Dominican Republic Growth Diagnostics Report

José María Fanelli

Rolando Guzman

Washington, DC,

September 19, 2007

Session I

Growth in Dominican Republic:

Stylized facts

Growth has accelerated since 1990. Per capita GDP grew 2.2% per year in the 1976-2006 period and 3.5 % in the 1991-2006 period.

(1) Remarkable long-run performance

Dominican Republic: Per Capita GDP

200.0

400.0

600.0

800.0

1,000.0

19

70

19

72

19

74

19

76

19

78

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

Year

RD

$ 1

97

0

The Dominican Republic’s PPP GDP has grown substantially in the last thirty years, the growth interruption during the “lost decade” was milder than in LA.

(1) Remarkable Long-run performance

GDP, PPP (constant 1995 international $)

0

50

100

150

200

250

300

350

400

450

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Dominican Republic Costa Rica

Latin America & Caribbean Chile

The Dominican Republic’s growth performance since the beginning of the nineties is comparable to Chile and outperforms LA, Central America, and the Caribbean.

(1) Remarkable Long-run performance

Dominican Republic Growth from an International Perspective

0

50

100

150

200

250

300

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

1995

Dol

lars

, 199

5=10

0

ChileDominican RepublicLatin AmericaCentral AmericaCosta RicaThe Caribbean

The country changed their comparative advantages and developed new sectors from scratch, like tourism and the Free Trade Zones (FTZ), compensating the fall in traditional exports. Remittances grew steadily and became one important source of revenues

(2) Deep structural transformations

Current Account Composition

-8.000

-6.000

-4.000

-2.000

0

2.000

4.000

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

US

$ M

illi

on

s

TBN

TBZ

Remittances

Services

Inv. Inc.

Other Current Transfers

Current Account

The economic structure changed substantially with increases in the participation of industry and services and a fall in agriculture

(2) Deep structural transformations

Sectoral Contribution to GDP Growth (%)1970-75 1975-80 1980-95 1985-90 1990-95 1995-2000 2000-05

Primary 26,06 16,10 23,63 -4,22 7,02 2,86 10,46

Industry (incl. Water & Electricity)

18,62 19,75 5,37 23,38 33,16 37,01 16,76

Construction 10,71 6,40 2,75 27,76 6,80 7,12 -2,21

Commerce & Rest. 17,00 17,97 18,28 8,44 27,47 17,42 18,02

Other Services 27,62 39,78 49,97 44,64 25,55 35,59 56,96

Total 100,00 100,00 100,00 100,00 100,00 100,00 100,00

GDP Composition1975 1980 1985 1990 1995 2000 2005

Primary 22,79 20,59 20,49 16,71 12,86 10,11 10,20

Industry (incl. water & electricity)

20,03 20,11 18,70 19,47 30,00 31,97 29,22

Construction 6,67 6,68 5,91 8,66 6,14 6,29 4,54

Commerce & Rest. 16,86 17,29 17,58 16,05 18,50 18,28 18,44

Other Services 33,65 35,33 37,32 39,12 32,49 33,35 37,60

Total 100,00 100,00 100,00 100,00 100,00 100,00 100,00

• The country has shown a remarkable ability to recover quickly after the occurrence of crisis in the eighties, nineties, and the current decade.

(3) Above average degree of policy effectiveness and a democratic polity

-10

-5

0

5

10

15

-15000000

-10000000

-5000000

0

5000000

10000000

15000000

20000000

25000000

Growth rate Deviation from trend

• The state supported the structural transformation; it plays a leading role concerning the development of the free trade zones and to some extent, tourism. Rapid signing of DR-CAFTA

• The government is currently introducing significant changes in the fiscal institutions to deal with the costs of the financial crisis and DR-CAFTA. Income tax; ITBIS (from 12% to 16%); other taxes.

• The country has managed to maintain the stability of the political institutions since the mid- sixties.

(3) Above average degree of policy effectiveness and a democratic polity

• Consumption is more volatile than income. Volatility fell in the nineties but increased again as a consequence of the financial crisis.

• Significant macroeconomic disequilibria in the 1980s, 1990s, and 2003.

• Costly financial crisis in 2003

(4) The economy is volatile

R epública Dominicana (R olling window 9 years)

0

10

20

30

40

50

60

70

80

90

100

VAR(g) VAR(AB)

República Dominicana (rolling window 9 years)

0

10

20

30

40

50

60

70

80

VAR(g) VAR(c)

(4) The economy is volatile

GDP and Consumption Volatility. Latin American Countries and United States

(1990-2002)

0

0,01

0,02

0,03

0,04

0,05

0,06

0,07

0,08

0,09

0,1

Arg

entin

a

Bra

zil

Canada

Chile

Colo

mbia

Costa

Ric

a

Dom

inic

an R

ep.

Ecuador

El S

alv

ador

Guate

mala

Hondura

s

Mexic

o

Nic

ara

gua

Para

guay

Perú

Trin. y T

ob.

