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UNU‐WIDER

Country Role Models for Development Success: The case of Costa Rica

Alberto Trejos

INCAE

Helsinki, June 2008

Country Role Models for Development Costa Rica

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1 Introduction: Costa Rican recent history and the implicit development strategy

While not as wealthy or dynamic as some other economies, Costa Rica has been moderately successful in terms of economic development, reaching a comparatively high income in Latin America, and one of the region’s highest growth rates in the last two decades. Along with growth, the Costa Rican economy has become more diversified and sophisticated, and avoided the excess volatility afflicting other developing countries. There has been progress in reducing poverty and improving consumption standards. At the current pace, Costa Rica will not become a developed country soon unless profound additional reforms are undertaken; nevertheless, its performance has been better than most, and the country has some enviable indicators.

In this paper, I express an opinion about why Costa Rica has achieved some economic success in the last quarter of a century, and I will highlight the combination of three particular sets of policies –which have been implemented quite well, are complementary to each other, and are very important—as the cause for these achievements. The first set of policies involves the strong investments and unusual decisions that Costa Rica made, during the XX Century, regarding democracy, peace, education, healthcare and the environment, and which explain the high levels of human development, institutional development, and labor productivity, that the country today enjoys. These measures were not taken, at the time, seeking economic value, but rather other –perhaps higher—objectives. Nevertheless, once taken, these features constituted a basis for huge potential productivity, as they reflected in the business climate, human capital, stability and rule of law. Under the binding constraints that the Costa Rican economy faced in the 1960s and 70s, this potential existed but was not unleashed.

The second set of policies that I will highlight is precisely the stabilization and (partial) liberalization measures undertaken since the mid 1980s. Due to these efforts, Costa Rica has maintained macroeconomic stability, as it now is in its 26th consecutive year of positive growth without a financial, fiscal, or balance of payments crisis. While the stabilization pursuits are by no means complete –and, in particular, the country still suffers inflation above international levels—progress has been significant. In the same period, some microeconomic reforms and deregulation has occurred, and the heavy‐handed state intervention of the mid XX Century has been traded for more modern supervision. All this was done very idiosyncratically. Costa Rica engaged in its own creative way in the execution of some of the reforms proposed by the international conventional wisdom of the


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time –today trivialized under the label of Washington Consensus—and refused to undertake others.

The third set is made up by the measures aimed at opening the Costa Rican economy and, more importantly, at promoting its exports and attracting foreign direct investment. This is an area of policy that has received strong priority for the last quarter of a century, and where there has been continuity and consistency. The results have been quite impressive. In particular, trade and FDI have been the way in which the economic potential coming from Costa Rican social and institutional development, and human capital, has materialized in diversification, technological improvement, higher incomes, and job creation.

The language that shall be used in this paper, as it is the language of this conference, would suggest that the choice of these three types of policies make up “a development strategy.” It is appropriate to point out, however, that while such a statement can be made in hindsight, it should be interpreted with care. In particular, these decisions were not necessarily made simultaneously, strategically selecting to do these things first and postpone others for later. Some of the policy omissions were indeed choices, but most were, rather, failures, in areas were reform was attempted but did not succeed. The political process itself shows some worrying signs, as it the decision‐making process has become cumbersome, and day to day management of government increasingly difficult.1

However, one should underline that in the last 20 years Costa Rica could have sacrificed or risked the large social and institutional achievements of the past, but instead chose to protect them, even during the fiscal stress of the debt crisis and post crisis. It is also the case that it was understood that no other economic objective could be attained without macroeconomic stabilization and some deregulation, and these things were pursued slowly but consistently. Finally, the priority given to export promotion was indeed a strategic choice, due to its complementarities with other measures. The somewhat good performance enjoyed since then in a variety of areas is, in my mind, primarily a consequence of these policies. So yes, there is a sense in which the three sets of policies discussed here constitute an incomplete but partially successful development strategy.

1 In Helping Reforms Deliver Growth: The role of Political and Institutional Obstacles (Center for Global Development, 2008), Jorge Cornick and I discuss in greater detail the overall economic reform process, and in particular the new difficulties in policymaking in the Costa Rica of today. I have borrowed extensively from the data work and preparatory efforts for that paper in writing this one, and thus am indebted to Cornick and our research assistant, Laura Muñoz.


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2 Is Costa Rica an economic success? In terms of income, growth and overall economic performance, Costa Rica is well ahead of the average country, yet not a dramatic success. With a per‐capita income of roughly $5,560 in 2007, it is clearly no longer a very poor country, but it is still far from the output and quality of life of developed nations. According to the IMF database, Costa Rican PPP‐corrected per‐capita income grew at an annual rate of 5.1% in the last 25 years, which makes it the second place in growth rates (see the next chart), and fourth in levels, in Latin America in that period. Hence, undoubtedly it is a dynamic economy, but its performance falls very short of a number of nations in farther lands that have achieved double‐digit growth year after year. Of course, some of the pre‐conditions for Costa Rica were particularly adverse –emerging from a deep debt crisis in the early 1980s, and facing worsening terms of trade—but others were favorable, including many years with peace, democracy and high investments in human capital.

Also, Costa Ricans do better than this income would suggest. According to the UNDP´s Report on Human Development for 2005‐06, a Costa Rican at birth enjoys a life expectancy of 78.2 years, and a 96.3% probability of reaching the age of 40, both numbers among the range for European nations. Also, 98% of the population has access to improved clean water, and 92% to adequate disposal of water refuse.

