Dominican Republic: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the Dominican Republic
Author: International Monetary Fund. Western Hemisphere Dept.
Publication Date:
15 Aug 2019
eISBN:
9781513511108
Language:
English
Keywords:
ISCR; CR; monetary policy; government; IMF staff calculation; inflation expectation; prompted authorities; headline inflation; exchange rate; private sector; foreign exchange; fiscal policy; operating income
Download PDF (1.1 MB)

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Dominican Republic

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Dominican Republic

Overview

1. The economy remains among the most dynamic in the Western Hemisphere, with low inflation and a stable external position. The Dominican Republic has enjoyed a strong expansion over the last five years (6% percent on average), supported by a strengthened policy framework, a supportive external environment and favorable terms of trade. Inflation remains muted, unemployment is at historical lows, and the external position is broadly in line with fundamentals. The strong growth performance—supported by a policy focus on strengthening social outcomes—has resulted in continued convergence of income per capita towards advanced economy levels, and a significant decline in poverty and inequality (Annex I).

2. The current growth momentum provides a window of opportunity to address remaining challenges to maintain a strong, sustainable and more inclusive growth. These challenges include moderate sustainability and affordability pressures on the fiscal position, despite strong growth; structural bottlenecks to higher productivity, especially in the electricity sector; still elevated poverty and inequality, while social safety nets are not fully developed. Although the upcoming general elections in May 2020 may be dominating the near-term policy landscape, the reform effort needs to be sustained to tackle these challenges.

Recent Developments

3. After a temporary moderation, growth regained momentum in 2018. The economy expanded by 7 percent in 2018, and the positive momentum continued in early 2019 despite a severe drought in the North, albeit at a slower pace. The dynamism in 2018 reflected a recovery in investment from its 2017 slump and a strengthening of consumption. Growth also benefitted from buoyant external demand, although the demand and fuel-price related pickup in imports turned its net contribution negative in 2018. The above-potential growth widened the output gap to an estimated 0.9 percent of potential GDP in 2018.

4. The timely relaxation of monetary policy in response to the economic slowdown in 2017, the supportive external conditions and strengthening incomes fueled the 2018 recovery.

  • Accommodative monetary conditions early in the year strengthened credit growth… The mid -2017 cut in the domestic policy rate and reserve requirements led to a recovery in credit growth (to above 12 percent by mid-2018), especially in sectors most affected by the mid-2017 slowdown, such as construction (Figure 3, top row). The strong demand response is consistent with the finding of the growth-at-risk exercise that domestic interest rates and credit are particularly potent when growth falls below its average values (Annex II).

  • …which moderated as the central bank removed the stimulus. The strong demand response and the anticipated inflation pressures led the central bank to reverse the easing cycle and increase its policy rate in July 2018 by 25 basis points to 5.5 percent. With the latest increase, the monetary policy stance became marginally contractionary at end-2018, moderating private sector credit growth to 10½ percent by March 2019. Overall financial conditions, however, were still supportive due to the real exchange rate depreciation (Figure 3, bottom row).

  • External financial conditions remained supportive. The nominal exchange rate depreciated moderately (by around 4 percent, more than in previous years) against the U.S. dollar in 2018 with narrowing interest differentials against advanced countries. Due to subdued inflationary pressures, the real exchange rate depreciated against the U.S. dollar along the nominal one, although in effective terms this depreciation was muted by the strong U.S. dollar vis-à-vis trading partners.

  • Stronger incomes with recovery in labor markets and growing remittances. Employment is growing strongly as discouraged workers reenter the labor force, increasing the labor force participation rate to an 18-year peak (64⅓ percent of active population) by end-2018 (Figure 4). This increase in the participation rate also led to a recent uptick in unemployment to 5.8 percent by end-2018, still below its long-term average. The bulk of the increase in employment has been in the formal sector, pushing formal employment to 43½ percent of the total at end-2018.1 Real wages also continued to grow, recovering only now to their levels before the 2003–04 financial crisis, and broadly in line with productivity growth, keeping unit labor costs largely unchanged since the crisis and inflationary pressures at bay. Wage growth has been stronger in the lower deciles of the wage distribution, thus lowering inequality and poverty. Net remittances strengthened to a historical high of 7.3 percent of GDP in 2018, further boosting incomes.

Figure 1.
Figure 1.

Dominican Republic: Growth and Social Indicators

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorities and IMF staff calculations.1/ Annual average of semi-annually reported values; based on the Official Bulletin of Monetary Poverty Statistics.2/ Methodological break in poverty and market income Gini between 2015 and 2016.
Figure 2.
Figure 2.

Dominican Republic: Strong Expansion Due to Recovery in Domestic Demand

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorities and IMF staff calculations.
Figure 3.
Figure 3.

Dominican Republic: Domestic Demand Supported by Financial Conditions…

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorites, IMF International Finance Statistics and IMF staff c alculations.1/ Based on the interbank interest rate and real effective exchange rate, presented as standardized deviations from January 2012.
Figure 4.
Figure 4.

