipts. External financing is also expected to be more constrained, with foreign direct investment dropping o f f and private sector access to external credit lines l ikely to be more limited than in the past. At the same time, slowing domestic demand and fears o f a deepening U S recession are a l l having an impact o n business confidence, and domestic investment which i s expected to decline from 27.4 percent o f GDP in 2008 to 21.8 percent in 2009.

14. Export growth and tourism receipts are expected to remain weak in the near term. Although the decline in Costa Rican exports induced by lower United States and European growth may be partly mitigated by a rising share o f exports to other nations, the overall impact on export growth i s expected to remain negative, given the global nature o f the crisis. The decline in export growth will be partly compensated by improvements in the terms o f trade, resulting in a lower oi l imports bill as international commodity prices decline f rom their earlier peaks. Indeed, the trade deficit i s projected to decline from 16.4 percent o f GDP in 2008 to 10.7 percent o f GDP in 2009. A s for the current account deficit, i t i s also projected to decline from 8.9 percent o f GDP in 2008 to about 5.3 percent o f GDP in 2009. This deficit i s expected to be financed mainly by FDI flows, which are projected at 4.4 percent o f GDP. This assumes a decline in FDI flows o f 2.8 percent o f GDP from 2007 when FDI reached 7.2 percent o f GDP.

15. Domestic and external demand i s projected to pick up again in 2010, in line with a gradual recovery in the United States, raising the real growth rate to 1.5 percent and 3.5 percent in 2010 and 2011 respectively. Over the past decade, Costa Rica has taken significant steps to diversify i ts export base away from primary commodities, and to remove important infrastructural, human capital and technological bamers to growth. A s the external environment improves again, growth is expected to return to its potential level, relying largely on the same sources o f growth as before, but aided by further advances in the liberalization o f trade under DR-CAFTA, the opening up o f the telecommunications and insurance markets, and increased investments in public infrastructure (roads and ports).

6

Response to the Crisis

16. The greatest source of risk for the economy is the uncertainty surrounding the severity and duration of the global economic and financial crisis. While the authorities are revising their macroeconomic pol icy parameters to account for the projected deterioration in the external environment and tightening financial markets, they also recognize that a further deterioration in the environment beyond the projected decline i s possible. Another critical component in the Government’s response to the crisis, therefore, .is to ensure adequate resource availability o n a contingent basis. This involves managing financing risks by seeking contingent financing f rom the multilateral financial institutions (see paragraph 1). This combined package o f reforms and risk management measures i s meant to allow priori ty public spending to remain o n track in the face o f further adverse shocks, while implementing longer run measures aimed at improving systemic robustness to crises and maintaining fiscal balance.

17. The Government’s macroeconomic strategy in response to the crisis focuses on the following broad policy objectives: (i) facilitating an orderly reduction in the external current account while seeking to minimize adverse effects on economic activity; (ii) gradually introducing greater exchange rate f lexibi l i ty and moving toward an inflation-targeting monetary policy; (iii) protecting the most vulnerable groups o f the population from the adverse effects o f the economic slowdown; (iv) reducing financial sector vulnerabilities; and (v) securing contingent financing from multilateral institutions to cover potential shortfalls.

18. The policy framework being implemented relies on both fiscal and monetary policy instruments in a manner consistent with long run sustainability. Central government expenditure will increase from 16.1 percent o f GDP in 2008 to 18.9 percent o f GDP in 2009, due largely to an increase in social and labor-intensive infrastructure spending. This appears to be an appropriate response from a countercyclical pol icy perspective. The expenditure increases aim to protect the poor from the adverse effects o f the crisis while strengthening the economy’s ability to recover growth when the external environment improves by removing remaining infrastructural constraints. On the revenue side, the Government has implemented a series o f administrative reforms to improve the efficiency o f revenue collection. However, given the expected growth slowdown, tax revenues are projected to decline to 15.4 percent o f GDP in 2009 from 15.7 percent o f GDP in 2008. As a result, the central government deficit i s expected to widen from 0.3 percent o f GDP in 2008 to 3.2 percent o f GDP in 2009. Similarly, the balance o f the overall public sector i s expected to deteriorate from a 0.1 o f GDP surplus in 2008 to a 4.1 percent o f GDP deficit in 2009.

19. The impact of higher fiscal spending will be a temporary, slight increase in public debt. Under baseline assumptions, the medium-tern projection is o f an increase in the gross public debt-to-GDP ratio from 35.6 percent at the end o f 2008 to 37.9 percent o f GDP by 2013. This i s slightly higher than the debt to GDP ratio at end-2008, but s t i l l much lower than that in 2007 (43.2 percent o f GDP). I t is also envisaged that there will be a slight increase from 11.5 percent o f GDP in 2008 to 12.1 percent o f GDP by 2013 in foreign-currency-denominated public debt. Annex 5 presents the assumptions underlying these projections. I t also presents a sensitivity analysis based o n more pessimistic scenarios including the possibility o f lower growth, higher

7

interest rates, looser fiscal policy, or a combination o f shocks. That analysis indicates that the public debt to GDP ratio is below 50 percent under al l considered scenarios.

20. The authorities have increased interest rates Jive times since May 2008 (most recently on January 22, 2009) in order to stop and reverse the increase in inflation, and submitted to the Assembly a bill to recapitalize the Central Bank, aimed at increasing the effectiveness of monetarypolicy. The easing o f food and fuel prices wil l support the disinflation strategy o f the Central Bank and inflation is expected to moderate in 2009 and 2010 when the consumer price index based inflation rate i s projected at 7 percent.

21. Recent interest rate increases and the sharp fall in commodity prices give the authorities more space to use monetary policy without endangering the inflation target while maintaining external stability. International reserves remain adequate and the mid-January adjustment in the exchange rate has eased domestic exchange market pressures. Greater exchange rate flexibility and declining inf lat ion are expected to help maintain real exchange rate equilibrium, by providing more space to the nominal exchange rate to adjust to a scenario o f declining capital inflows. Monetary tightening, exchange rate flexibilization, and seasonal improvement in the demand for colones has permitted reserve accumulation in the first quarter o f 2009. As o f mid-March 2009, international reserves stood at US$4.1 billion-r just over 4.3 months o f imports o f goods and services-representing an expected coverage ratio’ o f 63.6 percent in 2009.

22. The Government has also made significant efforts to reduce the risk offinancial stress. For example, in late 2008 the Central Bank introduced a temporary collateralized loan facility to provide the banking sector with liquidity in domestic currency, and broadened participation in the interbank money market. Similarly, the Central Bank has also modified regulations to safeguard liquidity holdings o f the banking system, including through raising the minimum 30- day liquidity requirement, while softening the thresholds o f other bank performance indicators that trigger deeper supervisory scrutiny. The Banking Superintendency has intensified monitoring o f key financial soundness indicators through the implementation o f an early stress system. The Government is also working with Congress to issue legislation aimed at strengthening consolidated bank supervision, and i s studying alternatives to address some key remaining weaknesses in the prudential framework for banks, including the absence o f a uniform deposit insurance scheme (public banks’ liabilities are fully guaranteed by the Government while private banks’ deposits have no guarantee) and o f an adequate framework for bank resolution.

23. As part of the Government’s strategy to provision against adverse shocks while maintaining macroeconomic stability, on December 17, 2008, the Board of the IDB approved a US$500 million loan under its Liquidity Program for Growth Sustainability window. The goal o f this operation, which i s s t i l l pending Congressional approval, i s t o facilitate access by the private productive sector t o f inancial resources to help sustain the country’s economic growth. I ts purpose i s t o provide financial inst i tut ions with liquidity to grant

‘The foreign exchange coverage ratio i s defined here as international reserves divided by the sum o f the annual projected average medium te rm Current Account Deficit, average medium/long term amortization payments, and average stock o f short term debt over 2009-2013.

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new short-term loans for work ing capital and trade f inancing in accordance with program requirements.

24. The Government also approached the IMF in late 2008 to explore the possibility of a Stand-by Arrangement. To this end, an IMF mission visited Costa Rica from January 26 to February 10, 2009. The Costa Rican authorities have indicated that they intend to treat the Arrangement as precautionary and do not intend to draw o n it unless required by currently uriforeseen events. The IMF Board has scheduled a discussion o f this proposed precautionary Standby Arrangement o f US$720 million’ for April 10,2009.

25. Similarly, in line with this notion of securing contingentfinancing in case the situation deteriorates more than anticipated, the Government’s program does not foresee a need to draw down IBRD resources under this operation in the base case scenario. So far the fiscal deficit i s expected to be financed largely with domestic borrowing, and a draw-down o f the proposed DPL-DDO funds i s only contemplated in case the planned domestic financing were not forthcoming. Moreover, the Government i s confident that the financial system, with total assets o f US$38 bi l l ion as o f end-2008, can absorb the combined public sector boirowing requirements o f about US$2 bi l l ion over the next two years. In particular, the pension funds, with assets o f nearly US$6 bi l l ion as o f end-2008, have room to absorb new public debt, especially given the expected fal l in demand for private credit.

26. On the whole, even though the economy is entering a downturn and there are significant risks to the short-term outlook associated with the difficult external environment, economic fundamentals are solid and provide an adequate basis for Bank development policy lending. Moreover, building o n Costa Rica’s strong macroeconomic record, this operation wil l contribute to helping the country weather some o f the potential downside risks associated with the current global crisis.

III. THE GOWRNMENT PROGRAM A N D PARTICIPATORY PROCESSES

27. The proposed operation supports the Government’s development program, which has been consulted with a broad range of stakeholders. The proposed DPL DDO was prepared in close dialogue with the Costa Rican authorities and supports specific components o f the Government’s National Development Plan, 2006-20 10. These components were widely consulted in the context o f the country’s consensus-building institutions and traditions. Moreover, legislative measures to carryout the National Development Plan have been subject to further consultations as new laws have made their way through Costa Rica’s Legislative Assembly.

28. The Costa Rican Government’s National Development Plan, 2006-201 0 is structured along Jive strategic policy lines that cover the social sectors, output and competitiveness, the environment, and institutional development, with the reduction o f poverty and inequality serving

492.3 million SDRs 9

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as the overriding development goal. To achieve this goal, the Government plan emphasizes the following broad development objectives:

Sustaining high economic growth and employment, Improving the quality and coverage o f the education system, Rehabilitating and expanding the country’s transport infrastructure, Strengthening public institutions and combating corruption across the public sector, Reversing the deterioration in public insecurity, and Promoting Costa Rica’s global presence.

29. An essential element of the Government’s strategy to achieve these objectives has been to seek a deeper integration into the global economy, especially through Costa Rica’s participation in the Dominican Republic-Central America Free Trade Agreement with the United States (DR-CAFTA). As part o f that strategy, the Government has prioritized a series o f reforms, referred to as the “complementary agenda”, to enable the implementation o f the DR- C A F T A Agreement, as well as reforms that are designed to boost Costa Rica’s competitiveness through actions to eliminate infrastructure shortcomings, sk i l ls gaps and excessive red tape. The current global financial crisis and economic slowdown have made i t more difficult to pursue these reform objectives and threaten to reverse Costa Rica’s recent gains in poverty reduction and social sector development.

30. Of the various reform initiatives being pursued by the Costa Rican government, this operation proposes to focus support on two broad lines of action, which are: (0 strengthening public finances and their transparency; and (io boosting Costa Rica ’s competitiveness. These actions are emphasized because they improve Costa Rica’s capacity to cope with adverse external shocks while maintaining both priori ty social expenditures and key competitiveness- enhancing reforms. This pol icy strategy will be critical for restoring high growth in the crisis recovery phase while keeping poverty on a declining trajectory. The pol icy actions underlying this strategy are discussed next.

A. Rendering Public Finances M o r e Efficient and Transparent

3 1. Key Issues. The increase in fiscal revenues over the past three years has permitted Costa Rica’s Government to raise social and public investment spending, without widening the fiscal deficit. This increase in targeted public spending may have been partly responsible for the rapid improvement in the country’s poverty indicators. The rise in fiscal revenues was due to both faster economic growth and greater efficiency in revenue collection, particularly through an improved tax administration. The deteriorating international economic environment since December 2007 has raised a danger o f economic contagion that could reduce the growth o f fiscal revenues and, thereby, undermine the recent expansion in social and public investment spending. Furthermore, the threat o f economic recession i s l ikely to raise demands for expanded social protection spending. These factors are threatening to raise the fiscal deficit, reversing the recent improvements in fiscal performance.

32. Government Actions on the Revenue Side. In response to the heightened need to assure adequate fiscal space for priority spending, the Government’s strategy focuses on further

10

improvements in fiscal transparency and efficiency. On the revenue side, this strategy involves hr ther improvements in tax administration through better information and facilitation o f tax payments, particularly for large tax payers," without revising tax rates. That is, the underlying tax structure i s not being modified. To implement this strategy, the Government, through i ts Tax Authority, has initiated a program o f legal, administrative and technical actions aimed at further strengthening i t s capabilities for tax administration by carrying out a series o f strategic actions, that include the:

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33.

Enactment o f L a w No. 8624 ("Ley de Cobro Judiciary), which streamlines the procedural and legal principles applicable to the recovery and collection o f debts (including tax- related debts) with the intervention o f specialized justice sector institutions; and the introduction o f oral procedures; Updating o f procedures for the filing and processing o f tax returns by Large Tax Payers and the issuance o f guidelines for the periodic updating o f a related tax-information base; Approval o f guidelines for the electronic filing and processing o f tax declarations (Tributacidn Digital); and Implementation o f the Government's Information Technology Project for Customs Control (TICA). The T I C A Project, which was launched in 2005, introduces the fol lowing improvements to render customs procedures more efficient: (i) the unification o f customs-related databases; (ii) the development o f a single electronic format to process export and import declarations; (iii) the use o f internet-based custom declarations; and (iv) the simplification o f documentation utilized to process standard transactions. The project i s being implemented in a gradual manner, beginning with the import module and followed by export and special regimes modules. As o f February 2009, the imports module has been implemented in al l seven customs agency posts' ' and the export module has been implemented in al l but two customs posts (Santamaria and Limdn). Full implementation o f the Project covering al l customs posts i s planned by end-2009.

In this pol icy area, prior action for this DPL-DDO consists o f the implementation o f a program o f actions to strengthen tax administration through: (i) the enactment o f L a w No. 8624 ("Ley de Cobro Judiciary); (ii) the issuance o f guidelines for the periodic updating o f the tax- information base related to Large Tax Pavers; (iii) the approval o f guidelines for the electronic filing and processing o f tax returns (Tributacibn Digital); and (iv) the implementation o f the Government's T I C A Proiect.

34. Expected Outcomes. Specific outcomes expected from these measures by 2010 are: (i) a tax revenue-to-GDP ratio that i s not less than the ratio achieved in 2007 (15.2 percent o f GDP), in spite o f the impact o f the global crisis o n growth; (ii) an increase in the users o f the e- based taxation system to represent at least 50 percent o f a l l central government tax revenues; and (iii) the implementation o f the exports regime module o f the T I C A project in al l customs agency posts.

