Country Report Dominican Republic
Economic growth in the Dominican Republic moderated once more last year and likely came in at 3.8% amid a deteriorating external environment. Additional public spending ahead of the presidential elections in May could not change this trend, but helped Danilo Medina Sanchez, the candidate of outgoing President Leonel Fernández Reyna, win the vote by a narrow margin. Yet, his victory came at the price of necessary fiscal consolidation, which could prove challenging amid weakening economic growth. Meanwhile, the already very weak external position of the Dominican Republic deteriorated in spite of rising foreign exchange earnings from mining activities. Given ongoing uncertainty about the renewal of an IMF standby-agreement (SBA) and the continuation of the Venezuelan PetroCaribe oil trading scheme, concerns among investors about balance-of-payments difficulties could increase.
Economic structure and growth
The Dominican Republic is one of the larger Caribbean economies with a nominal GDP of USD 58bn in 2012 and a population of 9.6 million. Located in the center of the Caribbean, it shares the island of Hispaniola with neighboring Haiti. Compared to its western neighbor, the Dominican Republic is relatively wealthy, as GDP per capita at PPP amounted to USD 12,202 (2012) versus USD 1,200 (2011) in Haiti. Income, however, is distributed highly unequally and human development is mediocre. In spite of its limited size, the Dominican Republic’s economy is relatively diversified. Being endowed with various natural resources, most importantly ferro-nickel and gold, as well as vast beaches and various historic cities, the country has become a major recipient of foreign direct investment (FDI) into its tourism, mining, and telecommunications sectors in recent years. These inflows have turned the Dominican Republic into one of the main tourist destinations in the Caribbean, catering to more than 4 million tourists in 2012. Besides tourism, the country also features a relatively diversified manufacturing sector that focuses on the production of textiles, garments, pharmaceuticals and medical appliances. Mining activities, once concentrated on the exploitation of ferro-nickel deposits, have gained in importance recently following the opening of new gold mines. The once dominant agricultural sector, which focuses on the production of cane sugar and cocoa, generated a mere 6% of GDP and less than 5% of total exports last year, but it remains an important employer. About half of the Dominican Republic’s exports are destined for the US market, while exports to neighboring Haiti, part of which are still related to ongoing post-earthquake reconstruction efforts, account for 20% of total exports. Reflecting the country’s heavy dependence on imported energy, fuels accounted for 27% of total imports in 2011, while imports of consumer goods amounted to 23%. The large share of fuel imports is mainly due to the Dominican Republic’s deficient and highly oil-dependent energy sector that haunts the country with recurrent black-outs and exposes the balance-of-payments to international oil price fluctuations.
The Dominican Republic’s banking sector is highly concentrated, as three banks hold about 60% of the system’s total assets. Less than 10% of bank assets are controlled by foreign banks. The sector is relatively solid, as non-performing loans remained relatively stable at 3.5% of total loans in September 2012 and the solvency ratio stood at about 15%. While lending to the private sector slowed last year, the outgoing government’s markedly increased funding needs ahead of the May 2012 presidential elections have increased the sector’s sovereign exposure.
Amid an increasingly challenging external environment, economic growth declined from 4.5% in 2011 to 3.8% last year. The slowdown was mainly driven by a fall in net external demand, which was caused by a combination of weakening export growth and rising imports on the back of growing pre-election spending that boosted domestic consumption and investments. Mainly driven by necessary fiscal consolidation measures (also see economic policy section), economic growth in 2013 is expected to cool down to about 3% before recovering to around 4% in 2014. We caution, however, that the risks to this outlook are strongly tilted to the downside, as the Dominican Republic’s strong dependence on external financing exposes the country to a renewed weakening of the global economic recovery and a rise in risk aversion vis-à-vis emerging markets. Moreover, rising concerns about last year’s fiscal deterioration, ongoing uncertainty regarding the renewal of an IMF credit line, as well as growing doubts about the continuation of subsidized oil deliveries under Venezuelan President Hugo Chávez’s PetroCaribe oil trading scheme could lead to deteriorating access to international capital markets.
