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The Dominican Republic: Resolving the Banking Crisis and Restoring Growth Cato Foreign Policy Briefing No. 83

The Dominican Republic: Resolving the Banking Crisis and Restoring Growth Cato Foreign Policy Briefing No. 83

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Published by Cato Institute
Executive Summary
After a decade of rapid economic growth, the Dominican Republic entered a downward spiral in 2003. The economy shrank for the first time since 1990, the inflation rate quadrupled, the Dominican peso collapsed, government debt more than doubled, interest rates soared, and the central bank incurred large losses.

That cascade of bad economic news followed a botched bank bailout. What had started as a garden-variety lender-of-last resort operation ended with the central bank taking over the second-largest private
bank in the Dominican Republic. That move decapitalized the central bank in one stroke and directly cost the Dominicans about 15 percent of GDP.

The public has lost confidence in the government and the central bank. To turn the economy around, president-elect Leonel Fernández must embrace a bold set of confidence-enhancing reforms. The centerpiece of those reforms must be a new Dominican monetary regime that will produce stable money.

The country should choose one of three monetary reform options: a currency board, a dollarized system, and a free banking regime. Each is feasible and would restore confidence in the Dominican Republic. In
addition to a monetary reform, the Dominican Republic must implement a bold tax reform that encourages legal work in the formal economy, savings, and investment. A flat-tax system set at 15 percent of income is recommended.
Executive Summary
After a decade of rapid economic growth, the Dominican Republic entered a downward spiral in 2003. The economy shrank for the first time since 1990, the inflation rate quadrupled, the Dominican peso collapsed, government debt more than doubled, interest rates soared, and the central bank incurred large losses.

That cascade of bad economic news followed a botched bank bailout. What had started as a garden-variety lender-of-last resort operation ended with the central bank taking over the second-largest private
bank in the Dominican Republic. That move decapitalized the central bank in one stroke and directly cost the Dominicans about 15 percent of GDP.

The public has lost confidence in the government and the central bank. To turn the economy around, president-elect Leonel Fernández must embrace a bold set of confidence-enhancing reforms. The centerpiece of those reforms must be a new Dominican monetary regime that will produce stable money.

The country should choose one of three monetary reform options: a currency board, a dollarized system, and a free banking regime. Each is feasible and would restore confidence in the Dominican Republic. In
addition to a monetary reform, the Dominican Republic must implement a bold tax reform that encourages legal work in the formal economy, savings, and investment. A flat-tax system set at 15 percent of income is recommended.

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The Dominican Republic
 Resolving the Banking Crisis and Restoring Growth
by Steve H. Hanke
Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Cato Institute. He is the author of a number of currency reform proposals and has participated in cur-rency reforms in Argentina, Bosnia-Herzegovina, Bulgaria, Ecuador, Estonia, Lithuania, and Montenegro.
No. 83
 After a decade of rapid economic growth,the Dominican Republic entered a down-ward spiral in 2003. The economy shrank forthe first time since 1990, the inflation ratequadrupled, the Dominican peso collapsed,government debt more than doubled, inter-est rates soared, and the central bankincurred large losses.That cascade of bad economic news fol-lowed a botched bank bailout. What hadstarted as a garden-variety lender-of-last-resort operation ended with the centralbank taking over the second-largest privatebank in the Dominican Republic. Thatmove decapitalized the central bank in onestroke and directly cost the Dominicansabout 15 percent of GDP.The public has lost confidence in the gov-ernment and the central bank. To turn theeconomy around, president-elect LeonelFernández must embrace a bold set of confi-dence-enhancing reforms. The centerpieceof those reforms must be a new Dominicanmonetary regime that will produce stablemoney.The country should choose one of threemonetary reform options: a currency board,a dollarized system, and a free bankingregime. Each is feasible and would restoreconfidence in the Dominican Republic. Inaddition to a monetary reform, the Do-minican Republic must implement a boldtax reform that encourages legal work inthe formal economy, savings, and invest-ment. A flat-tax system set at 15 percent of in-come is recommended.
 July 20, 2004
Executive Summary 
 