…and Recovering Incomes

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorities and IMF staff calculations.

5. Despite strong activity, there are no signs of overheating. Headline inflation accelerated to near the upper band of the inflation target (4±1 percent) by mid-2018, due to a weather-related shock to domestic food production and rising fuel prices. Both supply shocks reversed in the second half of the year, pushing headline inflation down to 1.2 percent at end-December (well below the target band). In early 2019, international oil market developments and a drought in the agricultural areas of the country drove headline inflation back up towards 1.5 percent in March. Core inflation failed to respond to demand conditions and remained stable at around 2.5 percent in 2018, easing slightly in the first quarter of 2019. Staff estimates suggest that the downside pressures from the second-round effects of the positive supply shocks have more than offset the upside pressures from demand and policy factors during 2018 and kept core inflation subdued (Figure 5). A higher than estimated potential growth could be another explanatory factor.

Figure 5.
Figure 5.

Dominican Republic: Inflation Remains Subdued

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: BCRD and IMF staff calculations.1/ Based on the IMF’s Monetary Policy Analysis and Forecasting (MPAF) model.
Figure 6.
Figure 6.

Dominican Republic: External Position Reflects Strong Fundamentals

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: BCRD and IMF staff calculations.1/ Capital account and net errors and omissions multiplied by negative one to reflect the BOP identify.
Figure 7.
Figure 7.
Figure 7.

Dominican Republic: Outlook

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: BCRD and IMF staff calculations.
Figure 8.
Figure 8.

Dominican Republic: Fiscal Risks

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: World Economic Outlook, National authorities and IMF staff calculations.1/ Based on a dataset of 186 countries.2/ Budget revenue ratios use nominal GDP in the budget.

6. The external position weakened somewhat in 2018 but remains solid. Higher oil prices and a demand-related increase in imports widened the current account deficit from a near balance to 1.4 percent of GDP in 2018, still stronger than the historical average. High external demand (especially for tourism), the depreciation of the real exchange rate, and strong remittances (which remain around 1 percent of GDP above the historical average) only somewhat offset these pressures. High remittances are linked to increasing U.S. employment and wages, as well as uncertainty surrounding U.S. immigration policy. The current account deficit stayed adequately financed by foreign direct investment (FDI), and reserve coverage reached 3.7 months of prospective imports (4.5 months excluding the imports of the free trade zones). Overall, the widening of the current account deficit in 2018—broadly in line with staff projections—has shifted the external positon from being considered moderately stronger than fundamentals in 2017 to broadly consistent with medium-term fundamentals and desirable policy settings in 2018 (Annex III).

7. The financial sector remains sound and macro-financial vulnerabilities appear limited, although financial depth is constrained. After expanding for more than a decade to around 27 percent of GDP, private credit stabilized at broadly these levels during 2018—remaining low by historical and international standards but closing the slightly positive credit-to-GDP gap of previous years. Further deepening may be hindered by crowding-out effects, as investing in sovereign debt (currently at about 15 percent of banks’ assets or 123 percent of their equity) provides attractive yields and does not carry capital requirements. Credit quality improved during 2018, with nonperforming assets falling to 1.6 percent of the loan portfolio by end-2018, while provisioning increased. Higher provisioning reduced somewhat capital adequacy during 2018, but—at 17.1 percent at year-end—it remains significantly above the regulatory minimum of 10 percent. Dollarization of assets and liabilities remained broadly stable at around 20 percent and 30 percent, respectively, and banks enjoy healthy liquidity and profitability. The consolidation of the banking system has continued through voluntary restructuring or liquidation.

uA01fig01

Credit Growth and Credit-to-GDP Gap

(Credit to the private sector)

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: BCRD and IMF staff calculations
Text Table.

Dominican Republic: Financial Soundness Heat Map 1/

article image
Sources: National authorities and IMF staff calculations.

Methodology is detailed at http://www-intranet.imf.org/departments/MCM/tools/tools/Pages/Financial%20Soundness%20Indicators%20(FSIs).aspx

Relative to previous reports, the deposit base now includes certificates of deposits, which are equivalent to term deposits in the local financial system.

Outlook and Risks

8. After the impressive growth performance over the past five years, economic activity is expected to slow to its potential. The tightening financial conditions, a less supportive external environment and higher oil prices (and on the supply side the early 2019 drought) are expected to slow down growth to around 5½ percent in 2019 and 5 percent over the medium term, both within the estimated range of potential growth. With positive supply shocks fading and negative supply shocks emerging amid drought conditions, inflation will gradually move back towards the inflation target band of 4±1 percent The external position is projected to normalize around somewhat higher deficits. The slowdown in remittances and the gradual moderation of gold exports will widen the current account deficit closer to its historical average of 3 percent of GDP over the medium term, offset partly by a projected fall in the oil bill (especially in 2019). FDI, particularly in the tourism sector, is expected to continue to more than adequately finance the current account deficit.

