Chart13 REAL EFFECTIVE EXCHANGE RATE (Increases mean Depreciation of Peso) 240220200-
8
180
£
160-
.
'
O)
o D x
140
-
120
(D "O
10080-
60-WrT 1985
1986
1987
1988
1989
1990
1991
1992
Chart14 IMPORTS, EXPORTS, TRADE AND CURREN! ACCOUNT BALANCES (In Millions of US$) ¿DUU-
1500/
1000-
/ ,/
/ /
-500-
' /
/
^ ^ ^
/ /
i I I
I /
' ' ^
1 1
' ^ '
1
/
<jl j
1/ R/
'
3 :3;i ;3 : ^ j
u ^ü rrip
•
/ / ' /
-
500-
R
/
2000-
3
3
' '< '/
/ a
3 a "
i
-1000-1500-
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
Imports
Exports
Trade Bal
Curr Acc Bal
Of the six elements cited to explain high lending rates, only the expectations of a devaluation are of a short run nature. The resolution of the other five problema requires fundamental mediumto-long run reforms of the system. These reforms will be supported by an IDB Financial Sector Loan. . (ii)
Competitiveness of the Exchange Rate: It is often argued that the peso is overvalued and thus a devaluation is prescribed to restore competitiveness. However, as Chart 13 shows, the real effective exchange rate has changed very little since 1990, when the stabilization was initiated. Besides, the DR has quickly achieved an inflation rate cióse to the international level, as necessary for the sustainability of the fixed exchange rate. Barring a banking crisis, it would be unwise to devalue the exchange rate because the fiscal-monetary fundamentáis are right and also because with a devaluation the anchor for today's low inflation would be lost. Competitiveness should be improved through the removal of supplyside constraints arising from infrastructure bottlenecks, imperfect market structure, and spurious regulations rather than through monetary means. At best, a devaluation would only lead to a transitory real deprecíation. If in any event, the authorities were to decide on a, say, 10% devaluation of the peso, the measure should be accompanied by the elimination of the prevailing 10% import surcharge -now applying to 40% of imports of "non-essential producís"- so as to offset part of the devaluation's inflationary impact while at the same time moving towards more tariff uniformity. Although a 10% devaluation might help in reducing the foreign exchange premium of deposit interest rates, that policy action is not recommended here.
B.3
The ünfolding Current Account Déficit
Assessment. The trade and current accounts of the balance of payments underwent growing imbalances since late 1991. The current account déficit jumped from 2.5% of GDP in 1991 to 6% of GDP in 1992. From a "partial equilibrium" viewpoint, this expanding déficit derives from a continuation of the decline in exports, initiated in 1989 combined with climbing import levéis. Exports dropped from US$658 million in 1991 to US$561 million in 1992, while imports increased from US$1.7 billion to US$2.2 billion (Chart 14 and Table II-6). The expanding revenues from tourism and Free Trade Zones which went from US$1.3 billion to US$1.6 billion was insufficient to offset the deterioration of the trade account. From a "general equilibrium" viewpoint, the source of the ünfolding current account imbalance is an excess of expenditure over income originating from a widening private sector budget déficit that was only partially buffered by a strenghening fiscal surplus. Indeed, the balance of payments is identical to the sum of the public and private sector budgets, and since the public sector is running a surplus, it follows that the current account déficit has its root in a private sector imbalance. Appendix I illustrates further this point. This privately led current account déficit fits the pattern recently observed in countries undergoing stabilization and running a fiscal surplus. The cases of México, 19
Table II-6: Summary of Balance of Payments (US$ million ) 1989
1990
1991
1992
1993 \a
-302.8
-206.4
-180.6
-472.1
-449.9
-1,039.4
-1,058.2
-1,070.5
-1,123.4
-1766.5
Exports, f.o.b.
924.4
734.7
658.3
561.7
527.8
Imports, f.o.b.
-1,963.8
-1,792.9
-1,728.8
-2,178.1
-2,294.3
Net Services
352.3
481.2
503.4
712.5
874.7
Receipts
1,162.8
1,282.4
1.338.1
1,603.7
1,775.8
(of which: tourism)
818.4
899.5
877.2
1,095.8
1,218.4
(of which: free trade zones)
198.5
199.5
255.2
287.4
316.1
-810.5
-801.3
-834.7
-891.3
-901.1
-295.7
-310.9
-295.4
-245.6
-242.6
Transfers (net)
384.3
370.6
386.5
431.8
441.8
CAPITAL ACCOUNT \b
-148.7
-300.6
249.1
382.1
339.0
Public sector capital
-15.6
-302.2
-133.7
-123.8
-35.7
Prívate sector capital \b
-133.0
1.7
382.8
505.9
374.7
(of which: direct investment)
110.0
132.8
145.0
179.0
200.0
(of which: other including e & o)
-243.0
-131.2
237.8
326.9
174.7
-451.5
-507.0
68.5
-90.0
-110.9
Net International Reserves \c
112.4
-75.7
-380.4
-123.6
57.0
Arrears \d
273.5
519.6
-662.5
-52.0
-588.8
Debt Relief
65.6
63.1
974.4
265.6
642.7
Gross International Reserves
122.8
68.8
426.1
489.0
495.4
Stock of Arrears
841.5
1479.0
779.1
627.5
--
CURRENT ACCOUNT Trade balance
Payments (of which interest)
OVERALL BALANCE FINANCING
MEMORÁNDUM ÍTEMS
\a \b \c \d
Programmed. Including errors and omissions. Negative number implies an increase. Excluding Central Bank arrears on reserve liabilities, which are included in the net international reserves.
