Foreign Policy Briefing No. 83

The Dominican Republic: Resolving the Banking Crisis and Restoring Growth

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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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.