Dominican Republic: deterioration of the risk after Bank Baninter's bankruptcy

The bankruptcy of the country's third bank, Baninter, in May 2003, has negatively affected the country not only economically and financially but also politically and socially.
The Dominican Republic has been suffering its first recession in thirteen years. The Baninter rescue cost the government an estimated $2.2 billion, or 15% of GDP, which caused the fiscal deficit to widen and public debt to swell thus exposing the country to external shocks with most of the debt denominated in US dollars. That situation has also caused a sharp rise in external debt whose sustainability will depend on rapid implementation of the IMF reform programme following the stand-by agreement concluded in August this year. The extent of short-term debt, particularly compared to low level of currency reserves, and the crisis of confidence triggered by the Baninter affair has made the country very vulnerable to sudden capital flight. In that context, the decline of the peso exchange rate has intensified, which has notably spurred inflationary pressures. Meanwhile, the entire banking sector has been severely shaken, revealing grave oversight and control deficiencies.
The scandal has underscored the country's structural weakness and the need to implement reforms to permit a return to strong and sustainable growth. In that regard, the urgent need to consolidate a relatively fragmented and poorly controlled banking sector weakened by the extent of dollar-denominated deposits should not be permitted to obscure other major problems. Besides the structural imbalance of public finances and a chronic shortage of foreign exchange, the country is very dependent on foreign investment and its economy needs diversification.
Meanwhile, the Baninter bankruptcy has affected the entire political class that the bank showered with generous gifts, further clouding the atmosphere in the run-up to the May 2004 presidential elections. Finally, the current period is not very conducive to implementing the austerity policy agreed with the IMF, especially with the social climate remaining tense in a context of persistent poverty and inequalities.


Contraction of GDP in 2003

From 1996 to 2000, the Dominican economy enjoyed growth rates exceeding 7% fuelled by major, mainly foreign, investments in the electricity, telecommunications, and tourism sectors and in customs-free areas. Very dependent on the United States, the country suffered greatly from the effects of the American economic slowdown and the 11 September attacks, which hurt tourism and dragged the growth rate down to 2.9%. A recovery developed in 2002 with GDP growth of 4.1%, driven mainly by increased public investment and, to a lesser extent, by household consumption, which thus permitted offsetting the sagging activity in the tourism sector and customs-free areas.
This year had been shaping up relatively well in growth terms with the economy expected to rise at least 4% thanks to upturns in manufacturing (customs-free areas) and tourism. The revelation in May of the fraud-tainted bankruptcy of the country's third bank, Baninter, has completely jeopardised that scenario with the country now expected to experience its first recession in thirteen years in 2003. The financial crisis has affected all domestic demand components. Cutbacks in public spending should cause a sharp decline in public investment. A loss of purchasing power by households, attributable to the sharp rise of prices coupled with a wage freeze, rising unemployment, and a marked increase in interest rates, has affected private consumption. Sagging investor confidence along with restrictions on bank credit and its increasing cost have been affecting private company investment. In this context, firm external demand — with exports increasing, due notably to the peso's continued decline, and tourism improving — will not be enough to stem a contraction of GDP this year of about 3% according to the IMF.
Concerning inflation, prices have been rising sharply due notably to the peso's marked depreciation, which has caused an upward adjustment of energy and imported oil prices. According to the IMF, the inflation rate should thus triple to reach 35 % by year-end.

In 2004, the Dominican economy should return to slightly positive growth, due notably to the stand-by agreement concluded with the IMF in August 2003, provided the authorities implement the fiscal and monetary measures needed to restore confidence and permit interest rates to drop. Meanwhile, the external demand contribution should remain positive in an improved international economic environment buoyed notably by the North American economic upturn. Manufacturing exports and tourism should thus continue trending up. In total, the IMF estimates growth of 0.5% for 2004 whereas the EIU foresees a gain of 1.9% but considers that forecast subject to caution due to possible negative effect of the presidential elections to be held in May next year.
One of the key factors influencing the price index in 2004 will be the foreign exchange market's behaviour. The IMF's intervention should contribute to stabilising the peso exchange rate despite the political uncertainties surrounding the upcoming presidential elections. According to the IMF, the inflation rate could be brought somewhat below 10% by year-end.
Further out, a return to the high growth rates that the country enjoyed in the past will depend on re-establishing a stable microeconomic environment. The authorities believe that the economy's strong growth potential has remained intact despite the financial crisis this year. The Dominican Republic's main asset is its status as the geographically closest country to the United States combining low labour costs and moderate political risk. The necessary transition to a range of higher value-added goods and services will nonetheless have to overcome a few obstacles, including an inadequate level of education and dependence on foreign investment.


Fiscal deficit should widen

The consolidated fiscal deficit widened in 2003 with public finances covering part of the cost of the Baninter bank rescue, that crisis having prompted IMF intervention with implementation of a two-year stand-by agreement. The objective is to bring the consolidated fiscal deficit down to 2.5% of GDP in 2004 with an IMF-instigated fiscal reform programme to be implemented after the May 2004 presidential elections.
In that context, public debt should peak at 48% of GDP in 2003/2004 with debt service representing about 15% of public revenues in 2004. Such a debt burden will expose the country to external shocks since 70% of that debt is denominated in US dollars.


