240-

Chart13REAL EFFECTIVE EXCHANGE RATE(Increases mean Depreciation of Peso)

220-

200-

8 180'

£ 160-O)

oD 140x(D

"O

- 120

100-

80-

.

60-WrT1985 1986 1987 1988 1989 1990 1991 1992

Chart14IMPORTS, EXPORTS, TRADE ANDCURREN! ACCOUNT BALANCES

(In Millions of US$)¿DUU-

2000-

1500-

1000-

500-

-500-

-1000-

-1500-

/

/

/

^^^

j

-

/

/

,/

'/

/

/

i 'I 'I

'11 '

1 /

<jl

I/

^

^ ^

j

1 R/ / '

3 :3 ;3 :

u;i^ürrip 3

//'/''<'/3

/

a 3

•

a

R

/

"i

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 theexpectations of a devaluation are of a short run nature. Theresolution of the other five problema requires fundamental medium-to-long run reforms of the system. These reforms will be supportedby an IDB Financial Sector Loan.

.

(ii) Competitiveness of the Exchange Rate: It is often argued that thepeso is overvalued and thus a devaluation is prescribed to restorecompetitiveness. However, as Chart 13 shows, the real effectiveexchange rate has changed very little since 1990, when thestabilization was initiated. Besides, the DR has quickly achievedan inflation rate cióse to the international level, as necessary forthe sustainability of the fixed exchange rate. Barring a bankingcrisis, it would be unwise to devalue the exchange rate because thefiscal-monetary fundamentáis are right and also because with adevaluation the anchor for today's low inflation would be lost.Competitiveness should be improved through the removal of supply-side constraints arising from infrastructure bottlenecks, imperfectmarket structure, and spurious regulations rather than throughmonetary means. At best, a devaluation would only lead to atransitory real deprecíation. If in any event, the authorities wereto decide on a, say, 10% devaluation of the peso, the measure shouldbe accompanied by the elimination of the prevailing 10% importsurcharge -now applying to 40% of imports of "non-essentialproducís"- so as to offset part of the devaluation's inflationaryimpact while at the same time moving towards more tariff uniformity.Although a 10% devaluation might help in reducing the foreignexchange premium of deposit interest rates, that policy action isnot recommended here.

B.3 The ünfolding Current Account Déficit

Assessment. The trade and current accounts of the balance of paymentsunderwent growing imbalances since late 1991. The current account déficitjumped from 2.5% of GDP in 1991 to 6% of GDP in 1992. From a "partialequilibrium" viewpoint, this expanding déficit derives from a continuationof the decline in exports, initiated in 1989 combined with climbing importlevéis. Exports dropped from US$658 million in 1991 to US$561 million in1992, while imports increased from US$1.7 billion to US$2.2 billion (Chart14 and Table II-6). The expanding revenues from tourism and Free TradeZones which went from US$1.3 billion to US$1.6 billion was insufficient tooffset the deterioration of the trade account. From a "generalequilibrium" viewpoint, the source of the ünfolding current accountimbalance is an excess of expenditure over income originating from awidening private sector budget déficit that was only partially buffered bya strenghening fiscal surplus. Indeed, the balance of payments isidentical to the sum of the public and private sector budgets, and sincethe public sector is running a surplus, it follows that the currentaccount déficit has its root in a private sector imbalance. Appendix Iillustrates further this point. This privately led current accountdéficit fits the pattern recently observed in countries undergoingstabilization and running a fiscal surplus. The cases of México,

19

Table II-6: Summary of Balance of Payments(US$ million )

CURRENT ACCOUNT

Trade balance

Exports, f.o.b.

Imports, f.o.b.

Net Services

Receipts

(of which: tourism)

(of which: free trade zones)

Payments

(of which interest)

Transfers (net)

CAPITAL ACCOUNT \b

Public sector capital

Prívate sector capital \b

(of which: direct investment)

(of which: other including e & o)

OVERALL BALANCE

1989

-302.8

-1,039.4

924.4

-1,963.8

352.3

1,162.8

818.4

198.5

-810.5

-295.7

384.3

-148.7

-15.6

-133.0

110.0

-243.0

-451.5

1990

-206.4

-1,058.2

734.7

-1,792.9

481.2

1,282.4

899.5

199.5

-801.3

-310.9

370.6

-300.6

-302.2

1.7

132.8

-131.2

-507.0

1991

-180.6

-1,070.5

658.3

-1,728.8

503.4

1.338.1

877.2

255.2

-834.7

-295.4

386.5

249.1

-133.7

382.8

145.0

237.8

68.5

1992

-472.1

-1,123.4

561.7

-2,178.1

712.5

1,603.7

1,095.8

287.4

-891.3

-245.6

431.8

382.1

-123.8

505.9

179.0

326.9

-90.0

1993 \a

-449.9

-1766.5

527.8

-2,294.3

874.7

1,775.8

1,218.4

316.1

-901.1

-242.6

441.8

339.0

-35.7

374.7

200.0

174.7

-110.9

FINANCING

Net International Reserves \c

Arrears \d

Debt Relief

112.4

273.5

65.6

-75.7

519.6

63.1

-380.4

-662.5

974.4

-123.6

-52.0

265.6

57.0

-588.8

642.7

MEMORÁNDUM ÍTEMS

Gross International Reserves

Stock of Arrears

122.8

841.5

68.8

1479.0

426.1

779.1

489.0

627.5

495.4

--

\a Programmed.\b Including errors and omissions.\c Negative number implies an increase.\d 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 thepattern are high nominal and real interest rates and a low (overvalued)exchange rate. The story goes that the high interest rates attractexternal capital inflows and these put downward pressure on the exchangerate -under a floating regime- or alternatively push up the monetaryaggregates and inflation under a fixed exchange rate. Either way capitalinflows typically transíate into a real appreciation of the exchange ratewhich, in turn, reduces the competitiveness of exports and makes imports

20

Table II-7Savings, Investment, and the Current Account Déficit.