PPP per capita GDP growth 1983-2006

0% 1% 2% 3% 4% 5% 6% 7% 8%

Chile Costa Rica

Uruguay Panama

Colombia El Salvador

Mexico Brazil

Ecuador Argentina

Peru Honduras

Bolivia Guatemala Venezuela Paraguay Nicaragua


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A remarkable 98.3% of the households have electricity services, and 58.4% a fixed phone line. According to the National Household Survey, the fraction that also owns an automobile rose from 14% in 1988 to 36% in 2004. Finally, 22.4% of the public budget goes to education, and most literacy and attainment indicators are quite positive. In all these respects, Costa Rica outranks almost all countries with similar income per capita.

Growth has been very stable, as is illustrated by the following chart. Since 1983, there has not been a single year of economic contraction. Job creation has been agile, not only because the productive sector has absorbed record numbers of entrants into the labor market –a demographically large generation was joined by record levels of immigration—but also because unemployment duration is very low. The acceleration of growth in the last five years is made more remarkable by the fact that during that period this very open –and commodity‐dependent— economy has suffered 24% deterioration in its terms of trade due to the oil‐metals‐grains price boom.

Growth in the last quarter of a century has also allowed a significant fall in the poverty rate, as the next chart indicates. The extreme poverty rate (that is, the Index of Human Poverty #1 of the UNDP) is under 5%. The fraction of the population below the national poverty line (in this case estimated with a local methodology based on the ECLA definition, and not appropriate for cross‐country comparisons) which was 55% during the debt crisis, returned to the pre‐crisis levels of around 30% by 1987, and is under 17% this year. This reduction has not

Costa Rican annual GDP growth

0%

1%

2%

3%

4%

5%

6%

7%

1982-87 1987-92 1992-97 1997-02 2002-07


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happened gradually, but rather on a few isolated spurts (during the stabilization after the debt crisis, in the mid 1990s, and in the last three years).

Successful poverty reduction has not come from growth, not from a better income distribution as, quite on the contrary, inequality has increased over most of this period. The following chart shows three measures of the Gini coefficient (using wage revenues, personal incomes and total household incomes).2 While not as high as during the volatile 1970s, or as during the debt crisis of 1980‐82, it increased between 1990 and today. Costa Rica’s income disparity, while not as high as in most other Latin American nations, is very high; also, the country is strongly exposed to international trends (like the increase in the education premium) that put pressure on income distribution.

2 Elaborated by Juan Diego Trejos, of the University of Costa Rica’s Institute of Economic Research, based on the Annual Household Survey


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In summary, Costa Rica’s economic performance at first glance is not stellar, but has achieved objectives than most other countries have failed to reach, and grown faster than almost all other Latin American countries in the last 25 years. Nevertheless, there are also important weaknesses. Compared to Asian and European countries, economic growth has not been impressive; income distribution, already skewed, has been growing increasingly unequal; and in a variety of policy areas, successive efforts have not been successful. Still, there are interesting lessons to be pursued from the Costa Rican case, as I hope the following pages illustrate.

3 Identifying a development strategy In the introduction, I posed the main idea of this paper: that to the extent that Costa Rica has achieved comparatively high economic growth, and other positive indicators of economic performance, this is largely due to the effects of three sets of policies implemented in the last 20‐25 years. First, Costa Rica protected (especially, from the impact of the debt crisis) and enhanced certain social and institutional achievements, in terms of human capital accumulation, democracy and human development, which it attained during the XX Century. Second, it enacted after the debt crisis certain basic economic reforms, aimed especially at macroeconomic stabilization, but also at deregulation and liberalization. Third, on the basis of a freer and more stable economy, the high potential productivity due to human development was unleashed by the intelligent integration of the economy in the international market, through successful measures aimed at export promotion and the attraction of foreign direct investment. The purpose of the rest of this chapter is to analyze each of these areas of policy in more detail.

Gini Coefficients

0.34 0.36 0.38 0.40 0.42 0.44 0.46 0.48 0.50 0.52

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Wages

Individual incomesFamily incomes


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3.1 Human capital, social achievements and institutional development

Costa Rica has a very peculiar political history, through which it has made some fairly remarkable choices, and pursued objectives that are more in line with the goals of developed nations than of most developing countries.

• Democracy. Costa Rica is one of the oldest and most mature democracies in the developing world. For many decades, the country has been governed by civilians, with limited powers established by law and institutionally supervised, that are selected in elections that are –by the standards of their time– open, participatory and fair. Institutional design and division of powers in Costa Rica are, and for long have been, analogous to Western style democracies; rule of law is strong. Citizens have clear, ample rights, known and well defended.3

• Peace and disarmament. In 1949, Costa Rica enacted a new Constitution that, among other things, disbanded the armed forces. Since then, the country has subsisted with no army, using diplomacy to defend its interests in the world, and deviating to civilian and social objectives resources that otherwise would have gone to weapons.4 Internal and border security are kept by a police force; there are no soldiers, heavy weapons, military orders or mandatory service. The country has been effectively and fully disarmed, unilaterally, for 60 years.

• Environmental preservation. Costa Rica has invested very heavily, since the 1970s, in the protection of its environment, aware of the biological treasure within its borders, that is much larger –in terms of biomass, biodiversity and the number of indigenous species– than the size of the country would suggest. Today, about 26% of the country has National Park status, and is guarded very strictly; counting other forms of environmental preservation,

3 Most historians place the initial date of Costa Rican democracy in the 1889 elections, as this was the last episode in which there was any danger of military intervention affecting the choice of the voters. Civilian, electoral‐based rule has lasted since then. Less than a dozen countries in the planet can claim to have been democratic at that time. An alternative view considers that the episodes of 1948 – when an attempted election fraud led to violence, government resignation and a new constitution—are too important an interruption to democratic order, and that the new constitution that emerged in 1949 as a result is the true beginning of national political maturity. Even under that criterion, the Costa Rican democracy, at 59 years old, is the oldest in Latin America.

