DEPARTMENT OF PLANS AND PROGRAMSMACROECONOMIC POLICY DIVISIÓN

DOMINICAN REPUBLIC:

MACROECONOMIC ASSESSMENT PAPER, 1993

This paper is based on the findings of a two-week mission that visitedSanto Domingo in May 1993. The report was elaborated by the followingteam: Ricardo Lago (Mission Leader); Inder Ruprah (Macro Policy Officer);Aliya Husain (Macro Policy Officer); Leonardo Auernheimer (Consultant,Texas A&M University); Willem Buiter (Consultant, Yale University). IdoiaOscáriz skillfully typed the document. Gregorio Arévalo (ProgrammingOfficer) also participated in the Mission to Santo Domingo and in theinital stage of the report.

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TABLE OF CONTENTS

I. MACROECONOMIC DEVELOPMENTS

I-A Past Economic Performance

I-B Macroeconomic Policy of the Current GovernmentB.l Stabilization Measures and ResultsB.2 Structural Reforms

II. FRAMEWORK FOR MACROECONOMIC STABILITY

II-A Fiscal PolicyA.l The Budget for 1993A.2 TaxationA.3 Public Expenditure and Budget ReformA.4 PrivatizationA.5 Social Security

II-B Monetary and Exchange Rate PolieÍesB.l Monetary Policy: Institutions and InstrumentsB.2 Interactions Between Exchange Rate and Monetary PoliciesB.3 The Unfolding Current Account Déficit

II-C Attaining Public Sector Solvency

II-D Attaining Financial Sector Solvency

III. FRAMEWORK FOR THE RESUMPTION OF PER-CAPITA GROWTH

III-A Improving Eficiency in Resource UseA.l Trade LiberalizationA.2 DeregulationA. 3 Policy towards TourismA.4 Free Trade Zones

III-B Enhancing Resource Mobilization and AllocationB.l Mobilizing Domestic SavingsB.2 Mobilizing External SavingsB.3 Improving Investment Allocation

IV. STANDING WITH OTHER MULTILATERALS

IV-A The International Monetary FundIV-B The World Bank

V. IMPLICATIONS FOR BANK STRATEGY

V-A Current Operational ProgramV-B Key Operational Issues and ConditionalityV-C Bank Exposure Considerations

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DOMINICAN REPUBLIC

MACROECONOMIC ASSESSMENT PAPER

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'I. MACROECONOMIC DEVELOPMENTS

I-A. Fast Economic Performance

Given its abundant natural resources and its proximity to Internationalmarkets, the Dominican economy has a high potential for export-ledeconomic growth. This growth potential was evident in the 1970s, when theeconomy grew on average at 9% annually while inflation remained at amodérate rate of 8%. This impressive performance was a result of prudentmacroeconomic policies and occurred despite the exístence of microeconomicdistortions and external shocks (i.e. the collapse of Bretton Woodsexchange system and the two oil price shocks). Both investment anddomestíc saving to GDP ratios increased significantly reaching 25% and 20%of GDP respectively at the end of the decade.

Beginning in the early eighties, however, macroeconomic imbalancesdeveloped leading to increasing trends in inflation and the foreign debt.Inflation peaked in 1990 at 101% and the debt-to-GDP ratio shot up from30% in 1980 to nearly 100% at the end of the decade. The deterioratingmacroeconomic framework resulted in declining savings and investmentratios leading to a downturn of per-capita income (see Chart 1). AverageGDP growth fell from 8% in the 1970's to 1.5% in the 1980's.

In the early 80's the public sector expanded but the quality of the publicservices deteriorated. Public sector employment doubled while publicsector real wages halved. The worsening of the country's infrastructureresulted in frequent electricity blackouts and a poorly maintainedtransport network. In turn social development standards remained amongthe worst in the región.

The exceptions to the generalized picture of decline in the eighties weretwo dynamic sectors: free trade zones and tourism. These sectorscontinued to expand employment and genérate foreign exchange at a fastpace. Their exports increased from 17% of the total in 1980 to 65% in1992. This vigorous record, in an otherwise declining economy, representsliving proof of the country's potential for gains from free trade.

Macroeconomic developments over the last ten years can be divided up intothree sub-periods.

1982 to 1986. The administration of President Jorge Blanco was marked bytwo stabilization attempts supported by the IMF. The first one waslaunched in 1982 but failed one year later. In the second attempt, thefiscal déficit was reduced from approximately 7% of GDP in 1984 to a nearbalance in 1985. Inflationary financing of the public sector was

i

Table 1-1: Summary of Macroeconomic Folíeles and Events 1971-1991

Years

1971-1978

1979-1982

1982-1986

1982, 3 -year IMFprogram,suspendedlate 1983

IMF one-yearStand- byin April1985

1986-AUGUST1990

AUGUST1990-PRESENT

Sept1991:18-monthStand- byand 6monthprogramf rom July1993.

Externa!Events

Collapse of BrettonWood system andfirst oil shock in1973.

Second oil priceshock in 1978.

Hurricane in 1979.

From 1981 highexterna 1 interestrates.

Uorldwide recessionin 1982

High externa 1interest rates plusInternational debtcrisis.

Anti-austerity riotsin April 1984.

From mid eightiesstart of boom intourism and FreeTrade Zones.

Civil disturbantesin 1986 and 1989.

Strong growth inTourism and FreeTrade Zones.

Decline in terms oftrade.

By 1992 Tourismincome and FreeTrade Zone exportshad reached 65% oftotal exports.

ExchangeRates

Fixed official rate atRD$1 per dollar with aparal leí rate.

Mi ñor appreciation ofreal exchange rate,and small positivepremium of dollar inparal leí market.

Dollar's premium inparal leí marketincreased to 30%.

Dollar's premiumreached 200% by 1984.

Jan. 1985 official andparal leí marketunified and free floatintroduced; ratefluctuated between 2.8and 3.3 RD$ perdollar.

Sep.1986 preferentialrate, of 2.96,introduced.

Frequent and largeshifts withinmúltiple exchangerates.

Official rate changedfrom 2.96 RD$ perdollar Dec. 1986 to11.35 by Oct. 1990.

In February 1991,unification ofexchange rates, andabolition of foreignexchange controls.

Managed float, rateconstant at RD$ 12.5per dollar.

FiscalSituation

Orthodox fiscalmanagement .

Small public sectorborrowing requirement(PSBR) except for1975 when it was asurplus of 2% of GDP.

Foreign debt rosefrom US$ 0.2 bilí ionin 1970 to US$ 0.7bilí ion in 1978.

High fiscal déficit.

PSBR increased to 7%of GDP in 1979 andremained over 6%1980-1.

Revenue down from 19%of GDP in 1970-5 to10% by 1982.

