Dominican Republic Macroeconomic Assessment 1993-Part 1 R V Lago W Buiter L Auernheimer

DEPARTMENT OF PLANS AND PROGRAMS MACROECONOMIC POLICY DIVISIÓN

DOMINICAN REPUBLIC: MACROECONOMIC ASSESSMENT PAPER, 1993

This paper is based on the findings of a two-week mission that visited Santo Domingo in May 1993. The report was elaborated by the following team: 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). Idoia Oscáriz skillfully typed the document. Gregorio Arévalo (Programming Officer) also participated in the Mission to Santo Domingo and in the inital stage of the report.

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TABLE OF CONTENTS

I.

II.

III.

IV.

MACROECONOMIC DEVELOPMENTS I-A

Past Economic Performance

I-B

Macroeconomic Policy of the Current Government B.l Stabilization Measures and Results B.2 Structural Reforms

FRAMEWORK FOR MACROECONOMIC STABILITY II-A

Fiscal Policy A.l The Budget for 1993 A.2 Taxation A.3 Public Expenditure and Budget Reform A.4 Privatization A.5 Social Security

II-B

Monetary and Exchange Rate PolieÍes B.l Monetary Policy: Institutions and Instruments B.2 Interactions Between Exchange Rate and Monetary Policies B.3 The Unfolding Current Account Déficit

II-C

Attaining Public Sector Solvency

II-D

Attaining Financial Sector Solvency

FRAMEWORK FOR THE RESUMPTION OF PER-CAPITA GROWTH III-A

Improving Eficiency in Resource Use A.l Trade Liberalization A.2 Deregulation A. 3 Policy towards Tourism A.4 Free Trade Zones

III-B

Enhancing Resource Mobilization and Allocation B.l Mobilizing Domestic Savings B.2 Mobilizing External Savings B.3 Improving Investment Allocation

STANDING WITH OTHER MULTILATERALS IV-A IV-B

V.

The International Monetary Fund The World Bank

IMPLICATIONS FOR BANK STRATEGY V-A V-B V-C

Current Operational Program Key Operational Issues and Conditionality Bank Exposure Considerations

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DOMINICAN REPUBLIC MACROECONOMIC ASSESSMENT PAPER

' I.

MACROECONOMIC DEVELOPMENTS

I-A.

Fast Economic Performance Given its abundant natural resources and its proximity to International markets, the Dominican economy has a high potential for export-led economic growth. This growth potential was evident in the 1970s, when the economy grew on average at 9% annually while inflation remained at a modérate rate of 8%. This impressive performance was a result of prudent macroeconomic policies and occurred despite the exístence of microeconomic distortions and external shocks (i.e. the collapse of Bretton Woods exchange system and the two oil price shocks).

Both investment and domestíc 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 imbalances developed leading to increasing trends in inflation and the foreign debt.

Inflation peaked in 1990 at 101% and the debt-to-GDP ratio shot up from 30% in 1980 to nearly 100% at the end of the decade. The deteriorating macroeconomic framework resulted in declining savings and investment ratios leading to a downturn of per-capita income (see Chart 1). Average GDP 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 public services deteriorated.

Public sector employment doubled while public sector real wages halved. The worsening of the country's infrastructure resulted in frequent electricity blackouts and a poorly maintained transport network. In turn social development standards remained among the worst in the región.

The exceptions to the generalized picture of decline in the eighties were two dynamic sectors: free trade zones and tourism.

These sectors continued to expand employment and genérate foreign exchange at a fast pace. Their exports increased from 17% of the total in 1980 to 65% in 1992. This vigorous record, in an otherwise declining economy, represents living proof of the country's potential for gains from free trade.

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

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

i

Table 1-1: Years

Externa!

Events

1971-1978

Collapse of Bretton Wood system and first oil shock in 1973.

Second oil price

shock in 1978.

Summary of Macroeconomic Folíeles and Events 1971-1991 Exchange Rates

Fiscal Situation

Fixed official rate at Orthodox fiscal

Monetary

Inflation and GDP Growth

Policy Moderately expansionary.

RD$1 per dollar with a management . paral leí rate.

Small public sector Mi ñor appreciation of borrowing requirement real exchange rate, (PSBR) except for and small positive 1975 when it was a premium of dollar in surplus of 2% of GDP.

M1 annual growth of 20% during 1970-74,

paral leí market.

1976-78.

Modérate inflation: (i) 9% during 1971-2 (i i) 15% during 1973-5

falling to 3% in 1975, and rising to . (i i i) 6% 1976-8 13% annual growth

Foreign debt rose from US$ 0.2 bilí ion

High GDP growth at 9% p.a.

in 1970 to US$ 0.7

bilí ion in 1978.

1979-1982

Hurricane in 1979.

Dollar's premium in paral leí market

High fiscal déficit.

From 1981 high

increased to 30%.

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

externa 1 interest rates.

Inflation rose to 25% in 1979 and then averaged M1 growth at 16% in 1979,

6% in 1978-82.

followed by

6%.p.a. growth 19802.

GDP growth fell to 2% in 1979 and than averaged 5% in 1980-82.

Revenue down from 19% of GDP in 1970-5 to

10% by 1982.

1982-1986

Uorldwide recession Dollar's premium Unsuccessful in 1982 reached 200% by 1984. stabi 1 ization

1982, 3 year IMF program, suspended

High externa 1 Jan. 1985 official and 1982 and abandoned in Expansionary with Large fluctuations in interest rates plus paral leí market large fluctuations in inflation. From 8% in 1983.

late 1983

crisis.

IMF one-

year Stand- by in April 1985

program, started in International debt

unified and free float

M1.

introduced; rate PSBR reached 7% of fluctuated between 2.8 GDP in 1984.