9. Risks to the outlook appear moderate and broadly balanced (Annex IV). On the downside, a faster-than-expected weakening of external demand—especially from the U.S.— is the main risk to growth, and it would only be mildly offset by the concomitant looser financing conditions if the U.S. monetary policy normalization cycle is slowed (a 1 pp temporary decline in U.S. demand is estimated to reduce growth in the Dominican Republic by 0.4pp through trade and remittances channels). Higher energy prices could contribute to weaker demand and wider fiscal and current account deficits. Domestically, the main risks stem from uncertainty about the domestic demand momentum relative to staffs baseline scenario, although these are tilted to the upside in the near term in light of the April 2019 increase in public sector wages and pensions, the ongoing wage negotiations in the private sector, and the negotiation of a free trade agreement with China, which could unlock Chinese markets for Dominican exports and attract tourists and foreign investment2 On the downside, potential extreme weather events could pose a risk to tourism and agricultural exports while cyberattacks could disrupt financial markets and commercial infrastructure.

Authorities’ Views

10. The authorities broadly share staff’s views on the economy’s cyclical position, outlook and risks. They see the economy as operating above potential and expect growth to move close to potential in 2019 but see more upside risks to near-term growth as the strong performance has persisted throughout the first quarter of 2019. Robust private investment (both domestic and foreign) and private consumption highlight the strong fundamentals supporting growth. The authorities consider a slowdown in the U.S. economy the largest downside risk to growth. They also expect headline inflation to remain towards the lower bound of the 4±1 percent target range by end-2019, and to move closer to the center of the band subsequently. Strong export performance, especially in tourism, and high remittances support the external position, which authorities expect to gradually converge to historical averages.

Policy Discussions

Policy discussions focused on (i) the need to strengthen the fiscal position and framework to reduce sustainability risks; (ii) maintaining a data-dependent monetary stance and progress in strengthening the financial system framework; and (iii) policies to support higher productivity and income convergence.

A. Fiscal Policies and Framework

11. Fiscal policy faces the challenge of maintaining sustainability, amid weak debt carrying capacity. Despite strong growth, consolidated public debt continues to grow as a share of GDP (53.1 percent of GDP in 2018) due to persistent structural deficits, averaging around 4½ percent of GDP over the last five years.3 The government is aiming to put a dent in the deficits through expenditure restraint and concerted efforts to increase tax collection by closing loopholes and curbing pervasive evasion (Annex V, section C). Ongoing efforts are critical for widening the revenue base and correcting previous governance gaps in revenue administration. However, the gains from revenue administration measures (estimated at 0.2 percent of GDP in 2018) have been broadly neutralized by declines in one-off revenues, and tax revenue has not visibly increased so far. The tax base remains low by international comparison (at 13.7 percent of GDP) due to widespread exemptions and incentives (tax expenditure in 2018 is estimated at 5.1 percent of GDP). In addition to a narrow tax base, the main contributors to persistent public sector deficits are the electricity sector (with an average annual subsidization cost of 1.7 percent of GDP during 2014–18) and a high interest burden (3.9 percent of GDP, or 28.5 percent of tax revenues in 2018). The high cost of debt relative to a narrow revenue stream suggests a low debt carrying capacity, with additional fiscal risks stemming from a high share of foreign currency debt (54 percent at the consolidated level) and relatively high financing needs (averaging 9⅓ percent of GDP in 2019–23) (Annex VI).

12. The authorities aim to continue improving the fiscal position in 2019, but this will be challenging. The planned adjustment relies on a high anticipated yield from revenue administration efforts (0.9 percent of GDP) to help offset higher investment in infrastructure and a growing interest bill.4 If successful, the authorities’ strategy would at least stabilize public debt or—if spending pressures are not significant—could even put debt on a downward path. However, the targets will be challenging to attain in the absence of substantive tax and electricity sector reforms, and with additional pressures from post-budget increases in minimum public sector wages and pensions (0.1–0.2 percent of GDP) and an expected scale-up in investment to upgrade the electricity infrastructure.5 Staff estimates that, without additional measures, consolidated deficits would remain at around 4 percent of GDP and debt would gradually increase in the medium term, reaching about 56.5 percent of GDP in five years.

uA01fig02

Consolidated Public Sector Overall Balance

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Source:Nat’ora a-1horifesara MF staff cicjli’ors.

13. Positive surprises to the fiscal outlook are possible, but there are also downside risks. On the upside, the authorities’ efforts to curb tax evasion may be more successful than assumed in staff’s baseline; cost savings from the new Punta Catalina coal-powered generation plant could be larger; and divesting state’s shares in the coal plant, as planned by the government, could also reduce debt directly, recovering at least partly the cost of its construction.6 On the downside, in addition to macroeconomic risks from higher borrowing costs, lower growth or a larger depreciation than expected, the government may face liabilities from potential arrears of non-central government entities to the private pension system. Finally, the government is exposed to fiscal risks from natural disasters (hurricanes, floods and earthquakes), although the authorities have also taken some steps to build resilience, including by signing a contingent precautionary loan with the World Bank (Catastrophe Deferred Drawdown Option, or CAT-DDO).