Unsuccessfulstabi 1 izationprogram, started in1982 and abandoned in1983.

PSBR reached 7% ofGDP in 1984.

Successfulstabi 1 ization in1985: budget balance,and revenue up to 16%of GDP.

PSBR rose again in1986 to 6% of GDP.

Foreign debt climbedto US$ 2.9 bilí ionin 1986 and defaultof debt service.

Expansionary publicinvestment program.

Growing PSBRaveraging 5% of GDP.

Foreign debt rose toUS$ 3.4 bilí ion by1990, with arrearsaccumulating.

Fiscal austerity.

Budget surplus of 1%of GDP during 1991-2.

Revenue rose to 19%of GDP.

Arrears cleared withmultilaterals.

MonetaryPolicy

Moderatelyexpansionary.

M1 annual growth of20% during 1970-74,falling to 3% in1975, and rising to .13% annual growth1976-78.

M1 growth at 16% in1979, followed by6%.p.a. growth 1980-2.

Expansionary withlarge fluctuations inM1.

M1 growth of 42% in1984, falling to 22%in 1985.

Highly expansionary.

Period's annualaverage M1 growthrate of 36%.

Control led interestrates resulted innegative real rates.

Monetary restraint.

Strong growth ofprívate sectorcredit.

Free interest ratesresulting in highpositive rates.

Inflation and GDP Growth

Modérate inflation:

(i) 9% during 1971-2

(i i) 15% during 1973-5

(i i i) 6% 1976-8

High GDP growth at 9%p.a.

Inflation rose to 25% in1979 and then averaged6% in 1978-82.

GDP growth fell to 2% in1979 and than averaged5% in 1980-82.

Large fluctuations ininflation. From 8% in1983, accelerated to 33%1984-5, and fell to 7%in 1986.

Low and falling GDPgrowth, turning negativein 1986.

Drama tic acceleration ofinflation reaching 100%by 1990. Annual averagefor period of 56%.

Demand pulled recoverypeaking at 7.8% in 1988but leading to arecession of -5.4% in1990.

Strong fall of inflationfrom an annual rate of101% at the end of 1990to 4% in 1991 and 6% by1992.

Negative growth rates in1990 and 1991. Growthresumed at 7.6% in 1992.

eliminated but the Central Bank continuad to run a quasi-fiscal déficit ofabout 2% of GDP. The fixed exchange rate was abandoned in favor of afloat. The results were impressive: inflation fell from a peak of 38% in1984 to 7% in 1986, but GDP plunged by 3%. However, in late 1986, debtservice payments were suspended and múltiple exchange rates reintroduced.

1986 to August 1990. Amidst social unrest, the new administration ofPresident Balaguer embarked on a public spending course financed throughmoney creation and accumulation of foreign debt arrears. Arrears reachedUS$1.5 billion by the end of 1990. The demand-led boom resulted in atransitory output expansión during 1987-89 at the expense of acceleratinginflation. The boom ended in 1990 when GDP declined by 5% and inflationreached 101%. Continuous shifts of the múltiple exchange rate coupledwith controls on interest rates resulted in massive capital flight. By1990 gross foreign reserves were equivalent to only two weeks of imports.

1990 to 1993. The reelected President Balaguer initiated a stabilizationcum structural reform program. An 18-month stand-by agreement with theIMF was signed in September 1991 and successfully concluded in March 1993.The evolution of the macroeconomic variables quickly showed positivereturns to this policy regime: the collapse of inflation and a fasteconomic recovery. In June 1993, a new 9-month program was signed withthe IMF.

I-B. Macroeconomic Policy of the Current Government

B.l Stabilization Measures and Results

In August 1990, the Government announced a multi-year program combiningstabilization measures with some structural reforms. The stabilizationmeasures are summarized in Table 1-2. The central ones were: i)elimination of the fiscal déficit; ii) a unified and market determinedexchange rate; and iii) tightening of monetary policy and liberalizationof interest rates. In addition, arrears to the multilaterals werepromptly cleared, and a debt rescheduling agreement was reached with theParis Club in November 1991.

As a result of the program adopted, the fiscal déficit, as measured by thepublic sector borrowing requirements (PSBR) went from a déficit of 5.0%of GDP in 1990 to a surplus of 0.1% of GDP in 1991 and 1.6% of GDP in1992. The improvement of public finance had its source in revenueincreases from import tariffs and implicit taxes on gasoline. Domestictax revenues declined slightly and expenditures were only reducedmarginally relative to 1990.

The economy experienced a dramatic turnaround: the exchange rate quicklystabilized at DR$12.5 per dollar and year-end inflation was reduced from101% in 1990 to only 4% in 1991 and 6.5% in 1992. GDP resumed growth at7.6% in 1992 after a 6% cumulative contraction in 1990-91. Further,preliminary data suggests an improvement in income distribution with thepoorer 40% of the population increasing its income share from 8.8% in 1989

ChartlPer Capita GDP, Gross Investment/GDP

and National Savings/GDP*105

100-

96-

; 90-

; se-I

: 80-

751Q.O<D 70H

S& 65-ü

I 60H

55-

60-

45

Per Capita GDP

35

-30 £o)3V

-25

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990l 3-VearMovnaAvefaoe

O.Q(5MO)

(O•8

15

-10

1992

Chart2External Debt Ratio and Inflation

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990Í^The160%iurroínttieDeb(/GDPraior1985isc)uema^toac)evaluationo(tneotficaexchanoerae.

1992

Table 1-2: Stabilization Measures 1990-1992

PoKcy Áreas Measures Adopted

Fiscal Revenues 1. Two fold increase in domestic petroleum prices. Thedifferential between the domestic price and the imported pricebecame an important revenue source yielding about 2% of GDP.

2. Elimination of subsidies to electricity, sugar, and wheatproducís (their prices were doubled in late 1990).

3. Improvement in the customs valuation of imports due to theunification of exchange rate ( unrealistic múltiple rates wereused before) and the use of CIF valúes rather than FOB.

4. Establishment of a 15% temporary import surcharge (laterreduced to 10% and is presently 4%), affecting about 40% ofimports (including crude oil, but not foodstuffs).

5. Tariff rates were multiplied by a coefficient of 1.3 in 1991.The coefficient was reduced to 1.2 in 1992, and 1.1 in 1993. Itwas elíminated in September 1993.

6. Imposition of a 2.5% tax on foreign exchange transactions,later reduced to 2%.

7. As a result of the latter four measures, tariff revenuesincreased by 3% of GDP from 1991 onwards.

Budgetary Policy 1. Public expenditure was reduced only marginally from 16 to15.6% of GDP in 1991. By 1992, expenditure had risen to 17.1%of GDP.