Anti-austerity riots and 3.3 RD$ per in April 1984. dollar.

Successful M1 growth of 42% in 1984, falling to 22% stabi 1 ization in From mid eighties Sep.1986 preferential 1985: budget balance, in 1985. start of boom in rate, of 2.96, and revenue up to 16% tourism and Free introduced. of GDP. Trade Zones.

1983, accelerated to 33% 1984-5, and fell to 7% in 1986.

Low and falling GDP

growth, turning negative in 1986.

PSBR rose again in 1986 to 6% of GDP.

Foreign debt climbed to US$ 2.9 bilí ion

in 1986 and default of debt service.

1986AUGUST 1990

Civil disturbantes

in 1986 and 1989.

Strong growth in

Tourism and Free Trade Zones.

Frequent and large shifts within múltiple exchange rates.

Expansionary public investment program.

Highly expansionary.

Growing PSBR

Period's annual average M1 growth rate of 36%.

averaging 5% of GDP. Official rate changed from 2.96 RD$ per Foreign debt rose to dollar Dec. 1986 to US$ 3.4 bilí ion by 11.35 by Oct. 1990.

1990, with arrears

Sept 1991:18-

month Stand- by and 6 month program f rom July 1993.

Decline in terms of trade.

By 1992 Tourism income and Free Trade Zone exports

had reached 65% of total exports.

In February 1991, unification of exchange rates, and abolition of foreign exchange controls.

inflation reaching 100% by 1990. Annual average for period of 56%.

Demand pulled recovery Control led interest rates resulted in negative real rates.

peaking at 7.8% in 1988 but leading to a recession of -5.4% in 1990.

Fiscal austerity.

Monetary restraint.

Strong fall of inflation

Budget surplus of 1%

Strong growth of

accumulating.

AUGUST 1990PRESENT

Drama tic acceleration of

from an annual rate of

of GDP during 1991-2. prívate sector credit.

Revenue rose to 19% Managed float, rate Free interest rates of GDP. constant at RD$ 12.5 resulting in high per dollar.

Arrears cleared with positive rates. multilaterals.

101% at the end of 1990 to 4% in 1991 and 6% by 1992.

Negative growth rates in 1990 and 1991. Growth

resumed at 7.6% in 1992.

eliminated but the Central Bank continuad to run a quasi-fiscal déficit of about 2% of GDP. The fixed exchange rate was abandoned in favor of a float. The results were impressive: inflation fell from a peak of 38% in 1984 to 7% in 1986, but GDP plunged by 3%. However, in late 1986, debt service payments were suspended and múltiple exchange rates reintroduced.

1986 to August 1990.

Amidst social unrest, the new administration of President Balaguer embarked on a public spending course financed through money creation and accumulation of foreign debt arrears. Arrears reached US$1.5 billion by the end of 1990.

The demand-led boom resulted in a transitory output expansión during 1987-89 at the expense of accelerating inflation. The boom ended in 1990 when GDP declined by 5% and inflation reached 101%. Continuous shifts of the múltiple exchange rate coupled with controls on interest rates resulted in massive capital flight. By 1990 gross foreign reserves were equivalent to only two weeks of imports.

1990 to 1993. The reelected President Balaguer initiated a stabilization cum structural reform program. An 18-month stand-by agreement with the IMF was signed in September 1991 and successfully concluded in March 1993.

The evolution of the macroeconomic variables quickly showed positive returns to this policy regime: the collapse of inflation and a fast economic recovery. In June 1993, a new 9-month program was signed with the 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 combining stabilization measures with some structural reforms. The stabilization measures are summarized in Table 1-2.

The central ones were: i) elimination of the fiscal déficit; ii) a unified and market determined exchange rate; and iii) tightening of monetary policy and liberalization of interest rates.

In addition, arrears to the multilaterals were promptly cleared, and a debt rescheduling agreement was reached with the Paris Club in November 1991.

As a result of the program adopted, the fiscal déficit, as measured by the public 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 in 1992.

The improvement of public finance had its source in revenue increases from import tariffs and implicit taxes on gasoline. Domestic tax revenues declined slightly and expenditures were only reduced marginally relative to 1990.

The economy experienced a dramatic turnaround: the exchange rate quickly stabilized at DR$12.5 per dollar and year-end inflation was reduced from 101% in 1990 to only 4% in 1991 and 6.5% in 1992. GDP resumed growth at 7.6% in 1992 after a 6% cumulative contraction in 1990-91. Further, preliminary data suggests an improvement in income distribution with the poorer 40% of the population increasing its income share from 8.8% in 1989

Chartl Per Capita GDP, Gross Investment/GDP and National Savings/GDP* 105

35

Per Capita GDP

100-

96-

-30 £

;

90-

o) 3

;

se-

:

80-

V I

Q. O <D

-25 O. Q (5 M

751

O)

70H

(O

S &

65-

15

ü I

60H 55-

-10

60-

45 1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

l 3-VearMovnaAvefaoe

Chart2 External Debt Ratio and Inflation

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

Í^The160%iurroínttieDeb(/GDPraior1985isc)uema^toac)evaluationo(tneotficaexchanoerae.

1990

1992

•8

Table 1-2: Stabilization Measures 1990-1992 PoKcy Áreas

Fiscal Revenues

Measures Adopted

1.

Two fold increase in domestic petroleum prices. The differential between the domestic price and the imported price became an important revenue source yielding about 2% of GDP.

2.

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

3.

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

4.

Establishment of a 15% temporary import surcharge (later reduced to 10% and is presently 4%), affecting about 40% of imports (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. It was 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 revenues increased by 3% of GDP from 1991 onwards.