(percent of GDP)

Prívate Investment (1)

Prívate Saving (2)

Prívate Sector Gap (3)-(l)-(2)

Public Investment (4)

Public Savings (5)

Public Sector Gap (6) - (4)-(5)

Current AccountGap (7)=(6)+(3)

1989

16.7

18.5

-1.8

11.3

5.0

6.3

4.5

1990

15.4

17.9

-2.5

6.6

1.2

5.4

2.9

1991

13.9

11.6

2.3

6.6

6.4

0.2

2.5

1992

- 15.4

8.1

7.3

7.7

9.0

-1.3

6.0

more attractive thus feeding back on the current account déficit. Asdiscussed above, there is no evidence that, in the case of the DR, highinterest rates and capital inflows might have caused a significant realappreciation of the exchange rate, unlike in the cases of the other threecountries.

The widening of the private sector déficit has resulted from both anincrease of private investment and a contraction of private savings. AsTable II-7 shows, in 1992 private investment increased by 1.5% of GDPwhile private savings dropped (consumption expanded) by 3.5% of GDP. Asa result, the leading forcé behind the growing current account imbalanceis private consumption. Several factors are responsible for the expansiónof private consumption. First, the increase in the purchasing power ofwages following the adjustment to mínimum wages and also the sudden dropof inflation in 1991. This latter effect stems from the elimination ofthe inflation tax -which can be viewed as a tax on wages- and isadditional to the 25% improvement of real mínimum wages granted in 1991.As Appendix II explains, stopping inflation could have led to anadditional improvement- in real wages of up to 7%. Second, the fastexpansión of domestic credit to the private sector. As noted in Table II-5, in 1992, it grew by the equivalent of 24% of the broad money supply8

due to reduction in reserve requirements. Another more limited butrevealing indicator of credit for consumption is purchases through creditcards which rose by 48% in real térras between 1991 and 1992. Finally, thedecline in import tariffs reduces the relative price of imports, togetherwith the massive imports of durable goods in anticipation of thepossibility of a closing up to trade if the reforms fail.

8 Part of the domestic credit to the private sector might have been fundedon capital inflows deposited at commercial banks.

21

It should be added that the increase in prívate consumption was partlyoffset by a strengthening of public savings, which expanded by 2.6% of GDPin 1992. Likewise, the rise in private investment was compounded by anincrease 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 whilethat of aggregate investment was 2.6%.

Issues. The two issues are sustainability and vulnerability. As tosustainability. there are three key questions. First, is the excessexpenditure the result of a one-time self-correcting process or else doesit require cool down policy action?. Some of the aforementioned factorsthat pushed up private consumption are one-and-for-all: the effect ofstopping inflation on wages; the rapid growth of domestic credit due tolower reserve requirements; and anticipatory imports of durables. Otherfactors, such as further tariff reductions and external capital inflowsare, in principie expected to continué. As a result, the net effect isthat the current déficit can be expected to narrow. The second questionis 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 toadditional investment and 0.9% to consumption. This shows that theprocess is safe on this account. What is worrisome, however, is thesectoral composition: public savings are expanding but privateconsumption is expanding fáster. The third question is whether the returnon investment will be sufficient to repay the debt service. The problemis that a significant share of the external financing of the currentaccount déficit comes in the forra of speculative capital inflows. Theyare attracted by high interest rates and they are lent to the privatesector at real annual rates of over 25%. This suggest the possibility ofborrower's default risk, thus indicating that the process might not besustainable.

Regarding vulnerability. the problem is that the foreign capital inflowsfinancing the current account déficit are mostly short-term andspeculative (Table II-6). If these are suddenly withdrawn it cannot beexpected that the excess expenditure will be automatically washed out. Asa result, a foreign exchange crisis will result. Preliminary data for thefirst half of 1993 appears to indícate that the current account déficit isnarrowing somewhat. In the absence of sufficient narrowing, cool-downpolicy 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 inthe región is above 10%) ; establishment of a 100% legal reserverequirement for the state-owned Banco de Reservas to ensure that theTreasury's surplus is not reshuffled as domestic credit; and strengthenedsupervisión by the Superintendency of consumer credit granted by thebanking system.

II.C Attaining Public Sector Solvencv

Background. The public debt is mainly foreign debt. The domestic publicdebt, 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-8External Debt Indicators

(percentages)

DominicanRepublic

Ecuador

México

Brazil

Perú

Latín America

Debt/GDP

56

10*

37

29

50

38

Debt/Exports ofGoods &Services

204

346

224

334

580

248

Debt Service Due/Exports ofGoods &Services

23

51

31

56

57

40

Debt percapita

•

590

1149

1226

760

1082

997

SecoiidaryMarketDiscount

75 \a

72

34

70

82

N.A.

