Dominican Republic Growth Diagnostics Report José María Fanelli Rolando Guzman Washington, DC,

1. Dominican Republic Growth Diagnostics Report José María Fanelli Rolando Guzman Washington, DC, September 19, 2007

2. Session I Growth in Dominican Republic: Stylized facts

3. (1) Remarkable long-run performance Growth has accelerated since 1990. Per capita GDP grew 2.2% per year in the 1976-2006 period and 3.5 % in the 1991-2006 period.

4. (1) Remarkable Long-run performance The Dominican Republic’s PPP GDP has grown substantially in the last thirty years, the growth interruption during the “lost decade” was milder than in LA.

5. (1) Remarkable Long-run performance The Dominican Republic’s growth performance since the beginning of the nineties is comparable to Chile and outperforms LA, Central America, and the Caribbean.

6. (2) Deep structural transformations The country changed their comparative advantages and developed new sectors from scratch, like tourism and the Free Trade Zones (FTZ), compensating the fall in traditional exports.Remittances grew steadily and became one important source of revenues

7. (2) Deep structural transformations The economic structure changed substantially with increases in the participation of industry and services and a fall in agriculture

8. (3) Above average degree of policy effectiveness and a democratic polity • The country has shown a remarkable ability to recover quickly after the occurrence of crisis in the eighties, nineties, and the current decade.

9. (3) Above average degree of policy effectiveness and a democratic polity • The state supported the structural transformation; it plays a leading role concerning the development of the free trade zones and to some extent, tourism. Rapid signing of DR-CAFTA • The government is currently introducing significant changes in the fiscal institutions to deal with the costs of the financial crisis and DR-CAFTA. Income tax; ITBIS (from 12% to 16%); other taxes. • The country has managed to maintain the stability of the political institutions since the mid- sixties.

10. (4) The economy is volatile • Consumption is more volatile than income. Volatility fell in the nineties but increased again as a consequence of the financial crisis. • Significant macroeconomic disequilibria in the 1980s, 1990s, and 2003. • Costly financial crisis in 2003

11. (4) The economy is volatile

12. (5) A set of key determinants of growth lags behind There is a certain degree of inconsistency between the country’s per capita GDP and its human development indicators

13. (5) A set of key determinants of growth lags behind

14. (5) A set of key determinants of growth lags behind • The infrastructure exhibits important weaknesses: • The energy system is inefficient; the system of subsidies has established a complex linkage between efficiency and distribution. • Ports and bad logistics impede the exploitation of comparative advantages associated with geography.

15. (5) A set of key determinants of growth lags behind The level of financial deepening is lower than expected, given the country’s per capita GDP.

16. (6) Concerns on trade specialization and the oil bill • A good part of the country’s sources of competitive advantage were associated with some features of the international architecture that have disappeared (the multi-fiber agreement) or are condemned to disappear (the possibility to grant special exceptions to the FTZs). • Increasing competition in apparel industry (notably, China). • Tourism has been much more dynamic than the FTZs, but was affected by the 11-S effect and further development calls for structural changes to face environmental problems and the exhaustion of the all-included strategy.

17. (6) Concerns on trade specialization and the oil bill • The oil bill has increased substantially in the present decade, from US$ 650 • million in 1998, to US$1.5 billion in 2000 to US$ 2.8 billion in 2005. • Increasing portion of total imports.

18. (7) Weak institutions • Despite the continuity of the democratic system, institutions are weak. • Flawed supervision contributed to generating the crisis • Inability to separate growth policies from distributional policies fuels the energy crisis. • Corruption

19. Working Hypotheses • The most important challenge facing the country is the weakening of the sectors that fueled the increase in productivity and competitiveness since the beginning of the nineties (FTZs and tourism). • The most pressing need is to find new sources of increment of productivity and competitiveness (strengthen self-discovery activities) while working on the existing long-run constraints (infrastructure, finance, and human capital). • The country has shown a remarkable flexibility to introducing adaptive reforms when the international and/or the domestic scenarios changed in the past. This is an asset in light of the tasks that the government must perform to strengthen self-discovery. • On the other hand, institutions are weak and this pose a constraint on the type of policies that can be implemented. • Remittances have contributed to reducing external and macro volatility, although at the price of increasing the country’s dependence on them, which could harm the development of the tradable sector and new self-discovery activities. • Remittances create a linkage between the macroeconomic regime and self-discovery policies via the effects of remittances on the real exchange rate. The macro regime matter to growth and competitiveness.

20. Working Hypotheses • FDI has a key role supplying technology and access to new foreign markets. However, FDI can indirectly harm competitiveness because of: • The effects on the real exchange rate in a context of increasing remittances; • Fiscal policies to promote FDI (“race to the bottom”) that absorb resources that can be used to support self-discovery and human capital accumulation. • The fiscal situation raises a number of doubts: it is necessary to raise resources to finance the central bank, social policies, the subsidies to the electricity sector, and self-discovery activities. This implies a level of tax burden that could harm competitiveness. • This means that it is central to: coordinate tightly policies to promote new activities to avoid wasting resources and address policy-induced distortions in governance structures, in particular the electricity sector. • The real exchange rate is likely to play a central role: it must strike the balance between competitiveness and human development. A depreciated exchange rate can be used to fuel the non-FTZ, non-tourism sector and to make the production of human capital cheaper. This raises the issue of the role of the exchange rate regime in the future.

21. Working Hypotheses • The lack of financial deepening may not be a binding constraint on those sectors in which FDI is important. However, it will likely be a serious obstacle concerning duality; it can pose a constraint on the growth of the non-FTZ sectors, and the development of domestic suppliers for the tourism sector and FTZ. • The allocation of remittances is key. They should be increasingly allocated to increasing human capital. In addition, better financial institutions can contribute to improving the allocation of remittances and to increasing savings. • The regional dimension is somewhat absent concerning: • Coordination to avoid race to the bottom policies • Development of regional financial markets (Examples: Bonds in Asia, Flar, and CAF). • Policies should take into account Haiti, which may play a role concerning the development of new activities: • Cheaper labor and opportunities to invest • Market for Dominican industrial exports (it is the third market)

22. Growth Diagnostics: Hypotheses Possible Problems High cost of finance Low returns to economic activity Bad international finance Bad national finance Low social returns Low appropriability Bad infrastructure Poor geography Low domestic saving Poor intermediation Government failures Market failures Low human capital Macro risks: Financial, monetary, fiscal instability Information externalities: self discovery Micro risks: Property rights, corruption, taxes Coordination externalities