1.

Public expenditure was reduced only marginally from 16 to 15.6% 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 the market exchange rates. The two rates became unified by February 1991. The exchange rate has since stabilized at around 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 the public sector contracting in 1991 and 1992. In August 1990, a 100% marginal reserve requirement was imposed for 90 days, rediscounting was suspended, and the opening of new financial institutions prohibíted until August 1991.

Budgetary Policy

to 12% in 1992.

On the negative side, Stabilization has been accompanied by a widening current account déficit -which reached 6% of GDP in 1992 up from 2.5% in 1991and increasingly higher nominal and real interest rates. Despite the unfolding current account déficit, the Central Bank's net International reserves have consistently built-up, owing to short term capital inflows, reaching US$375 million or about two months of imports by May 1993.

In early 1993, the 12-month inflation rate continued at 6.5% and GDP growth continued although at a slower pace than 1992.

4

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 5X to 35X from a system which had HO different rates ranging from 5% to 60X. The drastic reduction of tariff exemptions.

The computen ization of Customs and a minor, clearly insufficient reorganization.

Tax Reforms (1992)

Marginal personal income tax rates were lowered to a unified sea Ie between OX and 30X The highest marginal rate uas previously 75X. The number of brackets was reduced.

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

The "1TBIS" (valué added tax) was increased from 6X to 8X tax in 1992, and subject to minor administrativo improvements whereby exemptions were reduced.

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

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

Financial Sector Reforms (1991- 1992)

1.

In January of 1991 the Junta Monetaria decided to fully liberalize lending and deposit rates.

2.

In December of 1991, a unified legal reserve of 20% was established and the requirement of channeling selective credit was eliminated.

3.

In April and December number of resolutions to transform a system multiservice banking. sent to Congress.

Labor Legislation (1992)

of 1992, the Junta Monetaria issued a which established a prudential framework of specialized banking to a system of A draft of the new Financial Code was

An increase in the number of days of notice given for the termination of employment.

An increase in unemployment benefits.

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

Economic assistance to workers in cases of closure of the 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 labor legislation. These are summarized in Table 1-3. In addition, steps are being taken to restructure the electricity sector and education. A Civil Service Reform was enacted by Congress in 1991 but has not been implemented yet.

Little has been done in the área of public sector restructuring.

5

II.

r

FRAMEWORK FOR MACROECONOMIC STABILITY The Dominican economy has shown remarkable price-cost flexibility to the Government's shock disinflation program. Overnight, the exchange rate stabilized, inflation carne down to International levéis, and growth resumed shortly thereafter. Notwithstanding these achievements, two short term interrelated problems have arisen: (i) high and growing domestic interest rates; and (ii) an unfolding current account déficit.

Excessive prívate expenditures, largely in consumption, are at the root of the current account déficit, while high interest rates are procuring the short-term external capital inflows to finance it.

The problem with short-term inflows is their unreliability. In turn, the concern over high interest rates involves their potential effects on the solvency of both borrowers and financial intermediarles. A sudden withdrawal of capital inflows and/or a banking crisis could bring exchange rate stability and low inflation to an end. As a result, the unsustainable trends of these two variables need to be urgently corrected.

Over the longer term, the preservation of low inflation and a stable exchange rate will depend on the firm implementation of structural reforms in several key áreas. First, the public sector's revenue base needs to be Consolidated. Since the Government is committed to a preannounced trade reform, revenue losses from tariffs will have to be compensated by additional revenues from taxes on expenditure and income. Second, public expenditure will have to be restructured through, ínter alia, privatization of public enterprises, debureaucratization, and strengthening of the budgetary process.

Third, the external creditworthiness of the public sector, and of the country at large, needs to be reestablished by completing the already advanced debt restructuring and reduction plan of the Government. Fourth, the solvency of financial intermediarles needs to be improved through effective oversight of the system and by an up-graded prudential framework.

Existing losses of troubled banks will have to be assumed by shareholders, depositors and only residually by the State. And fifth, the current unfunded pensión fund system needs to be replaced in favor of one based on capitalization of individual contributions.

Decisive action towards implementation of these reforms would send a strong signal to the markets that exchange rate and price stability are indeed sustainable. This would set the stage for a decline in interest rates -by reducing both country risk and foreign exchange risk- thereby limíting 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 budget under this program -summarized in Table II-1- foresees a rough equilibrium in public sector borrowing requirements (PSBR), compared to small surpluses in 1991-92, and allows for a slight increase in the ratio of

6

Table II-l Dominican Republic: Public Finance 1989 - 1993 (Percentages of GDP)

1989

1990

1991

1992

1993 \a

16.9

12.9

16.1

18.6

18.5

Current Revenue

16.5

12.6

15.8

18.4

18.1

(of which tax revenues \b)

12.4

10.3

10.3

13.6

13.8

Capital Revenue

0.4

0.4

0.3

0.3

0.4

TOTAL EXPENDITURE (2)

21.8

15.9

15.6

17.1

17.7

Current Expendí ture

10.5

9.4

9.1

9.4

9.8

(of which accrued interest)

4.1

4.1

3.8

3.8

3.5

Capital Expenditure.

11.3

6.6

6.5

7.7

7.9

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

-4.9

-3.0

0.3

1.5

0.8

Déficit of Other Non Consolidated (4)

-2.2

-2.9

-1.1

-1.0

-1.7

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

-7.2

-5.9

-0.7

0.5

-0.9

Grants (6)

1.3

0.9

0.8

1.1

0.9

PUBLIC SECTOR BORROWING REQUIREMENT (5)+(6)\c

-5.9

-5.0

0.1

1.6

0.0

Externa 1 \d

4.4

3.7

2.5

1.1

-0.2

Oomestic

1.5

1.4

-2.6

-2.7

0.2

Primary Surplus

-1.9

-1.0

4.0

4.6

2.7

Current Savings

6.1

3.2

6.7

8.9

8.3

TOTAL REVENUE (1)

FINANCINQ

MEMO ÍTEMS

\a \b \c \d

Programmed.

