TBY Talks to Héctor Valdez Albizu, Governor of the Central Bank of the Dominican Republic, on monetary policy, inflation targeting, and IMF relations.
THE BUSINESS YEAR What monetary policies has the Central Bank of the Dominican Republic (CBDR) implemented in recent years and what elements have contributed to economic stability?
HECTOR VALDEZ ALBIZU The international economic crisis that began in 2008 caused a significant slowdown in global economic activity, which, combined with restrictions on capital flows, raised the need for a change in economic policies across the world. The spillover effect at the international level impacted the performance of major economies and, more noticeably, the eurozone. In this regard, in line with what happened in developed economies and in most of Latin America, the Dominican Republic implemented counter-cyclical fiscal and monetary policies in order to stimulate economic growth in the short term in a low-inflation environment. In effect, from 2009, given the unfavorable external situation, the CBDR adopted a more flexible monetary policy, reducing its monetary policy rate (MPR) by 550 basis points to lower the overnight rate from 9.5% to 4.0%, and decreased the reserve requirements ratio by 2.5 percentage points. The expansionary monetary policy measures were accompanied by a strong fiscal stimulus during 2H2009 and 1H2010. Public spending also increased, particularly investment, as part of the macroeconomic strategy defined in the IMF Stand-by Agreement. These measures had the expected effect, stimulating consumption and investment in the public and private sectors so that GDP grew at rates of 3.5% in 2009, the highest in Latin America, and 7.8% in 2010, fulfilling in both years the inflation targets set in the CBDR’s monetary program. Since late 2010 the CBDR, in a pro-active manner, chose to move to a more neutral monetary policy stance. It is now less expansive and aimed at bringing economic growth up to its potential. Between October 2010 and May 2011, the CBDR gradually increased its policy rate by 275 basis points, from 4% to 6.75%, while from May 2011 until May 2012, the MPR remained unchanged at 6.75%. It is important to note that since the last quarter of 2011 a major fiscal stimulus was verified in the form of an increase in the rate of public investment over that period, associated with the electoral process verified in May 2012. Later, in the second half of 2012, in the absence of inflationary pressure, weak domestic demand, and a fall in private sector credit, the CBDR chose to modify its monetary stance by reducing the MPR by 175 basis points, dropping from 6.75% to 5.0% between May and August 2012. At the end of 2012 it is expected that economic growth will stand at around 4% and inflation well below the lower limit of the inflation target of 5.5%, +/-1%. Monetary policy, combined with fiscal policy, has served as a counterweight in handling the international crisis, or at least mitigating its effects on the Dominican economy. Keeping the expectations of economic agents anchored to sound policymaking created certainty in investors, both local and foreign. An important element is the strength of the financial system. This sector was not contaminated with the toxic assets that led to the global crisis, and throughout the period of the international crisis has reflected high levels of solvency, capitalization, and profitability. This is mainly due to the implementation of laws and regulations by the Monetary Board, in line with core Basel principles and international best practices.
What measures have been taken to control the Dominican peso’s volatility on the international currency markets?
The relative stability of the peso with respect to the US dollar is due to several factors. First, the Dominican economy has seen a greater influx of hard currency, mainly FDI, while exports have been recovering. Furthermore, it is important to note that tourism revenue, which is the main source of foreign exchange, has remained on a growth curve to the extent that foreign visitors to our country have diversified. Although the arrival of European tourists has slowed, this has been more than offset by new tourists from South America, especially from Brazil, Venezuela, and Argentina. On the other hand, the stability of the Dominican peso has benefited from the certainty of the macroeconomic stability associated with the implementation of sound economic policies. Additionally, the CBDR has carried out exchange intervention operations in order to mitigate any volatility that could potentially affect the inflation target of this institution, given the persistent high level of pass-through from exchange rate to inflation.
What recent developments have there been in interest rates and what are your projections for the 2012-13 period?
From 2009, in an unfavorable external environment and under low inflationary pressures, the CBDR applied a counter-cyclical monetary policy, generating a significant reduction in market interest rates. One point to note is that if one takes into account the level where the market interest rate was at the beginning of the monetary stimulus, one could even say that the Dominican Republic was the country that achieved the highest reduction in rates in the region. The lending rate, in weighted average, declined by 14.43 percentage points, dropping from 25.17% in January 2009 to 10.74% in August 2010, thereby benefiting the private sector, which had access to historically low-interest loans. Toward the end of 2010, low interest rates caused an acceleration of private credit, generating strong momentum in domestic demand. In the context of rising international oil prices and other commodities, it became clear that higher credit growth could lead to excess demand in the economy, bringing economic growth above its potential. In this regard, in order to avoid large deviations from the inflation target and maintain sound macroeconomic conditions, the CBDR determined to begin withdrawing monetary stimuli implemented during the crisis, and so adopt a more neutral monetary policy stance, reflected by the gradual increases process in the MPR. These measures are gradually transmitted to market rates, which increased in stages, although below the levels of pre-crisis period. However, as of May 2012, with the reduction of the MPR, market rates began to show signs of reduction.