Argentina, and Perú in 1991-93 are at hand. The other elements of the pattern are high nominal and real interest rates and a low (overvalued) exchange rate. The story goes that the high interest rates attract external capital inflows and these put downward pressure on the exchange rate -under a floating regime- or alternatively push up the monetary aggregates and inflation under a fixed exchange rate. Either way capital inflows typically transíate into a real appreciation of the exchange rate which, in turn, reduces the competitiveness of exports and makes imports 20
Table II-7 Savings, Investment, and the Current Account Déficit. (percent of GDP) 1989
1990
1991
1992
Prívate Investment (1)
16.7
15.4
13.9
- 15.4
Prívate Saving
18.5
17.9
11.6
8.1
Prívate Sector Gap (3)-(l)-(2)
-1.8
-2.5
2.3
7.3
Public Investment
(4)
11.3
6.6
6.6
7.7
Public Savings
(5)
5.0
1.2
6.4
9.0
Public Sector Gap (5)
(6) - (4)-
6.3
5.4
0.2
-1.3
(7)=(6)+(3)
4.5
2.9
2.5
6.0
Current Account Gap
(2)
more attractive thus feeding back on the current account déficit. As discussed above, there is no evidence that, in the case of the DR, high interest rates and capital inflows might have caused a significant real appreciation of the exchange rate, unlike in the cases of the other three countries. The widening of the private sector déficit has resulted from both an increase of private investment and a contraction of private savings. As Table II-7 shows, in 1992 private investment increased by 1.5% of GDP while private savings dropped (consumption expanded) by 3.5% of GDP. As a result, the leading forcé behind the growing current account imbalance is private consumption. Several factors are responsible for the expansión of private consumption. First, the increase in the purchasing power of wages following the adjustment to mínimum wages and also the sudden drop of inflation in 1991. This latter effect stems from the elimination of the inflation tax -which can be viewed as a tax on wages- and is additional to the 25% improvement of real mínimum wages granted in 1991. As Appendix II explains, stopping inflation could have led to an additional improvement- in real wages of up to 7%. Second, the fast expansión of domestic credit to the private sector. As noted in Table II5, in 1992, it grew by the equivalent of 24% of the broad money supply8 due to reduction in reserve requirements. Another more limited but revealing indicator of credit for consumption is purchases through credit cards which rose by 48% in real térras between 1991 and 1992. Finally, the decline in import tariffs reduces the relative price of imports, together with the massive imports of durable goods in anticipation of the possibility of a closing up to trade if the reforms fail.
8
Part of the domestic credit to the private sector might have been funded on capital inflows deposited at commercial banks.
21
It should be added that the increase in prívate consumption was partly offset by a strengthening of public savings, which expanded by 2.6% of GDP in 1992. Likewise, the rise in private investment was compounded by an increase in public investment by 1.1% of GDP (Table II-7). As a result, the total expansión of aggregate consumption was only 0.9% of GDP while that of aggregate investment was 2.6%. Issues. The two issues are sustainability and vulnerability. As to sustainability. there are three key questions. First, is the excess expenditure the result of a one-time self-correcting process or else does it require cool down policy action?. Some of the aforementioned factors that pushed up private consumption are one-and-for-all: the effect of stopping inflation on wages; the rapid growth of domestic credit due to lower reserve requirements; and anticipatory imports of durables. Other factors, such as further tariff reductions and external capital inflows are, in principie expected to continué. As a result, the net effect is that the current déficit can be expected to narrow. The second question is whether the increase in the current account déficit (foreign savings) translates into incremental investment or consumption. As noted before, of the 3.5% of GDP deterioration of the current account, 2.6% went to additional investment and 0.9% to consumption. This shows that the process is safe on this account. What is worrisome, however, is the sectoral composition: public savings are expanding but private consumption is expanding fáster. The third question is whether the return on investment will be sufficient to repay the debt service. The problem is that a significant share of the external financing of the current account déficit comes in the forra of speculative capital inflows. They are attracted by high interest rates and they are lent to the private sector at real annual rates of over 25%. This suggest the possibility of borrower's default risk, thus indicating that the process might not be sustainable. Regarding vulnerability. the problem is that the foreign capital inflows financing the current account déficit are mostly short-term and speculative (Table II-6). If these are suddenly withdrawn it cannot be expected that the excess expenditure will be automatically washed out. As a result, a foreign exchange crisis will result. Preliminary data for the first half of 1993 appears to indícate that the current account déficit is narrowing somewhat. In the absence of sufficient narrowing, cool-down policy action will be called for. This could take the form of inter-alia: an increase in the valué added tax from 8% to 10% (in most countries in the región is above 10%) ; establishment of a 100% legal reserve requirement for the state-owned Banco de Reservas to ensure that the Treasury's surplus is not reshuffled as domestic credit; and strengthened supervisión by the Superintendency of consumer credit granted by the banking system. II.C
Attaining Public Sector Solvencv Background. The public debt is mainly foreign debt. The domestic public debt, mostly in the form of Central Bank's monetary stabilization bonds, can be considered negligible. At the end of 1992, the public debt stood 22
Table II-8 External Debt Indicators (percentages) Debt/GDP
Debt/ Exports of Goods & Services
Debt Service Due /Exports of Goods & Services
Debt per capita
•
Secoiidary Market Discount
56
204
23
590
75 \a
10*
346
51
1149
72
México
37
224
31
1226
34
Brazil
29
334
56
760
70
Perú
50
580
57
1082
82
248
40
997
N.A.
