Public Information Notice No. 02/66

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Dominican Republic

June 26, 2002

On June 7, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Dominican Republic.¹

Background

A stabilization and structural reform program, initiated in the early 1990s, helped to triple the average annual real GDP growth rate from 2¼ percent a year in the first half of the decade to 7¾ percent a year in the second half. Growth was supported by rising investment, including substantial foreign direct investment in the electricity, telecommunications, free-trade-zone, and tourism sectors. However in 2001, the economy was affected by two external shocks—the economic slowdown in the United States and Europe and the September 11 terrorist attacks. These shocks broadly coincided with the introduction of a package of fiscal measures, which had been designed in response to an overheating of the economy in the run-up to the 2000 presidential election. As a result, the economic growth rate fell by two-thirds to 2.7 percent in 2001. The weakness of economic activity, and declining international oil prices, contributed to a halving of the inflation rate to 4.4 percent at end-2001, while the unemployment rate rose to 15.6 percent (from 13.9 percent in 2000).

On a cyclically adjusted basis, the overall fiscal stance was restrictive (and broadly appropriate). The central government's fiscal deficit narrowed by half a percentage point of GDP to 1.7 percent, reflecting the fiscal adjustment. The net effect of the fiscal adjustment is estimated at 1½ percent of GDP. Part of the fiscal savings was offset by increases in the wage bill and investment outlays. The overall balance of the consolidated public sector remained unchanged at 2 percent of GDP, as the improvement in the central government deficit was offset by a deterioration in rest of the public sector.

As a result of the weakening of economic activity, the authorities eased the monetary stance in 2001 through the redemption of central bank paper. Lending rates fell by 800 basis points, to about 22 percent, contributing to an expansion in private sector credit by 24 percent (in line with the rate of increase in previous years, but double the rate of expansion of nominal GDP). The increase in liquidity also led to a near doubling of the rate of growth of broad money to 24 percent in 2001 (relative to 2000), while excess reserves jumped from 2.5 percent to 4.2 percent of base money.

Over the last several years, commercial bank foreign currency operations have been increasing due to a combination of a closely managed exchange rate (i.e., fixed for long periods of time), relatively lower borrowing costs abroad, and lower reserve requirements on foreign currency deposits than on domestic deposits. In 2001, foreign currency deposit growth accelerated strongly, possibly reflecting a perceived increase in exchange rate risk associated with the external shocks. These deposits were intermediated by commercial banks, resulting in a corresponding increase in foreign currency lending. By end-2001, foreign currency deposits and loans had risen to the equivalent of 7 and 8 percent of GDP, respectively, compared with 1 percent of GDP each in 1997.

Falling oil prices led to a narrowing of the external current account deficit in 2001 (to 3.9 percent of GDP from 5.2 percent of GDP in 2000). A large decline in oil imports was partly offset by a fall in export and tourism receipts (as a result of the external shocks). Net capital inflows remained strong as the sovereign bond proceeds and rising foreign direct investment (directed mainly to the electricity, tourism, and financial sectors) more than offset a reversal of short-term capital inflows (possibly owing to the decline in domestic interest rates). External public sector debt remained manageable at 19.5 percent of GDP. Excluding the US$500 million in proceeds from the sovereign bond issue, Net International Reserves (NIR) fell short of the end-2001 target (US$600 million), reaching US$462 million, only US$20 million over end-2000. Including the bond proceeds, by end-2001, gross official reserves stood at 1.8 months of imports of goods and services and 96 percent of short-term debt by residual maturity.

Toward the end of 2001, and into early 2002, the authorities tightened the stance of monetary policy, reflecting concern over pressures on the exchange rate from the liquidity in the banking system. Furthermore, the central government curtailed spending in January and the first half of February 2002. The central bank sold dollars in order to ease the pressure on the peso. As a result, NIR fell by over US$200 million in January–February, compared with an average decline of less than US$100 million in the corresponding period of the previous five years. On April 2, 2002, the Monetary Board issued a resolution mandating that the official exchange rate be set equal to a weighted average of the previous day's market rates, and immediately devalued the official exchange rate by 2½ percent. Since then the peso has shown a depreciating trend.

