Public Information Notice No. 01/24

Public Information Notice: IMF Concludes Article IV Consultation with Dominican Republic

March 14, 2001

On February 23, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Dominican Republic.¹

Background

For most of the last decade the Dominican Republic experienced an extended period of robust economic growth, declining unemployment rates, modest consumer price inflation, and a generally manageable external position. Indeed, in recent years, the Dominican Republic ranked among the world's fastest growing economies, with particularly strong performances in the construction, telecommunications, tourism, and free-trade sectors. In 2000, although economic growth continued at a brisk pace, higher oil import costs and a weakening of macroeconomic policies (associated with the electoral cycle) led to a widening of the external current account deficit and pressure on foreign exchange reserves.

In 1999, real GDP expanded by 8 percent, driven by domestic demand, especially investment. Despite the strong economic activity and a one-time adjustment in domestic fuel prices in October averaging about 20 percent, inflation remained subdued, helped by a fall in food prices as agricultural output recovered following Hurricane Georges. Greater-than-expected foreign direct investment more than financed the external current account deficit, contributing to an accumulation of almost US$200 million of official net international reserves (NIR). At end-1999, gross reserves reached the equivalent of one month of projected 2000 imports, 14 percent of M2, and 71 percent of short-term external debt—a modest improvement relative to end-1998.

Fiscal policy slippages emerged in the second half of 1999. Election-related expenditure overruns were compounded by delays in adjusting domestic fuel prices, resulting in dramatically reduced government proceeds from the oil differential. As a result, the central government deficit widened by one percentage point of GDP. The overall consolidated public sector deficit widened marginally to 2.8 percent of GDP, compared with the authorities' target of near balance. The quasi-fiscal deficit of the central bank remained broadly unchanged in relation to GDP at a half percent of GDP. The central government fiscal slippage, large capital inflows, and rapid growth of credit to the private sector put upward pressure on domestic demand and inflation, while monetary policy continued to rely on direct measures, such as temporary ceilings on bank credit.

With economic activity remaining buoyant in 2000, capacity constraints became binding and inflationary pressures heightened. Rising interest rates and less credit availability contributed to a deceleration of growth toward the end of the year. Growth was concentrated in the wholesale, retail, tourism, and manufacturing sectors. Domestic demand expanded at an even brisker pace, sustained primarily by private consumption, in contrast to 1999, when investment was the driving force. For the year as a whole, real GDP is estimated to have expanded by 7.8 percent. The rapid growth of domestic demand pushed the 12-month inflation rate to 9 percent by December. The unemployment rate declined, as output growth exceeded an increase in labor force participation rates.

The consolidated public sector deficit narrowed somewhat in relation to GDP in 2000. Central government revenue growth (13 percent) is estimated to have outpaced expenditure growth (10 percent), reflecting some tightening toward the end of the year. The deficit of the public enterprises (net of central government transfers) is estimated to have narrowed by one percent of GDP.

Brisk private sector demand, together with the persistent fiscal deficit in 2000, put pressure on official foreign exchange reserves. The stock of NIR fell to US$197 million in August (compared with US$547 million at end-1999). In response, in September the central bank increased exchange rate flexibility, adjusting the official exchange rate more frequently (weekly), and by year-end, NIR stood at US$442 million. Strong private sector credit demand combined with central bank credit controls, put upward pressure on interest rates—lending rates reached about 30 percent toward year-end, compared with 25 percent at the beginning of the year.

Reflecting strong domestic demand and the higher oil bill, the external current account deficit is estimated to have more than doubled, reaching 6.3 percent of GDP in 2000. Exports of goods and services continued to show robust growth, but the oil import bill increased by US$650 million (2½ percentage points of GDP). Gross receipts from free-trade-zone exports, tourism, and remittances from abroad, continued their strong expansion, growing by 10-16 percent, and representing a combined total equivalent to almost half of GDP. Nonetheless, the non-oil current account surplus is estimated to have declined by about one percent of GDP in 2000, reflecting the rapid expansion of domestic demand.

Pressures in the foreign exchange market intensified in 2000. The exchange rate spread widened to 2 percent, before a devaluation of that amount on September 5. At end-2000, gross reserves (US$637 million) were equivalent to one month of projected 2001 imports (goods and services, net of free-trade-zone imports), 11 percent of estimated M2, and 59 percent of short-term external debt.