Dominican Republic Ecuador
Latín America
38
\a This has decreased to 572 since the announcement of an agreement in principie of a Brady type plan in April 1993 Source: World Debt Tables, The World Bank; IMF Staff Reports; and Monthly Economic Review, 1993, The Institute of International Finance (IFF).
at US$ 4.4 billion or 56% of GDP. In turn, the debt service to exports ratio was 23%. These indicators roughly match the conventional wisdom safe ceilings of 50% for debt to GDP and 30% for debt service to exports. As Chart 17 shows, about half of the debt is bilateral with the other half equally dívided between commercial banks and multilaterals. Four events mark the progress achíeved in debt restructuring; first, the clearance of arrears with multilaterals in late 1991; second, the November 1991 agreement with París Club creditors to restructure debt service falling due until April 1993 as well as arrears; third, the buyback at a sizeable discount of the bilateral debt with México and Venezuela, two of the DR's largest bilateral creditors; and finally, the May 1993 agreement with the advisory committee of commercial creditors on a "term sheet" for a debt reduction-cum-buyback scheme under the Brady Plan. Under the agreement with the advisory committee, the DR intends to buyback or restructure US$775 million in principal and US$260 million of past due interest (PDI). Creditors will be able to choose between; (i) tendering principal and PDI claims against a cash buyback; (ii) exchanging principal claims for a collateralized discount bond or an uncollateralized interest reduction bond; (iii) trading PDI claims for an uncollateralized market rate bond. In addition, there will be a cash downpayment of 12.5% of total PDI. The deal is contingent on the attainment of a 50% reduction of principal plus PDI outstanding at the closing date. Assessment. The debt problem has stock and flow dimensions. The stock perspective is the relevant one to assess the country's debt overhang and thus the debt write-down the country needs. Objective indicators -such as the debt to GDP, debt service and debt per capita ratios- often shed light
23
Table II-9 Cash Cost of Brady Deal Under Different Assumptions (US$ million) Buyback Option \a
Discount, Bond Option \a
701
601
50Z
40X
30Z
10Z
222.5
196.2
169.9
143.6
117.3
30Z
240.4
214.1
187.8
161.5
135.2
205.7
179.4
153.1
50Z
170.9
70Z Xa
The raatrix assumes different percentages of debt traded at buyback (horizontal) and traded for discount bonds (vertical). For any matrix element, whatever remains to reach 100Z is traded for interest-reduction bonds.
on the country's ability to pay. According to these indicators the DR is not any worse than the average Latín American country (Table II-8). Indeed, it is in better shape than Ecuador and Perú and -for some indicators- than Brazil, the three other Latín American debtors with a yet to be settled commercial debt overhang. However, the huge secondary market discount on the DR's commercial debt comparable to those of the other three countries, índicates that the market's assessment of the DR's ability-cum-willingness to pay is indeed small. This might be due in part to the fact that the debt eligible for reduction -only commercial debt- is barely one-quarter of the total, much lower than the respective proportions for Brazil and Ecuador but comparable to that for Perú. From a flow perspective. the central question is whether the current, and future foreseeable, public finance stance is consistent with the preservation of solvency. This can be assessed by looking at the budget's primary balance.9 The primary surplus of the public sector reflects the "net transfer" of resources from the prívate sector to the public sector that are available to service the public debt. A sufficient condition for solvency is that the present discounted valué of the future primary surpluses must be no smaller than the valué of the outstanding debt. It can be shown that for this to hold, the permanent average primary surplus must be no lower than the difference between the real interest rate and the real GDP growth multiplied by the current debt to the GDP ratio. The analytics of this proposition is presented in Appendix I of the Macroeconomic Assessment Paper of Ecuador and therefore do not bear
The standard primary balance is equal to the difference between public revenues and non-interest expenditures. The primary surplus (or déficit) can be augmented by adding seignorage and the Central Bank's primary surplus to public revenues.
24
repetition here. 10 Given plausible projections for the real interest rate on the DR's external debt (6%) and GDP growth (a conservative 3.6% p.a.). and bearing in mind that the current debt stock to GDP is 56%, it follows that the long-run primary surplus required for solvency would be 1.3% of GDP. Of this total, 0.8% of GDP could be raised from seignorage.1L As a result, solvency requires a long-run primary surplus of the non-financial public sector equal to no less than 0.5% of GDP. The surpluses of 1991-92 were far higher than this threshold, 4% of GDP in 1991 and 4.6% in 1992 (Table II-l). It can thus be concluded that the public sector has made an extraordinary effort "on the flow" to attain solvency. As can be seen in Chart 2, this has led to a decline of the debt to GDP ratio. Issues. The strong primary surpluses of 1991-92, nevertheless, overstate the underlying budget trends and prospects. It was noted in sections IIA-2 and 3 that the improvement of the budget has been achieved through a combination of temporary, and probably self-liquidating revenue measures and strong compression of public spending in infrastructure and social services. Therefore, two actions are urgently required to restore solvency: first, the implementation of the tax and budget reforms explained in Section II; and second, the timely conclusión of the Brady deal. Two issues are involved in the resolution of the debt reduction deal: (i)
Pricing of the Options: It can be proven that buyback option is significantly lower ín valué than the other two options when the latter are discounted at any reasonable discount rate. In turn, the interest reduction-bond option appears to be less attractive than the discount-bond option at discount rates higher than 14%. As a result, debt holders are expected to favor the higher valué discount bond option. However, the DR has the right to withdraw from the deal if it does not obtain a 50% reduction in the stock of principal plus PDI. A massive selection of the discount bond option will not deliver this result. In consequence, creditors will have to be required to rebalance a large share of their commitment to the least attractive buyback option. This may prove to be a difficult and protracted process.12
(ii)
Cost of the Transaction:
Table II-9 presents the cash cost of the
10
Ecuador: Macroeconomic Assessment Paper, May 1993, Department of Plans of Programs, IDB. 11
Assuming: inflation at 5% p.a.; money equal to 10% of GDP
GDP real growth at 3.6%;
"The Dominican Republic's Brady deal: Kidder, Peabody and Co, May 20, 93. 25
and base
a preliminary assessment".
