Revisiting the economy

June 9, 2007

I have been meaning to write about the economy, but between
work, travel and the recent events, it has been hard to sit down and do it. The
Venezuelan economy continues to be dominated by the distortions that
I have described before
, except that they are much worse than they were
last time I wrote a long article about it. In September of last year, economic
variables looked much better than they do today. International Reserves were
higher, the deficit was lower, inflation was lower, monetary liquidity was
lower, the parallel rate was lower and Venezuela had a healthy balance of
payments pictures. Thus, the economic outlook has deteriorated, but the
authorities continue to act as if there was no problem In fact, the new
Minister of Finance Rodrigo Cabezas, insists that what is needed is a policy of
increasing Government spending in order to maintain growth, but it is precisely
the high growth of Government spending, which has been the primary driver in
the creation of these distortions. Spending has grown by 25% in real terms for
the last two years, which is simply unsustainable and this has created a wide
variety of distortions in the economy, which will sooner or later lead to a
financial crisis of such proportions, that it will take years to overcome it.


While the Government hailed the growth in first quarter GDP,
which came at 8% over the same quarter of 2007, the numbers are less pretty than
they may look at first sight. First, while the non-oil economy grew at a 10.6%
clip, fueled by high Government spending, the non-oil economy dropped 5.6% due
to lower oil production. Within non-oil sectors, those that grew were propelled
by Government spending and high monetary liquidity with the commerce,
construction and financial sectors growing by over 20% and more worrisome 9 of
the 12 showed slower growth. Unfortunately, we don’t know much about the
agricultural sector, as it is no longer reported by the Central Bank (funny,
no?) individually, but grouped with “others”.


But it was the balance of payments numbers that looked
worrisome, which showed a deficit of US$ 5.21 billion, down from a surplus a
year earlier. The current account surplus, which has been running positive in Venezuela and the rest of Latin
America thanks to the commodities boom, was only US$ 3.6 billion
down 47.7% from the same period in 2006. This was the result of the drop in oil
exports, but also due to the high levels of imports during the first quarter.
Imports were US$ 9.1 billion, a huge number for what is typically the slowest
quarter for imports in the year and up 47$ over the first quarter 2006.


To put the deficit in the balance of payments in
perspective, it is the largest of the last ten years, at a time when oil income
is booming. What this means is that once again, the economy is being run on the
back of the oil cycle and it is simply oil income which is providing growth,
while internal variables continue to deteriorate. Nothing new on the
mishandling of the Venezuelan economy, all previous recent crisis in ‘82, ‘89,
’94 and ‘02 were not that different. 
What is probably different this time around is that the huge imports are
destroying both agricultural and industrial capacity, as local inflation and
fear of controls have limited investment and made local production less


In the end, the balance of payment numbers indicate that
devaluation is looming in the horizon, no matter what the Government says. Unfortunately,
the more it is postponed, the larger it will be and the bigger the crisis
facing the country as these adjustments always lead to a contraction of the
economy and it takes time for people to recuperate their purchasing power and
for the economy to settle.


Then, the Ministry of Finance just published expenditures
for the first quarter and during those months, the Government spent US$ 15.2
billion and the deficit was US$ 3.8 billion an remarkable clip for what is
typically the slowest quarter of the year. What is worse is that since then,
the Government has cut the VAT, will cut it again on July 1st. and
will have to budget some  US$ 3 billion
for the salary increase for public workers announced on May 1st. Thus,
the revenue/expenses pictures will simply get worse.


The problem is that this time around there may be too many
distortions in the system to make the adjustment a normal one. First of all,
interest rates are deeply negative, which encourages people to spend and go
into debt, creating a potential time bomb for the financial system. But even
worse, in previous crisis, the Government had some way of making and adjustment
but this time around, it has little room for maneuver:


Inflation: May
inflation just came in and the rate continues to accelerate. CPI was 1.7% for
May, giving an accumulated value of 5.9% for the year, ahead of 2006, but this
includes a fairly artificial lowering of the inflation rate, because the Government
simply cut the Value Added Tax rate in March, which gave the rate a one time
kick down which has nothing to do with fundamentals. Even more worrisome, food
inflation is 29.6% and that does not take into account the fact that 30% of the
items under control can’t even be found in the markets, so the price remains
“constant” according to the Central Bank’s methodology.


Inflation is not going down, because of the excess monetary
liquidity and the lower offer of goods as noted in the first quarter report by
the Central Bank. Simply put: Too much money chasing for too few goods. There
is little encouragement to manufacture, if you can import the same product, get
controlled dollars and make the same profit at the end. That is why the
commerce sector is the best one to be in.


But even worse, such high level of inflation is what makes
the decision to devalue so difficult: Imagine adding fuel to the fire, adding
20% devaluation to the currency. It would be terrible for everyone, but would
hurt the poor the most. Unfortunately it is simply inevitable unless oil prices
were suddenly to jump up.


International Reserves are currently at US$ 24.4 billion, an
incredibly low level, given the strength in oil prices. This is the result of
removing the so called “excess” reserves for the development fund Fonden, together
with trying to fight the high monetary liquidity using a PDVSA bond and buying
the CANTV and Electricidad de Caracas shares. We are told repeatedly that this
should be of no concern, as the Government has lots of money in the development
funds, but I do not expect them to return these to the international reserves
and in any case, Fonden has already committed all but US$ 9.7 billion of its
funds, so the day they are needed they may not be there after all.


