Archive for October 12th, 2006

The interest rate distortion in Venezuela

October 12, 2006

The graph above shows a very interesting and you may say, historic, distortion in the Venezuelan economy created by this Government. The blue line shows the yield for 90 day Venezuelan Treasury Bills, which this week came out in the auction at 4.91%, while the magenta line shows the same, but for a 90 day US Treasury Bill where the yield stands at 4.98%. This graph makes no sense, Venezuela, a country in which inflation will top 15% for 2006, started paying this week, less than what you would get for yield in the US, a country where yearly inflation is running at a 3.8% clip.

What this means is that while savings get a positive rate of return in the US, they get a deeply negative rate of -10% in Venezuela, which is simply absurd. The reason for this is simple: exchange controls. Under normal circumstances, money would move easily abroad looking for a higher yield, which is possible in Venezuela, but not in massive amounts. Moreover, the Government has created so much money, monetary liquidity is up 70% during the last 12 months, while international reserves are barely up 7%, that there is lots of money looking for goods or where to be invested.

The Government is trying to use interest rates as a way to push inflation down, but while this worked a little when rates where much higher, it is reaching a point that it is not doing very much. In fact, interest rates have been pushed down by the Government all year, but inflation is moving in exactly the opposite direction.

What this means is that people have no inducement to save, as they will lose money by keeping their money in the bank and get paid a rate which is lower than inflation. Thus, they should spend all their money in buying goods or even getting credit to buy things as they are esentially gettng a free ride. The same applies to companies, they should just borrow money and make investments bigger than they planned, as they would be getting free money when they borrow.

That is exactly what is happening as companies are, for example, issuing their own local bonds or commercial paper to get even more attractive rates. The distortion is so huge that companies can issue local paper at rates of 7%, while their own bonds in dollars in the world markets trade at a yield to maturity of 9%. Clearly for an investor it would be better to have these, as your capital is protected from inflation and/or devaluation. As an individual, you could mortgage your home, buy dollars in the swap market and invest in in a dollar bond of any Venezuelan company paying 9-10%. You can meet payments with the interest you get and when the devaluation occurs, the principal you owe will be much smaller.

In the end, the results is that the rich get richer, since obviously only those that can leverage themselves or have access to CADIVI dollars can actually benefit from this.

The problem is that this can not go on forever. A distortion like this is unsound and will eventually explode in the Government’s face. First of all, as time goes on more and more people and companies will be doing this and this is, in the end, an artificial subsidy by the Government or the financial system. Second, this helped lower inflation but you are already sitting at 4.9% and rates can only go to zero, not lower. Thus, there is no much more you can do. Third, inflationary pressures are so strong that the more negative interest rates get, the more encouragement there will be to leverage more and more. Finally, were the Government to have less income, it could not continue supprting thsi artifical state much longer and things will explode.

And they will. At some unknown point in the future, there will be a devaluation, which will hurt the poor the most as usual and will make those that can play these sort of financial games (called arbitrage) much richer. When this happens, and you can be sure it’s coming, the financial system will suffer, which in turn will force the Government to interven more. It ain’t going to be pretty!

Bt you see, we have seen this movie before, as we like to say in Venezuela. Government after Government believes or thinks that the rules of economics are flexible and that they can innovate on economic matters. Ask CAP, Caldera or Luis Herrera who thought they could. Unfortunately distortions have never gotten as large as today, so the corrections will be much stronger. Who will be blamed?

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October 12, 2006