Large tax payers are defined as persons or corporations generating at least C./20,000 mi l l ion in gross income per year, andor with total assets o f at least C./20,000 million. I' These are Aduana de Caldera, Aduana Central, Aduana Santamaria, Aduana de Peiias Blancas, Aduana de Paso Canoa, Aduana de Limon, and Aduana de la Anexion.

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35. Government Actions on the Expenditure Side. The need for ensuring adequate fiscal space for priority expenditures also wil l require some adjustments o n the expenditure side. In the past, an important obstacle to an efficient prioritization o f public expenditures has been the lack o f attention to spending outcomes when formulating the fiscal budget, as we l l as the absence o f a medium-term expenditure framework. These shortcomings have l imi ted the Government’s capacity to match fiscal resources with the priorities expressed in the Government’s Development Plan. To address this problem, the Government has been advancing in developing the tools for introducing results-based budgets and a medium-term expenditure framework. In order to improve the process o f budgetary programming, increase fiscal transparency, and strengthen accountability, the Ministry o f Finance has implemented three measures: (i) the development o f a new budgetary programming methodology; (ii) the linkage o f the budget to operational and strategic institutional planning; and (iii) the development and improvement o f a medium-term fiscal framework. The framework i s results-oriented and based on the identification and definition o f medium-tern priorities. The expectation i s that the new methodology will generate useful information for policymakers, support the process o f allocation o f public resources, and inform the public o n the use o f public resources.

36. The linkage of the budget to operational and strategic institutional planning i s carried out at the national level with a short- and medium-term horizon, intended to increase the accountability of the budget. The government entities are required to link their institutional operational plans (Planes Operativos Institucionales, POI) to the National Development Plan according to the guidelines provided by the National Budget Off ice (Direccibn General de Presupuesto Nacional).

37. The medium-term fiscal framework is intended to support the budgetary process and contribute to the development of a sustainable fiscal policy in the medium term (a 3-year horizon in addition to the current budget year). The exercise involves the elaboration o f different central government fiscal scenarios based on the estimated revenue and expenditure flows associated with the baseline program and alternative pol icy proposals. Also, the Government has taken significant steps to gradually implement a results-based budget management aimed at improving the efficiency and transparency o f public spending. Specific measures taken to introduce results-based budgets into al l central government agencies are: (i) the establishment o f technical and methodological guidelines by MlDEPLAN for the alignment o f budget allocations with the Government’s development priorities as set forth in the NDP; and (ii) the establishment o f technical and financial guidelines by the Budget Directorate for the preparation o f results-based budget proposals for 2009 by al l government agencies.

38. In this pol icy area, prior actions for this DPL-DDO are the significant steps taken by the Government to gradually implement a results-based budget management system, including: {i) the establishment o f technical and methodological guidelines for the a l i m e n t o f budget allocations with the Government’s development priorities; and (ii) the establishment o f technical and financial guidelines for the preparation o f results-based budget proposals for 2009 by al l government agencies.

39. Expected Outcomes. All the central government ministries prepared their 2009 budgets with a medium-term framework and results-based format in accordance with the new guidelines.

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However, the rigor with which the budgets were prepared and the quality o f indicators used vary greatly. To improve the quality o f budget preparation, the Ministry o f Finance has been providing enhanced assistance to a gradually expanding sub-set o f public institutions. In the 2009 budget preparation cycle, six i lo t institutions were covered by the government’s program o f enhanced technical assistance. A specific outcome expected by 2010 i s that at least 12 ministries will be covered by the program.

IF

B. Improving Competitiveness by Removing the Secondary Education Bottleneck

40. Key Issues. Costa Rica’s Government continues to uphold the country’s traditional emphasis on education, reflected in comparatively high (by middle-income country standards) levels o f per-student public education spending, as we l l as in relatively favorable education attainment indicators. At the primary education level, Costa Rica’s gross enrollment rate has been approximately 110 percent since 2000, while the net enrollment rate has also remained stable at approximately 100 percent since 200013. At the secondary level (all modalities), the net enrollment rate (13-17 year olds) grew from 59.5 percent in 2000 to 69.3 percent in 2004, and then to 71.2 percent in 2007. Similarly, the secondary gross enrollment rate increased from 68.4 percent in 2000 to 84.0 percent in 2004 and to 87.9 percent in 2006. In both cases, the rapid increases in enrollment rates during the init ial years after 2000 can be attributed to construction of new schools between 2000 and 2006, as we l l as the introduction o f more flexible education modalities. However, the deceleration o f growth in secondary enrollment after 2004, coupled with unusually high school desertion rates, represents a major challenge. Currently, nearly two- thirds o f children starting secondary school drop out before finishing. In 2006, an estimated 20.1 percent o f seventh graders dropped out.

41. The Government has identifled several important reasons for the high dropout rates. On the demand side, there are socio-economic factors that prevent families from keeping their children in school. On the supply side, arbitrarily restrictive grade promotion and repetition policies appear to have had a particularly discouraging effect, as did the unusually high weighting o f standardized national tests in determining the promotion o f students to the lower secondary level (7th grade) and to the upper secondary level (loth grade).14 L o w education

’* These were the ministr ies o f internal security, finance, public works, health, education and agriculture. They were chosen on the basis o f the size o f public expenditures and strategic importance within the National Development Plan. l3 These numbers include traditional and non-traditional supply modes. (Estado de la Educacion, 2008). The World Bank has been supporting this effort through the IBRD-7284 loan, which has been financing education services in some remaining underserved pockets o f the population, especially M a an and Afro-Caribbean populations. l4 Before the promotion policies were reformed, students in 6” and 9 grade had to pass al l courses simultaneously to be promoted - if they failed one course, the entire coursework for the whole year had to be retaken. Also, students had to achieve an average grade o f at least 70 throughout the year g& in the last quarter in order to graduate. These rules were unnecessarily restrictive and caused many students to leave school after repeated failures. Another important factor appears to have been the lugh weight given to the results achieved on the national standardized test (60%) compared to the weight given to 6” grade course work (12.5%) in the overall weighted grade average that determines passage to lower secondary. Because o f t h i s imbalance, many students decided not to attend 6” grade in order to “cram” for the standardized test at home, wi th the result that they fall behind in their course work and then drop out o f 7” grade. The same situation applied to students in l ine for promotion to upper secondary. In light o f these findings, the Ministry o f Education amended the rules governing repetition and promotion to secondary by allowing students to make up a limited number o f failed courses without

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quality and lack o f relevance, as we l l as inadequate professional development opportunities for teachers also played a role.

42. Costa Rica ’s comparatively poor performance in secondary education indicators constitutes a significant shortcoming in view of the government’s emphasis on expanding the coverage and quality of education. I t also represents an obstacle to Costa Rican efforts to raise the country’s competitiveness, considering the empirical l inks between secondary education attainment and technology absorption. An important challenge in this regard i s posed by the emerging shortages o f skilled workers, pointing, in turn, to the need to strengthen the coverage, quality and pertinence o f secondary education. Moreover, raising secondary education attainment levels i s critically important for maximizing the benefits f rom greater globalization through DR- CAFTA, considering that trade liberalization has been shown to raise the returns to education, and especially to secondary education.

43. Government Actions. In general, the Government’s National Development Plan targets a further increase in the GDP-share o f public education spending to 6 percent in 2009, which has been approved in the budget. As highlighted by the Wor ld Bank’s Public Expenditure Review (2008), social expenditures, excluding contributory pensions, are progressive in Costa Rica. Within the category o f education spending, both primary and secondary education spending i s progressive, while spending on higher education i s regressive since it benefits the more affluent segments o f the population to a disproportionate extent (See Annex 6 for a summary analysis o f the progressivity o f social expenditures).

44. I n the context of strengthening secondary education while retaining a pro-poor focus, the government is undertaking a number of measures aimed at improving quality and reducing dropout rates. In order to tackle the demand side constraints to continued attendance in secondary schools, i t introduced the “Avancemos ” program, which provides cash transfers and other benefits to beneficiary families conditional o n their children attending secondary school. On the supply side, the Ministry o f Education has been seeking to increase the quality o f secondary education through a number o f targeted reforms. In this context, the government initiated a program o f actions aimed at raising secondary school enrollment and enhancing the quality o f secondary education, including the:

Expansion o f the gross number o f secondary education students receiving benefits under the Avancemos Program from 98,050 in 2007 to 156,909 in 2008;15 Amendment o f policies governing promotion and repetition o f secondary students;I6

losing an entire school year, and rendering the grade average for an entire year decisive for promotion, without separating out the last quarter. Also, while the standardized national tests continue to be given for education monitoring and evaluation purposes o f the Ministry o f Education, they are no longer counted for promotion purposes. l5 The Avancemos Program i s being implemented since 2006 through two executing agencies: the National Scholarship Fund (FONABE) and the Mixed Institute for Social Assistance (IMAS). The number o f beneficiaries receiving assistance through I M A S increased from 52,615 in 2007 to 56,125 in 2008, while the number o f beneficiaries receiving assistance through FONABE increased from 45,435 to 100,784 over that same period. There may have been some overlap among the beneficiaries receiving assistance from each executing agency, so the total number o f beneficiaries may be less than their gross sum. The possibility o f beneficiary overlaps has been reduced with the issue o f Executive Decree No. 34786, dated October 10,2008, according to which I M A S has been named the exclusive executing agency o f the Avancemos program as o f January 2009. l6 The exact nature o f these measures i s described at the end o f footnote 14.

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0 Establishment o f a teacher training institute (Instituto de Desarrollo Profesional Uladislao Gamez Solano) under the purview o f the Ministry o f Education; and

0 Approval o f guidelines to facilitate the participation o f Costa Rican students in international standardized testing programs (such as the Program for International Student Assessments, PISA).

45. In this pol icy area, prior action for the DPL-DDO consists o f the initiation o f a program o f actions that include: (i) the expansion o f the gross number o f secondary education students receiving benefits under the Avancemos Program from 98,050 in 2007 to 156,909 in 2008; lii) the amendment o f policies governing promotion and repetition o f Secondary students: (iii) the establishment o f a teacher training institute Unstituto de Desarrollo Profesional Uladislao Gamez Solano) under the purview o f the Ministry o f Education: and (iv) the approval o f guidelines to facilitate the participation o f Costa Rican students in international standardized testing; programs. such as PISA.

46. Expected Outcomes. Data on dropout rates in early 2009 suggest that some o f the measures taken under this program, especially the amendment o f government promotion and repetition policies, are already having a significant effect. The outcomes expected from these measures by 2010 are: (i) an increase in the total number o f beneficiaries o f the ‘Avancemos’ program to 200,000; (ii) a decline in the secondary dropout rate from 13.2 percent in 2006 to less than 10 percent; and (iii) an increase in the net enrollment rate in secondary school (13-17 year olds) from 70 percent in 2006 to at least 74 percent. Also, i t i s expected that Costa Rica will participate in the next Program for International Student Assessments, PISA, (scheduled for 2009-lo), as wel l as in future Assessments, and publish the results.

C. Boosting Competitiveness by Facilitating Market Entry

47. Costa Rica has completed the legislative reforms associated with the implementation of the complementary agenda linked to DR-CAFTA. As mentioned earlier, the pursuit o f greater integration into the global economy through participation in DR-CAFTA has been a cornerstone o f the government’s development strategy. Costa Rica’s participation in DR-CAFTA, however, could not be ratified until the prior commitments included under the complementary agenda were fulfilled. For Costa Rica, the most important commitments involved the passage o f framework legislation to permit the liberalization o f telecom and insurance markets, and the strengthening o f intellectual property rights. These reforms had been long postponed, but their approval by Congress over the course o f 2008 represents a major step forward in developing a more modern, efficient and competitive economy. Implementation o f these measures should help Costa Rica take maximum advantage o f the opportunities offered by DR-CAFTA in terms o f raising the quantity and quality o f trade, and in attracting foreign investment to ease infrastructural bottlenecks and facilitate technological transfer. Moreover, by having enshrined these reforms in the context o f a regional free trade agreement, they are l ikely to be locked in more permanently, which serves to hr ther enhance investor confidence. The main measures taken and outcomes expected from these measures are discussed next.

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Telecom m un ications

48. Kev Issues. Costa Rica’s long-term competitiveness i s closely l inked to improvements in telecommunications. Although basic indicators for the telecommunications sector reveal high penetration, other important issues such as the l o w quality o f service (both landline and mobile), the l ow penetration o f high-speed internet, the lack or delay in technological innovation, uncertainties in the allocation o f spectrum and overall slow pace o f investment point to the need for a more competitive environment.

49. With the aim o f expanding and deepening Costa Rica’s competitiveness, attract foreign investments in key sectors and further benefit f rom international trade, the government has enhanced the telecommunications sector through the enactment o f Law No. 8642 and Law No. 8660. The first o f these two laws establishes the general regulatory principles and overall framework for the sector; and the second one creates a new regulatory authority for the sector (SUTEL), establishes the pol icy function for the sector in the Ministry o f Environment, Energy, and Telecommunications, and removes many o f the administrative barriers o f the state-owned operator, ICE, to invest, incur debt, and hire/fire staff. These two new laws are mutually reinforcing and constitute a powerful reform package, which, in l ine with Costa Rica’s DR-CAFTA commitments, aims at introducing gradual, selective and regulated liberalization without privatization, while at the same t ime guaranteeing the benefit to the user in l ine with the social objectives o f universality and solidarity. The laws allow the entry o f new private operators to the country to compete with I C E in mobile services, internet and private networks (only fixed l ine service remains a monopoly), they create a solid regulatory framework to ensure fair competition, they create a new independent regulatory institution specialized in regulating the sector and establish user protection guarantees, in particular number portability as wel l as a universal service fund (FONATEL), which will support the provision o f service to rural and commercially unattractive areas and customers. The enactment o f these two laws is a prior action for this DPL-DDO.

Government Actions.

50. This legislative reform is expected to yield several broad development benefits: (i) penetration o f mobile and internet services wil l accelerate and services will become more affordable for the poorest regions and segments o f society thanks primarily to the introduction o f prepaid mobile services and investments promoted by the FONATEL; (ii) the country as a whole wil l become a more attractive destination for high value-added investment in knowledge economy services and products, and businesses wil l improve their competitiveness thanks to a host o f new services that will be provided on the basis o f cheaper availability o f broadband internet and lower cost o f international calls and bandwidth; and (iii) at the same time government services wil l become more efficient and effective, thanks to reliable and affordable high-speed connectivity in schools, health centers and government offices throughout the country, which wil l serve as the basis for e-government, I C T in schools, and many other e- society applications. More specifically, i t is expected that by 2010, (i) the new regulatory authority for the telecom sector is operating, having been fully staffed and equipped, and (ii) the implementation plan, including rules and regulations, o f the Universal Service Fund (FONATEL) wil l have been approved.

ExDected Outcomes.

