Publish in Perspectives - Wednesday, August 7, 2013
The economy of the Dominican Republic, here represented by capital Santo Domingo, only grew 0.3 percent in the first quarter. (Photo: Big Falo)
Willingness to "fix the fiscal" remains strong, but electricity subsidies remain a heavy burden on fiscal accounts.
BY FRANCO UCCELLI
Risks to political stability remain low; near-term electoral landscape is clear. President Danilo Medina will enjoy a two-thirds majority in Congress until the May 2016 general elections, which in principle should support the passage of reforms. Nevertheless, former President Leonel Fernandez remains a very powerful figure within the ruling Dominican Liberation Party (PLD) and many local pundits believe his ambition to seek a new presidential term in 2016 may undermine Medina's ability to mobilize support for his reform agenda. Meanwhile, the Dominican Revolutionary Party (PRD), the main opposition party, is in the midst of a power struggle and remains deeply fragmented, posing little threat to governability at this stage.
Growth is set to slow considerably in 2013 before strengthening in 2014. Real GDP growth of only 0.3 percent oya in 1Q13 prompted the central bank and the government to announce measures-such a reduction in interest rates, a considerable liquidity injection, and increased public investment-to stimulate economic activity and boost credit demand. Despite the authorities' best efforts, most locals believe full-year 2013 growth is unlikely to reach the 3.0 percent officially projected, but they also view the 2.0 percent estimated by the IMF as a bit too conservative. As such, the new market consensus for 2013 growth appears to be somewhere around 2.6 percent, in line with our expectations. Looking forward, updated models suggest growth is poised to exceed 5 percent in 2014, as new mining supply comes on stream and government consumption picks up, which is twice this year's rate yet still below the 5.9 percent potential estimated by the IMF.
Improved foreign reserve position mitigates FX risk. Largely driven by the issuance of a US$1 billion global bond offering in April, net international reserves surged nearly 20 percent, to US$3.8 billion in 1H13, and the official target calls for them to close 2013 at US$4 billion (6.6 percent of projected GDP), the highest level ever, yet still relatively low by international standards. While the DOP has already depreciated 4.4 percent so far this year, more than the 4.1 percent depreciation it recorded in full 2012, the authorities attribute much of the recent weakening to exogenous factors (elevated uncertainty in global financial markets, USD strength) and remain confident that the exchange rate will close 2013 at less than 43 pesos per USD, posting a cumulative depreciation of around 6 percent this year. The authorities have generally favored moderate depreciation of the exchange rate for the sake of improving the competitiveness of domestic exports and believe currency risk will continue to be mitigated by an improvement in the foreign reserve position. The authorities, who only manage the FX to reduce volatility and keep expectations contained, believe the exchange rate is aligned with the country's fundamentals.
Fiscal consolidation remains on track. Preliminary results for 1H13 show a government deficit of approximately DOP19 billion ($450 million), equivalent to 0.8 percent of projected full-year 2013 GDP. The partial number puts the shortfall on track to meet the DOP70 billion ($1.7 billion) target, equivalent to 2.8 percent of projected GDP, with relative ease. Should the target be met, it would represent a massive adjustment from the 6.6 percent of GDP central government deficit posted in 2012. The significant improvement would result from the combination of tax reforms, spending restraint, and the renegotiation of a contract with Barrick Gold (see below). The government aims to lower the fiscal deficit to 1.5 percent of GDP in 2014, 1.0 percent in 2015, and zero in 2016.
Renegotiation of Barrick contract will support fiscal revenues. It is estimated that the renegotiation of a contract with Barrick Gold (Canada), whose $4.6 billion investment in an underutilized gold mine since 2006 represents the largest single invested by a foreign company in the Dominican Republic, could generate some $400 million in revenues for the government during the course of this year alone. The new contract, which increases and advances tax payments on gold exports and raises the profit split to 51.3 percent from 37.1 percent for the country, is expect to boost fiscal revenues by more than $1.5 billion over the project's duration above and beyond the $10 billion estimated last March. Of the approximately $1.5 billion in fiscal revenues, Barrick is projected to provide $2.2 billion in 2013-16, making a sizable contribution to the Medina administration's efforts to eliminate the fiscal deficit altogether by the end of its term in office in 2016.