Progress has been made in improving the supervision and regulation of the financial system. The authorities' program of financial reform, initiated in 1991, has included liberalization of interest rates, rationalization of reserve requirements, adoption of regulations allowing the establishment of universal banks, restructuring the Superintendency of Banks, and consolidation of the banking system. According to the authorities, banks are in compliance with capital adequacy norms. In June 2000, the risk-based capital adequacy ratio for the banking sector stood at 11.4 percent, compared with a minimum requirement of 10 percent. In the face of increasing operations in foreign currency, the authorities have strengthened regulations on this type of operation with the aim of preventing excessive foreign borrowing by banks and monitoring exchange rate risk. In January 2001, the Monetary Board approved new prudential norms on loan classification, provisioning for credit risk, measurement of market risk, and provisioning for market risk.

Executive Board Assessment

Executive Directors commended the authorities for the solid performance of the Dominican economy in recent years, noting in particular the strong growth and low inflation over an extended period of time. They attributed these developments to prudent monetary and fiscal policies and the adoption of key structural reforms. Directors noted, however, that the weakening of fiscal policy in the run-up to the May 2000 presidential election coincided with a pick-up in inflation and a sharp deterioration in the terms of trade, leading to a substantial loss of foreign exchange reserves.

In light of the above, Directors welcomed the new authorities' commitment to strong policies, particularly through an ambitious fiscal adjustment planned for 2001, which should support the envisaged international reserve buildup. They highlighted the importance of the recent revenue measures, including a new hydrocarbon law and an increase in the value-added tax. These measures will help to ensure that adequate resources are available to finance priority expenditures in the social sector and for basic infrastructure, while maintaining macroeconomic stability. To complement the revenue measures, Directors underscored the importance of implementing adequate expenditure monitoring and control mechanisms to ensure that the budget's expenditure targets are not surpassed. In this regard, Directors urged the authorities to conduct a thorough review of public expenditure in order to promote expenditure rationalization, to heighten the quality of social outlays, and to help control overall expenditure. They also noted that publishing full information on how tax revenues are spent is key to improving governance. To enhance transparency and accountability in the budget process, Directors urged the authorities to proceed as quickly as possible with the integrated financial management program being implemented with the assistance of the Inter-American Development Bank.

Directors supported the authorities' plans to increase reliance on indirect monetary policy instruments and urged them to approve a new version of the Monetary and Financial Code that gives full independence to the central bank. Directors noted the progress that has been made in strengthening domestic prudential norms, including the recent tightening of classification and provisioning standards and the new requirements that banks monitor and provision for market risks. They welcomed the authorities' participation in the Financial Sector Assessment Program. Directors emphasized the importance of improving the transparency of commercial banks' reports, particularly as regards the volume of nonperforming loans, and looked forward to reviewing the forthcoming Financial Sector Stability Assessment report.

Regarding the external position, Directors noted that the medium-term prospects for the balance of payments are generally favorable. They noted, however, that the economy is still vulnerable to sudden and unexpected shocks, which called for a strengthening of the international reserves position. Therefore, they supported the authorities' prudential efforts to raise the stock of official net international reserves this year, as well as their longer-term objective to continue rebuilding reserves. In this context, Directors strongly encouraged the monetary authorities to continue to move toward a more flexible exchange rate policy. They stressed that attainment of the medium-term objectives will require strong and sustained policy implementation across all fronts. Directors welcomed the recent substantial reduction of import tariffs, which will foster the integration of the Dominican Republic into the world economy. Directors also called for the elimination of two existing multiple currency practices, and welcomed the authorities' commitment to reduce the foreign exchange commission during 2001.

Directors noted the substantial progress made in implementing structural reforms, although they stressed that improvements in the power sector should be speeded up. They emphasized the need for enhancing competition and establishing, as soon as possible, an adequate legal and regulatory framework for this sector of the economy. Directors also noted that further restructuring or divestment of other public sector assets, including state-owned financial institutions, would help to improve efficiency in the economy.

Directors were encouraged by the authorities' recognition of the need to improve the quality and timeliness of economic and financial statistics in conformity with the Fund's guidelines. They welcomed the efforts that are already underway to deal with the most serious data weaknesses. They underscored the importance of making progress in this area, especially with respect to the fiscal accounts, in order to facilitate policy making and effective surveillance. They also encouraged the authorities to subscribe to the SDDS.