Excluding oil price differential and taxes on foreign exchange.

Balance plus grants and central bank losses.

Including interest arrears and rescheduling.

public investment to GDP. However, it should be noted that public investment still remains at levéis considerably lower that those of the 1980's. Public sector current savings continué at a strong 8.3% of GDP and the primary surplus at 2.7% of GDP. As is known, the former indicator gauges the contribution of the public sector to the country's capital formation while the latter is the relevant ratio to assess the trend towards solvency. Domestic financing of the budget is set to rise from a credit contraction of nearly 3%, of GDP in 1991-92, to a slight expansión 0.2% of GDP in 1993. This is due to the fact that foreign financing vía accumulation of arrears -which was very significant in previous yearsvanishes because of the renegotiation and reduction of the foreign

7

commercial debt. The macroeconomic assumptions underlying the budget are a 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 major fiscal variables and maintenance of current levéis of relative publíc sector prices.

The IMF supported program provides good short-term collateral to economic agents for the continuation of fiscal-monetary restraint through this difficult pre-electoral period. It also enables the DR to conclude the debt reduction deal recently negotiated with commercial creditors. However, the key issues for the sustainability of fiscal balance, outlined below, are clearly not tackled.

A.2

Taxation

Assessment. Tax revenues represent about 15% of GDP, roughly equal to the average for developing countries. As shown in Chart 3, about 37% of total tax revenues come from tariffs on imports while an additional 10% are a result of the spread between the import cost and the local price of petroleum products, and still a further 2% comes from a tax on foreign exchange transactions. Consequently, about half of total revenues arise from differential taxes on international transactions thus distorting trade and artificially favoring import substitution activities.

The value-added tax, the so called ITBIS, represents the largest share of the remaining half of fiscal revenues. As explained in Section III-A., the collection of tariffs on imports is subject to cumbersome customs procedures that impair the delivery of inputs and raise costs of production.

In turn, the collection of domestic taxes is subject to rampant evasión.

Indeed, of the estimated 28,000 business registered under corporate taxes, only 8,000 file tax returns.

As for personal income taxes, of an estimated universe of 230,000 individuáis who are in principie liable to pay, only 56,000 are registered and of this number only 23,000 file tax returns. Likewise, a recent UNDP study on compliance with VAT indicates that evasión is no lower than 67% of the theoretical tax base. The new tax code enacted in June 1991 -the main features of which are presented in Table 1-3- has not become fully operative due to three key reasons: the need to issue the by-laws for the new income tax; the spurious división of labor between two collection agencies, Dirección del Impuesto sobre la Renta and Dirección de Rentas Internas; and the lack of an administrative reform necessary to enforce tax laws.

Issues. The budget surplus since 1991 has been achieved through temporary and probably self-liquidating revenue measures with a yield of between 5 and 6% of GDP. Taxes on international transactions are expected to decline because of the preannounced timetable of trade liberalization and also because the current level of imports is atypically high.

As a result, the consolidation and possibly the improvement of the tax revenue to GDP ratio requires further reform. In this endeavor, two key issues are involved: amendments to the tax laws and reform of tax administration.

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

ChartS Central Government Revenues: 1992 (Percentages)

, Other Reverme (10.5) Taxes on Goods & Services

Trade Tariffs (36.8)

(23.9)

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

(15.7) Income and Profit Taxes

Taxes on International Transactions

Other Taxes

Chart 4 Operations of the Consolidated Public Sector (In Percent of GDP)

(10)

1980

Revenues

1982

1984

1986

1988

1990

Expenditures & QFD -•- Déficit*

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

'

1992

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

The main measures regarding tax administration are as follows: (i) merging of the two tax collection agencies; (ii) creation of a unified new Taxpayer Registry on the basis of an updated survey; (iii) initiation of a comprehensive reorganization of tax administration personnel, under the mándate of the already approved but not yet operative Civil Service Law of 1990; (iv) replacement of the current system of direct collection by one of payment of taxes at commercial banks; and (v) up-grading and modernization of the data-processing department in the áreas of hardware, personnel and software.

It is estimated that the phasing in of the above reforms over the next two to three years would provide additional tax revenues no lower than 5% of GDP, thus more than compensating for the foreseeable decline of tariff revenues that will be brought about by the reduction of real imports and further tariff liberalization.

A.3.

Public Expenditure and Budget Reform

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

Regarding public sector budgeting, the main problem is the existence of special funds allocated discretionally by the Office of the Presidency.

Thus, in 1992, the budget approved by Congress included only 48% of actual Government appropriations for the year. The most important special fund is the so-called Ítem 1401 which accounts for 75% of all revenues exceeding the budgeted amount for the general fund.

These surplus resources are substantial because the revenue projections do not take

9

Table II-2 Selected Public Enterprises: A Summary Table

Ñame Corporación Dominicana de Electricidad (CDE)

Indicators

Activrty Generation.

Transmission, and Distribution of Electricity.

Expendí tures to GDP (1991)= 2.1% Current losses before Transfers to GDP (1990)= 0.5% Employment= 6,000

Remarks Approved government plan as follows: * New regulatory framework allowing private sector access to electricity generation and distribution. * División of CDE into three independent corporal i ons: generation, transmission, and distribution. * Total or partial divestiture and/or management contracts for the new exCDE generation and distribution compames.

