Market Call - March 2009

MARKET ENVIRONMENT

Overview

President Leonel Fernandez and the Central Bank (CB) remain optimistic about the capacity of the country to weather the current international crisis. Both have highlighted in recent statements that the country’s macroeconomic situation remains strong, with 5.3% GDP growth reported for 2008. Moreover, they have noted that the flow of investment will continue into the DR, with US$2.33 billion expected in 2009 alone, and US$14.5 billion promised over the next several years. At the same, as the CB has continued to lower benchmark rates and take other measures, one bank, the semi-autonomous Banco de Reservas, has lowered lending rates to 15-17%, depending on the type of loan. However, though it is clear that there is a great deal of pent-up liquidity in the system, lending rates in most banks have still not decreased noticeably (similarly with deposit rates). It is possible that a ‘crowding-out’ effect is taking place, with government debt being accumulated so rapidly that it is substituting the demand for private debt. But an increased debt burden, from both domestic and foreign sources, and which will include the issuance of new bonds, was foreseen in the 2009 national budget. This money will be used to overcome income shortfalls and meet a series of internal obligations. Unless there is another oil shock, or a complete deterioration of international financial markets, we believe that as the year progresses, and all or most government debt is placed, bank lending rates will eventually come down, spurring internal demand.

International Impacts

The major U.S. indices survived a volatile week marred by dismal economic reports and disappointing earnings releases as we entered the final month of the first quarter of 2009. The first week of March was particularly brutal, starting off a major selloff that led to the Dow’s lowest close in 12 years after AIG reported a $62 billion fourth-quarter loss, the largest in U.S. corporate history. Other financial stocks slipped on AIG’s news and continued to weigh heavily on the markets throughout the week. Economic reporting also sparked fluctuations in the markets as the Institute for Supply Management’s manufacturing index rose in February from January’s figure while another report showed that construction spending fell 3.3 percent in January. There was some good news, particularly since President Obama revealed his $75 billion foreclosure prevention plan. This gave investors hope that consumer spending could increase once homeowners facing foreclosure get some help. However, at the end of the week, the February jobs report was released, revealing that 651,000 jobs were eliminated in the month. Added to this, a private measure of the services sector shrank in February for the fifth straight month: the Institute for Supply Management, said that its services index fell to 41.6 last month from 42.9 in January (any reading below 50 indicates contraction). This is not surprising since major retailers including Target, Home Depot, and Macy’s Inc. reported depressed fourth-quarter results. Another widely watched index showed home prices tumbled by the sharpest annual rate on record and that sales of newly constructed homes fell 10% in January, sinking to the lowest level since the Census Bureau began keeping records in 1963.

These stark numbers unfortunately are not helped by the latest predictions for the international economy. This week, economists at the World Bank predicted that the global economy and the volume of global trade would both shrink this year for the first time since World War II. The World Bank said nations in Latin America, Africa and East Asia have had not only their growth stifled but their access to credit as well. The bank’s assessment for 2009 was gloomier than those of most private forecasters. It did not provide a specific estimate, but bank officials said its economists would be publishing one in the next several weeks. In late January, the International Monetary Fund reduced its estimate for global growth this year to just 0.5 percent, the lowest level in more than 60 years.

All this is bad news for the Dominican economy, which has already been impacted by the international crisis. The latest US-DR bilateral trade figures are that exports were down 5.7% and imports were up 8.5% for 2008. The DR trade deficit with the US in 2008 was US$2.62 billion, explains economist Luis Vargas, using US Department of Commerce data. Since 2005, the trade deficit has been growing. DR first posted a deficit of US$115 million in 2005, then US$818 million in 2006, which then increased to US$1.87 billion in 2007, the year of the signing of the DR-CAFTA free trade agreement. For 2008, the deficit is now at US$2.62 billion. Exports in 2004 were at US$4.52 billion, but have fallen to US$3.97 billion, four years later. Tobacco and Beverages have been the two top export performers at US$203.1 million, whereas diverse manufactured items has reaped US$960.4 million.