\a This has decreased to 572 since the announcement of an agreement in principie of a Brady type plan in April1993

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 exportsratio was 23%. These indicators roughly match the conventional wisdom safeceilings 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 halfequally dívided between commercial banks and multilaterals. Four eventsmark the progress achíeved in debt restructuring; first, the clearance ofarrears with multilaterals in late 1991; second, the November 1991agreement with París Club creditors to restructure debt service fallingdue until April 1993 as well as arrears; third, the buyback at a sizeablediscount of the bilateral debt with México and Venezuela, two of the DR'slargest bilateral creditors; and finally, the May 1993 agreement with theadvisory committee of commercial creditors on a "term sheet" for a debtreduction-cum-buyback scheme under the Brady Plan.

Under the agreement with the advisory committee, the DR intends to buybackor restructure US$775 million in principal and US$260 million of past dueinterest (PDI). Creditors will be able to choose between; (i) tenderingprincipal and PDI claims against a cash buyback; (ii) exchanging principalclaims for a collateralized discount bond or an uncollateralized interestreduction bond; (iii) trading PDI claims for an uncollateralized marketrate bond. In addition, there will be a cash downpayment of 12.5% oftotal PDI. The deal is contingent on the attainment of a 50% reduction ofprincipal plus PDI outstanding at the closing date.

Assessment. The debt problem has stock and flow dimensions. The stockperspective is the relevant one to assess the country's debt overhang andthus the debt write-down the country needs. Objective indicators -such asthe debt to GDP, debt service and debt per capita ratios- often shed light

23

Table II-9Cash Cost of Brady Deal Under Different Assumptions

(US$ million)

Discount, BondOption \a

Buyback Option \a

10Z

30Z

50Z

70Z

701 601 50Z

222.5 196.2 169.9

240.4 214.1 187.8

205.7

40X

143.6

161.5

179.4

30Z

117.3

135.2

153.1

170.9

Xa The raatrix assumes different percentages of debt traded at buyback (horizontal) and traded for discountbonds (vertical). For any matrix element, whatever remains to reach 100Z is traded for interest-reductionbonds.

on the country's ability to pay. According to these indicators the DR isnot any worse than the average Latín American country (Table II-8).

Indeed, it is in better shape than Ecuador and Perú and -for someindicators- than Brazil, the three other Latín American debtors with a yetto be settled commercial debt overhang. However, the huge secondarymarket discount on the DR's commercial debt comparable to those of theother three countries, índicates that the market's assessment of the DR'sability-cum-willingness to pay is indeed small. This might be due in partto the fact that the debt eligible for reduction -only commercial debt- isbarely one-quarter of the total, much lower than the respectiveproportions for Brazil and Ecuador but comparable to that for Perú.

From a flow perspective. the central question is whether the current, andfuture foreseeable, public finance stance is consistent with thepreservation of solvency. This can be assessed by looking at the budget'sprimary balance.9 The primary surplus of the public sector reflects the"net transfer" of resources from the prívate sector to the public sectorthat are available to service the public debt. A sufficient condition forsolvency is that the present discounted valué of the future primarysurpluses must be no smaller than the valué of the outstanding debt. Itcan be shown that for this to hold, the permanent average primary surplusmust be no lower than the difference between the real interest rate andthe real GDP growth multiplied by the current debt to the GDP ratio. Theanalytics of this proposition is presented in Appendix I of theMacroeconomic Assessment Paper of Ecuador and therefore do not bear

The standard primary balance is equal to the difference between publicrevenues and non-interest expenditures. The primary surplus (or déficit) can beaugmented by adding seignorage and the Central Bank's primary surplus to publicrevenues.

24

repetition here.10

Given plausible projections for the real interest rate on the DR'sexternal debt (6%) and GDP growth (a conservative 3.6% p.a.). and bearingin mind that the current debt stock to GDP is 56%, it follows that thelong-run primary surplus required for solvency would be 1.3% of GDP. Ofthis 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 publicsector equal to no less than 0.5% of GDP. The surpluses of 1991-92 werefar higher than this threshold, 4% of GDP in 1991 and 4.6% in 1992 (TableII-l). It can thus be concluded that the public sector has made anextraordinary effort "on the flow" to attain solvency. As can be seen inChart 2, this has led to a decline of the debt to GDP ratio.

Issues. The strong primary surpluses of 1991-92, nevertheless, overstatethe underlying budget trends and prospects. It was noted in sections II-A-2 and 3 that the improvement of the budget has been achieved through acombination of temporary, and probably self-liquidating revenue measuresand strong compression of public spending in infrastructure and socialservices. Therefore, two actions are urgently required to restoresolvency: first, the implementation of the tax and budget reformsexplained in Section II; and second, the timely conclusión of the Bradydeal.

Two issues are involved in the resolution of the debt reduction deal:

(i) Pricing of the Options: It can be proven that buyback option issignificantly lower ín valué than the other two options when thelatter are discounted at any reasonable discount rate. In turn, theinterest reduction-bond option appears to be less attractive thanthe discount-bond option at discount rates higher than 14%. As aresult, debt holders are expected to favor the higher valué discountbond option. However, the DR has the right to withdraw from thedeal if it does not obtain a 50% reduction in the stock of principalplus PDI. A massive selection of the discount bond option will notdeliver this result. In consequence, creditors will have to berequired to rebalance a large share of their commitment to the leastattractive buyback option. This may prove to be a difficult andprotracted 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 Plansof Programs, IDB.

