The Big Idea
Dominican Republic | Optimism
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The approval of the Dominican Republic’s Fiscal Responsibility Bill is encouraging. The legislation had been in limbo for almost a year after initial approval in the Senate. The fiscal rule limits budget growth to less than the pace of nominal GDP. Annual spending cannot exceed CPI + 3% compared to 5% trend GDP growth. Slower spending growth would shave off 0.2% to 0.3% of GDP in savings at a smaller deficit of 2.3% of GDP in 2027. The fiscal rule should further improve governance, allow for fiscal consolidation and improve the macro institutional framework. The progress on reform is necessary to anchor the recent outperformance of the country’s debt and allow a continuing path toward even tighter credit spreads.
Although the legislation is encouraging, it is not quite enough. The next phase shifts to tax reform. The threshold for getting upgraded to ‘BB’ is low, but higher ratings will require a slow reduction in debt ratios. The critical driver for rating agencies will be whether higher tax revenues prove sufficient to bring the trend 3%-of-GDP fiscal deficit closer to 2%, similar to International Monetary Fund recommendations. The commitment to reduce the debt leverage to 40%-of-GDP before to 2035 will require follow-up tax reform. The implementation of the fiscal rule would also benefit from a more flexible budget. There also may not be sufficient budget flexibility for complying with spending restraint. On lessons learned from the Costa Rica fiscal rule, the budget rigidity is particularly sensitive to any setbacks on revenues.
The reform agenda should kick off with the turnover of the legislature next month, with President Luis Abinader promising clarity on the August 16 transition. The tax reform is part of a broader agenda to strengthen institutions with tax reform, social security reform, labor reform, health and education reform. It’s not clear whether the ambitious reform agenda could slow the momentum on tax reform. However, political capital should provide significant margin that would extend well beyond a typical 3-month honeymoon. For final approval of the fiscal rule, it’s notable that the Abinader administration didn’t need to wait for the legislative turnover when majority support reaches more than 70% in the lower house and more than 90% in the senate.
The socialization process should also build broader support while adopting a less controversial approach to reducing the exemptions and immunizing vulnerable sectors. The tax reform proposal should be well advanced after on-and-off discussion for the past three years and Crees (Economic Strategy Center) having already drafted a proposal back in 2021. It is really a question of priorities. If the Abinader administration intends to seek an investment grade rating, then it has to target a deficit reduction. The investment grade rating coincident to a broader reform agenda would also potentially accelerate GDP growth even beyond the enviable 5% trend GDP growth. The 12-month review on the positive outlook on the Ba3/BB- ratings as well as the 2025 budget debate would merit for progress on the reform agenda later this year.
Is all the good news in the price? The Dominican Republic is already trading inside liquid ‘BB’ peers and has almost reached parity to illiquid ‘BB’ credits like Guatemala. It’s difficult not to see good relative value based on strong policy management and strong incentives for further fiscal consolidation. The shift on the issuance strategy towards local markets should also decrease the liquidity penalty, especially compared to Panama. The shift to develop local markets should reduce the prior chronic heavy Eurobond issuance and should also reduce the market beta for less volatile carry returns. The potential for capital gains depends on the slow trajectory towards investment grade ratings as debt ratios fall. Event risk should shift positive next month ahead of the release of the economic and political reforms with upside surprise if reforms are more comprehensive and if timeframe accelerates for approval in the second half of this year.
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