4 The UNDP 2005 Human Development Report only cites two countries, Iceland and Costa Rica, as having no military expenditures at all.


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over a third of the national territory is protected. This has allowed Costa Rica to be among the few nations in the world whose forest cover has increased, rather than shrunk, in the last two few years; the country is near being carbon‐neutral, and has the second‐lowest level of carbon emissions per‐capita among the 57 countries that the UNDP rates as “high human development.” Costa Rica has become one of the leading global destinations for environment‐related tourism, biological research and bioprospecting. Around 96% of the electricity is generated using renewable resources (hydro, aeolic and geothermic) rather than burning fossil fuels.

• Networks. Costa Rica’s networks of infrastructure are particularly deep. In even the smallest village in almost all the national territory there is a reasonable road connecting to the key highways,5 electricity service, phone service and potable water. There are schools and small clinics disseminated throughout the country. These networks have existed for a long time, and are built from the bottom‐up, in the sense that what makes them special is not the quality or size of the central arteries (the main highway, the key port, the big campus), but rather the quality, connectivity and density of the many capillaries. 6 Basic services are therefore disseminated across the country, rather than concentrated in the main cities, as in other developing nations.

• Human capital. Basic education has been mandatory since the XIX Century, and enrollment rates are (and have long been) high at all levels of education. There is an effective national system for job training, and a large number of universities and professional schools. The national health care system is broad, and 87.6% of the population is covered by health insurance through the Caja Costarricense del Seguro Social; the resulting positive health care indicators have been cited above. Worker’s rights are strong and widely respected. As a consequence, Costa Ricans have high levels of human

5 For instance, Costa Rica has more kms. of paved road per sq.km of territory than any other country in Latin America.

6 An exception to this characterization happens in certain telecom services, in particular internet and mobile phones. At 181 per 1000 inhabitants, Costa Rica has the second lowest rate of ownership of cell phones among high‐human development countries according to the UNDP 2005 report (the only worst‐off country is Cuba), and lower than 30 mid‐ or low‐development nations. There is no cellular signal in the oddest of places, including many spots in the metropolitan area.


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capital, and therefore high labor productivity. The Costa Rican worker is trained, disciplined, creative and industrious. 7

The reasons to pursue these goals are not economic. Environmental preservation, or demilitarization, for instance, are objectives in their own right, and as such are viewed by the population; there does not have to be an economic benefit in order to be worthwhile. Nevertheless, once society acquires these features, they become huge economic assets. The institutional development, predictability and rule of law of a democracy; the security, and the saving of fiscal resources, thanks to not having an army; the value that environmental preservation yields to tourism and agriculture; the low operating costs related to deep connectivity networks, etc., are huge treasures. In particular, the impact of human capital on productivity and on potential wages and output, is hard to substitute.8 In a backward, isolated and over‐regulated economy (like Costa Rica in the 1970s) these sources of wealth can not be tapped sufficiently; in a freer and more open economy, they can.

In many countries, the pursuits mentioned in this section are perceived as “luxuries” that society should afford only after it achieves growth (rather than do in order to get growth), and there is a fear that they would cost money that these governments did not have. Costa Rican history suggests the opposite; these higher goals can be economically more valuable than almost any other pursuit one can set eyes on in the shorter run.

3.2 Stabilization and deregulation Nearly 25 years ago, during the Latin American debt crisis, Costa Rica suffered a cumulative per‐capita income loss of nearly 20%.9 It was the consequence of

7 Notice for instance the emergence and dynamism of hi‐tech activities in Costa Rica, like the production of computer parts, medical equipment, and complex services. Costa Rica is a low‐wage provider of these things because the main competitors are developed nations; other poor countries simply lack the basic human skills to participate in those markets, even at much lower costs. After eight years of being heavily involved in the national FDI efforts, I am surprised about how often the quality, ability and mental flexibility of the Costa Rican people are cited as the reason why many sophisticated companies chose to operate here instead of other places that are, on paper, more competitive.

8 Most development‐accounting exercises, from Mankiw‐Romer‐Weil (1992) through Kleenow‐Rodriguez (1997) to dozens others, coincide on giving human capital a large fraction of the explanatory power for why some countries are wealthier, or grow faster, than others.

9 In general, the fiscal and balance of payments crisis of the early 1980s was proportionally bigger, and happened earlier, in Costa Rica than in the rest of the hemisphere. For instance, Costa Rica announced the default of its public foreign debt a year ahead of other countries in Latin America.


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structural problems associated with the economic model followed in the two previous decades, and of short term financial mismanagement; both weaknesses became unmanageable once terms of trade worsened during the oil crises. The structural components of the crisis were similar to those afflicting the rest of Latin America at the time: heavy‐handed state intervention in the economy, a protectionist model with good short term results but which encouraged rent seeking behavior rather than productivity and competitiveness, and an unsustainable long‐term balance of payments situation.

