Costa Rica Speculative Capital and Currency Controls

In the case of Costa Rica a strong local currency is hurting the productivity of the country. The Costa Rican currency the “Colon” is pegged to the U.S. Dollar by way of a managed float whose goal is to keep the Colon with a range of 495 to 506 Colones per Dollar. The Costa Rican Central Bank [BCCR] manages this monetary float system by buying dollars to take them out of circulation and thus maintaining the value of the currency within the established float.

However this monetary control system is in peril due to external factors which the Costa Rican Central Bank cannot control. The first is a weaker U.S. Dollar which makes the Costa Rican Colon stronger. A stronger Costa Rican currency hurts the export sector because it makes Costa Rican export products more expensive. The second is a constant influx of Dollars into the Costa Rican economy. Foreign investment into Costa Rica continues to grow due to the political and general economic stability of Costa Rica. The more Dollars the enter into the local economy the stronger the Costa Rican currency gets because of the oversupply. A further exacerbation of the problem is the high interest rate that is being paid for deposits in local currency compared to rates being offered around the world. In Costa Rican, financial institutions are paying between 6 to 10% interest for CD’s on Costa Rican currency. Well above the less then 2% being paid in other countries. This attractive interest rate has caught the eye of savy investors who are moving money into Costa Rica with the sole purpose of taking advantage of the interest rates. This speculative capital is referred to locally as “capital golondrina” which means “swallow” capital since the funds come into the country and just nest in a CD or Treasury Bond and when it expires they pull it out and leave the country. It provides no direct benefit to Costa Rica but does have an adverse effect on the currency float system. The Costa Rican President went as far as calling this speculative capital “weapons of mass destruction”.

As a result of this the Costa Rican government has been looking at ways to control this phenomenon. The suggestion has been to place a 38% tax rate on passive investment income. The current rate is 8% so by raising this tax significantly they hope to reduce the appeal for speculative capital. In the interim the government will attempt a reduction in the Costa Rican bank rate known as the “tasa basica pasiva” which is currently at 9.10% . This bank rate is established using a formula that takes into account the average interest rate paid for terms of 4-7 months by all the financial institutions including the Costa Rican Treasury Department and the Central Bank. Since the Costa Rican government owned banks [Banco Nacional de Costa Rica, Banco de Costa Rica, BancCredito, Banco Popular] make up the bulk of the (80%) of the depository institutions in the country they have an important impact on the overall bank interest rate when they either raise or lower their bank rates. In this case the government is pressuring the banks to start lowering the bank rates to make Costa Rica less attractive to speculative capital.

Ironically, it is the Costa Rican government that created the problem in the first place by raising the interest rates on Treasury Department notes in order to pay for the growing fiscal deficit.