14. Sustainably improving the fiscal position will require comprehensive reforms to broaden the tax base and address electricity sector weaknesses. To ensure fiscal sustainability, contain fiscal risks, and reduce borrowing costs, the upward debt dynamics should be reversed. Staff recommends targeting a debt reduction sufficiently below 50 percent of GDP to allow room for countercyclical policies and potential fiscal risk materialization without exceeding this ceiling.7 This will require an additional adjustment effort relative to staffs baseline of 2–2½ percent of GDP over two years to bring debt to 45–47 percent of GDP over five years, with a frontloaded adjustment warranted by the current cyclical position.8 The adjustment should focus on reducing generalized subsidies on electricity, rationalizing CIT incentives, phasing out the least progressive exemptions from the VAT, and reducing the high PIT threshold (less than 10 percent of those employed have income above the threshold). In doing this, the authorities would need to be mindful of the distributional effects of the measures, and the additional fiscal space created from a lower interest burden could be used to strengthen social protection and support growth through higher investment spending.9 In case of a negative demand shock, the authorities have some fiscal space to respond, but current demand, sustainability and affordability considerations argue against its use.

article image

15. Given the uncertainty around the fiscal policy path, a policy framework anchored on a medium-term debt target and fiscal responsibility would strengthen policy credibility. Such a framework would clarify the government’s medium-term objectives, guide current policies towards the debt anchor through an operational rule and remove policy uncertainty in light of the unlikely launch of discussions on the Fiscal Pact Enacting such fiscal responsibility legislation, which could enter in effect in 2020, would help advance the fiscal reform agenda in a pre-election environment, build public trust in fiscal policies and potentially lower the sovereign risk premium. The framework could also strengthen the management of fiscal risks, through the identification and quantification of existing exposures, developing principles for taking these on and strategies for managing them better. Staff welcomes the authorities’ work on developing a fiscal risk statement and encourages its publication during the next budget.

16. The authorities have focused on strengthening the institutional framework for fiscal policies. They are improving the quality and frequency of published fiscal statistics, including through transition to GFSM2014. They are also reinforcing the capacity of the debt management office; broadening the coverage of the treasury single account to virtually all public institutions; and strengthening the institutional capacity to assess risks from public-private partnerships (associated legislation is in congress). Ongoing reforms have also aimed to enhance governance: the procurement system has been modernized to allow real-time public access to information during the procurement cycle through a transactional portal; bearer shares have been eliminated, and tax fraud and bribery have been criminalized (Annex V).10 Remaining challenges include broadening the coverage of fiscal reporting and statistics (including debt) to public institutions outside the central government (municipalities and decentralized institutions), for which reforms have already been initiated, and revisiting the system of intergovernmental relations to clarify responsibilities and the intergovernmental transfer system.

Authorities’ Views

17. The authorities recognize that achieving the 2019 budget targets will be challenging but remain committed to improving the fiscal position. They believe that the staffs baseline scenario is too conservative and underestimates: (i) the ability of the envisaged revenue administration measures to increase the tax base, and (ii) the decline in the electricity sector deficits from lower electricity purchase prices with the entry into operation of Punta Catalina, as well as from the expected profits from the plant In their views, these two reforms, plus other measures, could deliver the needed adjustment to reduce the debt ratio over the medium term. The authorities agreed on the desirability of the fiscal responsibility framework, but they see its adoption as unlikely in the near term. A medium-term fiscal framework for 2018–22 has been developed and is being used internally to guide fiscal analysis, accompanied by an assessment of fiscal risks around the medium-term baseline projections. The authorities have also developed an internal fiscal risk report that assesses risks associated with macroeconomic shocks, natural disasters, the pension system, the electricity sector and public-private partnerships.

B. Monetary Policies

18. The monetary policy stance is appropriate, and any future change should depend on domestic demand and changes in external financing conditions. Muted inflationary pressures provide some space for keeping the monetary policy on hold, but policy should remain data dependent. The positive output gap and the potential second-round effects from rebounding fuel and food prices are consistent with a near-term recovery in inflation and may require monetary policy tightening, especially if tightening financial conditions in the rest of the world bear pressure on domestic inflation. At the same time, while the mid-2018 increase in the policy rate was effective in moderating credit growth, there are indicators that demand may be slowing, and signs of capacity constraints have not yet shown up in core inflation. This suggests that the authorities have room to keep the monetary policy stance unchanged until there are firmer indications of either resource pressures or slack.