11 Assuming: inflation at 5% p.a.; GDP real growth at 3.6%; and basemoney equal to 10% of GDP

"The Dominican Republic's Brady deal: a preliminary assessment".Kidder, Peabody and Co, May 20, 93.

25

deal -including buyback, collaterals and interest payments prior toclosing- assuming different combinations of the three options. Thetotal cost is expected to range between US$171 million (70% discountbond-30% buyback) and US$206 million (50%-50%). These figuresrepresent between one-third and one-half of current netinternational reserves. But only about one quarter would come froma drawdown of gross reserves. The rest will be raised from balanceof payment disbursement under the IMF's Stand-by and CompensatoryFinancing (about US$100 million prior to February 1994) and thefirst 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 bankinglaws of the 1960's set the stage for a proliferation of specializedintermediarles differentiated by: terms of deposits and lending; reserverequirements; interest rates; fiscal incentives; and credit allocation.As of September 1992, the formal prívate financial sector comprised 19commercial 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 shareof the market is operated by holding companies each owning a group ofspecialized banks. In addition, there are some 300 unregulated financialcompanies.

The Superintendency of Banks, under the jurisdiction of the Secretariat ofFinance, is responsible for the oversight of the system. Althoughoverstaffed with 800 low-pay employees, it lacks adequately trainedprofessionals . Inspections of banks are seldom, and loan classificationdata provided by the very banks never seems to be contested by theSuperintendency. As a result, the reported quality of the bank's loanportfolios seriously overstates the actual health of the system. Theproliferation of intermediarles in the 1980's coupled with virtually nosupervisión led to a score of banking failures in 1990.

Assessment. The DR's financial system is relatively broad by LatinAmerican standards. The ratio of the broad money supply to GDP is about28%. Although there is no formal deposit insurance, the tradition hasbeen that ailing formal banks are taken over by the Central Bank forliquidation and their deposits are fully paid off. At present, there aretwo banks and about 30 financial companies under liquidation. The CentralBank is reimbursing deposits of up to US$4,000 with cash and largerdeposits with a one-year bond at 10% interest. The cost of the bail-out,for 1993 alone, is estimated at about US$ 50 million. This practice of afull implicit guarantee on crisis deposits could bring stabilization to anend in the event of a médium-to-large scale banking crisis.

A study on the quality of the portfolios of five banks was conducted in1990 by an independent team of experts commissioned by the Central Bank.The sample included 506 large loans of 361 clients. The comparisonbetween the respective classifications of these loans by theSuperintendency and by the team is presented in Table 11-10. According to

26

Table 11-10Quality of Loan Portfolio of Selected Banks in 1990.\a

(percentage of loan portfolio)

Bank

A

B

C

D

E

Total

Category

Normal

Superin Team-tendency

85.6

84.7

81.0

74.5

55.9

81.1

55.8

56.5

41.1

40.7

17.7

49.5

PotentialFroblems

Superin Team-tendency

11.9

10.6

16.2

24.1

2.0

14.2

35.2

30.1

51.1

45.2

29.0

36.8

Default

Superin Team-tendency

2.6

4.6

2.8

1.4

41.2

4.6

6.4

13.3

7.8

13.8

12.2

12.2

DoubtfulRecovery \b

Superin Team-tendency

0.0

0.1

0.0

0.0

0.9

0.1

2.6

0.1

0.0

0.3

41.1

1.5

\a 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 Superintendencywas reassessed by an independent team commissioned by the Central Bank.

\b Note that there were no loans classified in the category "loss" by either the Superintendencyor 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 thefive banks were undercapitalized, with networth becoming negative in twoof them after considering the non-provisioned losses on abnormal loans.The results of this limited exercise give an indication of the potentialmagnitude of the problem.

In addition to the absence of supervisión, two other forces have driventhe process of the piling-up of bad loans. The first is stabilizationbecause successful disinflation typically leads to very high expost realinterest rates whích place many debtors under financial distress. Highlending interest rates -nominal and real- are a very serious problem inthe DR. At present, annual rates stand at 25% in real terms and 30% indollar terms (Charts 9 al 10). Although savings rates are also high byinternational standards (about 10% real), the unsustainable level of the"spreads" is the more fundamental cause of the high lending rates. Nowspreads stand at about 20% nominal over the average cost of funds (Chart11). The second factor is structural adjustment, since the opening-up tofreer trade and the liberalization of markets change relative prices andthrough them relative profitabilities across sectors and firms. Thisstructural shock misleads commercial bankers who tend to assess credit-worthiness on the basis of the borrowers' credit history which becomesirrelevant in such a context.