2. Modérate increases in public sector wages (by 30% in 1990,well below the year-end inflation rate of 101%).

Exchange Rate Policy 1. Program to eliminate differential between official and themarket exchange rates. The two rates became unified byFebruary 1991. The exchange rate has since stabilized ataround RDS12.50 per dollar under a managed float.

Monetary Policy 1. Full liberalization of interest rates in January of 1991.Initial decline of interest rates and spreads during 1991,followed by increases to very high levéis since March 1992.

2. Adoption of tight monetary targets, with domestic credit to thepublic sector contracting in 1991 and 1992. In August 1990, a100% marginal reserve requirement was imposed for 90 days,rediscounting was suspended, and the opening of new financialinstitutions prohibíted until August 1991.

to 12% in 1992.

On the negative side, Stabilization has been accompanied by a wideningcurrent account déficit -which reached 6% of GDP in 1992 up from 2.5% in1991- and increasingly higher nominal and real interest rates. Despitethe unfolding current account déficit, the Central Bank's netInternational reserves have consistently built-up, owing to short termcapital inflows, reaching US$375 million or about two months of imports byMay 1993. In early 1993, the 12-month inflation rate continued at 6.5%and GDP growth continued although at a slower pace than 1992.

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Table 1-3: Structural Reforms 1990-1992

Reform Áreas Measures Adoptad

Foreign Trade Reforms (1990) A simplifi catión of tariff rates to seven which range from 5Xto 35X from a system which had HO different rates ranging from5% to 60X.

The drastic reduction of tariff exemptions.

The computen ization of Customs and a minor, clearlyinsufficient reorganization.

Tax Reforms (1992) Marginal personal income tax rates were lowered to aunified sea Ie between OX and 30X The highest marginalrate uas previously 75X. The number of brackets wasreduced.

The establishment of an excise tax on alcohol,tobáceo, vehicles, long distance telephone, and hotelrooms.

The "1TBIS" (valué added tax) was increased from 6X to8X tax in 1992, and subject to minor administrativoimprovements whereby exemptions were reduced.

Corporate income taxes were set at 30X (which will begradually reduced to 25X over the next 4 years).

Some remaining tax incentives and exemptions are to be phasedout over a three year period.

Financial Sector Reforms(1991- 1992)

1. In January of 1991 the Junta Monetaria decided tofully liberalize lending and deposit rates.

2. In December of 1991, a unified legal reserve of 20% wasestablished and the requirement of channeling selective creditwas eliminated.

3. In April and December of 1992, the Junta Monetaria issued anumber of resolutions which established a prudential frameworkto transform a system of specialized banking to a system ofmultiservice banking. A draft of the new Financial Code wassent to Congress.

Labor Legislation (1992) An increase in the number of days of notice given for thetermination of employment.

An increase in unemployment benefits.

An increase in the number of days entitled to a worker in thecase of marriage, birth, or death in the family.

Economic assistance to workers in cases of closure ofthe plant, or incapacity to work.

B.2 Structural Reforms

The Government has implemented some Structural reforms in the áreas of:trade tariffs, taxation, monetary policy, the financial sector, and laborlegislation. These are summarized in Table 1-3. In addition, steps arebeing taken to restructure the electricity sector and education. A CivilService Reform was enacted by Congress in 1991 but has not beenimplemented yet. Little has been done in the área of public sectorrestructuring.

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II. FRAMEWORK FOR MACROECONOMIC STABILITY

The Dominican economy has shown remarkable price-cost flexibility to theGovernment's shock disinflation program. Overnight, the exchange ratestabilized, inflation carne down to International levéis, and growthresumed shortly thereafter. Notwithstanding these achievements, two shortterm interrelated problems have arisen: (i) high and growing domesticinterest rates; and (ii) an unfolding current account déficit.Excessive prívate expenditures, largely in consumption, are at the root ofthe current account déficit, while high interest rates are procuring theshort-term external capital inflows to finance it. The problem withshort-term inflows is their unreliability. In turn, the concern over high

r interest rates involves their potential effects on the solvency of bothborrowers and financial intermediarles. A sudden withdrawal of capitalinflows and/or a banking crisis could bring exchange rate stability andlow inflation to an end. As a result, the unsustainable trends of thesetwo variables need to be urgently corrected.

Over the longer term, the preservation of low inflation and a stableexchange rate will depend on the firm implementation of structural reformsin several key áreas. First, the public sector's revenue base needs to beConsolidated. Since the Government is committed to a preannounced tradereform, revenue losses from tariffs will have to be compensated byadditional revenues from taxes on expenditure and income. Second, publicexpenditure will have to be restructured through, ínter alia,privatization of public enterprises, debureaucratization, andstrengthening of the budgetary process. Third, the externalcreditworthiness of the public sector, and of the country at large, needsto be reestablished by completing the already advanced debt restructuringand reduction plan of the Government. Fourth, the solvency of financialintermediarles needs to be improved through effective oversight of thesystem and by an up-graded prudential framework. Existing losses oftroubled banks will have to be assumed by shareholders, depositors andonly residually by the State. And fifth, the current unfunded pensiónfund system needs to be replaced in favor of one based on capitalizationof individual contributions.

Decisive action towards implementation of these reforms would send astrong signal to the markets that exchange rate and price stability areindeed sustainable. This would set the stage for a decline in interestrates -by reducing both country risk and foreign exchange risk- therebylimíting short-lived speculative inflows.

II-A. Fiscal Policv

A.l The Budget for 1993

Assessment. In June 1993 the IMF approved a 9 month stand-by. The budgetunder this program -summarized in Table II-1- foresees a rough equilibriumin public sector borrowing requirements (PSBR), compared to smallsurpluses in 1991-92, and allows for a slight increase in the ratio of

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Table II-lDominican Republic: Public Finance 1989 - 1993

(Percentages of GDP)

TOTAL REVENUE (1)

Current Revenue

(of which tax revenues \b)

Capital Revenue

TOTAL EXPENDITURE (2)

Current Expendí ture

(of which accrued interest)

Capital Expenditure.

