Report No. 20192 Dominican Republic Social and Structural Policy Review Volume I March 23, 2000 Poverty Reduction and Economic Mtanagement Unit Latin America and the Caribbean Document of the World Bank 1. Currency Equivalents Currency Unit: Dominican Peso (DR$) Exchange Rate US$1.00 = DR$16.35 (as of March 22, 2000) 2. Fiscal Year January 1 - Dec 31 3. Acronyms and Abbreviations CB Central Bank CEA State Sugar Council CDE National Electricity Corporation FEyD Fundacion Economia y Desarollo FTZ Free Trade Zones GDP Gross Domestic Product INESPRE Price Stabilization Institute LAC Latin America and the Caribbean ONAPLAN National Planning Office ONAPRE National Budget Office SPI Banking Sector Superintendency WTO World Trade Organization Vice President David de Ferranti Country Director Orsalia Kalantzopoulos Sector Director Guillermo Perry Task Manager John Panzer PREFACE The Dominican Republic Social and Structural Policy Review was prepared by John Panzer based on the background work prepared over a ten month period by a team comprising Mr. Ayal Kimhi (Poverty), Mr. Raimundo Soto (Growth), Mr. Leonardo Auernheimer (Macroeconomic Assessment), Mr. Alberto Herrou (Trade Policy Reform), Mr. Claudio Sapelli (Education and Labor Markets), Mr. Antonio Corbi and Ms. Yira Mascaro (Banking), Mr. Damian Santos (Financial Management), and Fundacion Economia y Desarrollo (Public Expenditure Review). The SSPR contains a significant amount of original research for which we are indebted to the Fundacion Economia y Desarrollo (FEyD) and the Central Bank of the Dominican Republic. FEyD kindly made available to us its 1992 Household Income and Expenditure Survey which at the time of the preparation of this report was the only available survey of this type. The Central Bank provided the Bank with the 1991 and 1996 Labor Force Surveys on which much of the work on education and labor markets is based. Ms. Michelle Riboud and Mr. Maurice Shiff were peer reviewers and the report also benefited from thoughtful comments from Mr. Philip Young (IMF) and PREM colleagues in LAC, who are too many to mention. Mr. Edgardo Favaro, Lead Economist during the preparation of this report, and Ms. Orsalia Kalantzopoulos, Country Director, provided much support and guidance throughout the process. Ms. Andrea Kucey worked in several capacities in the preparation of the report, including the preparation of Volume II. The report was discussed with Government in August of 1999 and then in October 1999, when the data from the 1998 Central Bank Household Survey first became available. Through this process, parts of the report were used in discussions with President Fernandez in September of 1999, and later as input for the Comprehensive Development Framework initiative that culminated in December 1999 with a subscription to a common policy reform agenda by the three main political parties. The Central Bank of the Dominican Republic acted as our main counterpart for the preparation of this report. Our intense and frank discussions contributed significantly to this final product. ii TABLE OF CONTENTS Preface i Table of Contents iii Executive Summary vi 1 Economic and Social Reforms for Growth with Equity 1 A. Poverty and Economic Performance 1 B. Growth and Economic Structure 4 C. Government Policies for Growth with Equity 7 D. The Social and Structural Policy Review 10 2 Consolidating Macroeconomic Stability 11 A. Macroeconomic Assessment 11 B. Fiscal Vulnerabilities 12 C. Addressing Fiscal Vulnerabilities 15 D. Vulnerability from External Shocks 18 E. The Conduct of Monetary Policy 19 F. Conclusions 20 3 Trade Policy Reform 21 A. Trade Policy in the Dominican Republic 21 B. The Proposed Trade Reform 22 C. The Impact of Trade Liberalization 23 D. Considerations for Agriculture Sector Liberalization 24 E. Conclusions 27 4 Growth, Education, and the Labor Market 29 A. Economic Growth, Labor Force Composition, and Employment 29 B. Labor Market Response to a Changing Environment 31 C. Education Policies for a Changing Environment 32 D. Labor Market Policies for a Changing Environment 33 E. Conclusions 35 Annex 36 5 Financial Sector Deepening and the Banking Sector 38 A. Financial Sector Overview 38 B. Banking Sector Structure and Performance 39 C. Addressing Sector Risks through Regulation and Supervision 41 iii D. Addressing Sector Risks through Disclosure and Competition 43 E. Remedying Bank Problems and Exit Strategy 44 F. Corporate Governance, The Legal Framework, and Financial Deepening 45 G. Conclusions 45 6 Public Expenditure Policies for Poverty Reduction 47 A. Poverty Reduction and the Role of the State 47 B. Public Expenditures for Education 51 C. Public Expenditures for Agriculture and Rural Development 52 D. Safety Nets and Access to Basic Services 54 E. Conclusions 57 Annex A: Dominican Republic at a Glance 58 Annex B: Selected Economic Indicators 60 List of Tables 2 Table 1.1 Incidence of poverty by household head (%), 1998 3 Table 1.2 Distribution of household characteristics across income quintiles (%), 1998 4 Table 1.3 The determinants of per-capita income, 1992 4 Table 1.4 Economic structure and growth, 1991-1998 6 Table 1.5 Sources of growth estimates (%) 6 Table 1.6 Average productivity in the economy and the FTZs 7 Table 1.7 Total factor productivity growth of other developing countries 7 Table 1.8 The role of the State: The DR and other Latin American countries 8 Table 1.9 Policies and institutions in the DR and LAC 12 Table 2.1 Selected economic indicators 13 Table 2.2 Composition of public expenditures (% of GDP, 1995-1998) 17 Table 2.3 Expenditures by institution (as a % of total expenditures), 1980-1998 17 Table 2.4 Ratio of executed to approved budget by institutions and programs, 1994-1998 18 Table 2.5 DR: Determinants of private investment, 1979-1996 21 Table 3.1 Nominal Protection Rates (%) 22 Table 3.2 Tariff equivalents of non-tariff barriers (%) 22 Table 3.3 Scheduled tariff rates for agricultural products (%) 23 Table 3.4 Effective protection rates 24 Table 3.5 Impact of trade reforms 25 Table 3.6 Distribution of rural household characteristics across income quintiles 26 Table 3.7 Farmer characteristics by type of production and income 29 Table 4.1 Employment structure and growth (%), 1991-1996 31 Table 4.2 Labor force education distribution (%), 1991 and 1996 31 Table 4.3 Rates of return to education and experience (%), 1991-1997 33 Table 4.4 Ordered probit results of educational attainment 36 Table 4A. I Regression analysis of market segmentation: Dependent variable salary per hour 39 Table 5.1 Financial sector structure, 1998 40 Table 5.2 Banking system assets and liabilities (million RD$ Pesos) 1994-1999 42 Table 5.3 Days with overdue payment to classify as non-performing loans 42 Table 5.4 Minimum provision when marked as non-performing loans (%) iv Table 6.1 DR and Latin America: Size of the state and provision of basic public goods 47 Table 6.2 Social sector expenditures and the size of the state (%), 1980-1998 49 Table 6.3 Distribution of Ministry of Education budget (%), 1990-1997 51 Table 6.4 DR Access to public services (%), 1996 & 1998 56 List of Figures Figure 1.1 DR Inflation and GDP Growth, 1966-1998 1 Figure 2.1 Macroeconomic indicators 11 Figure 4.1 Labor participation rate by age (%), 1991-1997 29 Figure 5.1 Financial deepening climate Dr and LAC, 1990-1998 38 Figure 5.2 Financial deepening DR, 1970-98 38 Figure 5.3 Quarterly real interest rates and spread 41 Figure 6.1 DR and LAC: Public Expenditures by Sectors (as % of GDP) 48 List of Boxes Box 1.1 Contrasting Policy framework and The Dual Economy 5 Box 1.2 Status of Main Structural Reforms 9 Box 2.1 The Demand for Money, Growth, and Revenues from Money Creation 14 Box 2.2 The Political Cycle, Macroeconomic Management, and Interest Rates 15 Box 3.1 Income Transfer Programs to Farmers: The Case of Mexico's PROCAMPO 27 Box 4.1 The determinants of school attendance 30 Box 4.2 Labor Market Legislation in the DR: Policies vs. Outcomes 34 Box 5.1 Banking Sector Performnance Indicators 43 Box 5.2 Foreign Banks and the Evolution of the Banking System 44 Box 6.1 Public Expenditures, Input vs. Output Indicators, and the Modernization of the State 50 Box 6.2 The Efficiency of Private vs. Public Secondary Schools in the DR 52 Box 6.3 State Institutions and Agricultural Policy in the DR 53 Box 6.4 Main Safety Net Programs in the Dominican Republic, 1998 55 Volume II. Technical Papers 1. Capital Accumulation, Technological Changes and Growth. 1 2. Determinants of Poverty 16 3. Macroeconomic Policy 38 4. Commercial Policy 62 5. Regulatory Framework and Banking Sector Performance 83 6. Budget Law and Public Sector Management 97 v EXECUTIVE SUMMARY Where does the Dominican Republic government programs for human capital stand? formation and poverty alleviation. 1. Since the restoration of macroeconomic 4. While there is broad agreement on the stability in the early 1990s, the Dominican need and the direction of reforms, their Republic (DR) has been the fastest growing implementation is proving difficult. Interest economy in Latin America. By several groups have succeeded in delaying the accounts, growth, which has averaged eight implementation of economic reforms, percent per year from 1996 to 1999, is having a particularly trade liberalization. At the same positive impact in the quality of life of the time, the political establishment, including the average Dominican. Recent government government, has been delaying the agenda for estimates indicate that between 1992 and 1998 reform of the state, especially in the area of more than fifteen percent of the country's poor public financial management. emerged out of poverty. This finding is consistent with improvements in other indicators The face of poverty in the Dominican of welfare such as life expectancy, access to Republic water and sanitation, and average educational attainment of the labor force. 5. With a 1998 income per capita of US$1,770 but a highly skewed distribution of 2. Strong economic growth and poverty income, two million Dominicans still live in reduction has taken place in the midst of positive poverty. The Dominican poor share most of the changes in governance. After a deep political characteristics of the poor across the world: crisis in 1994, democratic institutions have large families, little or no education, and limited emerged strengthened, and both the legislative access to water and sanitation services. and judicial systems now enjoy unprecedented levels of independence. Civil society and the 6. Poverty tends to be especially severe in organized business community are also playing rural areas, where misdirected agriculture an increasing role in influencing policy making policies and insufficient public investments, through their growing demands for particularly in education, limit opportunities. accountability of state actions. Those able to achieve higher levels of education tend to migrate out of the rural areas leaving 3. In this fluid environment, the country is behind the most disadvantaged, creating in the undergoing a gradual but steady transformation process entrenched pockets of poverty. through the implementation of reforms, leaving Nowhere is that more true than in the areas behind the legacy of the Trujillo dictatorship bordering Haiti, where extreme poverty is (1930-61) that so strongly shaped the Dominican prevalent. society. This legacy includes an enormous centralization of powers in the Office of the 7. The poor are also vulnerable to President, weak systems for the accountability of catastrophic losses as this Caribbean country is government actions, inefficient state-owned routinely subjected to hurricanes. Publicly companies, high protection for industry and provided safety nets are practically non-existent, agriculture, and inordinately weak while the private safety nets, mainly in the form of remittances from the very large number of vi Dominicans living in the United States, benefit construction, and more recently, primarily the middle and higher income groups. telecommunications) that have been operating in an environment of competition with close links The ways out of poverty to the world economy. By contrast, other sectors such as agriculture, industry, energy, and 8. As long as strong growth is maintained financial services, have been beset by an and labor markets remain flexible enough to inadequate policy environment often permit wages to adjust to the changing structure characterized by high protectionism, insecure of the economy, many Dominicans will be able property rights, and misguided government to abandon poverty. Nevertheless, barring interventions. While the sectors operating in a significant efforts, many others will likely more liberal and distortion-free environment remain trapped in an inter-generational poverty have thrived, the others have performed poorly. cycle. 13. The SSPR's analysis of the sources of 9. Today, almost eighty five percent of poor growth indicates that the major difference household heads have not completed primary between current and past rates of economic education, and almost thirty percent have no growth has been the strong increase in total education whatsoever, facing enormous factor productivity, spurred in part by the opportunity constraints even within a growing economic stabilization and structural reform economy. While the educational attainment of programs of the early 1990s. Between 1992 and the younger generation is higher than that, of 1998 the average annual total factor productivity their parents, enrollment in secondary education growth was a high 2.3 percent, led by the remains low, when compared to other middle industrial free trade zones which have continued income countries. This poses a threat to the to thrive with a rate of annual productivity ability of the young to function effectively in growth in excess of ten percent. However, today's labor markets. international experience indicates that such high rates are exceedingly hard to maintain for 10. The SSPR estimates indicate that prolonged periods of time. throughout the 1990s the returns on education for workers who have only attained primary 14. For the DR to continue enjoying strong education remain low. This trend is most likely growth, moving ahead in the following two to continue given the strong influx of Haitian areas is essential. First, reduce macroeconomic immigrants, which results in ample supply of vulnerabilities through further tightening of low-skilled labor with low reservation wages. fiscal and monetary policies -- key determinants for the turnaround in economic performance 11. Significant poverty reduction will during the 1990s. Second, implement reforms therefore require the implementation of a that will provide a sound business environment. comprehensive poverty reduction strategy. This The privatization of the electricity sector, which strategy will be well advised to focus on the has recently been completed, and trade traditional areas of public policy such as liberalization which is still pending, stand out as education, adequate provision of property rights, important policy initiatives in this area. and family planning, for which the analytical work conducted for this SSPR confirms a strong Reducing macroeconomic bearing on per capita income. vulnerabilities Sustaining high economic growth 15. During the last eight years macroeconomic performance has been good. 12. For more than two decades the dynamism Fiscal policy has been tight, leading to low of the economy has relied on the few sectors inflation, overall public debt has been reduced, (industrial free trade zones, tourism, and the current level of government net assets is vii consistent with the maintenance of important effort to establish prudential macroeconomic stability at annual inflation regulations, but these are still short of best levels of about seven percent. Yet, behind these practice. Concurrently, the rapid expansion of positive aggregate indicators, there are important credit has brought new risks, now enhanced by a issues that still need to be addressed. macroeconomic management that leads to high interest rates, and provides incentives to move 16. There has been a significant shift in the financial intermediation outside of the banking composition of public expenditures, away from system to avoid Central Bank controls. investment and towards current consumption which, unless reversed, will threaten growth 21. Overall, to reduce macroeconomic prospects. While part of this shift has been the vulnerabilities and country risk the following result of increased attention to human measures will be essential. First, improvements development, it also reflects a significant growth in fiscal management. Budget reform is needed in public employment outside the education and to consolidate the overall public sector budget, health sectors. eliminate the extraordinary discretion in expenditures exercised from the Office of the 17. Moreover, the ensuing scarcity of Presidency, which in the recent past often resources to finance public investments coupled executed more than fifty percent of the total with inadequate budget control systems are budget, and eliminate arrears and unrecorded straining macroeconomic management. With debts. Public procurement reform is also needed national elections (Presidential and to increase transparency and control Congressional) now taking place every two expenditures. Eventually, the public sector years, the pressure to finance popular wage bill outside of the education and health infrastructure activities is mounting and the sectors will need to be addressed to restore a mechanisms for their financing becoming less better balance between current expenditures and transparent. public investments. Second, strengthening the banking sector through a combination of market 18. To accommodate a volatile fiscal policy, and regulatory mechanisms. Substantial monetary policy is carried out with an increasing improvements in the disclosure of information prevalence of discretion over rules. Credit to the and the implementation of more stringent private sector has been crowded-out by a regulations and supervision are still needed. As combination of high interest rates and other less long as fiscal policy allows it, monetary policy desirable instruments, such as the freezing of the should return to a pattern of increased banks' excess reserves or outright quantitative predictability that will lower the implicit tax on limits on private banks' commercial credit. the banking sector. 19. If persistent, this type of macroeconomic Advancing trade liberalization management could have a negative impact by weakening the banking sector. As it has been 22. Left behind by the wave of trade common in Latin America, the DR has had a liberalization that swept Latin America during weak banking sector, a legacy of the the 1980s, the DR now maintains the most macroeconomic crisis of the 1 980s and protectionist trade regime in the region. The inadequate regulations and controls. analysis of the SSPR indicates that the effective 20. The banks in the DR have regained protection rates for agriculture and the import strength in the 1 990s, helped by economic substitution industrial sector are in the sixty to strength a the 1990s,o helpetizan o economy one hundred percent range. Moreover, the anti- growth and the monetization of the economy exotba of curntraeplcsisquven which led to significant net transfers from to depositors. However, the strengthening of the to a twenty seven percent tax on all exports. banking system is a long-term process and Among exportables, tourism and agriculture bueanin sysemain. a Term p ess and bear the majority of the cost of this implicit tax vulnerabilities remina. There has been an viii since these are the sectors where non-traded and utilities. Most of these actions took place inputs are used most heavily. against a backdrop of fiscal austerity, low taxation, low recurrent expenditures, and low 23. Government has been unsuccessful in debt. implementing the needed trade reforms. In 1996, a Presidential Bill that called for 28. Elements of this strategy allowed the DR widespread reduction to a uniform 10 percent to avoid some of the worst instances of tariff was defeated by Congress. Today, a Free macroeconomic instability that were common in Trade Agreement signed with Central America Latin America during the 1970s and 1980s, and in 1998, which also calls for a significant as such had a beneficial effect on the poor. reduction in tariffs, has yet to be approved by However, the focus on infrastructure and Congress. productive activities came at the expense of supporting human development, particularly 24. The analysis of the SSPR indicates that education. the ratification of the Free Trade Agreement would reduce by half the current tax on exports. 29. The DR stands out in Latin America as Although there would be adjustment costs for the country that devotes the lowest share of its displaced industrial and agriculture activities, public resources to health, education, and public this would lead to improvements in consumers' security. Important challenges lie ahead as the welfare and real wages. country is making an effort to reallocate public resources by enhancing the role of the private 25. With agriculture still playing an important sector in the provision of infrastructure through role in the economic lives of the rural poor, and concessions and privatization, and to continue with large successful farmers exerting strong the recent increases in public expenditures. for political influence, there exists much opposition education and other social services. First, to advance trade liberalization in this sector. It resource reallocations of the magnitude that are must be recognized, however, that agricultural required in the DR take time to achieve. protection has failed to help the rural poor and Second, the implementation capacity of the imposes a heavy tax on poor urban consumers. public sector to engage in a comprehensive High protection taxes farmers who produce poverty reduction strategy remains very weak. export oriented crops such as coffee, cocoa, and Third, the current public resource envelope of tobacco. Moreover, state interventions through about 17 percent of GDP may prove to be import controls and direct marketing schemes insufficient to finance a strong poverty reduction have promoted rent-seeking and lack of strategy, even if resource reallocation takes transparency. place and efficiency is enhanced. 26. For agriculture, a gradual approach to The challenge of education liberalization could be envisaged in conjunction with a cash transfer program to protect the poor 30. Progress and new opportunities have during the transition. In sum, there is no produced a growing demand for education, justification to retain the government's role in which the labor market is rewarding with high administering import quotas and price support returns for those that can complete secondary schemes on a highly discretionary basis. and/or higher education. Net enrollment rates at the secondary level increased from 22 percent in Making government policies work for 1991 to 29 percent in 1996, a process that is the poor undoubtedly continuing. However, the public resources destined to education in the DR 27. For much of the last forty years, public remain very low, especially for secondary policies focused on the provision of education. infrastructure and gave considerable attention to the state's productive activities in agriculture ix 31. In 1997 and 1998 the ratio of public What could lie ahead? expenditures for education to GDP in the DR was 2.3 percent, substantially below the 3.8 35. To a large extent the DR is in an enviable percent average for Latin America. Secondary position among countries in the developing education accounted for only twelve percent of world. Strong growth is taking place albeit in an those expenditures, of which seventy five environment of limited policy reform. A percent was directed to urban areas. The dynamic private sector has demonstrated its analysis conducted for the SSPR indicates that capacity to thrive when provided with the right after controlling for variables such as family policy environment. The labor market is income and education of parents, the likelihood flexible enough and unemployment rates remain of attaining higher educational levels is low. The country has a privileged geographical significantly lower for those living in rural areas, location which is enhanced by the role of almost than for those living in Santo Domingo. The two million Dominicans who live in the United regional distribution of public expenditures does States and maintain close economic ties with therefore seem to have an impact on educational their home country. Democracy is continuously attainment, and education in rural areas would being strengthened and social peace prevails. increase if the resources were made available. 