The Big Idea
Dominican Republic | The next grade
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. This material does not constitute research.
Recent comments from Dominican Republic President Luis Abinader about reaching an investment grade rating at the end of this term seem out of synch with recent rating actions. The rating agencies recently explained that the country’s failure to approve tax reform led to delays last year in upgrading the credit. This is still the surprise setback that the market now has to reconcile with a path to investment grade. That path likely runs through spending constraint, something not quick or easy and requiring both budget savings and consistent revenues.
The Dominican Republic’s structural fiscal deficit has to drop from 3% to 2% of GDP and stay at that level over many years to gradually reduce debt ratios closer to the investment grade target of 40% of GDP. The fiscal deficit isn’t yet on this stabilizing path and high 5% GDP trend growth alone isn’t the formula. The first challenge is compliance with this year’s austere budget. This would allow for a one-notch upgrade to ‘BB’ and maybe the possibility of further positive rating action. The credit trades as a stable ‘BB’ and as a defensive proxy to the other more volatile ‘BB’ names in the region like Panama and Colombia.
The recent optimism from President Abinader again refocuses the debate on how to achieve an investment grade rating. This would validate effective policy management and improve potential for higher foreign direct investment and even higher trend GDP growth. The Central America and Caribbean region is unique for its positive rating momentum, with plenty of debate about which country is going to be first to achieve the coveted investment grade rating. There was huge optimism that the Abinader administration would trigger a wave of economic reform and accelerate the path to investment grade. The markets and rating agencies alike were focused specifically on tax reform for immediate improvement in the debt-service-to-revenue ratio.
There is still potential to reach a composite ‘BB’ rating with Fitch again reviewing its current positive outlook while the Moody’s positive outlook comes up for review this August. The execution of the conservative 2025 budget along with some efforts to improve tax collection efficiency may be enough for a lift after a lengthy positive outlook review.
The rating agencies should also consider progress on good governance and on strengthening institutions with recent approval of the fiscal rule. Budget performance this year will be critical for unwinding the recent stimulus and reducing spending from 19.6% of GDP in 2024 to 18.3% of GDP in 2025. The latest data do not yet show a trend reversal, with spending still high in January and February. If the economic team prioritizes a rating upgrade, then there should be efforts throughout the year to comply with this spending restraint. This spending restraint would not only allow for a ‘BB’ rating but also show the necessary commitment for a path of future rating upgrades. The Dominican Republic already trades with the ‘BB’ credits and arguably on the tighter range of valuations towards ’BB+’ credits as the liquid and stable alternative within Latin America.
This economic stability is clearly a benefit compared to peers, but the question is whether it is enough to reach an investment grade rating. The 5% trend GDP growth is enviable but isn’t enough to lower the debt ratios. The 5% GDP growth may benefit from a low tax base with many exemptions of the high 18% VAT rate. This high growth aligns with a roughly 3%-of-GDP trend fiscal deficit and alone isn’t a catalyst for fiscal consolidation.
The challenge for the Dominican Republic is the same challenge for Costa Rica. The spending restraint of the fiscal rule is designed to gradually reduce spending until the structural fiscal deficit reaches 2% of GDP and then gradually reduce debt ratios. The 2024 Article IV from the International Monetary Fund already programs this trajectory with the savings from the controversial electricity subsidies. The official projections instead assume a gradual reduction across the primary spending categories. These assumptions are optimistic based on the rigidity of the budget to accommodate the restrictive fiscal rule with fixed debt service, low capital expenditure and high mandated social spending.
There are also execution risks that any disappointment on revenues translates into higher fiscal deficits due to limited ability to cut spending. This has been the case for Costa Rica in 2023 and 2024. The latest headlines on US policy risks and the higher concerns about global stagflation are a reminder about the optionality of external shocks. If trend growth decelerates, this would push a higher burden on spending restraint and a slower trajectory toward investment grade.
There is no quick or easy path to lower the debt ratios to investment grade levels. The challenge is multi-year compliance with the fiscal rule to reach a debt stabilizing fiscal deficit of 2% of GDP and then sustaining that austerity over many years to lower debt to 40% of GDP in 2035. The fiscal rule itself assumes a 10-year horizon with rating agencies closely monitoring budget flexibility and progress on spending cutbacks.
This year’s budget performance is critical for delivering the programmed reduction in spending as the first important step toward compliance with the fiscal rule. The potential for upgrade should offer an anchor against turbulent external markets and the possibility of relative outperformance against weaker ‘BB’ names. The Dominican Republic offers resilient fundamentals and favorable technicals as already having completed their Eurobond funding needs this year. However, there is no room for setback on relative tight valuations with spending austerity the crux of the next rating upgrade and successful positive rating action as well as a buffer against any downside external shocks to growth.
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