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Insurance

51. Kev Issues. Costa Rica’s insurance sector has been dominated for a long time by a self- regulated, public monopoly. This has resulted in poor insurance services, delivered at a high cost to consumers. For example, Costa Rica’s insurance penetration ratio, at 2.03 percent in 2002, was the lowest among a l l middle-income countries in Lat in America (averaging 2.39 percent) and was substantially below the world average o f 8.14 percent.17 Costa Rica’s comparatively l o w penetration ratio i s mainly due to an absence o f l i fe ins&ance policies. In the non-life insurance sector, Costa Rica’s insurance penetration ratio is similar to the regional average, but the average premium per capita paid i s the highest in the region. Finally, another striking feature i s that Costa Rica’s insurance penetration ratio had been stagnant or declining over time, contrary to international trends. These observations point toward monopoly pricing and an absence o f competitive pressures.

52. Government Actions. With the signing o f DR-CAFTA, the Costa Rican government committed to liberalize the insurance sector, allowing the entrance o f the private sector into an industry that has hitherto been a state monopoly. In l ine with this commitment, the insurance sector has been enhanced by a series o f reforms aimed at modernizing its operation, improving delivery o f services and creating an effective oversight institutional framework, through the enactment o f L a w No. 8653. The enactment o f the new insurance law, which was approved bv the Congress in August 2008, i s a prior action for this DPL-DDO.

53. Expected Outcomes. By attracting new firms into the sector, the sector’s modernized legal and supervisory framework is expected to lead to lower insurance costs and expanded access to insurance services, further improving Costa Rica’s investment climate. The newly- created oversight entity for the insurance already has begun to operate under the temporary aegis o f the Superintendence o f Pensions, and fi l led about ha l f o f i ts staff vacancies. I t has both regulatory responsibilities (granting licenses, authorizations, etc) and supervisory responsibilities (financial solvency). A specific outcome expected from this reform i s that the oversight agency for the insurance sector i s fully staffed and operating by 201 0.

Intellectual Property Rights (IPRs)

54. Key Issues. Costa Rica has had a fairly effective legal framework governing intellectual property rights for some time. Nevertheless, the existing laws also contained shortcomings that limited Costa Rica’s potential to attract foreign investors, especially in areas o f innovative technologies. There i s considerable evidence that the quality o f intellectual property rights i s significantly correlated with (a) Foreign Direct Investment (FDI) from the United States and (b) FDI in technology/Research and Development (R&D) intensive industries. For example, contrary to “tariff-jumping investments” or green-field investments in production platforms (such as Intel), FDI in joint-ventures becomes more attractive to foreign investors. Such a change in the investment approach has implications for technological diffusion to the host country and facilitates productivity-enhancing knowledge spillovers. Furthermore, international empirical evidence also suggests that the efficiency o f R&D investments in terms o f increasing

These indicators are from Thoburn, Craig and Monica Caceres, “Costa Rica: The Insurance Sector”, World Bank 17

mission report, April 2004, unpublished.

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the number o f patents received by local inventors per dollar spent in R&D tends to improve with the strength o f IPRs. Costa Rica already has enjoyed considerable success in the init ial phases o f developing its manufacturing, but recent analytical work (World Bank 2005 and 2007) identified the existence o f R&D bottlenecks as a key impediment to further development o f innovative economic activities. By helping to ease the R&D bottleneck, improvements in the quality o f intellectual property rights offer an important opportunity to advance toward the next phase o f development in the high-technology sectors.

55. Government Actions. With the signing o f DR-CAFTA, the government also committed to remove remaining shortcomings o f Costa Rica’s previous intellectual property rights legislation. Fol lowing up on this commitment, Costa Rica’s intellectual property regime has undergone a series o f reforms aimed at meeting Costa Rica’s obligations under relevant treaties and conventions and promoting technological innovation, through the enactment o f Law No. 8631, Law No. 8632, L a w No. 8633, L a w No. 8635, Law No. 8636, L a w No. 8656, and Law No. 8686. The enactment o f these seven laws, which were approved by Congress between March and December 2008, i s a prior action for this DPL-DDO.

56. Expected Outcomes. A specific outcome expected from‘this improvement in the IPR legal framework by 2010 i s the emergence o f an increase in expressions o f interest by foreign investors in collaborative FDI projects in technology intensive sectors.

I K BANK SUPPORT TO THE GOVERNMENT’S PROGRAM

A. Links to the CPS

57. Though not specifically identified in the 2008 Country Partnership Strategy (CPS) (Report No. 432 76-CR)’ the proposed Public Finance and‘ Competitiveness DPL-DDO is fully consistent with the objectives of Bank engagement laid out in the CPS. The current CPS includes a very selective, demand-driven program, based on the Government’s pol icy priorities. I ts timeframe i s August 2008 through December 2010, covering the remaining term o f the current administration and an additional seven months following the next presidential transition in M a y 2010. The CPS supports the Government’s objective o f developing a comprehensive risk management framework in the context o f an increasingly unfavorable external environment. This framework seeks to protect the fiscal space needed to sustain targeted social protection measures and the program o f competitiveness-enhancing reforms. The medium-term strategic objectives o f the CPS are: (i) to address emerging challenges to continued growth and competitiveness, in particular with respect to infrastructure shortcomings, skills gaps and excessive red tape; and (ii) to sustain and deepen recent gains with respect to poverty reduction, social sector development and the environment.

58. Preparation of this DPL-DDO operation was initiated in response to a specific request from the Government of Costa Rica to help support its program. During the Annual Meetings in October 2008, the Costa Rican Government requested a development po l icy loan from the Bank to prepare for a possible deterioration o f the global financial and economic crisis. However, given that so far the country’s financing requirements are expected to be met with domestic financing (see paragraph 25), the entire DPL operation is being proposed with a DDO

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option. The Government views the availability o f Bank’s financing-together with that o f the IDB and the IMF-as key to maintaining investor confidence.

B. Collaboration with the IMF and other External Partners

59. The Bank has consulted with both the IMF and the IDB during the preparation of this operation. Consultation with the IMF has been particularly close in the context o f carrying out the Debt Sustainability Analysis summarized in Annex 5 and in the assessment o f macroeconomic and financial risks. The prior actions in the proposed DPL-DDO complement the actions in the IMF program. Structural measures contemplated in the Stand-by Arrangement focus on pending financial sector and money market reforms, and target the fiscal deficit and debt ratio as outcome indicators. The program supported by the Stand-by would allow social spending to continue increasing, while implementing longer run measures aimed at improving systemic robustness to crises and maintaining fiscal balance.

C. Relationship to Other Bank Operations

60. Although it is a single-tranche operation, the actions being supported by the DPL-DDO have formed part of a longer-standing policy dialogue that has been carried out through various ongoing lending operations and, particularly, in the context of the Bank’s Analytical and Advisory Activities (AAA) support. With regard to lending, the DPL-DDO i s complemented by and complements Bank operations in education, telecommunications, and disaster management.

Equity and Efficiency of Education Project (Active, P073892): This US$30-million loan has the following objectives: to reduce existing education quality gaps in rural education (including indigenous and afro-descendent communities) and to improve the equity and efficiency in the allocation, administration and utilization o f education sector resources. Specifically, project outcomes are measured by the fol lowing indicators: (i) reduction o f existing rural education gaps in primary education quality, equity, and internal efficiency; (ii) development o f cost-effective strategies to increase access to, and improve the quality of, secondary education rural modalities; (iii) improve the impact o f equity programs for low- income students; and (iv) enhance the efficiency o f the education sector’s institutional and economic resources allocated to the rural sector.

Telecom Modernization Project (Pipeline, PI 01 71 8): The project’s development objective i s to promote the universal accessibility o f a wide range o f quality modern telecommunications services provided by multiple service providers in a well-regulated competitive environment, contributing to economic growth, competitiveness and social cohesion. This wil l be achieved through: (i) the modernization o f the legal, regulatory and institutional framework; (ii) the introduction o f fair competition and private participation; (iii) the modernization o f ICE; and (iv) the promotion o f investment in the provision o f service to rural and isolated poor areas and vulnerable groups. The proposed project has four main interrelated components aimed at achieving the project development objective: (i) Telecommunications Solidarity Program (US$12.6 million); (ii) Institutional development o f SUTEL to promote competition and market opening (US$1 1.7 million);

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(iii) Modernization o f the pol icy and regulatory environment for the telecommunications sector (US$2.2 million); and (iv) I C E modernization (US$l million).

CAT-DDO (P111926): As part o f its medium-tern r isk management strategy, the Government requested a DPL with CAT-DDO in the amount o f US$65 million. The objective o f the DPL with CAT-DDO i s to protect Costa Rica’s budget by making liquidity immediately available in the event o f a natural disaster to help mitigate the impact o f the catastrophe on affected people. This loan was declared effective on March 5, 2009, and will be available for disbursement fol lowing a government request. Throughout the drawdown period, the satisfactory implementation o f the hazard r isk management program wil l be periodically monitored.

D. Lessons Learned

61. The 2004 CPS reestablished a closer relationship between Costa Rica and the Bank Group afer a ten-year interval of limited engagement. The CPS had a focus o n knowledge sharing and mutual learning in a few carefully-selected areas. The lessons learned in implementation indicate that to be effective operations need to support core government programs and policies in response to government demand.

62. I n line with the above, the recent CPS, discussed in September 2008, articulates a demand-driven and highly selective work program which focuses on areas in which the Government believes it can benefit from the Bank’s global experience and from new lending and AAA which are tailored to the country’s needs. In particular, the Government considers that the Bank’s new financing instruments, such as the DDO, can play a key element o f Costa Rica’s risk management strategy. As a result, the proposed operation responds to the Government’s request for targeted support and is closely aligned with key priorities in the government’s reform program.

63. The DPL DDO also builds on best practice principles for well performing middle- income countries, including: (i) an emphasis on upfront action instead o f ex-post conditionality (see Box 1 and Box 2); (ii) support o f a government reform program instead o f specific conditionality (Section 111); and (iii) strong analytical underpinnings and links to Bank investment lending (see Table 3).

E. Analytical Underpinnings

64. The DPL-DDO i s especially rooted in the findings of recent analytical work, some of which is outlined in Table 3. The Public Expenditure Review in 2008 was particularly relevant in carrying out the policy dialogue associated with the prior actions involving the measures to strengthen public finances and their transparency. The DR-CAFTA study, in turn, was most relevant for the implementation o f the complementary agenda involving the telecommunications sector, the insurance sector and intellectual property rights.

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Table 3: Links between the DrODOSed DPL-DDO and Prior Analvtical Work

Public Expenditure Review (FYOS)

Poverty Assessment W 0 7 )

CEM (FY06)

DR-CAFTA: Challenges and Opportunities for Central America (FY05)

Analytical Reports - Findings and Recommendations

To ensure fiscal space for high- priority social and competitiveness programs and maintain debt sustainability as growth slows down, Costa Rica must improve tax administration, improve i t s tax base information, and selectively reallocate expenditures to improve efficiencv o f Dublic SDendinE. Despite considerable investment and some progress in education, the country st i l l lags behind the Latin America and upper-middle income country averages for access and attainment at the secondary school level. Th is adversely affects the ability o f the poor to participate in and benefit f rom economic growth. Lack o f R&D investment i s a part o f the problem. Remove infrastructural bottlenecks, especially in the telecom sector, in order to improve productivity. Implement the complementary agenda to ensure gains from trade are realized in a broad-based manner.

Links to proposed DPL-DDO Actions (see Matrix of Policy Actions and Expected Outcomes)

Implementation o f measures to improve tax administration

0 Presentation o f new technical and methodological guidelines for the preparation o f results-based budgets and a medium-term expenditure framework.

0 Increased enrollment in secondary education through (i) expansion in the number o f beneficiaries o f the ‘Avancemos’ program, and (ii) changing grade promotion policies at the secondary level.

0 Improvement in education quality through (i) better incentives for teachers to engage in training activities; (ii) creation o f the “Instituto de Capacitacion del Docente”; (iii) application o f standardized national tests, and (iv) participation in international standardized tests exercises.

Approval o f a new Telecommunications law that modernizes the sector framework.

0 Approval o f DR-CAFTA related legislation, including a new Insurance law that modernizes the sector framework, and a reformed law on Intellectual Property Rights to improve the investment climate.

V. THE PROPOSED OPERATION

A. Operation Description

65. The proposed operation is a single-tranche Development Policy Loan with Deferred Draw-Down Option that seeks to support several key objectives of the government’s National Development Plan. It is expected to play an important role in the government’s contingency planning to cover potential financing gaps in the event that the global economic and financial environment worsens significantly, threatens the implementation o f important reforms and undermines the capacity to sustain key social programs. In this context, the proposed operation i s supporting specific actions under two thematic pol icy areas, which are: (i) the strengthening o f public finances; and (ii) boosting the country’s competitiveness. At a time when Costa Rica i s prioritizing the continuation o f reforms and targeted social spending to protect the poor, this operation wil l help fill the budgetary financing gap in the event that external conditions worsen.

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B. Policy Areas

66. The specific policy actions supported by the proposed DPL-DDO are fully aligned with, and drawn from, the Government strategy and program, as described earlier. They also address core challenges identified in Bank analytical reports, including the PER. These pol icy actions, which are proposed as prior actions for Board Presentation o f the DPL-DDO, are listed in Box 1.

67. The expected value-added of this operation mainly consists of helping to prevent the Government’s reform program from being undermined by fiscal constraints induced by adverse external shocks, rather than in financing new reform measures in addition to those that had already been contemplated. As noted earlier, Costa Rica already has been exhibiting a good track record in poverty reduction, reform implementation and fiscal discipline. The Bank has been supporting this program, largely through i t s AAA-work, and the authorities request that this support continue in the form o f this proposed operation.

Box 1. Prior Actions for Board Presentation of the Proposed DPL-DDO I. RENDERING PUBLIC FINANCES MORE EFFICIENT AND TRANSPARENT

Strengthening Revenue Collections. Implemented a program o f actions to strengthen tax administration through (i) the enactment o f Law No. 8624 (“Ley de Coho Judicial”), (ii) the issuance o f guidelines for the periodic updating o f the tax-information base related to Large Tax Payers, (iii) the approval o f guidelines for the electronic filing and processing o f tax returns (Tributacidn Digital), and (iv) the implementation o f the government’s T ICA Project.

Improving the Quality of Public Expenditures. The Government has taken significant steps to gradually implement a results-based budget management system, including (i) the establishment o f technical and methodological guidelines for the alignment o f budget allocations with the Government’s development priorities, and (ii) the establishment o f technical and financial guidelines for the preparation o f results-based budget proposals for 2009 by al l government agencies.

11. IMPROVING COMPETITIVENESS BY REMOVING THE SECONDARY EDUCATION BOTTLENECK

Secondary Education Reforms. The Government has initiated a program o f actions that include (i) the expansion o f the gross number o f secondary education students receiving benefits under the Avancemos Program from 98,050 in 2007 to 156,909 in 2008, (ii) the amendment o f policies governing promotion and repetition o f secondary students, (iii) the establishment o f a teacher training institute (Znstituto de Desarrollo Profesional Uladislao Gamez Solano) under the purview o f the Ministry o f Education, and (iv) the approval o f guidelines to facilitate the participation o f Costa Rican students in international standardized testing programs, such as PISA.