36. In this context, the implementation of 32. Providing the rural and urban poor with institutional and policy reforms could have a the opportunity to attain secondary education considerable payoff for poverty reduction. In could be a key element of the govemment's many areas, the momentum for economic poverty reduction strategy. Yet, it is also highly reform, including trade liberalization, is too unlikely that the Dominican state will have the strong to be detained, and implementation seems institutional capacity to do achieve these reforrns to be a matter of time. Yet, economic reforms on its own. It is therefore important to start by themselves will be insufficient to achieve developing a partnership strategy with the broad poverty reduction. private sector for the needed expansion of the secondary education school network. 37. Ultimately, the implementation of a comprehensive poverty reduction strategy will Tackling extreme poverty require a stronger role of the state in the direct provision or the financing of key public or semi- 33. Public policy in this case could focus on public goods. This will demand more resources protecting children through the establishment of and increased taxation. However, unless there is safety nets that will curtail malnutrition, expand a genuine desire to make the state more efficient vaccination programs to at least ninety percent and accountable for the resources it utilizes it is of the population, and provide safe water. On not clear that such avenue would or should be the productive side, agriculture remains very pursued. The political establishment has yet to important for the rural poor and programs come to terms with this trade-off. Until then ranging from redistribution of state land to poverty reduction will fall short of this country's targeted extension plans could have an important considerable potential. positive impact. 34. Unfortunately, a comprehensive public policy strategy to address these issues is still lacking. Safety net type programs are small in size, tend to be poorly targeted, and their implementation is often tied to political objectives. There is also a total absence of evaluation and tracking mechanisms to monitor performance and impact. x 1. ECONOMIC AND SOCIAL REFORMS FOR GROWTH WITH EQUITY A. Poverty and Economic Performance 1. Since the restoration of macroeconomic stability in 1991, the Dominican Republic is in the midst of a remarkable period of economic growth. Since 1992, the Dominican Republic has been one of the fastest growing economies in Latin America. Average annual economic growth since 1992 has exceeded 6 percent, and during the last three years the average annual growth rate has been a very high 8 percent. This very positive economic performance followed many years of poor performance. The 1980s, were characterized by slow and fluctuating growth, rising inflation, and a deterioration in social conditions. A mild recovery in 1986-87, achieved through expansionary fiscal and monetary policies, culminated with historically high levels of inflation and negative growth in 1990. In response to this crisis, the government undertook a very successful stabilization program based on eliminating the fiscal deficit through tax reforms and implementing a mild trade reform and financial sector liberalization. Stability and restored confidence in the economy led to a growth in savings, investment, increased productivity, and ultimately growth. Income per capita (GNP), which had decreased from US$1,170 in 1980 to US$860 in 1991, has been rising steadily to US$1,770 in 1998. Figure 1.1 DR Inflation and GDP Growth, 1966 - 1999 50%- 45%. 40%/ 35% -Inflation 300% 25%. 20%. 15% 10% -5% YGDP Growth -10% 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2. Strong growth has been accompanied by poverty reduction, but in 1998 more than 2 million Dominicans, or almost 26 percent of the population, still lived in poverty. While assessing the evolution of poverty across time can prove difficult due to lack of consistent data, recent analysis conducted by the Central Bank indicates there has been a marked reduction in poverty from 31.2 percent in 1992 to 25.8 percent in 1998. Moreover, this analysis also indicates that more than 90 percent of the reduction in poverty can be explained by economic growth and only about 10 percent by improvements in the distribution of income. Although this very recent analysis will likely be the subject of some debate, there can be little question that the quality of life of the average Dominican has been improving as measured by other indicators such as declining unemployment, improvements in educational attainment and access to services, and lower participation of children in the labor force. 1 Chapter 1 3. Poverty in the DR shares most of the characteristics of poverty across the world and in Latin America. The poor have larger families, less education, and less access to water and sanitation services. In the DR, a high proportion of the poor derives their income from agriculture and poverty is particularly severe in rural areas along the border with Haiti. To a large extent poverty tends to be especially severe in rural areas where misdirected agriculture policies and insufficient public investments, especially in education, limit the opportunities of the population. For lack of opportunities those able to achieve higher levels of education tend to migrate leaving behind the most disadvantaged and helping create entrenched pockets of poverty. In 1998, one third of rural households (32.2 percent) lived in poverty, more than double the proportion of urban households in poverty (15.1 percent). By the same token, both the poverty gap and the severity of poverty were significantly higher in rural areas. Table 1.1 Incidence of poverty by household head (%), 1998 Poverty Contribution to Extreme Poverty Contribution to (7 37.8 23.4 11.1 23.2 ECONOMIC ACTIVITY Agriculture 33.7 25.5 10.3 26.2 Industry 16.8 10.6 3.9 8.4 Construction 15.3 3.6 3.7 3.0 Commerce 13.8 10.9 3.4 8.9 Hotel & Restaurant 6.0 0.9 1.6 0.8 Transport & Communication 14.9 4.3 3.7 3.6 Source: Central Bank of the Dominican Republic. 4. Remittances from abroad reach a large number of households, however they do not significantly impact the poor. This implies the establishment of targeted safety nets could be a priority. With a significant number of Dominicans living in the United States, remittances from abroad play a very important role in the economy accounting for roughly 10 percent of GDP. For the poor, however, remittances from within the country, which are part of domestic transfers, tend to be much more important. This would indicate that international migration in the DR, as it has been found in other countries, is mostly a middle class phenomenon and does not play an important role in providing a safety net for the poor or contribute to improvements in equity. This has strong implications on public policies to address the vulnerability of the poor, who unlike the middle and upper income population cannot rely on remittances at times of distress, thus reinforcing the need for a much stronger role of the State on social protection issues. 2 Economic and Social Reforms for Growth with Equity Table 1.2 Distribution of household characteristics across income quintiles (%), 1998 1st 2nd 3rd 4th 5th quintile quintile quintile quintile quintile Number of household members 5.1 4.7 4.3 3.8 3.3 Rural resident 51.4 39.4 30.8 26.1 14.3 Female head of household 32.9 29.2 28.7 27.6 24.8 Infrastructure Rent or free use of home 28.8 33.8 36.9 40.9 45.1 Owns home 71.2 66.2 63.1 59.1 54.9 Indoor sanitation 18.7 32.1 39.9 55.9 76.2 Indoor running water 25.6 41.6 44.2 57.9 75.6 Outdoor running water 50.7 38.7 39.7 32.3 17.9 Electricity 78.8 82.9 89.5 91.4 95.7 Education No schooling 28.8 18.8 14.6 10.8 6.0 Primary Incomplete 54.7 56.8 55.1 46.4 29.5 Primary Completed 4.5 6.4 8.0 8.3 6.3 Secondary Incomplete 7.4 12.5 10.3 13.2 11.5 Secondary Completed 3.2 3.6 6.5 10.4 12.5 University 1.5 1.9 5.6 10.9 34.3 Share of source of household monetary income Income from employment 35.5 38.7 42.0 42.8 42.2 Income from self employment 45.9 46.1 42.5 41.1 37.2 Income from pensions, insurance, interest 0.3 0.3 0.8 0.7 5.0 Income from domestic transfers 14.8 8.3 7.6 7.0 6.4 Income from remittances outside DR 3.6 6.6 7.6 8.6 9.3 Source: Central Bank Dominican Republic. 5. The traditional areas of public policy such as education, provision of property rights, and family planning are key determinants of per-capita income and can be very important for poverty reduction. The analysis of the determinants of per capita income based on the 1992 household survey show that very policy sensitive issues such as family size and the distribution of assets are key determinants of poverty (Table 1.3). Education and family planning/public health programs for those that demand it can contribute significantly to a reduction in poverty as each additional household member is associated with a decline in income per capita of nine percent. Also, confirming results found in many other countries, access to land and land titling can help reduce poverty. Land titling both in urban and rural areas is a very good investment. With respect to education, the impact of schooling on per capita income is positive and significant at all levels, but increases with the level of education. This result indicates that significant efforts are needed in order to raise the level of schooling of poor Dominicans and avoid a further deterioration in income distribution. 3 Chapter I Table 1.3 The determinants of per-capita income, 1992 All sample households Rural households only Explanatory variable Coeff. t-ratio Signif. Coeff. t-ratio Signif. Constant 6.69 55.40 0.00 6.70 41.15 0.00 Rural resident -0.19 -3.47 0.00 Santo Domingo area 0.30 5.09 0.00 0.13 1.22 0.22 Ln(landholdings per capita) 0.11 4.08 0.00 0.15 4.89 0.00 Has title to some land 0.21 2.63 0.01 0.18 2.04 0.04 Number of household members -0.09 -9.60 0.00 -0.09 -7.14 0.00 Female head of household -0.13 -2.17 0.03 -0.01 -0.06 0.96 1-6 years of schooling 0.17 2.87 0.00 0.18 2.48 0.01 7-8 years of schooling 0.40 4.69 0.00 0.32 2.50 0.01 9-12 years of schooling 0.40 4.75 0.00 0.18 1.37 0.17 More than 12 years of schooling 0.90 9.35 0.00 0.31 1.50 0.13 R-squared 0.34 0.25 F-statistic 20.96 6.60 Source: Bank estimates based on FEyD. The dependent variable is the natural logarithm of monthly per-capita income. Number of observations 1182. B. Growth and Economic Structure 6. With more than 2 million people living in poverty, sustaining the current high growth rates remains a critical objective. There are questions, however, whether the current structure of the economy can continue to sustain high growth in the long run. For the last thirty years much of the dynamism in the DR's economy has come from the development of the industrial free trade zones (1970s and 1980s), tourism (1980s and 1990s), and telecommunications (1990s). Common to all these sectors has been the ability to operate in an environment characterized by strong links to the world economy and a strong competition. By contrast, the more traditional sectors such as agriculture and industry have been beset by a policy environment that often includes high protectionism, insecure property rights, and undue government interventions (See Box 1.1). The two distinct policy environments have led to what in fact is a dual economy, raising questions on whether current strong growth can be sustained in the long run resting on the strengths of just a few sectors. Table 1.4 Economic structure and growth, 1991-1998 1991 1998 1991-98 1991-98 (In perent (Inpercent Average Annual Contribution to (In percent (In percent Growth Growth (In percent) (In percent) Construction 7.5 12.1 13.8 20.7 Commerce 12.4 12.9 6.8 12.5 Hotel, Bar, & Rest. 4.2 7.0 14.0 14.3 Industry 14.9 13.1 4.3 7.5 Telecommunications 2.4 4.7 16.5 9.0 Agriculture 13.9 11.7 3.5 6.8 FTZ" 3.3 3.4 7.2 5.3 Total Economy 100.0 100.0 6.1 100.0 Source: Central Bank of the Dominican Republic. ' The national accounts methodology does not fully capture the contribution to growth of the FTZs, since it is based only on the wage bill and not on value added. 4 Economic and Social Reforms for Growth with Equity a" 1.1 Contast Polkcy Framw, rk awd Th Dual Economy _ _ du*strW- T5r1ltur. ourin : Telecom-. FTZ Tax Sytem 8 AT - om6 % VAT - --ny VAT - %i. VAT Tax fre sWus : ~~~~exemtons-... .0% .. cise tax - . 1o% sewlce tax -10% t on revenues seleCve prodicts earmred for Wabor 2 s5% mrn OXPOsee 25% marial 25% margn inom etx E .o t W : . ., ...... - - .. . : : ; Som;e ta b - - : ys Labi ml MnAn w iwninu waeium WaSe Mimum_age g... E lon IJSS1, . ................. US$ļOAn U$SSn US$i-; .m- : $14Oo terl"m US 1.i-o, . . . pubc*ctor U $.4.:M. Paflt shaflg1P2 fiOtashhIng 10% Pi sha 10% ProlNt sharin 10% NOprottsring Noproftsmlwt So-al se-rt 12S% secursty 12.5% $ocia secty 12.54 Social secrt 12,5% Soca secur* 12.5% StandardtTninato Standard terination Stanrd temna Stdardterminatio Standard terminatn clausescasscaue lue , , - - - -tX,,, s,,,, ,es-w,,,,S. Property robli5 wih tanten- State Owmnerp of Vey mited prolms- ar Propey Rig lear Propety Fghts . ... 4f;0% of 10t81 fam land t.-ough leased space on . .ust*l parks Ontly 40% of a l:s land-s rowned competton flip larlts Whg arafs 4191*% orrptiv ftt Wot Highly competitve . &Proet.o. : . . . import quotas Iot qudtas State entrpises rG we por. . . . ~~~~~~~~monpotyofe .m: .i:nt.GemrveninI _ _ _ _ _ c h a n n else _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7. Analysis of the sources of growth indicates that a major force behind current high-sustained growth has been an unprecedented high growth in total factor productivity. The estimates of sources of growth indicate that the strong growth taking place since 1992 is largely the result of both significant capital accumulation and important total factor productivity growth. The ratio of investment to GDP, which had declined from about 23 percent in the 1970s to 20 percent during the 1982-91 period, has been consistently increasing since 1992 averaging more than 24 percent for the 1992-98 period. By the same token, total factor productivity growth since 1992 has averaged a historically high 2.3 percent per year. Such high productivity growth is unprecedented for the DR. While some of the high productivity growth in the early 1990s may be attributable to the rebound from the poor performance in the 1980s, improvements in productivity are also likely the result of enhanced macroeconomic stability 5 Chapter I and improvements in the policy environment mainly through the mild trade liberalization initiated in 1992 and financial sector reforms. Table 1.5 Sources of growth estimates (%) GDP Capital Labor P dTotal Factor GDP CptlLbrProductivity Growth Pro GrwhGrowth Contri- SaeiGrwhContri- Shr m Contri- Share in Period a )(Per (Per bution to GDP (Per bution to GDP bution to GDP annum) Growth Growth annum) Growth Growth Growth Growth 1973-98 4.6 4.5 2.8 62.3 3.6 1.3 29.2 0.4 8.5 1973-82 5.6 5.3 3.4 59.6 4.1 1.5 26.7 0.8 13.7 1983-91 2.2 3.6 2.3 106.1 3.9 1.4 65.8 -1.6 -71.9 1992-98 6.1 4.4 2.8 45.8 2.6 1.0 15.8 2.3 38.3 Source: World Bank. 8. Another impressive feature in the DR, has been the consistently high total factor productivity growth of the FTZs, which could serve as an indicator of the country's significant long term potential. The analysis of the sources of growth for the FTZs shows remarkable productivity growth. From 1973 to 1998, the annual average productivity growth of the FTZs has consistently been about ten times higher than that of the economy at large and the growth in average productivity per worker has been equally significant (Table 1.6). This difference is somewhat of an indication of the output gains that could be derived if the type of liberal regulatory environment that applies to the FTZs were to be extended to the economy at large. Table 1.6 Average productivity in the economy and the FTZs (%) Free-Trade Zones Economy Period VA Growthi Growth in Average VA GDP Growth Growth in Average per Worker GDP per Worker 1973-98 21.3 3.28 4.6 1.12 1973-82 18.9 -2.23 5.6 2.10 1983-91 29.1 3.96 2.2 -1.56 1992-98 14.7 8.70 6.1 3.44 Source: World Bank. 9. Continued macroeconomic stability and steady progress in the implementation of structural reforms will be key to sustaining high growth. Maintaining GDP growth rates between 7 and 8 percent per year will require maintaining high productivity growth. The experience of the 1980s where macroeconomic instability was strongly associated with declining capital accumulation and productivity would indicate that the continuation of macroeconomic stability is very important for growth. However, past performance of the Dominican Republic, and the international experience (Table 1.7), indicate that the current productivity growth of the DR of about 2.3 percent can be exceedingly hard to maintain. Continued improvements in the policy environment in areas such as expanded competition and linkages to the world economy, secure property rights, improvements in the quality of govermment expenditures, and higher educational attainment will be the key to sustaining high economic growth. As evidenced by the policy and institutional assessment of Table 1.9, the DR still has ample space for improvement in these areas. 6 Economic and Social Reforms for Growth with Equity Table 1.7 Total factor productivity growth of other developing countries (%) Korea Taiwan Singapore Chile Ireland Morocco Jordan 1960-70 0.60 1.40 0.10 1.40 2.50 4.60 -1.10 1970-80 0.80 1.10 0.40 0.00 1.70 -0.20 3.00 1980-86 2.50 1.80 -0.80 -1.90 1.20 -0.30 -2.60 1986-92 1.90 2.50 4.00 3.80 3.40 -1.20 -4.30 Source: Bosworth, Collins and Chen, 1995. C. Government Policies for Growth with Equity 10. While the state has a very important role to play in promoting economic growth and poverty reduction, until now its performance has been mixed. For much of the last forty years the underlying philosophy for government public policy intervention emphasized the need to provide infrastructure, while giving considerable attention to the state's own productive activities, mainly in agriculture. Most of these actions took place against a backdrop of fiscal austerity with low taxation, low government recurrent expenditures, and low debt. These policies had the merit of providing a relatively stable macroeconomic environment and the DR avoided the painful episodes of very high inflation and negative growth of many other Latin American countries. But unfortunately, while avoiding the big crisis of other countries, the DR failed to pursue more forcefully the institutional and policy reforms that would have allowed stronger poverty reduction. Table 1.8 The role of the State: The DR and other Latin American countries Share of government expenditures DR (1998) High Medium Low over GDP(%) Education 2.5 5.2 3.9 2.3 Health 1.5 5.1 2.0 1.1 Social security 0.7 10.3 4.9 1.0 Order & security 0.6 2.2 1.2 0.6 Productive activities 2 3.4 2.5 1.0 0.8 High Income Medium Income Low Income Social Indicators DR (1998) per capita per capita (Us$ooo- per capita (USS (US$2,500) 2,500) < 1,000) Gini Coefficient 45.5 52.9 51.1 48.7 Enrollment rate-primary (%/) 103.0 105.3 103.5 110.5 Enrollment rate - secondary (%/.) 41.0 61.2 49.6 39.5 Access to safe water (%/o) 71.0 78.0 66.0 62.0 Vaccine DPT < 12 (%) 83.0 86.0 87.0 90.0 Matemal mortality ratio 110.0 118.0 180.0 250.0 Child malnutrition (%) 8.0 5.4 12.5 19.3 Sources: Government Finance Statistics, IMF, DR Planning Office, World Bank Development Indicators. I Based on ordered ranks among 15 Latin American countries. 2 Excluding roads. 3 1998 Estimate by Central Bank. Gini coefficient estimate for 1992 (FEyD) and 1996 (IDB) was roughly 50.0. 7 Chapter I 11. A particularly important shortfall has been the failure to more forcefully promote human development and provide a safety net for the very poor. Overall, the state's attention to productive activities came at the expense of supporting human development, especially education. Government expenditures in social services have been exceedingly low, and while they have been increasing in the past three years, they are still well below the standards of many other developing countries at a similar development stage. Moreover, beyond the issue of expenditures the quality and effectiveness of government spending remains in doubt. It is important to point however, that outcome indicators on education and health tend to be better than what could have been predicted based solely on inputs, measured as government expenditures. This is very possibly a reflection of the dynamism of private initiatives and of self-help, which has been able to take place in the midst of steady, if not stellar growth, and the avoidance of large crises. However, for the poor and the extremely poor, still sorely lacking are the strategies and targeted programs that can help them raise their education and eliminate some of the most compelling aspects of poverty such as child malnutrition. Table 1.9 Policies and institutions in the DR and LAC DR High freedom Medium freedom Low freedom Wall Street Journal's 1998 indices of economic freedom 1 Overall economic freedom 3.35 2.40 2.80 3.40 Trade 5.00 3.20 3.00 4.30 Taxation 2.50 3.10 3.10 3.20 Govemment intervention 2.00 2.00 2.00 2.50 Property rights 4.00 2.00 2.90 3.50 Regulation 4.00 2.70 3.40 3.90 Wages & price controls 2.00 1.90 2.40 2.80 Banking 3.00 2.00 2.00 2.90 Foreign investment 3.00 2.00 2.40 3.30 The Freedom's house 1998 index of political freedom 2 2.50 1.60 2.50 3.70 l The indices range from 1 to 5, a higher index represents less freedom. 2 The indices range from I to 7, a higher index represents less freedom. 3 The World Bank Country Policy and htstitutional Assessments range from I (low) to 6 (high): 1-unsatisfactory for extended period, 2-unsatisfactory, 3- mnderately unsatisfactory, 4-moderately satisfactory, 5-good, 6-good for extended pil - lower middle income group countries Sources: The Wall Street Journal Index of Economic Freedoms, 1999. The Freedom House, 1999. The World Bank. 12. Aware of this situation, the implementation of important structural reforms was deemed a critical element to maintain high growth and start building a comprehensive poverty reduction strategy. With stabilization largely achieved the Fernandez administration took office in 1996 with an ambitious agenda of institutional and policy reforms. Such reforms were a natural progression in the process to modernize the country's institutions, and more strongly depart from the legacy of the Trujillo dictatorship (1930-61) that still shapes many aspects of the Dominican state. This legacy included an enormous centralization of power in the Office of the President, relatively weak judicial and legislative branches, inefficient state-owned companies, high protection to industry and agriculture, and ultimately, problems of governance and lack of transparency that limited private sector development and the effectiveness of government expenditures. 