Consejo Estatal del Azúcar (CEA)

Holding company of 10 sugar refineries also owning, sugar plantations, and transport inf rastructure.

Expendí tures to GDP (1990)= 1.7%

* Expropriated from the Trujillo family.

Losses before Transfers to GDP (1990)= 0.1%

* Rising cost of production, obsolete equipment, and declining US market quota for the DR.

Employment= 20,000 Dominicans and about 30,000 foreigners

Corporación Dominicana de Empresas Estatales CCORDE)

Rosario Dominicana

Holding company of 24 majority owned and 15 mi ñor i ty owned enterprises in all sectors (textil e, milling, food, transportation, automobiles, services etc).

* But to be divested in parts for alternative potential means: agricultural producers, free trade zones, tourism developers, urban soil etc. * Expropriated from the Trujillo f ami ly.

Employment= 9,000

Gold mining company owned by the Central Bank.

n.a.

* Few of the firms enjoy regulatory preferences, others are protected by restrictions to international trade, and one of them , Molinos Dominicanos, enjoys monopoly power. * Exports down from US$60 mi U ion in 1982-83 to US$26 mi U ion in 1992. * In need of major investments.

CORPHOTELS

Banco de Reservas

INFRATUR

Fondo de Inversión para el Desarrollo (FIDE)

Holding of 14 hotels some of thetn leased to the prívate sector.

Largest commercial bank which also has some treasury functions.

* Deteriorating facilities. n.a.

* Léase often at low rents and arrears in renta 1 payments.

Share in deposits of the banking system: 40%

* 60% of lending to the public sector. * High share of non-performing loans.

Department of the Central Bank in charge of : ( i ) protnot i on of tourism projects and infrastructure; and of (i i) provisión of subsidized loans for prívate hotel construction.

* The provisión of loans is funded in part by international loans from the IDB and World Bank. n.a.

Central Bank secondtier window to provide subsidized loans for investment projects.

n.a.

* Funding from the Central Bank and multilateral institutions. * First tier loans in the hands of 50 intermediar i es.

10

account of expected inflation and also because there is delibérate underestimation.

In addition, there are other special funds established on specific sources of revenues such as royalties from the mine company Falconbridge, oil price differential etc. Resources from special funds are also freely assigned by the Office of the Presidency to specific public entitíes or "bulky" public investment project. A recent example of the latter is the US$800 million irrigation-electricity project of HigueyAguacate.

Issues. First, the reform of the state should be initiated urgently. The start of the process could be the implementation of the service reform in key public institutions such as the Central Bank, the Superintendency of Banking, Tax Administration, Customs, and the Ministry of Finance. The building-up of a skilled and dedicated body of civil servants, remunerated at comparable salaries to those of the private sector, is a key prerequisite for the successful continuation of the economic program.

Second, the budget system needs to be replaced by one without special funds and with precise mechanisms of execution, audit and control. Also, all major expenditure ítems need to be placed under competitive tender procedures. The budget of autonomous agencies needs to be brought under the control of ONAPRES, the National Budget Office. Third, a far reaching study on the structure and efficiency of public expenditures needs to be undertaken urgently, particularly for education, health and infrastructure.

A.4.

Privatization

Assessment. The characteristics of public enterprises are summarized in Table II-2 and their finances are provided in Table II-3. Performance has improved since the 5% of GDP Consolidated current losses of the mid 1980's, but they still register current account déficits of over 0.5% of GDP and require capital transfers and/or borrowing in order to finance their investments. The political decisión to design a broad privatization program has not been made yet.

However, this policy is an essential element in the modernization and reform of the state. So far, the only examples of privatization are: the trash collection service of Santo Domingo; the services of the new international airport; and some involvement of two multinationals in two firms of CORDE, a public holding company. Recently, a more fundamental turn towards privatization has been taken in the electricity sector. The new regulatory framework permita private sector involvement in generation and distribution, and the Government is even thinking about, at least, partial privatization of the generation and distribution network of CDE, the power utility.

A frequently stated political argument that runs against the privatization of CEA and CORDE is that these business were expropriated from Trujillo and 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 the production and marketing of private (rival and excludable) goods or

11

Table II-3 Summary Operations of Public Enterprises.

(In Percent of GDP) 1988

1993

1989

1990

1991

1992

10.0

6.8

7.6

7.4

8.3

9.0

3.1

1.8

1.6

1.6

1.7

2.6

10.5

9.2

8.7

8.7

9.3

9.4

Current

7.0

5.8

7.2

6.6

7.0

7.1

Capital

3.5

3.4

1.5

2.1

2.3

2.3

-0.8

-2.2

-1.1

-1.3

-1.0

-0.3

Current Account Balance Before Transfers

-0.4

-0.8

-1.2

-0.7

-0.8

-0.6

Overall Balance Before Transfers

-3.8

-4.2

-2.6

-2.8

-3.0

-2.9

TOTAL REVENUE (of which Transfers) TOTAL EXPENDITURE \b

OVERALL BALANCE AFTER TRANSFERS

\a

MEMO ÍTEMS

\a Programmed. \b Includes interest due on the external debt arrears of the public enterprises. services.1 Therefore, the maín objective behind privatization should be efficiency gains. Four other considerations play a role in determining the modality of privatization: (i) public sectors revenue needs; (íi) finding the buyers that will manage the assets in the most efficient manner; (iii) equity considerations, i.e. fairness in the distribution of the rents from privatization; and (iv) the post privatization cooperative environment: (i)

Revenue Needs: Even if public enterprises were given away, privatization will have a positive impact on the Government's budget because there would be no public claim on losses and because privatized firms would pay taxes. Thus, the privatization period should not be extended with a protracted search for a potential buyer that would maximize Government revenues from the sale.