19. The central bank continues to strengthen the monetary policy framework and its credibility is increasingly anchoring inflation expectations. Evidence from surveys on macroeconomic expectations shows that inflation expectations are well-anchored seven years after the switch to inflation targeting (Annex VII). To further increase the credibility of its inflation targeting framework, the central bank has recently introduced forward guidance in the monthly press releases and will launch a foreign exchange trading platform in June 2019. The introduction of the platform is expected to increase market transparency, lower price dispersion and information asymmetry, and help promote usage of foreign exchange derivatives.11 While exchange rate volatility is relatively limited, the real exchange rate has been broadly in line with fundamentals, there are no sustained pressures on the currency, and foreign exchange interventions have been moderate and double-sided. With inflation expectations increasingly anchored and with the foreign exchange trading platform in place soon, the authorities would be in a position to increasingly limit the use of foreign exchange interventions to smoothing excessive volatility or accumulating reserves.

uA01fig03

Expected Inflation and Inflation Targeting

(Forecast horizon: End of next year, percent)

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: BCRD and IMF staff calculations

20. The strong external position allows further accumulation of reserve buffers, but the pace will likely be constrained by high sterilization costs. Reserve coverage has increased to 68 percent of the IMF’s reserve adequacy (ARA) metric compared to only 28 percent in 2012, but remains below the recommended 100–150 percent12 Staff considers that there is scope for further accumulation of international reserves, taking advantage of the favorable external position. Nevertheless, the rate of such accumulation will be constrained by the costs of sterilizing the reserves: the relatively high domestic interest rates imply a significant negative carry for reserves. This adds to the already large quasi-fiscal deficit and debt of the central bank, a legacy of recapitalizing commercial banks during the 2003–04 crisis and sterilizing the associated debt service (Figure 9). A recent agreement to recapitalize the central bank aims to gradually move these quasi-fiscal liabilities to the balance sheet of the central government over a 15-year period; draft legislation to this effect will be submitted to congress as soon as the agreement is formalized. The approval of the plan and steadfast adherence to the recapitalization schedule will be important for strengthening the central bank’s financial position and improving public debt management13

Figure 9.
Figure 9.

Dominican Republic: Reserves and Central Bank Financial Position

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorities and IMF staff calculations.1/ Includes reserve position in the IMF.
Figure 11.
Figure 11.

Dominican Republic: Electricity Sector

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: National authorities and IMF staff calculations.
Figure 10.
Figure 10.

Dominican Republic: Financial Sector Developments

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Source: National authorities, World Bank Development Indicators and IMF staff calculations.1/ CAPDR includes the Dominican Republic, Nicaragua, Honduras, El Salvador, Guatemala, Costa Rica, and Panama.2/ Financial margin refers to net interest income. The latest data for Honduras is 2016.

Authorities’ Views

21. The authorities agreed that the neutral policy stance and continued reserve accumulation are appropriate. They stand ready to tighten if inflationary pressures increase while remaining vigilant to downside risks to the global economy and domestic demand moderation. They will continue to exploit the favorable external balance and the steady inflow of foreign exchange to build precautionary buffers. The implementation of the electronic exchange trading platform will help to make the foreign exchange market more transparent and efficient, including through developing the foreign exchange derivatives market. An updated agreement to recapitalize the central bank will help reduce the quasi-fiscal deficit and raise its capital to an adequate level.

C. Financial Sector Policies

22. Macro-financial risks appear limited, but pockets of vulnerability remain and are monitored by authorities. The financial system remains healthy by international comparison, in terms of its capitalization, asset quality, liquidity and profitability (¶; text table). Limited information about borrower creditworthiness and a large share of foreign currency loans extended to non-exporters (although highly collateralized) may be adding to credit risks.14 Bank profitability relies on high intermediation spreads to offset operating costs (suggesting room for exploiting economies of scale through consolidation) and on high commissions (likely undermining ongoing efforts to increase financial inclusion).15 Other risks may also require attention, including potential liquidity risks in banks that have large shares of wholesale deposits from pension funds, and large investments in sovereign debt that could expose banks to interest risk. Pension funds, which became over the years the largest institutional investor (17 percent of GDP in assets), also have a high concentration of their portfolio in sovereign debt. Finally, risks in the financial cooperatives are not well known – the sector is relatively small (3 percent of financial system assets), but some cooperatives are as large as banks and are not regulated or supervised.

Text Table.

Financial Soundness Indicators in 2018: Regional Perspective1

article image
Source: National authorities, World Bank Development Indicators and IMF staff calculations.

Covers the overall financial sector.

CAPDR includes the Dominican Republic, Nicaragua, Honduras, El Salvador, Guatemala, Costa Rica, and Panama.

LA5 includes Brazil, Chile, Colombia, Mexico, and Peru.

23. The authorities continue to strengthen the financing system through improved bank and systemic risk oversight, upgrading its regulation and institutional framework:

  • The authorities are modernizing the institutional framework for systemic financial oversight. Macroprudential surveillance has been strengthened with the operationalization of the Systemic Risk Committee —chaired by the Central Bank and comprising the Ministry of Finance and the Bank Superintendency. The committee recently launched the Financial Stability Report, providing an overview of the financial system health and its resilience to shocks.16 Given contained macro-stability risks, no macroprudential tool was deployed yet, and the authorities continue to develop their toolkit

  • The authorities are gradually moving towards adopting international reporting (IFRS) and supervisory (Basel III) principles, with remaining gaps related to consolidated supervision, capital, market risk and liquidity requirements. The mark-to-market regulation, in particular, is being rolled out gradually by 2020 and could reveal additional capital requirements, especially if financial conditions tighten.