An attempt to elabórate on these ideas within a simple formal framework ispresented in Appendix IV. In particular, the key issue analyzed there ishow 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 8percentage points) after undergoing an initial rise in the non-performingportfolio. However, "large shocks", even of a transitory nature, drivethe system permanently into insolvency. The two "large shocks" consideredin the Appendix are: a financial shock in the form of a temporary jump ofthe annual real interest rate by 40 points; and a structural adjustmentshock in the form of an opening up to foreign trade that translates intoan initial decline of the typical borrower's relative price from 1 to 0.57for then to step-up gradually towards a permanent level of 1.1 (i.e. 10%higher than the initial relative price). Although this simple frameworkclearly does not replícate the complexities of the DR's financialdynamics, 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 throughrestructuring and recapitalization institutions, and the exit of insolventbanks; (ü) establishing a prudential framework in line with theguidelines of the Basle Convention: (iü) building-up an effectiveSuperintendency of Banks. The first action deals with the "stock problem",the existence of losses on past loans now hidden in banks' portfolios. Thesecond and third actions are necessary to prevent the system from takingnew bad loans "on the flow".

The Financial Sector Loan approved by the 1DB in September 1993 supportsthe enactment of a new Monetary and Financial Code and the creation of anew Superintendency.13 It must be noted that a new effective managerialteam has already been appointed to the Superintendency and most of the newprudential measures are already in effect through Monetary BoardResolutions, even prior to the approval by Congress of the Monetary andFinancial Code. Under the new framework, banks will now follow the modelof múltiple banking -a program of mergers of existing specialized banks isforeseen- and banks are given a phase in a period of 72 months to reachthe capital adequacy levéis, new provisions, loan concentration ceilingsetc. This is an important reform program that will have a very positiveeffect on solvency "on the flow".

It is of the essence, however, that a one-time early clean-up of thesystem be implemented as soon as the Superintendency can count on aassessment of banks' portfolios. Although this is not explicitlyconsidered in the reform under the IDB loan, recapitalization of banksand the exit of insolvent áreas are necessary conditions for thepreservation of financial and macroeconomic stability.

13 The content of the reform program is detailed in the Loan Document ofthe 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 andhuman capital interacting with a reasonably undistorted market economyintegrated with the rest of the world. Macroeconomic stability is a keypre-condition for a distortion-free environment. In turn, stable rules ofthe game are essential to elicit a vigorous investment drive. Thesesimple and now widely accepted ideas have a very straightforwardapplication to the DR. In the 1970's, per-capita income expanded by acumulative 50% in a climate of low inflation, modérate external debt andclimbing investment (Charts 1 and 2). By contrast in the 1980's frequentchanges in the rules of the game and growing macroeconomic instabilityprompted a stagnation of per-capita incomes. Two economic sectors havebeen the exception to the generalized decline: tourism and free tradezones (FTZ). These sectors have rapidly expanded their production,employment, and foreign exchange income. In 1980, their revenuesrepresented barely 17% of total foreign exchange earnings. Today theyrepresent two-thirds (Charts 15 and 16). Not surprisingly, these twoenclave sectors opérate in interaction with the rest of the world and haveenjoyed non-discretional, unaltered rules of the game in the forra ofliberal investment codes. This framework of relative immunity to internaldistortions has allowed foreign and local investors to put at work in theDR their money and also the "ideas" that have proven successful elsewhere.Furthermore, the sectors stand out as a living proof of the potentialgains that the DR can achieve through broader integration in the worldeconomy, deregulation, and stability. New endogenous growth theories haveemphasized the effect on growth of: the acquisition of knowledge throughInternational trade and foreign investment; the complementaritíes betweenprivate capital and social infrastructure; the positive externalitiesarising from the development of a better skilled labor market. AppendixV provides a framework for the understanding of these ideas in the contextof 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% inthe 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 wasabout 24% in the 1970's and 21% in the 1980's. Thus, with the help ofgrowth accounting methods, it is estimated that 83% of the reduction inGDP growth was due to a fall in efficiency and only 17% due to reducedinvestment. As a result, growth prospects could be enhanced tremendouslyby improving the gains from macroeconomic stability, trade, the abolitionof spurious regulations and red tape, etc. Gains can also be achievedthrough better sectoral policies -including policies towards tourism andFree-Trade Zones- and in general, through a long term plan to strengthenthe quality of public administration and governance. Therefore, it is ofutmost importance that the Civil Service reform law issued in 1990 beimplemented as soon as possible. Other efficiency enhancing policies suchas privatization and restructuring of public enterprises have already beendealt with in this report.

29

A.l Trade Liberalization

Assessment. Important steps have been taken since September 1990 toliberaliza trade. Many quantitative restrictions have been phased-out;múltiple exchange rates have been abolished; and the number of tariffpositions and their levéis have been lowered to nine rates ranging from 0%to 35%. Moreover, under the Tariff Law of August 1993, -exemptions totariffs for sectors operating under special contracts with the State havebeen terminated. The tax code of 1991 also eliminated existing loopholesunder the promotion laws. This is a very important reform because tariffand tax exemptions afforded by special contracts and by promotion laws -for tourism, agroindustry, industry, electricity, forestry etc.- createdarbitrary loopholes and distorted resource allocation. The fiscal revenueforegone through these exemptions was estimated at about 20% of total taxrevenues in 1990. Other positive measures of trade liberalizationcontained in the new Tariff Code are the abolition of the uplift factor(desmonte) of 1.1 -that multiplied tariff rates- and the reduction of theadditional import surcharge, levied on about 40% of imports, from 7% to*f *.