8 Economic and Social Reforms for Growth with Equity Box U StaUsw gf Main Stquctra RfWorms Area Issues Staus Prvatlzez* on1rWDa Sect Deveopment Airport 20 year concession of operations of Competted in Apil 199. Contract fmajor inteatn airport awaits ratifcation by Congress. Electity Pratize distribution and generotion Completed in March/April 1M99 Of etrlly through sale Of 50% of ,stateco,many shares' ManaemAt -conl hld by priva shaeholders. Sugr mills . yeew lease of 10 governmn sugar Cobml in September 19M. rmils an4 associated :L Telecommunications stab,ish modem -reoguatory Telecomrunications Lawapproved, frameworkand new regulory body. 1998, regulatory body established June 109. Competton & Property Rights Estabsh modern compeiion and Law sent to Congress in November Legislaton consumer rigs Low and:new 1999. regulaory body. New property rights LaW. Electricity Law Establish mnodem reglatory Pending Conrssional approval framewori and regutatory body. since 1993. TAde Reform Tariff Reform Liberalize Trade through Free Trade Pendig Congressional approval Aremnt with Central Amerika. since 1998, Reduction off rates to 15'40-0 rane in year 2000. ^Fnancl Sedtor eid Capit a iots*, Monetary and Financial Code Esabtish policy and regulatory Approved by Congress on framewortc for financial seor and the October 1999. Partial veto from Central Bank. executive l.k. SocialSecury Reform substte pay as you go Being discussed in Congres. system by individual capitalizato scheme. Capial Markets Law Estish policy and regulatory Pending appral by Congres since framework fo sector development. Ociober 1998. MfoderM zaUon of the State Public Procuremeft Law EstabUsh new mo competiv rules Pending Congresonal appval for publi procurement. since 1998. Public Accounting Law Modernize public accounting system. Pending Congressional appral since 199;8 9 Chapter 1 13. In the midst of a very fluid political environment, the implementation of reforms has been delayed. In the past few years significant efforts have been made to implement these reforms. Important achievements have been made in strengthening the judicial and legislative powers, and through the privatization (capitalization) of entities such as the state electricity company and the leasing of the state sugar mills. However, key legislation including tariff reform for trade liberalization, a new competition and intellectual property rights law, and comprehensive regulatory framework for the financial sector and the Central Bank have yet to be passed and/or ratified by the executive. D. The Social and Structural Policy Review 14. Poverty reduction in the DR will require sustaining economic growth for a long period, and at the same time a more determined role of the state in helping to build up the assets of the poor, including their educational attainment. This Social and Structural Policy Review (SSPR) analyzes many of the most important policy and institutional reforms that can help achieve that goal. In all the areas analyzed, the country is already moving in the direction of implementing needed reforms. But the required consensus and/or political will to implement them are still sometimes lacking. In that context, to call on the attention of Dominican policy-makers, the SSPR purposefully focuses on the pending agenda, rather than on a detailed account of the state of progress achieved. 15. Since recent events have proven that macroeconomic stability is a minimum necessary condition to make current growth sustainable, Chapter 2 focuses on the policy and institutional reforms needed to consolidate macroeconomic stability. Chapter 3 focuses on the challenge of trade liberalization, which is likely to be the most important pending structural reform because of its impact on long term growth and employment.- Special attention is paid in this section to the potential transition costs for the poor who may be negatively affected in the short run. Chapter 4 focuses on the main challenges confronting the education system and future labor market policies. Chapter 5 focuses on the status and pending reforms to strengthen the banking system and increase financial deepening. Finally, Chapter 6 analyzes the state's resource and institutional capacity to implement and support a poverty reduction strategy through public expenditures. This SSPR does not have a specific chapter on poverty or governance because the two are crosscutting issues that form part of the analysis throughout the SSPR. Finally, there are some important areas that this SSPR could not cover. They include a thorough assessment of the policy and institutional framework for private sector development, including the functioning of the judicial system. In that area, new work is underway. The same holds true for a more comprehensive public expenditure review and its relation to a poverty strategy. Work in this area is also underway and will be based on new household survey data. 10 2. CONSOLIDATING MACROECONOMIC STABILITY A. Macroeconomic Assessment 1. During the last eight years the performance of aggregate monetary and fiscal variables has been quite remarkable. The current level of government net assets, e.g., external debt, central bank debt and gross reserves, are compatible with price stability and average inflation of about 7 percent. With economic growth continuing at a strong pace, 8.3 percent for 1999, and an average of 8 percent for the last three years, prospects for the near future remain favorable based on the continued dynamism of tourism, telecommunications, construction and the FTZs. 2. Fiscal policy has been generally tight leading Figure 2.1 Macroeconomic indicators to low inflation. The combined non-financial public sector deficit averaged 1.4 percent of GDP during 1995- Growth and Inflation 1997. The 1998 increase in the deficit to 1.8 percent of to . 14 GDP was largely due to the impact of hurricane 8 12 Georges', and is expected to be lower in 1999 when final 6 + \ data is available. End of year inflation has been steadily + 4 falling from 8.4 percent in 1997 to 5.1 percent in 1999. 2 1 11 _ 3. Within a flexible exchange rate system there 1994 1995 1996 1997 1998 has been a gradual appreciation of the domestic 1==GDPgrowdA - CP1nf1aotn currency. Since 1992 there has been an appreciation of Fiscal and External Balances the Peso of about 20 percent. Such an appreciation is . common in times of stabilization and monetization and , . actually could be considered low when compared to -2A other countries. Deficits in the external current account has increased from 1.6 percent of GDP in 96-97 to about v -5 3.4 percent in 1999, which is a desirable development 1994 1995 1996 1997 1998 for a growing economy that will need external savings to -4-- Overall Fiscal Balance -CAB facilitate growth. Moreover, the current account deficit is partly being financed by very strong inflows of Investment and Savings foreign direct investment. While there has been a growing trade balance deficit it is being financed by 24 Z foreign exchange revenues from tourism (US$2.2 billion 21 in 1999) and remittances (US$1.5 billion in 1999). 4. Savings and investment remain strong and 1994 1995 1996 1997 1998 there has been important debt reduction. The saving GDI effort continues to be strong exceeding 20 percent of GDP allowing for the financing of a growing rate of Real Exchange and Interest Rate investment. Much progress has also been accomplished 125. 25 in debt reduction. The external debt has been 120 120 decreasing, arrears have been cleared, and the debt-to- 115. *5 GDP ratio now stands at about 27 percent, which is a ^ . very manageable level. The level of domestic public 105. l10 debt is also modest at about 4 percent of GDP. There 1994 1995 1996 1997 1998 are, however, concerns on the possible build-up of a I_REER +Reallnbrest Rate higher level of unrecorded domestic debt to suppliers. 11 Chapter 2 Table 2.1 Selected economic indicators 1994 1995 1996 1997 1998 Sep. 99 Output (real growth, %) GDP (mp) per capita 2.0 2.4 4.8 5.7 4.8 - GDP at market prices 4.3 4.8 7.3 8.2 7.3 8.0 Saving-Investment (% of GDP) Gross Domestic investment 23.8 21.7 21.1 22.0 25.8 29.9 of which Gov't investment 9.8 7.4 7.6 5.7 5.7 7.0 Extemal saving (=-CAB) 2.7 1.6 1.6 1.1 2.4 3.1 Gross national saving 21.1 20.1 19.5 21.0 23.4 -- Government saving 6.4 6.7 6.8 3.6 5.2 -- Non-govemment saving 15.0 13.4 12.7 17.7 18.3 18.3 General Government (% of GDP) Total revenues 15.9 16.3 15.6 17.2 17.1 18.2 Tax revenues (CG) 13.6 13.6 13.1 14.7 15.0 16.8 Total expenditures, of which 15.9 14.5 14.9 15.3 15.9 17.7 Currentexpenditure 8.8 8.7 9.1 11.1 12.0 12.4 Overall Balance 0.0 2.3 0.7 1.9 1.2 0.5 Money & Debt Inflation Rate (average CPI, %) 8.3 12.5 5.4 8.3 4.8 6.6 XGNFS (real growth, /) i/ 9.2 2.8 6.3 10.8 4.4 -- Total gross reserves 2/ 0.8 1.0 0.9 0.9 0.9 1.1 Total gross reserves/M2 (%) 10.5 13.3 11.6 10.5 11.8 15.5 DOD/GDPmp (30%) 40.9 37.3 32.5 28.1 26.9 -- DOD/XGS (175%) 3' 105.9 99.9 84.1 71.4 68.0 -- Other NetExportsofFTZ(millionsofUS$) 804.6 901.2 961.0 1,179.7 1,399.5 1,114.8 Tourism Receipts (millions of US$) 1,428.8 1,570.8 1,780.5 2,099.4 2,141.7 1,808.8 Remittances 756.7 794.5 914.0 1,088.9 1,326.0 1,014.6 Source: Central Bank ofthe Dominican Republic and Bank staff estimates. 1/ Expons of goads and non-factor services; includes net exports from free-trade zones. 2/ In months of imports of goods and services. 3/ Exports of Goods and Services. 5. In the following years, the key challenge for macroeconomic management will be to continue to provide a stable environment for strong economic growth. This will require the maintenance of low and stable inflation, avoiding high and volatile interest rates, and reducing country risk. Achieving these objectives will require addressing existing vulnerabilities. Notwithstanding the very good economic management that took place in the aftermath of hurricane Georges in 1998, until now macroeconomic management has not been seriously tested by negative shocks. It is at this time, in the midst of what have been favorable conditions, that it is important to undertake institutional and policy reforms to reduce the economy's vulnerability to possible future shocks. B. Fiscal Vulnerabilities 6. The most significant threat to macroeconomic stability comes from the country's fiscal vulnerability. For many years the DR's fiscal vulnerability was associated with low tax revenues which averaged between 12 to 14 percent of GDP. In that context, fiscal balances were usually maintained through low public sector wages and limited provision of public education and health. In recent years, while there has been a significant increase in tax revenues, fiscal vulnerabilities remain and may have possibly even increased. This increase can be attributed to: (a) significant increases in current 12 Consolidating Macroeconomic Stability expenditures; (b) insufficient progress in modernization the financial management of the state that makes it increasingly hard to contain and monitor overall expenditures; and (c) political reforms that call for altemnate Congressional or Presidential elections every two years. 7. In the past three years there has been a significant shift in the composition of expenditures, away from investment and towards increased current consumption. This shift has been partially the result of the government's increased attention to human development issues; for example the budget for education increased from an average of 1.9 percent of GDP in 1994-96 to about 2.5 percent of GDP in 1998 and an overall policy to increase public sector salaries to levels closer to those in the private sector to reduce corruption and increase efficiency. But it also reflects significant growth in public employment outside the education sector, and growing transfers to the state-run electricity and sugar companies, whose management and, in some cases equity positions, are being transferred to the private sector through capitalization or long term leasing arrangements. While the completion of the private sector participation process in the electricity and sugar sectors could lead to a reduction in current expenditures of about 0.5 to 0.7 percent of GDP, the growth of employment and the wage bill have long term implications on fiscal vulnerability that need to be addressed. Table 2.2 Composition of public expenditures (% of GDP), 1995 - 1998 1995 1996 1997 1998 Current Expenditures 7.2 7.8 10.6 11.1 Current Expenditures Adjusted 6.0 6.5 9.1 N/A Wages 3.5 3.6 5.1 5.2 Transfers 1.9 2.5 3.3 3.5 Capital Expenditures 7.0 6.6 5.5 5.1 Investment 4.5 4.6 2.8 2.7 Capital Transfers 1.7 1.3 1.6 1.3 Amortization 0.7 0.7 1.6 0.8 'Current Expenditures Adjusted equals tot' current expenditures minus wages ifor education. Source: Based on ONAPRES 8. Barring significant improvements in the quality of current expenditures, the maintenance of strong growth could be hindered, increasing the fiscal vulnerability. There is ample evidence across countries that increases in current expenditures of the form that have taken place in the DR, i.e. in the absence of a program for the modernization of the state, tend to reduce growth through at least two channels: (a) they are generally a good measure of non-productive allocation of resources; and (b) if perceived as a deterrent to productivity growth, they are associated with future increases in tax rates and can reduce private investment. This has been extensively documented in panel regressions explaining the differences in growth across countries. This has been compounded in the DR by the concomitant decline in public investment to accommodate the growth in current expenditures. 9. A lower GDP growth would not only affect the tax revenues collected by the central government, but would also affect the revenues from the inflation tax. Until now, strong growth has allowed for significant revenues from money creation with low inflation. Between 1992 and 1998, the monetization of the economy yielded important revenues from money creation while maintaining a low inflation rate. These revenues, averaging 1.3 percent of GDP per year, were equivalent to two thirds of the public education budget during that period, or the full service of the foreign debt. The high elasticity of income in the demand for money and the high rate of economic growth facilitated the combination of high revenues and low inflation. Between 1992 and 1998, the average annual rate of growth of base money was about 16 percent while the average inflation rate was roughly 7.4 percent.2 Maintenance of 13 Chapter 2 high revenues from money creation with low inflation requires strong growth. Moreover, the high (negative) elasticity of demand with respect to inflation indicates that even a small increase in the reliance of money creation to finance the consolidated public sector fiscal deficit could have a very large impact on inflation. t$00~ ~ ~ ~ ~~~~~~I AN'0 NUUU St :X.} SS .N , a 0 0000 wOlVariable0S Coff ti" a's 10. Because the DR has a tradition of deteriorating fiscal management during important electoral periods, rfscal vulnerabilities may have been increased by political reforms that call for either Congressional and local government elections or Presidential elections every two years. While aggregate macroeconomic indicators often mask the impact of the political cycle on the economy, there is enough evidence that fiscal policy tends to follow a cyclical pattern, with increases in expenditures and declines in the effectiveness of tax collections during the run-up to elections. These events are then usually followed by strong adjustments to maintain stability. This cyclical behavior creates inefficiencies and imposes costs on several fronts. First, it enhances uncertainty. For example, 1 4 Consolidating Macroeconomic Stability the variance of inflation in the DR has been relatively high for a low inflation country. Second, the cost of adjustment is often borne by the private sector through higher and more volatile real interest rates. Third, public expenditure adjustments are often costly and inefficient because they rely on stopping on- going public works, increased financing of expenditures through arrears and unrecorded debts, or reduction in (non-wage) current expenditures that hinder the daily functioning of the public sector. Box 2.2 The PoitffIcal Cycsl, Macoeconfic Managemnt and IntrestRates A ioose ficail poliy in the run-rp to fte Congressiol elctios of May 1998 was requird to acoltinodate mofoney gwth of base mtney w cdi ho been progesIvey rduced to about 5 percent in mid S997, inceased in la 1997 t about percent To curtail the Impt oney growth on Inflain and the s,,k nge ra, te Oenftra Bank fbllowed a policy to reduce t money multipier. Imposition of marginal reser reqrements, freezing of basn excess reserves in- the Central ank, and sterilation trough Cenftra Bank sho m deb were t p i mens. In March of t998 hfe money mu ltili m a 116 0 95, tgged n a h that d t higher intet ates. The nroinal Oending) interest rateshich had been delng since 19$ rose ftom 1.5 t 2 pernt between Febnrary and May of 1998. As the requrement to ifnre the reserveosit ratio rduce the banks , the spread between loan and deposit terest rates increased fo 8rb to 10 peent. Whe- stabiiatn was achved, t was at the cost of inreasig te vulnerabity of fte financial and real sectors. Dpedbit 90itcoefdimint4 Inltio=n 0.3 0.2q5 infation (-1) 0.186 1.079 inflaton (-2) -0.027 -0.155 inflation 0(-3) 4-093 $-0606 mulipher -0.410 -0.264 mulqptiper (-1,) -0.08 _2. multIpller(22) 401 W j-2.904 mutiplier --) 4.014 -3.737 C 0.575 -.880 !LR __ 7.S397 OW- 1.974 N40 =3 observations .~~~o the To ver the possible impa d te iqudity eff on the nominal in_te rates, a lagged regression was estmated usig the nominal lending nerest rate as a dendent variable, and using mt obsatins 194 to 1998. The resut are as expedede' a fall in t mney nmulter is assodatd with a ise in the interest rate, and inceases in inflation ed to higher interest rates.- WhatIs rahe suprllng is that in the sot runVh multifier seemw to have a higher eXplanatory power than th inftio rate, 15 Chapter 2 C Addressing Fiscal Vulnerabilities 11. Modernizing the financial management of the State will be critical to reduce fiscal vulnerabilities by monitoring and controlling more effectively government expenditures. The institutional and legal framework for financial administration dates back to 1969, a period of a highly centralized and authoritarian state, where more than 50 percent of the budget was directly managed by the Presidency, together with all civil service personnel hiring decisions. With such significant powers vested in the Presidency, the mechanisms and informnation systems to control expenditures, wages, and personnel hiring decisions were not developed. Today, the absence of such mechanisms and the continued powers vested on the Presidency make it difficult to manage the growing amount of resources in the hands of the state. The main elements that permeate fiscal discipline are: (a) Lack of consolidation for overall public sector budget. The public sector budget refers only to the Central Govermment and does not include the non-financial autonomous entities. The shortcomings of this mechanism have become increasingly evident in recent years when the current transfers to the public enterprises have increased dramatically. For example, the transfers to public enterprises averaged about 5 percent of total central government expenditures from 1980 to 1996, almost doubled to 9.4 percent in 1997 and are expected to have been higher in 1998. Moreover, some of these increases have very often been non- anticipated (e.g. the State Sugar Conglomerate (CEA)) putting undue pressure on fiscal management. (b) Special Budget Accounts that do not allow for classification and identification of expenditures. These accounts include No 112 "Specific Executing Agencies", and No 114 "Reserves". One important shortcoming of these accounts is their impact on the control of public employment and the wage bill. The lack of an exact ex-post classification of expenditures makes it impossible to know the level of employment and the associated long- term budget commitments in these categories. (c) The Presidential Fund (Fund 1401). Between 1986 and 1997 roughly 50 percent of the country's budget was directly executed by the Office of the Presidency through the use of Fund 1401. The Fund has two sources of funding: (i) 75 percent of tax revenues in excess of those projected in the budget approved by Congress; and (ii) 100 percent of the "non-utilized funds" from the different executing agencies. In reality, these "non-utilized funds" are a tax on the Ministries and executing agencies that in the last five years have accounted for roughly two thirds of the 1401 Fund. (d) Poor procurement practices and unrecorded debts. Uncertainty over availability of resources encourages use of supplier's credit and unrecorded debts. In principle, Ministries and executing agencies cannot make contracts without spending authorization from the Budget Office. In practice, however, implementing units systematically violate this regulation by using supplier's credit to implement programs for which they presume they will get (or are entitled to) funding. This limits the ability to control expenditures reducing also cost-effectiveness and transparency. 16 Consolidating Macroeconomic Stability Table 2.3 Expenditures by institution (as a % of total expenditures), 1980-1998 1980-1985 1986-1990 1991-1996 1997 1998* Presidency 15.6 47.6 52.3 37.8 21.5 Finance 16.8 12.5 15.6 22.1 23.6 Education 12.5 7.7 7.9 10.6 13.8 Public Health & Social Assistance 8.7 6.2 5.7 7.1 9.1 Agriculture 13.0 6.3 3.5 4.1 7.6 Interior and Police 7.2 5.5 4.9 6.5 6.7 Armed Forces 11.1 6.6 5.3 6.2 6,2 Public Works and Communications 10.3 4.2 1.7 1.1 5.1 * Preliminary Source: Based on ONAPRE. Table 2.4 Ratio of executed to approved budget by institution and programs, 1994-98 1994 1995 1996 1997 1998* Presidency 4.38 5.08 5.24 5.49 2.04 All other 0.54 0.56 0.62 0.97 0.93 Defense 0.89 0.53 0.56 0.82 1.03 Justice & Order 0.74 0.56 0.55 0.95 0.99 Education 1.00 0.93 0.88 1.20 1.06 Health 0.91 1.76 0.78 0.96 0.88 Agriculture 0.93 0.71 0.74 0.92 1.05 Transport 3.48 2.67 2.34 1.52 1.02 Urban Works 8.53 4.64 69.70 54.62 15.56 Electricity 0.75 1.73 2.46 4.31 1 .03 * Preliminary Source: Based on ONAPRE. 12. The government is working to improve financial management, by limiting its use of Fund 1401, and has been working on a reform agenda that would include several aspects of public sector management and budget reform. These include: (i) the establishment of a comprehensive budget that would include the non-financial public sector both for expenditures and sources of funds; (ii) the establishment of a uniform system of accounts that will eliminate the special treatment of special funds or accounts that make, for example, the control of the wage bill very difficult; and (iii) the elimination of incentives to under-fund activities of the Ministries' and implementing agencies by stopping the automatic transfer of those funds to the Presidency. This in turn will make the budget formulation more meaningful and can set the groundwork to address the pervasive problems of extensive use of supplieres credit and unrecorded debts. Passage of these reforms, is critical to institutionalize the changes that have started to take place. 13. Improving the focus of the public investment program would alleviate the negative impact on growth of increased current expenditures. Focus on what are traditionally considered public goods could be a priority. Reversing the trend of growing current expenditures will not be easy, since it is not clear that an important deterioration in public sector wages would enhance efficiency, and a program of employment reduction, while needed, is likely to be implemented in a very gradual manner. In the meantime, increasing the efficiency of public investments could be a priority. In the DR, this could be achieved by focusing public investments on traditional public goods. It is a well-known proposition 17 Chapter 2 that the net impact of public investments on growth can be reduced, and could potentially even be negative in the cases that public investment simply crowds-out private investment. Empirical analysis for the DR shows (Table 2.5) that public investment does in fact crowd-out some private investment. However, the crowding-out effect is roughly 18 percent, indicating that for each $100 of public investment, there is a net contribution of $82 to total investment. What is more remarkable however, is the finding that the negative crowding out of private investment comes from public investments, which are not basic public goods. Investment in basic public goods (roads, water, and sewerage) in fact has a crowding-in effect of private investment of about 30 percent. Table 2.5 DR: Determinants of private investment, 1979-1996 Constant Change Lagged GDP Openness Lagged Public Investment AR(l) P7 DW Cost Change Growth Excess Capital Wages Capacity Total Lagged Lagged basic publicOte2 ______ ______ ~~~goods Ot er -2.353 -0.013 -0.234 1.481 0.279 0.069 -0.177 0.816 0.71 2.14 (-10.47) (-1.59) (-1.72) (3.70) (2.36) (3.09) (-2.50) (9.84) -1.258 -0.019 -0.129 1.030 0.259 0.045 0.296 -0.151 0.872 0.76 1.96 (-2.92) (-2.37) (-1.32) (4.41) (2.39) (1.14) (3.88) (-2.98) (8.51) Notes: T-statistic.in parenthesis. N = 18 observations. " Basic public goods involve investments in transport, ral roads, water & sewerage 7/ Other includes housing, irrigation, cornnmunications, energy, agriculture and urban developments. Source: Bank estimates based on public investment classification from ONAPLAN 14. As the government works to increase the efficiency of expenditures, consideration should be given to tax reform to increase revenues for social expenditures, and to help build up reserves that will reduce the vulnerability to external shocks. There is an ongoing debate in the country on whether the current tax revenue base of about 16 percent of GDP is sufficient to address needs for improvements in education, health, and the development of safety nets (see Chapter 6). In addition, the implementation of trade liberalization or social security reform may likely demand additional tax resources. For example, trade reform in agriculture will require resources to provide compensation to poor farmers in their transition to produce other crops. Possible reforms to the social security system will require financing of existing contingent liabilities. While neither of these costs have been fully assessed, combined they could add to at least 1 percent of GDP, and would be very difficult to finance with the current tax revenue base. Increasing tax revenues to attain a primary surplus to accumulate reserves would also be desirable. D. Vulnerability from external shocks 15. Economic diversification and debt reduction have reduced the external vulnerability of this economy. For the past twenty years the growth of tourism, the FTZ sector, and the continued strength of remittances from Dominicans living abroad have reduced the risks from external shocks when compared to times in which the economy largely depended on exporting commodities such as sugar and nickel. With tourism highly dependent on Europe, the FTZ serving a large consumer base market in the US, and remittances tied to the continued family relations, the correlation between these three risks is perceived as low. The low level of debt also makes the economy relatively less vulnerable to raising interest rates. 