BALANCE (1)-(2) = (3)

Déficit of Other Non Consolidated(4)

OVERALL BALANCE (3)+(4) = (5)

Grants (6)

PUBLIC SECTOR BORROWINGREQUIREMENT (5)+(6)\c

1989

16.9

16.5

12.4

0.4

21.8

10.5

4.1

11.3

-4.9

-2.2

-7.2

1.3

-5.9

1990

12.9

12.6

10.3

0.4

15.9

9.4

4.1

6.6

-3.0

-2.9

-5.9

0.9

-5.0

1991

16.1

15.8

10.3

0.3

15.6

9.1

3.8

6.5

0.3

-1.1

-0.7

0.8

0.1

1992

18.6

18.4

13.6

0.3

17.1

9.4

3.8

7.7

1.5

-1.0

0.5

1.1

1.6

1993 \a

18.5

18.1

13.8

0.4

17.7

9.8

3.5

7.9

0.8

-1.7

-0.9

0.9

0.0

FINANCINQ

Externa 1 \d

Oomestic

4.4

1.5

3.7

1.4

2.5

-2.6

1.1

-2.7

-0.2

0.2

MEMO ÍTEMS

Primary Surplus

Current Savings

-1.9

6.1

-1.0

3.2

4.0

6.7

4.6

8.9

2.7

8.3

\a Programmed.\b Excluding oil price differential and taxes on foreign exchange.\c Balance plus grants and central bank losses.\d Including interest arrears and rescheduling.

public investment to GDP. However, it should be noted that publicinvestment still remains at levéis considerably lower that those of the1980's. Public sector current savings continué at a strong 8.3% of GDPand the primary surplus at 2.7% of GDP. As is known, the former indicatorgauges the contribution of the public sector to the country's capitalformation while the latter is the relevant ratio to assess the trendtowards solvency. Domestic financing of the budget is set to rise from acredit contraction of nearly 3%, of GDP in 1991-92, to a slight expansión0.2% of GDP in 1993. This is due to the fact that foreign financing víaaccumulation of arrears -which was very significant in previous years-vanishes because of the renegotiation and reduction of the foreign

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commercial debt. The macroeconomic assumptions underlying the budget area GDP growth rate of 5% and a target inflation rate of between 5% and 8%.

Issues. The budget assumes a continuation of the trends in the majorfiscal variables and maintenance of current levéis of relative publícsector prices. The IMF supported program provides good short-termcollateral to economic agents for the continuation of fiscal-monetaryrestraint through this difficult pre-electoral period. It also enablesthe DR to conclude the debt reduction deal recently negotiated withcommercial creditors. However, the key issues for the sustainability offiscal balance, outlined below, are clearly not tackled.

A.2 Taxation

Assessment. Tax revenues represent about 15% of GDP, roughly equal to theaverage for developing countries. As shown in Chart 3, about 37% of totaltax revenues come from tariffs on imports while an additional 10% are aresult of the spread between the import cost and the local price ofpetroleum products, and still a further 2% comes from a tax on foreignexchange transactions. Consequently, about half of total revenues arisefrom differential taxes on international transactions thus distortingtrade and artificially favoring import substitution activities. Thevalue-added tax, the so called ITBIS, represents the largest share of theremaining half of fiscal revenues. As explained in Section III-A., thecollection of tariffs on imports is subject to cumbersome customsprocedures that impair the delivery of inputs and raise costs ofproduction. In turn, the collection of domestic taxes is subject torampant evasión. Indeed, of the estimated 28,000 business registeredunder corporate taxes, only 8,000 file tax returns. As for personalincome taxes, of an estimated universe of 230,000 individuáis who are inprincipie liable to pay, only 56,000 are registered and of this numberonly 23,000 file tax returns. Likewise, a recent UNDP study on compliancewith VAT indicates that evasión is no lower than 67% of the theoreticaltax base. The new tax code enacted in June 1991 -the main features ofwhich are presented in Table 1-3- has not become fully operative due tothree key reasons: the need to issue the by-laws for the new income tax;the spurious división of labor between two collection agencies, Direccióndel Impuesto sobre la Renta and Dirección de Rentas Internas; and thelack of an administrative reform necessary to enforce tax laws.

Issues. The budget surplus since 1991 has been achieved through temporaryand probably self-liquidating revenue measures with a yield of between 5and 6% of GDP. Taxes on international transactions are expected todecline because of the preannounced timetable of trade liberalization andalso because the current level of imports is atypically high. As aresult, the consolidation and possibly the improvement of the tax revenueto GDP ratio requires further reform. In this endeavor, two key issuesare involved: amendments to the tax laws and reform of taxadministration.

The main measures regarding the tax framework are the following: (i)increase in the rate of the value-added tax from the current 8% to 15%, a

ChartSCentral Government Revenues: 1992

(Percentages)

, Other Reverme(10.5)

Trade Tariffs (36.8)

Sale of Forelgn Currency (2.8)Oil Price DifferenUal (10.3)

Taxes on Goods & Services

(23.9)

(15.7) Income and Profit Taxes

Taxes on International Transactions Other Taxes

Chart 4Operations of the Consolidated

Public Sector(In Percent of GDP)

(10)1980 1982 1984 1986 1988 1990 1992

Revenues Expenditures & QFD -•- Déficit*

* Includes quasi-fiscal déficit (QFD) but excludes grants

'

rate more in line with the Latín American average, together with furtherelimination of exemptions, in particular services; (ii) replacement ofthe current "implicit" tax on petroleum products by an explicit tax to belevied at an ad-valorem rate on "ex-refinery" prices, so as to rule outvulnerability of revenues to exchange rate or international price changes;(iii) a ríse in the rate of excise taxes applicable to tobáceo, alcoholbeverages and automobiles to 30%, still low compared to the Latin Americanaverage which in the cases of tobáceo and alcohol reaches 90%; (iv)establishment of a minimum tax on corporate income, á la México equivalentto 2% of the firm's gross assets so as to counteract fraud through two-tier accounting and also to bring all registered businesses into the taxnet; and (v) establishment of clear-cut deadlines for payments andpenalties for delays.

The main measures regarding tax administration are as follows: (i)merging of the two tax collection agencies; (ii) creation of a unifiednew Taxpayer Registry on the basis of an updated survey; (iii)initiation of a comprehensive reorganization of tax administrationpersonnel, under the mándate of the already approved but not yetoperative Civil Service Law of 1990; (iv) replacement of the currentsystem of direct collection by one of payment of taxes at commercialbanks; and (v) up-grading and modernization of the data-processingdepartment in the áreas of hardware, personnel and software. It isestimated that the phasing in of the above reforms over the next two tothree years would provide additional tax revenues no lower than 5% of GDP,thus more than compensating for the foreseeable decline of tariff revenuesthat will be brought about by the reduction of real imports and furthertariff liberalization.

A.3. Public Expenditure and Budget Reform

Assessment. The reduction of total public expenditures, from an averageof 21% of GDP in 1987-89 to 16% in 1991-92, has played a major role in theDR's stabilization. Most of the expenditure reduction carne from publicinvestment, some of it of low quality. In fact, current spending has beensteadily maintained at about 10% of GDP for the last 20 years. Publicexpenditure magnitudes and ratios, however, belie the deeper issue of the"quality" of both public goods and services. From this perspective, theDR is probably well below other countries with comparable income levéis interms of quality of education, health and public administration at largeas well as in adequate maintenance of the road network and unreliabilityof electrical supply. A Civil Service Reform Law, issued in 1990, theimplementation of which is essential for the successful management of allthe reforms underway, has not been put into effect yet.

