Public Information Notice No. 05/162

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Dominican Republic

December 7, 2005

On October 17, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Dominican Republic.¹

Background

The Dominican Republic has staged a remarkable turnaround in economic and financial conditions since mid-2004. In 2003, a deep financial crisis led to a severe recession combined with a significant rise in public indebtedness, high inflation, and depreciation of the currency. Upon taking office in August 2004, a new administration formulated a comprehensive and ambitious program aimed at addressing the weaknesses in macroeconomic policies and in a wide range of structural areas. The rebound in confidence and activity that followed has resulted in a virtuous cycle of declining inflation and interest rates, reserve accumulation, and exchange rate stability. The Fund approved a 28-month Stand-By Arrangement in January 2005 in support of this program.

The economic recovery is strengthening and inflation has declined considerably. Real GDP growth accelerated to 5.8 percent year-on-year during the first half of 2005, reflecting strength in communications, commerce, and tourism-related activities, and it is projected at 4.5 percent for the year as a whole. On the demand side, a rebound in private consumption led the recovery, as confidence and real incomes rose. In this context, the unemployment rate dropped from 19.7 percent in 2004 to 18.4 percent in the first half of 2005. The 12-month inflation rate fell from 28.7 percent in December 2004 to about zero in August 2005, and is projected at 6-9 percent during 2005.

The external current account surplus has narrowed from 7.6 percent of GDP in 2004 to 2.3 percent in the first half of 2005 due to stronger domestic demand and rising oil prices. A further narrowing is expected for the year as a whole. The current account surplus and lower-than-expected net private capital outflows (including errors and omissions) supported an increase in net international reserves (NIR) to about US$650 million in September 2005.

Central bank's net domestic assets have been reduced and base money has remained stable. While the stock of central bank certificates has risen due to the sterilization of foreign exchange purchases and interest payments on the debt stock, maturities have been lengthened and interest rates have declined substantially.

There has been a major fiscal adjustment in the first half of 2005, as the non-financial public sector moved from a deficit of 3.3 percent of GDP in 2004 to a surplus of 1.2 percent, reflecting buoyant revenues, tight expenditure control, and savings in the interest bill arising from a more appreciated peso. Government transfers to the electricity sector are expected to remain high, however, due to lack of success in improving the cash-recovery index of public distribution companies, higher generation costs caused by rising oil prices, and increased electricity supply. To improve performance, the authorities recently appointed private managers to the state-owned distributors.

The authorities have made major progress in external debt restructuring. They have successfully engaged creditors in a collaborative effort to address the public sector's short-term liquidity constraints, in a manner consistent with debt sustainability. Two global bonds with a principal of US$1.1 billion were exchanged, extending the maturity of this debt by 5 years; bondholders' participation reached 97 percent. At the same time, memoranda of understanding have been signed with external commercial banks and suppliers to restructure debts equivalent to about US$550 million. Paris Club creditors are scheduled to consider comparability of treatment and the rescheduling of pre-cut-off-date obligations maturing in 2005 in mid-October. Success in debt restructuring has led to improved credit ratings and reductions in external bond spreads, which have fallen from around 700 basis points in early 2005 to close to 300 basis points.

Progress on structural reforms has gained momentum recently, with the submission to Congress of a tax reform and draft legislation to strengthen fiscal institutions. Progress has also been made in bringing bank regulations in line with international best practices and ensuring that banks meet capitalization requirements.

Executive Board Assessment

Executive Directors commended the Dominican Republic's authorities for the implementation of sound macroeconomic policies and the progress made in addressing institutional weaknesses, which have resulted in a significant improvement in economic performance since the financial crisis of 2003. Economic growth has accelerated, inflation has fallen to very low levels, unemployment and the public debt ratio have declined, and net international reserves have risen considerably. Directors considered that the rapid return of confidence and financial stability has created a promising base for consolidating the progress made and further strengthening economic institutions.

At the same time, Directors stressed that significant vulnerabilities remain that may yet jeopardize growth and stability. They highlighted, in particular, the considerable fiscal challenges; the remaining financial risks; the pervasive institutional weaknesses in the fiscal, electricity, and banking sectors; and high oil prices. Directors urged the authorities to take advantage of the improved economic climate to push ahead decisively with the structural reform agenda.