Financial mismanagement exacerbated the problems: exchange rate adjustments were postponed; foreign (bland) loans were used in lieu of tax increases and/or reduction of public expenditure; and rapid monetary expansion was allowed. By mid 1982, the Public sector deficit had reached a 17% of the Gross Domestic Product (GDP); annual inflation exceeded 80%; real wages had dropped one third, and the exchange rate skyrocketed when foreign reserves ran out. External debt was approximately 100% of GDP.10

After the crisis hit bottom in 1982, and a new government with strong electoral mandate was voted in, Costa Rica went through reform, in an attempt to stabilize the economy and solve some of the most blatant structural problems. Vigilance on these matters has been a constant since then.

• Fiscal adjustment. As the following charts reveal, the fiscal situation has been under control, government deficits have been low, 11 and indebtedness has plummeted. Costa Rica has kept a relatively good record since renegotiating its foreign debt in 1987, regaining access to national and international credit and maintaining acceptable credit ratings. To achieve this, Congress has frequently passed both permanent and transitory tax reforms, while expenditure growth was kept under manageable limits, mostly by postponing investments in infrastructure. Meanwhile, health, education and the environment, along with the network of safety‐net institutions, were better protected from fiscal cuts, unlike several other Latin American countries during debt recovery.

10 This summary borrows from Lizano, Eduardo, “Adjustment and growth of the Costa Rica economy 1982‐1994.” Academia de Centroamérica. San José, 1999. When otherwise unmentioned, all macroeconomic data in this paper are taken from the CEFSA database, which itself is built upon official statistics.

11 The 1994 spike reflects a one time, non recurring event: the bankruptcy of a government owned bank. Losses arising from bankruptcy were absorbed by the Treasury.


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Tax revenue as % of GDP

10%

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1982 1985 1988 1991 1994 1997 2000 2003 2006

Central Government Deficit

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1982 1985 1988 1991 1994 1997 2000 2003 2006


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• Balance of payments adjustment. Costa Rica put its balance of payments in order, even accumulating sizeable foreign reserves as a buffer. The Costa Rican colon is fully convertible, with no restrictions on the amounts that can be held, brought in and out of the country, or traded into another currency, whether for “current” or “capital” transactions. Also, short‐term interest rate policy has been applied to prevent excessive flows of short‐term capital without imposing quantitative restrictions. The real exchange rate remained fairly stable between 1984‐06, due to a crawling‐peg system designed for that purpose.12

12 Interestingly, the Central Bank announced in October 2006, after 22 years of crawling peg, a departure from the system, transitioning into price bands, presumably on the way to a free float. The logic is simple: the growth in tax revenues will allow the government, in the near future, to make transfers to the CB to compensate its financial losses, and hopefully reduce inflation. This would become futile if the Central Bank, anyway, has to issue un‐sterilizable quantities of new currency, as it supports the crawling peg in the presence of growing inflows of foreign currency due to exports, FDI and financial transactions.

Costa Rican public debt

0% 20%

40% 60% 80%

100% 120%

140% 160%

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Local

Foreign


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• Financial markets. Until 1995, Costa Rican law only allowed the government to do financial intermediation through commercial banks. Allowing the existence of private banks was a big change, which allowed more competition in interest rates, better services and wider access to credit. It required, on the other hand, the enhancement of the institutions that perform financial supervision, and the regulatory laws. In addition to banking reform, a comprehensive reform to the pension system was performed, transiting from a pay‐as‐you‐go and demographically bankrupt

Real exchange rate

93

96

99

102

105

108

111

114

Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

Multilateral Bilateral

Foreign Net Reserves

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1982 1985 1988 1991 1994 1997 2000 2003 2006

$US Mill


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system where all pensions were managed by the government, to a system that is fully funded, solvent, and allowing each individual worker to choose the (private or public) institution that manages his pension.

• Simplification. Various efforts were made to eliminate redundant paperwork, expensive interaction with government, and excessive regulation. These attempts have not been entirely successful, as red tape has a tendency to re‐emerge on its own.

• Industrial policy deregulation. The pre‐crisis Costa Rican economy was very heavily micro‐managed by the government. Some reforms since then attempted to create liberties that allowed private initiative to undertake most decisions. For example, the Central Bank ceased to set detailed loan portfolio quotas and predetermined interest rates, by sector and bank. The Economics Ministry gradually reduced the number of goods for which it regulated maximum prices; there is only one today (rice). A separate authority, based on purely technical criteria, carries out the price regulation for public services. Government no longer carries out the commercialization of grains and other foodstuffs (as it did through the “Consejo Nacional de la Producción”) nor subsidizes some products. All the publicly owned business under CODESA, a public corporation, were either closed or privatized.13

These policies created a basis of stability for individuals and companies to operate. Costa Rica has not had another moment of economic crisis since 1982: government runs ordinary finances, borrows at reasonable rates, and is never in arrears, after the debt renegotiation of 1987; reserves are sufficient and the Central Bank has been able to run the exchange rate policy of its choice; financial institutions are adequately supervised, and despite a few isolated bank failures –none of which evolved into a system‐wide problem—they (including the 50% of the banking sector that is state‐owned) operate effectively. There has not even been a single year of GDP contraction in this quarter of a century. This stability, and a simpler and less distorted economy due to basic deregulation, became the foundations for an economy where private initiative can respond to market incentives, operate and grow.

While these measures were the natural response to the situation faced in the early 1980s, they also followed the consensus among policy analysts at the time,

13 CODESA held, at its peak, two cement plants, two sugar mills (in a country that has dozens), an aluminum foil manufacturer (in a country without aluminum), several boats and ferries, the Costa Rican Stock exchange, among other companies. It never turned a profit.