(ii)

Efficient Management: The selling to the highest bidder, after a reasonable timeframe for advertising and tender, might help in screening the most efficient buyer. Nevertheless, since the highest bidder is the one expecting the highest future stream of profit, the Government should ensure that the profits result from the buyer's efficiency and not from spurious market power. Thus, the Government should refrain from bilateral dealings with prospective buyers on the post-privatization regulatory framework.

(iii) Equity: The spreading of the benefits of privatization widely should be a central goal. Moreover, this course of action will ensure popular support for privatization.

Linking privatization revenues to incremental social spending -as has been done in México,

1

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

I

12

(iv)

A.5

Venezuela and Perú among others- is an effective approach to gain consensus. Alternatively, distributing transferable privatization coupons -that can be used as cash by the buyers of enterprises- or even distributing a fraction of the shares of the very enterprises among the "adult population" -say, through a lottery among registered voters- is an approach that creates a climate favorable to "people's capitalism", and that has been effeotive in some Eastern European Countries. In the DR, this latter method may be particularly appealing for the divestiture of the former Trujillo possessions, now in the hands of the CEA and CORDE holdings, because it takes the assets away from the state bureaucracy and returns them to the people. Moreover, the foreseeable resale of the distributedshares of these two holdings would quickly place their enterprises in the hands of efficient private managers. These will carry out the subsequent spins-offs and divestiture of each specific firm thereby minimizing the demands made on the limited administrative capacity of the state. ' Competitive Environment: As argued in (ii), the defining of a clearcut and non-negotiable competitive legal framework is a prerequisite for privatization. This is especially important for sectors not subject to international arbitrage such as Utilities and services (the so-called non-tradable or sheltered sectors). The DR has taken a very positive step in this direction with the definition of the new free-entry framework for generation and distribution of electricity. Regarding import or export competing industries, trade liberalization perfectly complements privatization by providing external competitive discipline.

Social Security

Assessments. The social security system, managed by IDSS, is vested to provide a full range of coverage and services for private sector employees, including retirement, health, disability, life, and maternity insurance. Membership is compulsory wíth no opt-out for firms/workers who also 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. The state is supposed to contribute a further 2.5% but does not do so. Given the low quality of the health services provided and the low and declining pensions (now at about US$40 per month), evasión is high with only about 14% of economically active population contributing. The finances of IDSS are shown in Table II-4. Contributions go to a general fund with most resources going to pay for the operation and expansión of the IDSS health facilities and administrative expenses. As a result, the pensión system is not only unfunded but not even a pay-as-you-go system because current pensión out-payments are calculated residually and are unrelated to current and past Contributions. The poor productivity and quality of IDSS's health services can be gauged by the following two indicators: the occupancy rate of beds in IDSS hospitals was 37% ín 1991; and the IDSS employs 3,000 doctors for 4,000,000 beneficiarles while the Costa Rican Social Security employs 1,300 doctors for 2 million beneficiarles.

13

Table II-4 Revenues and Ezpenditures of RD's Social Security Institute (percentage of GDP) 1987

1990

1991

1992

1993 \a

Revenues

0.61

0.56

0.58

0.66

9.74

Expendí tures

0.62

0.60

0.59

0.66

0.91

-0.01

-0.04

-0.01

0.00

-0.17

Balance

\a Programmed.

Issues. A law approved by Congress in 1990, but not yet effective by decisión of the Executive, proposes an expansión of coverage of benefits to all the dependents of insured workers together with an íncrease of the contribution paid by the workers from 2.5% of basic salary to 4% and of the contribution paid by the employer from 7.5% to 12%. On the basis of a recent thorough study commissioned by the National Council of Businessmen2 that sheds light on the Information given above, and considering the fact that workers view the current system as a puré tax on wages, any broadening of coverage and contributions to expand IDSS's health services should be put on hold awaitíng fundamental reform of the system and, in general, of the State's health policy.

Regarding retirement benefits, the current system should be discontinued and replaced by a privately administered competitive pensión fund system, á la Chile, 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 have to be assumed by the Treasury. Of course, the current capitalized valué of past contributions would have to be grandfathered out of the public purse in the form of a performing bond that beneficiarles could transfer to a prívate pensión fund.

II-B. Monetarv and Exchange Rate Policies B.l

Monetary Policy:

Institutions and Instruments

Monetary and exchange rate policies are formulated by the Monetary Board and implemented by the Central Bank.

Members of the Board are the Governor of the Bank, the Secretarles of Industry and of Finance and seven representatives of the private sector appointed by the President for a three year period. The Superintendency of Banks, which depends on the Ministry of Finance, is in charge of the supervisión of financial institutions.

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

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

14-

Constitution, which conferred ampie powers to the Monetary Board. As part of the structural reforms the Monetary-Financial Code has recently been submitted to Congress.

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

In the past, the traditional instrumenta of monetary policy were: interest rate controls, mandatory allocation of credit, changes in reserve requirements and m煤ltiple exchange rates. They have been abolished. The Central Bank will exercise restraint, and open market operations will be the main instrument. The new Monetary-Financial Code provides the legal framework 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 the external sector and the exchange rate are fundamental for monetary developments. Although prices and monetary aggregates are ultimately and roughly associated (Chart 5) , the ci贸se correlation between prices and the exchange rate, with exchange rate movements preceding price movements, is even more clear (Chart 6).

During the last fifteen years, the country has had a pattern of stop-go policies, and a lack of continuity in exchange rate and monetary rules.3 This is apparent in Chart 7, which plots the inflation rate since 1970 against the inflation rate in the USA as a benchmark.