III. BOOSTING COMPETITIVENESS BY FACILITATING MARKET ENTRY 0 Telecom Reform. The telecommunications sector has been enhanced by a series o f reforms aimed at modernizing

i t s operations, improving delivery o f services, and establishing an effective institutional framework and regulatory regime, through the enactment o f Law No. 8642 and Law No. 8660.

Modernization of Insurance Sector. The insurance sector has been enhanced by a series o f reforms aimed at modernizing i t s operation, improving delivery o f services and creating an effective oversight institutional framework, through the enactment o f Law No. 8653.

Improving Intellectual Property Rights. Costa Rica’s intellectual property regime has undergone a series o f reforms aimed at meeting Costa Rica’s obligations under relevant treaties and conventions and promoting technological innovation, through the enactment o f Law No. 8631, Law No. 8632, Law No. 8633, Law No. 8635, Law No. 8636, Law No. 8656, and Law No. 8686.

0

0

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68. I n addition to achieving the prior actions listed in Box 1, the Costa Rican authorities also have succeeded in maintaining a stable macroeconomic framework A s indicated earlier (paragraph 26), as wel l as in the IMF Relations Note (Annex 3), macroeconomic management has remained broadly favorable so far, even though there has been a widening fiscal and external deficit. Also, the Bank wil l review the macroeconomic framework at a frequency consistent with the information needs o f the Bank (but not less than once every 12 months).

Policy Area

C. Expected Outcomes

201 0 Outcome Indicators

69. The main objectives of this operation are to: (i) strengthen public finances and their transparency by enhancing the efficiency of revenue generation and results-based management of expenditures; and (ii) boost competitiveness by enhancing secondary education attainment, facilitating market entry in the telecommunications and insurance sectors, and strengthening the legal framework pertaining to intellectual property rights. The measures and reforms supported by the proposed operation would be evaluated o n the basis o f specific outcomes that can be measured at the end o f 2010. These expected outcomes are summarized in Table 4 and presented in more detail in the DPL-DDO policy matrix in Annex 2.

2. Improving the Quality of Public Expenditures

At least 12 min is t r ies have been provided with enhanced technical assistance in the preparation o f their annual budget under the new budget guidelines.

I. Rendering Public Finances More Efficient and Transparent

in secondary education and improving the quality o f secondary education

1. Strengthening Revenue Collection

0 Secondary drop-out rate falls f rom 13.2% in 2006 to less than 10%. 0 Net secondary enrollment rate (1 3-1 7 year olds) increases from 70% in 2006 to at

least 74%. Participation in the PISA and publication o f assessment results.

0 The GDP-share o f tax revenues i s maintained at or above the level acheved in 2007 (15.2 percent o f GDP).

0 No. o f users o f e-based taxation increase to represent at least 50% o f al l central government tax revenues. Implementation o f exports regime module o f the T ICA project in al l customs agency posts.

4. Telecom Reform

5. Modernization o f Insurance Sector

6. Improving Intellectual Property Rights

New regulatory authority i s fully staffed and equipped. Approval o f implementation plan, including rules and regulations, o f the Universal Service Fund (FONATEL). Oversight agency supervising the insurance sector i s fully staffed and operating.

Increase in expressions o f interest by foreign investors in collaborative FDI projects in technology intensive sectors.

111. Boosting Competitiveness by Facilitating Market Entry

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D. Proposed Loan Amount

70. million. The borrower is the Republic o f Costa Rica.

The total loan amount that has been allocated for the proposed DPL-DDO is US$SOO

71. The Government is planning to finance its central government gross financing requirement (dejkit plus public debt amortization) of roughly US$2.1 billion in 2009 for the most part through domestic borrowing. With the onset o f the global financial crisis, however, the government feels compelled to seek contingent external financing in case firther liquidity shocks dry up domestic borrowing opportunities or render their terms much less favorable than IBRD terms. The proposed loan amount would cover about one-quarter o f the projected total gross domestic financing requirement.

Box 2: Good Practice Principles on Conditionality Principle 1: Reinforce Country Ownership. T h e operation was developed within the objectives o f the government’s Medium-Term Plan, which establishes clear priorities developed through wide consultation wi th stakeholders and broader civi l society. The priority legislative agenda was developed in consultation wi th the Parliamentary leadership on an ongoing basis. Bank support focuses on supporting the government’s plan as outlined in the Country Partnership Strategy (2008-2010). These CPS focus areas have al l benefited f i om broad political support as evidenced by the approval o f a l l related legislation.

Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework. The Bank’s support i s summarized in a brief and focused policy matrix. I t i s expected, that the Bank and the IDB will be providing support in the form o f loans or contingent credit. Bo th institutions draw on the country’s development plan, thereby ensuring coordination among them and consistency o f support. Both have been supporting measures to enhance public financial management, rationalize Public Bodies, strengthen tax administration, and improve competitiveness.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances. The Country Financial Accountability Assessment (CFAA), completed in 2005, indicates that the fiduciary environment in Costa Rica i s generally adequate, stating that the treasury management i s solid and the internal control has in place a legal ftamework and independence, w h c h are the basis for a sound Public Financial Management (PFM) system. The funds f i om the proposed DPL-DDO would be handled through this system.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement. T h e Bank’s policy matrix uses a limited set o f prior actions (Annex 2). They address key development policies prioritized in the Country Partnership Strategy.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support. As agreed with the government, the proposed DPL-DDO w i l l entail semi-annual reviews to evaluate program progress and macroeconomic outlook. Monitoring and evaluation o f the program will take place within the government’s own processes. Subject to satisfactory overall program implementation, th is process will allow the government to access financing as per the terms o f the Bank. The policy matrix in Annex 2 contains a range o f outcome indicators, both quantitative and qualitative, which are to be assessed as part o f the operation implementation and are closely linked to the supported policy actions and to the government’s own objectives.

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VI. OPERA TION I M P L E M E N T A TION

A. Poverty and Social Impacts

72. The specific actions supported by the proposed operation are likely to have significant positive poverty and distributional effects over the long-run. Actions aimed at reducing secondary school dropout rates among the poor and improving the quality o f schools wil l l ikely contribute to closing income gaps in the future. Avancemos, the CCT program associated with reducing secondary school dropout rates, supports the real consumption o f beneficiary families. Similarly, fiscal pol icy changes supported by the proposed DPL include measures to improve the efficiency o f public expenditures, which wil l allow selective reallocation o f resources to where they are most needed: human capacity formation and social protection. Although there is n o information readily available o n the progressiveness o f Costa Rica’s current tax structure, the revenue-side fiscal measures supported by this operation are not l ikely to have a regressive impact for two reasons: one i s the emphasis o n collecting revenues f rom Large Tax Payers and the other i s that the overall tax rate structure remains unchanged. In this context, i t i s useful to keep in mind that Costa Rica has one o f the most equitable income distributions in the region.

Box 3: DR-CAFTA: Estimated Distributional Consequences for Costa Rica Distributional consequences o f the DR-CAFTA for Costa Rica are expected to be minimal for the following reasons:

Implementation o f the complementary agenda has commenced with the satisfaction o f all associated legal requirements. T h i s agenda includes the necessary regulatory and institutional reforms necessary for maximizing the potential benefits o f the trade agreement. Costa h c a has a very small number o f poor agricultural producers relative to other Central American countries and therefore distributional consequences through agricultural incomes are unlikely to be significant. It should also be noted that the agreement provides for extended phase-outs o f sensitive items such as dairy products that Costa Rica does produce, process, and export. Costa Rica had one o f the lowest average MEN import tariffs in the world prior to CAFTA implementation and thus the impact o f the CAFTA tariff reforms in this country are likely to be small, as the lion’s share o f any adjustment costs to unilateral reforms had already been absorbed. The distributional impact o f non-tariff related changes due to the free trade agreement are likely to be small given the nature o f Costa Rica’s social policies - for example, medicines are provided through the public health care system and are typically generics, so the higher cost o f medicines due to stricter enforcement o f intellectual property rights will be small and will be absorbed by the social security institute (Caja de Seguridad Social). In recognition o f empirical findings that differences in education almost fully explain inequality in Costa Rica, the Government i s prioritizing the strengthening o f secondary education institutions, including through the reform measures supported by this proposed operation.

Source: World Bank (2005) “Challenges of DR-CAFTA ’ I , and Jimenez, Ranulfo (2006), “DR-CAFTA: What does it do and What are the Options”, Academia de Centro America.

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73. Component III of the policy matrix supports the Government’s key international commitment, Le., the complementary agenda of the DR-CAFTA. During the negotiations that led to the agreement, the Ministry o f Commerce undertook a large, well-disseminated program o f outreach and broad-based consultations, which i s thoroughly documented. All stakeholders and interested organizations and individuals participated in these discussions-producer associations, consumer groups, NGOs, members o f Congress f rom al l political parties, church representatives, high schools, universities, think-tanks, and concerned citizens. One o f the themes o f these discussions was the distributional impact o f the trade agreement, particularly through agricultural incomes. These concerns were addressed in the framing o f the agreement, decisions on tari f f phase-outs, excluded sectors, and the content o f the complementary agenda. The Bank also addressed this issue (see B o x 3). The goal o f the Government, Congress, and stakeholders at that time was and s t i l l i s to develop and implement a complementary agenda that wil l allow signatory countries to maximize the benefits o f greater free trade, while prioritizing shared growth. The Bank wil l periodically review distributional developments in Costa Rica as part o f the Bank’s ongoing pol icy dialogue.

B. Environmental Aspects

74. Costa Rica’s pioneering environmental efforts have long since been recognized. This i s especially the case in the context o f exploiting links between conservation and poverty reduction, and halting deforestation while pursuing innovative partnerships with the private sector to protect forests and biodiversity. It has set aside about 25 percent o f its land to protected areas and has put in place innovative ways to pay i t s citizens for good environmental practices. Given Costa Rica’s r ich biodiversity-about 5 percent o f known species world-wide-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 we l l as for local environmental services, where water bi l ls in some parts o f the country now include a charge to pay farmers upstream for “producing water”. Studies show payments for these local and global services can be effective ways to reduce rural poverty in a sustainable way.

75. The specific actions supported by the proposed operation are not likely to have significant effects on the environment, forests or other natural resources. However concerns have been expressed regarding the potential environmental impact o f the opening o f the telecommunications sector. The government has been proactive in addressing these risks by requesting an environmental assessment from the Wor ld Bank (World Bank 2008). This assessment included identification o f potential environmental, socioeconomic and health and safety impacts derived from the subprojects to be financed under the Telecommunications Sector Modernization project, which i s being supported by the Bank (see Section IV B), a reference framework or environmental management plan, and an action plan to mitigate identified impacts. The government’s strategy, therefore, seeks to prioritize the sound environmental management o f the telecommunications sector in collaboration with the Bank.

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C. Monitoring and Evaluation

76. The Ministry of Finance i s responsible for the implementation of the proposed DPL- DDO. I t wil l also coordinate actions among the concerned l ine agencies in the event o f draw- down, including, in particular, the Ministry Education (for aspects concerning the education sector) and the Ministry o f Commerce (for aspects concerning the complementary agenda o f the CAFTA-DR). Together with the Ministry o f Finance, these institutions will collect the necessary data to assess implementation progress and report i t to the Bank, taking into account both process advances and service statistics, survey and other data that might be used to assess the achievement o f the program’s end outcomes.

77. The Ministry of Finance and the Bank have also agreed to conduct reviews ofprogram progress on a semi-annual basis. These reviews wil l a im at identifying areas o f strengths and weaknesses, and possible assistance needed to maintain momentum toward the planned medium- term outcomes. They wil l also assess possible downside risks and agree o n measures to address these to the extent feasible. The government and the Bank team will jointly evaluate progress towards achieving the outcomes laid out for the DPL program and, if necessary, agree o n course corrections.

D. Fiduciary Aspects

78. The Country Financial Accountability Assessment (CFM), completed in 2005, indicates that the fiduciary environment in Costa Rica is generally adequate, stating that the treasury management is solid and the internal control has in place a legal framework and independence, which are the basis for a sound Public Financial Management (PFM) system. The methodologies for budget formulation are wel l documented and are applied. There are efficient controls o n government funds liquidity, and the financial reports provide considerable information on government finances. The government has built a strong foundation for a well- functioning PFM system (particularly with regard to the Integrated Financial Management Information System (IFMIS) or the Integrated Financial Administration System (SIGAF), including Expenditure Execution and Treasury subsystems), and has a clear vision for further modernization. Treasury operations are managed through a highly effective single treasury account system. The control framework i s n o w consistent with international standards, and implementation across the entire public sector i s in progress.

E. Disbursement and Auditing

79. Given that the Government has already met the prior actions for release laid out in the policy matrix, the full amount of the loan will be available as a line of credit that can be drawn down subject to satisfactory semi-annual reviews and an adequate macroeconomic framework The DDO allows countries to defer disbursements for up to three years and, upon renewal, for another three years. This product was deemed appropriate for the proposed operation since it is designed for countries that have no immediate need for funds but that might suddenly need them if unforeseen events occurred, which made it dif f icult for them to access the capital markets.

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80. The Bank would make loan disbursements to a dedicated account that forms part of the country’s official foreign exchange reserves at the Central Bank of Costa Rica. After the deposit o f DPL-DDO proceeds, the Central Bank o f Costa Rica would immediately credit the disbursed amount to the Ministry o f Finance Treasury Single Account (Cuenta Unica de Tesoreria), thus becoming available to finance budgeted expenditures. Within two weeks o f this operation, the Ministry wil l provide the Bank with a written confirmation. The legal agreement will include an audit clause for the audit o f financial transactions f rom the receipt o f the loan proceeds by the Central Bank to the transfer o f the local currency equivalent into a treasury account designated for budget expenditures.

81. The Central Bank of Costa Rica is the financial agent of the Government. At the conclusion o f writing this project document, there i s n o IMF Safeguards Assessment, and the Central Bank publishes i ts Annual Financial Statements without an opinion o f independent auditors; rather, i t i s signed by the Internal Auditor instead.

F. Risks

82. The operation i s exposed to three main risks: from the external economic environment, from lack ofpolicy continuity, and from natural disasters. On the economic front, the main risk derives from the ongoing global financial crisis and the possibility o f a deep and prolonged world recession. The current global situation i s anticipated to adversely impact growth as private sector credit becomes tighter, foreign demand for Costa Rican exports declines, and foreign direct investment weakens. The government crisis prevention strategy relies o n the availability o f ample liquidity buffers to provide a first-line o f defense in case o f larger than expected external shocks. The government has negotiated a precautionary Stand-by program with the IMF (to be approved in April 2009) and a loan with the IDB that would help provide additional foreign currency liquidity to the banking sector. The proposed World Bank DPL-DDO is part o f this package and would allow the authorities to sustain budget spending in case o f domestic financing shortfall. Should the global slowdown be more protracted than anticipated some o f the program outcomes may be delayed. Risks o f economic slowdown have been incorporated into the macroeconomic program and the Bank and the Fund are maintaining an ongoing dialogue with the authorities on macroeconomic pol icy issues. In case o f unanticipated financial sector developments, both institutions would be available to provide consultation and support to the authorities as deemed appropriate.

