Dominica: Debt Sustainability Analysis
Author:
International Monetary Fund
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Publication Date:
20 Sep 2007
eISBN:
9781451810967
ISBN:
9781451810967
Language:
English
Keywords:
ISCR; CR; debt; Dominica; authority; reform strategy; government; debt path; creating flow; sustainability framework; debt service-to-revenue; debt to GDP ratio; Debt sustainability analysis; Public and publicly-guaranteed external debt; Caribbean; service-to-revenue ratio
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This 2007 Article IV Consultation highlights that Dominica has fully recovered from the 2001–02 economic and financial crisis. Output growth has rebounded, reaching 4 percent in 2006, and it is expected to remain above trend in 2007. The rebound is driven by a pickup in tourism, recovery in banana production, and buoyant construction and offshore school activity. Inflation has remained subdued, reflecting stabilizing oil prices, and is projected to remain low. The external current account deficit narrowed sharply in 2006, and is likely to remain large at about 20 percent of GDP in 2007.

Abstract

This 2007 Article IV Consultation highlights that Dominica has fully recovered from the 2001–02 economic and financial crisis. Output growth has rebounded, reaching 4 percent in 2006, and it is expected to remain above trend in 2007. The rebound is driven by a pickup in tourism, recovery in banana production, and buoyant construction and offshore school activity. Inflation has remained subdued, reflecting stabilizing oil prices, and is projected to remain low. The external current account deficit narrowed sharply in 2006, and is likely to remain large at about 20 percent of GDP in 2007.

I. Introduction

1. After a restructuring of its public sector debt, a strong fiscal turnaround, and a rebound of economic activity, Dominica has been able to improve its debt sustainability outlook. The debt restructuring that started in 2004, jointly with donors help, allowed a reduction in debt’s face value and improved the terms of a large portion of the existing debt. The central government primary balance, which had been in deficit since 1997, has exhibited sound surpluses in the last three years in the context of a PRGF program (concluded in December 2006). Growth rebounded under program and the government has started the implementation of the Growth and Social Protection Strategy (GSPS), which constitutes a comprehensive strategy to foster private sector-led growth and reduce poverty while maintaining prudent fiscal policy.

II. Underlying DSA Assumptions

2. Staff has prepared a baseline scenario whose main parameters are consistent with the authorities projections under the GSPS, and with staff projections and assumptions in the 2005 Article IV consultation DSA.

Baseline Macroeconomic Assumptions (2007-27)

  • Real GDP growth is projected at 3 percent (as in GSPS and 2005 Article IV DSA). While this assumption implies a rate of growth higher than the average observed in the 1990s (2 percent), it seems consistent with the stronger growth observed in the period 2004-06, with the reforms envisaged, and with the projected international environment (see Box 2). Inflation is projected to remain low (1.5 percent per year), consistent with historical averages.

  • Primary balance of the central government remains at 3 percent of GDP over the projection period (as in GSPS and 2005 Article IV DSA), while public enterprises run an overall deficit of 0.5 percent of GDP. The assumption about the government primary balance is consistent with the strong fiscal turnaround Dominica has had in recent years. The assumption on public enterprises follows the average observed during the period 1999-2006. External grants are assumed to remain at 8.3 percent of GDP broadly in line with the GSPS. This number is high by historical standards although it is lower than the grants actually received and not out of bound given the authorities’ attempt to improve the management of aid and aid-related expenditures. Given the uncertain grants outlook, we undertake a stress test below.

  • Annual disbursements of external concessional debt reach 1.5 percent of GDP (as in 2005 Article IV DSA), consistent with the country’s public sector investment program (PSIP). The financing terms are similar to those of existing external debt. New domestic financing is projected to be available at an interest rate of 7 percent (as in 2005 Article IV DSA).

  • The current account deficit is assumed to remain high in a transition period (2007-12), while gradually falling to a level fully financed by the projected external grants and FDI. This assumes that: (i) banks continue to use their external assets to extend domestic credit and that the government draws down its deposits to finance its investment program (government deposits in domestic banks have increased substantially given the recent increase in grants received. Banks have allocated a large fraction of those deposits to external assets); and (ii) the loss of export revenue associated with the closure of a large factory is partially and temporarily compensated by a decline in private agent’s foreign assets.

  • FDI is assumed to remain at the 2006 level (8 percent of GDP). While this number is higher than its historical average (so helping finance the current account), its actual net impact is not large since it is linked in the projections to foreign firms’ retained earnings (which increase the current account deficit).