Regarding public sector budgeting, the main problem is the existence ofspecial funds allocated discretionally by the Office of the Presidency.Thus, in 1992, the budget approved by Congress included only 48% of actualGovernment appropriations for the year. The most important special fundis the so-called Ítem 1401 which accounts for 75% of all revenuesexceeding the budgeted amount for the general fund. These surplusresources are substantial because the revenue projections do not take

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Table II-2Selected Public Enterprises: A Summary Table

Ñame

CorporaciónDominicana deElectricidad (CDE)

Consejo Estatal delAzúcar (CEA)

CorporaciónDominicana deEmpresas EstatalesCCORDE)

Rosario Dominicana

CORPHOTELS

Banco de Reservas

INFRATUR

Fondo de Inversiónpara el Desarrollo(FIDE)

Activrty

Generation.Transmission, andDistribution ofElectricity.

Holding company of 10sugar refineries alsoowning, sugarplantations, andtransportinf rastructure.

Holding company of 24majority owned and 15mi ñor i ty ownedenterprises in allsectors (textil e,milling, food,transportation,automobiles, servicesetc).

Gold mining companyowned by the CentralBank.

Holding of 14 hotelssome of thetn leased tothe prívate sector.

Largest commercialbank which also hassome treasuryfunctions.

Department of theCentral Bank in chargeof : ( i ) protnot i on oftourism projects andinfrastructure; and of(i i) provisión ofsubsidized loans forprívate hotelconstruction.

Central Bank second-tier window to providesubsidized loans forinvestment projects.

Indicators

Expendí tures to GDP(1991)= 2.1%

Current losses beforeTransfers to GDP(1990)= 0.5%

Employment= 6,000

Expendí tures to GDP(1990)= 1.7%

Losses before Transfersto GDP (1990)= 0.1%

Employment= 20,000Dominicans and about30,000 foreigners

Employment= 9,000

n.a.

n.a.

Share in deposits ofthe banking system: 40%

n.a.

n.a.

Remarks

Approved government plan as follows:

* New regulatory framework allowingprivate sector access to electricitygeneration and distribution.

* División of CDE into threeindependent corporal i ons:generation, transmission, anddistribution.

* Total or partial divestiture and/ormanagement contracts for the new ex-CDE generation and distributioncompames.

* Expropriated from the Trujillofamily.

* Rising cost of production, obsoleteequipment, and declining US marketquota for the DR.

* But to be divested in parts foralternative potential means:agricultural producers, free tradezones, tourism developers, urban soiletc.

* Expropriated from the Trujillof ami ly.

* Few of the firms enjoy regulatorypreferences, others are protected byrestrictions to international trade,and one of them , MolinosDominicanos, enjoys monopoly power.

* Exports down from US$60 mi U ion in1982-83 to US$26 mi U ion in 1992.

* In need of major investments.

* Deteriorating facilities.

* Léase often at low rents andarrears in renta 1 payments.

* 60% of lending to the publicsector.

* High share of non-performing loans.

* The provisión of loans is funded inpart by international loans from theIDB and World Bank.

* Funding from the Central Bank andmultilateral institutions.

* First tier loans in the hands of 50intermediar i es.

10

account of expected inflation and also because there is delibérateunderestimation. In addition, there are other special funds establishedon specific sources of revenues such as royalties from the mine companyFalconbridge, oil price differential etc. Resources from special fundsare also freely assigned by the Office of the Presidency to specificpublic entitíes or "bulky" public investment project. A recent example ofthe latter is the US$800 million irrigation-electricity project of Higuey-Aguacate.

Issues. First, the reform of the state should be initiated urgently. Thestart of the process could be the implementation of the service reform inkey public institutions such as the Central Bank, the Superintendency ofBanking, Tax Administration, Customs, and the Ministry of Finance. Thebuilding-up of a skilled and dedicated body of civil servants, remuneratedat comparable salaries to those of the private sector, is a keyprerequisite for the successful continuation of the economic program.Second, the budget system needs to be replaced by one without specialfunds and with precise mechanisms of execution, audit and control. Also,all major expenditure ítems need to be placed under competitive tenderprocedures. The budget of autonomous agencies needs to be brought underthe control of ONAPRES, the National Budget Office. Third, a far reachingstudy on the structure and efficiency of public expenditures needs to beundertaken urgently, particularly for education, health andinfrastructure.

A.4. Privatization

Assessment. The characteristics of public enterprises are summarized inTable II-2 and their finances are provided in Table II-3. Performance hasimproved since the 5% of GDP Consolidated current losses of the mid1980's, but they still register current account déficits of over 0.5% ofGDP and require capital transfers and/or borrowing in order to financetheir investments. The political decisión to design a broad privatizationprogram has not been made yet. However, this policy is an essentialelement in the modernization and reform of the state. So far, the onlyexamples of privatization are: the trash collection service of SantoDomingo; the services of the new international airport; and someinvolvement of two multinationals in two firms of CORDE, a public holdingcompany. Recently, a more fundamental turn towards privatization has beentaken in the electricity sector. The new regulatory framework permitaprivate sector involvement in generation and distribution, and theGovernment is even thinking about, at least, partial privatization of thegeneration and distribution network of CDE, the power utility. Afrequently stated political argument that runs against the privatizationof CEA and CORDE is that these business were expropriated from Trujilloand thus are viewed as a revindication of the people.

Issues. The record of public enterprises in the DR, and elsewhere,documents that the public sector has a comparative disadvantage in theproduction and marketing of private (rival and excludable) goods or

11

Table II-3Summary Operations of Public Enterprises.

(In Percent of GDP)

TOTAL REVENUE

(of which Transfers)

TOTAL EXPENDITURE \b

Current

Capital

OVERALL BALANCE AFTERTRANSFERS

1988

10.0

3.1

10.5

7.0

3.5

-0.8

1989

6.8

1.8

9.2

5.8

3.4

-2.2

1990

7.6

1.6

8.7

7.2

1.5

-1.1

1991

7.4

1.6

8.7

6.6

2.1

-1.3

1992

8.3

1.7

9.3

7.0

2.3

-1.0

1993 \a

9.0

2.6

9.4

7.1

2.3

-0.3

MEMO ÍTEMS

Current Account BalanceBefore Transfers

Overall Balance BeforeTransfers

-0.4

-3.8

-0.8

-4.2

-1.2

-2.6

-0.7

-2.8

-0.8

-3.0

-0.6

-2.9

\a\b

Programmed.Includes interest due on the external debt arrears of the public enterprises.

services.1 Therefore, the maín objective behind privatization should beefficiency gains. Four other considerations play a role in determiningthe modality of privatization: (i) public sectors revenue needs; (íi)finding the buyers that will manage the assets in the most efficientmanner; (iii) equity considerations, i.e. fairness in the distributionof the rents from privatization; and (iv) the post privatizationcooperative environment:

(i) Revenue Needs: Even if public enterprises were given away,privatization will have a positive impact on the Government's budgetbecause there would be no public claim on losses and becauseprivatized firms would pay taxes. Thus, the privatization periodshould not be extended with a protracted search for a potentialbuyer that would maximize Government revenues from the sale.