83. The program can also be affected by lack ofpolicy continuity. In addition to the r isk mentioned in the previous paragraph, the global crisis could also divert the Government’s attention from its medium term structural reform agenda as it concentrates o n crisis management. In such a case the medium term outcomes associated to the program would be compromised. To manage this risk, the Bank will ho ld frequent consultations with the Government in the context o f the planned semiannual reviews o f the DPL DDO. As noted above (paragraph 77) these reviews wil l be key to assess possible deviations from the Government’s program and agree o n assistance that may be needed to correct those deviations.

84. Natural disasters could also affect program outcomes. Due to i ts geographic location and geotectonic characteristics, Costa Rica is exposed to a large variety o f natural hazards,

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including hydro-meteorological (floods, cyclones and landslides) and geophysical (earthquakes and volcanoes). Indeed, on January 8, 2009, Costa Rica was struck by an earthquake (6.3 degrees o n the Richter scale). The earthquake took 34 lives and displaced more than 1200 people. Thus the onset o f additional disasters could cause a major strain o n public finances and reverse recent gains in poverty reduction. A s shown by the government’s reaction to the January 2009 earthquake, this risk i s partly mitigated by the strong emergency management system developed by Costa Rica as wel l as by the Bank’s CAT-DDO operation (which became effective March 5, 2009). Moreover, should a natural disaster occur, the engagement through the DPL- DDO would enable the Bank to support the government in revising i ts strategy as needed to harmonize between short-term imperatives and medium- to longer-term socio-economic development goals.

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ANNEX 1: LETTER OF DEVELOPMENT POLICY English Translation

Republic o f Costa Rica Ministry o f Finance Office o f the Minister

16 March 2009 DM-347-2009

Robert Zoellick President o f the International Bank for Reconstruction and Development Washington, D C

Re: Policy Letter - DPL-DDO Loan Strengthening o f Public Finance and Competitiveness

Dear Sir:

First, I would l ike to express the gratitude o f the Government and people o f Costa Rica for the support given by the World Bank to our country in its efforts to achieve our goals o f sustainable development and poverty eradication. One o f the fundamental commitments o f the Government o f President Dr. Oscar Arias, clearly established as one o f the pillars o f national development in accordance with the Mil lennium Development Goals, i s the fight against poverty and inequality. To achieve this goal, one o f the priorities o f the Government o f Costa Rica i s to target the most vulnerable members o f the population through programs aimed at improving their living conditions.

Nonetheless, the turbulent international economy has made it necessary for the Government to take measures to ensure the continuity o f these social efforts, while at the same time addressing the risks associated with the most serious economic crisis o f the past 80 years.

During recent years, Costa Rica has had an excellent economic performance, with strong economic growth through 2008, when the economy began to decelerate. Fiscal performance has improved considerably, achieving a fiscal surplus o f 0.6 percent in 2007 and 0.2 percent o f GDP in 2008, the first fiscal surpluses achieved by Costa Rica in more than f ive decades.

This fiscal performance is based primarily o n an increase in the tax burden, which increased from 13.3 percent o f GDP in 2005 to 15.3 percent o f GDP in 2008, and on the country’s economic growth, which grew by 8.8 percent and 7.8 percent in 2006 and 2007, respectively.

In the third quarter o f 2008, the effects o f the international crisis began to have an impact, especially on economic growth which is expected to considerably decline in 2009. With the aim o f mitigating the impact o f the international economic crisis, the country has taken fiscal measures, principally by increasing spending o n capital investments and transfers (for example,

30

cash transfers conditioned o n school enrolmenthetention), which i s expected to generate a fiscal deficit in 2009. This situation i s not expected to affect the sustainability o f public debt, which has been significantly reduced in recent years. Debt as a percentage o f GDP for the central government as well as for the consolidated public sector has been on a declining path, with public sector debt falling from 61.6 percent in 2003 to 40.3 percent in 2008.

Central government debt declined from 40 percent o f GDP in 2003 to 24.7 percent in 2008. The Government strategy i s to utilize this financing space created in recent years to mitigate the fa l l in fiscal income, which i s the underlying cause o f the projected fiscal deficit.

In this economic context, and keeping in mind the uncertainty in the international macroeconomic and financial environment as wel l as possible repercussions o n domestic conditions, i t is necessary to have a financial instrument designed to serve as a backstop and contingency in case international and national economic conditions deteriorate beyond the level reasonably forecast in macroeconomic projections. Such an instrument can help protect against a major liquidity squeeze and help provide financial cover for the country in such a way that priori ty programs and projects are not affected, particularly those targeted to contain the impact o f the international crisis o n employment, poverty, education and production, and at the same time allow the financing o f the programs and projects included in the National Development Plan.

The. National Development Plan 2006-2010’* i s based on five priori ty areas: social policy, productive policy, environmental policy, institutional reform, and external relations. These areas encompass 16 sectors and cover the broad national goals detailed below:

Reduce poverty and inequality

0

0

0

Combat corruption in al l areas o f public sector activity

Increase economic growth and employment Improve the quality and increase the coverage o f the education system Reduce the level o f criminality, drug trafficking and drug addiction, and reverse the feeling o f insecurity experienced by citizens Strengthen public institutions and order the priorities o f the State Rehabilitate and expand the country’s transportation infrastructure Strengthen external relations and regain Costa Rica’s role in the world

As a fundamental part o f this strategy, the Government has sought to expand the integration o f Costa Rica in the world economy, promoting the incorporation o f the country in the free trade agreement between Central America and the Dominican Republic and the United States (DR- CAFTA), and taking the necessary measures for the approval o f DR-CAFTA’s complementary agenda, in particular the opening o f the telecommunications and insurance sectors and the strengthening o f intellectual property rights. These measures, however, need to be accompanied by efforts toward fiscal strengthening, investment to improve competitiveness and social redistribution o f the benefits derived from the commercial opening. In this respect, investments

’* Pursuant to Article 4 o f the Financial Management and Public Budgets Law No. 8 13 1 , “. . . The National Development Plan shall constitute the global framework that will guide institutional operational plans, according to the corresponding level o f autonomy based on applicable legal and constitutional provisions.”

31

in education, health, science, technology, and poverty reduction are indispensable strategic actions o f the Government which could be negatively impacted by a continued deepening o f the international economic crisis.

To strengthen public finances, this administration has made strong efforts to increase collection while at the same time maintaining sensible spending policies, a combination that, along with accelerated growth in the past two years, led to the best fiscal results in 50 years. The actions taken by the Government to increase collection include mainly measures aimed at improving tax information and facilitating payments, without the introduction o f new taxes to date. These initiatives include the implementation o f Information Technology for Customs Control (TICA, for its initials in Spanish), the accelerated implementation o f digital taxation which allows electronic processing, presentation and payment o f tax declarations, and improvements in the programs for large taxpayers and the simplified tax regime. Another measure worth mentioning within this context i s the approval o f the Judicial Collection L a w (No. 8624) that strengthens, among others, judicial proceedings to counteract tax evasion.

With these actions, an important increase i s expected not only in the number o f taxpayers who utilize digital services but also in the percentage o f collections from these instruments, particularly when the export modules o f T I C A are implemented in the customs offices o f L i m o n and Caldera.

On the spending side, efforts have focused on improving medium- and long-term planning, mainly for the principal government programs. T o accomplish this, the Government i s making progress in the development o f tools to introduce results-based budgeting and the implementation o f a medium-term framework. To strengthen the budgetary programming process, increase fiscal transparency and consolidate the registry system, the Ministry o f Finance has implemented three important measures: development o f a new methodology for budgetary programming, linkage o f the budget to institutional, operational, and strategic planning, and improving the medium-term fiscal framework. These actions are framed in a results-based follow-up o n the identification and definition o f medium-term priorities. The expectation is that the new methodology wil l generate useful information for decision-makers and wil l help in the process o f earmarking public resources, while at the same t ime informing the public on the use o f public resources, thus promoting transparency and accountability. '

Actions aimed at improving the budgeting process and the evaluation o f results are being implemented gradually, establishing pi lot plans with the ministries responsible for the Government's priori ty programs and that maintain certain institutional capacity, in such a way that more ministerial entities are gradually incorporated.

Another group o f strategic activities promoted by this administration are related to the DR- C A F T A implementation agenda, where three o f the fundamental pillars include the opening o f the telecommunication and insurance markets and the strengthening o f intellectual property rights. The effectiveness date o f the free trade agreement and the actions taken in the above- mentioned areas represent an important opportunity to position Costa Rica in the global economy and to attract foreign direct investment that allows the transfer o f technology and infrastructure.

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In the telecommunications area, the country has taken decisive steps toward opening the sector through the approval and publication o f two laws: The General Telecommunications Law (No. 8642), which provides a framework for the operation and regulation o f the sector, and the Strengthening and Modernization o f the Public Entities o f the Telecommunication Sector L a w (No. 8660), which establishes the Telecommunications Superintendency (SUTEL) regulatory agency, reforms the Ministry o f Environment and Energy to become the Ministry o f Environment, Energy and Telecommunications (MINAET), and eliminates a number o f administrative, budgetary, and financial requirements so that the current state-run Costa Rican Electricity Institute (ICE) prepare itself for the opening o f the market and competition.

The legislation mentioned above not only creates a legal framework for the operation, supervision, and regulation o f the telecommunications sector, but also creates mechanisms to promote universal access to services, such as the National Telecommunications Fund (FONATEL), whose objective i s to support the establishment o f services in rural areas or in non- commercially attractive areas, principally supporting schools in rural areas and minority population groups.

As a result o f these measures, it is expected that within the next two years the country will have a larger number o f Internet and telecommunication service providers that will generate greater competition and efficiency in the sector. At the same time this will lead to greater coverage and the introduction o f services that wil l indirectly offer more business opportunities, especially in areas with high technology content that wil l favor education efforts in rural areas and promote public sector efficiency through interconnectivity in areas such as health, education, customs and tax collection, among others.

As in the case o f telecommunications, the insurance sector has been preparing the legal and supervisory framework for the entrance o f new market participants. Approval o f L a w 8653 (Insurance Market Regulatory Law), includes comprehensive reforms to L a w No. 12 o f October 30, 1924, ends state monopoly o f the insurance sector, and creates the General Insurance Superintendency (SUGESE). These measures should promote not only a greater supply o f service providers but also increased competition, lower prices, and a wider range o f services.

The last broad area worth mentioning is the major effort underway to modify and introduce a new regulatory framework for the protection o f intellectual property rights, which are intended to significantly strengthen legal security and in thus attract foreign investment, especially in industries associated with research, innovation, and technological development. This legal framework wil l also promote innovation in high value-added areas in the agricultural sector, especially in the production o f new vegetable and animal products and capitalization o f research in biodiversity.

Finally, as part o f the National Development Plan, a series o f social programs are targeted to complement efforts to reduce poverty and social inequality and to redistribute wealth. Although Costa Rica has been at the vanguard with its social spending, particularly in primary and secondary education, in recent years we have witnessed a decline in education indicators, mainly in secondary education. This decline includes reduced enrollment, increased school desertion and

33

higher repetition rates, a l l o f which caused great concern to the Government when it designed i ts development plans.

The above represents an obstacle in the efforts o f Costa Rica to achieve its competitiveness goals, especially when considering the empirical relationship between secondary education and the absorption o f new technologies. Thus, finding a solution to education problems i s a key element not only to improving competitiveness but also in obtaining higher value-added benefits from free trade agreements.

The National Development Plan calls for an increase in education spending, which increases by 6 percent o f GDP in the approved 2009 budget. According to the Wor ld Bank’s Public Expenditure Review (2008), apart from member-fbnded retirement pensions, social spending i s progressive in Costa Rica, including primary and secondary education spending.

In the context o f consolidating secondary education while targeting priori ty attention to the poorest population groups, the Government i s launching a number o f measures aimed at improving education quality and reducing school desertion. The Avancemos program provides cash transfers to beneficiary families on the condition that their children regularly attend secondary school and complete their studies. T o date, more than 100,000 secondary school students are benefitting from this program, and the number i s expected to increase to 200,000 students in 2010.

On the supply side, the Ministry o f Education i s seeking to increase the quality o f secondary education with a number o f reforms aimed at modifying the evaluation and repetition schemes, and modernizing the curriculum to make it more attractive to students. Other important measures taken are the creation o f the new Professional Development Institute Uladislao Gamez Solano and the decision by the Government to promote the participation o f Costa Rica in international learning evaluations, such as the PISA Program.

Without doubt the sustainability and continuity o f the strategic actions outlined above require an important fiscal effort that could be threatened in the current international economic crisis context. The financial assistance and support o f the World Bank will help in taking the necessary contingency measures and guarantee the continuity o f these activities, which are o f vital importance to facilitate the process o f incorporating Costa Rica in the free international trade processes without r isking the sustainability o f its social agenda.

Please accept my thanks for your kind attention and I remain,

Sincerely yours,

Guillermo E. Zuiiiga Chaves Minister

34

Original in Spanish

16 de marzo de 2009 DM-347-2009

Robert B. Zoellick, Presidente Banco lnternacional de Reconstruction y Foment0 Washington, DC

Ref.: Carta de Potitica - Prdsbmo DPL-DDO para et Fortalecimiento de las Finanaas Publicas y la Cornpeiifividad

Estimado seiior:

En primer lugar deseo expresarle el agradecimiento de nuestro Gobierno y del pueblo costarricense por el apoyo brindado por el Banco Mundial a nuestro pals en sus esfuerzos de alcanzar nuestras metas de desarrotlo sostenibte y de enadicacion de la pobreza. Uno de 10s principales comprornisos del gobierna del Presidente Dr. Oscar Arias y claramente establecido como uno de 10s ejes del desarrollo nacional, en concordancia con 10s Objetivos de Desarrollo del Milenio, es la lucha frontal contra la pobreza y la desigualdad. Para el logro de esta meta el Gobierno costarricense tiene como prioridad la atencion a 10s grupos mas vulnerables de la poblacibn, a travtjs de programas orientados a mejorar sus condiciones de vida.

Sin embargo el convulso entorno economico internacional, hacen necesarlo que el Gobierno de la Repubfica tome las medidas necesarias para asegurarse la continuidad de 10s esfuerzos sociales realizados, a la vez que se administran los riesgos asociados a una de las crisis mas profundas en 10s dltimos 80 aaos.

Durante 10s ultimos aiios, Costa Rica ha tenido un excelente desempeiio economico, el crecimiento economico habia sido sobresaliente hasta el a m 2008 en donde comenzb a desacelerarse la economia. Por su parte el desempeiio fiscal ha venido mejorando sustancialmente llegando en el 2007 a obtenerse un superavit fiscal del 0.6% y en el 2008 de 0.2%, estas cifras toman mas relevancia si consideramos que Costa Rica no habia tenido superavits fiscales en mas de cinco decadas.