III. Evaluation of Public Sector Debt Sustainability

Dominica’s public debt as of end-2006

3. As of end-2006 Dominica’s public sector debt stood at 102 percent of GDP, of which 71 percent of GDP represented external debt and the remaining 31 percent represented domestic debt. Regarding the external debt, the largest share is owed to multilateral creditors (around 43 percent of GDP, with the Caribbean Development Bank holding around two thirds of that), followed by the debt with bilateral and commercial creditors (around 16 and 12 percent of GDP, respectively). In the domestic front, the largest creditor is Dominica’s own Social Security System (around 13 percent of GDP) followed by a commercial bank with a significant government stake. In NPV terms, public sector debt stood at around 88 percent of GDP, due to the concessionality attached to most of the external debt (whose NPV was around 56 percent of GDP).1

The baseline scenario

4. Under the baseline scenario (Table 1a.), all the indicators show a progressive improvement in terms of debt sustainability. The only indicator that does not decline continuously is the debt service to revenue ratio, which temporarily shows an upward trend and then a decline in 2011.2 Even though the increase in the indicator is temporary, it is important, however, to take into account that it remains high for several years, which calls for maintaining fiscal discipline in order to avoid liquidity constraints. Under this scenario, Dominica would reach a public debt to GDP ratio of 60 percent—the guidance of the ECCB—by 2017.

Table 1a.

Dominica: Public Sector Debt Sustainability Framework, Baseline Scenario, 2004-27

(In percent of GDP, unless otherwise indicated)

article image
Sources: Country authorities; and Fund staff estimates and projections.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Nonfinancial public sector (includes debt with Dominica’s Social Security System).

Refers to external debt. Assumes that nonpartcipating creditors receive the intermediate bond. Excludes external interest arrears. Arrears with participating creditors have been settled as part of the debt restructuring. Arrears with nonparticipating creditors are either in dispute or expected to be settled when an agreement is reached. Undisputed interest arrears are approximately 0.4 percent of GDP

For 2005, it includes the reallocation of part of an external bond (around 4 percent of GDP) from external to domestic

Fiscal year aggregates are averaged to estimate calendar year figures.

In 2004/05, it is assumed that all nonparticipating creditors received the intermediate bond, which carries a face value reduction of 20 percent.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium- and long-term debt.

Alternative scenarios and stress tests

Changes in growth and primary balance

5. Economic growth and the primary balance are the two key drivers of Dominica’s debt path and both are subject to large exogenous shocks, such as volatility of grants (see below) and of foreign growth (see Box 2).

6. The sensitivity analysis illustrates two important points (Table 1b.). First, if Dominica’s primary balance and economic growth return to their averages of the last ten years (a primary deficit of 0.1 percent and annual growth of 0.9 percent), then public debt starts rising again (Scenario A.1), although the path of the debt increase is not steep. Second, if Dominica can maintain the fiscal effort projected for 2007 (a primary balance of 4.8 percent) public debt stays on a declining path (Scenario A.2).

Table 1b.

Dominica: Sensitivity Analysis for Key Indicators of Public Debt 2007-27

article image
Sources: Country authorities; and Fund staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of 20 (i.e., the length of the projection period)

Revenues are defined inclusive of grants.

7. In addition, the sensitivity analysis shows the importance of sustaining growth. In the alternative Scenario A.3, in which growth falls to 2.3 percent per year, debt initially declines but later returns to an ascending path. This is because as output growth slows, fiscal revenues are projected to decline relative to the baseline scenario while expenditures are assumed to remain constant relative to the baseline scenario (which produces a deterioration of the primary balance). Figure 2 shows the individual contributions of growth and primary balance to the debt path. The importance of growth in debt sustainability is clear from the second panel, but it is also clear that public debt remains on a declining path if Dominica is able to maintain a primary balance of 3 percent of GDP even if growth were to decline to an annual rate of 1 percent.

Dominica: External Shocks and Growth

Since independence in 1978, Dominica has gone through periodic difficulties. The island was ravaged by hurricanes; experienced with banana-driven booms and busts; and more recently suffered from a debt and economic crisis. The lack of economies of scale and accessibility increases business costs. Also, as a small state, it faces more volatile growth and terms of trade, more prone to natural disasters, and more vulnerable to external shocks.

