July 20 2004 No 83 The Dominican Republic Resolving the Banking Crisis and Restoring Growth by Steve H Hanke 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 lastresort 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 gov ernment and the central bank To turn the economy around president elect Leonel Fern ndez 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 in come is recommended 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 currency reforms in Argentina Bosnia Herzegovina Bulgaria Ecuador Estonia Lithuania and Montenegro A bungled bank bailout caused the Dominican Republic s current problems Introduction The Botched Bailout During the decade 1992 2002 the Dominican Republic was an economic success story The real gross domestic product grew 74 percent As a result the Dominican Republic closed its income gap with the United States moving from a real GDP per person of approximately 12 percent of the U 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 it was 10 5 percent Government debt was relatively low reaching only 26 percent of GDP in 2002 The success story came to an abrupt halt in 2003 when the economy shrank for the first time since 1990 by 0 4 percent and inflation jumped to 42 7 percent The official central exchange rate of the Dominican peso depreciated from 17 76 per U S dollar at the end 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 57 percent of GDP and the government teetered on the edge of default 1 The government s Price Controls Department also swung into action Chicken eggs cement and bottled water were added to the list of items covered by price ceilings and the price control police promised to add 25 more items to the list 2 Not surprisingly record numbers of destitute Dominicans took to the sea in rickety vessels destined for Puerto Rico and brighter employment prospects 3 The Dominican Republic entered this downward spiral following a botched bank bailout The collateral damage from the bailout has now spread throughout the economy Lacking a strategy to restore confidence and growth the Dominican Republic will record a second straight year of recession and double digit inflation On May 16 2004 Leonel Fern ndez was elected president That was the easy part Now Fern ndez must develop a strategy to turn the economy around That will require a bold set of confidence enhancing reforms 4 A bungled bank bailout caused the Dominican Republic s current problems In September 2002 the country s third largest bank and second largest private bank Banco Intercontinental began to experience increased withdrawals of deposits To tide over Baninter as the bank is nicknamed the central bank freely provided loans Indeed it was a classic case in which the lender of lastresort skids had been greased for abuse Baninter s president Ramon B ez Figueroa had seen to that by distributing lavish gifts to government officials Thanks to a media empire controlled by Baninter the public supported at least initially the central bank loans In March 2003 another local bank Banco del Progreso expressed interest in acquiring Baninter However when it examined Baninter s books it found evidence of extensive undisclosed problems and backed out of the acquisition A further investigation discovered that Baninter s top management had kept a double set of books for 14 years Those accounting shenanigans had fooled everyone including the government bank auditors The scale of the fraud ended any possibility of a normal takeover As a result the central bank took over Baninter in April 2003 and in one stoke decapitalized itself Baninter was declared bankrupt in May and dissolved in July Baninter s liabilities exceeded its assets by 55 billion pesos or 2 2 billion at the exchange rate of the time That amounted to a whopping 15 percent of the Dominican Republic s GDP and more than two thirds of the annual government budget A law adopted in 2002 provided for a deposit insurance fund to guarantee deposits up to 500 000 pesos per depositor at the market exchange rate of the time about 24 000 But at the time Baninter failed the fund was not yet operational 5 The government nevertheless decided to bail out all Baninter s depositors for the full value of their deposits including amounts in excess 2 of 500 000 pesos The main beneficiaries of that socialization of Baninter s deposit losses were 80 large depositors whose deposits accounted for three quarters of the total Their benefactors the Dominican taxpaying public have involuntarily been left holding the bag and a large bag it is Indeed taxpayers have been saddled with a large increase in the public debt one that carries very high interest rates Not surprisingly the public has lost confidence in the government and the central bank 6 This episode is yet another case in which a garden variety lender of last resort operation ended in a looting fiasco 7 In the 1980s there were 45 major banking crises around the world and like the Dominican crisis they resulted in most if not all of the banking systems capital being wiped out In the 1990s the number of banking crises jumped to 63 The
View Full Document
Unlocking...