35

Este desempeiio fiscal se ha basado principalmente en un aumento de la carga tributaria la cual pas6 de 13.3% del PIB en el afio 2005 a 15.3% en el 2008 y al crecimiento econbmico que ha rnantenido el pais en el cual alcanzo en 10s aiios 2006 y 2007

respectivarnen te. el 8.8% y el 7.8%

Desde el tercer trimestre del aiio pasado (2008) se han comenzado a ver 10s efectos de la crisis internacional principalmente en cuanto al crecimiento economico el cual se espera se desacelere sensiblemente durante el 2009. Con el fin de contrarrestar la crisis internacional el pais ha tornado medidas fiscales incrementando principalmente el gasto en inversion de capital y en transferencias (Ej: Transferencias de dinero condicionadas a la pemanencia en el cofegio) lo cual se estima generarti un deterioro de la posici6n fiscal en el 2009. Esta situacion no se espera que afecte fa sostenibilidad del endeudamiento publico por cuanto el mismo se habia venido reduciendo significativamente en 10s rjltimos afios. En el grdfico se puede observar la evolucion de la raz6n DeudalPiB tanto para el Gobierno Central corn0 para todo el sector publico pasando del 61.6% en el aAo 2003 al40.3% en el 2008 para todo el sector publico.

En el cas0 del Gobierno Central esta tendencia se confirma pasando la mencionada razdn del 40.0% en el 2003 al 24.7% en el 2008. La estrategia del Gobierno consiste precisamente en utilizar este espacio de financiamiento que ha generado con el fin de contrarrestar la caida en deficit fiscal.

86% €Q%

55% 5(1%

45% 40%

+ - ~ ~ ~ a i o w y. mudadeC&WmCen(r-sl

10s ingresos fiscales raz6n por la cual se proyecta un

36

En ese context0 econcimico y teniendo presente la ya conocida incertidumbre en el entorno macroeconbmico y financiero internacional y las repercusiones que tenga en las condiciones internas es que se hace necesario contar con un instrumento financiero orientado precisamente a servir de respafdo y contingencia en cas0 de que las condiciones economicas internacionales y nacionales desmejoren mas all6 de lo razonablemente previsto en 10s escenarios macroeconbmicos y que incidan en un estrujarniento importante de la liquidez nacional y por lo tanto en la necesidad de cubrir at pais financieramente, con el objetivo de no desfavorecer 10s programas y proyectos prioritarios, particularmente aquellos orientados a contener 10s efectos de la crisis internacional sobre el empleo, la pobreza, la educacion y la produccicin y que a la vez pemita el financiamiento de 10s programas y proyectos establecidos en el Plan Nacional de Desarrollo.

E4 Plan Nacional de Desarrollo 2006-2010,‘ gira en torno a cinco ejes prirtcipales politica social, politica productiva, politica ambiental, reforma institucional y politica exterior; 10s cuales agrupan a 10s 16 sectores; y responde a las grandes rnetas nacionales que se detallan a wntinuacion:

e

0

e

Cornbatir la corrupci6n en todo el smbito de la accion del sector publico La reduccibn de la pobreza y la desigualdad lncrementar el crecimiento de la economia y el empleo Mejorar la calidad y ampliar la cobertura del sistema educativo Detener las tasas de crecimiento de la criminalidad, el trafico de drogas y la drogadiccion y revertir la sensacibn de creciente inseguridad por parte de todos 10s ciudadanos Fortalecer las instituciones pliblicas y ordenar las prioridades del Estado Recuperat y ampliar la infraestructura de transporte del pais Ennoblecer la politica exterior y recuperar el papel de Costa Rica en et mundo

Como parte fundamental en esta estrategia el gobierno ha buscado profundizar la integracion de Costa Rica en la economia mundial, promoviendo la incorporacibn del pais en el Tratado de Libre mrnercio entre Centroamerica -Republica Dominicana y Estados Unidos (DR-CAFTA por sus siglas en ingles) y

’ El artfcuto 4 de la Ley de Administracion Financiera y Presupuestos Pdblicos N“ 8 13 1 cstablecc .‘... El Plan Nacional de Desanallu constituirh el marco global que orientarh 10s planes operativos institucionales. s e g h el iiivel de atitonom fa que corrcsportda de conformidad con las disposicioiies legalcs y coiistitucionalcs peninentes.”

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desarrollando las medidas necesarias para la aprobacibn de la agenda complementaria en torno a1 tratado de Jibre comercio en donde destaca la apertura del sector de Telecomunicaciones, del Sector Seguros y el fortalecimiento de la defensa a la propiedad intelectual, entre otros. Sin embargo estas medidas deben estar acornpatladas de un esfueno importante de rnejorarniento fiscal, de inversion en cornpetitividad y redistribucibn social de 10s beneficios derivados de la apertura comercial, por lo que la inversibn en educacibn, salud, ciencia y tecnologia, reducci6n de la pobreza y otros se tornan indispensables, dentro de las acciones estrategicas del Gobierno, acciones que podrian verse irnpactadas de forma desfavorable de continuar el agravamiento de la crisis econbmica internacional.

En el imbito del fortalecimiento de las finanzas publicas, Bsta administracidn se caracterizo por impulsar un mayor esfueno en la recaudacion a la vez que se llev6 a cabo una potitica de gastos responsable, la anterior combinacion junto a 10s acelerados crecimientos econbrnicos de 10s ultimos dos aoos propiciaron 10s mejores resultados fiscales de 10s ultimos 50 afios. Las acciones emprendidas por el Gobierno en su esfueno de aumentar la recaudacion incluyen principalmente medidas que van orientadas a la administracibn tributaria mejorando la informaci6n y el pago de 10s impuestos, sin que se haya introducido a la fecha nuevos impuestos. Estas iniciativas incorporan la implementacidn del TlCA (Tecnologia de Informacion para el Control Aduanero), la aceleracibn de las acciones para la irnplernentacih de Tributacidn Digital que permite el procesamiento, presentacibn y pago electronico de las declaraciones fiscales y ias mejoras en 10s programas de Grandes Contribuyentes y Regimenes Simplificados. Otra medida que merece resaltar en este context0 es la aprobacibn de la Ley de Cobro Judicial (No. 8624), que fortalece, entre otros, 10s procesos judiciales para contrarrestar la evasion de irnpuestos.

Con lo anterior se espera incrementar de forma importante, no solo el ntjmero de declarantes que utilizan 10s servicios digitales sin0 tambih el porcentaje de recaudacibn por estos instrumentos a la vez que se concluyen 10s procesos de implementacidn de 10s mcjdulos de exportaciones de TlCA en las aduanas de Limbn y Caldera.

Por el lado de 10s Gastos 10s esfuerzos se han centralizado en mejorar la planificacion de mediano y largo plazo principalmente para la prograrnacion de 10s principales programas del Gobierno. Para tratar este problerna, el gobierno ha estado avanzando en el desarrollo de las herrarnientas para introducir

38

presupuestos basados en resultados y el establecimiento de un marco a medio plazo. Para mejorar el proceso de la programacidn presupuestaria, aumentar la transparencia fiscal, y consolidar 10s sistemas de registro, el Ministerio de Hacienda ha puesto en ejecucion tres medidas importantes, el desarrollo de una nueva metodologia de programacion presupuestaria, el acoplamiento del presupuesto a1 planeamiento institucional operacional y estrat&ico y el desarrotlo de la mejora de un marco fiscal a medio plazo. Estas qcciones se enmarcan en un seguimiento fundamentado en resultados y se basa en la identiftcacian y la definicibn de prioridades a mediano plazo. La expectativa es que la nueva metodologia generara la informacibn uti1 para 10s tomadores de decision y proporcionara la ayuda para el proceso de asignacion de 10s recursos publicos, a la vez que informara al pubtico de 10s resultados del uso del recurso publico, fomentando la transparencia y la rendicidn de cuentas.

Las acciones dirigidas a la mejora de proceso de presupuesto y la evaluacibn de 10s resultados se han &ado implementando en forma gradual, estableciendo planes pilotos con 10s Ministerios que concentran 10s programas prioritarios para el Gobierno y que mantienen cierta capacidad institucional, de forma que paulatinamente se vayan incorporando mas entidades rninisteriales.

Otro grupo de actividades estratbgicas promovidas por esta administracion tienen que ver con la agenda de implementaci6n del DR-CAFTA en donde tres de 10s ejes fundamentates son la apertura del mercado de telecomunicaciones, de seguros y la consolidacion en la defensa de 10s derechos de propiedad intelectual. La entrada en vigencia del tratado de libre comercio y las disposiciones tomadas alrededor de 10s ejes mencionados constituyen una importante oportunidad para el posicionamiento de Costa Rica en la economla global y la atraccidn de inversion extranjera directa que permita la transferencia tecnoibgica y de infraestructum.

En el campo de las telecomunicaciones el pais ha dado pasos firmes hacia la apertura del sector mediante la publicacidn de la Ley 8642 (Ley General de Telecomunicaciones) que proporciona el marco general para el funcionamiento y regulacion del sector y la Ley 8660 (Fortalecimiento y Modernizacion de las Entidades Publicas del Sector Telecomunicaciones), en. donde se estabtece fa creacih del ente regulador (Superintendencia de Telecomunicacion, SUTEL), se reforma a1 Ministerio de Arnbiente y Energia para que se convierta en el ente rector del sector de telecomunicaciones, convirtikndose en el Ministerio de Ambiente, Energia y Tetecomunicaciones (MINAET), a1 tiempo que se eliminan una serie de lineamientos adrninistrativos, presupuestarios y financieros para que

39

la actual empresa estatal lnstituto Costarricense de Electricidad (ICE) pueda prepararse para la apertura y la entrada de la competencia.

Por otra parte la legislacion senalada a la vez que crea el marco juridico para la operacion, supervision, regulacion y rectoria del sector de telecomunicaciones, tambikn crea algunos elementos que promueven la universalizacion y acceso a 10s servicios como el Fondo Nacional de Telecomunicaciones (FONATEL) cuyo objetivo es apoyar el establecimiento de 10s servicios en Breas rurales o que comercialmente no resuitan atractivas, apoyando principalmente a escuelas en zonas rural y poblaciones minoritarias.

Como resultado de estas medidas, se espera que en 10s pr6ximos dos aiios se tengan en el pais un mayor numero de proveedores de servicios de Internet y telecomunicaciones que permita generar una mayor competitividad y eficiencia en el sector, al tiempo qua se logra una mayor cobertura y penetracion de 10s servicios que indirectamente proporcionaran mayores oportunidades de negocio, especialmente en aquellas &reas con alto contenido tecnologico, se favorecen 10s esfuerzos en educacibn, principalmente las de zonas rurales, y se promueve la eficiencia estatal mediante la interconectividad en areas como Salud, Educacion, Aduanas y Tributacion entre otras.

De igual forma que en Telecomunicacidn, en Seguros se ha estado preparando el marco juridico y de supervisibn para el ingreso de nuevos participantes. Con la creacion de la Ley 8653 (Ley Reguladora del Mercado de Seguros) se incluyen reformas integrales a la Ley No 12 del 30 de octubre de 1924, se rompe con el monopolio estatal en el campo de 10s seguros y se crea la Superintendencia General de Seguros (SUGESE). Con estas medidas adernas de un aumento en la oferta de proveedores de servicios se espera una mayor penetracion y competitividad en el area, unido a menores precios y una gama mas amplia de servicios.

La ultima gran &ea que resulta importante mencionar es el esfuerzo que se ha realizado en las modificaciones e introduccion de un nuevo marco regulatorio para la protecci6n de 10s derechos de propiedad intelectual que se espera impulse de una forma importante la seguridad juridica y por tanto favorezca la atraccion de inversion extranjera, principalrnente en industrias asociados a la investigacion, innovacion y desarrollo tecnologico. Este marco juridico tambien impulsara la innovacion en &reas de alto valor agregado en el sector agricultura, donde

40

destamn la produccion de nuevas variedades animates y vegetales y la capitalizacion de la investigacibn en la biodiversidad.

Finalmente, como parte del Plan Nacional de Desarrollo, se mantienen una serie de programas sociales orientados a complementar 10s esfuerzos en la reduccibn de la pobreza, la igualdad social y la distribuci6n de la riqueza. A pesar de que Costa Rica se ha mantenido en la vanguardia en su gasto social y particularmente en la importancia de la educacidn primaria y secundaria, en 10s ultimos afios se plasm0 una disminuci6n en 10s indicadores asociados a la educacion, principalmente la secundaria. Reducciones en la matricula, aumentos en el porcentaje de desercibn e incrementos en la repitencia son algunos de 10s indicadores que preocuparon a1 Gobierno de ta Republica al preparar su plan de Gobierno.

Lo anterior representa un obsthculo en 10s esfuenos de Costa Rica para alcanzar las metas de competitividad, especialmente si se considera la relacibn empirica entre educacion segundaria y la absorcibn de tecnologia, convitti6ndose la solucion a 10s problemas de educacion un elemento clave, no sofo para mejorar la competitividad del pais sin0 tambien para obtener el mayor valor agregado de 10s beneficios de 10s tratados de libre comercio.

El Plan de Desarrollo Nacional del gobierno apunta a un aumento en el porcentaje del gasto en educacidn en relaci6n ai Producto lnterno Bruto (PIB), que pasa a un 6.0% en 2009 y que se ha aprobado en el presupuesto. Segun lo destacado por la Revision del Gasto Pifblico del Banco Mundial (2008), 10s gastos sociales, except0 pensiones contributarias, son progresivos en Costa Rica, incluyendo 10s gastos en educacidn primaria y secundaria.

En el context0 de consolidar la educacibn secundaria mientras se conserva como prioridad la poblacion mas pobre, el gobierno esth ernprendiendo un nClmero de medidas dirigidas a mejorar la calidad y reducir 10s porcentajes de desercion. El programa “Avancemos”, proporciona una transferencia de efectivo a las familias del beneficiario condicionadas a que sus niiios que atienden a la secundaria, permanezcan y concluyan sus estudios. Hasta la fecha, mas de 100,000 estudiantes de secundaria estan siendo beneficiados por este programa, y se espera alcanzar alrededor de 200,000 estudiantes para 201 0.

En el lado de la fuente, el ministerio de la educacibn esta intentando aumentar la calidad de la educacion secundaria con un numero de reformas orientadas a

41

modificar las esquemas de evaluation y repitencia y modernizar 10s programas de estudio haciendolos mas atractivos para el estudiante. Otras medidas importantes en este contexto han sido la creacion del nuevo lnstituto de Desarrollo Profesional Uladislao Garnez Solano y la decision del Gobierno de promover la participacidn de Costa Rica en las evaluaciones internacionales de aprendizaje, corn0 el Prograrna PISA.

Sin duda el rnantenimiento y continuidad de las acciones estrategicas planteados requieren de un esfuerzo fiscal importante que se podria ver amenazada en el actual contexto de crisis econ6rnica internacional, por lo que la ayuda y soporte financieru del Banco, que perrnita tornar las medidas contingentes y garanticen la continuidad de las actividades resulta de vital importancia para favorecer el proceso de incorporaci6n de Costa Rica en 10s prowsos de fibre comercio sin poner en riesgo fa sostenibilidad de la agenda social.

AI agradecer su atencibn, aprovecho la ocasion para rnanifestarle las rnuestras de mi consideracion y estirna.

