* Capital inflows soar amid interest rate arbitrage
* New measures seek to limit private sector credit
* Officials fear destabilizing foreign capital exit
By Isabella Cota
SAN JOSE, Jan 31 (Reuters) - Costa Rica will slap limits on bank lending in a bid to prevent borrowers from exploiting an interest rate gap that has sparked a local credit boom and drawn an influx of potentially destabilizing foreign capital.
Over the last two years, locals and foreigners alike have been taking advantage of differences between the rates on dollar- and colon-denominated loans and borrowing heavily in dollars - a repeat of lending practices that have caused havoc in other emerging markets.
The interest rate gap was so wide that for a brief period last year, savvy investors could take out a dollar loan at 6 percent and deposit the same funds in local currency to earn more than 11 percent: a gain of 5 percent or more.
Central bank President Rodrigo Bolanos said on Thursday state and commercial banks would face limits on lending in both dollars and colons this year to curb the lending boom and reduce the attractiveness of colon deposits.
“The measures will temper private sector credit growth and contribute to a rebalancing of this portfolio toward the national currency to avoid families and businesses becoming too exposed to currency risk,” the central bank said.
The gap between dollar loans and colon deposits has now narrowed to about 1 percent. But foreign investors still see Costa Rica’s benchmark rate of 8.3 percent as attractive, given rates near zero in developed economies, and continue to convert dollars into colons to invest in local debt.
This puts upward pressure on the currency, which the central bank aims to keep in a band against the U.S. dollar, and officials fear it could lead to destabilizing outflows when the investments mature and the trade is reversed.
Policymakers have announced higher taxes on foreign investment to deter speculators. The latest measures aim to limit the domestic implications of the interest rate gap.
Growth in private sector credit leapt from 5.9 percent in 2010 to 11.9 percent in 2011 and 15 percent in 2012, with dollar loans soaring 18.7 percent last year, central bank figures show.
Eastern European countries have struggled to control problems stemming from similarly heavy borrowing in foreign currencies. In Hungary, for example, many households took out loans denominated in Swiss francs because of lower rates.
But when the global crisis pushed the forint down sharply against the franc, rising loan payments pushed families to default on mortgages, cut private spending and strained bank balance sheets, dragging on the country’s economy.
Under the new limits to apply until Oct. 31, banks whose credit in dollars grew by more than 20 percent in 2012 will not be able to lend more than 30 percent of the amount loaned last year.
Those that registered growth in dollar loans of under 20 percent will only be able to increase credit by 6 percent and credit growth in colons will be capped at 9 percent. But it was not clear how the limits would be enforced.
“What really doesn’t help is when the banks bring in dollars from overseas to lend them here because it’s cheaper to do that than lend in colons,” Costa Rica central bank General Manager Felix Delgado said.
Growth in Costa Rica’s economy, which is about the same size of the U.S. state of Maine, is forecast to slow to 4 percent this year from an expected 5.1 percent in 2012, according to new central bank forecasts.
Bolanos said Costa Rica would keep its inflation target at 5 percent in 2013-14, with a 1 percentage point tolerance zone on each side.
The exchange rate band will also remain. Costa Rica aims to set a 500-per-dollar floor for the colon with a creeping ceiling. Defending that band forced the central bank to spend $1.5 billion buying dollars between March 2012 and Jan. 11, with 84 percent of the purchases made after September as overseas investors piled into the interest rate carry trade.
The country emerged as an investment hotspot last year when it returned to international debt markets with a successful Eurobond issue, its first foray into international markets since 2004. The central bank said Costa Rica would aim to issue another $1 billion in Eurobonds each year in 2013 and 2014.