What are your inflation targets and what challenges are there to price stability in the country?
As of January 2012, the CBDR formally began operations under inflation targeting in order to give certainty to economic agents and make further institutional progress in the operation of monetary policy. This decision was not impromptu. For years the movements in money supply in the economy were almost entirely reflected in inflation, so we could achieve the policy objective by controlling the money supply. However, after the domestic banking crisis of 2003-2004 there was a weakening of the relationship between money supply and inflation. Additionally, the Dominican financial market’s development resulted in a wider range of products such as debit and credit cards and other forms of electronic payments, which made the amount of money supply demanded by economic agents less predictable. Given these structural efforts and based on a process of analysis of the best practices of modern central banking, we were determined to prepare the CBDR to adopt a new monetary policy strategy based on inflation targeting. In effect since 2005, and with the valuable assistance of experts from the central banks of emerging and developed economies as well as the IMF, the CBDR incorporated the technical changes necessary to operate under the new scheme. As a result of these efforts, macro econometric models were developed to project key variables and simulate policies, and studies were conducted on the monetary policy transmission mechanism. Based on these studies, the CBDR’s overnight rate was adopted as the monetary policy rate, the main policy signaling instrument in the inflation targeting scheme. In the Dominican Republic the overnight rate is the reference rate signaling to economic agents the policy stance of the CBDR. Decisions on the policy rate have been taken monthly since January 2008 in a monetary policy meeting, in which the balance of internal and external risks on compliance with the inflation target are discussed. After each meeting, a statement that briefly describes the macroeconomic reasoning behind each monetary policy decision, especially with regard to the policy rate, is published on the CBDR’s website. In addition to technical advances described herein, it was decided that the CBDR meet several of the initial preconditions suggested by experts to adopt an inflation targeting scheme. In this regard, since 2002 the CBDR has a legal mandate, the main objective of which is price stability, which is also contained in the new Constitution of the Republic. This legal mandate also states that the CBDR has autonomy to determine its purpose and independence in the management of its monetary policy instruments. Dominican monetary law also establishes the absence of fiscal dominance by explicitly prohibiting the CBDR to finance the government. Finally, the country now has a stable financial system that allows monetary policy to focus on the inflation target without being diverted by issues related to the health of the financial system. The decision to adopt an inflation targeting scheme has led to a process of preparation for years. It was the result of a long internal reflection and intense debate of ideas aimed at providing sustainability in the long term to macroeconomic stability. Clearly, the current external environment poses an enormous challenge for policymakers. The volatility of oil prices and other international commodities, as well as the evolution of the European crisis, pose risks that should be carefully monitored. The CBDR is closely monitoring these events in order to react in time when the balance of risks points to possible deviations from the inflation target.
What is the role of the CBDR in expanding the country’s capital markets?
The CBDR is the leading securities issuer in the Dominican Republic. This has been the result of its involvement in the rescue of the financial system after the domestic banking crisis of 2003-2004, through open market operations for sterilization to bring liquidity under control in the economy. The CBDR’ s securities have driven the secondary market in the Dominican Republic, together with securities from the Ministry of Finance, by offering at auction a range of government securities with competitive performance and zero risk.
What is the CBDR’s stance regarding the new agreement with the IMF?
In the last decade the Dominican Republic has had two Stand-By Arrangements with the IMF. The first was in 2005 to restore macroeconomic stability and the health of the financial system after the local banking crisis of 2003-2004. The second agreement was in 2009, in order to try to mitigate the impact of the international crisis and allow the country greater access to international credit. In both agreements, significant progress was made in terms of the implementation of sound macroeconomic policies, the strengthening of the financial system, and the restoration of economic growth with low inflation and various structural reforms. In current times of significant restrictions on public finances due to an expansionary fiscal policy implemented since late 2011, combined with falling tax revenues and higher energy subsidies, it has generated deviations in fiscal deficits in 2011 and 2012. The Dominican authorities, including the CBRD, are aware that the external environment and the current fiscal conditions pose a huge challenge. That is why they favor a new agreement with the IMF to support the government’s efforts to stabilize the fiscal accounts through a set of long-term measures to sustain macroeconomic stability. In this regard, they have been working on the design and implementation of an economic program, accompanied by the IMF, to address these issues. In addition, the current government has an important structural reform agenda, especially in the fiscal sector, where it has been setting up a comprehensive reform incorporating revenue increases, spending cuts, and institutional strengthening elements. This reform would ensure fiscal sustainability over time, as well as a downward trend in the public debt levels as a ratio of GDP. The program also includes a series of government measures that will help improve the financial conditions of the energy sector and reduce overtime transfers to this sector by the central government. In addition, the development of a comprehensive social inclusion program to strengthen poverty reduction and to create jobs, favoring social spending, especially in education, has been proposed.
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© The Business Year - October 2012