Issues. The positive effects of trade reform have been largely offset bythe inefficiency of Customs and the Port Authority. The dispatching ofimports is subject to an average delay of about 30 days (down from 60 daysbefore the recent "shy" reform of Customs). Import procedures requiremúltiple steps and forty different signatures. All imports are subject toonsite physical verification. Moreover, valuation is frequently arbitraryand geared to meeting tariff revenue targets. (Comparing the Customssystem of the DR and México, import valué per employee in the DR is onlyUS$ 0.8 million while in México is US$21 million). Delays by the PortAuthority are also a major bottleneck. Port tariffs are set as a functionof time (US$12 per day and container) and not of operation. All thisreveáis that, for the DR to benefit fully from International trade, thereorganization of Customs and ports is an urgent priority.

A.2 Deregulat ion

Assessment. Spurious regulation of markets and barriers to entry, legalor factual, result in high costs for producers and the need to carryexcessive inventories. Several examples of recent deregulation are athand. In transportation, road haulage was dominated by two organizationof truckers. The effect was that tariffs per Km were 72% higher then inCosta Rica and that transportation rates between Santo Domingo and PuertoPlata were higher than shipping costs from Miami to Santo Domingo. Whenauthorities ruled and enforced a policy of new entrants, tariffs quicklydropped by 40%. Likewise the monopoly of CODETEL in telecommunicationsresulted in tariffs for international calis that were four-fold of thosein the USA. The recent entry of TRICOM and All American Cables as longdistance operators has yielded discounts of up to 60% on previous tariffs.Something similar occurred with the existence of import quotas forvehicles that favored concessionaires, allowing them to reap margins of upto 70%.

30

Issues. Recent steps in deregulation have been successful but verylimited. The experience of México in this field should be a goodreference for the DR. The authorities should consider commissioning casestudies of market structure and regulatory framework for selected sectorsso 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 economyover the last ten years, substituting for the secularly declining foreignexchange earnings of exports. From 1989 to 1992, exports dropped fromUS$0.9 billion to US$0.5 billion while tourism revenues jumped from US$0.8billion to US$1.1 billion. The current supply of hotel rooms is more thandouble then those of Cuba, Jamaica and Puerto Rico and is slightly higherthan that of Cancun. Also, despite the international recession since1990, the DR has managed to maintain occupancy rates at over 70%. Theprovenance of tourists by country is well diversified with about half fromEuropean countries and one-third from the US and Canadá. Total directemployment 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, nearly10X of the economically active population depend on tourism for theirlivíng.

Issues. The backward linkages of tourist services, with local productionof foodstuffs, textiles, furniture, construction materials etc., offer thethe DR the possibility of using the tourism as a "big push" factor for thedevelopment of local industries, operating very much along the linesexplained by old-vintage development theories of the big-push. The keyissue is that these infant industries should develop with sufficientefficiency and competitiveness to be able to switch towards the domesticmarket or exports if and when tourism stagnates. This is why continuedprogress in trade liberalization is so critical for the DR at present. Onthe other hand, experience in other Caribbean Countries indicates that adevelopment strategy fully reliant on tourism is at best risky. As incomeand wages improve, the country will lose market share to emerging lower-wage competitors. Needless to say, the DR will have to confront toughcompetition from, Lnter-alLa, Belize, Central America and post-Castro Cubain the coming future. Promotional policies, including subsidized credit(i.e. INFRATUR) and generous tax loopholes are not a good avenue to followbecause they undermine fiscal and financial discipline in the system.Rather, the real promotional effort should rest on reliable electricalsupply, low import tariffs, no taxes foreign exchange transactions, andfree 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 offirms operating in FTZs increased from 71 in 1980 to 400 in 1992, andemployment expanded from 36,000 to 150,000. The number of FTZ's is now27. The gross valué of their exports in 1992 totalled cióse to US$1

31

Chart 15Composition of Total Exports: 1980*

(Percentages)

Other

Export Zones /o ¿\v • i

Tourism Recelpts (13.2)

(*) Exports in 1980 totalled US$ 1.313 billion

Chart 16Composition of Total Exports: 1992*

(Percentages)

-

Export Zones (13.9)(26.0) FOB Exports

(50.6)-Tourism Receipts

(*) Exports in 1992 totalled 2.165 billionv '

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 traditionalsense, as they import most inputs free of tariffs and are obliged toexport virtually all the production.

Issues. Employment in the FTZ's is overwhelmingly unskilled, young, andfemale. To the extent that young workers acquire knowledge and skillsthat are of valué outside the FTZ, the system must be providing animportant growth externality for the rest of the economy. As Appendix Villustrates, externalities of this type are critical from an endogenousgrowth perspective. Also, the fact that most employees are new-entrantfemales contributes to the improvement of wage differentials by gender.FTZ's might become less relevant if trade liberalization proceeds. Theexpansión prospects of the scheme might also be at risk if the NAFTAagreement is put into effect. However, for the time being, the Governmentof the DR has approved the establishment of two more zones -withprospective creation of 20,000 new Jobs- and is considering preliminaryapproval of another four. The Government should decisively continué tosupport to scheme through four key actions: (i) improving customsprocedures so that current delays in the clearance of imports and theirdelivery by bonded-trucks is reduced to the minimum; (ii) promoting aframework for the improvement and reliability of key local inputs (i.e.electricity, telephone, transportation, etc.)14; and (iii) enacting aneven more liberal code in terms of length of licenses (now at 15 yearsrenewable) and other conditions; and (iv) strengthening trainingprograms for new entrants. At present, FTZ's with the help of theInstituto de Formación Técnica (INFOTET) provide three months of trainingin basic skills to new workers. INFOTET is jointly financed by theGovernment, business and trade unions. Firms contribute with 1% of thepayroll. The upgrading of training programs so as to meet therequirements of the FTZ's should be a high priority to make FTZ moreattractive to investors.