  • Risk-based supervision is also being strengthened with a recent tightening of reporting requirements.

  • Putting in place a strong cybersecurity framework has become a critical priority for the authorities. The recent strategic plan for 2018–21 and the cybersecurity regulation for the financial sector, both approved in 2018, aim to create a state-of-the-art cybersecurity center that would provide cyber defense and data protection functions to the central bank, commercial banks, and other public institutions (Annex V, section B).

24. Further action is needed to strengthen the authorities’ ability to respond to risks and prevent their buildup.

  • Nonbank financial system needs to be brought into the supervisory perimeter. Reforms to bring the regulation and supervision of the sector on a par with banks are critical but need to be designed carefully so as not to overwhelm the financial regulatory capacity.

  • Further developing the prudential toolkit. This would require legislative and regulatory changes that would bring the regulatory, reporting and resolution regimes closer to international norms, including to allow for (i) countercyclical and risk-based capital requirements;17 (ii) improved consolidated financial supervision; (iii) automatic increases in the capital of the public bank (the largest in the system), which are currently done through one-off legislation; (iv) tuning up the resolution tools for banks and households; and (v) formalizing regulatory limits on borrower leverage. In addition, developing a housing price index would help monitor risks given the rapid development of the sector. These reforms, along with those to bring bank commissions to regional averages, are already being considered by the authorities. The authorities should also monitor risks associated with concentrated exposure to sovereign risk and analyze prospects of allowing pension funds to diversify investments abroad while preserving macroeconomic stability.

  • Continue efforts in effectively implementing the AML/CFT framework. The authorities overhauled the AML/CFT legal framework in 2017, and GAFILAT’s 2018 AML/CFT assessment found a relatively strong technical compliance with the Financial Action Task Force (FATF) standard. However, the assessment also concluded that the AML/CFT regime is only effective to some extent and that major improvements are needed to mitigate money laundering and terrorism financing risks.

Authorities’ Views

25. The authorities noted that the financial system, having benefitted from years of continuous reforms since the 2003–04 crisis, is strong and has ample capital and liquidity cushions. Nevertheless, they are committed to continued vigilance and integrating additional tools to strengthen supervisory oversight over banks and the overall system to prevent a buildup of risks. They also agreed with the need to regulate and supervise financial cooperatives, but views differed on whether the supervision should rest with the current bank authorities (without affecting the current quality of bank supervision) or with a new self-supervisory authority.

D. Policies for Stronger and More Inclusive Growth

26. The main medium-term challenge is to boost productivity and continue improving social outcomes. The National Development Strategy for 2010–30, which guides the authorities’ reform agenda, aims at reaching advanced economy status by 2030. While the country’s economic outlook is very favorable, staff’s baseline medium-term growth projections (around 5 percent, or 4 percent in per capita terms) suggest a slower convergence to these levels (Annex I). The authorities have focused on measures that are feasible and can yield quick productivity gains. However, structural policies need to address a few long-standing bottlenecks weighing on the potential growth outlook, including costly electricity disruptions, administrative and regulatory hurdles, shortages of skilled labor, weak institutions and inefficiencies in the transport sector.

27. Improving the investment climate has been a strong policy focus over the past few years. The National Competitiveness Council, headed by the President, has fostered closer collaboration between the private and the public sector to improve the business environment and increase productivity. Its structural reform agenda in 2018 focused on trade facilitation and easing regulatory requirements, including through the introduction of a one-stop shop for exports and one for construction permits, significant reduction in the time for obtaining permits, extending operating hours for ports and airports, simplifying customs procedures, and good progress in implementing the recently ratified WTO Trade Facilitation agreement, among others. In 2019, the agenda will focus on promoting innovation, the weakest-rated pillar in the World Economic Forum’s competitiveness index for the country. Progress has also been made in the last few years in strengthening institutions and governance (another relative weakness) in some areas, especially in curbing tax evasion, reforming revenue administration and improving the AML/CFT legal framework (Annex V).

uA01fig04

Global Competitiveness Index 4.0

(Index, from 1 to 100, where 1: worst and 100: best)

Citation: IMF Staff Country Reports 2019, 273; 10.5089/9781513511108.002.A001

Sources: World Economic Forum and IMF Staff calculations.1/ LAC stands for Latin America and the Caribbean.

28. Promoting more inclusive growth through social reforms has been the long-standing focus of the current administration. Strengthening of the physical and human infrastructure in the education and health sectors, where outcomes lag regional peers, has been supported by higher investments, wage increases, and training of teachers for the additional schools. The government has recently initiated a reform of the pension system, which aims at increasing returns through a reduction in pension fund fees and regularization of employer arrears, and at improving the administration of the system.

29. Going forward, structural reforms will need to tackle areas that present the most binding constraints on growth and social inclusion.