It clearly establishes the periodicity of departures of the latter from the former associated with stop-go policies, and the increasing amplitude of those departures (i.e., the intensity of the disequilibria) since 1978.

Another feature which emerges from the data, is a nearly contemporaneous and inverse association between inflation and real money (Chart 8). This also suggests that the money market and inflationary expectations adjust very quickly in the DR. Thus, not only do inconsistent policies bring about early crises, but also credible stabilization efforts have quick results.

This is why the current stabilization program prompted a spectacular collapse of inflation with virtually no recessionary impact.

The exchange rate has stayed de facto fixed at DR$12.5 per dollar since 1991 despite the fact that the exchange market is officially under a managed float. This has been feasible due to the Central Bank's domestic

3

This pattern is characterized by the following sequence: an excessive expansi贸n of domestic credit to finance public expenditure or meet revenue shortfalls; loss of foreign exchange reserves; imposition of exchange controls; and finally an exchange rate crisis. This is typically followed by a stabilization program that after some time is abandoned in favor of renewed domestic credit expansi贸n.

15

Chart 5 INFLATION AND MONEY GROWTH (Annual Rates, Last 12 Months) 120

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 I

1985

1986

1987

1988

1989

1990

u 11111 1991

i i i i 1 1 1 ri 1 1 1 1992

Chart 6 EXCH RATE DEVALUATION AND INFLATION (Annual Rates, Last 12 Months) 120

-20 ' M i i n i m i M i m i i M i m i i

1985

1986

1987

1988

1989

1990

1991

1992

Constitution, which conferred ampie powers to the Monetary Board. As part of the structural reforms the Monetary-Financial Code has recently been submitted to Congress.

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

In the past, the traditional instruments of monetary policy were: interest rate controls, mandatory allocation of credit, changes in reserve requirements and m煤ltiple exchange rates. They have been abolished. The Central Bank will exercise restraint, and open market operations will be the main instrument. The new Monetary-Financial Code provides the legal framework 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 the external sector and the exchange rate are fundamental for monetary developments. Although prices and monetary aggregates are ultimately and roughly associated (Chart 5) , the ci贸se correlation between prices and the exchange rate, with exchange rate movements preceding price movements, is even more clear (Chart 6).

During the last fifteen years, the country has had a pattern of stop-go policies, and a lack of continuity in exchange rate and monetary rules.3 This is apparent in Chart 7, which plots the inflation rate since 1970 against the inflation rate in the USA as a benchmark.

It clear ly establishes the periodicity of departures of the latter from the former associated with stop-go policies, and the increasing amplitude of those departures (i.e., the intensity of the disequilibria) since 1978.

Another feature which emerges from the data, is a nearly contemporaneous and inverse association between inflation and real money (Chart 8). This also suggests that the money market and inflationary expectations adjust very quickly in the DR. Thus, not only do inconsistent policies bring about early crises, but also credible stabilization efforts have quick results.

This is why the current stabilization program prompted a spectacular collapse of inflation with virtually no recessionary impact.

The exchange rate has stayed de facto fixed at DR$12.5 per dollar since 1991 despite the fact that the exchange market is officially under a managed float. This has been feasible due to the Central Bank's domestic

3

This pattern is characterized by the following sequence: an excessive expansi贸n of domestic credit to finance public expenditure or meet revenue shortfalls; loss of foreign exchange reserves; imposition of exchange controls; and finally an exchange rate crisis. This is typically followed by a stabilization program that after some time is abandoned in favor of renewed domestic credit expansi贸n.

15

Table II-5 Dominican Republic: Financial Survey - Uses and Sources of Broad (Percentage changes as defined below )\b

Money \a

1988

1989

1990

1991

1992

1993 \c

66.5

29.3

32.5

34.2

29.2

9.3

a. Money

33.3

11.3

19.7

14.1

14.0

4.6

b. Quasi - Money

33.2

18.0

12.8

20.1

15.2

4.7

B. BROAD MONEY SUPPLY (Sources)

66.5

29.3

32.5

34.2

29.2

9.3

a. Net International Reserves

17.2

-8.5

-4.5

33.8

7.3

-2.8

b. Net Credit to Public Sector

27.9

7.8

6.9

-9.8

-12.9

3.3

c. Credit to Private Sector

21.1

30.9

19.8

15.8

25.1

7.8

d. Other Net Assets

0.3

-0.9

10.3

9.7

8.1

1.1

Base Money \d

95.2

14.6

44.7

60.3

10.0

7.4

Inflation Rate \e

57.6

41.2

100.7

4.0

6.7

5.0-8.0

2.7

2.3

2.1

1.7

2.3

2.2

3.5

4.1

6.6

4.6

3.9

3.9

42,393

60,355

90,722

98,054

102,957

A. BROAD MONEY SUPPLY (Uses)

MEMORĂ NDUM Ă?TEMS:

Broad Money Supply

Multiptier \f

Income Velocity of Broad Money Nominal GDP (mi U ion pesos)

28,353

\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 financial system 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 those of the years, 1989-90, of soaring inflation and macroeconomic instability.

However, unlike those years, fast money growth is now consistent with low inflation rates, 4% in 1991 and 6 . 7 % in 1992. This is so because the demand for money has been increasing at a fast pace -the so-called remonetization process- after the public sector budget was brought into balance. In other words, in the case at hand, the growth in the quantity

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

16

Chart?