External shocks are a key challenge to sustaining growth in Dominica. In a standard vector auto-regression analysis,3 staff found that a 1 percentage point shock to the U.S. output affects Dominica output roughly by the same magnitude, doubles the effect on some larger countries in the region, such as Mexico and Canada. Similarly, staff found that Dominica is particularly vulnerable to other external shocks: more than half of its growth volatility can be explained by growth volatility of its main trading partners; and typical shocks to annual banana prices (about 14 percentage points) and aid inflows (about 2¾ percent of GDP) affect Dominica GDP by ¾-1 percentage point over a year or two.

A03ufig03

Dominica: Response of growth to a 1 percentage point shock to U.S. growth

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A003

A03ufig04

Dominica: Response of growth to a 1 percentage point shock to U.S. growth

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A003

Source: Fund staff estimates.1/ Argentina, Brazl, Chile, Colombia, Mexco and Peru.

Decline in external grants

8. External grants to the central government are expected to reach around 8 percent of GDP in the fiscal year 2006-074, around 3 percentage points above its historical average. Figure 2 (lower panel) illustrates the impact of a 3 percent of GDP decline in external aid from 2009 on. The results present two alternative scenarios: (i) the partial adjustment scenario, which assumes that government cuts investment spending by around 1.5 percent of GDP and finances the rest of the aid decline with larger borrowing (the increase in borrowing is assumed to increase interest rates by 1 percentage point). The other scenario assumes no cuts in public investment. The aid decline is financed entirely via higher borrowing, which increase interest rates by 2 percentage points. In both scenarios, the new borrowing is assumed to be domestic.

9. As the figure illustrates, under the no adjustments scenario, public debt quickly starts rising again due to the cascading effects of rising debt and higher refinancing rates. The debt to GDP ratio stabilizes at around 62 under the partial adjustment scenario.

Other shocks

10. We also assessed shocks to interest rates, the impact of natural disasters, and the balance sheet implications of a depreciation of the U.S. dollar against other major international currencies.

  • Natural disasters produce an initial increase in debt but the latter returns to a declining trajectory after growth is restored and fiscal costs of reconstruction have ended.5

  • Interest rates shocks have little impact on Dominica’s public debt path of most of its debt, including domestic debt, has fixed interest rates.

  • A depreciation of the U.S. dollar against other major currencies would have a modest balance sheet effect on Dominica’s public debt: around 70 percent of the external debt is denominated in the U.S. dollar, 19 percent in SDR (where the U.S. dollar weigh is about 50 percent), and around 4 percent is denominated in the Euro. The rest is denominated in the EC dollar, and other currencies that are pegged to the U.S. dollar.

IV. Evaluation of External Debt Sustainability

11. Dominica’s external debt is mostly owed by the public sector, since private sector borrowing takes place with domestic commercial banks. Due to this feature, the external DSA has to a large extent the same properties as the public sector DSA.

12. External debt remains on a declining path in the baseline scenario (Table 2a.). Similarly to the public debt DSA, the only indicators of debt sustainability that do not decline continuously are those related to the share of external debt service as a percent of exports and public sector revenues. Both indicators increase up to 2010 as a consequence of the features of the debt restructuring and then start declining. The closure of operations of a large foreign manufacturing company also contributes to the increase of the debt service as a share of exports. The large residuals observed in the first five years of the projections period reflect our assumptions regarding the temporary financing of part of the current account deficit by a reduction in bank’s and private agents’ net foreign assets.

Table 2a.

Dominica: External Debt Sustainability Framework, Baseline Scenario, 2004-27 1/

(In percent of GDP, unless otherwise indicated)

article image
Source: Staff simulations.

Only includes both public sector external debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Derived as [r - g - r(1+g)]/(1+g+r+gr) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and r = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

In 2005, it includes the reallocation of part of an external bond (around 4 percent of GDP) from external to domestic. It also includes a negative FDI flow reflecting extraordinary dividends paid by a foreign company (5 percent of GDP), which were made out of an account in a foreign bank.

Assumes that NPV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the NPV of new debt).

13. Sensitivity tests show a picture similar to the public debt DSA (Table 2b.). If key variables were to return to their historical averages (Scenario A.1) external debt would return to an ascending path, as lower grants, lower FDI, and lower growth would push external debt up. Higher interest rates (Scenario A.2) do not significantly impact the external debt paths as in the baseline scenario Dominica faces low financing needs (see previous section).

Table 2b.