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throughout Latin America and the developing world. In this sense, it is interesting not only to mention what Costa Rica did, but also what it chose not to do. For instance, unlike other countries in the hemisphere, public utilities (water, power and telecommunications) were not privatized; government continued holding (and learned to run profitably) the companies that provide those basic services. As another example, despite the depth of the expenditure restraints that became necessary to balance the fiscal numbers, the budget for key social services was protected, not cut. Expenditures on health and education, for instance, rebounded relatively quickly after the crisis was put out.14 Costa Rica, thus, implemented a somewhat heterodox reform package which, broadly speaking fit within the policy consensus of the time.

Moreover, Costa Rica was a deep reformer but a slow one. Deep because the country was building upon the foundation of good institutions and of historically‐acquired strengths (most importantly, in human capital), and also as whatever reform was implemented, was done comprehensively, seeking the support of public opinion, and with care for detail. But slow, as evidenced, most dramatically, by the fact that macroeconomic stabilization is incomplete, at least in the sense that inflation remains in double digits, and that in some key markets (telecoms, for instance) deregulation as taken very long.15

3.3 Trade and investment Arguably the main reason why Costa Rica has been able to enjoy relatively high economic growth is the progress in its efforts to internationalize its economy, liberalize trade, promote exports and attract foreign direct investment. In any economy, there are good reasons why the pursuit of globalization is a better idea than the alternatives; those reasons get enhanced in a country that is peculiar –so comparative advantage potential gains are bigger, ‐ small –so there are economies of scale to be reaped in the international market, ‐ and backward –so there is value in the technological transfer often implicit in trade and FDI. But more to the point,

14 There may be a lesson in this. Those countries that pursue fiscal probity and macro stability in the short run, perhaps under the incentive and supervision of international financial institutions, without caring about the political sustainability of what they do in the long run, will probably only show good numbers for a little while. Same goes for countries where good investments in growth foundations are the ones that get sacrificed; debt sustainability, and dynamic tax collection, usually only happen in economies that grow fast.

15 Despite the healthy finances of the non‐financial public sector, the Costa Rican Central Bank still holds a large deficit, as it was the repository of many international obligations during the debt renegotiation. This helps explain the high inflation.


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in the case of Costa Rica, the opportunity to enter the international market has become a feasible way of taking economic advantage of the many non‐economic strengths mentioned in section 3.1. This is a uniquely productive country that can compete at producing complex things in a stable environment with an educated labor force; we are not merely exporters of raw materials and low wages.

Exports of goods - FOB

0

1.000

2.000

3.000

4.0005.000

6.000

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9.000

10.000

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

FTZ manufLocal manufOther agTraditional

There are several dimensions in which the internationalization of the Costa Rican economy has been successful:

• Export growth. As the previous chart illustrates, exports of goods have grown very dramatically, from $870mm in 1982 to $9,368mm in 2007, for an average annual growth rate of 9.5%. This growth has been almost uninterrupted –exports only fell during the 2000‐2002 world recession. The engine for the expansion are not the traditional export products (coffee, bananas, beef and sugar), but rather new goods and services. For instance, other “non‐traditional” agricultural goods grew from almost nothing to surpassing the old products by 2005. Manufacturing exports have boomed, both from local firms and from foreign firms in special processing zones (FTZs). Finally, Costa Rica has become an important services provider worldwide, including prominently high‐value ecological and adventure tourism, and also professional and business‐related services, like software, back offices, medical services, etc.


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The policies that have been pursued to achieve this have been varied. Notably, trade liberalization, in the form of unilateral tariff phase‐outs and non‐tariff barrier reductions, has reduced the anti‐export bias –which is high in a country that depends on foreign raw materials for its manufacturing— and induced a more competitive supply of logistics and trade‐related services. Preferential access to key markets has been achieved and protected, be it in the form of unilateral preferences received from the US and Europe, membership in the Central American Common Market (that is slowly evolving into a Costums Union), 16 very active participation in multilateral negotiations and, notably, bilateral free trade agreements with partners that amount to 93% of the current trade, including the United States (Costa Ricans voted for membership in CAFTA in a national referendum held last October 7) and the European Union. These agreements have also been instrumental in committing to some necessary reforms. As was mentioned before, exchange rate policy has avoided real over‐valuation, and secured competitive and stable terms of trade for exporters. Finally, one should mention that between 1983 and 1998, there was an export subsidy (in the form of a tax credit worth 15% of the value of exports) that also induced many local companies, especially in agriculture, to enter the export market. While those subsidies were eliminated once they became corrupt and too expensive, today there are more sophisticated methods of support for exporters, in particular in training, technical support, simplified paperwork and improved logistics, facilitated partly by PROCOMER, a private branch of the Ministry of Foreign Trade. DAACI, another branch of that ministry, oversees the implementation of trade agreements and offers support to local exporters in dealing with the trade policies of foreign governments.

• Export diversification. Back in 1982, four unprocessed commodities that had been our staple products for one hundred years (coffee, sugar, bananas and beef) amounted to 61% of total exports; non‐durable consumption goods provided to the highly protected Central American Common Market amounted to almost everything else. Trade barriers were so high, the anti‐

16 The CACM started in the early 1960s, and products originary from these nations (almost without exception) can be sold tariff‐free within the union. There are also several joint initiatives regarding rules, and the elimination of non‐tariff barriers, among the member nations. It has been successful in promoting the economic integration among these small nations: today, along with lots of investment, nearly $3.500 million per year get traded within the common market. A commitment exists to seek the evolution of the CACM into a full costums union within the next few years.