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ANNEX 3. Costa Rica-Assessment Letter to the World Bank Statement by the IMF Staff

March 19,2009

This letter updates the assessment o f the IMF Executive Board at the time o f the 2007 Article IV Consultation with Costa Rica (see the Public Information Notice o f March 10,2008, available at httu://www.imf.org/extemal/np/sec/pn/2008/pn083 1 .him). The next Article IV Consultation i s scheduled to take place in the second half o f 2009.

1. Macroeconomic performance during 2008 was somewhat weaker than anticipated at the time of the 2007 Article IV consultation. Real GDP grew by less than 3 percent (less than hal f the average growth during 2003-07) with a sharp decline in the fourth quarter. Inflation (12-month rate) exceeded 16 percent in October 2008, but fell below 14 percent by year-end as economic activity faltered and import prices declined. While the external current account deficit reached almost 9 percent o f GDP, the deterioration halted in the second semester due to a lower o i l bill and weaker non-oil imports. The exchange rate, however, was under pressure since July 2008, requiring substantial sales o f foreign exchange reserves to defend the currency band, as capital inflows reversed and external financing conditions tightened.

2. With the global crisis deepening, Costa Rica faces a challenging outlook. Growth in 2009 i s projected to slow to % percent, and recover to 1% percent in 2010. Inflation i s estimated to decline to about 8 percent, and the deficit in the external current account to fall below 5% percent o f GDP by year end. Credit conditions wil l remain tight and the quality o f bank loan portfolios i s likely to deteriorate somewhat. Risks to the economic outlook are generally tilted to the downside. In particular, the adverse effects o f the global financial and economic crises on the balance o f payments could be more severe than currently anticipated.

3. Against this background, the authorities are adopting a reasonably well-balanced crisis prevention strategy. In January 2009, the Central Bank increased the rate o f crawl o f the ceiling o f the currency band (from 3 to 9 percent on an annual basis) and raised deposit interest rates. Higher public spending to support activity together with lower revenues are projected to increase the deficit o f the combined public sector above 4percent o f GDP, the bulk o f which i s to be financed with domestic borrowing. On the financial sector, the authorities have taken several measures to enhance crisis preparedness, including by boosting banks’ liquidity buffers, adopting regulatory changes, and recapitalizing public banks. In addition, the authorities are in the process o f securing contingent financing from international financial institutions o f about US$1.75 bi l l ion to strengthen their foreign currency liquidity buffers and protect the economy against larger-than-anticipated shocks to the balance o f payments.

4. The IMP Executive Board i s expected to discuss in April2009 a 15-month Stand-By Arrangement (SBA) to support the authorities’ economic program. The arrangement, which the authorities plan to treat as precautionary, would involve access o f SDR 492.3 mil l ion (about US$720 million). The arrangement supports the authorities’ macroeconomic policies and objectives for 2009, including the adoption o f countercyclical fiscal policy, expansion o f the social safety net, the widening o f the exchange rate band and the inflation target. The structural component o f the program will aim at strengthening the financial sector safety net and making progress in the transition to a more flexible exchange rate and an inflation targeting regime.

46

Table 1. Costa Rica: Selected Economic Indicators

I. Social Indicators

Per capita income (2008, U.S. dollars) Population (July 2008, millions) 4.5 Poverty (2008, percent of households) Life expectancy (2005, years)

6,580

79.1

Unemployment (2008, percent of labor force)

Extreme poverty (2008, percent of households)

4.9 17.7 3.5

II. Economic Indicators

Est. 2005 2006 2007 2008

(Annual percentage change, unless otherwise indicated)

National income and Prices GDP at constant prices Implicit deflator Consumer prices (end of period)

External sector Merchandise exports (percent change) I / Merchandise imports (percent change) I / Terms of trade (-deterioration) Real Effective Exchange Rate (eop; - depreciation) 2/

Banking System (Depository institutions) Net domestic assets

Of which: Credit to private sector Broad money Lending interest rate (end of period)

Combined Public Sector 31 Combined public sector primary balance Combined public sector overall balance

Central government balance Central bank balance Other public enterprises and entities balance

Gross Domestic investment

Gross National Savings

External Current Account Balance

Combined Public Sector Debt (gross) 31 Of which: External public debt

Change in net international reserves (- increase) Net international reserves 4/

GDP (in millions of US. dollars) in months of nonmaquila imports

5.9 8.8 10.6 11.0 14.1 9.4

10.1 11.0 5.8 13.1

-5.1 -4.1 0.0 0.9

15.1 26.7 30.4 28.5 29.1 25.3 24.0 20.7

(in percent of GDP)

3.4 2.8 -1.7 -0.7 -2.8 -1.4 -1.4 -1.1 0.3 0.0

26.4 26.4

21.8 21.8

-4.9 -4.5

52.7 47.8 15.9 13.2

7.8 9.3

10.8

12.3 21.4 -1.4 2.8

25.5 38.3 16.3 16.3

4.1 1.2 0.3

-0.7 0.4

26.4

21.8

-6.3

43.2 10.5

(In millions of U.S. dollars, unless otherwise indicated)

-393 -1,034 -999 2,081 3,115 4,114

3.4 4.1 4.3 19,967 22.528 26,269

2.9 12.4 13.9

21.3 29.4 -3.2 5.4

21.4 30.8 18.3 20.7

2.3 0.2

-0.3 -0.2 0.0

27.4

18.1

-8.9

35.6 9.0

315 3,799

5.0 29,828

Sources: Central Bank of Costa Rica; Ministry of Finance; and Fund staff projections.

I / In value terms, excludes maquila raw materials. 2/ 2008 as of December. 3/ Combined Public sector = Central government + Central bank + Other public enterprises and entities excluding ICE. 51 2007 includes a one-off adjustment of US159.7 million for reclassification of capital contribution to FLAR.

47

ANNEX 4

Costa Rica a t a glance 9/24/08

Key Development Indicators

(2007)

Population, mid-year (millions) Surface area (thousand sq. km) Population growth (Yo) Urban population (%of total population)

GNI (Atlas method, US$ billions) GNI per capita (Atlas method, US$) GNI per capita (PPP, international $)

GDP growth (%) GDP per capita growth ( O h )

(most recent estimate, 2000-2007)

Poverty headcount ratio at $1.25 a day (PPP. %) Poverty headcount ratio at $2.00 a day (PPP. %) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5)

Adult literacy, male (% of ages 15 and older) Adult literacy, female (% of ages 15 and older) Gross primary enrollment, male ( O h of age group) Gross primary enrollment, female (% of age group)

Access to an improved water source (% of population) Access to improved sanitation facilities (% of population)

Costa Rica

4.5 51 1.4 63

24.8 5,560 8,340

6.3 4.8

79 11

95 95

112 111

98 96

Latin America 8 Carib.

563 20.421

1.2 78

3,118 5,540 9,320

5.7 4.5

8 18 73 22 5

91 89

120 116

91 78

Upper middle income

823 41.497

0.6 75

5,750 6,987

11,868

5.8 5.1

70 22

94 92

112 109

95 83

Net Aid Flows

(US$ millionsj Net ODA and official aid Top 3 donors (in 2006):

Germany European Commission Japan

Aid (%of GNI) Aid per capita (US$)

Long-Term Economic Trends

Consumer prices (annual % change) GDP implicit deflator (annual % change)

Exchange rate (annual average, local per US$) Terms of trade index (2000 = 100)

Population. mid-year (millions) GDP (US$ millions)

Agriculture industry

Services

Household final consumption expenditure General gov't final consumption expenditure Gross capital formation

Exports of goods and services Imports of goods and services Gross savings

Manufacturing

1980

64

13 0 4

1.4 27

18.1 18.8

8.6 101

2.3 4,831

20.2 30.8 21.1 62.6

65.5 18.2 26.6

26.5 36.8 12.2

1990 2000

227 11

25 1 5 1

40 -8

3.2 0.1 74 3

19.0 11.0 17.1 7.0

91.5 308.2 95 100

3.1 3.9 7,403 15,946

(% of GDP) 12.3 9.5 29.9 32.1 22.6 25.3 57.8 58.5

72.9 67.0 14.7 13.3 18.5 16.9

30.2 48.6 36.3 45.8 9.8 12.5

2007 a

24

7 7 6

0.1 5

8.0 7.9

516.6 87

4.5 25,225

9.0 30.9 22.5 60.1

74.7 5.0

27.0

50.9 57.6 21.8

Age distribution, 2007

Male Female

75-79

5 0 6 4

15-49

3c.M

75-19

04

15 10 5 0 5 10 15

percent

Jnder-5 mortality rate (per 1,000)

60 1

50

40

30

20

i o

0 1990 1995 20W 2006

OCosta Rica OLatm Amenca & the Caribbean

IGrowth of GDP and GDP per capita (%)

95 W 05

I L G D P -GDP per capita

1980-90 1990-2000 2000-07 (averaga annual growth %)

2.7 2.4 1.8 3.1 5.3 5.2

3.3 4.1 3.7 3.5 6.2 5.9 3.5 8.8 5.9 2.7 4.7 5.2

3.8 5.1 3.7 1.1 2.0 1.4 5.6 5.1 10.1

6.2 10.9 8.0 7.8 9.2 7.5

Note: Figures in italics are for years other than those specified. 2007 data are preliminary. .. indicates data are not available. a. Aid data are for 2006.

Development Economics, Development Data Group (DECDG).

48

Costa Rica ~ ~~~

Balance of Payments and Trade

(US$ millions) Total merchandise exports (fob) Total merchandise imports (cif) Net trade in goods and services

Workers' remittances and compensation of employees (receipts)

Current account balance as a % of GDP

Reserves. including gold

Central Government Finance

(% oFGDP) Current revenue (including grants)

Current expenditure

Overall surplusldeficit

Highest marginal tax rate (%)

Tax revenue

Individual Cwporate

External Debt and Resource Flows

(US$ millions) Total debt outstanding and disbursed Total debt service Debt relief (HIPC. MDRI)

Total debt (% of GDP) Total debt service (% of exports)

Foreign direct investment (net inflows) Portfolio equity (net inflows)

2000

5,813 6,389

454

136

-705 4 . 4

1,318

12.4 12.3 14.0

-3.0

25 30

4,456 648 -

27.9 8.0

409 0

~

2007

9.285 12,269 -1,692

650

-1,306 -5.2

3,590

15.3 15.1 15.6

-1.2

25 30

6,832 597

-

30.7 5.0

1,469 0

ornposltlon of total external debt, 2006

2.979

s$ millions

Private Sector Development

Time required to start a business (days) Cost to start a business (% of GNI per capita) Time required to register propem (days)

Ranked as a major constraint to business (% of managers Surveyed who agreed)

Access tdcost of financing Anticompetitive w informal practices

Stock market capitalization (% of GDP) Bank capital to asset ratio (%)

2000 2008

- 60 - 20.5 - 21

2000 2007

.. 80.1

.. 48.7

18.3 8.1 10.8 10.7

Governance lndlcators, 2000 and 2007

Voice and acmuntability

Polibcal stability

Regulatory quality

Rule of Im

Control of mrruption

0 m 75 1w 25

2007 Country's percentile rank (0-100) 0 2000 tagher VdW hnp'y Mer rnungr

Sauce. KaUfmannXrBav.MsSlrYUi. WoM Bank

2000 2007 Technology and Infrastructure

Paved roads (% of total) Fixed line and mobile phone

High technology exports subscribers (per 1,000 people)

(% of manufactured exports)

22.0 24.4

28 66

51.6 44.7

Environment

Agricultural land (% of land area) 56 57 46.5 46.8 Forest area (% of land area)

Nationally protected areas (% of land area) .. 23.5

Freshwater resources per capita (cu. meters) .. 25,975 Freshwater withdrawal (% of internal resources) 2.4

C02 emissions per capita (mt) 1.4 1.5

GDP per unit of energy use (2005 PPP $per kg of oil equivalent) 7.5 8.0

Energy use per capita (kg of oil equivalent) e42 883

(US$ millions)

IBRD Total debt outstanding and disbursed 121 45 Disbursements 6 1 Principal repayments 33 9 Interest payments 12 3

IDA Total debt outstanding and disbursed Disbursements Total debt service

2 1 0 0 0 0

IFC (flsca/yoar) Total disbursed and outstanding portfolio 46 112

of which IFC own account 41 57 Disbursements fw IFC own account Portfolio sales, prepayments and

repayments for IFC own account

MlGA Gross exoosure

0 0

4 37

72 187

Note: Figures in italics are for years other than those specifled. 2007 data are preliminary. .. indicates data are not available. -indicates observation is not applicable.

Development Economics, Development Data Group (DECDG).

9/24/08

49

Millennium Development Goals Costa Rica

With selected targets to achieve between 1990 and 2015 (estimate closest to date shown, t/- 2 years)

Goal 1: halve the rates for extreme poverty a n d malnut r i t ion 1990 1995 2000 2007 Poverty headcount ratio at $1.25 a day (PPP, % of population) Poverty headcount ratio at national poverty line (% of population) 23.0 Share of income or consumption to the poorest qunitile (%) 4.0 3.0 4.1 4. I Prevalence of malnutriition (% of children under 5)

22.0

Goal 2: ensure that children are able to complete primary schooling Primaw school enrollment (net. %) 87 . . . Prima4 completion rate (% of relevant age group) Secondary school enrollment (gross, %) Youth literacy rate (% of people ages 15-24)

75 82 87 89 45 61 86

98

Goal 3: eliminate gender disparity in education and empower women Ratio of girls to boys in primary and secondary education (%) 101 101 102

Proportion of seats held by women in national parliament (%) 11 16 19 39 Women employed in the nonagricultural sector (% of nonagricultural employment) 37 37 39 40

Goal 4: reduce under-5 mortality by two-thirds Under-5 mortality rate (per 1,000) 18 16 14 I 2 Infant mortality rate (per 1,000 live births) 16 14 13 11 Measles immunization (proportion of one-year olds immunized. %) 90 91 82 89

Goal 5: reduce maternal mortality by three-fourths Maternal mortality ratio (modeled estimate, per 100,000 live births) 30

Contraceptive prevalence (% of women ages 1549) 75 80 96 Births attended by skilled health staff (% of total) 98 96 90

Goal 6: halt and begin to reverse the spread of HlVlAlDS and other major diseases Prevalence of HIV (%of population ages 1549) 0.2 0.4 Incidence of tuberculosis (per 100,000 people) 22 19 17 14 Tuberculosis cases detected under DOTS (%) 119 I02

Goal 7: halve the proportion of people without sustainable access to basic needs Access to an improved water source (% of population) 96 97 08 Access to improved sanitation facilities (% of population) 94 95 98 96 Forest area (% of total land area) 50.2 46.5 46.8 Nationally protected areas (x of total land area) 23.6 C02 emissions (metric tons per capita) 0.9 1.4 1.4 1.5 GDP per unit of energy use (constant 2005 PPP $ per kg of oil equivalent) 7.4 7.4 7.5 8.0

Goal 8: develop a global partnership for development Telephone mainlines (per 100 people) 9.2 13.8 22.9 32.2 Mobile phone subscribers (per 100 people) Internet users (per 100 people) Personal computers (per 100 people)

Iducation indicators (%)

25 W L 2wo 2w2 2004 2006

+Primary net enrollmmt ratio (..)