(ii) Efficient Management: The selling to the highest bidder, after areasonable timeframe for advertising and tender, might help inscreening the most efficient buyer. Nevertheless, since the highestbidder is the one expecting the highest future stream of profit, theGovernment should ensure that the profits result from the buyer'sefficiency and not from spurious market power. Thus, the Governmentshould refrain from bilateral dealings with prospective buyers onthe post-privatization regulatory framework.

(iii) Equity: The spreading of the benefits of privatization widelyshould be a central goal. Moreover, this course of action willensure popular support for privatization. Linking privatizationrevenues to incremental social spending -as has been done in México,

1 Private goods, contrary to public goods, are those whose consumption isrival (my use of one unit precludes yours) and excludable (property rights overthem can be enforced at negligible cost).

I

12

Venezuela and Perú among others- is an effective approach to gainconsensus. Alternatively, distributing transferable privatizationcoupons -that can be used as cash by the buyers of enterprises- oreven distributing a fraction of the shares of the very enterprisesamong the "adult population" -say, through a lottery amongregistered voters- is an approach that creates a climate favorableto "people's capitalism", and that has been effeotive in someEastern European Countries. In the DR, this latter method may beparticularly appealing for the divestiture of the former Trujillopossessions, now in the hands of the CEA and CORDE holdings, becauseit takes the assets away from the state bureaucracy and returns themto the people. Moreover, the foreseeable resale of the distributed-shares of these two holdings would quickly place their enterprisesin the hands of efficient private managers. These will carry outthe subsequent spins-offs and divestiture of each specific firmthereby minimizing the demands made on the limited administrativecapacity of the state.

'(iv) Competitive Environment: As argued in (ii), the defining of a

clearcut and non-negotiable competitive legal framework is aprerequisite for privatization. This is especially important forsectors not subject to international arbitrage such as Utilities andservices (the so-called non-tradable or sheltered sectors). The DRhas taken a very positive step in this direction with the definitionof the new free-entry framework for generation and distribution ofelectricity. Regarding import or export competing industries, tradeliberalization perfectly complements privatization by providingexternal competitive discipline.

A.5 Social Security

Assessments. The social security system, managed by IDSS, is vested toprovide a full range of coverage and services for private sectoremployees, including retirement, health, disability, life, and maternityinsurance. Membership is compulsory wíth no opt-out for firms/workers whoalso choose to have a private insurance. Contributions are as follows:7.5% of basíc wage provided by the employer and 2.5% by the worker. Thestate is supposed to contribute a further 2.5% but does not do so. Giventhe low quality of the health services provided and the low and decliningpensions (now at about US$40 per month), evasión is high with only about14% of economically active population contributing. The finances of IDSSare shown in Table II-4. Contributions go to a general fund with mostresources going to pay for the operation and expansión of the IDSS healthfacilities and administrative expenses. As a result, the pensión systemis not only unfunded but not even a pay-as-you-go system because currentpensión out-payments are calculated residually and are unrelated tocurrent and past Contributions. The poor productivity and quality ofIDSS's health services can be gauged by the following two indicators: theoccupancy rate of beds in IDSS hospitals was 37% ín 1991; and the IDSSemploys 3,000 doctors for 4,000,000 beneficiarles while the Costa RicanSocial Security employs 1,300 doctors for 2 million beneficiarles.

13

Table II-4Revenues and Ezpenditures of RD's Social Security Institute

(percentage of GDP)

Revenues

Expendí tures

Balance

1987

0.61

0.62

-0.01

1990

0.56

0.60

-0.04

1991

0.58

0.59

-0.01

1992

0.66

0.66

0.00

1993 \a

9.74

0.91

-0.17

\a Programmed.

II-B.

Issues. A law approved by Congress in 1990, but not yet effective bydecisión of the Executive, proposes an expansión of coverage of benefitsto all the dependents of insured workers together with an íncrease of thecontribution paid by the workers from 2.5% of basic salary to 4% and ofthe contribution paid by the employer from 7.5% to 12%. On the basis ofa recent thorough study commissioned by the National Council ofBusinessmen2 that sheds light on the Information given above, andconsidering the fact that workers view the current system as a puré tax onwages, any broadening of coverage and contributions to expand IDSS'shealth services should be put on hold awaitíng fundamental reform of thesystem and, in general, of the State's health policy. Regardingretirement benefits, the current system should be discontinued andreplaced by a privately administered competitive pensión fund system, á laChile, based on capitalization of independent accounts. Otherwise,further future liabilities would accrue and, as the system matures (i.e.the number of retirees approaches that of contributions), this will haveto be assumed by the Treasury. Of course, the current capitalized valuéof past contributions would have to be grandfathered out of the publicpurse in the form of a performing bond that beneficiarles could transferto a prívate pensión fund.

Monetarv and Exchange Rate Policies

B.l Monetary Policy: Institutions and Instruments

Monetary and exchange rate policies are formulated by the Monetary Boardand implemented by the Central Bank. Members of the Board are theGovernor of the Bank, the Secretarles of Industry and of Finance and sevenrepresentatives of the private sector appointed by the President for athree year period. The Superintendency of Banks, which depends on theMinistry of Finance, is in charge of the supervisión of financialinstitutions.

The legal framework for monetary policy has been, until now, given by the

"Diagnóstico Financiero-Actuarial y Costo de Factibilidad de laAmpliación de Cobertura sin Modificar el Modelo de Prestación del IDSS", by PérezMontes, and Díaz Santana, Santo Domingo, December 1992.

14-

Constitution, which conferred ampie powers to the Monetary Board. As partof the structural reforms the Monetary-Financial Code has recently beensubmitted to Congress.

An important participant in the process of monetary and credit policy isthe Banco de Reservas, a Government-owned commercial bank, that acts asthe financial agent of the Government, takes deposits from, and lendsmostly to public institutions.

In the past, the traditional instrumenta of monetary policy were:interest rate controls, mandatory allocation of credit, changes in reserverequirements and múltiple exchange rates. They have been abolished. TheCentral Bank will exercise restraint, and open market operations will bethe main instrument. The new Monetary-Financial Code provides the legalframework for open-market operations.

B.2 Interaction between Exchange Rate and Monetary Policies

Assessment. As in any small open economy, in the DR, events in theexternal sector and the exchange rate are fundamental for monetarydevelopments. Although prices and monetary aggregates are ultimately androughly associated (Chart 5) , the cióse correlation between prices and theexchange rate, with exchange rate movements preceding price movements, iseven more clear (Chart 6).