Dominica: Sensitivity Analyses for Key Indicators of Public and Publicly Guaranteed External Debt, 2007-27

(In percent)

article image
Source: Staff projections and simulations.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline, while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

V. Conclusions and Comparison with the 2005 Article IV Consultation DSA

14. Dominica has improved its debt sustainability outlook since the previous Article IV consultation (2005), mostly due to stronger than projected fiscal performance and economic growth. Public debt for end-2007 is currently projected at 96 percent of GDP, which is 3.5 percentage points lower than the projections made in the last Article IV consultation. At the same time, Dominica has introduced a reform to its pension system, which targets one of the main vulnerabilities to debt sustainability identified in the 2005 Article IV consultation. Dominica has also made progress in reducing debt-related vulnerabilities, particularly by joining the Caribbean Catastrophe Insurance Facility.

15. In spite of the progress achieved, important debt-related vulnerabilities remain, as: (i) public debt is high (over 100 percent of GDP), which gives the government little room to maneuver in case of unforeseen events; (ii) there is a bunching of payments between 2009 and 2011; (iii) the arrival of new grants is uncertain; and (iv) the country is exposed to external shocks and natural disasters.

16. The government’s medium-term reform strategy, which appropriately envisages the maintenance of a fiscal policy geared at achieving a primary surplus target of 3 percent of GDP and thereby bringing about a gradual reduction in the debt ratio, constitutes, therefore, a step in the right direction. The structural reforms proposed in the government strategy will—via its positive impact on economic growth—also help to attain the objective of reducing debt related vulnerabilities.

Figure 1.
Figure 1.

Dominica: Indicators of Public Debt Under Alternative Scenarios, 2007-27 1/

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A003

Source: Staff projections and simulations.1/ Most extreme stress test is test that yields highest ratio in 2017.2/ Revenue including grants.
Figure 2.
Figure 2.

Dominica: Debt Sustainability Analysis

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A003

Source: Fund staff calculations based on data from Dominica authorities.1/ Assumes that grants decline to the pre-crisis historical average in 2009.
Figure 3.
Figure 3.

Dominica: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007-27

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A003

Source: Staff projections and simulations.
1

The figures could change somewhat depending on the final agreement with hold-out creditors (since different options have different hair-cuts). These final agreements, however, should not have a material impact on the debt sustainability paths given that all restructuring options available for restructuring have the same NPV. The simulations in this appendix assume that hold-out creditors take the intermediate bond, which carries a hair-cut of 20 percent. The discount rate for the NPV calculations is 5 percent.

2

The initial upward trend is mainly caused by the early repayment clause that was included in Dominica’s debt restructuring agreement. Under that clause, there is an increase in amortization starting in 2009 and a bunching of payments up to 2011.

3

Based on the methodology used in World Economic Outlook, April 2007, Chapter 4.

4

Measured as grants spent, in line with IMF Country Report No. 05/384.

5

It is assumed that the shock costs the government 9 percent of GDP over a three-year period (thus exhausting the primary surpluses assumed under the baseline scenario) and causes real growth to decline to zero over the same period. This shock is costlier than the standard shock reported in IMF Country Report No. 04/335, in particular. In addition, the actual impact of this shock could be lower given the recent participation of Dominica into the Caribbean Catastrophe Insurance Facility—a regional insurance pool organized by the World Bank—has lowered the costs of catastrophe insurance and is expected to mitigate fiscal costs in the event of extreme hurricanes.

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Cover IMF Staff Country Reports
Dominica: 2007 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
Volume/Issue:
Volume 2007: Issue 322
Publisher:
International Monetary Fund
ISBN:
9781451810967
ISSN:
1934-7685
Pages:
58
DOI:
https://doi.org/10.5089/9781451810967.002
  • View in gallery

    Dominica: Response of growth to a 1 percentage point shock to U.S. growth

  • View in gallery

    Dominica: Response of growth to a 1 percentage point shock to U.S. growth

  • Figure 1.
    View in gallery
    Figure 1.

    Dominica: Indicators of Public Debt Under Alternative Scenarios, 2007-27 1/

  • Figure 2.
    View in gallery
    Figure 2.

    Dominica: Debt Sustainability Analysis

    (In percent of GDP)

  • Figure 3.
    View in gallery
    Figure 3.

    Dominica: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007-27

Dominica: Response of growth to a 1 percentage point shock to U.S. growth

Dominica: Response of growth to a 1 percentage point shock to U.S. growth
Figure 1.

Dominica: Indicators of Public Debt Under Alternative Scenarios, 2007-27 1/
Figure 2.

Dominica: Debt Sustainability Analysis

(In percent of GDP)
Figure 3.

Dominica: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007-27