Unite

d S

tate

s

Uru

guay

1960-1989 1991-2005

There is a certain degree of inconsistency between the country’s per capita GDP and its human development indicators

(5) A set of key determinants of growth lags behind

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140 160 180

Human Development Indicators Ranking

PP

P p

er c

apit

a G

DP

Ran

kin

g

Dominican Republic

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140 160 180

Life Expectancy at Birth

PP

P p

er

cap

ita G

DP

Ran

kin

g

Dominican Republic

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140 160 180

Adult Literacy Rate

PP

P p

er c

apit

a G

DP

Ran

kin

g

Dominican Republic

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140 160 180

Combined gross enrolment ratio for primary, secondary and tertiary schools (%)

PP

P p

er c

apita

GD

P R

anki

ng

Dominican Republic

(5) A set of key determinants of growth lags behind

• The infrastructure exhibits important weaknesses:

• The energy system is inefficient; the system of subsidies has established a complex linkage between efficiency and distribution.

• Ports and bad logistics impede the exploitation of comparative advantages associated with geography.

(5) A set of key determinants of growth lags behind

The level of financial deepening is lower than expected, given the country’s per capita GDP.

(5) A set of key determinants of growth lags behind

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

5.5

6

0 0.5 1 1.5 2 2.5 3

Private Credit / GDP

Sto

ck

Ma

rke

t c

ap

. /

GD

P

Financial Underdevelopment - Banks: (<49.5% GDP)

Financial Underdevelopment - Markets

(< 44.1% GDP)

Dominican Republic

• A good part of the country’s sources of competitive advantage were associated with some features of the international architecture that have disappeared (the multi-fiber agreement) or are condemned to disappear (the possibility to grant special exceptions to the FTZs).

• Increasing competition in apparel industry (notably, China).

• Tourism has been much more dynamic than the FTZs, but was affected by the 11-S effect and further development calls for structural changes to face environmental problems and the exhaustion of the all-included strategy.

(6) Concerns on trade specialization and the oil bill

• The oil bill has increased substantially in the present decade, from US$ 650

million in 1998, to US$1.5 billion in 2000 to US$ 2.8 billion in 2005.

• Increasing portion of total imports.

(6) Concerns on trade specialization and the oil bill

Oil Imports

0

500

1.000

1.500

2.000

2.500

3.000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

Mil

l U

S$

0

5

10

15

20

25

30

%

% Total Imports

Mill US$

Despite the continuity of the democratic system, institutions are weak.

• Flawed supervision contributed to generating the crisis

• Inability to separate growth policies from distributional policies fuels the energy crisis.

• Corruption

(7) Weak institutions

The most important challenge facing the country is the weakening of the sectors that fueled the increase in productivity and competitiveness since the beginning of the nineties (FTZs and tourism).

The most pressing need is to find new sources of increment of productivity and competitiveness (strengthen self-discovery activities) while working on the existing long-run constraints (infrastructure, finance, and human capital).

The country has shown a remarkable flexibility to introducing adaptive reforms when the international and/or the domestic scenarios changed in the past. This is an asset in light of the tasks that the government must perform to strengthen self-discovery.

On the other hand, institutions are weak and this pose a constraint on the type of policies that can be implemented.

Remittances have contributed to reducing external and macro volatility, although at the price of increasing the country’s dependence on them, which could harm the development of the tradable sector and new self-discovery activities.

Remittances create a linkage between the macroeconomic regime and self-discovery policies via the effects of remittances on the real exchange rate. The macro regime matter to growth and competitiveness.

Working Hypotheses

FDI has a key role supplying technology and access to new foreign markets. However, FDI can indirectly harm competitiveness because of:

• The effects on the real exchange rate in a context of increasing remittances;

• Fiscal policies to promote FDI (“race to the bottom”) that absorb resources that can be used to support self-discovery and human capital accumulation.

The fiscal situation raises a number of doubts: it is necessary to raise resources to finance the central bank, social policies, the subsidies to the electricity sector, and self-discovery activities. This implies a level of tax burden that could harm competitiveness.

This means that it is central to: coordinate tightly policies to promote new activities to avoid wasting resources and address policy-induced distortions in governance structures, in particular the electricity sector.

The real exchange rate is likely to play a central role: it must strike the balance between competitiveness and human development. A depreciated exchange rate can be used to fuel the non-FTZ, non-tourism sector and to make the production of human capital cheaper. This raises the issue of the role of the exchange rate regime in the future.

Working Hypotheses

The lack of financial deepening may not be a binding constraint on those sectors in which FDI is important. However, it will likely be a serious obstacle concerning duality; it can pose a constraint on the growth of the non-FTZ sectors, and the development of domestic suppliers for the tourism sector and FTZ.

The allocation of remittances is key. They should be increasingly allocated to increasing human capital. In addition, better financial institutions can contribute to improving the allocation of remittances and to increasing savings.

The regional dimension is somewhat absent concerning:

• Coordination to avoid race to the bottom policies

• Development of regional financial markets (Examples: Bonds in Asia, Flar, and CAF).

Policies should take into account Haiti, which may play a role concerning the development of new activities:

• Cheaper labor and opportunities to invest

• Market for Dominican industrial exports (it is the third market)

Working Hypotheses

Growth Diagnostics: Hypotheses

Micro risks: Property rights,

corruption, taxes

Low domestic

saving

Bad national finance

Bad international

finance

High cost of finance

Possible Problems

Information externalities:

self discovery

Coordination externalities

Market failures

Government failures

Low appropriability

Low social

returns

Low returns to

economic activity

Low human capital

Bad infrastructure

Poor geography

Macro risks: Financial, monetary,

fiscal instability

Poor intermediatio

n