During the last fifteen years, the country has had a pattern of stop-gopolicies, and a lack of continuity in exchange rate and monetary rules.3

This is apparent in Chart 7, which plots the inflation rate since 1970against the inflation rate in the USA as a benchmark. It clearlyestablishes the periodicity of departures of the latter from the formerassociated with stop-go policies, and the increasing amplitude of thosedepartures (i.e., the intensity of the disequilibria) since 1978.

Another feature which emerges from the data, is a nearly contemporaneousand inverse association between inflation and real money (Chart 8). Thisalso suggests that the money market and inflationary expectations adjustvery quickly in the DR. Thus, not only do inconsistent policies bringabout early crises, but also credible stabilization efforts have quickresults. This is why the current stabilization program prompted aspectacular collapse of inflation with virtually no recessionary impact.

The exchange rate has stayed de facto fixed at DR$12.5 per dollar since1991 despite the fact that the exchange market is officially under amanaged float. This has been feasible due to the Central Bank's domestic

3 This pattern is characterized by the following sequence: an excessiveexpansión of domestic credit to finance public expenditure or meet revenue short-falls; loss of foreign exchange reserves; imposition of exchange controls; andfinally an exchange rate crisis. This is typically followed by a stabilizationprogram that after some time is abandoned in favor of renewed domestic creditexpansión.

15

120

Chart 5INFLATION AND MONEY GROWTH

(Annual Rates, Last 12 Months)

l i l i I TT I I I I II I I I I I 11 I I I Ti I I u I I I I Fl I I M II I I I1985 1986 1987 1988 1989

120

1990u 111111991

i i i i111 ri 1 1 11992

Chart 6EXCH RATE DEVALUATION AND INFLATION

(Annual Rates, Last 12 Months)

-20 ' M i i n i m i M i m i i M i m i i1985 1986 1987 1988 1989 1990 1991 1992

Constitution, which conferred ampie powers to the Monetary Board. As partof the structural reforms the Monetary-Financial Code has recently beensubmitted to Congress.

An important participant in the process of monetary and credit policy isthe Banco de Reservas, a Government-owned commercial bank, that acts asthe financial agent of the Government, takes deposits from, and lendsmostly to public institutions.

In the past, the traditional instruments of monetary policy were:interest rate controls, mandatory allocation of credit, changes in reserverequirements and múltiple exchange rates. They have been abolished. TheCentral Bank will exercise restraint, and open market operations will bethe main instrument. The new Monetary-Financial Code provides the legalframework for open-market operations.

B.2 Interaction between Exchange Rate and Monetary Policies

Assessment. As in any small open economy, in the DR, events in theexternal sector and the exchange rate are fundamental for monetarydevelopments. Although prices and monetary aggregates are ultimately androughly associated (Chart 5) , the cióse correlation between prices and theexchange rate, with exchange rate movements preceding price movements, iseven more clear (Chart 6).

During the last fifteen years, the country has had a pattern of stop-gopolicies, and a lack of continuity in exchange rate and monetary rules.3

This is apparent in Chart 7, which plots the inflation rate since 1970against the inflation rate in the USA as a benchmark. It clear lyestablishes the periodicity of departures of the latter from the formerassociated with stop-go policies, and the increasing amplitude of thosedepartures (i.e., the intensity of the disequilibria) since 1978.

Another feature which emerges from the data, is a nearly contemporaneousand inverse association between inflation and real money (Chart 8). Thisalso suggests that the money market and inflationary expectations adjustvery quickly in the DR. Thus, not only do inconsistent policies bringabout early crises, but also credible stabilization efforts have quickresults. This is why the current stabilization program prompted aspectacular collapse of inflation with virtually no recessionary impact.

The exchange rate has stayed de facto fixed at DR$12.5 per dollar since1991 despite the fact that the exchange market is officially under amanaged float. This has been feasible due to the Central Bank's domestic

3 This pattern is characterized by the following sequence: an excessiveexpansión of domestic credit to finance public expenditure or meet revenue short-falls; loss of foreign exchange reserves; imposition of exchange controls; andfinally an exchange rate crisis. This is typically followed by a stabilizationprogram that after some time is abandoned in favor of renewed domestic creditexpansión.

15

Table II-5Dominican Republic: Financial Survey - Uses and Sources of Broad Money \a

(Percentage changes as defined below )\b

A. BROAD MONEY SUPPLY (Uses)

a. Money

b. Quasi - Money

B. BROAD MONEY SUPPLY (Sources)

a. Net International Reserves

b. Net Credit to Public Sector

c. Credit to Private Sector

d. Other Net Assets

1988

66.5

33.3

33.2

66.5

17.2

27.9

21.1

0.3

1989

29.3

11.3

18.0

29.3

-8.5

7.8

30.9

-0.9

1990

32.5

19.7

12.8

32.5

-4.5

6.9

19.8

10.3

1991

34.2

14.1

20.1

34.2

33.8

-9.8

15.8

9.7

1992

29.2

14.0

15.2

29.2

7.3

-12.9

25.1

8.1

1993 \c

9.3

4.6

4.7

9.3

-2.8

3.3

7.8

1.1

MEMORÁNDUM ÍTEMS:

Base Money \d

Inflation Rate \e

Broad Money Supply Multiptier \f

Income Velocity of Broad Money

Nominal GDP (mi U ion pesos)

95.2

57.6

2.7

3.5

28,353

14.6

41.2

2.3

4.1

42,393

44.7

100.7

2.1

6.6

60,355

60.3

4.0

1.7

4.6

90,722

10.0

6.7

2.3

3.9

98,054

7.4

5.0-8.0

2.2

3.9

102,957

\a Based on the accounts of the Consolidated Banking System.\b Increase of each variable during the period as a percentage of the stock of broad money outstanding

at the end of the previous year.\c Programmed.\d Base money growth calculated with respect to the stock of base money outstanding at the end of the

previous year.\e Twelve months ending in December.\f The ratio of broad money to base money.

Source: IMF, and Central Bank of the Dominican Republic, and IDB staff calculations.

credit restraint, in turn, a result of the public sector's budget surplus.

As Table II-5 shows, domestic credit from the Consolidated financialsystem to the public sector declined by 10% in 1991 and 13% in 1992. *Despite this decline, the broad money supply expanded at the rate of 34%in 1991 and 29% in 1992. Paradoxically, these rates are as high as thoseof the years, 1989-90, of soaring inflation and macroeconomic instability.However, unlike those years, fast money growth is now consistent with lowinflation rates, 4% in 1991 and 6 . 7 % in 1992. This is so because thedemand for money has been increasing at a fast pace -the so-calledremonetization process- after the public sector budget was brought intobalance. In other words, in the case at hand, the growth in the quantity

* Note that these percentage rates are calculated as the flow (change) ofthe variable in the year divided by the stock of broad money as of the end ofprevious year.

