The Big Idea

Dominican Republic cuts rates as inflation drops toward target

| June 9, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Dominican Republic’s central bank, in a widely anticipated move, followed recently in the footsteps of Uruguay and Costa Rica and cut rates. The bank reduced rates from 8.5% to 8.0% after observing a near normalization in inflation and as concern continues to build about downside risks to growth. The decision reflects the bank’s flexibility in managing the balance between economic growth and inflation.

The central bank, in its post-meeting communique, emphasized its expectation that actual inflation would revert back within the target band as domestic economic demand moderated. While the bank provided no explicit guidance for the next meeting, its statement underscored a dual objective of targeting inflation and maintaining macroeconomic stability. With policy rates still restrictive and a lag in the transmission mechanism, an aggressive cycle of rate cuts should lead to outperformance of local rates in the early stages of the easing cycle.

Recent data on May inflation confirmed a full convergence back within the target band, with a year-on-year rate of 4.5%. The numbers also showed month-over-month deflation of -0.2% and a clear collapse from peak levels last year. The downward trend in inflation was further supported by monthly core inflation rates ranging from 0.2% to 0.3% between March and May 2023, with low diffusion across economic sectors. The central bank’s decision to proactively cut rates in anticipation of softer-than-expected May inflation aligns with the quick reversal in growth and inflation dynamics and the lag in restrictive policy rates. The bank also acknowledged the high nominal rates across the region and the initiation of easing cycles.

Monetary expansion has decelerated, with M1 money supply shifting from a 30% to 10% pace between 2021 and May 2023. This deceleration in monetary expansion has been accompanied by a slowdown in monthly economic activity to 1.2% year-on-year from January to April 2023.

First-quarter data further illustrates the economic situation, with average economic activity at 1.48%. Unreleased April data is expected to confirm a worse trend, with the lower 1.2% year-on-year average for January to April 2023. While manufacturing, mining, and construction sectors contracted, the agriculture and service sectors remained resilient. The primary concern for the country, known for its high trend GDP growth of 5%, is the downside risks to growth, which may fall below 4% this year. The central bank’s previous communique explicitly highlighted these downside risks to growth. While the economy benefits from a dynamic tourism sector, the central bank will need to continue shifting towards neutral or accommodative rates to support a stronger economic recovery in the second half of 2023.

The neutral policy rate is up for debate, with current levels at 3.5% not far from the average pre-Covid real rates of 3.0% (2014-2019). However, with inflation already converging within the target band and economic activity significantly below the latest trend growth of 5% and the higher trend growth of 6.2% from 2014 to 2019, the central bank may consider expansionary policy. The monetary board has also implemented extraordinary liquidity measures, including a reduction in the reserve requirement and the establishment of a new Quick Liquidity Facility for private sector financing. While the central bank remains independent with a sole target of price stability, the current tame inflation may influence a shift towards expansionary policies, especially with the approaching 2024 election cycle. Interestingly, President Abinader submitted a fiscal responsibility law to congress during an economic deceleration and not too far from the general elections in May 2024. This move aligns with recommendations from the last Article IV summary review by the International Monetary Fund (IMF).

The proactive policy by the central bank supports a constructive investment strategy for both local and external debt. Despite s stronger credit trajectory for the Dominican Republic relative to Colombia, the country’s external debt has lagged behind the recent rally in liquid ‘BB’ peers like Colombia. This is reflected in near-flat spread differentials  in the 10-year sector. However, the outperformance of local rates should continue during the early stages of the expansionary rate cut cycle. Additionally, there may be further appreciation of the currency due to cross-border financial inflows, and the dual currency bonds should keep up a strong performance. The initiation of the rate cut cycle may also stimulate demand in the Dominican Republic’s local markets and encourage the re-entry of more dual-currency issuance.

Siobhan Morden
siobhan.morden@santander.us
1 (212) 692-2539

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