Publish in Perspectives - Wednesday, October 21, 2015
Monetary authorities have not only lowered the level of inflation, but have also reduced its volatility, a remarkable feat. (Photo: Dominican Government)
accounts have improved markedly, boosting buffers against financial shocks.
BY FRANCO UCCELLI
Growth has been quite strong, yet lower oil prices have kept inflation in check. Real GDP is officially projected to expand 6.0-6.5 percent in 2015, one of the highest - if not the highest - rates in Latin America and the Caribbean, before moderating to its potential of 5.0 percent in 2016. Meanwhile, inflationary pressures have been quite soft, largely due to lower oil prices and well anchored expectations, currently tracking below the target range of 4 percent (+/-1 percent). That being said, inflation readings are expected to converge to the range during the course of 2016, driven largely by base effects. Through proactive policy-making and enhanced credibility, the monetary authorities have not only lowered the level of inflation, but have also reduced its volatility, a remarkable feat. So far this year, the central bank has eased monetary conditions amid muted price pressures in order to lower market interest rates and boost economic growth, and it has worked as expected. An inflation targeting scheme was formally implemented in the Dominican Republic in 2012.
Fiscal consolidation continues in full force. After overspending ahead of the 2012 presidential election led the central government deficit to widen to 6.7 percent of GDP from 2.5 percent in 2011, the Medina administration implemented a series of reforms designed to right the fiscal ship. Thanks to a combination of higher revenues and expenditure restraint, the central government shortfall shrank by more than 4 percentage points to close 2013 at 2.6 percent of GDP, where it stayed in 2014, and is officially projected to print at 2.3 percent in both 2015 and 2016, supported by primary surpluses of 0.4 percent of GDP this year and 0.6 percent next. The recent decline in the shortfall has taken place despite a sizable increase in education spending to 4.0 percent of GDP starting in 2013 -- one of President Medina's key campaign promises-from 2.5 percent previously, the sort of investment in human capital that authorities believe will help to bolster growth potential in the future.
A new fiscal reform may be in the works. Despite the sizable fiscal improvement of the past few years, tax revenues in the Dominican Republic still account for only about 14 percent of GDP, a level that by most prudential measures is much too low. This had led some locals to speculate that the government may be planning to propose a new fiscal reform, but surely not until after the upcoming general elections, which are scheduled for next May. The focus, most speculators believe, would not be on increasing tax rates per se, as they are already above regional averages, but rather on eliminating tax exemptions, which at the moment are much too high. Local experts believe that a comprehensive fiscal reform could generate a total adjustment of as much as 3 percent of GDP -- 2.5 percent from tax reform plus 0.5 percent from expenditure rationalization-, something that, if fully implemented (low probability), would eliminate the deficit altogether.
Financing plan will tap multiple sources to cover short-term needs. Gross financing needs are likely to total $3.6 billion in 2016, the result of a fiscal deficit of $1.6bn, amortizations for $1.8 billion, and $200 million in payments to recapitalize regional financial institutions, such as CABEI and CAF. While the government has the discretion to choose how to raise funds to cover its needs, a break from the past when it had to lock in its financing strategy well ahead of time, the basic plan for next year calls for the government to issue a global bond for $1.25 billion and local bonds for $1 billion, and to borrow $300 million in project finance credits, $250 million from Petrocaribe, and $800 million in budget support loans from multilateral lending institutions. It is unlikely that the placement of a new global bond -- for $1.25 billion or otherwise-will take place before the May 2016 presidential election, as the government deliberately delays issuing internationally to avoid giving the impression that it may use the funds for political/electoral gain.
The oil dividend has been invested in the electricity sector. After considering a number of alternatives, including a further reduction in the fiscal deficit or increased capital spending in assorted public projects, the Medina administration opted to spend this year's estimated 0.5 percent of GDP oil dividend (i.e. the fiscal savings from lower-than-expected oil prices) directly in the electricity sector. The approximately $335 million in savings are being used to partly finance the construction of two coal-based electricity generation plants, which entail a $2 billion investment and are expected to go on line in 2017. If everything goes according to plan, the new coal plants will replace virtually all remaining fuel-dependent generation in the country and help to reduce the country's still-hefty dependence on oil imports.
Financial impact of Fed normalization is expected to be fairly limited. Since most of the public debt stock has fixed interest rates already, Dominican authorities believe monetary policy normalization (i.e. rate hikes) in the US, so long as it is gradual and orderly, as is widely expected, is likely to have only limited impact on the country's debt burden. Moreover, some private sector pundits believe that given that the Dominican risk premium has recently declined, interest rates paid by Dominican debt instruments may remain stable even if they climb in the US, resulting in a narrowing of the spread between the two countries. Interestingly, the Medina administration is anticipating the country's interest bill to inch up from 2.8 percent of GDP in 2015 to 3.0 percent in 2016, something that it plans to offset by boosting the primary surplus from 2.8 percent of GDP this year to 0.6 percent next. Authorities are expected to shift to a more contractionary monetary policy after US rate normalization starts.
Despite lower oil prices, subsidies to the electricity sector are set to remain high. Notwithstanding a sharp drop in average fuel prices, official transfers to the electricity sector are projected to total around $1 billion in 2015, only a relatively small improvement from 2014 levels, and to stay virtually unchanged in 2016, as the government utilizes additional resources to pay down arrears owed to power generators and to invest in electricity infrastructure, namely the two coal plants under construction. At present, a $1 billion subsidy bill represents 1.5 percent of GDP and accounts for more than 60 percent of the central government deficit.
External accounts have improved markedly, boosting buffers against financial shocks. Benefiting from lower oil prices and higher remittance ($4.8 billion forecast for 2015) and tourism ($6.1 billion forecast for 2015) flows, the current account deficit (CAD) has steadily narrowed from 7.5 percent of GDP in 2011 to a projected 2.0 percent in both 2015 and 2016. A smaller CAD, coupled with the high level of foreign direct investment (FDI) that has more than fully financed it, has boosted the level of international reserves to historical highs, with gross levels accounting for 3.5 months of imports in year-end 2014, an all-time record. The notable improvement in external balances has allowed the Dominican Republic to close its external financing gap much faster than expected and to fortify its financial buffers against external shocks.
Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on a recent trip report. Republished with permission.