The Big Idea

Dominican Republic | Optimism

| February 23, 2024

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 outperformance of the Dominical Republic against ‘BB’ peers could easily be explained by election optimism. Performance in any ‘BB’ credit usually depends on a combination of carry and potential for a breakout to investment grade. It’s still early in the election cycle, but the incumbent has momentum for a first round win. This suggests optimism for stronger political capital and opportunity for fiscal reform. That supports relative outperformance for the Dominican Republic and the rational for seeing better relative value this year on potential for an investment grade rating.

There was stark contrast in my trip from Panama to the Dominican Republic in mid-February with one credit vulnerable to losing its investment grade rating and the other with potential to win one. It’s still soon in the election cycle, but the debate was not whether President Abinader is re-elected but whether in the first round on May 19 or the second round on June 30 with 55% support close to the 50% threshold first round win. The strength of recent municipal elections suggests underlying support for a first-round win—the ruling PRM won 121/158 mayoralties, far above the 52% win in 2020.  The current administration also benefits from the upsurge in economic activity with the central bank expecting upside to 5% to 5.5% GDP growth this year. There was already a turnaround late last year on what appears as a recovery towards 5% trend GDP growth after a cycle of monetary stimulus and normalization in mining operations.

This stronger political mandate would provide an ideal backdrop for fiscal reform.  There has been much debate about fiscal reform with a renewed political mandate the ideal opportunity to finally push forward controversial reform. The introduction of the fiscal rule to the legislature represents the first step with frequent communication with the International Monetary Fund and rating agencies on the context and rationale for achieving an investment grade rating. It’s still early to assess the specifics (IMF Article IV provides some guidance) on burden sharing (lower VAT exemptions or wealth taxes).

There is almost no budget flexibility on low capex, rising electricity subsidies and the high contingent liability to re-capitalize the central bank. There is a clear priority to achieve an investment grade rating with higher revenues the only viable alternative to shift the fiscal deficit closer to 2% of GDP and the debt stock gradually lower towards 40% of GDP. There is no quick fix on debt sustainability as the fiscal rule stipulates low 40% of GDP ratios only in 2035. However, the markets would prefer tax reform over spending restraint on the lower execution risk to stabilize the debt dynamics.

There has already been a significant rally on the long end of the curve with near convergence to the illiquid ‘BB’ credits like Guatemala and Costa Rica and a divergence from the liquid ‘BB’ credits Colombia and Panama. This may reflect the optimism of the investment grade potential or the stronger technicals on the improving supply-and-demand of less Eurobond issuance and a local bid on the tight DOP/USD interest rate differential. The central bank seems comfortable on maintaining a slightly restrictive policy rate after pronounced year-to-date foreign exchange weakness. There is more flexibility to tolerate foreign exchange strength after the 2.4% depreciation in January—fastest monthly depreciation since 2007—and the strong recovery in economic activity late last year. The foreign exchange stability is critical on further developing local markets with a funding strategy that has shifted for less Eurobond issuance. This disparate funding strategy should reinforce a clear differential between Panama and the Dominican Republic with a lower liquidity penalty and a stronger credit trajectory. The curve now seems quite flat after the aggressive outperformance of the longer tenors with potential for bullish curve steepening.

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

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