USA / DOMINICA – The COVID-19 pandemic has hit Dominica hard, impacting tourism and related sectors. Recovery in the medium term is promising, underpinned by a large public investment program to build resilience to natural disasters, largely financed by buoyant Citizenship by Investment (CBI) revenue. On the fiscal front, near term policies should prioritize expenditure efficiency, while avoiding additional taxes and fees that hamper the recovery of the private sector and the business climate.
With public debt approaching 106 percent of GDP after the pandemic, passing the Fiscal Responsibility Bill will support public debt reduction and the sustainability of the government development plan. The authorities should also reconsider the allocation of a portion of CBI revenue to build an insurance framework against natural disasters and debt reduction. On the financial sector front, priority should be given to the capitalization of credit unions and the reduction of non-performing loans (NPLs).
Recent developments, outlook and risks
The COVID-19 pandemic has taken a heavy toll on the Dominican economy. GDP is estimated to have contracted by 11 percent in 2020 and to have shown a modest recovery of 3.7 percent in 2021 underpinned by a sharp reduction in tourism and related sectors, plus the Covid-19 outbreak that forced a lockdown in August 2021. Since March 2020, the government had a swift reaction to the pandemic by carrying out health spending and social transfers. However, despite ample vaccine and testing availability, vaccination remains below 40 percent of the population due to hesitancy.
Output decline was contained by strong growth in the construction sector due to the large public investment program in housing and infrastructure resilient to natural disasters, financed with record-high CBI revenue of 30 percent of GDP. Despite sharp declines in tax revenue and increase in spending, large CBI revenue led to a small reduction in the fiscal balance in FY2020. However, the estimated public debt increased to 106 percent of GDP in 2020 with higher official borrowing. In this context, the current account deficit is estimated to have widened into near 30 percent of GDP, underpinned by the loss of tourism exports and increase in imports related the public investment, and the increase in commodity prices, albeit contained by a decline in private demand for imports.
The financial sector has remained liquid and stable during the pandemic, but NPLs are above prudential benchmarks. The loan service moratoria authorized by the regulators of banks and credit unions helped support firms and households affected by loss of income, helping contain a deterioration in portfolio performance. Despite an improvement relative to 2020, NPLs remain high, in the range of 11-14 percent of loans for banks and 10-17 percent for credit unions (the prudential benchmark is 5 percent in both sectors).
To comply with the ECCB requirement, banks have prepared plans to increase provisioning to 100 percent of NPLs by 2024—pre-Covid precautionary increase in provisions with adoption of IFRS9 standards in 2018 has facilitated this process. Most loans under moratoria have currently normalized. The financial sector remains liquid with an increase in deposits underpinned by prudent private spending, government transfers, the loan moratoria, and increase in foreign remittances.
The growth outlook is promising, supported by the large public investment program and the projected gradual recovery in tourism with added hotel capacity. The government plans to maintain high levels of public investment into the medium term financed mainly by CBI revenue. Key projects include a new international airport, housing resilient to natural disasters, roads improvement, a resilient water and sewage network, improvements in the hospital capacity (including a new hospital financed by the People’s Republic of China), and a geothermal electricity plant.
These projects will accelerate growth in the near term during the construction phase and will also increase potential output in the long term – including spillovers in tourism and reduction of fossil fuel dependency, all of which improve Dominica’s external sustainability and competitiveness. GDP is projected to reach pre-pandemic levels by 2023, averaging 5 percent growth per year through 2022-26, tourism recovery would be supported by the ongoing construction of new hotels and the inauguration of direct flights from the United States from December 2021.
Risks to the outlook are skewed to the downside. Main risks include renewed worldwide and domestic Covid-19 contagion waves, leading to loss of tourism revenue and forcing lockdowns and mobility restrictions; a decline in CBI revenue below expectations; and insufficient progress on local vaccination due to continued hesitancy. Weakness in the financial sector, particularly the credit unions, where 4 out of 6 institutions have thin capital buffers below the regulation requirement, could amplify downside risks and may result in contingent fiscal liabilities.
In the near term, the government should continue maximizing the effort to increase vaccination, which is critical from health and economic recovery perspectives. Continuing public communication and education campaigns to address vaccine hesitancy and building additional health care centers could prove critical in possible contagion outbreaks.
Reallocation of windfall CBI revenue to balance public investment with government financial resilience and debt sustainability would strengthen the outlook. Thus far, the authorities have used the majority of CBI revenue to invest in infrastructure resilient to natural disasters. This is understandable considering Dominica’s significant exposure. Moreover, the improvements in infrastructure in the public investment plan are important and expected to boost potential output – especially with resilient investments in roads, electricity generation, a new hospital, and the water and sanitation network. However, the risks to the outlook justify the allocation of a portion of CBI revenue to the Vulnerability and Resiliency Fund (VRF) for self-insurance against natural disasters (at least 10 percent of GDP plus annual savings of about 1.5 percent of GDP to ensure its long-term sustainability), and to reduce public debt with targeted net-repayments once output has recovered.
This would increase fiscal buffers, speed up post-disaster recovery with funding for reconstruction and rehabilitation, and create space to access external financing in the event of a large natural disaster or a prolonged pandemic. This strategy would better support the long-term sustainability of the public investment plan and development agenda while protecting public finances, especially considering their long execution horizon. It would also support the achievement of the regional debt target of 60 percent of GDP by 2035 by reducing the impact of natural disaster shocks on public debt, while helping avert a debt crisis after an extreme shock. This allocation, however, would come at the cost of lower public investment, which could reduce the estimated output level by about 3-4 percentage points of GDP in the medium term.