A marked reduction of the country's trade deficit

An import decline in a context of recession and sharp peso depreciation with exports to the United States rising should result in a marked reduction of the country's trade deficit in 2003 and 2004. Coupled with increased tourism revenues, that should permit a slight current account surplus to develop. Financing needs should thus diminish very markedly and be partially covered by international financial institutions amid stagnating foreign direct investment inflows.


A substantial increase in external debt

A substantial increase in external debt in 2003 and again in 2004 coupled with a recession and nominal GDP decline should cause a disquieting rise of the debt to GDP ratio (38.3% end-2003 against 26.3% end-2001). However, the financial crisis triggered in May 2003 and recourse to the IMF have changed the way the debt looks. The bloating of public debt has actually been the main cause of the growing debt problem whereas international financial-institution intervention should now permit managing the debt so as to progressively transform short-term external commitments into longer-term financing. With the increase of its external debt, the Dominican Republic will be vulnerable to external and internal shocks. The situation should nonetheless be sustainable subject to effective rapid implementation of the IMF reform programme. Debt ratios have still remained substantially lower than those of the major South American countries, particularly in comparison to exports (slightly over 50%).

A high vulnerability to sudden capital flight

With substantial short-term debt that is expected to represent nearly three times the low level of currency reserves end-2003 and one-and-a-half times end-2004, the Dominican Republic will be extremely vulnerable to sudden capital flight and the crisis of confidence triggered by the Baninter bankruptcy has not helped matters. Moreover, after having lost one-third of its value against the US dollar in 2002, the Dominican peso depreciated a further 40 % during the first nine months this year and the currency could suffer from political developments in the run-up to the presidential elections in May 2004. Finally, fallout from the banking crisis has prompted a tightening of monetary policy with easing inflation a priority objective of the IMF programme along with institutional reforms intended to increase Central Bank independence.


The Baninter collapse exposed grave deficiencies of the banking sector

The fraud-tainted bankruptcy revealed in May 2003 of Banco Intercontinental (Baninter), the country's third bank with 10% of total deposits, after authorities took control in April, severely weakened the entire Dominican banking sector. The Baninter collapse exposed grave deficiencies in the oversight and control of the banking sector. The Baninter situation deteriorated early this year after failure of a merger and re-capitalisation plan. The accounting audit undertaken by authorities in relation to that plan brought to light instances of embezzlement and fraud perpetrated within the bank during the past fourteen years. The announcement of a Central Bank guarantee covering all Baninter liabilities permitted averting a depositor panic. As a prerequisite to IMF intervention, the Baninter was dissolved in July 2003. The Canadian bank, Scotiabank, already present in the country, purchased some assets with the remainder liquidated.
Concurrently, revelations of problems of poor management and illicit practices affected two other banks, Bancredito and Mercantil, representing 10% of total deposits. The Dominican industrial group Leon Jimenez acquired Bancredito in June (though its bank, Banco Profesional). Mercantil's management has been replaced but restructuring plans remain to be finalized.

Dominican banking sector remained extremely weak. Although the sector is relatively fragmented, comprising about thirty banks, small in size except for the savings banks and specialised lending institutions, it is also cartelised. Increasing competition by setting up foreign financial institutions thus appears desirable. However, despite implementation of a new monetary and financial code intended to attract foreign operators, Scotiabank and Citibank are the only two foreign banks operating directly in the country with the Spanish bank Sabadell holding a 20% interest in Banco Hipotecario Dominicano.
End-2002, finally, foreign currency deposits represented nearly twice the country's foreign exchange reserves. In recent years, foreign exchange operations by banks have in fact increased sharply amid lower borrowing costs abroad and the peso depreciation. Increasing dollarisation of bank liabilities has resulted. As 2003 began, currency deposits represented 35% of total deposits whereas foreign currency loans represented 46% of all loans. In February 2003, the Central Bank thus had to set limits on the granting of currency loans. Concomitantly in the Baninter affair (as mentioned above), the Central Bank had to play a role of lender of last resort, injecting cash drawn from its already very limited reserves into that bank to avert a depositor panic on foreign currency deposits.

The Baninter bank bankruptcy has tainted the entire political class

The Baninter bank bankruptcy in May 2003 has tainted the entire political class with the leaders of the various political formations having received illicit payments from that bank for many years. That scandal has further clouded the political climate in the run-up to the presidential elections in May 2004. Despite his unpopularity, President Mejia, from the social-democratic leaning PRD party, would like to run again. However, opinion polls have been giving a clear advantage to former president Leonel Fernandez, who is the candidate of the main opposition party.
In any case, the government team will have to implement a policy to restore macroeconomic stability and the future government will have to comply with that programme. The current pre-electoral period has nonetheless not been conducive to pursuing austerity policy especially with the social situation remaining tense in a context of poverty and inequalities

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