deal -including buyback, collaterals and interest payments prior to closing- assuming different combinations of the three options. The total cost is expected to range between US$171 million (70% discount bond-30% buyback) and US$206 million (50%-50%). These figures represent between one-third and one-half of current net international reserves. But only about one quarter would come from a drawdown of gross reserves. The rest will be raised from balance of payment disbursement under the IMF's Stand-by and Compensatory Financing (about US$100 million prior to February 1994) and the first tranche of IDB's financial sector loan (about US$52 million). II-D. Attainlng Financial Sector Solvencv Background. The DR's financial system is highly segmented. The banking laws of the 1960's set the stage for a proliferation of specialized intermediarles differentiated by: terms of deposits and lending; reserve requirements; interest rates; fiscal incentives; and credit allocation. As of September 1992, the formal prĂvate financial sector comprised 19 commercial banks (70% of deposits); 38 development banks (5% of deposits); 14 mortgage banks (6% of deposits); and 19 savings and loan associations (19% of deposits). This diversity belies the fact that the largest share of the market is operated by holding companies each owning a group of specialized banks. In addition, there are some 300 unregulated financial companies. The Superintendency of Banks, under the jurisdiction of the Secretariat of Finance, is responsible for the oversight of the system. Although overstaffed with 800 low-pay employees, it lacks adequately trained professionals . Inspections of banks are seldom, and loan classification data provided by the very banks never seems to be contested by the Superintendency. As a result, the reported quality of the bank's loan portfolios seriously overstates the actual health of the system. The proliferation of intermediarles in the 1980's coupled with virtually no supervisiĂłn led to a score of banking failures in 1990. Assessment. The DR's financial system is relatively broad by Latin American standards. The ratio of the broad money supply to GDP is about 28%. Although there is no formal deposit insurance, the tradition has been that ailing formal banks are taken over by the Central Bank for liquidation and their deposits are fully paid off. At present, there are two banks and about 30 financial companies under liquidation. The Central Bank is reimbursing deposits of up to US$4,000 with cash and larger deposits with a one-year bond at 10% interest. The cost of the bail-out, for 1993 alone, is estimated at about US$ 50 million. This practice of a full implicit guarantee on crisis deposits could bring stabilization to an end in the event of a mĂŠdium-to-large scale banking crisis. A study on the quality of the portfolios of five banks was conducted in 1990 by an independent team of experts commissioned by the Central Bank. The sample included 506 large loans of 361 clients. The comparison between the respective classifications of these loans by the Superintendency and by the team is presented in Table 11-10. According to
26
Table 11-10 Quality of Loan Portfolio of Selected Banks in 1990.\a (percentage of loan portfolio) Category Normal
Bank
Superin -tendency
Team
Potential Froblems Superin Team -tendency
Default Superin -tendency
Team
Doubtful Recovery \b Superin Team -tendency
A
85.6
55.8
11.9
35.2
2.6
6.4
0.0
2.6
B
84.7
56.5
10.6
30.1
4.6
13.3
0.1
0.1
C
81.0
41.1
16.2
51.1
2.8
7.8
0.0
0.0
D
74.5
40.7
24.1
45.2
1.4
13.8
0.0
0.3
E
55.9
17.7
2.0
29.0
41.2
12.2
0.9
41.1
Total
81.1
49.5
14.2
36.8
4.6
12.2
0.1
1.5
\a
\b
Based on a sample of five banks with total assets equal to 28Z of total banking assets. The sample comprises 506 loans of 361 clients. The classification provided by the Superintendency was reassessed by an independent team commissioned by the Central Bank. Note that there were no loans classified in the category "loss" by either the Superintendency or the Central Bank team.
the Superintendency, 81% of total loan balances were classified in "normal" standing whereas the team found that only 50% could be deemed as "normal". Using the classification by the team, the effect was that the five banks were undercapitalized, with networth becoming negative in two of them after considering the non-provisioned losses on abnormal loans. The results of this limited exercise give an indication of the potential magnitude of the problem. In addition to the absence of supervisi贸n, two other forces have driven the process of the piling-up of bad loans. The first is stabilization because successful disinflation typically leads to very high expost real interest rates wh铆ch place many debtors under financial distress. High lending interest rates -nominal and real- are a very serious problem in the DR. At present, annual rates stand at 25% in real terms and 30% in dollar terms (Charts 9 al 10). Although savings rates are also high by international standards (about 10% real), the unsustainable level of the "spreads" is the more fundamental cause of the high lending rates. Now spreads stand at about 20% nominal over the average cost of funds (Chart 11). The second factor is structural adjustment, since the opening-up to freer trade and the liberalization of markets change relative prices and through them relative profitabilities across sectors and firms. This structural shock misleads commercial bankers who tend to assess creditworthiness on the basis of the borrowers' credit history which becomes irrelevant in such a context. An attempt to elab贸rate on these ideas within a simple formal framework is presented in Appendix IV. In particular, the key issue analyzed there is how big a shock of real interest rates and/or structural adjustment can be
27
withstood by the banking system without going permanently into insolvency. The main finding is that the system easily recovers over time from a "small shock" (say, a temporary jump of annual real interest rates by 8 percentage points) after undergoing an initial rise in the non-performing portfolio. However, "large shocks", even of a transitory nature, drive the system permanently into insolvency. The two "large shocks" considered in the Appendix are: a financial shock in the form of a temporary jump of the annual real interest rate by 40 points; and a structural adjustment shock in the form of an opening up to foreign trade that translates into an initial decline of the typical borrower's relative price from 1 to 0.57 for then to step-up gradually towards a permanent level of 1.1 (i.e. 10% higher than the initial relative price). Although this simple framework clearly does not replícate the complexities of the DR's financial dynamics, it does provide insight on the main risks involved. Issues. Reforming the DR's financial system has three key dimensions: (i) cleaning-up the portfolio of bad loans to distressed enterprises through restructuring and recapitalization institutions, and the exit of insolvent banks; (ü) establishing a prudential framework in line with the guidelines of the Basle Convention: (iü) building-up an effective Superintendency of Banks. The first action deals with the "stock problem", the existence of losses on past loans now hidden in banks' portfolios. The second and third actions are necessary to prevent the system from taking new bad loans "on the flow". The Financial Sector Loan approved by the 1DB in September 1993 supports the enactment of a new Monetary and Financial Code and the creation of a new Superintendency.13 It must be noted that a new effective managerial team has already been appointed to the Superintendency and most of the new prudential measures are already in effect through Monetary Board Resolutions, even prior to the approval by Congress of the Monetary and Financial Code. Under the new framework, banks will now follow the model of múltiple banking -a program of mergers of existing specialized banks is foreseen- and banks are given a phase in a period of 72 months to reach the capital adequacy levéis, new provisions, loan concentration ceilings etc. This is an important reform program that will have a very positive effect on solvency "on the flow". It is of the essence, however, that a one-time early clean-up of the system be implemented as soon as the Superintendency can count on a assessment of banks' portfolios. Although this is not explicitly considered in the reform under the IDB loan, recapitalization of banks and the exit of insolvent áreas are necessary conditions for the preservation of financial and macroeconomic stability.