  • Electricity sector. The electricity sector faces multi-decade weaknesses caused by infrastructure gaps and inefficiencies in the state-run transmission and distribution sectors.18 The Electricity Pact agreed among most civil society participants in 2018 after three years of negotiation, has not been enacted due to opposition by some stakeholders.19 While a broadly supported Pact would provide the needed backing for reforms —including the alignment of electricity tariffs closer to costs and the institutional reform of the sector—the authorities could undertake needed reforms even in the absence of the pact. The authorities’ strategy to improve the financial standing of the sector currently relies on (i) the coming online of the new coal-fueled power plant (Punta Catalina) to reduce electricity costs and shield the sector from the more volatile fuel prices; (ii) increased investments to help reduce infrastructure gaps and technical losses in the electricity sector; and (iii) continued shift towards green and gas energy. In staff estimates, these may not be sufficient to eliminate the deficit in the sector without tariff adjustments, higher investments, and increased efficiency in the sector—although upside risks around the gains from the coal plant are high (¶13).

  • Aligning education with needed skills. Weak educational outcomes have limited the Dominican Republic’s capacity for innovation and attracting skill-intensive industries. The primary and secondary education reforms started in 2014 under the auspices of the Education Pact have not had time to translate into improved outcomes. As these reforms mature, there is scope for developing vocational education to address skill mismatches and better align tertiary training to productive needs; the authorities are currently developing such a strategy.

  • Addressing weaknesses in product and labor markets. In product markets, the cost of cargo transport is one of the highest in the region due to the oligopoly structure of the sector and strong trade unions; reforms could help reduce logistics costs across the economy and improve competitiveness. In labor markets, the almost 30-year-old labor code needs to be modernized to allow more flexible working hours and improve the mediation/litigation mechanisms. There is broad agreement among the social partners in these areas, but reforms have stalled on disagreements about the severance pay, where a right balance is being sought between relieving the burden on employers and providing protection to employees in case of unemployment.

  • Further strengthening the investment environment. A simpler, more streamlined and broader-based tax system—in addition to supporting a fiscal adjustment—would also relieve the compliance and the tax burden on the formal sector, facilitate formalization, and remove one of the major doing-business impediments cited by the private sector. The investment environment would also benefit from steadfast implementation of ongoing reforms to improve the efficiency and governance of state institutions, including to reduce vulnerability to corruption, and from addressing other remaining vulnerabilities.

  • Further progress in improving social outcomes will require deeper social security reforms. The social security system, established in 2001, currently receives contributions for pension, healthcare and other social insurance schemes only from those formally employed (43½ of the population). Two of the system’s pillars have not been fully operationalized due to fiscal costs, preventing access to pension and healthcare insurance by the self-employed or those employed in the informal sector (contributory-subsidized pillar) and by those that cannot contribute (subsidized pillar). Even the active contributory pillar is not functioning efficiently, as many employers have accumulated arrears to the privately-managed funded schemes; controls over contributions and arrears are weak; and pension benefits are estimated to be inadequate when the first wave of retirements under the system picks up in about five years (the replacement rate is currently estimated at 30 percent of last wages). The authorities have recently tabled a reform of the social security system to strengthen the management and control of the system, regularize arrears, and reduce pension fund fees in order to increase pension benefits. Staff welcomes these important steps, but a more far-reaching reform, including parametric adjustments, will be needed to ensure broader access to the social security system and adequate retirement income when the system matures.

Authorities’ Views

30. The authorities agree that achieving a higher level of income and social prosperity hinges on the country’s ability to boost productivity and strengthen social safety nets. This spurred the relaunch of the National Competitiveness Council to identify, together with the private sector, obstacles to easier trade, business environment and innovation. It also fueled the multi-year focus on strengthening the education and health sectors, fostering financial inclusion, boosting employment and incomes, and developing opportunities for the less privileged. In education, the authorities pointed out that as reforms mature, the focus will shift from building infrastructure to training teachers – but results in terms of improved educational outcomes and reducing shortages of skilled labor will take longer to materialize. In healthcare, the focus remains on building modern well-equipped hospitals. The authorities acknowledged that outstanding reforms to simplify the tax system, modernize the labor code, broaden social security coverage and benefits, and addressing electricity sector deficits—many of which have undergone extensive discussions with the civil society—require extended negotiations and consensus building that can lengthen the process. They argued, however, that substantial progress was made on many fronts already: the launch of a new power plant and expected large investments in distribution infrastructure should improve electricity supply and reduce costs for the state-owned distribution companies; and the reforms of the management of social security and pension fund fees will help increase retirement income.

Staff Appraisal

31. The economy likely reached its cyclical peak in 2018 and is expected to moderate to potential growth rates. The strong expansion over the past decades and the economic and social reforms being put in place have made the economy more resilient and brought many people out of poverty. However, even at potential growth rates of 5–5½ percent, incomes will converge only slowly to advanced economy levels. A combination of factors is holding back higher productivity and growth, including unreliable electricity supply, weak institutions and red tape, a complex tax system, and relatively weak social safety nets. These should be addressed while the cyclical position remains favorable and external demand strong, to safeguard against potential headwinds, especially from external global factors.

