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O C C A S I O N A L   P A P E R      
The Dominican Republic
Stabilization, Reform, and Growth

By a Staff Team led by Philip Young

©2001 International Monetary Fund
January 29, 2002

Philip Young
I.    Stabilization and Structural Reforms
Alessandro Giustiniani and Randa Sab

The Lost Decade: 1981–90
The Initial Phase of the Reform Effort: 1991–95
A New Beginning: 1996–2000
The Challenges Ahead
II.    Trade Reform Continues
Jimmy McHugh and Werner Keller

The Trade Regime Prior to the 1990 Reforms
Trade Reforms in the 1990s
Free-Trade Zones
Trade Agreements
III.    Successful External Debt Restructuring
Jaime Cardoso and Werner Keller

The 1980s—First Round of External Debt Restructuring 20
The 1990s—Second Round of External Debt Restructuring 20
The 1991 Paris Club Debt Rescheduling 23
Non-Paris Club Debt Rescheduling: 1991–97
Evolution of Payments Arrears in 1990–2000
Past, Present, and Future Debt-Service Payments
External Debt Policy
IV.    A Review of Fiscal Policy During the 1990s and Current Policy Considerations
David Dunn and Alessandro Giustiniani

Contribution of Fiscal Policy to Macroeconomic Stability During the 1990s
Tax Reform and Administration
Reforming the Budget Process and Redirecting Public Expenditure
V.    Capital Accumulation, Total Factor Productivity, and Growth
John Panzer and Raimundo Soto

Sources of Growth in the Dominican Republic
Sources of Growth Excluding the FTZs
Sources of Growth for the FTZs
The Role of Public Investment in Growth
VI.    Money Demand in a Small Open Economy: The Case of the Dominican Republic
Francisco Nadal-De Simone

The Estimated Equations and the Estimation Technique
Unit Roots, Cointegration, and Long-Run Elasticities
The Long-Run Elasticities of the Model
Conclusion and Policy Implications
VII.    Exchange Market Pressure, Monetary Policy, and Interest Rates: Recent Evidence from the Dominican Republic
Evan Tanner

Exchange Market Pressure in the Dominican Republic:
An Overview
EMP and Monetary Policy: A Vector Autoregression Approach
Estimation Results
Summary and Policy Implications
I.    Governance Issues
V.    Economy-Wide Data
VI.    A Stylized Open Economy Model
Unit Roots and Cointegration
I.      1. Main Macroeconomic Indicators
    2. Structural Reforms
    3. Selected Political Risk Components—Comparison with
        Western Hemisphere Countries
II.      4. Import Tariff Structure
    5. Initial Import Level Before Contingent Tariff Applies
    6. Schedule of Contingent Tariffs  
    7. Index of Trade Restrictiveness  
    8. Import Tariff Rates  
    9. Free-Trade Zone Activity  
III.    10. Outstanding External Public Debt Sector  
  11. Medium- and Long-Term Public External Debt Service
  12. Outstanding External Public Sector Arrears
  13. Total Rescheduled Debt
  14. Summary of the 1994 Restructuring of Commercial Bank Debt
IV.    15. Summary of the Consolidated Public Sector
  16. Summary Operations of the Central Government
  17. Tax Revenue by Source
V.    18. Economic Structure and Growth, 1991–98
  19. Production Function Estimates, 1970–98
  20. Sources of Growth Estimates
  21. Total Factor Productivity Growth of Other
        Developing Countries
  22. Estimates of Sources of Growth in the FTZS
  23. Average Productivity in the Economy and the FTZs
  24. Composition of Public Expenditures, 1995–98
  25. The Determinants of Private Investment, 1979–96
  26. Data Sources
  27. Data Used in Estimations and Simulations
  28. Unit Root Tests
  29. Causality Tests
VI.    30. Unit Root Tests at 5 Percent Level
  31. Perron Unit Root Test on the Foreign Interest Rate
        at 5 Percent
  32. The Johansen-Juselius Maximum Likelihood Test for
  33. The Phillips-Loretan Nonlinear Dynamic Least Squares
  34. Exchange Market Pressure and Related Variables
  35. Summary of Estimates, Vector Autoregression
        System Equation
        a. F-Tests for Exclusion  
        b. Impulse Response Functions  
I.      1. Scatter Diagram of Real GDP Growth Rates and
        Inflation Rates
III.      2. Changes in Composition of External Public Sector Debt
IV.      3. The Overall Public Sector, Net Domestic Bank Credit
        to Public Sector, and Inflation
V.      4. Kalman-Filter Estimates of the Share of Capital in
        FTZ Production Function
VI.      5. Residuals from Model 1—M1
    6. Residuals from Model 1—M2
    7. Residuals from Model 2—M1
    8. Residuals from Model 2—M2  
    9. Residuals from Model 3—M1
  10. Residuals from Model 3—M2
  11. A Transitory Monetary Expansion
  12. A Permanent Monetary Expansion
VII.    13. EMP, Credit Growth, and Interest Rate Differential
  14. Response of EMP to Shocks
  15. Response of Interest Rate Differential to Shocks
  16. Response of Credit Growth to Shocks

I.  Overview

Philip Young

This Occasional Paper is a compilation of papers that are linked by a common theme—stabilization, structural reform, and economic growth in the Dominican Republic. The papers summarize the authorities' stabilization efforts, how these efforts were subsequently reinforced by certain key structural reforms, and other related developments that help explain the remarkable performance of the Dominican Republic's economy in the 1990s during which the country achieved one of the highest output growth rates in Latin America, combined with low inflation, and a much improved external debt profile. The performance is all the more striking when contrasted with the severe imbalances of the previous decade—one of widening external current account and public sector deficits, accelerating inflation, and declining growth.