13
The content of the reform program is detailed in the Loan Document of the Financial Sector Loan, DR-0016, IDB, 1993. It does not bear repetition here. 28
III.
FRAMEWORK FOR THE RESUMPTION OF PER-CAPITA GROWTH Sustainable growth requires a steady flow of investment in physical and human capital interacting with a reasonably undistorted market economy integrated with the rest of the world. Macroeconomic stability is a key pre-condition for a distortion-free environment. In turn, stable rules of the game are essential to elicit a vigorous investment drive. These simple and now widely accepted ideas have a very straightforward application to the DR. In the 1970's, per-capita income expanded by a cumulative 50% in a climate of low inflation, modérate external debt and climbing investment (Charts 1 and 2). By contrast in the 1980's frequent changes in the rules of the game and growing macroeconomic instability prompted a stagnation of per-capita incomes. Two economic sectors have been the exception to the generalized decline: tourism and free trade zones (FTZ). These sectors have rapidly expanded their production, employment, and foreign exchange income. In 1980, their revenues represented barely 17% of total foreign exchange earnings. Today they represent two-thirds (Charts 15 and 16). Not surprisingly, these two enclave sectors opérate in interaction with the rest of the world and have enjoyed non-discretional, unaltered rules of the game in the forra of liberal investment codes. This framework of relative immunity to internal distortions has allowed foreign and local investors to put at work in the DR their money and also the "ideas" that have proven successful elsewhere. Furthermore, the sectors stand out as a living proof of the potential gains that the DR can achieve through broader integration in the world economy, deregulation, and stability. New endogenous growth theories have emphasized the effect on growth of: the acquisition of knowledge through International trade and foreign investment; the complementaritíes between private capital and social infrastructure; the positive externalities arising from the development of a better skilled labor market. Appendix V provides a framework for the understanding of these ideas in the context of the DR economy.
III-A.
Improving Efficiency in Resource Use
The growth rate of GDP declined from 8.5% annual in the 1970's to 2.5% in the 1980's. Most of the slow down was due to a reduction of efficiency. In fact, the gross investment to GDP ratio did not decline by much. It was about 24% in the 1970's and 21% in the 1980's. Thus, with the help of growth accounting methods, it is estimated that 83% of the reduction in GDP growth was due to a fall in efficiency and only 17% due to reduced investment. As a result, growth prospects could be enhanced tremendously by improving the gains from macroeconomic stability, trade, the abolition of spurious regulations and red tape, etc. Gains can also be achieved through better sectoral policies -including policies towards tourism and Free-Trade Zones- and in general, through a long term plan to strengthen the quality of public administration and governance. Therefore, it is of utmost importance that the Civil Service reform law issued in 1990 be implemented as soon as possible. Other efficiency enhancing policies such as privatization and restructuring of public enterprises have already been dealt with in this report. 29
A.l
Trade Liberalization
Assessment. Important steps have been taken since September 1990 to liberaliza trade. Many quantitative restrictions have been phased-out; múltiple exchange rates have been abolished; and the number of tariff positions and their levéis have been lowered to nine rates ranging from 0% to 35%. Moreover, under the Tariff Law of August 1993, -exemptions to tariffs for sectors operating under special contracts with the State have been terminated. The tax code of 1991 also eliminated existing loopholes under the promotion laws. This is a very important reform because tariff and tax exemptions afforded by special contracts and by promotion laws for tourism, agroindustry, industry, electricity, forestry etc.- created arbitrary loopholes and distorted resource allocation. The fiscal revenue foregone through these exemptions was estimated at about 20% of total tax revenues in 1990. Other positive measures of trade liberalization contained in the new Tariff Code are the abolition of the uplift factor (desmonte) of 1.1 -that multiplied tariff rates- and the reduction of the additional import surcharge, levied on about 40% of imports, from 7% to *f *. Issues. The positive effects of trade reform have been largely offset by the inefficiency of Customs and the Port Authority. The dispatching of imports is subject to an average delay of about 30 days (down from 60 days before the recent "shy" reform of Customs). Import procedures require múltiple steps and forty different signatures. All imports are subject to onsite physical verification. Moreover, valuation is frequently arbitrary and geared to meeting tariff revenue targets. (Comparing the Customs system of the DR and México, import valué per employee in the DR is only US$ 0.8 million while in México is US$21 million). Delays by the Port Authority are also a major bottleneck. Port tariffs are set as a function of time (US$12 per day and container) and not of operation. All this reveáis that, for the DR to benefit fully from International trade, the reorganization of Customs and ports is an urgent priority. A.2
Deregulat ion
Assessment. Spurious regulation of markets and barriers to entry, legal or factual, result in high costs for producers and the need to carry excessive inventories. Several examples of recent deregulation are at hand. In transportation, road haulage was dominated by two organization of truckers. The effect was that tariffs per Km were 72% higher then in Costa Rica and that transportation rates between Santo Domingo and Puerto Plata were higher than shipping costs from Miami to Santo Domingo. When authorities ruled and enforced a policy of new entrants, tariffs quickly dropped by 40%. Likewise the monopoly of CODETEL in telecommunications resulted in tariffs for international calis that were four-fold of those in the USA. The recent entry of TRICOM and All American Cables as long distance operators has yielded discounts of up to 60% on previous tariffs. Something similar occurred with the existence of import quotas for vehicles that favored concessionaires, allowing them to reap margins of up to 70%.