32. Undertaking fiscal adjustment in the near term would reduce uncertainty about fiscal sustainability and take due advantage of the favorable cyclical conditions. While the public debt level of around 53 percent of GDP does not breach accepted sustainability thresholds and is broadly in line with other emerging markets, its dynamics remain unfavorable despite vibrant growth and ambitious revenue administration reforms. In addition, high interest costs, a low revenue base, and a large share of foreign currency debt limit the country’s debt carrying capacity. Tax administration reforms alone are not likely to be sufficient to put a dent in public deficits, which would require addressing the main deficit drivers – the electricity sector and base-eroding tax incentives and exemptions. Reforms in both areas are politically and socially difficult but should be designed to offset their negative distributional effects. A meaningful fiscal adjustment would not only contribute to reducing real interest rates but would also create additional fiscal space to strengthen social safety nets and undertake priority infrastructure projects.

33. A credible fiscal path is needed, especially if deficits take longer to reduce. Fiscal responsibility legislation could help establish a medium-term debt anchor, mark out the path towards this debt target through an operational rule, and determine responses to and accountability for structural deviations from targets. It could also establish a framework for taking on fiscal risks, including from public-private partnerships, and limit contingent liabilities. Such legislation could impart additional credibility to the needed fiscal adjustment, with positive feedback effects on sovereign spreads.

34. Monetary policy faces weak inflation, despite strong demand, and a neutral policy setting appears appropriate. The recent policy tightening has slowed credit growth, helping the economy adjust towards potential levels. With core inflation still weak, monetary policy has room to remain on hold in the near term, while being mindful of both upside and downside pressures on inflation, including from external financial conditions, the speed of moderation of domestic demand, and higher food and fuel prices.

35. The external position is broadly in line with fundamentals. The temporary boost in remittances and steady foreign exchange inflows, especially from tourism, provide conditions that are favorable to continue building the needed reserve buffers. Nevertheless, the pace of such a buildup will be moderated by its sterilization costs amid already high quasi-fiscal deficits. Finalizing and implementing the agreement to recapitalize the central bank will be important for reducing the burden of the quasi-fiscal losses on monetary policy. The introduction of the electronic foreign exchange trading platform and the development of the foreign exchange derivatives market will help further strengthen the monetary policy framework.

36. Systemic financial risks appear limited, but progress in strengthening the financial system architecture should continue. The strengthening of the systemic risk oversight through the development of the macroprudential policy framework, a continued strengthening of bank regulation and supervision, and cybersecurity reforms are welcome reforms to strengthen the financial system. The main challenge going forward will be the steady implementation of these reforms, including the transition to international regulatory and reporting standards in the banking system, developing tools to monitor risks in all corners of the financial system (including housing and borrower creditworthiness), and bringing the financial cooperative sector into the financial system’s supervisory and regulatory net without overwhelming it Staff also welcomes the revised AML/CFT legislation and encourages the authorities to work on ensuring its effectiveness.

37. There is a pressing need to address barriers to higher productivity, income convergence and social inclusion. Staff commends the fast pace of structural reforms to remove trade and investment barriers, strengthen the education and health systems, and improve the administration and regulation of the social security system. Nevertheless, important bottlenecks to an improved doing business environment remain. Needed reforms to address them include the implementation of the Electricity Pact, reducing the complexity of the tax system, stopping anti-competitive business practices, especially in transportation, and modernizing the labor code to allow for more flexible work arrangements. Social outcomes would also be strengthened further by widening access to the social security system, which would help reduce informality, and ensuring adequate retirement incomes.

38. It is recommended that the next Article IV consultations take place on the standard 12- month cycle.

Table 1.

Dominican Republic: Selected Economic Indicators

article image
Sources: National authorities; World Bank; and IMF staff calculations.

Latest available.

Improvement in 2015 reflects the grant element of a debt buy back operation with Venezuela’s state owned-oil company (PDVSA) of 3.1 percent of GDP.

The consolidated public sector includes the central government, some decentralized entities, the electricity holding company, and the central bank.

Table 2.

Dominican Republic: Public Sector Accounts

(in percent of GDP)

article image
Sources: National authorities and IMF staff calculations.

Based on Government Financial Statistics Manual (GFSM) 2014.

Outcome in 2015 reflects the grant element of a debt buy back operation with Venezuela’s state owned-oil company (PDVSA) of 3.1 percent of GDP.

Net of one-off revenues, including gains from PDVSA debt buy back.

Adjusts revenues and expenditures for the economic cycle, and excludes one-off gains from PDVSA debt buy back

Before government transers; it covers the Dominican Corporation of State Electricity Companies (CDEEE).

Table 3.

Dominican Republic: Public Sector Accounts

(in billions of Dominican pesos)

article image
Sources: National authorities and IMF staff calculations.

Based on Government Financial Statistics Manual (GFSM) 2014.

Outcome in 2015 reflects the grant element of a debt buy back operation with Venezuela’s state owned-oil company (PDVSA) of 3.1 percent of GDP.

Before government transers; it covers the Dominican Corporation of State Electricity Companies (CDEEE).