Introduction
During the decade 1992–2002, the Do-minican Republic was an economic successstory. The real gross domestic product grew74 percent. As a result, the DominicanRepublic closed its income gap with theUnited States, moving from a real GDP perperson of approximately 12 percent of theU.S. level in 1992 to 18 percent in 2002.Inflation was in single digits, except in 1995,when it hit 14.3 percent, and in 2002, when itwas 10.5 percent. Government debt was rela-tively low, reaching only 26 percent of GDPin 2002.The success story came to an abrupt haltin 2003, when the economy shrank for thefirst time since 1990 (by 0.4 percent) andinflation jumped to 42.7 percent. The officialcentral exchange rate of the Dominican pesodepreciated from 17.76 per U.S. dollar at theend of 2002 to 35 per dollar at the end of 2003. It is currently close to 45 per dollar.Government debt more than doubled (to 57percent of GDP), and the governmentteetered on the edge of default.
1
The govern-ment’s Price Controls Department alsoswung into action. Chicken, eggs, cement,and bottled water were added to the list of items covered by price ceilings, and the pricecontrol police promised to add 25 moreitems to the list.
2
Not surprisingly, recordnumbers of destitute Dominicans took tothe sea in rickety vessels destined for PuertoRico and brighter employment prospects.
3
The Dominican Republic entered thisdownward spiral following a botched bank bailout. The collateral damage from thebailout has now spread throughout the econ-omy. Lacking a strategy to restore confidenceand growth, the Dominican Republic willrecord a second straight year of recession anddouble-digit inflation.On May 16, 2004, Leonel Fernández waselected president. That was the easy part.Now Fernández must develop a strategy toturn the economy around. That will require abold set of confidence-enhancing reforms.
4
The Botched Bailout
A bungled bank bailout caused theDominican Republic’s current problems. InSeptember 2002 the country’s third-largestbank (and second-largest private bank),Banco Intercontinental, began to experienceincreased withdrawals of deposits. To tideover Baninter, as the bank is nicknamed, thecentral bank freely provided loans. Indeed, itwas a classic case in which the lender-of-last-resort skids had been greased for abuse.Baninter’s president Ramon Báez Figueroahad seen to that by distributing lavish gifts togovernment officials. Thanks to a mediaempire controlled by Baninter, the publicsupported (at least initially) the central bank loans.In March 2003 another local bank, Bancodel Progreso, expressed interest in acquiringBaninter. However, when it examined Ban-inter’s books, it found evidence of extensiveundisclosed problems and backed out of theacquisition. A further investigation discoveredthat Baninter’s top management had kept adouble set of books for 14 years. Thoseaccounting shenanigans had fooled everyone,including the government bank auditors.The scale of the fraud ended any possibil-ity of a normal takeover. As a result, the cen-tral bank took over Baninter in April 2003and in one stoke decapitalized itself.Baninter was declared bankrupt in May anddissolved in July. Baninter’s liabilities exceed-ed its assets by 55 billion pesos, or $2.2 bil-lion, at the exchange rate of the time. Thatamounted to a whopping 15 percent of theDominican Republic’s GDP and more thantwo-thirds of the annual government budget.A law adopted in 2002 provided for adeposit insurance fund to guarantee depositsup to 500,000 pesos per depositor (at themarket exchange rate of the time, about$24,000). But at the time Baninter failed, thefund was not yet operational.
5
The govern-ment nevertheless decided to bail out allBaninter’s depositors for the
 full
value of their deposits, including amounts in excess
2
A bungled bank bailout causedthe DominicanRepublic’scurrentproblems.
 
of 500,000 pesos. The main beneficiaries of that socialization of Baninter’s deposit losseswere 80 large depositors whose depositsaccounted for three-quarters of the total.Their benefactors—the Dominican taxpayingpublic—have involuntarily been left holdingthe bag, and a large bag it is. Indeed, taxpay-ers have been saddled with a large increase inthe public debt, one that carries very highinterest rates. Not surprisingly, the publichas lost confidence in the government andthe central bank.
6
This episode is yet another case in which agarden-variety lender-of-last-resort operationended in a looting fiasco.
7
In the 1980s therewere 45 major banking crises around theworld, and, like the Dominican crisis, theyresulted in most, if not all, of the banking sys-tems’ capital being wiped out. In the 1990sthe number of banking crises jumped to 63.The average direct costs of those bailoutsamounted to a staggering 15 to 20 percent of GDP.
8
The Vicious Circle
To finance the direct costs of the Baninterbailout, the government resorted to the clas-sic measures: printing money, issuing moredebt, and raising tax rates. The resulting indi-rect costs are classic, too: a toxic combinationof surging inflation, a depreciating currency,higher interest rates, a collapse in public con-fidence, and a shrinking economy.The monetary base rose from 39 billionpesos in April 2003 to 78 billion pesos inDecember. The government understood,though, that resolving the bailout by print-ing money alone might lead to a completemeltdown of the currency. In consequence,the central bank also issued about 55 billionpesos of new securities in 2003. To make thesecurities attractive to the public, morecheese had to be placed in the trap. The cen-tral bank has done that by paying very highinterest rates. For example, at the auction of May 19, 2004, the weighted average yield on14-day central bank certificates of depositwas 60.25 percent; for the less popular 35-dayCDs the yield was 58.78 percent, and for thestill less popular 56-day CDs it was 56.12 per-cent.
9
The total of financing from printingmoney and issuing debt exceeded the origi-nal bailout amount of 55 billion pesos forBaninter, because of the peso’s depreciationand because the central bank lent to thesmaller troubled banks, too. The governmentalso increased taxes, notably a 5 percent taxon exports, and introduced more price con-trols.To ease the pain, the Dominican Republicstruck a deal in January 2004 with theInternational Monetary Fund. The IMF fore-casts inflation of 14 percent, economicgrowth of –1 percent, and government debtof 54 percent of GDP for 2004. Privateobservers are less optimistic. For example,the Swiss bank UBS forecasts inflation of 25percent, growth of –4 percent, and govern-ment debt of 61 percent of GDP.
10
However,the government is paying very high rates of interest and runs the risk of falling into a“debt trap.” Although most observers stillthink the country will avoid such a trap, theeconomy is on a knifes edge. With no turn-around strategy on the table, prognostica-tions concerning the avoidance of a debt trapcould quickly become little more than wish-ful thinking.
A History of Problems withLocal Monetary Policy
The Dominican Republic has never suf-fered a typical Latin American–type hyperin-flation, but the long-term record of Domini-can currency has been spotty at best. TheDominican government began issuing papermoney in 1844. When first issued, the Do-minican paper peso was nominally equal tothe silver dollar (
 peso fuerte
) issued by Spain,Mexico, and the United States. However, thegovernment resorted so often to the printingpress that the rate eventually depreciated to 50paper pesos per silver dollar. In 1869 the gov-ernment authorized a national bank to issue
3
To finance thedirect costs of the bailout, thegovernmentresorted to theclassic measures:printing money,issuing more debt,and raising taxrates.

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