30
Issues. Recent steps in deregulation have been successful but very limited. The experience of México in this field should be a good reference for the DR. The authorities should consider commissioning case studies of market structure and regulatory framework for selected sectors so as to identify measures that could promote more competitive markets. A.3
Policy towards Tourism
Assessment. Tourism has become the leading sector of the DR's economy over the last ten years, substituting for the secularly declining foreign exchange earnings of exports. From 1989 to 1992, exports dropped from US$0.9 billion to US$0.5 billion while tourism revenues jumped from US$0.8 billion to US$1.1 billion. The current supply of hotel rooms is more than double then those of Cuba, Jamaica and Puerto Rico and is slightly higher than that of Cancun. Also, despite the international recession since 1990, the DR has managed to maintain occupancy rates at over 70%. The provenance of tourists by country is well diversified with about half from European countries and one-third from the US and Canadá. Total direct employment by the sector is calculated at about 60,000. In addition, using international norms for the indirect-to-direct employment ratio, indirect employment can be estimated at over 120,000. As a result, nearly 10X of the economically active population depend on tourism for their livíng. Issues. The backward linkages of tourist services, with local production of foodstuffs, textiles, furniture, construction materials etc., offer the the DR the possibility of using the tourism as a "big push" factor for the development of local industries, operating very much along the lines explained by old-vintage development theories of the big-push. The key issue is that these infant industries should develop with sufficient efficiency and competitiveness to be able to switch towards the domestic market or exports if and when tourism stagnates. This is why continued progress in trade liberalization is so critical for the DR at present. On the other hand, experience in other Caribbean Countries indicates that a development strategy fully reliant on tourism is at best risky. As income and wages improve, the country will lose market share to emerging lowerwage competitors. Needless to say, the DR will have to confront tough competition from, Lnter-alLa, Belize, Central America and post-Castro Cuba in the coming future. Promotional policies, including subsidized credit (i.e. INFRATUR) and generous tax loopholes are not a good avenue to follow because they undermine fiscal and financial discipline in the system. Rather, the real promotional effort should rest on reliable electrical supply, low import tariffs, no taxes foreign exchange transactions, and free remittance of profits. A.4
Free Trade Zones
Assessment. While in existence since the 1960's, the Free Trade Zones (FTZ) did not become an important factor until the 1980's. The number of firms operating in FTZs increased from 71 in 1980 to 400 in 1992, and employment expanded from 36,000 to 150,000. The number of FTZ's is now 27. The gross valué of their exports in 1992 totalled cióse to US$1 31
Chart 15 Composition of Total Exports: 1980* (Percentages)
Other Export Zones v/o â&#x20AC;˘Âż\i Tourism Recelpts (13.2)
(*) Exports in 1980 totalled US$ 1.313 billion
-
Chart 16 Composition of Total Exports: 1992* (Percentages)
(26.0) FOB Exports
Export Zones (13.9)
(50.6)Tourism Receipts
v(*)
'
Exports in 1992 totalled 2.165 billion
billion but only one-third of this was surrendered to the Central Bank. This one-third representa the DR's valué added as labor, electricity, local inputs and taxes. The main ítems produced by FTZ's are textiles, electronics and tobáceo. Firms in FTZ's are enclaves in the traditional sense, as they import most inputs free of tariffs and are obliged to export virtually all the production. Issues. Employment in the FTZ's is overwhelmingly unskilled, young, and female. To the extent that young workers acquire knowledge and skills that are of valué outside the FTZ, the system must be providing an important growth externality for the rest of the economy. As Appendix V illustrates, externalities of this type are critical from an endogenous growth perspective. Also, the fact that most employees are new-entrant females contributes to the improvement of wage differentials by gender. FTZ's might become less relevant if trade liberalization proceeds. The expansión prospects of the scheme might also be at risk if the NAFTA agreement is put into effect. However, for the time being, the Government of the DR has approved the establishment of two more zones -with prospective creation of 20,000 new Jobs- and is considering preliminary approval of another four. The Government should decisively continué to support to scheme through four key actions: (i) improving customs procedures so that current delays in the clearance of imports and their delivery by bonded-trucks is reduced to the minimum; (ii) promoting a framework for the improvement and reliability of key local inputs (i.e. electricity, telephone, transportation, etc.)14; and (iii) enacting an even more liberal code in terms of length of licenses (now at 15 years renewable) and other conditions; and (iv) strengthening training programs for new entrants. At present, FTZ's with the help of the Instituto de Formación Técnica (INFOTET) provide three months of training in basic skills to new workers. INFOTET is jointly financed by the Government, business and trade unions. Firms contribute with 1% of the payroll. The upgrading of training programs so as to meet the requirements of the FTZ's should be a high priority to make FTZ more attractive to investors. III-B.