16. But the low level of reserves, and difficulties in accessing international markets to ameliorate the impact of possible shocks is a source of concern. The macroeconomic management problems of the 1 980s led to a significant loss in Central Bank reserves from which there has only been a very moderate recuperation. Gross reserves at about US$700 million, are equivalent to about 1 month of 18 Consolidating Macroeconomic Stability imports or 13 percent of M2. Even considering that under the DR's floating exchange rate regime the nominal exchange rate is supposed to act as an equilibrating mechanism, and reserves do not play as clear cut a role as under an exchange rate anchor system this reserve level is low and does not provide enough of a cushion to soften temporary shocks. More so, since the country's legal framework makes it very difficult to borrow from international markets as DR legislation requires Congressional approval for all public debt. Building up reserves would be desirable, provided it is achieved through increasing the primary surplus, which in the current context is hard to foresee without an increase in tax revenues as a share of GDP. If that is not possible, an alternative could be to establish access to a credit line paying a retainer fee. The latter would require approval by Congress, which could be sought in the context of a new Foreign Indebtedness Law, which would grant the executive, in conjunction with the budget process, the right to access a certain amount of foreign financing per year. E. The Conduct of Monetary Policy 17. Future monetary policy could strive to provide more information to the markets on objectives, intermediate targets, and instruments. Under a floating exchange rate system the monetary authority has the ability to control monetary aggregates, and the market, as any other price determines the exchange rate. The question then arises, as it does in a closed economy, of how the Central Bank conducts its monetary policy. The Central Bank often defines its objectives of monetary policy as "achieving macroeconomic stability", subject to various quantitative targets that include a maximum target inflation rate consistent with a certain GDP growth and a target level of net international reserves. Although it is not explicitly stated as an objective, Central Bank actions and references indicate that "exchange rate stability" is another objective, and sometimes even a priority. 18. Conduct of monetary policy privileges discretion over rules. Providing the market with clearer indications of the rules to be followed would improve the policy environment for macroeconomic management. Until now, given the volatility in the fiscal front, monetary policy has been managed with a prevalence of discretion over rules3 However, over the medium term, both fiscal and monetary policy could strive together to provide added transparency of actions and predictive ability to the market. The CB currently uses open market operations ("Certificados de Participacion") as one of its main instruments of monetary policy. In the absence of a stock of government securities, this is an acceptable instrument. Indeed, open market operations are universally seen as the appropriate and most neutral instrument. Frequently, though, it resorts to other, more inefficient instruments, like changes in reserve requirements, freezing of excess reserves, or outright direct quantitative limits on private bank's commercial credit. These procedures entail inefficiencies and also can debilitate the financial sector (see Chapter 5), by decreasing the commercial banks' profitability, which translates into a higher spread between borrowing and lending rates. F. Conclusions * Stabilization has played a key role in triggering strong growth and is exceedingly important to maintain. The Dominican Republic already has a satisfactory record and has proven its commitment to macroeconomic stability. The main challenge for the future is to establish the institutional reforms that will further consolidate stability and at the same time start improving the quality and predictability of macroeconomic management. This can help to further promote savings and investment, reduce interest rates and reduce country risk. * The main source of vulnerabilities comes from the fiscal front, especially on the expenditure side. Reforms to the Budget Law and the modernization of the financial management of the State are important to reduce the volatility of fiscal policy through improved control of expenditures. The 19 Chapter 2 completion of the ongoing privatization of public enterprises could be an important element of this strategy. Increasing the predictability and controls over expenditures would allow carrying out a monetary policy that would rely more on rules vs. discretion, result in a better mix of policy instruments, and enhance market information. Endnotes I In September of 1998 the hurricane caused damages equivalent to US$2.2 billion or 14 percent of GDP. 2 The income elasticity is estimated at 1.42, which combined with an average growth of GDP for 1992-98 of 6 percent yields and increase of demand of about 8.5 percent. The average rate of growth of the money base was 16 percent. The difference between 16 percent and 8.5percent --7.5 percent-- is almost identical to the average inflation of the 1992-98 period. 3 The term "discretional" is used here in its strict technical meaning. Discretionality has no negative implication, and has nothing to do with "capricious", "erratic" or "arbitrary" behavior. It simply means a regime under which the monetary authority uses its instruments in reaction to events in the economy, rather than setting exogenous targets for the magnitudes that can directly control, such as the monetary base. Indeed, the DR Central Bank has used its discretionality very wisely during the past few years, and continues to do so. 20 3. TRADE POLICY REFORM A. Trade Policy in the Dominican Republic 1. Protectionism remains very high. Left behind by the wave of liberal reforms that swept much of the region during the last two decades, the DR has today one of the most protectionist trade regimes in Latin America. Tariff rates ranging between 0% and 35% are escalated along the production chain to provide additional effective protection. Non-tariff barriers to key products also further enhance protection and the discriminatory application of value added or excise taxes to imported products whose domestic production is not taxed at the same rate. Bank estimates of the output weighted nominal protection rates indicate that they reach the 35 to 45 percent range for agriculture, and the large import substitution manufacturing sectors (food processing, beverages, and tobacco). Effective protection rates, on the other hand are much higher reaching the 60% to 100% ranges for several categories of products (Table 3.4). Table 3.1 Nominal protection rates (%) Activity Protection Rate Agriculture 39.56 Import-Substitution Manufacturing 33.02 Grain Mills 44.54 Food Processing 40.98 Beverages and Tobacco Manufacturing 45.16 Textiles and Wearing Apparel 32.00 Footwear and Leather Manufacturing 35.00 Petroleum Refineries 5.90 Chemicals 16.37 Rubber and Plastic Products 24.00 Non-Metal Products 18.88 Metal Products 20.00 Other Manufacturing 17.37 Intermediate Goods 15.69 Consumer Goods 28.53 Source: World Bank estimates based on 1997 customs data and Central Bank 1995 input-output production matfix. 2. Non-tariff barriers prevail for the most important agriculture products. There is no clear policy on how these trade barriers are managed or on who benefits from the significant rents associated to these imports. Imports of rice, red beans, sugar, onion, garlic, milk, poultry, and tomato paste are subject to quotas and import licenses whose tariff range from 35% to 85% in 1997. These commodities represent around 40 percent of the 1995 agricultural output and 12 percent of non-FTZ manufacturing production and are consumed massively, especially by the poor. The granting of import licenses do not follow either clear procedures or criteria and government authorities have wide discretional powers in their use. In general, imports are authorized depending on domestic price conditions. As statutory tariffs are significantly lower than the protection level, those who have access to the quotas can capture significant rents. A common arrangement has been to distribute those rents among the government import agency, INESPRE, (National Institute for Price Stabilization) and interest groups within each industry, mainly producer associations. INESPRE's share of imports has been increasing lately possibly encouraged by the fact that its associated rents, unlike an import tariff, enter directly into their budget. This allows the pursuit of programs that often have high political content such as price support interventions for specific farmers and direct marketing schemes at the retail level. Ultimately, the joint interests of producer associations and INESPRE --closely tied to the executive power-- result in a strong deterrent to sector reforms. 21 Trade Policy Reform Table 3.2 Tariff equivalents of non-tariff barriers (%) Commodity Statutory Rate Tariff Equivalent Corn 5.00 85.17 Red Beans 25.00 69.55 Onions 25.00 37.87 Garlic 25.00 34.53 Poultry 25.00 74.82 Pasteurized Milk 20.00 48.36 Milk in Powder 20.00 53.36 Polished Rice 20.00 43.00 Raw Sugar 15.00 42.11 Refined Sugar 15.00 37.67 Source: World Bank estimates. B. The Proposed Trade Reform 3. The government is pursuing trade liberalization. To improve the country's competitiveness and sustain economic growth, the government is pursuing trade liberalization in the context of a Free Trade Agreement signed with Central America in 1998 which now awaits ratification from Congress. The proposed tariff reform would reduce the average tariff rate and tariff dispersion by establishing a four-tier tariff system with 0-5-10-15 percent rates. Furthermore, a complementary tax reform bill to compensate for the expected tax revenue losses brought by liberalization would reduce the excessive reliance on import taxes, which now account for 28 percent of total tax revenues, and eliminate the discriminatory treatment on imports of value added and excise taxes. 4. The most protected agricultural products, however, will remain highly protected. While the proposed trade reform is a clear advance from the current situation, protection to key agricultural products is likely to remain very high, and even increase. The products that currently benefit from non-tariff protection will however continue to do so under the proposed trade agreement. The DR and the World Trade Organization (WTO) have already agreed in the maintenance of import quotas, which would be relaxed over a six year period with imports above the quota subjected to very high tariffs. The quotas negotiated with the WTO will most likely be restrictive as they are being set at lower levels than the 1998 authorized imports (except for maize), and the marginal tariff rates negotiated with the WTO are higher than the tariff equivalents of existing restrictions for 1997. As a result, implementation of this agreement may lead to higher protection levels. Table 3.3 Scheduled tariff rates for agricultural products (%) 1997 ' 1999 2001 2003 2005 Maize 85 60 53 46 40 Milk 48 83 74 65 56 Beans 70 95 93 91 89 Onions 38 97 97 97 97 Rice 43 114 109 104 99 Garlic 35 119 107 103 99 Poultry 75 136 124 111 99 Sugar 38 94 91 88 85 'Corresponds to tariff equivalent of current protection. Source: World Bank estimates (1997) and ONAPLAN. 22 Trade Policy Reform Table 3.4 Effective protection rates (%) 3Effective Protection Rates Activity Current Proposal 10% Uniform Rice (paddy) 84.84 67.98 13.57 Exportable Crops -2.42 -1.12 -2.33 Other Agriculture 46.53 27.44 10.16 Livestock 100.70 70.68 19.78 Mining -16.62 -6.09 -9.11 Grain Mills 57.06 44.91 10.33 Food Processing 61.19 43.68 14.22 Beverages and Tobacco 80.67 26.92 12.55 Textiles 66.33 26.97 10.56 Footwear and Leather 67.13 29.75 10.89 Petroleum Refineries -1.55 -3.29 12.26 Chemicals 23.79 10.23 12.44 Rubber and Plastic Products 33.79 14.30 10.37 Non-Metal Products 21.54 13.67 11.14 Metal Products 49.76 15.31 17.30 Other Manufacturing 24.21 12.61 11.89 Food Processing (EPZs) -0.99 -0.49 -0.35 Tobacco Manufacturing (EPZs) -0.67 -0.32 -0.24 Wearing Apparel (EPZs) -1.90 -0,93 -0.67 Footwear and Leather (EPZs) -1.91 -0.93 -0.67 Other Manufacturing (EPZs) -1.70 -0.84 -0.58 Hotels and Restaurants -13.20 -3.92 -5.39 Value Added Weighted Averages: Import Substitution Activities 0.61 0.37 0.14 Exportable Activities -0.08 -0.03 -0.04 Notes: (*) QRs are maintained. Source: Bank estimates based on 1995 Central Bank input-output matrix and 1997 trade data. C. The Impact of Trade Liberalization 5. Trade liberalization will benefit the export sector. Implementation of the trade reform currently in Congress would have a positive effect on the export sector by reducing the degree of the negative protection it now faces. The impact of these reforms, however, is not fully captured through simple comparisons in the evolution of effective protection rates. Protection to the import substitution sector has other, more significant effects through its impact on the price of non traded goods which acts like a tax on exportsI and also has a dampening effect on the protection given to the import substitute sector. 6. Current trade policies are equivalent to a 27 percent tax on exports. Bank estimates indicate that the export sector currently bears 55 percent of the tax burden associated to the change in the price ratio of traded to non-traded goods, the equivalent of a 27 percent tax on exports. The remaining tax burden is borne by the import sector, dampening part of the protection effort (equivalent to a 21 percent tax). Since all exportables and import substitution goods demand some non-traded goods as inputs, they invariably pay part of this tax on trade, including the FTZs. Among exportables, tourism, and agriculture 23 Trade Policy Reform are likely to be the strongest beneficiaries from trade liberalization as they tend to consume non-traded goods more heavily. In addition, the government could also establish domestic tax-rebate mechanisms for the non-FTZ export oriented industries whose export potential is now further limited by lack of such policy. Table 3.5 Impact of trade reforms (%) Impact of Reforms on: Current 10 % Uniform Free Trade Proposal Tariff Relative Value Added Prices: Import-Substitution Activities -9.2 -15.7 -21.7 Exportable Activities: 12.2 16.8 26.7 - Commodities 8.8 13.7 21.7 - Tourism 16.8 21.1 33.5 Implicit Tax on Trade -21.3 -32.5 -48.4 Prices of Non-Traded Goods: -5.4 -10.2 -13.9 - Paddy -9.1 -38.5 -45.9 - Livestock -15.0 -40.3 -50.2 - Services -4.8 -7.8 -11.1 Nominal Wages -5.3 -9.5 -12.8 Real Wages 1.8 1.4 4.9 Consumer Price Index -7.0 -10.7 -16.9 Consumers' Welfare 1.9 5.1 7.8 Source: World Bank estimates 7. The proposed trade reform would reduce the current tax on exports by half and would also increase real wages. Estimates using a general equilibrium model indicate that the proposed trade reform would result in an average increase of 12 percent in the price of exportables relative to non-traded goods. As a result, almost half of the current tax on exports of 27 percent would be eliminated. The analysis can be extended to estimate the impact of trade reform on the returns to factors of production, the general price level, and welfare?. The impact of changes in commercial policy on real wages would depend on the consumers' patterns of expenditures through its impact on the cost of a consumption basket. The proposed trade reform would reduce the cost of living (or the price index) by 7%, but it would also entail a reduction in nominal wages. However, the purchasing power of wages would increase by 1.8% implying that current protection rates redistribute income against labor. As a result of the reductions in the cost of living, consumers' welfare would also increase. These outcomes, however, could be substantially improved if more aggressive trade reform is pursued, especially for agriculture. For example, under a 10% uniform tariff (a reform proposal presented by the Government in late 1996 but that was rejected by Congress), improvements in consumer welfare would more than double with respect to the current trade policy reform. D. Considerations forAgriculture Sector Liberalization 8. The policy environment has not been good for agriculture. Efforts to shield agriculture from external competition have not yielded good results. Protectionism has unduly taxed areas of comparative advantage such as coffee, cocoa, and tobacco, and state interventions through INESPRE have crowded- out private sector development and promoted a rent-seeking culture. The inefficiency of the state- dominated sugar sector and lack of adequate property rights have also deterred sector development. Today, the sector accounts for less than 13 percent of GDP, down from 23 percent in 1970, a shrinking share of employment (roughly 20 percent of total employment), and is no longer the main source of income for rural area inhabitants, except for a group of successful large farmers. 24 Trade Policy Reform Table 3.6 Distribution of rural household characteristics across income quintiles, 1992 All 1st 2nd 3rd 4th 5th households quintile quintile quintile quintile quintile Total household income 50.67 19.86 29.42 37.64 52.56 113.45 Number of household members 5.30 6.82 5.89 5.08 4.71 4.01 Landed household 0.49 0.54 0.55 0.44 0.41 0.48 Fraction of land owned and titled 0.41 0.31 0.45 0.46 0.26 0.52 Incidence of source of household income (%) Has income from employment 0.56 0.62 0.60 0.59 0.62 0.40 Has income from self employment 0.38 0.22 0.38 0.35 0.42 0.50 Has income from agriculture 0.55 0.66 0.59 0.48 0.50 0.50 Share of source of household income (%) Employment 0.24 0.44 0.35 0.35 0.32 0.11 Self employment 0.22 0.07 0.16 0.17 0.21 0.27 Agriculture 0.18 0.15 0.14 0.12 0.13 0.25 Family business 0.08 0.05 0.03 0.04 0.06 0.11 Pensions, insurance, interest 0.01 0.01 0.01 0.01 0.02 0.01 Remittances from within the DR 0.02 0.04 0.06 0.02 0.02 0.o0 Remittances from outside the DR 0.05 0.01 0.02 0.05 0.03 0.07 Source: World Bank estimates based on FeyD Survey (1992). 9. The existing policies also do not help reduce poverty as protectionism more than proportionally benefits high income producers and taxes to a larger extent the poorest consumers. Among the rural households, income from agriculture accounts for less than 15 percent of total income for all quintiles of the population, except the 20 percent with the highest income. Compared with the rest of the population, farm income is much more important for this higher income group accounting for 25 percent of total income, with agriculture almost being the main source of their income3 The more successful farmers are most likely the ones receiving the rents from protectionist policies. By the same token, in 1992, the poorest 20 percent of the population spent more than 60 percent of their income in food, with the poorest 10 percent spending almost 30 percent of their income in rice, sugar, and red beans, three highly protected products. 10. Furthering trade liberalization in agriculture while protecting the poorest farmers could be an important policy for overall poverty reduction and improved governance. Trade liberalization in the agriculture sector could be gradually undertaken through a series of steps. First, the incentive for market interventions and high protection by rent-seeking government agencies and other interest groups could be eliminated by adopting a transparent mechanism to auction the existing quotas with revenues from those being channeled to the general treasury as is done with tariff revenues. Second, the tariffs negotiated with the WTO could be interpreted as an authorized ceiling and the government could refrain from adopting them and instead undertake a gradual liberalization using as a starting point for the tariff level the current tariff equivalent of existing quotas. Third, a program to support poor farmers affected by the liberalization would need to be put in place during the transition. 25 Trade Policy Reforn Table 3.7 Farmer characteristics by type of production and income (%), 1992 Import Exportable Both High income Low income substitute Share income agriculture 35 13 41 33 27 Average size landholding 74 108 143 137 74 Land access titling 25 49 47 42 32 Ql income 35 34 16 Q2 income 16 19 35 Q3 income 22 21 18 Q4 income 10 22 18 Q5 income 18 7 13 Grow rice 44 9 38 18 Grow red beans 32 53 31 27 Grow maize 50 78 27 46 Grow plantain 44 49 23 19 Grow coffee 46 56 15 31 Grow cocoa 33 13 8 14 Source: World Bank estimates based on FEyD Survey (1992). 1l. While the import-substitute sector includes a relatively high proportion of high-income farmers, it also contains a large proportion of the most vulnerable and poorest farmers, which would require special programs under a liberalization program. While farmers producing import substitute crops tend, on average, to have higher incomes than those producing exportables or a mix of both4, farmers producing import substitute crops tend also to be particularly vulnerable. This is due to the fact that a large proportion of them (35 percent) belong to the lowest quintile in terms of income, and they are over-represented in terms of extreme poverty with almost 10 percent falling in that category. While the poorest farmers producing import substitute products tend to be those producing maize (and the exportable coffee), the most vulnerable appear to be those producing rice because rice producers often do not mix their production with other crops and they are less diversified. If further liberalization took place, the government could seek to compensate these poor farmers through direct cash transfers and programs that could facilitate the substitution of other crops, including, for example, providing them with land titling. 26 Trade Policy Reform Box 3.1 Income Transfer Prgramms to Farmers: The Case of Mexico's PROCAMPO PROCAMPO is a direc income transfer program to compensate for the negative pioce effect of NAFTA on Mexio's producers of 9 tradiona crops (oom, beans, rime wheat, sorghum, barey, soybeans, cotton, and cardamom) who, face US. and Canadian competitiom The program was launched in 1994 and is expected to last 15 years. Throughout Fat period the program provies a fixed incorme of US$70 per year ectae egardless of prodution as long as fthe land continues to be used for agricutura production. The impact oi PROAMPC) on the Ejido sector was recently assessed, and ts main findings wete: * Paripation is ver hi covering about 90 percent of Mexicoscultivated areas. Participationwa equally strong among smei,t medium, and large farmers. * On average PROCAMPO payments provide 8 percent of Ejlidatario: househol icomne, but te prram's contribution represents up to 40 percent of income for farmers in the poorest deie. - Althogh PROCAMPO was not desined as an wai-poverty pogram, PROCAMPO, as could be expected of a cashtransfer program, redues poverty. * There is initial evidence tat Fe program has generated a mutltpier effec on the income generating potential of its beneficiaries. The main hypothesis for tis finding is that either through the effect Of cash availablity or a reduction in risk avesion of Ws beneficiaries, the program may help ncrease instments and facilitate Xt choice of riskier activities that have higher rates of retum. Conclusions C Increased openness to trade is one of the most important pending policies to sustain strong economic growth in the Dominican Republic. Trade reform can play an important role in supporting growth by making modem technology more profitable for domestic firms and by opening up the possibility frontier for specialization. Also, by reducing the implicit and explicit tax on exports, trade liberalization would provide an added boost to the already thriving tourism and FTZ sectors, and help develop more efficient and outward looking agriculture and industrial sectors. * The proposed trade liberalization now in Congress is a significant move in the right direction, but failure to proceed with liberalization in the agriculture sector will limit the benefits of this reform, especially on the poor. The government would be well advised to pursue a gradual but more aggressive policy towards trade liberalization in agriculture while providing adequate safety net mechanisms to the most vulnerable farmers. In this same area, even if in the short run current high protection were to be maintained, the country and the government would benefit by a more transparent management of non-tariff barriers. 