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export bias so strong, and the currency so overvalued, that nothing outside the traditional commodities was competitive in the world markets (from which we still had to acquire most raw materials, and oil). Due to this concentration of our trade, the volatility in the terms of trade was a major source of instability for our economy.17 In the last 25 years, as the economy has opened and the CACM has ceased to be an enhanced domestic market to pursue import substitution, Costa Rican exports have diversified significantly. Today, it exports over 3000 products, and while some individual items have become relatively important, not one individual export item exceeds 17% of the total, and the implicit real price of exports is rather stable.18 This indicates that the reforms mentioned in the last bullet point have mostly unleashed the potential that Costa Rica had in new export activities, and not only enhanced the performance of the old economic drivers.

• Export sophistication. Along with diversification comes sophistication: new exports are mostly goods and services intensive in human capital, technology and advanced inputs, rather than unprocessed commodities. Emblematically, our lead export went from bananas to Pentium chips; the second item is no longer coffee but, rather, hospital equipment. More formally, Lall, Weiss and Zhang (World Development 34, 2006) develop an index of export sophistication, and find that Costa Rica’s exports are more than one standard deviation more technically complex than its income and location predict. Sophisticated export products not only grant bragging rights: this is an strategic dimension to trade policy. On the one hand, the strengths that allow a country to be a provider of medical equipment, software or specialized electronics, for instance, are deep, stable and hard to acquire; those industries are the most dynamic in today’s world economy, and once they emerge in a country, they can also evolve, and hardly disappear on a whim. Meanwhile, the natural resources and low wages that explain competitiveness in unsophisticated activities are fragile and easy to emulate. On the other hand, industries of complex exportable goods are a much better reflection than traditional products of the country’s

17 To illustrate, consider that in May 1997, you could buy 12.5 barrels of oil with a bag of unroasted Costa Rican coffee; by 2001, you could buy 2.4 barrels, and today less than one.

18 Measured in gross value, computer chips got to be 30% of total exports in 1999, shortly after the INTEL investment in Costa Rica; gross value is also very volatile, due to the oscillation of transfer prices. But value added (a much more relevant measure of the economic impact of the activity) is significantly smaller and more stable.


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development objectives. A nation that invests heavily in education wants its educated workers doing high technology, not cutting fruit; if it invests in the environment, it wants to have ecotourism, not extensive crops; if it wants women in the workforce, it wants jobs in light manufacturing and services, not herding cattle.

• Attraction of high‐quality FDI. Much of the growth in exports, especially in manufacturing, hi‐tech goods and services, takes place through foreign firms that choose Costa Rica as their location to produce; foreign direct investment has been key, and expanded very quickly, as the previous chart illustrates. Standing foreign‐owned productive capital in 2006 was estimated at nearly $6.7 billion. Most of this FDI is “greenfield” –new productive assets, not acquisitions‐ in activities that are new and strategic for Costa Rica. 19 Also, most of it seeks this location as a production facility; the attraction is NOT the size of the local market, the presence of a key natural resource or the value of a privatized state asset. FDI per capita was $360 in 2007, eight times more than China´s.

19 The exception to this is the portion of FDI associated to real estate. Not unlike other popular tourism destinations, Costa Rica is currently undergoing a real estate boom, especially in beachfront properties, which are used as second homes by US and European buyers.

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1985 1988 1991 1994 1997 2000 2003 2006

Annual flows of foreign direct investment (US$ mill)


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The driver of foreign investment, then, is that Costa Rica is a stable country (politically and macroeconomically), with a competitive enough business climate and, especially, with superb labor productivity. It is human capital what attracts companies, especially in hi‐tech activities, to Costa Rica. Of course, other policy initiatives also had something to do with this. For example, tax incentives, since there is a special tax regime for some foreign investors, who can establish in Free Trade Zones, and be exempt from taxes on profits, purchases and foreign trade, and also enjoy special, simplified administrative procedures for all imports and exports. Also, there is a private non‐profit institution, CINDE, whose whole purpose is to facilitate the foreign investment process, by promoting country brand, identifying and luring potential investors, facilitating their visits and information gathering, aiding in their decision making and installation, and maintaining contact after initial investment. It also assumes some think‐tank roles regarding the national debate about business climate improvement and competitiveness initiatives, on matters like education and training, logistics, infrastructure, energy, communications, finance, government regulation, standards, etc.

3.4 What the “strategy” has missed The story that I have described so far is one of an incomplete success. A country with some severe limitations, facing the worst economic crisis of its life, but building upon real abilities amassed during better times, initiates an agenda of reform. Several major areas of policy are left for later, or are pursued without results. On the other hand, the country does succeed in stabilizing the economy and getting out of the crisis. With that under the belt, some basic measures directed at deregulation and trade liberalization unleash the economic opportunities coming from the value of the “real abilities” mentioned above. Growth accelerates. But important as that is, the reform agenda is not complete, as there is much more to do in a variety of topics. Perhaps first among those is recovering the capability to produce infrastructure. Let me be clear. Yes, I did say above that one of Costa Rica’s historical strengths is that it developed in the second half of the XX Century a valuable and dense network of infrastructure, and that in that network priority was given, correctly, to capillaries (multiple small connections throughout the country) rather than arteries (major central projects). I also said that in designing fiscal policy after the crisis, priority had been given to stabilization, and to preserving the value of social services, so that large infrastructure projects had been correctly postponed until later.


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There is no contradiction; the situation has changed. While I believe that it was good thinking what led us to priorize rural roads over mega highways, clinics over large hospitals, and local water projects over large ports, it is now the case that, after thirty years of not building anything large, some of these delays have caught up with us. And now we can afford, without putting too much stress on the public finances, to build some of the badly needed infrastructure along with attending other needs. In fact, not building certain roads, ports and facilities is probably costing us (in lost growth and hence lost tax revenue) more than we are saving.