ANNUAL INFLATION RATE (Last12 Months) 120

Dominican Republic

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990 1992

Chart 8 REAL MONETARY BASE AND THE INFLATION RATE 120

-100

c O) o -80

a>

OL C

I

-60

CC

C

-40 I

-20

1985

1986

1987

1988

1989

1990

1991

1992

ChartS NOMINAL ANNUAL INTERÉS! RA!ES

40-

35-

30-

25-

o

20-

• O.

Borrowing Rate (Excl DD) 15-

10-

Borrowing Rate (Incl DD)

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

MAY

'

JUL

SEP

NOV

JAN 93

CharMO

REAL ANNUAL INTERÉS! RA!ES*

40-

35-

30-

<D O.

15-

10-

0a—r JUL91 SEP NOV JAN 92 (*) Annual InflaHon Tor trie last 6 months

MAR

MAY

JUL

SEP

NOV

JAN 93

MAR

of money was driven by an upward trend of the real demand for money brought about by the dramatic fall of inflationary expectations. Indeed, in a small open economy under a fixed exchange rate, the nominal money supply is fully endogenous. It is determined by the interplay between the demand for money and movements of International reserves. In the current context of the DR, the "incipient" monetary contraction, arising from the budget surplus, prompted an offsetting inflow of international reserves so as to accommodate the expanding demand for money. Table II-5 shows that the accumulation of international reserves by itself caused growth in broad money of 34% in 1991 and 7% in 1992. Needless to say that this monetary growth was further compounded by the secondary expansión of credit 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 for a small open economy, like the DR, integrated in the currency área of the US dollar. Under a fixed exchange rate the Central Bank stands ready to buy and sell foreign exchange at the prevailing exchange rate. The key for the sustainability of the system is a path of accumulation of the Central Bank's international reserves that guarantees the credibility of the present and future convertibility of the currency at the prevailing exchange rate. A necessary condition to achieve this is a sufficiently restrictive Central Bank domestic credit policy.7 In fact, this has been the monetary policy followed by the DR since 1991, as indicated by the negative growth of domestic credit to the public sector -which accounts for almost the totality of Central Bank domestic credit-. A rule of thumb for the future is that Central Bank domestic credit growth be no higher than the sum of GDP real growth and international inflation.

In this case, any expansión of the real demand for money (the so-called remonetization) will be accommodated by accumulation of international reserves, thus continuing to strengthen the creditability in the currency.

The authorities confront two policy issues: high interest rates; and concerns of some economic agents about the competitiveness of the exchange rate: (i)

5

Interest Rates: The evolution of interest rates over the last two years is shown in Charts 8 through 11. The trends can be summarized as follows. Until March 1992, there was a steady fall, particularly

Now, legal reserve requirements stand at 20%

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

7

Another condition is the preservation of the solvency of financial intermediaries, particularly when commercial banks' deposits are explicitly or implicitly guaranteed by the Central Bank.

17

Chart11 SPREAD BETWEEN ANNUAL AVG BORROWING AND PRIME NOMINAL LENDING RATES

30

25-

20-

B o OL

10-

5-

Due to Reserve Requirement

JUL91

SEP

NOV

JAN 92

MAR

MAY

JUL

SEP

NOV

JAN 93

MAR

unan 12 PROPORTION OF DEPOSITS HELO BY THE BANCO DE RESERVAS AND COMMERCIAL BANKS (Percentages) •

co de Reservas (30.1)

Others (28.5)

Foreign Banks (8.6) co Popular (20.2)

Bco del Comercio (12.7)

.

of lending rates, resulting from the decline in inflationary expectations. In that month, interest rates bottomed out at about 20% annually for lending and 12% for deposits.

Since then rates have, again, picked up with the lending rate rising by about 10 percentage points by the second quarter of 1993. Therefore, rates are very high under any standard.

The lending rate, now at 30% annually, is about 23% in real terms and equivalent to fourfold of the US prime rate.

In turn, the deposit rate, now at about 14% annually, is over 10 percentage points above the US rates for deposits certificates. High interest rates are due to both a high International spread and a high domestic spread, as defined below.

On the one hand, there is a high "International spread" between the DR peso deposit rate and the US deposit rate.

As Appendix III explains, this spread can be accounted for by the following three components: (a) expectations of a devaluation of the peso; (b) the default risk of DR deposits in the absence of complete de jure or de facto deposit insurance; and (c) market segmentation however small- reflecting less than perfect capital mobility. Since the latter two components are of a more structural nature, it stands to reason that they have a stronger bearing on the permanently high level of the deposit rate.

Whereas the increasing devaluation premium, appears to be responsible for the recent increase of the deposit rate. Surveys undertaken by commercial banks indĂ­cate that there is a generalized expectation of a, say, 10% devaluation before the 1994 presidential elections. This expectation is linked to the uncertainty as to economic policy prior to and after the elections.

On the other hand, there is a high "domestic spread" between the local lending rates and deposit rates.

As Chart 11 shows, this spread has been rapidly increasing since March 1992, representing the 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 defaultrisk premium charged on borrowers; (b) the cost of non-interest bearing reserve requirements; and (c) the mark-up arising from the existence of market power in the banking system (often resulting in cost-permissiveness and high intermediation costs).

The first element appears to be the driving forcĂŠ behind the recent surge of the "domestic spread" because neither the cost of reserve requirements Ăąor market power have changed significantly over the last one and a half years. However, these latter two elements are important to find an explanation for the permanently high spreads.

The default risk premium discussed at length in Section II-D and Appendix IV, which deals with the interaction between interest rates and the solvency of the financial system. Needless to say that the issuance in 1992 by the Monetary Board of strict capital adequacy rules and a prudential framework seem to have moved commercial banks to improve the assessment of borrowers' default risk in the wake of an officially understated -and probably worsening- non-performing portfolio.

18