27 Trade Policy Reforn Endnotes This tax results from the increase in the price of non-traded goods brought about by protection. This price increase is a result of: (i) a combination of higher demand brought about by consumers that move away from higher priced importables; and (ii) lower supply as producers of non traded goods will move resources to the import substitution sector. The increase in price of non-traded goods also implies a reduction in the relative price of both importable and exportables with respect to non-traded goods. For the import substitute sector this results in a dampening of the protection received through tariffs (or quotas). For the export sector it is equivalent to a tax, which affects all exports, including the FTZs. 2 It must be noted that the model used has restrictions. For example, it does not analyze the transition path from one equilibrium to another. Capital is supposed to be sector specific, limiting some of the supply response, while the labor market is assumed to be in full employment at all times. The emerging results, which could obviously be used in an indicative manner, are nevertheless useful. For example, they confirm that freer trade increases exports, welfare, and real wages in a country like the DR. Results are also consistent with other methodologies used for estimating the burden of the trade tax on exportables. Our estimate for the DR, at 55%, is very similar to the one found for many other countries (about 60%). For a complete desc.ription of the assumptions of the model, see Section 4. 3 This is also true for the population at large (rural and urban) as the fraction of income derived from agriculture is negatively related to per capita income, but the differences among quintiles are much smaller, indicating that farmers in the higher quintiles derive larger portions of their income from agriculture 4 For this analysis farmers were classified according to production of rice, maize, and red beans (import substitute) and plantain, coffee, and cocoa (exportables). 28 4. GROWTH, EDUCATION, AND THE LABOR MARKET A. Economic Growth, Labor Force Composition, and Employment 1. Strong growth has been accompanied by a changing composition in output and employment. The structural changes that were initiated in the late 1970s with the emergence of the FTZs and the development of tourism were accelerated after the 1991 stabilization program leading to strong changes in the composition of output and in the demand for labor. From 1991 to 1996, more than 62 percent of the growth in employment (excluding agriculture) took place in the service, commerce, and financial sectors. During the same period, there were also some important changes in relative wages, led by the substantial increase in wages of the service sector. Table 4.1 Employment structure and growth (%), 1991-1996l Share Employment Share Labor Participation Change Relative Growth Growth Wages Services 28.10 26.10 18.90 Commerce 25.10 27.60 0.60 Industry 13.70 15.10 Transport 12.50 12.90 -0.70 Construction 9.50 7.00 -0.01 Finance 9.20 9.70 2.10 Electricity 1.30 1.40 21.10 Total 100.00 100.00 Does not include agriculture and non specified activities. Source: World Bank estimates. 2. Important changes in the characteristics of the labor force have also taken place, led by a sharp fall in the rate of youth labor force participation and a significant growth in the average education level of the labor force. The changes in the composition of employment have taken place at a time that the characteristics of the labor force are also changing. Between 1991 and 1996 the rate of growth of the labor force was 1.1 percent, and substantially lower than the rate of growth of the population (1.9 percent). This difference has been largely the result of a very healthy decrease in the rate of participation of youth (ages 10-19) in the labor market. While the latter can still be considered high, especially for males, during recent years it has declined significantly, particularly in the 15-19 age category. Young girls' participation in the labor market is more limited than boys at all levels, which is Figure 4.1 Labor participation rate by age (%), 1991-1997 Ages 10-14 Ages 15-19 Ages 20-24 12 - 9970 64.4 100 89.1 86.6 915.8 jj 9 48.7 49.9 74 10 8.6 50 80 70.6 5.8 40 34.0 60 656.7 30 40 4, 20 4 2 1. _2 10. 20 0, 0 0 All Male Female All Male Female All Male Female *1997 Source: Central Bank Dominican Republic. 29 Chapter 4 consistent with the fact that school attendance for girls is higher than for boys. The most important factors affecting the likelihood of attending school between 6 and 18 years of age are gender, the level of the mother's education, residence in Santo Domingo, and access to remittances from abroad. Residing in rural areas and belonging to a large family reduce the probability of attending school (see Box 4.1). The gradual but sustained increase in educational attainment, especially of women, the smaller family size evidenced by significant drops in the rate of growth of the population in the last decades, and the growing opportunities in Santo Domingo, have therefore contributed to this decrease in youth labor force participation and is a process that will likely continue. 3. The gradual but sustained improvement in educational attainment of the population has led to important changes in the characteristics of the labor force. In 1996 more than 55 percent of the females in the labor force had either secondary or higher education, and there was a very significant decline in the proportion of males in the labor force who only attained primary education. The biggest change overall has been the significant increase in the proportion of the labor force with a university education. 30 Growth, Education, and the Labor Market Table 4.2 Labor force education distribution (%), 1991 and 1996 ALL MALE FEMALE 1991 1996 1991 1996 1991 1996 No Education 7.5 7.8 8.7 9.1 5.3 5.4 Primary 52.2 46.9 56.4 51.2 44.2 39.1 Secondary 28.6 29.4 25.4 27.0 34.9 34.0 University 11.6 15.8 9.5 12.8 15.6 21.5 Source: Central Bank Dominican Republic. B. Labor Market Response to a Changing Environment 4. Structural changes such as those taking place in the DR will test the capacity for adjustment of both the labor market and the educational system. While strong economic growth can have a very positive impact through the growth in the demand for labor it also brings about adjustment costs. Workers are displaced from activities that become unprofitable, experience in some particular jobs become obsolete lowering productivity and earning potential, and there is added uncertainty on whether the educational system can support the new developing sectors. Analyzing the rates of return to education can shed light on the impact of these changes because they summarize the productivity of the human capital and the prospects for future investments. 5. In what is now a familiar pattern in many growing economies, the rate of return to education is low for primary education but raises with the educational level, yielding high returns to university education. Estimates of the rates of return show that, independent of gender, the rates of return to education are low for primary education. Education only provides significant value for those entering the latter part of high school, e.g., after the first ten years of schooling. This implies that desertion of students before the completion of 10th grade has significant costs for the economy and the well-being of the individuals2. While comparison of the rates of return for education among countries can be difficult unless the same methodology is followed, both the level and pattern found in the DR is also taking place in other countries undergoing strong growth and structural changes3. Table 4.3 Rates of return to education and experience (%), 1991-1997 Sample All Men Women Year 1997 1991 1997 1991 1997 1991 Primary 1st half 5.60 5.60 5.60 5.20 6.00 7.00 Primary 2nd half 7.00 3.60 7.70 3.70 5.00 0.00 Secondary 1st half 3.50 19.00 3.50 20.40 4.60 .17.50 Secondary 2nd half 12.10 2.00 9.10 1.00 16.10 0.10 University 1st half 10.40 13.90 11.50 8.30 7.90 19.70 University 2nd half 17.20 20.30 16.50 25.20 18.90 18.00 Experience 3.30 4.10 3.60 4.70 2.60 2.90 Experience2 -0.04 -0.04 -0.05 -0.05 -0.03 -0.03 Source: World Bank estimates based on Central Bank Income & Employment surveys. 31 Chapter 4 6. Within a changing economy the rate of return to workers' experience has fallen, and the decrease has been most marked for men. Following a similar pattern to other countries such as Chile and Argentina4, the rapid changing structure of the economy seems to have made certain human capital obsolete. The rates of return to experience have dropped by more than one percentage point for males between 1991 and 1997, and this fall has been much higher for males than females. This could be expected as the former tends to invest more in specific human capital due to their stronger attachment to the workforce. 7. The profile of rates of return to education and the drop in the return to experience of males has important implications on the distribution of benefits of growth to the less educated. The low rates of return for workers with primary education would indicate that there is an excess supply of workers with low education. This very possibly reflects the large stock of people who entered the labor market in the 1970s and 1980s with only primary education, who now also have to compete with the a strong influx of Haitian immigrants. These workers with less education may also be particularly affected by the lower returns to experience as the structure of the economy continues to change. On the other hand, the biggest scarcity of human capital seems now to be concentrated in the more educated population, who are likely to benefit proportionally more from the growing economy. In this context, growth while benefiting society in general may benefit educated workers more through this transition and will hinder improvements in income distribution. 8. Policies to strengthen the education system and maintain flexibility in the labor markets can play an important role. Differences in rates of return to education and the overall development of the country will continue to yield a growing demand for education, especially at the secondary level. For both efficiency and equity considerations, more attention and resources need to be devoted to encouraging children to remain in school and complete at least ten years of education. On the other hand, for those already in the work force and who face the prospects of low returns, strong competition from immigrant workers, and loss of relevant skills or experience, an important policy would be to provide an environment of flexibility in the labor market to ensure that they remain employed. This will help in avoiding mistakes made by countries like Chile or Argentina in which labor market rigidities during periods of strong change contributed to very high levels of unemployment. C. Education Policies for a Changing Environment 9. The growing demand for higher educational attainment will severely test the public sector's capacity to respond. Increasing the coverage of secondary education as its demand grows will be critical for the current school-age generation to benefit from strong growth and help sustain it. Net enrollment rates at the secondary level have increased from 22 percent in 1991 to 29 percent in 1996, a process that will undoubtedly continue. However, the resources destined to education and especially secondary education in the DR are still exceedingly low and unlikely to be able to cope with growing demand. For 1997 and 1998, the ratio of public expenditures in education to GDP was 2.3 percent, well below the average for Latin America at 3.8 percent of GDP and the secondary education sector has been receiving only 12 percent of the total education budget. Moreover, of these very limited resources, in 1996 almost 75 percent were directed to urban areas. Expanding service delivery will also be a challenge because of the limited implementation capacity of the public school system. Were the government willing to pursue an aggressive plan of increased coverage of secondary education, then an increased reliance on partnerships with the non-public sector needs to be explored. There is already evidence dating back to 1989, that in .the DR the private school system, for any given level of quality or costs, is more efficient than the public sector. 32 Growth, Education, and the Labor Market 10. Policies to subsidize the demand for secondary education, and increase the public supply of secondary schools could be considered a priority to sustain high growth and improve income distribution. It is well known that opportunities to access education are dependent on the family's income and wealth, and is restricted due to the presence of imperfect credit markets that do not allow the poor to borrow to finance their children's education. To some extent the low participation rates of the population in secondary schools can be explained by poverty and the inability to afford education. In that context, the development of targeted programs to strongly subsidize the education of the poor could be very important. Nevertheless, available evidence also can support the notion that in some areas lack of schools may be an important constraint. An analysis of the determinants of educational attainment shows that as expected, educational attainment is positively related to both parents' education and income per capita. It is also higher for females corroborating data from other sources. A very interesting result is that even when controlled by income, geography seems to have a significant impact in determining educational attainment. Residing in rural areas has a strong negative impact on educational attainment, while residing in Santo Domingo has a very positive one. This could very likely be the result of restricted supply of educational services in rural areas. Table 4.4 Ordered probit results of educational attainment, 1992 Parameters Estimate t-value Signific. Female 0.371 3.979 0.000 Family size -0.057 -3.121 0.001 Birth order 0.165 3.801 0.000 Father with primary schooling 0.419 2.919 0.002 Father with intermediate schooling 0.666 2.989 0.001 Father with secondary schooling 0.944 2.671 0.004 Father with higher schooling 1.187 3.501 0.000 Mother with primary schooling 0.337 2.771 0.003 Mother with intermediate schooling 1.068 5.701 0.000 Mother with secondary schooling 0.938 4.326 0.000 Mother with higher schooling 1.075 2.393 0.008 Rural -0.400 -3.563 0.000 Income per capita 0.177 3.781 0.000 Has land -0.257 -1.507 0.066 Has title to some of the land -0.270 -1.497 0.067 Has income from remittances from outside the DR 0.002 0.018 0.493 Santo Domingo area 0.246 2.144 0.016 Number of observations 692 Source: World Bank estimates based on FEyD survey (1992). D. Labor Market Policiesfor a Changing Environment 11. As the labor force tends to be more vulnerable in a rapidly changing economy, protecting employment could be a guiding principle for labor market policies. Redressing the low returns to education by increasing the earnings of the workers with little education may be an exceedingly difficult undertaking. The observed low and declining rates of return to education could be the outcome of excess supply of low educated human capital, a low productivity economy, or poor quality of the worker's skills. It is very possible that in the DR all three forces are at work. From a policy perspective, the best way to change this dynamic could come from improving the overall productivity of the economy through trade liberalization and other structural reforms. However, even in that case, parts of the labor force will have difficulty adjusting to the new skills being demanded and will experience a loss in the value of their 33 Chapter 4 experience. For these cases, protecting the employment of workers with low productivity because of lack of education or depreciation of skills will require maintenance of a flexible labor market. distortios tt e eReal Minimum Wages g y UnemploymentRatesbr 19912) is ver Argetia Chile Sad(in c onstant 1985 DR pesors e) ad i m o p 8. t w a w. T c26t00t ar8necpi.~cntiuin osc~ ewt a.7j.sial . thyaent ikdt mii,in,i,,i mumwages 28re reterpis 8 6.6 e6 9 7-0 6-9 ..... .1600 ./enrPe5iliEii6||||||||f'i a110 4 n d.3for a reltiel con0lic free niomn etwreenlao r nin, the goenet.n th prvt sect.o rfl 1, p E rceni t. publi: seMce ix iS 0 e , 11 ^ X,lc erXcX 0 ' .jtt 1 90t99 199 193 194 195 9961997199 < 991 1992 1993 1994 1995 1996 1997 1998 .0l00t0 *; i -gf g ourceMinistry of Labor .Buc:Cnrlsk t$0i. 12. The labor market in the DR seems to be working well witt implementation of labor market legislation providing enough flexibility to facilitate needed adjustments. In principle, thae most important aspects of the labor code that could discourage employma ent are e existence of multiple minimum wages and legislation associated with the costs of terminating contracts. In the DR there is a 34 Growth, Education, and the Labor Market multiplicity of minimum wages, which, if binding, could result in market segmentation and enhance unemployment. Similarly, the cost of termination of contracts could be considered onerous, especially if minimum wages were binding. 13. An analysis of the differences between the formal and informal sector indicate that workers are compensated in both sectors according to similar criteria and there is no market segmentation. Minimum wages can lead to distortions and if they depart substantially from the opportunity cost of labor, it gives rise to evasion. The evasion is reflected in the employment of people in the informal sector where regulations are evaded and which would tend to be characterized by poorer conditions of employment and wages. An alternative is that informal sector activities are chosen because of the different characteristics of the labor. In this latter case, the informal sector would not have lower wages. To determine which of these two characterizations best fit the informal sector in the DR an analysis of the rates of return to human capital was carried out both for the formal and informal sectoi5. The results indicate that: (a) base salary levels before considering people's education and experience tend to be higher in the informal sector. That would imply that a person without any education or experience would tend to do better by being employed in the informal sector; and (b) the rates of return to education are not significantly different between both formal and informal sectors, except for people with only primary education where the rate of return to education in the formal sector (7.1 percent) tends to be higher than in the informal sector (5.5 percent). Overall, the estimates of 1997 data would confirm that workers in the informal sector are rewarded in response to similar criteria as those in the formal sector and informal market. (See Annex 4). E. Conclusions * Sustained progress is leading to important structural changes in the composition of the labor force and the demands for labor. The average education of the population is increasing and the labor market is strongly rewarding higher educational attaimnent while the returns to education for those with less than 9 or 10 years of education remains very low. These dynamics will likely be reinforced in the following years. The demand for education will grow in response to the higher returns and aided by the higher family incomes. The returns to education of the less educated population may continue to lag, especially if the strong immigration from Haiti continues and structural reforms, including trade liberalization, are not pursued more forcefully. * The main emerging policy challenges will be to have the largest proportion of the population be a part of this dynamic welfare-enhancing process. That will require making educational opportunities more readily available for the poor, especially those living in rural areas. In some cases, increased supply of educational facilities may be the appropriate response, but one that would need to be complemented from direct subsidies to the demand to encourage all students to reach at least 10 years of education. Serious thought also needs to be given to mechanisms for delivery of services that can rely on the non-public sector and that have already proven to be more efficient in the DR. * For those workers already in the labor force, and especially those with little education, government policies could center on the protection of their employment by avoiding distortions that can discourage employment. Continued prudence in the setting of minimum wages, and the eventual implementation of a modern social security system with strong links between contributions and benefits could be important future steps. 35 Chapter 4 Annex 4 Table 4A.1 Regression Analysis Market Segmentation: Dependent variable salary per hour 1997 Sample All Women Men Constant 2,53 2,92 2,66 (36.5) (22.6) (33.2) Primary Education 0,071 0,047 0,076 (9.6) (3.4) (8.7) Secondary Education 0,083 0,104 0,07 (9.7) (7.0) (6.6) University Education 0,14 0,119 0,148 (16.1) (9.5) (12.3) Interaction Primary- Informal Sector -0,016 -0,014 -0,017 (2.1) (1.0) (1.7) Interaction Secondary-Informal Sector -OjO22 -0,027 -0,023 (1.4) (1.1) (1.2) Interaction University- Informal Sector -0,039 -0,048 -0,022 (1.7) (1.5) (0.6) Experience 0,035 0,02 0,039 (9-1) (2.7) (8.6) Experience2 -0,00032 -0,00063 -0,00028 (2.0) (2.1) (1.4) Gender (men= 1) 0,285 (15.0) Informal Sector 0,0677 0,0077 0,0967 (1.7) (0.1) (1.9) Interaction Education - Experience -0,00012 0,00033 -0,000197 (0.7) (1.0) (0.9) Hours of Work -0,018 -0,216 -0,0163 (25.0) (19.3) (17.5) 0,315 0,404 0,276 N 5434 1674 3759 Note: t-statistics in parenthesis. 36 Growth, Education, and the Labor Market Endnotes I The existing information on real wages is not used because in 1994 there was a significant jump on real wages across sectors that cannot be explained. For that reason we choose to rely on relative differences under the assumption that all sectors were equally affected by the 1994 change in methodology. The industrial sector is used as a numeraire. 2 Alternative estimates of earning equations also indicate that although schooling has a positive effect on earnings, the effect is significant only with nine or more years of schooling. Given the questions on the quality and scarcity of data in the DR, estimates of earning equations were carried out with an alternative data set from the 1992 FEyD Survey. The results show that for the three categories of employment (employee, self-employed, and farm laborer) schooling has a very strong and positive effect on earnings only for those with more than nine years of schooling 3 For South Korea see "Rates of Return to Education" in the International Encyclopedia of Economics of Education, Elsiver, 1995. For Latin America see Psacharopoulos and Ying Chu Ng, "Earnings and Education in Latin America", World Bank, 1992. 4 For Chile, see Sapelli, Claudio, "Ajuste Estructural y Mercado de Trabajo: Una Explicaci6n de la Persistencia del Desempleo en Chile: 1975-1980", Estudios de Economia, December 1990. For Argentina, see Pessino, op. cit. 5 The Central Bank assigns almost 45% of the employed labor force in the DR to that sector. Their definition, which is the one used in this analysis, includes all workers employed in enterprises with fewer than five workers regardless of occupation except for professionals, people in management and administrative capacities, and office employees. 