Inflation

Inflation for January 2009, as measured by the Consumer Price Index (CPI) registered at 0.28% for the month of January, for an annual rate of 3.68%. The Central Bank (CB) attributes the drop to a decrease in the value of fuel purchases, which in turn impacted transportation costs (decreased by 0.87%). The CB says that January’s CPI reflects an increase in prices of chicken (2.16%), rice (2.21%), milk (6.81%), eggs (3.86%), pork meat (4.05%), and cigarettes (7.04%), amongst other goods. In total, the group Food, Beverages and Tobacco increased by 0.99%.

As we reported last month, we expect inflation in coming months to be lower, as inventories are replenished at lower market prices. The government expects a rate of inflation of 6 to 7 percent for 2009, assuming the price of oil remains at around US$50 per barrel.

Government sector

In his state of the nation address on 27 February, President Leonel Fernandez sent an optimistic message to Dominicans, saying that the country was weathering the storm of the current financial crisis and that there are positive prospects ahead. His speech noted several salient point, including the fact that the DR´s GDP was 5.3%, higher than the 4.6% average for Latin America and the Caribbean, and the world average of 3.4%. This growth was a result of a 19.9% growth in communications, 13.7% in the financial sector, 5.0% in the commercial sector, and 10.3% in the water and energy sector. Agriculture was down 3.4%, free trade zones by 1.1%, construction by 0.4% and mining activities by 30%.

Among the social works projects promised by President Fernandez to boost the economy, are completing the Santo Domingo agricultural produce market (MercaSantoDomingo); implement the Training Program for Rural Youth, to train and encourage young people to stay in rural areas; send to Congress a bill worth US$13 million for the approval of Farming Insurance; construction of industrial complexes focused on developing small and medium sized companies; send a bill to Congress to stimulate development of the DR mortgage market by creating new financing mechanisms and permitting the use of pension funds; and expedite the use of US$20 million approved by Colombia’s Bancoldex to build housing nationwide. To this is added a long list of infrastructure projects that include the construction of bridges and highways to better the access to tourist spots across the country.

Though these projects are certainly necessary, they do not address other underlying issues that have been criticized in recent weeks. The Economic Commission on Latin America and the Caribbean (ECLAC) recently published a report card grading governments on their responses to the current international crisis. Even though the government is recognized for having implemented certain monetary and financial measures to alleviate the crisis, it gets a failing grade in its use of fiscal policy; exchange rate controls, labor and social policy, and its policies regarding specific economic sectors. Locally, the government has been criticized for two areas of its fiscal policy, mainly the overall expenditure of the government and its level of indebtedness.

Indebtedness

Regarding the government’s level of indebtedness, the Office of Public Credit informs that the public debt increased by US$664.1 million in 2008, and that the internal debt had an increase of US$3,503.5. The increase in the latter was due principally to the placement of bonds in order to comply with Law 167-07 that authorized the Recapitalization of the Central Bank, as well as the debt of the Guaranteed Private Sector, which, since it was not paid by the debtor institution became obligation of the Central Government. The total of the debt is US$11,218.3 millions, equal to 24.3% of GDP, of which US$10,862.9 million belong to the Central Government and the rest to the non financial public system.

It is also important to note that 51.4% of the external debt is with bilateral organizations, while 25.3% is with multilateral organisms. The increase in 2008 of the external debt was due main to an increase in the debt with bilateral organisms, which increased 36% for a total of US$208.4 million. Regarding the internal debt, 65.8% of it corresponds to the bonds issued to recapitalize the Central Bank, whereas 65.7% of it is with commercial banks. The increase in the internal debt with the commercial banking sector was equal to US$607.2 million in 2008.