Political and social situation
Following the peaceful presidential elections of May 20th, 2012, the political situation in the Dominican Republic is quite stable. Having won 51% of the vote in a very tight race, Danilo Medina Sanchez of the centrist Partido Liberación Dominicana (PLD) beat former president Hipolito Meija of the opposition Partido Revolucionario Dominicana (PRD) and was sworn in as new president on August 16th, 2012. He succeeds former PLD-president Leonel Fernández Reyna, who was barred from re-election by a constitutional ban on three successive presidential terms. With no Congressional elections being scheduled before May 2016, when simultaneous legislative and presidential elections will be held, Mr. Medina should benefit from the PLD’s sizeable parliamentary majority of 31 out of 32 seats in the Senate and 105 out of 183 seats in the chamber of deputies. Given the need for considerable fiscal consolidation and painful reforms of the ailing energy sector in order to qualify for the renewal of an, in our view essential, IMF standby agreement (SBA), the new president’s strong support base in Congress should provide a window of opportunity that is certainly welcome. Even though negotiations over another IMF SBA have not yet yielded results, we expect that it will be approved later this year.
Notwithstanding the president’s powerful position, his very narrow victory in spite of substantial pre-election government spending by the previous PLD-government illustrates that the party did not manage to sufficiently address lingering social problems. Partly owing to still rampant corruption and clientilism, a highly-skewed income distribution and a seriously underperforming educational system, only a few have been able to benefit from the country’s recent economic success so far, while recurrent periods of high inflation put pressure on disposable incomes. Reflecting still widespread poverty, food price inflation ranked highest among voters concerns, followed by rising worries about the spreading of drug-related violence.
Owing to its geographic location in the center of the Caribbean, its proximity to the US Commonwealth of Puerto Rico, a shared porous border with impoverished Haiti, as well as weak corruption-ridden public institutions, the Dominican Republic has seen drug trafficking activities increase in recent years. Within ten years, the country’s homicide rate doubled from 12.5 murders per 100,000 inhabitants in 2001 to 25 murders per 100,000 inhabitants in 2011. Still, the problem is far from reaching Central American proportions. Even though various measures to improve law enforcement have been presented in recent years, we do not expect a swift implementation, as fiscal consolidation currently takes center stage. Notwithstanding, increased co-operation with the US in security matters should help keep the problem largely at bay in the coming years.
The Dominican Republic’s external relations are generally good and have improved further thanks to the commitment of the previous president Fernández Reyna. The country’s bilateral relations with the US are cordial, in spite of the Dominican Republic’s strong ties with Venezuela that bring with them considerable subsidized crude oil deliveries. At the official level, historic animosities with neighboring Haiti are receding, as the Dominican Republic remains committed to ongoing reconstruction efforts. The recent proposal for a joint free-trade agreement, as well as the establishment of a Venezuelan-Dominican Solidarity for Haiti-fund under the PetroCaribe scheme, bear witness to this. Still, racist attitudes against Haitians remain among Dominicans amid fears of illegal immigration.
The Dominican Republic’s economic policies generally focus on improving the country’s attractiveness for foreign direct investment by means of favorable tax treatment, investments in infrastructure, as well as the conclusion of various free-trade agreements to ensure preferential market access for Dominican exports. While President Medina has not yet revealed any specifics of his government’s plan, during the election campaign he has committed himself to the implementation of the National Development Strategy 2010-30 (Estrategia Nacional de Desarrollo (END)) that was approved by Congress in January 2012. Besides proposing development objectives such as reducing infant mortality and improving literacy rates, the END focuses on three core areas – fiscal reform, education reform, and energy-sector reform – which represent the island nation’s most pressing problems. While the END remains rather vague about actual targets, it should provide a useful coherent guideline to broaden the Dominican Republic’s economic and social policies and help to address lingering policy issues that continue to put the country’s economic stability at risk. It remains to be seen, however, whether President Medina will manage to stick to the END throughout his presidential term, as the previous government at times opted for short-term fixes instead of long-term solutions.
Notwithstanding these concerns, the recently-passed budget for 2013 underlines the new government’s commitment to the END. While aiming for a reduction of the fiscal deficit from 5.5% of GDP in 2012 to 2.8% of GDP in 2013, the 2013 budget keeps spending constant in real terms and reallocates funds to education, agriculture, health, tourism and the promotion of small and medium-sized enterprises. Meanwhile, rising tax revenues on the back of recently enacted tax increases are expected to bring about the aspired reduction of the budget deficit. However, given the weak state of the country’s public institutions and downside risks to the growth outlook, a budget deficit of about 3.6% of GDP seems more likely.