37 5. FINANCIAL SECTOR DEEPENING AND THE BANKING SECTOR A. Financial Sector Overview 1. Financial deepening is important for economic growth. There is ample literature stressing the linkages between financial deepening and economic growth. This linkage may take place through increased savings and investment, or, as importantly, by increasing the economy's total factor productivity growth through the improved allocation of resources to the areas of highest return. Within a process of economic reforms, such as the one that has gradually been taking place in the DR, the existence of a well-functioning banking system becomes even more critical to facilitate the efficient reallocation of resources across sectors. 2. In the DR macroeconomic stability and growth have yielded a steady increase in financial sector deepening. But deepening is still low compared to other Latin American countries, and is particularly low by world standards. Notwithstanding the progress of the last few years, financial deepening in the DR continues to be low when compared with other countries in the region DR and LAC, 1990-98 and the world. In 1997 the ratio of quasi 359 money to GDP (M3-M1) was 16 percent compared to an average of 28 percent in LAG, 30% close to 60 percent in the OECD countries, 25% and more than 130 percent in other niewly- industrialized Asian economies. The ratio of2 04 M2 to GDP that had declined from about 25 percent of GDP in 1975 to less than 17 percent15 of GDP in 1985 has been steadily increasing 10% l to 29 percent of GDP in 1998. By the same token, there has been an equally significant 5% l increase in credit, especially credit to the 1990 1991 1992 1993 1994 1995 1996 1997 private sector which accounts for more than 80 percent of total credit. Figure 5.2 Financial deepening DR, 1970-98 100% 3 . The lack of financial depth has been 90% accompanied by limited financial 80% instruments, absence of capital markets 70% development, and institutional weaknesses 60% that create difficult creditor-debtor relations. In the DR, as in the rest of Latin America financial deepening has been 40%1 hampered by deep institutional weaknesses 30% such as poorly defined and enforced property20 rights, and a legal system, including the 10% judiciary, that encourages difficult creditor- 0% debtor relations. As a result, risk increases 1970 1980 1990 1992 1994 1996 1998 and market depth is leading, for example, to a situation in which large segments of the population have not found easy access to formal credit markets. In addition to these institutional issues, past macroeconomic instability, interest rate controls, and the government's repudiation of its domestic debt also hindered sector development. Today, the financial sector still operates mostly on short-term instruments and in the absence of government securities the Central Bank's Certificados de Participacion 38 Financial Sector Deepening and the Banking Sector (CPs) are the main vehicle to manage liquidity. Cognizant of these deficiencies and to promote financial sector deepening, a new Capital Markets Law was sent for Congressional approval in October 1998, but the law has yet to be approved. B. Banking Sector Structure and Performance 4. The financial sector in the DR is dominated by commercial banks, among which foreign banks have a small presence. In 1998, 14 Commercial banks accounted for about 74 percent of total assets and loans. The banking sector is dominated by domestic banks and the government's Banco de Reservas is the country's second largest bank, with more than 22 percent of total assets of the banking system. All domestic banks have close ownership and their shares are not publicly traded. Unlike other countries in the region, the presence of foreign banks in the Dominican Republic is limited, although it is expected to increase (see Box 5.2). Table 5.1 Financial sector structure, 1998 Banking Sector No. Assets Loans Deposits Millions of millions of millions of ______ __ RD$ sector share D$ sector share RD$ sector share Government 1 19,964 22.7 9,752 22.4 8,914 25.8 Domestic-large 5 50,351 57.2 24,607 56.6 16,763 48.6 Domestic-small 6 11,043 12.6 5,509 12.7 6,479 18.8 Foreign 2 6,593 7.5 3,599 8.3 2,333 6.8 Other Financial Assets Loans Deposits Institutions Development Banks 14 3,669 2,657 Savings and Loans 19 19,427 12,048 Financieros 120 4,639 2,677 Source: Superintendency of Banks. 5. The banking system has been experiencing a strong growth, bringing with it new risks associated to the rapid credit expansion and changes in the composition of the bank's liabilities. Between 1994 and 1998 the average annual rate of growth of assets and liabilities was roughly 24 percent, including a very strong growth in credit of 38 percent in 1997. Ample international experience indicates that very rapid growth in credit, especially such as the one that took place in 1997, can often bring greater credit risks as banks' increase their client base making it more likely that riskier customers will be served by the system. New risks have also been brought by the growing reliance on foreign lines of credit as the rate of growth in credit amply surpassed that of domestic deposits. The significant growth in foreign exchange liabilities, both from depositors and foreign banks' lines of credit point to heightened foreign exchange risks, particularly as there is little information available on the banks' activities in currency hedging via the use of derivative products. 39 Chapter 5 Table 5.2 Banking system assets and liabilities (million RD$ Pesos), 1994-1999 1994 1995 1996 1997 1998 June 1999 LIABILITIES 33,477.76 40,095.27 50,067.05 65,880.29 80,017.40 89,491.05 Rate of Growth (%) 19.77 24.87 31.58 21.46 11.84 As % of GDP 24.34 24.71 27.28 30.63 33.18 35.00 Deposits (short & long term) 16,723.60 19,821.87 24,976.56 31,066.41 34,140.07 37,696.59 Rate of Growth (%) 18.53 26.01 24.38 9.89 10.42 As % of GDP 12.16 12.21 13.61 14.45 14.15 14.74 Foreign Exchange Deposits 207.52 445.58 1,109.62 2,779.87 6,075.18 7,717.44 Rate of Growth (%) 114.72 149.03 150.52 118.54 27.03 As % of GDP 0.15 0.27 0.60 1.29 2.52 3.02 Foreign Exchange Financing 235.15 596.57 1,312.89 2,579.30 5,093.37 5,066.37 Rate of Growth (%) 153.70 120.07 96.46 97.47 -0.53 As % of GDP 0.17 0.37 0.72 1.20 2.11 1.98 ASSETS 37,143.99 44,251.82 54,878.68 72,104.36 88,047.87 97,983.90 Rate of Growth (%) 19.14 24.01 31.39 22.11 11.28 As % of GDP 27.00 27.27 29.90 33.53 36.51 38.33 Credit in Local Currency 18,181.31 22,251.93 27,034.79 37,431.01 43,534.89 45,461.58 Rate of Growth (%) 22.39 21.49 38.45 16.31 4.43 As % of GDP 13.22 13.71 14.73 17.40 18.05 17.78 Credit in Foreign Currency 320.24 526.70 1,508.51 3,412.29 7,243.46 9,594.74 Rate of Growth (%) 64.47 186.41 126.20 112.28 32.46 As % of GDP 0.23 0.32 0.82 1.59 3.00 3.75 Source: Superintendency of Banks. 6. There are also new risks tied to macroeconomic management, particularly the role of monetary policy to accommodate increased government expenditures. As discussed in Chapter 2, monetary policy during the last two years has been to accommodate volatile public expenditures through a combination of instruments that included, increases in the interest rate paid on the Certificados de Participacion and, at least as important, taxing the banking system through measures such as the unanticipated freeze of excess reserves, and establishing limits to credit to the private sector. These measures have led to: (a) A rise in real interest rates and the spread. During the last twelve months the average real interest rate on loans has exceeded 20 percent affecting debtor's ability to pay and increasing the risk for the banking system. (b) A substitution towards dollar denominated transactions. Policy volatility has encouraged the banking sector to rely on dollar liabilities. Until October of 1999, dollar deposits were not subjected to reserve requirements (up to a limit of three times the capital of the Bank), while domestic currency deposits are subject to a 20 percent reserve requirement and excess reserves are also subject to unanticipated freezes. This could explain the increase in exposure to foreign exchange liabilities, which at the end of 1998 averaged nearly 200 percent of outstanding equity and reserves, and had more than doubled since 1995. To address this situation, the monetary authorities recently imposed a 10 percent reserve requirement on foreign exchange deposits. (c) A dangerous incentive to move financial intermediation outside the banking system to avoid Central Bank controls. This is not a trivial problem, considering that already there were significant concerns 40 Financial Sector Deepening and the Banking Sector for the lack of consolidated accounting with the bank's offshore activities. Further increases in financial intermediation outside the purview of the monetary authorities and outside the Bank Superintendency controls enhance the system's risks and cast further doubt over the accuracy of the industry's performance indicators. 7. But while the economy continues to perform well and the Figure 5.3 Quarterly real interest rates and spread (%) rate of growth of deposits continues 25% to be high, increased risks are unlikely to surface. As long as the rate 20% of growth of deposits is higher than the deposit interest rate --which has been 15% fluctuating between 10 and 15 percent in the last five years-- there will 10% continue to be a net transfer of resources to the banks from depositors. 5, Banks can then easily remain liquid even if they roll over their loans 0% ~: ~ (including unpaid interests) and make '95 '95 '95 '95 '96 '96 '96 '96 '97 '97 '97 '97 '98 '98 '98 '98 '99 '99 little or no returns on assets. The key Source: World Bank estimates based on Central Bank data test, however, takes place if the rate of growth of the bank deposits (including foreign exchange lines of credit) is lower than the deposit interest rate. Banks then face the need to make a net transfer of funds to depositors, which requires transferring resources from their borrowers or running down their stock of liquidity. Despite indications that such an occurrence was possible, given the sharp decrease in Peso denominated deposits in 1998 the market assessment of these risks seems to be low. Thompson's Bank-Watch Rating System recently gave four Dominican Banks their best short-term debt rating LC 1 (local currency risk 1 . 8. The challenge facing the DR is to continue to take measures that can strengthen sector development while in a period of strong economic growth. In recent years the regulatory authorities have made very important efforts to establish prudential norms and to strengthen supervision. The measures that continue to be taken in these areas are very positive. These measures by themselves, however, are unlikely to yield strong sector development and financial deepening. They would need to be complemented by actions in the areas of: (a) macroeconomic management, including the development of a long term liquid market for treasury instruments and avoidance of discretionary measures discussed in para. 6; (b) improvements in the legal framework and the administration of justice in relation to creditor- debtor relations; and (c) market regulation through improved disclosure and the entry of foreign banks. C Addressing Sector Risks through Regulation and Supervision 9. Continued improvements in regulations and supervision are needed to conform to international best practices. The regulatory authorities are very aware of this need and are taking measures in that direction. A minimum capital requirement of 9 percent of risk-weighted assets was established in 1992, and was raised to 10 percent in 1998. This is a single measure of capital, which includes common and ordinary shares, legal and other reserves, retained and current earnings, and real estate value changes. There is, however, no distinction between Tier I and Tier II capital, as per the Basle rules standards. While the level of the solvency ratio is adequate, the actual weighting of assets is still less stringent than in other countries in the region. Consideration could be given to raising the weights and clarifying the definition of capital in accordance with the new Capital Accord now in progress. 41 Chapter 5 10. Important advances have taken place regarding risk grading and provisioning norms, but problem debt classification and provision requirements are still short of best practice. Both the classification of non-performing loans and the provision requirements associated with them are still less stringent when compared to best practice in other countries. For example, in Argentina or Chile, consumer loans with payments overdue over 90 days are classified as non-performing and require provisions of 25 percent (Argentina) or 60 percent (Chile). Similarly, Colombia and Peru also classify consumer loans as non-performing after 90 days of payment arrears requiring provisions of 50 and 60 percent respectively. By contrast, the DR only requires a 20 percent provisioning for consumer loans with overdue payments between 90 and 120 days. The same arguments apply for mortgage and commercial loans. The regulatory authorities are currently preparing a program of new prudential norms that will likely be implemented in year 2000. Such a program is expected to bring the regulations in the DR closer to international best practice. While more stringent classifications are adopted, it could also be important to move the classification process towards aforward-looking assessment of capacity to pay. Table 5.3 Days with overdue payment to classify as non-performing loans Consumer Mortgage Commercial Argentina 90 90 90 Brazil 60 360 60 Chile 90 90 90 Colombia 90 120 120 Mexico 60/90 180 30 Peru 90 90 15 DR (category C2) 120) 180 Subjective Source: World Bank fEom several sources. Table 5.4 Minimum provision when marked as non-performing loans (%) Consumer Mortgage Commercial Argentina 25 12 25 Brazil 100 100 100 Chile 60 10 Subjective Colombia 50 20 20 Mexico 45 35 45 Peru 60 50 50 DR 40 20 Subjective Source: World Bank from several sources. 11. Bank reporting requirements and supervision capacities are in the process of being strengthened. Current mandatory information and frequency of reports still lag behind other countries in the region. Income statements, for example, are reported on a quarterly basis where best practice in Latin America is to present this information at least on a monthly basis (Argentina requires daily reports). Moreover, the information does not include the data needed to determine the value of risk-weighted assets, such as a breakdown of the asset portfolio of the banks to determine the adequacy of capital and perform independent (by outsiders) assessments of solvency. Supervision on the information provided by the banks takes place with twice a year on-site inspections, but it is not clear how adequate this auditing is. More off-site use could also take place to help establish a warning system for crisis prevention. The regulatory authorities are now working to improve the information systems and are expecting to implement new regulations in the year 2000. Important areas for inclusion in this program are: (a) information on assets and liabilities not only by clients but also by groups of clients/companies which will require the establishment of "consolidated accounts" by groups; (b) breakdowns of assets and liabilities by maturity, currency, industry sector and by geographical area to enable the risk concentration to be identified, monitored and controlled; (c) credit facilities showing total facilities granted, by customer and 42 Financial Sector Deepening and the Banking Sector group; (d) a list of all exposures to guarantors to facilitate their assessment of credit risk; (e) margin variation reports on standard interest rates of both banking assets and liabilities. Box 54 BainkIg Sector Pedormanc Idicatom In the last four ys the Industry capt asse ratio has avraged about 9 percnt exceeding th Basl prudential norms. Howeer, lak of detailed information precdude estimates Of the Tatiof capt to.rsk-Welgted assets. Since acording to the DRFs regulatons the maximum weight is 100 perwent (see Table 5,4), the riskweghted ratio w be higher than the gross number of about 9 percert, probably very cose to the 10 percent stipulated by DR's ruatons. Thecost approxirmatioa could be made to isk-wuhted capi would exclude liqu asses (weight of zero). This ltion - yds a capial assetatio of 15.6 pernt for the indust"y In fte ORt how , fiancal ihstitutions do not wrry sodated accountng wit, for example, their off-shore iotities. The experience in other counies has show that this someftme may teswkTdo*dresslrngan1ddoUbiekntnof capitak There been a signiftrc in registered ntn-ffomu loans, which are now repored at low l1els, T-ihe ndu-sk0didnorin falng blans to total loans ratio has derased from 3.6 percent in 1995 to 2.1 percet in 199 Howeer, t must be taken ino accnt that the defnition f nonfrmi i ian in Other counties (see Table 5.3) and under-eportng may also be a poblem since povisioning cannot he deducted as an expense encouraging under-rpoting. Economic rturms have been dscining, but sl remain high. Barks remain highly liuid. The return -on equity fe from i percent in 1997 to 30.6 percent in 199 and that of assts from nearly 2 percent In 197 to LI percnt in 1998. The dedQne in proitbility: Is consistent with the inces in te shae of liquid assets in the bak blance shets and the increase fn:the cost of funds because of the decline in the rate of grow of deposis. The cot of funds measued as the ratio -of iest expense o tal is a t p on 1998 f 7 perent in 1996 and 7.8 percent In . The Industry-wide lvel of liquidi is well abve tat reqtired by the regulaton (20 perce Tota iquid assets to toal deposits was 34.6 percent in 1998, down from neaty 40 perentin 1995 but hiethan In both I99and 1959W AeaeIndusftr financial ratio ( I,19-98___ E E 9^2 81 5 8S ~~~~~~~~~~~~~D16-7 Dec-Os CapitalAsets 92 tO0 8.8 9.1 Foreign ceny liabiitescapitaland e ps 82.9 136. 188. 193. :onperforg loans total loans - -386 2.f- 2.1 2.1 Provisions Ionerming loan 85.8 100. 143. Operatio expenses/tot icme 386 39.6 42 38.6 .fiai I peronn expen dil1 187 195. 191. 204 Return on equity (before Wes and resenm 31.8 34.9 34.5 30. Return ot assets 1.8 1. 2 1.1 Liquid assets deposils 397 30. 31. 346 l.nterest expenseJdepsi - 9.3 7.8 7.1 9S. D. Addressing Sector Risks through Disclosure and Competition 12. Supervision needs to be complemented with market incentives for self-regulation through means such as enhanced public disclosure. It is widely recognised among policy makers that banking supervision alone does not prevent bank failures. Evidence does show however, that modem public disclosure regulation on banks' quarterly, semi-annually and annual results and other important information, is a powerful tool to encourage market-enforced discipline. The DR could benefit from regulations that promote market transparency through greater public disclosure requirements for banks 43 Chapter 5 such as the publication of monthly income statements of all financial institutions. At the same time, the DR could also consider establishing heavy penalties including personal liability on managers and the Board of Directors that produce false or misleading statements. Such regulations could encourage bank management to adopt and maintain prudent risk positions as a result of increased general public awareness of the bank's risks and performance. 13. Increased entry of foreign banks could also help reduce sector risks in the long run. The banking system could benefit significantly from a stronger presence of foreign banks as it has been taking place in other countries of the region. Increased foreign bank participation would enhance competition, and would provide important transfers of organization, technology, and managerial capacities. They can also provide an inexpensive way to train the sector labor force which is characterized by its mobility. Finally, the presence of foreign banks could significantly help in dealing with risks and assisting the regulatory role of the Superintendency. Their accordance with international accounting standards, and use of consolidated statements of off-shore facilities would set new standards for the industry that would eventually lead other banks to follow suit and thus encourage self-regulation that would complement and facilitate the role of the supervision authorities. E. Remedying Bank Problems and Exit Strategy 14. In thee absence of an adequate Monetary and Financial Code, the current legislation is not sufficient to address bank problem issues. Presently the authorities have limited guidance and resources to control a financial probler.h and existing regulations on bank failures refer only to cases of capital adequacy shortfalls3. This is a very important area for which intesa ational best practices are still to be developed. In the meantime, it would .e abeneficial for the authorities to always have in their possession the "formally executed documents" establishing the terms and conditions under which banks will have access to the lender of last resort facility. The Central Bank could also, to the fullest extent possible, have in its possession the collateral necessary for discount window borrowings. In addition, it would be very beneficial that an institution, other than the Central Bank be given the authority and responsibility to liquidate failed banks or encourage mergers. 44 Financial Sector Deepening and the Banking Sector 15. The establishment of a deposit insurance scheme to protect small depositors could prove beneficial over the current implicit insurance system, but needs to be established within an overall exit strategy. Until now, the Central Bank has bailed out depositors from failing institutions and it is likely that there is a market perception that the government will continue to do so in order to protect depositors. This results in a moral hazard problem and establishment of a formal Deposit Insurance Scheme (DIS) could be preferable. The authorities could promote a DIS with a suitable limit or cap on the level of individual deposit-coverage. The most common elements of a well-functioning DIS could include: (i) a cap or limit on individual deposit-coverage; (ii) a scheme financed by the DR's financial sector in the same way that the industry is now financing the SPI; (iii) an initial capitalisation that comes from a governmental source. However, development of a DIS should not take place in a vacuum, but instead within an overall legal and policy framework dealing with an exit strategy for problem banks. F. Corporate Governance, the Legal Framework, and Financial Deepening 16. The legal environment where terms and conditions of contracts are observed, and where legal recourse, including taking possession of collateral is possible without undue delay is not strong. Anecdotal evidence through discussions with lawyers and banks indicate that a credit dispute takes on average two to three years to be resolved by the courts and that court decisions are highly volatile and non-transparent. If the court decision could allow for a transfer of land as collateral to the banks, the Land Registry Office might also take a long time to certify the transfer because of the poor working conditions and the alleged prevalence of petty corruption. Absence of suitable collateral also discourages access to credit and financial deepening. The 1992 FEyD Income and Expenditure Survey, indicates that the fraction of land owned and titled was less than 45 percent at the national level, with slightly over 50 percent in urban areas. By the same token, adequate registry systems for movable assets are also lacking. Addressing these issues is critical for the sound development of financial systems, and for development in general. Additional research and work in this area is clearly needed and could be the subject of upcoming Bank ESW on the workings of the judicial system. 