This level is not expected to decrease in 2009. The World Bank alone is expected to lend US$300 million. The DR also expects to receive US$180 million from the Inter-American Development Bank (IDB). Large portions of these funds will go towards adjusting the budget and on supporting education, health, energy and potable water programs. The government also expects to borrow US$1.9 billion from various international lenders, including the Andean Development Corporation; the Central American Economic Integration Bank; PetroCaribe; National Economic and Social Development Bank (Brazil), and Spanish Government Funds (FAD). Added to this will be around US$500 million in domestic debt, raised through bond issues and bank loans.

The other main criticism has been the level of government spending, especially considering shortfalls in tax receipts. Though the budget did not foresee an increase in spending with respect to 2008, the Secretary of Economy, Planning and Development, Temistocles Montas, announced that because of the decline in tax collections and the difficulties to access international credit, the DR will decrease public spending from 19 to 16 per cent of Gross Domestic Product (GDP) in 2009. There will also be relief in 2009 with the decline of the country’s fuel bill.

Dollar-Generating Industries

Central Bank Governor Hector Valdez Albizu informed that the DR ended 2008 with a US$318 deficit in the balance of payment. Valdez Albizu says that the DR was the country in the region with second lowest level of currency depreciation and that the DR managed to obtain US$340 million in reserves. International gross reserves were US$2.64 billion, net US$2.15 billion, and liquid reserves were at US$3.76 billion.

Valdez Albizu predicts the DR will receive US$2.35 billion in direct investment in 2009. Though high, this figure is lower than the record US$2.88 billion achieved last year, which helped to balance the effects of increases in fuel, raw materials and inputs.

Remittances were US$3.1 billion, up 2.1%, compared to US$3.04 billion in 2007. It has been posited that remittances to the DR are fairly inelastic, since they go towards the purchase of basic goods and are therefore deemed by relatives to be an essential expense. However, remittances are expected to reduce as people lose their jobs, or are forced to live on a reduced budget, and are simply unable to send money.

In the free-zone sector, exports increased by 0.5%, even though the aggregated value of the sector decreased by 1.1%. This was due mainly to decreases in the textile sector where there were losses of 16.3% in the value of the exports. Jobs were reduced in the sector, but the good news is that 50 new companies applied to start operations.

Tourism receipts in 2008 totaled US$4.2 billion, up 4.3%, making it the leading foreign currency producer. However, figures for the month of January demonstrate what many had predicted: a decline of 2.05% with respect to January 2008. The impact of the international crisis clearly is limiting, and will impact, the disposable income of potential tourists, reducing their overall numbers.

Domestic Demand

January car sales are down, according to Fernando Lama, president of the Dominican Association Vehicle Concessionaires and Manufacturers (Acofave). He explains that in December 2008, some 1,474 new cars were sold, while only 1,074 new cars were sold in January 2009. This also compares negatively with respect to the sale of 2,326 new vehicles in January 2008. Meanwhile, Vehicle Dealers Association (Anadive) president Victor Ventura says sales collapsed when interest rates jumped from 14% to 30% in the second half of 2008. He added that recent interest rate cuts by the Central Bank are not enough. Some car dealers are discounting as much as US$1,000 to US$1,500 in accessories as a way to get consumers to buy.

The housing market and the complementary construction sector took steep dives last year as a result of a decrease in housing demand. According to construction sector representative Ramon Elias Hidalgo of Constructora Cohisa, house sales in 2008 dropped by 50% compared to 2007. Hidalgo believes that the outlook for 2009 is worrisome. He said that despite the decrease in interest rates there is still reticence in the market. He added that buyers are concerned about taking on debt due to the possible risk of unemployment. One of the recently announced measures was a reduction in the cost of cement, by close to 5%.

Exchange rate

The exchange rate posted a clear trend toward depreciation, even though it had several variations during the month. So far, the depreciation has not been as severe as the worst forecasts. In part, this could be helped by the fact that the government, though faced with a lower entry of dollars, has made clear that it will borrow a great amount of money from foreign banks, helping to reduce the shortfall.