III-B. Enhancing Resource Mobilization and Allocation

B.l Mobilizing Domestic Saving

Assessment. National savings declined markedly during the last decadecompared to the 1970's (Chart 1). In the period 1982-92 gross nationalsavings averaged about 16%, down from nearly 20% in the period 1975-81.The relative contributions of the public and prívate sectors to nationalsavings have changed drastically over the last three years with publicsector savings expanding to reach a share of 40% of the total. As wasnoted elsewhere, the ratio of prívate savings to GDP have actually plunged

1A In a survey on the bottlenecks to which FTZ are subject undertaken in1987, 50% of the firms questioned reported the unreliability of the electricalsupply 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 probablyassociated with the current economic reform program. As people discountto the present the higher the permanent income (wealth) of the DR, theyincrease 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. Thisdrop subsequently vanishes. The fact that the public sector isstrengthening savings might also contribute in part to declining prívatesaving expenditure decisions, something that economists refer as"Ricardian equivalence". Nevertheless, in a more structural vein, it canbe argued that savings in the DR are also constrained by the restrictivemenú of savings options, now practically limited to bank deposits. Thecreation of the Santo Domingo Stock Exchange in 1991 opens newpossibilities. The Government could invigorate the development of acapital market in three ways. First, the enactment of a new SecuritiesLaw would replace the now fragmented and out-of-date legislation ontransactions in equities and firms disclosure requirement. Second, theGovernment could spur the surge of institutional investors through theprivatization of pensión funds. And third, the Stock Exchange could beused 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 banklending to the Government. Unfortunately, these funds financedunsustainable budget déficits and contributed to procrastinatedadjustment. By contrast, foreign investment has also been steady andquantitatively important. The sectors favored by investors havetraditionally been tourism, FTZ's, and mining (particularly the firmFALCONBRIDGE) due to the Government's more liberal schemes towards foreigninvestment in these sectors. These schemes included generous tax andprofit remittance provisions and also the possibility of negotiatingbilateral contracts with the State. By contrast the legal framework forforeign investment in other sectors is very restrictive.

Issues. The Central Bank is preparing a new Investment Code that ingeneral, is intended to put foreign investors parí passu with nationals.Thus, previous authorization for investments -other than those in a shortnegative list- will not be required and profit remittance restrictionswill be eased. This is a very positive step. However, in order to giveinvestors guarantees against expropriations, and political and otherrisks, the authority should consider subscribing to MIGA, OPIC and otherguárantee agreements.

B.3 Improving Investment Allocation

Assessment and Issues. Prívate investment over the last ten years hasbeen 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 increasedinefficiency in resource use. The allocation of prívate investment isexpected to benefit from current reforms towards a less distorted marketeconomy. In turn, the authorlties should urgently initiate therestructuring of public investment. As noted in Section II A-3 andelsewhere in the report, this restructuring includes inter-alia: (i)consolidation of all public expenditures within the budget throughelimination of special funds; (ii) establishment of effective control byONAPRES of all public spending; (iii) allocation of sufficient resourcesto necessary recurrent costs (i.e. road maintenance); (iv) moving awayfrom low return large-scale public investments; and (v) improvingresource allocation towards human capital, particularly in basiceducation, health and sanitation. In another vein, recent steps taken bythe Government to reorganize and partially privatize the power sector arepositive and can be expected to help in tackling critical bottlenecks toproduction.

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IV. STANDING WITH OTHER MULTILATERALS

IV-A. The International Monetarv Fund

Over the past decade, the Dominican Republic has entered into severalstand-by agreements with the IMF. In 1982 the country entered into a 3-year IMF Extended Fund Facility which was not fully utilized due tounderperformance. In 1985, a one-year Stand-by was fully disbursed. Thecurrent Government entered into a 19-month Stand-by arrangement in Augustof 1991 which expired in March of 1993. All targets of that arrangementwere met with margins.

In July 1993, the current Government signed a new Stand-by that stretchesuntil March 1994. Total drawings under the program amount to theequivalent of SDR 31.8 million (20% of the quota). The last drawing isscheduled for February 1994. In parallel, the IMF also approved in July1993 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 dialogueand projects with the flexibilíty to take advantage of opportunities asthey open. Concerns about creditworthiness and exposure are notconsidered binding constraints. The IBRD's share in the DR's total debtis 3.3% and the IBRD's debt service to exports is 2.1%. The scale of thenew lending program will depend on the continuation of macroeconomicstability of economic reform. The base scenario involves loan approvalstotalling US$241 million during 1993-96. This program includes: (i) aUS$51 million multisectoral line of credit for the private sector to bechannelled by the Central Bank, as second tier, to the commercial banks asfirst tier; (ii) a US$30 million project for pilot irrigation in áreaswhere land is fully titled; (iü) a US$70 million loan for power insupport of the Government's power sector strategy and conditional upon theintended privatization of CDE; (iv) two projects for the social sectors,US$30 for education and US$20 million for health; and (v) US$40 millionfor agricultural development. Under this lending program, the nettransfer from the IBRD is expected to shift from a negative US$9 millionin 1992 to a small positive level in 1995.