16

Chart?ANNUAL INFLATION RATE

(Last12 Months)120

Dominican Republic

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992

Chart 8REAL MONETARY BASE

AND THE INFLATION RATE120

-100

cO)o

-80

-60

-40

-20

a>OLC

ICCC

I

1985 1986 1987 1988 1989 1990 1991 1992

40-

ChartSNOMINAL ANNUAL INTERÉS! RA!ES

35-

30-

25-

o 20-

•O.

15-

10-

Borrowing Rate (Excl DD)

Borrowing Rate (Incl DD)

JUL91 SEP NOV JAN 92 MAR MAY ' JUL SEP NOV JAN 93 MAR(*) DD refH s to non-rterest bearing demand deposts

CharMOREAL ANNUAL INTERÉS! RA!ES*

40-

35-

30-

<DO.

15-

10-

0a—rJUL91 SEP NOV JAN 92 MAR MAY JUL SEP NOV JAN 93

(*) Annual InflaHon Tor trie last 6 months

of money was driven by an upward trend of the real demand for moneybrought about by the dramatic fall of inflationary expectations. Indeed,in a small open economy under a fixed exchange rate, the nominal moneysupply is fully endogenous. It is determined by the interplay between thedemand for money and movements of International reserves. In the currentcontext of the DR, the "incipient" monetary contraction, arising from thebudget surplus, prompted an offsetting inflow of international reserves soas to accommodate the expanding demand for money. Table II-5 shows thatthe accumulation of international reserves by itself caused growth inbroad money of 34% in 1991 and 7% in 1992. Needless to say that thismonetary growth was further compounded by the secondary expansión ofcredit to the prívate sector inherent to a fractional reserve system5.The growth of credit to the prívate sector was particularly high in 1992,equivalent to 25% of the previous year stock of broad money6.

Issues. The current fixed exchange rate regime is the most suitable fora small open economy, like the DR, integrated in the currency área of theUS dollar. Under a fixed exchange rate the Central Bank stands ready tobuy and sell foreign exchange at the prevailing exchange rate. The keyfor the sustainability of the system is a path of accumulation of theCentral Bank's international reserves that guarantees the credibility ofthe present and future convertibility of the currency at the prevailingexchange rate. A necessary condition to achieve this is a sufficientlyrestrictive Central Bank domestic credit policy.7 In fact, this has beenthe monetary policy followed by the DR since 1991, as indicated by thenegative growth of domestic credit to the public sector -which accountsfor almost the totality of Central Bank domestic credit-. A rule of thumbfor the future is that Central Bank domestic credit growth be no higherthan the sum of GDP real growth and international inflation. In thiscase, any expansión of the real demand for money (the so-calledremonetization) will be accommodated by accumulation of internationalreserves, thus continuing to strengthen the creditability in the currency.

The authorities confront two policy issues: high interest rates; andconcerns of some economic agents about the competitiveness of the exchangerate:

(i) Interest Rates: The evolution of interest rates over the last twoyears is shown in Charts 8 through 11. The trends can be summarizedas follows. Until March 1992, there was a steady fall, particularly

5 Now, legal reserve requirements stand at 20%

The reduction of legal reserve requirements to 20% in late 1991 alsocontributed to the fast growth of credit to the prívate sector in 1992. Note thecorresponding jump in the money supply multiplier from 1.7 in 1991 to 2.3 in1992.

7 Another condition is the preservation of the solvency of financialintermediaries, particularly when commercial banks' deposits are explicitly orimplicitly guaranteed by the Central Bank.

17

30

Chart11SPREAD BETWEEN ANNUAL AVG BORROWING

AND PRIME NOMINAL LENDING RATES

25-

20-

BoOL

10-

5-Due to Reserve Requirement

JUL91 SEP NOV JAN 92 MAR MAY JUL SEP NOV JAN 93 MAR

unan 12PROPORTION OF DEPOSITS HELO BY THE

BANCO DE RESERVAS AND COMMERCIAL BANKS(Percentages)

•

Others (28.5)

Foreign Banks (8.6)

Bco del Comercio (12.7)

co de Reservas (30.1)

co Popular (20.2)

.

of lending rates, resulting from the decline in inflationaryexpectations. In that month, interest rates bottomed out at about20% annually for lending and 12% for deposits. Since then rateshave, again, picked up with the lending rate rising by about 10percentage points by the second quarter of 1993. Therefore, ratesare very high under any standard. The lending rate, now at 30%annually, is about 23% in real terms and equivalent to fourfold ofthe US prime rate. In turn, the deposit rate, now at about 14%annually, is over 10 percentage points above the US rates fordeposits certificates. High interest rates are due to both a highInternational spread and a high domestic spread, as defined below.

On the one hand, there is a high "International spread" between theDR peso deposit rate and the US deposit rate. As Appendix IIIexplains, this spread can be accounted for by the following threecomponents: (a) expectations of a devaluation of the peso; (b)the default risk of DR deposits in the absence of complete de jureor de facto deposit insurance; and (c) market segmentation -however small- reflecting less than perfect capital mobility. Sincethe latter two components are of a more structural nature, it standsto reason that they have a stronger bearing on the permanently highlevel of the deposit rate. Whereas the increasing devaluationpremium, appears to be responsible for the recent increase of thedeposit rate. Surveys undertaken by commercial banks indícate thatthere is a generalized expectation of a, say, 10% devaluation beforethe 1994 presidential elections. This expectation is linked to theuncertainty as to economic policy prior to and after the elections.

On the other hand, there is a high "domestic spread" between thelocal lending rates and deposit rates. As Chart 11 shows, thisspread has been rapidly increasing since March 1992, representingthe main factor contributing to the recent climb of lending rates.The spread now stands at 20% annual. As explained in Appendix III,three elements make up this "domestic spread": (a) the default-risk premium charged on borrowers; (b) the cost of non-interestbearing reserve requirements; and (c) the mark-up arising from theexistence of market power in the banking system (often resulting incost-permissiveness and high intermediation costs). The firstelement appears to be the driving forcé behind the recent surge ofthe "domestic spread" because neither the cost of reserverequirements ñor market power have changed significantly over thelast one and a half years. However, these latter two elements areimportant to find an explanation for the permanently high spreads.The default risk premium discussed at length in Section II-D andAppendix IV, which deals with the interaction between interest ratesand the solvency of the financial system. Needless to say that theissuance in 1992 by the Monetary Board of strict capital adequacyrules and a prudential framework seem to have moved commercial banksto improve the assessment of borrowers' default risk in the wake ofan officially understated -and probably worsening- non-performingportfolio.

18