Self-insurance in the VRF should be topped up with additional coverage for large and extreme disasters, as part of a layered insurance framework. The first layer, the VRF, would cover relatively more recurrent but less damaging disasters. A second layer could include increased coverage under the Caribbean Catastrophe Risk Insurance Facility (CCRIF) – with a re-calibration of the triggers to activate under more severe disasters. The government could also consider a third layer of state-contingent instruments calibrated to trigger after extreme events, including for example the World Bank CAT-DDO facility.
A re-prioritization in the execution of the fiscal consolidation plan committed to in the 2020 Rapid Credit Facility disbursement could support the recovery better. Thus far the government has made progress on several measures it committed to establishing limits on discretional tax exemptions on imports; advanced preparations of an income tax reform including a presumptive tax (which could be passed in FY2022); and launching a property tax reform to incentivize the use of idle property in prime urban areas. Beyond this, the government intention to avoid additional new taxes or charges is welcome, consistent with the objective of creating a favorable environment for private investment while minimizing the burden on tax administration, which is affected by limited capacity.
The actuarial analysis update of the pension system by the Dominica Social Security (DSS) planed by early 2022 (delayed due to covid mobility restrictions) would trigger parametric amendments if needed for sustainability. These measures improve allocational efficiency while addressing long-term contingent liabilities, therefore contributing to the sustainability of the public investment plan within the regional debt target commitment. However, the introduction of a solid waste charge could be delayed or reconsidered, in light of the low potential revenue and the additional tax administration burden, while a reduction of the preferential rate on diesel could be done later once the economy has recovered, to reduce its distortionary impact.
The government should prioritize cost-saving expenditure efficiency measures and begin preparations for their implementation as soon as feasible. These include a civil service reform including a review of allowances (at an advanced stage with support from CARICAD); and better targeting of social transfers the national census needed to update the Ministry of Social Services’ database, has been delayed to 2022 due to the pandemic. Measures could be taken to reduce informality and increase the tax base (Fund staff estimates indicate that over 30 percent of the Dominica economy is informal), including by ensuring the registration with the DSS of workers employed in the public investment projects and with the introduction of the presumptive tax.
To strengthen the public debt sustainability outlook and support achievement of the regional debt target, the government should maintain progress on institutional fiscal reforms. Re-submission to parliament the Fiscal Responsibility Bill, after a consultation with affected parties to ensure political support which will be critical for societal commitment and an effective implementation. Other ongoing reforms that should be completed include the new Public Procurement and Disposal of Public Property Act to modernize public procurement; and a framework to monitor state-owned enterprises, important to identify contingent liabilities and for fiscal planning.
The government’s fiscal plan should internalize the long-term implications of the large public investments. On the positive side, the projects are mostly financed with CBI revenue which implies that the external and fiscal solvency position has improved with the buildup of valuable revenue-generating assets that are expected to have positive spillovers on private investment and growth. On the downside, the added capital stock will require sustained recurrent maintenance spending – underscoring the importance of disaster resiliency, which has been incorporated in all the projects. With low-cost geothermal electricity generation, the government should maximize the potential reduction of electricity tariffs, currently among the highest in the world. This would improve further external competitiveness and the business environment.
Domestic banks should prepare a capitalization plan to comply with the provisioning targets set by the ECCB. Banks operating in Dominica are working on medium-term plans to strengthen capital buffers in 2022-24, including to meet increasing loan-loss provisioning requirements set by the ECCB (60 percent of loans by 2022 and 100 percent by 2024). Preliminary staff analysis indicates that domestic banks would have to increase provisioning by 55 percent in 2022 (an amount equivalent to 1.6 percent of GDP and near 20 percent of capital) and by 160 percent by 2024 (3 percent of GDP and near 60 percent of capital) relative to their 2021Q1 value. Delays in reducing remaining NPLs could add to this need.
Considering the weaknesses in the credit union sector, a plan is needed to address capital shortfalls as soon as feasible. The national regulator of non-bank financial institutions should stress test credit unions and insurance companies in lieu of the risks to the outlook. While the loan moratorium and restructuring has helped maintain financial stability during the pandemic, credit unions should prepare a plan to reduce NPLs. The modernization of foreclosure legislation could facilitate seizing collateral and aid the resolution of new and longstanding NPLs. The regulator should enforce a plan to bring all credit unions’ capital above the regulatory minimum and prepare other structural reforms to support financial stability.
The latter includes the consideration of options to provide liquidity assistance to the sector. This is important considering their size and macro criticality – assets of credit unions and insurance companies exceed 75 percent of GDP, and credit unions deposit their liquid assets in the domestic banks. Long-standing plans to modernize the regulation in line with regional harmonization strategy, should be advanced in the near term. Additional human and financial resources, and independence from the Ministry of Finance, would strengthen supervision effectiveness and accelerate compliance. The capitalization of financial institutions and progress on regulatory reform are critical to support private sector growth, while reducing the need of government support after a shock, thereby improving the public debt outlook.
Continued progress on AML/CFT legislation framework is important to minimize risks to correspondent banking relationships. Dominica completed its mutual evaluation round with the Caribbean Financial Action Task Force during 2008-14 and has addressed identified deficiencies (a reevaluation is planned in 2022). With the passage of legislation amendments in 2020, Dominica designated the ECCB as the competent authority for the AML/CFT regulation and supervision of the banking sector.
Strengthening of resources and independence of the national regulator will help address weaknesses in the non-bank financial sector and non-financial businesses, especially risk assessment capacity and training of law enforcement agencies. The latter commitment is critically important considering the significant contribution the program makes to government revenues; and concerns about the vulnerability of CBRs. Considering Dominica’s plan to adopt the digital currency launched by the ECCB in 2020 and given the DCash platform is owned by the ECCB and transactions will be limited to registered participants who have acquired a Dwallet, there is potential to reduce ML/TF vulnerability.