Enhancing Resource Mobilization and Allocation B.l
Mobilizing Domestic Saving
Assessment. National savings declined markedly during the last decade compared to the 1970's (Chart 1). In the period 1982-92 gross national savings averaged about 16%, down from nearly 20% in the period 1975-81. The relative contributions of the public and prívate sectors to national savings have changed drastically over the last three years with public sector savings expanding to reach a share of 40% of the total. As was noted elsewhere, the ratio of prívate savings to GDP have actually plunged
1A
In a survey on the bottlenecks to which FTZ are subject undertaken in 1987, 50% of the firms questioned reported the unreliability of the electrical supply as the main factor, while 40% reported customs procedures. 32
in 1991-92 prompting a decline in national savings. Issues. Paradoxically, the recent drop of prívate savings is probably associated with the current economic reform program. As people discount to the present the higher the permanent income (wealth) of the DR, they increase their consumption further than the rate of current GDP growth. For a while this is reflected in a drop of the savings to GDP ratio. This drop subsequently vanishes. The fact that the public sector is strengthening savings might also contribute in part to declining prívate saving expenditure decisions, something that economists refer as "Ricardian equivalence". Nevertheless, in a more structural vein, it can be argued that savings in the DR are also constrained by the restrictive menú of savings options, now practically limited to bank deposits. The creation of the Santo Domingo Stock Exchange in 1991 opens new possibilities. The Government could invigorate the development of a capital market in three ways. First, the enactment of a new Securities Law would replace the now fragmented and out-of-date legislation on transactions in equities and firms disclosure requirement. Second, the Government could spur the surge of institutional investors through the privatization of pensión funds. And third, the Stock Exchange could be used in the privatization of some public enterprises. B.2
Mobilizing External Savings
Assessment. External savings (the current account déficit) averaged 4.6% of GDP in 1982-92 representing a very important source of financing. During the 1980's a big share of it carne in the form of commercial bank lending to the Government. Unfortunately, these funds financed unsustainable budget déficits and contributed to procrastinated adjustment. By contrast, foreign investment has also been steady and quantitatively important. The sectors favored by investors have traditionally been tourism, FTZ's, and mining (particularly the firm FALCONBRIDGE) due to the Government's more liberal schemes towards foreign investment in these sectors. These schemes included generous tax and profit remittance provisions and also the possibility of negotiating bilateral contracts with the State. By contrast the legal framework for foreign investment in other sectors is very restrictive. Issues. The Central Bank is preparing a new Investment Code that in general, is intended to put foreign investors parí passu with nationals. Thus, previous authorization for investments -other than those in a short negative list- will not be required and profit remittance restrictions will be eased. This is a very positive step. However, in order to give investors guarantees against expropriations, and political and other risks, the authority should consider subscribing to MIGA, OPIC and other guárantee agreements. B.3
Improving Investment Allocation
Assessment and Issues. Prívate investment over the last ten years has been twice as high as public investment (14% versus 7% of GDP). Significant improvements can be achieved in either one because, as 33
mentioned above, most of the slowdown in growth has been due to increased inefficiency in resource use. The allocation of prĂvate investment is expected to benefit from current reforms towards a less distorted market economy. In turn, the authorlties should urgently initiate the restructuring of public investment. As noted in Section II A-3 and elsewhere in the report, this restructuring includes inter-alia: (i) consolidation of all public expenditures within the budget through elimination of special funds; (ii) establishment of effective control by ONAPRES of all public spending; (iii) allocation of sufficient resources to necessary recurrent costs (i.e. road maintenance); (iv) moving away from low return large-scale public investments; and (v) improving resource allocation towards human capital, particularly in basic education, health and sanitation. In another vein, recent steps taken by the Government to reorganize and partially privatize the power sector are positive and can be expected to help in tackling critical bottlenecks to production.
34
IV.
STANDING WITH OTHER MULTILATERALS
IV-A. The International Monetarv Fund Over the past decade, the Dominican Republic has entered into several stand-by agreements with the IMF. In 1982 the country entered into a 3year IMF Extended Fund Facility which was not fully utilized due to underperformance. In 1985, a one-year Stand-by was fully disbursed. The current Government entered into a 19-month Stand-by arrangement in August of 1991 which expired in March of 1993. All targets of that arrangement were met with margins. In July 1993, the current Government signed a new Stand-by that stretches until March 1994. Total drawings under the program amount to the equivalent of SDR 31.8 million (20% of the quota). The last drawing is scheduled for February 1994. In parallel, the IMF also approved in July 1993 a further SDR 34.5 million under the Compensatory Financing Facility. IV-B. The World Bank The World Bank describes its strategy as a cautious investment in dialogue and projects with the flexibilíty to take advantage of opportunities as they open. Concerns about creditworthiness and exposure are not considered binding constraints. The IBRD's share in the DR's total debt is 3.3% and the IBRD's debt service to exports is 2.1%. The scale of the new lending program will depend on the continuation of macroeconomic stability of economic reform. The base scenario involves loan approvals totalling US$241 million during 1993-96. This program includes: (i) a US$51 million multisectoral line of credit for the private sector to be channelled by the Central Bank, as second tier, to the commercial banks as first tier; (ii) a US$30 million project for pilot irrigation in áreas where land is fully titled; (iü) a US$70 million loan for power in support of the Government's power sector strategy and conditional upon the intended privatization of CDE; (iv) two projects for the social sectors, US$30 for education and US$20 million for health; and (v) US$40 million for agricultural development. Under this lending program, the net transfer from the IBRD is expected to shift from a negative US$9 million in 1992 to a small positive level in 1995.