As a result of these imbalances, by the end of the 1980s, pressures on the balance of payments and prices had reached unsustainable levels. The government suspended certain external debt-service payments, giving rise to large external payments arrears. Conditions deteriorated to such an extent that a drastic reorientation of policies was urgently needed. This is the setting for Chapter I, Stabilization and Structural Reforms, which describes the authorities' structural reform efforts in the 1990s. The lesson that emerges is that a great deal was accomplished on the structural front, which contributed fundamentally to the extended period of growth observed in the 1990s. The administration of President Hipólito Mejía has continued, if not accelerated, the reform momentum, with the approval of a new hydrocarbons law (removing administration discretion from the setting of domestic fuels prices), substantially reducing the average external tariff rate, and increasing consumption taxes to encourage saving and provide the needed resources for priority social expenditures. Nonetheless, a comprehensive reform agenda (much of which is currently being considered by congress) lies ahead. It includes modernization of the public administration, improving the transparency of economic policies, and strengthening the supervisory and regulatory framework of the financial system.

During the 1980s, in order to protect domestic industries, the authorities often resorted to trade-
restricting measures. This resulted in a highly protected domestic industry, which was ill-prepared to enter an increasingly competitive world market. Recognizing that domestic firms risked being unable to keep pace with international conglomerates, the authorities have embarked on a trade reform program. Chapter II, Trade Reform Continues, provides a history of these reforms, which form an integral part of the structural reform agenda. The restrictiveness of the trade regime has been diminishing—for example, congress recently approved several regional trade agreements, lowered tariffs further in 2001, and plans additional reductions in coming years—and this is leading to a harmonization of the Dominican Republic's trade policies with those of its neighbors.

The authorities often resorted to external arrears as a means of financing the external current account deficits of the 1980s. Although rescheduling agreements were reached with the international banking community and with the Paris Club of official creditors in the mid-1980s, they met with limited success until the authorities embarked on their stabilization program of the early 1990s. Chapter III, Successful External Debt Restructuring, gives an overview of these developments and highlights the improvement in the external debt profile in recent years.

The deepening fiscal imbalances of the 1980s, largely financed domestically, but also with external arrears, led to rapidly accelerating inflation. The economic system was at risk of collapse and it needed a rapid and substantial fiscal adjustment. In just one year, the consolidated public sector balance turned from a deficit of more than 3 percent of GDP in 1990 to near balance in the following year. The underlying theme of Chapter IV, A Review of Fiscal Policy During the 1990s and Current Policy Considerations, is that the subsequent maintenance of fiscal discipline over a number of years has been a key factor behind the exemplary performance of the Dominican economy. The chapter includes a discussion of the major tax reforms and improvements in administration that were implemented during the 1990s, as well as developments in expenditure policy. It concludes with a look ahead to the recently initiated Integrated Financial Management Program, which is expected to yield substantial benefits in terms of transparency and rationalization of the fiscal accounts.

Chapter V, Capital Accumulation, Total Factor Productivity, and Growth, considers trends in capital accumulation, technological change, and economic growth. The restoration of macroeconomic stability and the initiation of structural reforms coincided with strong economic growth and poverty reduction. The chapter shows that this growth was anchored by a resurgence of capital formation and strong productivity growth. Sustaining high economic growth rates requires continuous efforts in fostering investment and productivity growth. This in turn will necessitate continued structural reforms and investment in health and education, the types of investment that help to "crowd in" rather than "crowd out" private sector investment.

In addition to the chapters described above, this paper also includes two technical papers, Chapters VI and VII. The first provides an empirical estimation of money demand in the Dominican Republic. Real money balances are found to be cointegrated with real GDP and interest rates. In the short run, changes in opportunity cost variables (including either domestic interest rates or the differential between domestic and U.S. interest rates) also help explain changes in real money balances. The strength of this relationship holds up over time when money is defined as M2. It dissipates over time, however, when money is measured as M1 (that is, the long-run coefficient is not statistically significant). In the second paper, monetary and exchange rate policies (including reserve movements) are combined in a model of exchange market pressure defined as the sum of exchange rate depreciation and the outflow of official reserves. Consistent with a stable money demand, a reduction in domestic credit results in a decline in the exchange market pressure index. Thus, contractionary monetary policy can be effective in raising official reserves.