The Financial Sector Assessment Program (FSAP) mission found no strong signals of financial distress. However, it noted that the lack of appropriately calculated indicators, and the difficulty of assessing developments over time as a result of changes in definitions and prudential norms, precluded a definitive assessment of the health of the financial system. However, the authorities are implementing new norms that will require the use of better quality indicators, thus allowing a more accurate assessment of the health of the financial system. According to official estimates, the ratio of nonperforming loans in 2001 was broadly unchanged (relative to 2000) at 2.2 percent (this definition treats only the overdue portion of the loan as nonperforming, not the entire loan balance), while the risk-adjusted capital asset ratio remained stable. The authorities are revising the definition of nonperforming loans to bring it more in line with international standards. Bank profitability declined in part because of the economic slowdown and higher provisioning as a result of stricter classification and prudential norms. The Superintendency of Banks is strengthening its supervisory capacity through technical assistance from the InterAmerican Development Bank. The Superintendency of Banks raised penalties for misclassification of loans, established accrual accounting, and created an anti-money laundering unit. In February 2002, the Monetary Board endorsed a draft Monetary and Financial Law (MFL), aimed at modernizing the legal and regulatory framework. The draft is to be sent to congress later this year.

Executive Board Assessment

Directors commended the authorities for their longstanding commitment to macroeconomic stability and the implementation of key structural reforms, which have been instrumental in enabling the Dominican Republic to achieve strong economic growth and low inflation in the past decade. However, a significant slowdown of economic activity occurred last year due to an unfavorable international environment coupled with fiscal tightening necessary to contain signs of overheating.

Against this backdrop, Directors welcomed the authorities' commitment to reinvigorate the reform process, while maintaining macroeconomic stability, to restore the strong growth of the past. They also underscored the importance of further reducing the vulnerability to shocks by strengthening external competitiveness, building a larger foreign exchange reserve cushion, and further strengthening the banking system. Continued prudent monetary and fiscal policies, a flexible exchange rate regime, and efficiency-enhancing structural reforms, will help the authorities meet these objectives.

While the fiscal stance is broadly appropriate, Directors saw scope for a modest further tightening through reductions in the wage bill, nonessential current expenditures, and low priority capital expenditures. If sustained over the medium term, savings in these areas will create welcome room for higher social spending and infrastructure investments. Directors urged the authorities to press ahead with their efforts to strengthen public debt management, including the phasing out of domestic arrears.

Directors encouraged the authorities to continue to tighten the monetary conditions until excess liquidity is reduced substantially and private sector credit growth slows to a rate more in line with economic activity and the inflation objective, while being careful not to curtail the recent recovery. They welcomed the move away from a managed exchange rate toward a more market-determined one, as well as the authorities' commitment to further build up official reserves.

Directors noted that, based on preliminary data, available financial sector indicators do not show a deterioration of loan portfolio quality. Nevertheless, the authorities should continue to monitor the situation closely in view of the recent slowdown in economic activity.

Directors were encouraged by the progress made in reforming the legal and regulatory framework for the financial system. They welcomed the steps that the authorities are taking, following their participation in the FSAP, to follow up on the recommendations contained in the Financial Sector Stability Assessment Report, and encouraged them to continue their efforts to strengthen the financial system. They strongly welcomed the authorities' intention to bring banking sector statistics more in line with international standards.

Directors urged the authorities to eliminate multiple currency practices, which introduce distortions in the foreign exchange market that hamper its efficient functioning. The adoption of a firm timetable, as contemplated in the draft Monetary and Financial Law for the elimination of the multiple currency practices, would be a welcome step in this regard.

Directors noted that trade and structural reforms have led to a more open, dynamic economy. These reforms will need to be sustained to ensure continued strong growth and improvements in social welfare. They supported the authorities' efforts to press ahead with their reform agenda, including enhancing policy transparency and improving governance. A top reform priority should be the electricity sector, where high costs and complex financial arrangements are having negative effects on the rest of the economy. Directors commended the authorities' efforts to combat money laundering and the financing of terrorism.

Directors commended the authorities for the improvements in the quality of economic and financial statistics, which allow for effective Fund surveillance. Future efforts should address delays in the preparation and publication of data for the consolidated public sector and uncertainties about the extent of domestic arrears. Directors encouraged the authorities to participate in the General Data Dissemination System.