Electricity subsidies remain a heavy burden on fiscal accounts. With little hope that the government will raise electricity tariffs (they have not been adjusted in more than two years) or materially improve collection levels (close to 40 percent of the power generated nobody pays for) to reduce large subsidies to the sector, these are likely to remain a heavy burden on public accounts for some time to come. Indeed, the government has budgeted $1.05 billion (1.7 percent of projected GDP) in current transfers to the sector for 2013, a considerable amount by any measure. However, with international oil prices trending higher and preliminary evidence for 1H13 suggesting that subsidies are already running 10 percent above budget, the prospects of easing the subsidy burden in the near term look grim.
Petrocaribe amendment or elimination would affect public finances considerably. With very long repayment periods and a modest 1 percent interest rate, the Petrocaribe financing scheme has been a very important source of cheap financing for the Dominican Republic, one of its largest beneficiaries. Since the program's inception in 2005, the country has received $3.4 billion in loans from Petrocaribe, accounting for more than 24 percent of its external non-financial public sector debt. While cheap financing has been a blessing for the Dominican Republic in times of need, its heavy reliance on the scheme may prove otherwise, as the possible modification of its contractual terms or its elimination altogether amid Venezuela's growing fiscal constraints may force the Dominican Republic to search for more expensive financing sources, such as multilateral or the market, to cover its needs, putting undue pressure on its public finances.
The recent rise in the public debt burden disqualifies the Dominican Republic as a low-debt country. Widening fiscal deficits and elevated debt service obligations have led the non-financial public debt to triple in nominal terms to $22.2 billion and to double in relative terms to 37 percent of GDP. Although lower fiscal shortfalls and the resulting decline in financing needs are expected to moderate the rise in the public debt burden, the Dominican Republic can no longer claim to be a low-debt country, with its debt burden now in line with the median for both Latin America and the emerging markets universe as a whole.
Sharp increase in metal exports is set to narrow the current account deficit; rise in tourism and remittance inflows will also help. After shrinking to 6.8 percent of GDP in 2012 from 7.9 percent in 2011, the current account deficit is expected to narrow to around 4.5 percent of GDP, as gold and ferronickel exports increase sharply and tourism and remittance inflows continue to expand (albeit modestly), and imports contract this year owing to soft domestic demand and a decline in capital investments. A further decrease, to 3.7 percent of GDP, is expected in 2014 as gold exports kick into full gear and the relative weight of oil imports moderates somewhat.
Despite moderation after a one-off boost in 2012, FDI inflows will remain substantial. Following extraordinarily strong foreign direct investment (FDI) inflows is 2012, when the tally reached nearly $3.6 billion (6.1 percent of GDP) supported largely by the foreign acquisition of a local brewing company, more moderate, yet still considerable inflows are forecast for the years ahead. FDI is expected to top $2 billion (3.4 percent of projected GDP) in 2013, and to average over $2.4 billion (3.7 percent of projected GDP) between 2014 and 2017.
The government is unlikely to seek a new IMF loan accord in the near term. Given the degree of conditionality (particularly on the electricity sector front), that one would entail, most local observers believe the Medina administration is unlikely to pursue a new IMF loan accord, such as a Stand-By Arrangement, at least in the near term. The only scenario for an accord that would go beyond the current post-program monitoring (PPM) that appears plausible is one where the government runs out of financing alternatives amid the elimination of the Petrocaribe scheme. Even under those circumstances, however, a new agreement would probably be negotiated along the lines of traditional IMF programs, which generally do not provide budget support, making it difficult for the government to secure a new program without providing proper assurances that disbursements would not be used simply to finance the fiscal deficit.
Franco Uccelli is an analyst with JP Morgan Chase. This column is based on a recent trip report. Republished with permission.