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Table V-lIndicators of IDB Exposure in 1992

(Percentages and Ratios)

IDB Debt/GDP (%) \a

IDB Debt/Total Multilateral Debt (X) \b

IDB Debt Serví ce/Exports of GNFS (%) \c

IDB Relative Exposure Ratio (GDP-Based) \d

IDB Relative Exposure Ratio (Export-Based) \f

Dominican Republic

2.5

36.5

3.5

1.5

0.7

Latín America

1.7

27.2

1.9

1.4 - 4.0 \e

0.7 - 1.9 \g

\a Excludes concessional debt.\b Includes IMF. Excludes concessional debt.\c Goods and non-finane i al servi ees.\d 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.\e 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).\f Same ratio, but normalized instead by the share of the country's exports of GNFS in Latin America's

overall exports of GNFS.\g 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: World Debt Tables 1992-93.

V. IMPLICATIONS FOR BANK STRATEGY

V-A. Current Operational Proeram

As of July 31, 1993, the IDB's loan portfolio consisted of nine projectsshowing undisbursed balances of US$286 million. Subsequently, inSeptember 1993, the Board approved the US$102 million financial SectorLoan. The conditions of which support the new legal framework for thefinancial sector and the reorganization of banking supervisión. This loancomprises three tranches, with front-loading of US$52 million intended tohelp the DR with the cash-cost of the already negotiated but yet to beconcluded debt reduction program. Two other project totalling US$62million for agricultural development are scheduled to be approved beforethe end of 1993.

The lending program envisaged for 1994 includes five more loans withcombined commitments of US$207 million. Three of those loans deal witháreas that have been identified in the report as in need of urgent reform:power sector; ports; and health. It is critical that the power andports loans be conditional, as intended, on a new regulatory frameworkconsistent with progressive prívate sector participation. It is alsoconvenient that, to the extent possible, financing for new publicinvestments 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 yetimplemented legislation to increase social security premiums should alsobe considered under the loan conditions. Also, given the current

36

CharMTComposition of Long-Term Debt in 1992

/^^ . j __\

Suppliers and others (3.6)-i

(Percentages)

Commerclal Banks (25.6)

Multilateral (25.0)

"

(45.8) Bilateral

OOÜCEOü.

u.OUJ

Chart 18IDB Relativa Exposure Patios*

4 8 é 10

SHARE OF REGION'S GDP OR EXPORTS (%)(*) Selected Countrles

Note: (G) Corresponda to GDP Share(E) Corresponda to Export Shares

'

«

inefficiency of health services provided by IDSS, a decisíve attemptshould be made to persuade the authorities towards a system in whichhealth services would be contracted out to third parties.

Since the DR's debt levéis are relatively manageable compared to othercountries in the región, once the commercial debt reduction is concluded,a balance of payments support further to the Financial Sector Loan doesnot appear necessary. Therefore, if either an Investment Sector Loan ora Social Sector Loan are included in the pipeline, their disbursementsshould be as small as possible (i.e. no more than a total of US$50million).

V-B. Kev Operational Issues and Conditionalltv

They can be divided into the following three categories: conditionality,project implementation, and supervisión. Regarding conditionality, it isconvenient that all future projects are kept within the perspective of thetwo key goals of: reorganizing the Civil Service and establishing a legalframework consistent with prívate sector development. Thus, loans shouldconsider adequate conditions towards these goals. Current technicalassistance for tax administration should be broadened to include Customsreform and the improvement of public budgeting. In addition, a way shouldbe devised to place a general condition on all loans to the effect thatthe public budgeting system be improved in the áreas of coverage, planningand auditing. In particular, the elimination of special funds should bea matter of high priority. As to project implementation, the record ofthe DR with IDB and World Bank projects is poor. As a result, specialemphasis should be placed in building up the implementation capacity ofexecuting agencies through for example, hands-on technical assistance.Regarding supervisión, given the fragility of the banking system, the Bankshould strengthen supervisión of the Financial Sector Loan, throughout itsexecution.

V-C. Bank Exposure Considerations

As Table V-l and Chart 18 show, the IDB's exposure to the DR is slightlyhigher than the average for Latin-America when using ratios of exposure toGDP. This is why the so-called IDB relative exposure ratio in Table V-lis higher than 1. By contrast, when using exposure to exports as therelevant indicator, the IDB's exposure to the DR is lower than the averagefor Latin America. Consequently, exposure is not a binding constraint.

If the Government elected after the upcoming May 1994 election continúesthe implementation of the reform program, the Bank should keenly expandits lending program to provide a positive transfer (disbursement minusdebt service). The fact that since 1991 the net transfer has beenneeative is worrisome.°

An economic plan detailing the future reform agenda has been preparedjointly by the Central Bank and the Fundación de Economía y Desarrollounder the guidance of the World Bank, IMF, and the IDB (DPL/MPO). ThePlan is entitled Programa Hacroeconomico de Mediano Plazo 1993-98 and was

37

finalized in June 1993. Performance against this Plan will be critical inassessing the course of the DR's reform procesa.

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