The Big Idea
Dominican Republic | Safe haven
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The Dominican Republic’s policy priority for now focuses on counter-cyclical stimulus to support its ‘BB’ credit ratings. This should reinforce its status as a safe haven relative to credits more sensitive to general market conditions such as Colombia and Panama. especially given the contrasting fiscal and funding metrics. The Dominican Republic offers a defensive alternative with an overall favorable balance of risk and reward.
The International Monetary Fund’s latest annual report on the Dominican Republic focuses on the resiliency of the economy and the policy flexibility it needs to return to trend 5% GDP growth. It highlights recent monetary and fiscal stimulus as well as greater foreign exchange flexibility. This is the hallmark of the ‘BB’ fundamentals for the country.
There are some lingering concerns with how Fitch treats its positive outlook in the 12-month review in November. The outlook has been in review for a lengthy 24 months. The agency has to assess whether the ‘BB-‘ rating upgrades to ‘BB’ or shifts back to neutral. A fiscal deficit that has gone from 3% of GDP to 3.5% of GDP may conform with the country’s fiscal rule, but it doesn’t point to fiscal consolidation and lower debt ratios. There is debate about the pros and cons of high counter-cyclical policy flexibility compared to the rigor of the fiscal rule. The timing of the rating review is not ideal. However, the worst-case scenario of reaffirmation of a ‘BB-‘ rating wouldn’t compromise the already composite ‘BB/Ba2’ rating from the other agencies.
The IMF makes typical recommendations of budget flexibility through either higher revenues or lower electricity subsidies. This will become increasingly important for adopting the fiscal rule over the next few years. The quick fix is tax reform. That would provide a buffer of higher revenues and higher conviction around fiscal consolidation. The alternative is a structural reduction in spending. This is not easy for the low budgets across Central America and particularly for the low capital expenditure. There is also vulnerability to any revenue setbacks that would slow the pace fiscal adjustment while still conforming with the spending restraint of the fiscal rule. The prior IMF annual report included the critical assumption of electricity subsidy cuts of around 1% of GDP to conform with the trend fiscal deficit of 2% of GDP necessary for lower debt ratios. This was a clear recommendation, especially necessary for higher capital expenditure and recapitalization of the central bank.
The near-term policy priority focuses on the importance of a cyclical recovery with 5% trend GDP growth necessary for broader policy realignment, including the target 3%-of-GDP fiscal deficit. This may prompt a more dynamic financing strategy that shifts funding externally does not restrict domestic liquidity, especially after the recent decline in interbank rates from 12% to below 9%. The IMF blames
“…tighter external and domestic financing conditions (that) have weighed on activity this year…. The BCRD’s liquidity measures enacted in June and the reformulated budget’s fiscal stimulus should support a pick-up in activity in the second half of the year and help to close the output gap. Beyond 2025, growth is expected to gradually return to its potential, supported by investment and productivity growth in line with past trends.”
The economic reform agenda may require first the realignment of trend growth, especially considering “high uncertainty and possibly tighter global financial conditions.” High growth is the backbone for political support and necessary for a controversial reform agenda including tax reform or electricity sector reform.
Counter-cyclical policy flexibility and economic resiliency offers critical defensive credit characteristics, especially compared to other liquid ‘BB’ peers. The sovereign’s lower sensitivity to general market direction is increasingly relevant at a mature phase of spread compression and near convergence among the ‘BB’ credits. This spread convergence doesn’t differentiate fundamentals among the ‘BB’ credits. The balance of risk-and-reward should favor the economic stability in the Dominican Republic against the uncertainty and fluidity of the fiscal and financing trajectory of its peers, such as Panama and Colombia. Under a risk-off scenario, the stronger relative fundamentals should allow the Dominican Republic to outperform while current tight relative valuations should constrain the additional gains of more sensitive credits. And the best relative value looks like it is for the intermediate sector of the curve relative to Panama.
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