The Big Idea
Dominican Republic | Persistent oil shock
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With continuing uncertainty around oil prices and global growth, it’s no surprise that Fitch shifted the Dominican Republic’s ‘BB-‘ rating from outlook positive back to neutral. This doesn’t suggest any threat of crisis, but it does show low policy flexibility to counter downside risks to growth and thinner economic buffers compared to peers. This should increase the Dominican Republic’s market sensitivity to any increase in external risk aversion. That makes the more defensive shorter tenors of the country’s flat curve better value relative to ‘BB’ peers.
The near complete recovery across emerging market credit this month raises the risk of complacency, especially considering the impact of stubbornly high oil prices across the oil importers of Central America. The Dominican Republic is most vulnerable compared to its ‘BB’ peers for its heavy reliance on oil imports, the least policy flexibility and the lowest economic buffers. The Dominican Republic is perhaps the most vulnerable, with Fitch shifting the positive outlook back to neutral. But Fitch also rules out worst case scenarios across the region, writing “Downgrades are unlikely, barring severe scenarios.” The credit differentiation is based on the respective policy response to the protracted oil shock.
The initial fallout is clearly inconvenient considering the country’s below-trend growth that’s only beginning to improve. This clearly explains the recently higher fuel subsidies and contrasts with the hands-off approach from Costa Rica, where above-trend growth and below-trend inflation can accommodate the full pass-through of this adverse external shock. The Dominican Republic’s weaker economic trends require maximum policy flexibility. However, the above-trend inflation may constrain monetary policy flexibility while the rigid fiscal rule may also constrain counter-cyclical fiscal stimulus. Is there flexibility to finance higher fuel subsidies? Costa Rica has a proven track record on its adherence to the fiscal rule even through the pandemic. The Dominican Republic just launched their fiscal rule last year.
It is far too soon to trigger an escape clause and conversely, it’s not easy under the restrictive budgets across Central America to reallocate spending. However, there should be some marginal flexibility under the fiscal rule for a slightly higher fiscal deficit and also marginal flexibility under the budget to prioritize expenditures. If we reference the 2022 oil price shock for a full year at $100 a barrel, this would translate into a 0.6% of GDP in additional fuel subsidies that would require a combination of budgetary efficiency and slightly higher fiscal deficit (3.2% to 3.4% of GDP) aligned with the fiscal rule. There are only a few weeks of budget data this month to assess the initial impact. The spending trends year-to-date through April 17 show a small primary surplus with spending under pacing revenues with lower capital spending the typical adjustment mechanism for fiscal restraint.
The spending restraint is not ideal, but there is no flexibility for either fiscal or monetary stimulus under the fiscal rule and with above-trend inflation. The secondary impact from the oil shock will be important to monitor. It leaves the country vulnerable to revenue slowdown and lower domestic consumption either through the inflationary shock or the external threat of a global slowdown in tourism and remittances. The budget remains vulnerable if it depends on economic recovery with the central bank already revising down GDP growth projections this year to 3.5% to 4.0%. The latest economic activity data provides some room for optimism with upward momentum to 4.1% growth year-over-year through the first quarter of this year and 5.1% year-over-year through March.
The duration of the oil shock will test policy flexibility and the balancing act of maintaining the fiscal rule while promoting economic recovery. The high oil dependence and low policy flexibility should sustain the higher market beta relative to ‘BB’ peers, especially under the preferential liquidity of its benchmark status. This would explain the recent underperformance relative to Guatemala and Costa Rica.
My preference remains on the shorter end of the Eurobond curve with higher margin relative to the steep curve in Brazil and more defensive against a scenario of protracted bouts of external risk aversion. The recent outperformance of Colombia post debt buyback also exposes relative cheapness of the Dominican Republic against all ‘BB’ comps in the region on the shorter tenors.
2026.
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