35
Table V-l Indicators of IDB Exposure in 1992 (Percentages and Ratios) Dominican Republic IDB Debt/GDP (%) \a
2.5
IDB Debt/Total Multilateral Debt (X) \b
36.5
Latín America 1.7
27.2
IDB Debt Serví ce/Exports of GNFS (%) \c
3.5
IDB Relative Exposure Ratio (GDP-Based) \d
1.5
1.4 - 4.0 \e
IDB Relative Exposure Ratio (Export-Based) \f
0.7
0.7 - 1.9 \g
\a \b \c \d \e \f \g
1.9
Excludes concessional debt. Includes IMF. Excludes concessional debt. Goods and non-finane i al servi ees. This indicator equals of the ratio between the country's share in IDB'stotal loan portfolio, divided (normalized) by the share of that country's GDP in Latin America's overall GDP. Range of relative exposure for countries in the región of per capita income within US$150 from Dominican Republic's (Guatemala, El Salvador, Paraguay and Ecuador). Same ratio, but normalized instead by the share of the country's exports of GNFS in Latin America's overall exports of GNFS. Range of relative exposure given for countries in the región with a per capita income within US$150 from the Dominican Republic's.
Source:
Calculations based on IDB and IMF data, and World Bank:
V.
IMPLICATIONS FOR BANK STRATEGY
V-A.
Current Operational Proeram
World Debt Tables 1992-93.
As of July 31, 1993, the IDB's loan portfolio consisted of nine projects showing undisbursed balances of US$286 million. Subsequently, in September 1993, the Board approved the US$102 million financial Sector Loan. The conditions of which support the new legal framework for the financial sector and the reorganization of banking supervisión. This loan comprises three tranches, with front-loading of US$52 million intended to help the DR with the cash-cost of the already negotiated but yet to be concluded debt reduction program. Two other project totalling US$62 million for agricultural development are scheduled to be approved before the end of 1993. The lending program envisaged for 1994 includes five more loans with combined commitments of US$207 million. Three of those loans deal with áreas that have been identified in the report as in need of urgent reform: power sector; ports; and health. It is critical that the power and ports loans be conditional, as intended, on a new regulatory framework consistent with progressive prívate sector participation. It is also convenient that, to the extent possible, financing for new public investments in these áreas be minimized. Regarding the health project, the separation of health and pensión services of the Social Security (IDSS) should be pursued fully. The repeal of the approved but not yet implemented legislation to increase social security premiums should also be considered under the loan conditions. Also, given the current
36
CharMT Composition of/^^Long-Term Debt in 1992 . j __\ (Percentages)
" Suppliers and others Commerclal Banks
(3.6)-i
(25.6)
(45.8) Bilateral
Multilateral
(25.0)
Chart 18 IDB Relativa Exposure Patios*
O O Ü CE O ü.
u. O UJ
4
8
é
SHARE OF REGION'S GDP OR EXPORTS (%) (*) Selected Countrles Note: (G) Corresponda to GDP Share (E) Corresponda to Export Shares
'
«
10
inefficiency of health services provided by IDSS, a decisíve attempt should be made to persuade the authorities towards a system in which health services would be contracted out to third parties. Since the DR's debt levéis are relatively manageable compared to other countries in the región, once the commercial debt reduction is concluded, a balance of payments support further to the Financial Sector Loan does not appear necessary. Therefore, if either an Investment Sector Loan or a Social Sector Loan are included in the pipeline, their disbursements should be as small as possible (i.e. no more than a total of US$50 million). V-B.
Kev Operational Issues and Conditionalltv They can be divided into the following three categories: conditionality, project implementation, and supervisión. Regarding conditionality, it is convenient that all future projects are kept within the perspective of the two key goals of: reorganizing the Civil Service and establishing a legal framework consistent with prívate sector development. Thus, loans should consider adequate conditions towards these goals. Current technical assistance for tax administration should be broadened to include Customs reform and the improvement of public budgeting. In addition, a way should be devised to place a general condition on all loans to the effect that the public budgeting system be improved in the áreas of coverage, planning and auditing. In particular, the elimination of special funds should be a matter of high priority. As to project implementation, the record of the DR with IDB and World Bank projects is poor. As a result, special emphasis should be placed in building up the implementation capacity of executing agencies through for example, hands-on technical assistance. Regarding supervisión, given the fragility of the banking system, the Bank should strengthen supervisión of the Financial Sector Loan, throughout its execution.
V-C.
Bank Exposure
Considerations
As Table V-l and Chart 18 show, the IDB's exposure to the DR is slightly higher than the average for Latin-America when using ratios of exposure to GDP. This is why the so-called IDB relative exposure ratio in Table V-l is higher than 1. By contrast, when using exposure to exports as the relevant indicator, the IDB's exposure to the DR is lower than the average for Latin America. Consequently, exposure is not a binding constraint. If the Government elected after the upcoming May 1994 election continúes the implementation of the reform program, the Bank should keenly expand its lending program to provide a positive transfer (disbursement minus debt service). The fact that since 1991 the net transfer has been neeative is worrisome. ° An economic plan detailing the future reform agenda has been prepared jointly by the Central Bank and the Fundación de Economía y Desarrollo under the guidance of the World Bank, IMF, and the IDB (DPL/MPO). The Plan is entitled Programa Hacroeconomico de Mediano Plazo 1993-98 and was 37
finalized in June 1993. Performance against this Plan will be critical in assessing the course of the DR's reform procesa.
38