Directors welcomed the decline in the public sector deficit, and called for further consolidation of the public finances to reduce macroeconomic vulnerabilities. They commended the authorities' intention to achieve a primary surplus that would generate the resources needed to reduce the consolidated debt-to-GDP ratio over time to more manageable levels. Directors encouraged the authorities to save at least some of the windfall from lower-than-expected interest payments, and to strongly resist spending pressures in order to achieve the needed fiscal adjustment.

Directors welcomed the tax reform presented to Congress, which will improve the equity and efficiency of the tax system by broadening the tax base, bringing excises closer to international levels, and increasing reliance on withholding schemes to curb tax evasion. Directors stressed that the timely passage and implementation of the tax reform is essential in light of the expected revenue losses that will follow the dismantling of trade-related taxes, the foreign exchange commission, and the financial transactions tax. Directors encouraged the authorities to protect and better target social spending, including energy subsidies.

Directors stressed that achievement of the medium-term fiscal targets will depend largely on ongoing efforts to strengthen the fiscal framework as well as fiscal transparency and accountability. They noted that weaknesses in coordination among different public sector agencies continue to hinder planning and execution of fiscal policy. They urged the authorities to seek early congressional approval of the proposed legislation to overhaul financial management procedures and centralize fiscal functions in one cabinet post. In addition, Directors welcomed the proposed organic budget law, which will reinforce the role of the budget in limiting and allocating spending, thereby enhancing the government's ability to meet the fiscal objectives. Directors acknowledged the progress made in improving the fiscal statistics, particularly regarding externally-financed investment projects. They advised the authorities to strengthen reporting procedures and the overall monitoring framework so that deviations can be identified and corrective actions taken promptly.

Directors urged the authorities to address decisively the continuing high operating costs and low revenue recovery of the electricity sector, particularly the state-owned distributors, to mitigate fiscal vulnerabilities stemming from quasi-fiscal losses. In this regard, Directors noted the need to modify the regulatory framework to reflect best practices. They welcomed the appointment of private managers for state-owned distributors, and stressed that these managers should have full powers to take the necessary measures to reduce fraud, terminate service to delinquent customers, and rationalize staffing levels.

Directors commended the central bank for its success in quickly bringing down inflation and restoring the credibility of monetary policy. They observed that the main challenge for the central bank is to refine its policy framework to enhance monetary control and policy communication, while allowing an appropriate role for market forces in determining interest rates. In this regard, they advised the central bank to move gradually toward specifying the objective for inflation and formalizing an inflation-targeting framework. Some Directors cautioned that inflation targeting should not be introduced before the institutional framework is fully in place and inflation expectations are sufficiently stable. Directors also stressed the need to strengthen the independence of the central bank, and encouraged further development of a domestic money market.

Directors encouraged the central bank to continue supporting a flexible exchange rate system, with intervention geared at meeting the reserves targets and smoothing short-term fluctuations.

Directors welcomed the improvements to the banking regulatory framework, but noted that enhancing the capacity and independence of the superintendency of banks remains a key priority. They called for early submission and approval of the revised Monetary and Financial Law to the Congress. Directors urged the authorities to take advantage of the current positive macroeconomic conditions to enforce regulations effectively and to encourage banks to improve their loan portfolios and the quality of their balance sheets. This should be supplemented by consolidated accounting and supervision measures. Directors welcomed the publication of the report by an independent panel of experts on the institutional weaknesses that contributed to the banking crisis of 2003. They stressed that full prosecution of those involved in fraudulent practices leading up to the banking crisis is essential to ensure observance of the financial laws. Directors welcomed the authorities' intention to implement the recommendations of the safeguards assessment of the central bank.

Directors commended the authorities for their market-friendly approach in conducting a successful debt exchange and in discussing debt restructuring with private creditors. They encouraged the authorities to continue with this approach, which is consistent with the Fund's policy on lending into arrears, until all debt restructuring negotiations are finalized.

Directors encouraged the authorities to modernize the institutional and legal framework to enhance competitiveness and reap the benefits of the Dominican Republic-Central American Free Trade Agreement. Directors noted that the most important gains are likely to be dynamic, as new opportunities are created.