Fixed Income Market and Rates

The Central Bank again cut the interest rates it is paying on deposits. Overnight deposits are now at 6%, down from 7.0%, and Lombarda deposits at 11.5%, down from 12.5%. This was the third cut in two months. Another positive news was reported by CB Governor Hector Valdez Albizu, who noted that the country’s credit “spread” dropped more than 700 points in the past month which makes it a safer haven to invest.

Easing of monetary policy, and the fact that the DR seems to be a safer investment, normally leads to greater liquidity in the financial system (overlooking the fact that M1 money supply has decreased 5.5% as of 16 February versus one year ago, since this measure takes into account a point of great liquidity in the system vs. another point after the impact of the application of restrictive monetary policy over half a year which is only now starting to reverse itself). Add to this over US$80 million in Law 119 government bonds maturing in April, and it is easy to see why there has been a three-fold increase in demand for short-term (365 days or less) CB debt since January of this year. Moreover, the pension fund system has funds equal to US$2 billion, or 5% of the Gross Domestic Product. This money can be invested in government securities.

All this liquidity should be pushing down interest rates, and to some extent it is. Average lending rates rates closed February at 23.39%, or 1.78% lower than January. During the first week of March, rates have even gone as low as 21.14%. This decrease is concomitant with the decrease in deposit rates, which have gone down from 12.70% in January to 11.75% in February, almost a 1% drop, and during the first week of March have gone as low as 11.10%. This is surprising taking into account the fact that the interbank rate has gone down from 14.33% in January to 11.36% in February, and currently stands at 9.17% for the first week of March. This is nearly a 5% drop.

One possible reason for the resistance by banks to lower rates is that, while private demand for loans is not increasing, and has in fact gone down, public sector indebtedness has increased. Private sector borrowing in February was down: according to official figures, bank loans to the private sector decreased by more than US$56 million during the first 16 days of February, going from US$6.88 billion to US$6.83 billion. With respect to December 2008, the last month before monetary easing began, the reduction was even more significant: a US$254 million decrease. This might be due to fears by consumers and businesses alike that the international financial storm might yet impact the country directly. Or, more likely, businesses are waiting for rates to go down before they decide to indebt themselves.

At the same time, public sector borrowing registered a significant increase this year (as well as last, nearly doubling with respect to 2007). So far this year, loans to the public sector have increased by almost US$100 million. Several analysts have criticized this rapid increase in government indebtedness, including the president of the National Business Council, Lisandro Macarulla. Some have noted that it is precisely this increase in the public debt which has not permitted interest rates to go down. However, we think this argument is not valid for three reasons: first of all, the level of debt projected for the Government for 2009 is less than that of 2008 (with commercial banks), and yet last year there did not seem to be any impact on interest rates due to government indebtedness. Second, the amount of the private debt has gone down more than the increase in public debt. This means that the public debt is not pressuring the market and is really only substituting part of the decrease in the private debt. Finally, the Banco de Reservas (one of the largest creditors of the Central Government) announced in February that it was lowering its lending rates to 15-17% for loans in the construction and home-building sectors. This proves that the banks have the capacity to lower rates in the current market.

Taking into account the fat that banks have a high level of solvency, and that therefore they do not need to capitalize themselves (maintaining artificially high the spread between the lending and deposit rates), one explanation for the high rates is that banks are waiting for the government to place most of its debt before lowering rates (especially since they know exactly how much debt the government needs to place). We expect, therefore, that as public debt is placed (relatively soon since the money is necessary to fulfill certain obligations), rates will begin to come down, especially if the private sector keep postponing placing debt.

Confirming our analysis that bank rates are artificially high, we see that the yield for letters has reduced noticeably over the month of February, with only a slight increase in the last week of March, which came after it was revealed how much the government has indebted itself over the course of 2009. An interesting situation is that whereas for the last 9 weeks, only 61% of demand for letters has been met, in the last nine weeks of 2008, nearly 95% of demand was met. This clearly indicates a great amount of liquidity in the system.