17. At every level, improved corporate governance is also needed. Corporate governance in the DR remains weak. Accounting practices by businesses including the banks are not consistent or fully reliable. This is part of a long standing corporate culture, facilitated by the closed economy and the concentration of wealth. In this type of environment, where family business prevails, and the scope of transactions and the number of important players in the market is limited, personal relations and direct knowledge provide enough information for markets to work--albeit not too efficiently. The country, however has already changed too much, and will continue to so, for this type of arrangement to be effective. Improved governance is now critical and reliable use of accounting for enterprises and banks would be an important and needed structural reform. Its adoption, which could be encouraged through the improved supervision of the tax system, will help improve financial deepening. G. Conclusions * During the 1980s and the early 1990s, the prevalence of new, less experienced domestic banks, weak supervision and regulations, and a difficult macroeconomic environment, led to recurrent banking problems. Since then, economic growth and macroeconomic stability have led to some increased financial deepening, but financial sector development remains low as critical sector legislation such as the passage of the Monetary and Financial Code or the Capital Markets Law continue to await Congressional approval. * Despite the efforts to improve sector regulations and supervision, the increase in financial deepening, reflected primarily in a strong increase in credit, has been accompanied by new risks. Part of these risks are inherent to fast sector growth as new, possibly riskier, clients are being served. But other 45 Chapter 5 very important risks are linked to macroeconomic management issues. Monetary policies to accommodate increased government expenditures through a crowding-out of private expenditures have exerted a cost: high real interest rates, reduced bank profitability, higher exposure to exchange rate risk, and disintermediation in the fortnal banking system. The rapid expansion of credit in an environment of high real interest rates and still insufficiently strong supervision is a source of concern. * Addressing sector risks remains a critical issue, one of which the authorities are keenly aware. To that end, improved macroeconomic management (discussed in Chapter 2), and continued government efforts to promote market self-regulation through public disclosure and strengthened prudential regulations are critical. Endnotes I This rating is also influenced by the likelihood that the government would intervene to support creditors if a problem were to arise. The record in the DR shows that the Government will indeed take such actions if needed. 2 The last such problem occurred in March 1996, Banco de Comercio Dominicano suffered a liquidity short-fall despite its apparently strong capital adequacy ratio. The bank represented at that time, 14 per cent of the DR's total banking assets and almost 17 per cent of its deposits. The CB had to put in place mechanisms to avoid a run-on-deposits, including injecting liquidity, authorising a US$300 million sale of loans classified as "A" to the Central Bank, granting guarantees to retail depositors, and finally the Central Bank had to buy the majority of the bank's equity capital to acquire the bank's total control to be able to manage the situation. The total cost for the taxpayer was about 1 per cent of the country's GDP. 3 .When the solvency ratio falls below the required 10 percent, the regulations call to avoid further lending; transfer to the Central Bank any deposit increase, avoid dividend payments, and stop usage of stop any credit facility from the Central Bank. When a bank's capital adequacy falls below 6 per cent the head of the Superintendency of Banks can appoint a Deputy with sufficient powers for up to 90 days "to correct the situation". If the capital of the bank falls below 4 per cent and the situation is not regularised in 10 days, the Monetary Board can take over the failing bank in order to liquidate it. 46 6. PUBLIC EXPENDITURE POLICIES FOR POVERTY REDUCTION A. Poverty Reduction and the Role of the State 1. The state can play an important role in achieving poverty reduction. There are, however, lingering questions on whether the Dominican state has the organizational capacity and the resources to undertake a strong poverty reduction strategy. The analysis of the previous sections clearly indicate that the state can play an important role for poverty reduction. In addition to the policy actions needed to make current high growth rates sustainable, some of the most critical issues are related to the need to increase the educational attainment of the poor beyond primary education, improve the productivity in agriculture where the majority of the extreme poor derive a large part of their income, and establish the minimum basic safety nets, especially for children at risk. However, three broad issues need to be addressed to facilitate the implementation of a poverty reduction strategy: (i) the size of the state; (ii) the allocation of the resources managed by the state; and (iii) the effectiveness of public expenditures. 2. Measured by either the ratio of revenues to GDP or central government expenditures to GDP the Dominican state has remained among the smallest in the region. This holds true even when taking into account the non-financial autonomous agencies of the public sector. In 1997, the total revenues (net of central government transfers) of these agencies were about 6 percent of GDP with the recently privatized State Electricity Company accounting for half of them. The question that emerges is whether the DR can increase public expenditures to the social areas and maintain a strong public investment program within the existing budget envelope. 3. Notwithstanding the low revenue to GDP ratio, the country's low debt service requirements and the limited demands on budget resources for social security imply that the country's resource envelope to pursue a poverty reduction strategy is similar to the regional average. While the ratio of revenues or central government expenditures to GDP in the DR are among the lowest in the region, the availability of resources for poverty reduction also depends on the other obligations of the state. In this respect, the DR has the salient characteristic that resources needed to finance the social security system are still very low, and that debt service requirements are very low. Net of those two categories of expenditures the resource availability in the DR is similar to that of countries with much higher ratios of tax revenues over GDP. Table 6.1 DR and Latin America: Size of the state and provision of basic public goods Expenditure/ GDP Expenditure*/GDP Education/ Health/ Public Security/ EpdteDPteie*DExpenditure* Expenditure Expenditure Bolivia (97) 29.3 21.2 27.8 5.2 9.0 Colombia (93) 27.2 21.2 22.6 22.2 11.3 Brazil (94) 47.3 21.0 23.8 19.5 8.1 Costa Rica (96) 30.6 18.2 28.0 37.4 11.0 Panama (96) 27.8 18.1 26.0 31.5 4.4 Chile (97) 22.6 15.3 24.8 17.0 7.8 Dom. Republic (97) 16.1 14.5 15.0 12.9 4.8 Argentina (96) 23.7 13.8 25.4 13.0 9.4 Mexico (96) 19.6 13.5 32.6 8.1 1.5 Uruguay (97) 31.7 11.0 20.9 17.3 9.1 Paraguay (93) 12.3 10.1 28.7 9.9 7.9 El Salvador (97) 13.0 10.1 23.8 12.9 19.8 Source: World Bank estimates based on Government Finance Statistics Yearbook, 1998, IMF. Expenditure* defined as total expenditure minus expenditure for social security and interest on debt service. 47 Chapter 6 4. While the resource envelope for poverty reduction is similar to the average of the region, there is a marked difference in the way resources are allocated in the DR. A reorientation of expenditures could allow the DR to increase social expenditures. The DR stands out from other countries by destining significantly lower resources to, for examnple, education, health, and public security. At the same time, it consistently devotes more public resources than other countries to areas such as energy, communications, mining, petroleum, manufacturing, and construction (see Figure 6.1). If expenditures for education in the DR were closer to the region's averages (26 percent of adjusted expenditures, instead of 15 percent) the public education budget could increase by 50 percent to 3.8 percent of GDP, in line with the region's average. This would indicate that it is possible to engage more actively in a poverty reduction strategy before expanding the tax base. However, a very aggressive education program, for example, would require resources in excess of 5 percent of GDP, testing the ability of the state to pursue such a program within the current budget envelope. Figure 6.1 DR and LAC: Public Expenditures by Sectors (as % of GDP) Health Agriculture 8 1.4 7 1.2 5.7 1.2 6 1.0 5 4. 4. 0.9 0.8 0. 07 4 0.8 .7 0 3 2.60.0. 2111 1 1 1 119 1.8 1.6 1.5 1 3 104 0.4 2 1.3 1.1 1.1 1.0 0.9 11,3~~~~~~~~~~~~~~~~~~~0. 0.3 01.2 0.3 o 0.2 i '? e e 0~~~7 z 000 0 4r x o 4K>v0 e, elo °o, /,,,FJ0 ' Non-agriculture productive activities: energy, Education petroleum, mining, manufacturing, 7 3 construction 5.9 6 505048472.0 . 3.8 ~~~~~~~~2 4 3.5 0.5~~~~~~. 0.0 0.3 0.2 0.3 010.1 0.1 O ,2 0.0 0.0 0. (.9 'ZO 48 Public Expenditure Policies for Poverty Reduction 5. The improved allocation of resources across and within sectors could be considered a priority. But even if that were to take place, a strong poverty reduction strategy will eventually also need an increase in overall government resources. The maintenance of a small state has had positive implications. It has allowed for low taxation, a light debt burden, and has made episodes of macroeconomic instability the exception rather than the rule. In fact, broad indicators of poverty, educational attainment, and health show that outcomes tend in general to be better than what public expenditures would predict. This would indicate that for many cases, the shared responsibility between private individuals and the state in financing education or health has been positive and the key challenge is not to crowd-out private expenditures but to make public expenditures more efficient and better targeted. However, a more ambitious poverty reduction strategy will require additional resources, especially because it is not realistic to expect that the reallocation of expenditures from miss-directed government activities can be done swiftly. In the meantime and while those reallocations take place, it may be necessary to increase tax revenues to support the implementation of basic programs for education, especially at the secondary level, and safety net programs. 6. The increase in government resources through increased taxation should, however, take place only within the context of a modernization of the state. Despite recent efforts, the Dominican state still lacks the capacity to measure the effectiveness of its own interventions, and in all likelihood the current efficiency of government expenditures is low. Lack of information systems, inadequate systems of checks and balances regarding government expenditures, an excessively centralized process of resource allocation and administration, and outmoded procurement practices continue to plague the public sector. In this context, it would only be advisable to increase the size of the state if at the same time strong efforts were undertaken to improve implementation capacities. While there are many on-going efforts in this area, and some success (Box. 6.1), there is still ample room to improve the implementation of these initiatives. Table 6.2 Social sector expenditures and the size of the state (%), 1980-1998 1980-85 1986-90 1991-96 1997 1998 Public Expenditures/GDP 13.9 14.9 14.4 16.1 16.2 Current Expenditures/GDP 10.1 7.7 6.8 10.6 11.1 Capital Expenditures/GDP 3.8 7.2 7.6 5.5 5.1 Social Sector Expenditures/GDP 5.1 5.7 5.6 6.2 6.3 Education/GDP 2.0 1.5 1.6 2.2 2.5 Health/GDP 1.1 1.1 1.2 1.4 1.5 Housing/GDP 0.1 1.1 0.7 0.3 0.3 Sanitation/GDP 0.2 0.6 1.2 0.6 0.5 Source: Estimates based on ONAPRES data 49 Chapter 6 Box 84 Public Expenditures, Input vs. Output Indoatore, and the Modernization of theState Much of the ongoing debate on the allocation of public expenditures revolves around the sizeof the state and allocations between socisIsecto, productiveactivities, and capital ormationAiowever, still largely missing in the cusslon are issues reiSted to the effectiveness of government expenditures. Developing the capacity to analyze the relation between expenditures and outcomes could be an important component of the pending agenda fbt the mod rnizalion of state institutions. It is very likely that efflcieny of government spending is quite low based on the following stylized factsz Information systems. In the last two years the National Plannng Oflice (ONAPLAN) has been working towards the establishment of a Poverty map base on the 1993 census, and has undertaken tie role of entrelizing information on government social programs to Improve coordination. Still lacking however; is the development of a swveybased information system to help larget government expenditures, assess the impact of government ,rngrams 4 monitor poverty. Information of on..going social programs remains unavailable for lack f inforniation sy$erns on the public invest program. The Government is worldng with'IDB assistance In the development of such a program but it has yet to be implemented. Government programs remain Mgbly centrsIized Until very recently roughly 50 percent of the budget was executed by the Presidnoy and tranefers to losbt governments accounted for about 25 percent of total govrnment expenditures or less than 05 percent of GDf. While in the lest two years transfers to local governments have increased4o 4percentof GLP and the Presldency execution of the budget has been drasticlly redubed a strategy to devolve responibllities to communities and local governments in the provleion of some srv*ces is yet to be developed. The current decentralization effort of public healt$ services is a promIsing initiative that needs to be encouraged and, if successful, extended to other areas. Central government procurentent continues to be carried ont largely through direct contracting practices. This encurages re3t.siel1ng activttie and very po ily reduce the purchasing power of state expend-itures. The Goverhment Asubmiie a new Procurement Law 40 Con-gres 4&i$ich would limit its ability to rely on direct cpntractig practices but would not eliminate it The Government is working with the Bank on  rocureme-t Assessment Review, whose-outcome could help define a strategy for irnpIernenttion of reforms. - Resources are watered-4own and accountability lost because of the-roliferatlon of state Institutions. In additIon to the Central Government's 14 Mnistrles-, there are 44 government autonomous agencies. including6in the financial sector. There are also several ad-hoc Convnissions institutions leads which operate-almost with Ministerial ran The - large number of -Ing leveL to an - atomization of their actsvities, pron,tes over-employment in-the public sector-, and limits accountability for results. This becomes even more evident when considering the large amount of resources handled by the Presidency. While resource-$ handled-by tl4e Pre-sidency have been decreasing, still lacklngts a -- - strategy to start consolidating public institutions as a means to reduce public employment and improve accountability and fflciency-it is unlikely that this issue, however, will be addressed before the year 2000 presidential elec-tions. A bright area in the modernizatlen of the state has been tax administra-Uon The Government has made significant improvements towards tax administration, especially on collections of the value added tax, Continued improvements are very lilely as well. 50 Public Expenditure Policies for Poverty Reduction B. Public Expenditures for Education 7. One of the most important elements to reduce poverty and increase equity is to continue to increase the educational attainment of the poor to at least more than eight years of education. As pointed out in Chapter 4, the economic rate of return to primary education has remained low during the 1990s and attendance of primary schools is really only a good investment in so much as it is a needed step to move into secondary education.' In the absence of credit markets that can support poor students to continue their education into secondary schools, education policy could pay special attention to lowering the private costs of the poor to attend schools beyond primary education. 8. The development of targeted programs to increase the educational attainment of the poor is needed. These programs could possibly rely on subsidies to the demand. In the DR there is already evidence that private schools can provide secondary education in a more effective manner that is both lower in cost and with higher educational achievement. By the same token, the very low coverage of secondary education, especially in rural areas, indicates that a policy for increased educational attainment of the poor would require that poor children complete primary education in a more timely manner and also would require a significant expansion of the network of secondary schools. The future government strategy could very well be based on targeted subsidies to the demand for schooling, with resources following the students to either private or public schools. In this context, the subsidy could be greater for poorer students, whose schools, in turn, would seek the means to attract them (e.g. via provision of food and transportation), by addressing in a decentralized manner the constraints preventing their attendance to school. 9. Development of education programs targeted to the poor will require additional resources, some of which could come from reallocations within the sector. Not only are sector expenditures low, but non-core programs and administrative overheads consume a large part of the already small budget, watering-down the limited resources to the sector. For example, while between 1995 and 1997 the nominal increase in public expenditures for education was a high 58 percent, the fastest growing expenditure categories were overhead administrative costs, and transfers to the university system which grew by more than 200 percent in this two year period. At the same time, the growth in resources directed to secondary education was 60 percent, and for primary education only 33 percent. Table 6.3 Distribution of Ministry of Education budget (%), 1990-1997 1990-94 1995 1996 1997 1998 Administration 11.5 12.1 12.2 18.1 13.6 Primary Education 48.5 54.5 50.3 47.2 49.2 Secondary Education 10.5 9.9 9.4 10.2 8.7 University 10.4 7.1 11.6 11.2 21.6 Adult Education 3.4 3.4 3.3 3.0 2.8 Other 15.7 13 13.2 10.3 4.1 Source: ONAPRES 10. Improved targeting can also provide resources to help finance programs for the poor. Incidence of expenditure analysis (Table 6.6) indicate that current education expenditures do benefit the poor largely as a result of self-selection since students from higher income families tend to attend private schools. In 1995-96, the latter accounted for about 20 percent of all primary education students and 30 percent of secondary education students. Similarly, self- 51 Chapter 6 selection makes public expenditures in university education regressive, with almost 40 percent of the total benefits going to the students that belong to the top 20 percent of the population in income. The distribution of benefits of education to the poor is limited by the low coverage of secondary education and the relatively large expenditures for university education. C Public Expenditures forAgriculture and Rural Development 11 s The lack of dynamism of agriculture deters the ability to achieve poverty reduction and enhances social risks. These come through the evolution of a dual society where poor rural inhabitants, without enough skills to migrate, remain very poor and do not share on the benerits of development. While poverty and especially extreme poverty is concentrated in rural areas, agriculture remains the main economic activity for the rural poor. In 1992, almost two thirds of the poorest 20 percent of rural household heads (all living in extreme poverty) classified agriculture as their main economic activity (33 percent agriculture producer, and 30 percent farm labor). By the same doth t he lack of significance of higher education levels (beyond ninth grade) in contributing to increased income in rural areas (Table 1.6) indicates that the rural sector cannot support human capital intensive activities, and this leads to a migration of the most educated. Without increases in the productivity of rural activities only the less educated and less able will remain. This helps to create entrenched poverty and a dual society. This process is already taking place, and is particularly evident in the border areas with Haiti. 11 o Increasing agriculture productivity is therefore an important objective. The state already spends significant resources to promote agriculture, but policies and public expenditures are misdirected. When compared to other countries in the region (Fig.6.1), the DR stands out by the significant public resources it allocates to agriculture. In 1997, public sector expenditures accounted for roughly t percent of GDP, while at the same time the revenues of the 52 Public Expenditure Policies for Poverty Reduction non-financial autonomous agencies led by CEA accounted for another 0.7 percent of GDP. Total public sector spending on agriculture at 1.7 percent of GDP has been larger, for example, than for the health sector2. Unfortunately, current public expenditures in agriculture are likely to be very unproductive and have little impact on improving productivity. One very important development, however, has been the divestment of all 11 CEA sugar mills and associated land to the private sector through a 30-year lease program. This will liberate important fiscal resources that can be directed to other areas, such as a compensation program for farmers eventually affected by trade liberalization (see Box 3.1), and may possibly bring increased dynamism to the decaying sugar industry. -KBox 6.3 Sbbt fstion and A;rlinFe XPoli n .t OR The stte's direct inteetn. airiculturem ta place thru-gh a mywad of Instits. The Secretary Of AgEtufture (SEA) Is Xharged withovetalf W o6 y t Agricut Sank (BARD) channels> credkt to the, s r.efo Pic xwn (IESP} Isinvole in pr support schemes, administig the ip-q of seei prods ii is enaged h marketing and' raiW sales. -e - t* ni Instit ofWter Resources ( manages rigati. Other mpoant uIncude the Natonal AgWoian nstute ( 1t i Instlte for Crdit to Cooperatives the OoZin;can Sugar Couheit, th~ National Cotton lnstitute~ the Natinal Countci for Animal PrOductoon, the : Nationa Foundation for Rural Commisions and Boards are chimed with addressing scfi or issues. Bcausa d the larg r.ie oF nttton an no-ransparent policy .environment there are many ovelappg mde ad contradic ti on or Policies. One exampe oontadtoy polikes s lNESPRE's tole in suporti high: farm prices, we it also implements haIs supposedl or A'' (PR T On the one haIn iNESPRE has become X t )hle to istreth et f pr tugh poeiosm INSPFRE not o dternas the tiin quant:t oey agriture imports su as chkken and rice, but: lso, hs a f t s pici exected by 1ESRE t Fe peohe 1othatsu is often bebseen 30 and 1O pert above intaonalpes. However, at thie same teINE admiiniters the PRATO program in whicre it sells gove ir o p e pres lghtiy-bew sng maket pis. Sin*eprices ire determined atthe mrgin. PROALTO does not play a role in redg mwket prices or in povery alleviation. 12. Expenditures for activities that have strong public good characteristics, and where state intervention can help increase productivity, are negligible. Resources for research, extension, market information, and natural resource management account for less than 10 percent of the budget of the Ministry of Agriculture, or less than the administrative overhead of the central functions of the Ministry. One area that could be of special concern is that state's role in support of research and extension which is almost non existent. The Secretary of Agriculture's budget for research and extension is approximately 0.15 percent of the agriculture GDP and about ten times less than minimum recommended for such activities. Moreover, 99 percent of those resources go to pay salaries severely limiting the effectiveness of expenditures. Under these circumstances, it would not be surprising that productivity remains low, as yields continue to be well below regional and world standards. 