The problem is that today, even when resources are allocated for this purpose, we have a difficult time seeing the results. Weak government institutions, confronting an increasing and now overwhelming network of checks and balances, often loses. Not only we need to convince ourselves that now can afford –and desperately need—some key highways, at least one new airport, investment in ports, etc; we need to re‐learn how they are made.20

A second priority has to do with reform in some important services, and in particular telecoms. As mentioned above, the impressive Costa Rican achievements in human development, that make it seem a richer country than it is, stop when we look at data on telecommunications, and in particular on mobile telephony and internet services. These services are very important for a country’s business competitiveness, especially if software, back‐office services and tourism are key industries. The intense ideological debate on the topic –as the government’s telecom monopoly has come to symbolize the state‐run economy of the past that many remember fondly—has impeded the execution of almost any measure, and we have fallen behind.

As of now, it seems that we will be able to surpass that hurdle. As one of the commitments within CAFTA –the free trade agreement with the US—Costa Rica gets to keep in its government its telecom company, but a regulatory body must be created, in order to allow competition, as the company is to lose its monopoly status. A middle ground was found, were reform was neither postponed (what the most conservative Costa Ricans wanted), nor engaged including privatization (the proposal from the other end of the ideological spectrum); also, were competition is allowed, but the regulation involves a number of checks and concerns that normally the US would not want, including provisions to guarantee incentives for a universal service with progressive pricing.

20 See Cornick and Trejos (2008) as a reference for this section.


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A third priority has to do with changing the tax system, not only to enhance fairness and close a number of loopholes, but also to raise the level of revenue collected. The macroeconomic situation hardly validates this as a priority; recall the much reduced debt, and the surplus. But one should go beyond that. Costa Rican citizens expect a lot from their government, and some of those expectations are not being adequately fulfilled today due to fiscal restraints. And it is important to lower the inflation rate to international standards, an objective that would require the Executive branch to reabsorb the service of the old debts that are now held by the Central Bank, and explain its financial losses.

Fourth, as described in length in Cornick and Trejos (2008), it is vital to recover the ability of the Costa Rican government to make and implement decisions, and to run efficiently the day to day management of public affairs. While the glass is certainly not completely empty, it is the case that during the early stages of stabilization, government reform was confused with downsizing, a myriad of checks and balances were created, and weakened institutions lost effectiveness. Also, the political system is very slow, among other reasons because the congressional rules and procedures are arcane, and were designed for a two‐party system, not a multi‐party democracy.

I leave for last what I consider to be the most important topic: Costa Rica needs to find ways to improve income distribution, becoming as equitable as nations in other areas of the world. It is important to realize, along the way, that inequality is not a consequence of the measures that we undertook to accelerate economic growth in the last 25 years –in fact, the distributional problem was much worst before—but rather from the absence of new measures and policies. Rather than simply undo recent measures (as some propose), or increase the resources allocated to the same social institutions and programs that exist today, meeting our distributional challenges will require new thinking.

Why? Because the nature of the distributional problem has changed. The demographics of the Costa Rican household are different, and in fact there is perhaps 10‐15% of the population that would solve their income problems through aggregate economic growth alone. The immigration phenomenon presents quite a challenge, not only because of the sheer size of it, and the stress that the many new “clients” of government services pose; more importantly, because immigrants compete in the labor force with the Costa Ricans with similar skills and education levels, and those happen to be the poorest workers. The distributional problems of today are also related with the increase in the education premium: the wage returns of additional scholarity and training. This poses both a very valuable instrument (education efforts are more effective than ever at closing income gaps) and a challenge (those missed by those efforts are put in a bigger disadvantage).


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Much of the inequality in Costa Rica is regional (the poverty rate among the 64% of the population that lives in the Central region is less than half that of the 36% that lives in the periphery). And there are new aspects of the distributional challenges, like issues related to security and crime. For all of the above, reducing inequality will require new measures, and not simply endowing the old distributional institutions with more resources.

A more complete development strategy would have added, to the three sets of policies mentioned in previous chapters, more effective action about infrastructure, telecoms and income distribution, and higher taxation. More importantly, if the current strategy cannot deliver better outcomes on some of these other areas (in particular, in income distribution, infrastructure and security), the very sustainability of the –so far, successful‐ combination of policies would fall in question. It is important to note, for example, that the political opponents to reform, in Costa Rica, are very conservative in nature, in the sense that they idealize the country’s condition in the distant past, and that they put higher priority on undoing post‐crisis reform, than on adding other measures to it.

3.5 Who makes it happen? The role of domestic and international actors

Consensus is important in Costa Rican politics. In the local decision‐making process, a middle ground is usually sought and negotiated. For most issues, while a majority is formally sufficient to go ahead, value is placed on seeking alternatives that could have a broader basis of support. Hence the difficulty that the system has dealing with issues that are yes‐or‐no (like ratifying a trade agreement), and do not lend themselves to consensus building.

Some of the political, environmental, social and economic decisions that were described in section 3.1 were controversial during their time; for instance, the original National Parks law, or the creation of the national social security system, were not unanimously supported. Other decisions were not necessarily made consciously; the infrastructure network was built piece by piece over decades, without following a unified design, and in 1889 people were not deciding on 120 years of democracy, but rather on the outcome of a single election. But it is interesting to note that, controversial as they may have seemed, they are today nearly unanimous. Finding somebody that disagrees with democratic tradition, unilateral disarmament, environmental preservation, labor protection or the investments in health and education is nearly impossible.