Moreover, higher-than-budgeted transfers to the ailing electricity sector represent an important recurrent downside risk for the Dominican Republic’s government finances. Insufficient coverage of input costs by electricity tariffs, the source of continuous fiscal transfers, will likely persist in the coming years as the government has not yet implemented a mechanism for automatic adjustments of electricity tariffs to oil price increases. Unless this change is realized, government finances will remain exposed to variations in global oil prices. Notwithstanding, various steps have been taken to broaden the energy mix and shield the country from oil price fluctuations, ranging from increased use of renewable energies to subsidized crude oil deliveries.
Given an expected budget deficit of 3.6% of GDP, the public debt ratio will likely increase to 43% of GDP this year. Even though the public debt load remains manageable, we note that the dependence on highly concessionary PetroCaribe-funding rose continuously in recent years. This trend increases the risks of a sudden hefty hike in debt service costs in case a new Venezuelan government were to change the currently very lenient repayment conditions.
In line with the recently expired IMF standby-agreement, a fully-fledged inflation targeting regime has been adopted by the Central Bank of the Dominican Republic in early 2012. It replaces a multitude of, at times, contradicting policy objectives. Under the new regime, gradually declining inflation targets, including a ±1% tolerance band, have been set to meet a 4% inflation target from 2015 onwards. Since the new regime forces the central bank to focus on one policy objective only, it has to allow greater exchange rate volatility while trying to anchor long-term inflation expectations. Given the island nation’s heavy dependence on imported oil, this could prove difficult, however, as the managed float of the exchange rate helped buffer supply-side induced inflation shocks. Benefitting from relatively stable food and fuel prices, inflation moderated from 8.5% in 2011 to 3.7% last year.
Balance of Payments
Benefitting from relatively stable crude oil prices and rising mining exports, the Dominican Republic’s large current account deficit improved slightly from 8.1% of GDP in 2011 to a still sizeable 7.7% of GDP last year. Reflecting ongoing growth of the tourism sector, the structural services surplus increased marginally from 5.6% of GDP to 6% of GDP last year, though this effect was counteracted by a comparable decline in the transfers surplus as family remittances from the US and crisis-torn Spain remain weak. Since gold production is expected to reach full capacity next year while the tourism sector should benefit from relatively resilient growth in Latin America, this year’s current account deficit is expected to decline strongly to about 5.5% of GDP. We caution, however, that this estimate assumes a continuation of subsidized PetroCaribe oil deliveries. Given daily deliveries of approximately 50,000 barrels of Venezuelan crude oil, a possible termination of PetroCaribe could increase the trade balance deficit by 2-3% of GDP. The financing of the sizeable current account deficits remains a major weakness of the Dominican Republic. Last year, about 70% of the current account deficit was covered by foreign direct investments, while net portfolio inflows financed about 5%. Debt financing to cover the remaining deficit thus remains crucial.
In contrast to its weak balance of payments position, the structure of the Dominican Republic’s foreign debt looks relatively favorable. Total foreign debt amounted to a still manageable 29% of GDP last year. Short-term debt, which amounts to 12% of total foreign debt, was small and continued to decline. Public medium- to long-term debt, owed mostly on concessional terms to bilateral and multilateral creditors, accounted for almost 80% of total external debt. Going forward, external debt is expected to stabilize at about 30% of GDP.
Reflecting the weak balance of payments situation, the Dominican Republic’s liquidity position is quite poor and has deteriorated in 2012. The country’s gross foreign exchange (FX) reserves declined by 17% from USD 4.1bn in 2011 to USD 3.4bn in 2012, which corresponds to a very weak import cover of 2.1 months. While the country’s FX reserves are expected to recover to about USD 4.2bn next year, the import cover ratio is estimated to only improve to a still very weak 2.4 months. In this respect, the increased risk of alterations or even a complete cessation of the PetroCaribe oil trading scheme poses particular risks, as this could result in strongly rising import expenses and increasing debt service costs. Consequently, the renewal of the recently expired IMF SBA is certainly welcome. This would not only provide funding at concessional rates, but also support investor confidence.