13. Insecure property rights and state ownership of the majority of the country's land also hinder productivity. Property rights are muddled and insecure, and land transactions highly involved and opaque. Transferring ownership of state-owned farmland to private hands, including the poor landless rural inhabitants is an important policy whose implementation has started with assistance of the IDB. The state controls 47 percent of the country's farmland while producing 19 percent of its output. State entities manage 22 percent of the land, with IAD being the largest landowner followed by CEA. Moreover, according to data from the 1992 FEyD 53 Chapter 6 survey, only about 40 percent of the land held in private hands is titled. Transferring public land to farmers will require improved administration of land cadasters, the IAD, and the court system. It will also require the revision of legislation that is often contradictory or ambiguous. Law 145 of 1975 prohibits the sale of agrarian reform land without overturning Law 132 of 1967, which appears to assert that right. Law 282 of 1972 calls for IAD to acquire all idle private farm land, while Law 290 of the same year mandates the expropriation by IAD of portions of private lands benefiting from irrigation services. 14. To compensate for the sector's low productivity, the state continues to provide high protection and subsidize inputs for many products. While areas where the role of the state is important are neglected, there are a number of state institutions dedicated to assist farmers through subsided credit, seeds, land preparation, and water. In all cases, these activities are carried out directly by State institutions crowding out the private sector. Not only is there already significant worldwide evidence that this type of assistance has very low returns, but the manner in which it is carried out, also encourages unproductive rent seeking. 15. Ultimately, agriculture development consistent with poverty reduction requires a redefinition of the role of the state, its policies, and its institutions. As it was also discussed in Chapter 3, current agriculture sector policies hurt the poor. The poor farmers that supposedly benefit from current polices are caught in a cycle of dependency of government protection and subsidies, but with little hope of being able to abandon their poverty in this policy environment. The poor at large are hurt because of the inordinately high cost of the food. Changing policies will require very significant changes in the large state apparatus that has been mounted to implement them. D. Safety Nets and Access to Basic Services 16. The Dominican Republic has yet to establish a minimum safety net system for the very poor. The incidence of expenditure analysis indicates that the major beneficiaries from government subsidies are not the poor. The DR still lacks from the information systems that would allow them to identify the population at higher risk, inventory the myriad of programs that supposedly are for poverty alleviation, and measure their effectiveness. As is commonly the case in the absence of well-targeted programs, the poor are unlikely to reap enough benefits from government subsidies for their lack of access to the programs that are being subsidized. While some targeting is achieved through self-selection in the cases of lower education, including the health and school feeding program, subsidies for higher education, water, and electricity benefit mostly the higher income population. The poor either lack access, or tend to have a lower consumption of these services. In the electricity sector for example, only about 50 percent of the rural poor have access to electricity and therefore the poorest segment of the whole population does not have access to one of the most onerous subsidy programs of the State. 54 Public Expenditure Policies for Poverty Reduction Box 6.4 Main Safety Net Progams In the Domfinican RtepublIc. 1998 OBJECTIVE -CHAPACTERISTICS FUNDING BENEFICMIES (USUnillion)- Emergency Employment Program Maged -by, t Presideny, 'provides 19.6 up to 2770D shoit trm employment- at ii.mum direct jobs. - ewag.: Actual a PmVkjS emplymnentand other forms of diec assistance. No dlear. targetng mechanism. Prry Sool Feeding Program Comprles state-provd6 fd rations 8" Betwn i and in urban areas, a special ram for 1.2 milion -bordr areas, and:a tfund transfr - children program for areas-of pxtremepovet in Ised areas Non", a r alt pimay sit siiithiew plic school system". Presidenc Social Plan Distbution of food baskets, Non 15.5 450,000 food targeted proramn with uncer selecton baskets per of benefiaries. mo Low Cost Lunch Program -Stae-run restaranttpe syslem tat 47+ 75,000 meats per -prloies Meals at subsidiz prices, bneficiary day Copayment of beneficiaries p meai I payenrs abot U$.3. Pro-am n mostly male workers in urban areasl 'Food For AI' Distbution Program Sate-rmu food sales at slg below 2.9+ Expected to mrwket prices. Due to proonism, beneficiary each more than the .;pri'es tend to be signiflcatty paymemos i I tiIon highe than world prices, Norgeted cornsumers program. Prei -eviqenunicates that it mostly serves te urban mIdde aridlower middlrcore, populton Popular Phamacies State-run phamacy system sell lo 7.7+ 17loitIes price- -medicnes, Sel-argtng by beneficiary geograhoi locaton of establihmerts. payments Main are poor and twer middle income fimiries. Basic fatnluctut Communty lfrastructure Fund Comprise Social Investment Fund, 6.6 200,00O Communidad Digna. and Neighborhood householdsyear Comissi on Program. Soume: Communkad Dow Office of the Pmswcy 55 Chapter 6 17. Given the low amount of resources destined to social programs, developing the policies and the information systems that will allow improved targeting of existing programs is a priority. There is a very broad agenda for reforms that lies ahead to provide access of key services to the poor. As it has been discussed before, the ongoing capitalization of CDE will allow additional resources to be directed to social areas. However, still remaining is the question of whether without a stronger effort to modernize the state institutions and implement some policy reforms, those additional resources will reach the poor in an effective manner. For that, significant capacity building at the National Planning Office and the line Ministries will be essential. It must be noted, however, that the recently completed Income and Expenditure Survey carried out by the Central Bank, provides an excellent base to start work identifying the main beneficiaries of government programs and the impact of government policies on the poor. Table 6.4 DR Access to public services (%), 1996 & 1998 IST 2nd 3rd 4th 5th quintile quintile quintile quintile quintile Education Total (1996) 22.7 23.3 21.4 17.7 15.7 Primary (1996) 28.8 26.4 21.8 13.9 9.2 Secondary (1996) 17.6 19.9 22.9 24.1 14.9 University (1996) 3.2 14.5 18.5 25.6 38.3 Public (1998) 26.3 27.9 20.9 14.6 8.9 Private (1998) 8.6 14.1 20.0 23.1 34.3 Health Health Preventive Vaccines (1996) 25.0 23.0 21.0 19.0 13.0 Pregnancy Services (1996) 31.0 25.0 20.0 15.0 9.0 Papa Nicolau (1996) 26.0 24.0 21.0 19.0 10.0 Child Preventive (1996) 31.0 24.0 21.0 15.0 8.0 Health Curative Public Hospital (1998) 27.2 24.7 26.6 14.8 6.7 Social Security Hospital (1998) 8.2 28.2 23.9 23.3 16.3 Rural Clinic (1998) 36.7 32.7 24.4 5.1 0.2 Public Pharmacy (1998) 28.3 29.5 19.8 16.8 5.3 Electricity Total (1998) 78.8 82.9 89.5 91.4 95.7 Urban (1996) 97.1 98.4 99.2 98.4 97.3 Rural (1996) 47.3 54.5 59.2 68.2 70.9 Water(inside house) Total (1998) 25.6 41.6 44.2 57.9 75.6 Urban (1996) 33.0 39.0 48.6 55.8 71.8 Rural (1996) 5.7 6.8 9.8 9.8 17.6 Source: 1996 ENDESA survey and Health Users Survey, Siglo 21 Foundation. 1998 Central Bank DR. 18. Development of new programs that can serve as a safety net for the very poor could also be considered a priority. Much effort could be given to the development of more targeted programs to serve as a safety net for the extremely poor. These could include the selective expansion of the current (non-targeted) school breakfast program, a more ambitious feeding program in areas of extreme poverty to reduce malnutrition, and basic public health programs to extend vaccination coverage to at least 90 percent of children. At the same time, the establishment of direct cash programs could be implemented. 56 Public Expenditure Policies for Poverty Reduction E. Conclusions * The poor in the DR, as in the rest of the world, have less education, larger families, limited access to basic services like water and sanitation, and limited physical assets. Even when they have the latter, as in the case of land, insecure property rights diminish their value. For many, these characteristics severely constrain their capacity to abandon poverty even in the midst of a growing economy. * The state is called to play a key role in addressing these constraints. To achieve this, the most critical issue is to modernize and reorient many of the ongoing state activities. Too many resources are destined to areas outside the proper provision of public goods or actions to improve equity. A reallocation of resources towards primary and secondary education, basic public health, programs to transfer state-owned land to the landless poor, and the provision of secure property rights are all areas where government actions could have a significant impact on poverty. * Large budget reallocations are very difficult to implement, and even if significant progress were made, a strong poverty reduction strategy would still be unlikely within the current budget envelope. It could be advisable for the DR to seek a gradual increase in the resources available to the state for poverty reduction. * An increase in the size of the state, however, should take place provided it is undertaken together with modernization efforts to achieve increased cost-effectiveness and accountability. e Finally, there is an important group of Dominicans that live in extreme poverty who for lack of education and physical assets are unlikely to abandon poverty even in the midst of strong economic growth. Provision of a basic safety net, with, for example the objective of encouraging a higher educational attainment of their children, and provision of very basic public health services is key to avoiding the inter-generation cycle of poverty and the evolution of a dual society. Some elements of this problem are already present, particularly along the border areas with Haiti and need very special attention. Endnotes ' This type of argument also finds support in cross-country studies on the impact of education on growth. For example, Robert J. Barro's empirical work on growth (The Determinants of Economic Growth - A Cross Country Empirical Study, MIT Press, 1997), determines that only secondary schooling attainment is a significant variable in explaining economic growth. 2 The role of the state presence in agriculture is not even closely captured by this revenue or expenditure measures. In reality, the state presence has a much larger impact through the distorting policy environment. 57 Annexes Dominican Republic at a glance Latin Lower- POVERTY and SOCIAL Dominican America middle- Republic & Carib. income Devlopment diamond' 1998 Population, mid-year (millions) 8.3 502 908 Life expectancy GNP per capita (Atlas method US$) 1,770 3,940 1,710 GNP (Atlas method. US$ billions) 14.6 1,978 1.557 Average annual growth, 1992-98 Populaton (%/) 1.8 1.6 1.1 GNP Grs Labor force (%) 2.6 2.3 1.5 p Gross per primary Most recent estimate (latest year available, 1992-98 capita enrollment Poverty (% of population below national poverty line, 21 Urban population (% of total population; 64 75 68 Life expectancy at birth (years) 71 70 68 Infant mortality (per 1,000 live births) 40 32 38 Child malnutrtion (% of children under 5; 6 8 .. Access to safe water Access to safe water (% of population) 73 75 75 Illiteracv (% of population age 15+) 17 13 14 Gross pnmary enrollment (% of school-ae population; 103 113 103 Dominican Republic Male 103 .. 105 Lower-middle-income group Female 104 .. 100 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1977 1987 1997 1998 Economic ratros GDP (US$ billions) 4.6 5.8 15.1 15.9 Gross domestic investmenVGDP 21.8 24.2 22.0 25.8 Trade Exports of qoods and services/GDP 20.0 25.6 31.4 30.6 Gross domestic savings/GDP 17.6 12.4 17.3 16.9 Gross national savings/GDP 18.9 18.6 21.0 23.6 T Current account balance/GDP -2.8 -6.2 -1.1 -2.2 Domestic Ie n Interest payments/GDP 1.1 1.9 1.2 1.1 Savings Investment Total debtVGOP 24.5 67.3 28.1 Sn Total debt service/exports 13.2 18.4 7.7 Present value of debt/GDP .. .. 25.5 Present value of debtVexports .. .. 64.6 Indebtedness 1977487 1988-98 1997 1998 1999-03 (average annual growth, GDP 3.0 4.2 8.1 7.0 6.8 Dominican Repubic GNP per capita -12.4 0.3 18.4 -6.6 5.1 Lower-middle-income group Exports of goods and services 8.1 6.0 10.8 4.4 7.7 STRUCTURE of the ECONOMY 1977 1987 1997 1998 Growth rates of output and investent (%) (% of GOP) 4 - Agnculture 20.1 11.9 12.4 11.6 Industry 29.5 20.7 32.3 32.8 20 1 Manufacturing 19.0 12.8 17.0 16.6 j1 Services 50.4 67.4 55.3 55.6 0 1.10+ 93 s 9 96 97 93 Private consumption 78.3 81.9 75.0 74.9 -201 General govemment consumption 4.1 5.8 7.8 8.2 Imports of goods and services 24.2 37.4 36.2 39.5 1 97747 199884 1997 199S Growth rates of exports and imports (%) (average annual -rowth, Agriculture 0.7 2.0 3.4 0.8 30- Industry -1.7 5.6 10.6 8.6 2 Manufacturing -1.4 5.3 7.9 4.7 Services 5.7 4.0 7.9 7.5 10 Prvate consumption 2.8 2.8 3.3 7.2 s General govemment consumption 8.6 16.4 61.0 12.9 o0 Gross domestic investment 34 13.1 25.8 30.3 .5 93 94 sr 97 93 Imports of goods and services 4.8 4.8 10.2 17.1 - Expos -imports Gross national product -10.4 2.2 20.6 -4.9 1 Note: 1998 data are preliminary estirmates. - The diamonds show four kev indicators in the countrv (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete. 56 Dominican Republic PRICES and GOVERNMENT FINANCE 1977 1987 1997 1998 Inflation (%e) OomesUic pnices (% change) 15 T Consumer prices 12.9 15.9 8.3 4.8 10t Inplicit GDP deflator 10.6 14.5 8.4 5.1 Govemnment finanes (% of GOP, includes ouent giants, o Current revenue 16.1 15.9 93 94 95 96 97 98 Current budget balance 4.5 3 53GP defator .c P Overall surplusideficit -1.4 -1.6 -----GOP d_t_ator_____CPI TRADE (US$ millions) 1977 1987 1997 1998 Export and import Wvets (USS millions) Total expons (fob) 905 1,017 889 6.000 T Raw sugar 73 172 144 5.000 Gold 66 50 89 4000c Manufactures 96 217 232 Total imports (ci) 2,223 4,192 4,897 3**00 Food 24 396 437 2,000 *fl*111 Fuel and energy 507 890 648 1.000 Capital goods 356 1,148 1,082 o 92 93 94 96 96 97 98 Export price index (1995-100) .. 70 0 Import price index (1995--100) 61 0 * Exports lmporms Tem s of trade (t995=100) 116 L I____ BALANCE of PAYMENTS 1977 1987 1997 19 19S7 m198i7ns) 1997 8 Current account balance to GOP ratio (%/) (US$ -1tiions) Exports of goods and services 927 1,655 4,731 4,863 0 Imports of goods and services 1,097 2,423 5,451 6,283 Resouice balance -170 -768 -720 -1,419 I2I I . Net income -98 -299 -795 -901 j3 - Net current transfers 140 705 1,352 1,969 i l l Current account balance -129 -362 -163 352 Financing items (net) 171 152 203 450 4 - Changes in net reserves -43 210 -40 -98 7 memo: Reserves including gold (US$ millions) .. 149 556 659 Conversion rate (DEC, local4USS) 1.0 3.8 14.3 15.3 EXTERNAL DEBT and RESOURCE FLOWS 1977 1987 1997 1998 (US$ millions) Total debt outstanding and disbursed 1.124 3.923 4,239 IBRD 23 219 209 0 IDA 11 21 16 0 :A 209 316 Total debt service 140 307 468 _:9 IBRD 4 35 44 0 D:741 IDA 0 0 1 0 Compositon of net resource flows Officialgrants 11 50 49 F:6271 Official creditors 53 59 -94 Private creditors 84 2 -4 Foreign direct investment 72 89 405 Portofoio equity ° _ Er 1,867 Worid Bank program Commitments 0 0 75 0 A. IBRD E - Bilateral Disbursements 6 17 13 0 s - IDA 0 -Other mutiateral F- Prvate Principal repayments 2 19 29 0 c IMP G - short-term Net flows 3 -2 -16 0 Interest payments 2 16 16 0 Net transfers 1 -18 -32 0 Development Economics 59 Annex B1. Dominican Republic: Selected Economic and Financial Indicators 1994 1995 1996 1997 1998 (Annual percentage changes, unless otherwise indicated) Income and prices Real GDP 4.3 4.8 7.3 8.2 7.3 Real GDP per capita 2.0 2.4 4.8 5.7 4.8 GDP deflator 8.2 12.6 5.4 8.3 4.9 Consumer prices (end of year) 14.3 9.2 3.9 8.4 7.8 Consumer prices (period average) 8.3 12.5 5.4 8.3 4.8 External sector Exports (fo.b.) 14.0 15.1 7.5 15.2 4.1 Traditional exports(f.o.b.) 22.3 18.4 8.4 7.6 -12.7 Traditional export volume 17.4 7.9 12.0 15.2 -11.1 Netfreetradezoneexports(f.o.b.) 7.3 12.0 6.6 22.8 18.6 Imports (fo.b.) 7.0 5.8 13.2 17.1 16.8 Imports volume 4.0 -3.8 15.2 27.0 20.0 Terms oftrade 1.3 -0.2 -1.4 1.3 0.9 Nominal effective exchange rate (end-period, depreciation-) 1.0 -1.6 1.8 -1.7 -10.8 Real effective exchange rate (end-period, depreciation-) 6.2 4.2 2.6 4.3 -5.4 Nonfinancial public sector Total revenue 5.9 22.7 11.2 28.1 12.5 Total expenditure 14.3 0.8 23.3 23.9 16.4 Banking system Domestic credit (net) 1/2/ 16.4 7.9 7.1 3.0 -0.6 Public sector (net) 1/ 13.2 0.4 1.3 2.0 3.7 Private sector 1/ 8.2 12.1 16.3 18.3 13.5 Other 1/ 8.8 1,9 2.3 1.0 3.8 Private sector credit (real) -0.3 10.0 22.6 19.1 11.7 Moneyandquasi-money(M2) 9.0 19.3 18.8 23.3 21.5 Velocity (GDP/M2) 3/ 3.7 3.5 3.3 3.2 3.0 Lending interest rate (91-180 days, period average) 28.0 30.8 24.8 21.3 26.6 Deposit interest rate (90-day maturity, period average) 13.6 15.8 13.8 13.3 17.0 (In percent of GDP) Public sector current account balance 6.3 6,9 4.8 3.6 3.5 Consolidate public sector balance, including quasi-ffscal operatio -4.1 -1.0 -1.8 -2.1 -2.5 Gross domestic investment 23.6 21.5 21.0 21.9 25.7 Gross national saving 21.0 20.0 19.4 20.8 23.5 Extemal current account balance 4/ -2.6 -1.5 -1.6 -1.1 -2.2 Public extemal debt (end of period including IMF) 4/ 36.6 32.9 28.3 23.3 22.3 Interest payments on extemal public debt 4/ 1.8 1.9 1.6 1.3 1.2 (In millions of U.S. dollars) Overall balance of payments -606.9 100.4 -13.7 92.7 63.0 Change in gross intemational reserves (increase-) 469.6 -137.0 -39.4 -109.2 -99.6 Net change in arrears 5/ -971.0 31.2 23.6 -192.2 -37.2 Debt relief 588.4 5.4 7.8 79.1 2.3 Exceptional financing 6/ 519.9 0.0 21.7 130.2 71.5 Net intemational reserves, end of period -31.8 105.2 144.6 254.4 354.0 Gross official reserves, end of period 259.1 390.1 374.9 414.5 512.6 (In months of imports of goods and services ) 7/ 0.7 1.0 0.8 0.8 0.9 (In percent of M2) 10.5 13.3 11.6 10.5 11.8 Net use of Fund resources -8.2 -33.9 -59.5 -62.5 27.3 Sources: Central Bank of the Dominican Republic; and IMF estimates and projections 1/ In relation to the liabilities to the private sector at the beginning of the peiod. 2/ Defined as liabilities to the private sector lees net foreign ase and liabilities, including medium-and long-term debt. 3/ Defined as the ratio of GDP to the average of the end-period stock of M2 of two consecutive years. Figures are in level terms. 4/ GDP converted into U.S. dollars usaing a weighted average of mikct and official exchange rates. 5/ Includes net payment of past due obliations paid within the graee period. 6/ In response to Hurricane Georges, Paris Club creditors infosnsally7 agreed to tolerate arrears for up to six months on debt service due from September 22. 1998 to December31, 1999. 7/ In relation to months of imports of goods and services during the upcoming year. 60 Annex B2. Dominican Republic: Summary Operations of the Central Government 1994 1995 1996 1997 1998 (In millions of Dominican pesos) Total revenue 20,254 24,584 26,457 34,732 38,566 Current revenue 20,131 24,407 25,975 34,233 38,219 Taxrevenue 18,729 22,070 24,006 31,516 36,174 Taxes on income and profits 3,212 4,121 4,605 5,906 6,893 Taxes on property 143 178 205 301 324 Taxes on goods and services 12,354 11,159 12,143 16,169 18,398 Of which Oil price differential 3,144 3,401 3,372 5,229 6,215 Taxes on international trade 2,919 6,509 6,949 9,008 10,404 Othertaxes 101 103 107 132 155 Nontax revenue 1,402 2,337 1,969 2,717 2,045 Capital revenue 123 178 482 499 347 Total expenditure 23,526 23,263 29,049 36,316 40,437 Current expenditure 10,776 12,774 16,568 24,616 28,983 Wages and salaries 4,241 5,636 6,537 10,951 11,211 Goods and services 2,927 2,033 2,357 3,263 1,500 Interest 1,461 1,747 2,384 2,410 1,814 Current transfers 2,146 3,002 4,508 7,139 8,133 Other 2/ 0 356 781 854 6,325 Capital expenditure 12,750 10,489 12,481 11,700 11,454 Fixed investment 2/ 8,299 7,647 9,906 8,126 7,597 Capital transfers 3,774 2,667 2,457 3,493 3,715 Other 678 175 119 82 142 Current account balance 9,355 11,633 9,408 9,617 9,236 Capital account balance -12,627 -10,311 -12,000 -11,201 -11,107 Other transfers payments 3/ -1,039 -1,080 -943 -511 -580 Statistical discrepancies -274 62 477 -967 -1,358 Overall balance -4,584 303 -3,058 -3,062 -3,809 Financing 4,584 -303 3,058 3,062 3,809 Foreign 285 403 180 -570 16 Domestic 4,299 -706 2,879 3,632 3,793 Banking system 3,139 -1,512 845 1,075 1,236 Domestic arrears (net change) 1,160 522 2,124 1,261 4,046 Private sector 0 283 -91 1,296 -1,489 Discount on debt buybacks 0 0 0 0 0 (In percent of GDP) Total revenue 14.7 15.1 14.4 16.1 15.9 Current revenue 14.6 15.0 14.2 15.9 15.8 Tax revenue 13.6 13.6 13.1 14.7 15.0 Ofwhich Oil price differential 2.3 2.1 1.8 2.4 2.6 Nontaxrevenue 1.0 1.4 1.1 1.3 0.8 Capital revenue 0.1 0.1 0.3 0.2 0.1 Total expenditure 21 17.1 14.3 15.8 16.9 16.7 Currentexpenditure 7.8 7.9 9.0 11.4 12.0 Capital expenditure 9.3 6.5 6.8 5.4 4.7 Current account balance 6.8 7.2 5.1 4.5 3.8 Capital account balance -9.2 -6.4 -6.5 -5.2 -4.6 Other transfers payments 3/ -0.8 -0.7 -0.5 -0.2 -0.2 Statistical discrepancies -0.2 0.0 0.3 -0.4 -0.6 Overall balance -3.3 0.2 -1.7 -1.4 -1.6 Financing 3.3 -0.2 1.7 1.4 1.6 Foreign 0.2 0.2 0.1 -0.3 0.0 Domestic 3.1 -0.4 1.6 1.7 1.6 Banking system 2.3 -0.9 0.5 0.5 0.5 Other 0.8 0.5 1.1 1.2 1.1 Sources: The National Budget Office (ONAPRE); the Central Bank of the Dominican Republic; and IMF estimates. 1/ Projections account for the capitalization of the state electricity company (CDE) and that beginning in July 1999, transfers to CDE are eliminated and explicit payments are made for purchases of electricity. 2/ Includes extra budget expenditure not reported by ONAPRE. 3/ Payments on accounts of the external debt service of the public enterprises. 61 Annex B3. Dominican Republic: Summary Balance of Payments (In millions of U.S. dollars, unless otherwise indicated) 1994 1995 1996 1997 1998 Current account -283 -183 -213 -163 -352 Trade balance -1,451 -1,391 -1,674 -1,995 -2,609 Exports, fo.b. 736 872 946 1,017 889 Imports, f.o.b. -2,992 -3,164 -3,581 -4,192 -4,897 Net exports of free trade zones 8,058 901 961 1,180 1,400 Services balance (net) 867 985 1,019 1,275 1,189 Of which Tourism receipts 1,429 1,571 1,781 2,099 2,142 Income (net) -682 -769 -725 -795 -901 Transfers (net) 983 992 1,168 1,352 1,969 Of which Insurance claims 33 16 37 37 330 Capital and financial account 274 208 90 449 717 Direct investment 207 414 97 421 691 Portfolio investment -39 -3 -7 -8 -21 Medium- and long-term loans -78 27 -8 -32 22 Of which Disbursements to public sector l/ 112 147 97 109 190 Other, including short-terrn capital 184 -231 9 69 26 Errors and omissions -598 75 109 -194 -303 Overall balance -607 100 -14 93 63 Financing 607 -100 14 -93 -63 Net international reserves (increase-) 470 -137 -39 -110 -100 Net change in arrears 2/ -971 31 24 -192 -37 Debt relief 588 5 8 79 2 Net exceptional financing 3/ 520 0 22 130 72 Memorandum items: -2.6 -1.5 -1.6 -1.1 -2.2 Current account (in percent of GDP) 25.9 390.0 375.0 415.0 513.0 Gross reserves 0.7 1.0 0.8 0.8 0.9 In months of imports of goods and services 4/ 5/ 10.5 13.3 11.6 10.5 11.8 In percent of M2 -32 105 145 254 354 Net international reserves -8 -34 -60 -63 27 Net use of Fund resources 3,946 3,999 3,807 3,509 3,541 External public sector debt 36.6 32.9 28.3 23.3 22.3 InpercentofGDP 589 476 460 451 398 Scheduled external public sector debt service 6/ 17.3 12.6 11.2 9.5 8.2 In percent of exports of goods and services S/ 219 223 210 188 177 Interest on external public sector debt 6/ 370 253 251 263 221 GDP (millions of U.S. dollars) 10,785 12,158 13,463 15,058 15,900 Official exchange rate 7/ 12.62 12.87 12.97 14.11 14.82 Marketexchangerate7/ 12.81 13.49 13.80 14.33 15.31 Weighted average exchange rate 7/ 12.76 13.35 13.63 14.28 15.21 Sources: Central Bank of the Dominican Republic; and EMF estimates and projections. 2/ In 1998 disbursements include refinancing of debt service (US$20 million) owed to Venezuela and a US$34 million net credit for an electricity generation facility, the balance of which is settled in the capitalization of CDE in 1999. 1/ Includes net payment obligations paid within the grace period. 3/ In response to Hurricane Georges, Paris Club creditors infornally agreed to tolerate arrears for up to six months on debt service due from September 22, 1998 to December 31, 1999. 4/ In relation to imports of goods and services during the upcoming year. 5/ Net imports of the free trade zones. 6/ Refers to interest and amortization due on medium - and long-term debt, including Fund credits. 7/ Period average, in Dominican pesos per U.S. dollar. 62