+Ratio of girls to boys in primary 8 secondary education

Measles immunization (% of I-year olds)

1w.

1990 1995 20w 20c6

0 Costa Rlca Latin America athe Caribbean

0.0 0.5 5.4 33.8 0.0 0.4 5.8 33.8

6.8 15.3 23.1

ICT indicators (per 1,000 people)

1801

zwo 2002 2w4 2 w 6

0 Fixed + mobile subscribers Internet users

Note: Figures in italics are for years other than those specified. ._ indicates data are not available.

Development Economics, Development Data Group (DECDG).

9/24/08

50

ANNEX 5. Debt Sustainability Analysis”

1. The outlook on Costa Rica’s medium-term debt sustainability framework has deteriorated as a result o f the global financial turbulence experienced over the second ha l f o f 2008. The debt sustainability analysis in this program document incorporates the expected negative impact o f a more prolonged global financial crisis than previously expected.

2. Before the crisis, growth was expected to moderate to about 4 percent per year over 2008-2009 and recover to 4.5 percent over 2010-2013. The revised medium term macroeconomic framework suggests that the Costa Rican economy will be hit the hardest in 2009, with real GDP growth projected to fa l l to 0.5 percent, and recover to 1.5 percent in 2010 and an average o f 4.6 percent thereafter. The assumption o n recovery is based o n a recovery o f the U S economy, the structural reforms adopted during the last decade, further integration o f the Costa Rican economy into the global economy, continued output diversification, and higher public spending in infrastructure. Inflation i s expected to fa l l to 4.0 percent as the inflationary impact o f rising commodity prices abates and the impact o f monetary tightening controls second- order effects o f food and fuel inflation.

3. Costa Rica’s external and public debt outlook i s sustainable. The baseline scenario estimates that total external debt (public and private) remains more or less constant at around 31 percent o f GDP between 2007 and 2013. Over the same period, total public debt (including the non-financial public sector and the Central Bank) falls from 43.2 percent o f GDP to 37.9 percent o f GDP. This would be consistent with a primary deficit averaging 0.04 percent o f GDP between 2009 and 2013. The public sector foreign currency denominated debt would be reduced from 17.3 percent o f GDP in 2007 to 12.1 percent o f GDP in 2013.20

Table A5.1: Main Underlying Baseline Assumptions

Real GDP Growth (%) 7.8 2.9 0.5 1.5 3.5 4.5 5.2 Average Nominal Interest Rate on Public Debt (%) 10.0 8.1 10.9 11.2 9.1 8.9 8.7 Average Real Interest Rate (%) 0.7 -4.3 0.7 3.4 3.3 4.5 4.6 Inflation Rate (GDP deflator, %) 9.3 12.4 10.2 7.8 5.7 4.4 4.1 Growth o f real primary spending (deflated by GDP deflator, in percent) 8.0 18.5 3.5 3.2 2.3 2.6 3.8

2007 I 2008 2009 2010 2011 2012 2013

Primary deficit 11 -5.3 -3.2 0.6 0.4 0.2 -0.3 -0.7 Current Account Balance (“A o f GDP) -6.3 -8.9 -5.3 -5.3 -5.4 -5.5 -5.2

Source: IMF and WB, March 2009. /I The primary deficit i s the public sector balance minus gross interest expenditure, so does not coincide with f igures in Table 1.

~~ ~~

l 9 The projections in this Annex are based on an estimated CPI inflation rate o f 13.9 percent for 2008. *’ Due to increased net external disbursements calculated as follows ($350 mi l l ion + $135 mi l l ion f rom the IDB - roads and financial sector respectively; $150 mil l ion sale o f bonds to the Govt. of China; amortization net o f other small commitments $240 million; th is adds to a net increase in disbursements o f 2.3 percent o f 2009 GDP.

51

Table A5.2: Public Sector Debt Sustainability Analysis (in percent o f GDP, unless otherwise indicated)

2007 2008 2009 2010 2011 2012 2013

Total External Debt (public +private) 31.0 29.7 30.6 31.0 31.1 31.4 30.7 Public sector debt 1/ 43.2 35.6 36.9 38.4 38.8 38.6 37.9

olw foreign currency denominated 17.3 11.5 11.9 12.4 12.5 12.4 12.1

Baseline Projections

11 Public Sector Debt includes NFPS debt and the Central B a n k 21 Derived as nominal interest expenditure divided by previous per iod debt stock

4. The previous conclusion regarding the sustainability o f Costa Rica’s debt (both public and external) i s maintained under more pessimistic macroeconomic scenarios. Taking into account the main r isk to the medium-term outlook, Table A5.3 presents projected debt dynamics under the fol lowing alternative scenarios: higher interest rates, lower GDP growth, lower current account balance (external debt), lower primary balance (public debt), combined shock, and a sharp nominal depreciation in 2009.

Higher interest rates (Scenarios A I and BI): With a positive one-half standard deviation shock to the interest rate o n external and public debt (equivalent to an interest rate increase o f 0.7 percent for the external debt and 1.1 percent for the public debt), the external debt to GDP ratio would rise slightly to 31.9 percent, while the public debt to GDP ratio would rise to 40 percent. Lower GDP growth (Scenarios A2 and B2): With a negative one-half standard deviation shock to the real growth rate (equivalent to a decline in growth o f 1.4 percentage points), external and public debt stocks, as a proportion o f GDP, would increase by 2.1 and 12.6 percentage points respectively. Lower current account balance (Scenario A3): With a negative one-half standard deviation to the non-interest current account balance (equivalent to 0.4 percentage points o f GDP) external debt rises slightly to 32.7 percent o f GDP by 2013. Lower primary balance (Scenario B3): With a negative one-half standard deviation to the primary balance o f the overall public sector (equivalent to 0.7 percentage points o f GDP) combined public sector debt rises to 41.3 percent o f GDP by 2013. Combined shock (Scenarios A4 and B4): A combination o f A1 to A3 and B1 to B3 for external and public debt respectively, but using one-fourth standard deviation shocks, would result in external and public debt stocks, as a proportion o f GDP, increasing by 3.2 and 6.5 percentage points respectively. Sharp exchange rate depreciation: A 30 percent depreciation in the exchange rate in 2009 leads to external and public debt r ising to 36.2 and 45.5 percent o f GDP respectively by 2013.

52

Table A5.3: Public Debt Sustainability Analysis: Alternative Scenarios A. External Debt Scenarios - Bound Tests 2007 2008 2009 2010 2011 2012 2013 Al . Nominal interest rate i s at baseline plus one-half standard deviation 31.0 29.7 30.9 31.5 31.9 32.4 31.9 A2. Real GDP growth i s at baseline minus one-half standard deviations 3 1 .O 29.7 3 1 .O 3 1.6 3 1.9 32.4 3 1.8 A3. Non-interest current account i s at baseline minus one-half standard deviations 31.0 29.7 31.1 31.8 32.4 33.1 32.7 A4. Combination o f B1-B3 using 1/4 standard deviation shocks 31.0 29.7 31.1 31.9 32.5 33.3 32.9 A5. One time 30 percent real depreciation in 2009 31.0 29.7 43.7 42.1 40.3 38.9 36.2

B. Public Debt Scenarios - Bound Tests B 1. Real interest rate i s at baseline plus one standard deviations 43.2 35.6 37.3 39.2 40.2 40.5 40.0 B2. Real GDP growth i s at baseline minus one-half standard deviation 43.2 35.6 37.9 41.0 43.6 46.1 48.2 B3. Primary balance i s at baseline minus one-half standard deviation 43.2 35.6 37.6 39.7 41.0 41.6 41.3 B4. Combination o f B 1-B3 using one-quarter standard deviation shocks 43.2 35.6 37.7 40.0 41.4 42.2 42.1 B5. One time 30 percent real depreciation in 2009 43.2 35.6 44.0 45.8 46.4 46.4 45.5

53

ANNEX 6: The Progressivity of Social Expenditures2'

6.1 In calculating the distributional impact o f social expenditures, the standard methodology assumes that benefits are equal to the expenditure level and that there are constant benefits per beneficiary, independent o f where the service was provided or o f beneficiary characteristics such as age or sex. I t then classifies social expenditures as progressive, neutral or regressive depending on whether the poor receive a greater, the same, or lesser share o f expenditures than their share in population. The progressive expenditure category i s also known as pro-poor. However, this methodology considers only the distribution o f benefits and ignores how the expenditure resources were raised-for instance, a program that raises 90 percent o f the resources fi-om the wealthiest 10 percent o f the population but distributes 15 percent o f the benefits to the same group would not be considered pro-poor even though there i s a redistribution o f resources towards the poor.

6.2 Using this methodology, Costa Rica i s one o f the few countries with pro- oor or progressive PESP. I t has the second lowest concentration coefficient or quasi-Gini2' o f the selected countries in the region (Figure A6.1). Interestingly, other countries with pro-poor social expenditures also have relative high levels o f PESP. Social protection programs are not reflected in the graph because only a few countries had available data.

Figure A6.1: PESP Concentration Coefficient, Excluding Social Protection

0.15 I I

0.10 0.05 0.00

-0.05 -0.10 -0.15 -0.20 -0.25 -0.30 ' 1

I

Source: CEPALIECLAC 2006.

21 Source: Costa Rica: Poverty Assessment, World Bank 2007; Costa Rica: Public Expenditure Review, World Bank, 2008. 22 The quasi-Gini for PESP plots the cumulative public expenditures going to various households, from poorest to richest. When the curve l ies above the 45-degree l ine (i.e. when the poorest households receive a disproportionately high share of expenditures), the Gini i s said to be negative. A quasi-Gini therefore vanes between -1 and 1, with positive values denoting regressive expenditures and negative values progressive expenditures.

54

6.3 Overall PESP23 in Costa Rica are progressive if contributive pensions are excluded.24 Indeed, PESP without the contributive pensions are progressive and have become increasingly pro-poor over time, with al l o f the major social programs turning pro-poor by 2004. Since health and education expenditures have universal coverage, they are only mildly progressive. Social protection programs, which are oriented towards the poor, have an appropriately pro-poor quasi- Gini o f -0.41. In 2004 contributive pensions were regressive (quasi-Gini o f 0.66), even more so than household income (quasi-Gini o f 0.60). (Table A6.1)

PESP (without Contributive Pensions) Education Health Social Protection Others

Total Household Income Total PESP Contributive Pensions

-0.006 -0.071 0.168 -0.014 -0.067 -0.041 -0.175 -0.409 0.197 0.143

0.504 0.602 0.01 1 0.030 0.540 0.661

23 Including health, education and social protection programs Costa Rica has a pension system that covers mainly older persons who are unable to provide for themselves.

Because these pensions do not require the beneficiaries to have contributed to the system, they are called the non- contributive pensions as opposed to the traditional pensions requiring prior contributions.

24

55

MAP SECTION

CCoorrddii ll lleerraa ddee GGuuaannaaccaassttee

CCoorrddii ll lleerraa CCeennttrraall

CCoorrddii ll lleerraa ddee TTaallaammaannccaa

CCoorrddii ll lleerraa ddee TTii llaarráánn

Cerro ChirripoCerro Chirripo(3,810 m)(3,810 m)

Cerro DurikaCerro Durika(3,296 m)(3,296 m)

Volcán TurrialbaVolcán Turrialba(3,328 m)(3,328 m)

Volcán IrazúVolcán Irazú(3,432 m)(3,432 m)

Cerro KámukCerro Kámuk(3,554 m)(3,554 m)

A L A J U E L AA L A J U E L A

G U A N A C A S T EG U A N A C A S T E

P U NP U N TTA R E N A SA R E N A SC AC A RR TTA G OA G O

L I M Ó NL I M Ó N

P U NP U N TTA R E N A SA R E N A S

HHEE

RREE

DDII AA

SS AA NN JJ OO SS ÉÉ

TTeemmppiissqquuee

NicoyaNicoya

Santa CruzSanta Cruz

La CruzLa Cruz

UpalaUpala

CañasCañas

San RamónSan Ramón

PuertoPuertoViejoViejo

GuácimoGuácimo

SiquirresSiquirres

BribriBribri

SixaolaSixaola

TurrialbaTurrialba

San IsidroSan Isidro

NeilyNeily

San VitoSan Vito

PalmarPalmarSurSur

GolfitoGolfito

San IgnacioSan Ignacio

San MarcosSan Marcos

SantiagoSantiago

JacóJacó

OrotinaOrotina

QuesadaQuesada

San RafaelSan Rafael

Los ChilesLos Chiles

CarmonaCarmona

PlayaPlayaNaranjoNaranjo

LiberiaLiberia

PuntarenasPuntarenasAlajuelaAlajuela HerediaHeredia

CartagoCartago

SAN JOSÉSAN JOSÉ

SSiixxaaoollaa

CChhiirrrr

iippóó

ddeell AA

ttlláánnttii

ccoo

GGeenneerraall

RReevvee

nnttaazzóónn

CChhiirrrr

iippóó

SSaann CC

aarrllooss

GGrraannddee

Lago deLago deArenalArenal

A L A J U E L A

G U A N A C A S T E

P U N TA R E N A SC A R TA G O

L I M Ó N

P U N TA R E N A S

HE

RE

DI A

S A N J O S É

Tempisque

Nicoya

Garza

Santa Cruz

Flamingo

La Cruz

Upala

Cañas

San Ramón

PuertoViejo

Guácimo

Siquirres

Bribri

Sixaola

Turrialba

San Isidro

Neily

San Vito

PalmarSur

Golfito

Parrita

San Ignacio

San Marcos

Dominical

PuertoQuepos

Santiago

Jacó

Orotina

Quesada

San Rafael

Los Chiles

Carmona

PlayaNaranjo

Liberia

PuntarenasAlajuela Heredia

Cartago

Puerto Limon

SAN JOSÉ

NICARAGUA

PANAMA

Sixaola

Chirr

ipó

del A

tlánti

co

General

Reve

ntazón

Chirr

ipó

San C

arlos

Grande

Lago deArenal

Caribbean Sea

Bahía deCoronado

PACIFICOCEAN

Golfo deNicoya

Golfo dePapagayo

Lago deNicaragua

Golfo Dulce

To Rivas

To Changuinola

To Cerro Pando

To Puerto

Armüelles

To David

Cordi l lera de Guanacaste

Cordi l lera Central

Cordi l lera de Talamanca

Cordi l lera de Ti larán

Cerro Chirripó(3,810 m)

Cerro Durika(3,296 m)

Volcán Turrialba(3,328 m)

Volcán Irazú(3,432 m)

Cerro Kámuk(3,554 m)

86ºW 85ºW 84ºW 83ºW 82ºW

84ºW 83ºW 82ºW

10ºN

11ºN

9ºN

10ºN

11ºN

COSTA RICA

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 20 40

0 20 40 Miles

60 Kilometers

IBRD 33392R

JULY 2008

COSTA RICASELECTED CITIES AND TOWNS

PROVINCE CAPITALS

NATIONAL CAPITAL

RIVERS

MAIN ROADS

RAILROADS

PROVINCE BOUNDARIES

INTERNATIONAL BOUNDARIES