The other two sets of policies are, of course, more controversial, but one has to acknowledge the value of crises to consolidate opinions. The 1980‐82 recession


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was so deep, and defenders of the status quo were so weakened, that the first couple of administrations that implemented stabilization and liberalization afterwards barely encountered opposition. The financial restraints they faced also hardly permitted considering other options.

In the process, a political class of lawyers and party activists yielded control of policy to “technocrats”, mostly economists, transforming quite deeply the way policy decisions are made. A handful of individuals are very important in this change. Technocrats were less immersed in party politics than their predecessors; they could communicate with the technocrats from other parties much more easily. Technocrats were also knowledgeable participants of an international discussion regarding policy and reform. Foreign consensus on certain topics was not only entering the country as conditions demanded by international organizations, but also as shared ideas by technocrats that participated in the debate. This allowed more local ownership of a more tailor‐made and selective set of policies than in other Central American nations. Costa Rica has not had a policy‐based program with the IMF or the World Bank since 1995, yet the general direction of stabilization and deregulation policy, that never quite got their stamp of approval, has survived 13 years since their departure, and counting.

As the dominant parties began to be joined at their technocratic, pro‐reform side, their other side manifested its opposition to the direction the country was taking, but this opposition took a long time to organize. In very recent years it finally did, around a very heterogeneous movement that shares its conservative longing for the past, and a loose membership in the left of the political spectrum. Its bases of support are, essentially, government bureaucrats, universities and the church: three bodies more popular with the old state‐linked middle class than with the emerging new working and middle classes, or with business.

The role of business organizations in the national policy debate has also evolved in the last 25 years. Initially friendly to deregulation and liberalization, and lukewarm about bearing the cost of stabilization, they opposed the opening of the economy to international trade, as they held the main beneficiaries of protectionism. As the economy as a whole became more open, however, exporting companies became a higher fraction of the private sector, and the dynamism of the local market became very sensitive to the rate of export growth; that started to turn the tide. Also, foreign companies began participating in business chambers and institutions. In the last few years, as anti‐business political forces have focused their energy on opposing trade (and, prominently, opposing CAFTA), business organizations consolidated their support for the current trade policy.


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4 Conclusion In this paper, I have argued that Costa Rica’s economic performance in the last quarter of a century has been closer to a success than a failure, and that this is the natural result of policies that have had a certain unifying logic. I have highlighted the role of three sets of policies. First are those that have made Costa Rica a special place, peaceful, stable and with valuable skills, for decades. Second, are the policies that enable the Costa Rican economy to be stable and that allows for certain basic market institutions, lacking until very recently. Finally, there is the aggressive pursuit of export‐led growth and FDI attraction.

What makes this collection of policies a development strategy is that they make collective sense: the engage in the prioritary problems and opportunities, and they complement each other well. For example, FDI attraction is particularly valuable in a place where human skills, among other characteristics, are going to attract modern companies to do sophisticated activities in the country, with large future potential. If the key comparative advantage of the country was given by the presence of a certain mineral, for example, FDI attraction would neither be difficult nor that important.

On the other hand, I am reluctant to describe this as a strategy, because it is obvious that many things are missing. In other words, that many policy areas were not consciously postponed in an effort to priorize, but rather were put front and center, attempted, and failed. In the last 10 years, distributional policies, and those related to the creation of major infrastructure, are the main such failures.

What can other countries learn from this experience? I believe that the main lesson is that some very fundamental societal challenges, related to social, human and institutional development, are too valuable to leave for later. I can think of no economic decision undertaken by Costa Rica that has yielded more economic fruits than democracy, disarmament, environmental protection or social programs. The very phrase “Second Generation of Reforms”, lately used to refer to these concerns about human capital and institutions, in a way suggests that these were things to be attempted later, after a stable and dynamic market economy had been built. But at least in Latin America, looking back at our numbers about comparative growth rates, there is something to be said about the fact that Chile, Costa Rica and Uruguay, the three countries that more clearly seem to have attempted things in the opposite order, are also the three fastest growers in the last two decades. Strategies that neglect this, try to get quick solutions from quicker policies, and leave these fundamental priorities for later, will very dubiously succeed past the simple achievement of apparent macroeconomic stability, and the growth of some simple, low‐cost industries.


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A second lesson is the role that consensus, local validation, and a “tailor‐made” approach, played in Costa Rican policy‐making. We may have been slow implementing these policies, but we also have been consistent, and certain directions, once taken, hardly reverse on a whim. Countries were policy design comes from outside with little customization, or were governments rush to act without creating a wide enough basis of support, may be quicker to act, but probably will also be quicker to undo.

A third and final lesson has to do with the value of trade for a very small, developing economy. The fact that reforms were able to generate some quick successes, and a basis of support, had to do with the velocity and strength with which trade policy yielded results. I am very convinced that there is no coincidence in the fact that no small country has achieved very fast rates of growth while pursuing isolation. The value of exploiting comparative advantages, operating in a larger market, subjecting local monopolies to competition, adopting technology and having a piece of the economy that can grow double digits, is just too large to give up. The Costa Rican trade story is no defense of laissez faire, as the successful policies were often proactive. It offers no guarantees, as the process to develop a dynamic export sector, and attract interesting companies, involved complex challenges and required good design. But it does help to conclude that for the smallest countries in the developing world, joining the global markets is a wonderful opportunity, at least when done well.

trejos costa rica - facultyfaculty.nps.edu/relooney/success-costarica.pdfalso, costa ricans do...

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