While the Minister of Finance has said that he expects
reserves to recover near US$ 30 billion by the end of the year, even if true,
it will not help much given that monetary liquidity is expected to increase by
another 45% by year’s end. And is this huge growth in monetary liquidity that
has been pressuring the currency via the parallel market and the dropping
reserves have also begun to unnerve foreign investors. It is the typical
mismanagement of the oil cycle, where the Government feels invulnerable to any
setback in the oil markets, but it is more vulnerable than ever.


Monetary Liquidity:
The Government seemed to finally realize that the huge growth in monetary
liquidity last year was pressuring the parallel market, which in turn was
pressuring inflation. Thus, it decided to do something and issued first Bono
del SUR II, and later US$ 7.5 billion in PDVSA bonds, a staggering amount for a
private issue. The theory was that this US$ 9 billion (There was US$ 750
million in a dollar linked bond in local currency in the Bono del Sur) would
push the parallel rate lower, by increasing dollar supply to the market and
reducing monetary liquidity. The problem is that despite this huge issuance,
monetary liquidity is only US$ 3 billion below its peak and pressures have not
been reduced. And guess what? After an initial psychological drop the parallel
rate is above Bs. 4,000 once again and not the Bs. 3,000 that Government
experts had predicted.


As we describe below, this becomes worse going forward, as
the amount of issuance in the next few months is limited by the announced
withdrawal from the IMF as well as the fact that the PDVSA bonds are still
being digested by the market.


Parallel Rate:
The parallel rate, which was at Bs. 2,700 last September shot up near Bs. 4.500
early in the year, dropped to Bs. 3,500 when the PDVSA bond was issued, but the
impact was only psychological and the price is now near Bs. 4,100. And it seems
extremely unlikely to drop at this time. There are three factors that influence
this market. Monetary liquidity, psychology and Government intervention.
Monetary liquidity is excessive and unlikely to drop, psychology is very
negative as people worry about Government threats to the private sector and
dropping reserves and recent issuance shows that Government intervention only
has a very brief and temporary effect. Thus, you can expect the parallel rate
to simply drift lower between now and the end of the year. And this, in turn,
will continue to pressure inflation.


Another problem with the parallel rate shooting up is that
arbitrage opportunities become more attractive. When the difference between the
official rate of Bs. 2,150 to the US$ and the parallel rate was Bs.
400, the difference was not too significant for people to find ways to play it.
But today, with the parallel rate at Bs. 4,100, the difference is almost 100%
and it is too interesting to pass up. First of all, everyone that can do it
takes advantage of requesting Internet dollars, which everyone is entitled to
US$ 3,500, at the official rate. I have heard of the existence of outfits that
go around buying the Internet allocations for those that do not have the Bs. To
do it and even the credit card to do it. This seems to be more widespread, as
one hears about it more and more.


Then there is travel. After two and half years of fixed
exchange rate and significant inflation, buying airline tickets at the official
rate of Bs. 2,150 to the US$ is one of the best deals in town, much like cars
subsidized at that rate are such a bargain. Thus people are traveling more and
more and taking advantage of the US$ 5,400 per person everyone is entitled to.
(Of course, only the well to do can afford it!)


Then there is the fact that if you get official dollars for
whatever you sell or make, with the inflation rate running at 20%, people are
actually borrowing to import products and raw materials and bringing two to
three years of stock at the favorable official exchange rate.


And then there is of course, corruption.


Sovereign bonds: For
the last three years the Venezuelan Government has used the issuance of dollar
denominated bond in local currency as a way of relieving some of the pressures
in the economy. The strategy worked for a while, but as shown by the issuance
of the PDVSA bond, the impact of these issues is not what it used to be due the
huge growth in monetary liquidity. But now, with the decision to withdraw from
the IMF, the Government ahs complicated matters by announcing a measure which
most international analysts find illogical due to its consequences.


Basically, Chavez himself made this decision and it was
clear that the full consequences were not known to him or his collaborators.
The main problem is that all of 
Venezuela’s debt was issued with conditions among which was one which if
this happened, 25% of the holders of each bond issued by the country could get
together and ask for the acceleration, the early payment of the bond.


Obviously, if the bond is above 100, you have no interest in
doing this, but if it is below 100, you can make some money by voting to accelerate.
As the Government keeps saying that it will withdraw, investors have been
buying bonds below 100 and going short those above 100. Essentially when you go
short, you borrow the bond from someone else and sell it, in the belief that it
will go down and you can buy it at a lower price later.


Combine this with lower reserves, deteriorating balance of
payments and there has been an important sell off of Venezuelan bonds in the
last two months. On top of that, many investors have been selling Venezuelan bonds
to purchase PDVSA ones, because they have a higher yield and because PDVSA owns
CITGO, which is worth more than the amount of bonds outstanding of PDVSA and
thus CITGO represents a guarantee if the company ever decided to stop making


This sell off and volatility in the country’s bonds limit
the ability of the country to place new debt, so, for the time being at least,
the main strategy used by the Government in the past to reduce the distortions
in the economy, will not be available. Even if it were, the large PDVSA issue
and the small impact it had on monetary liquidity and the parallel rate,
demonstrates that the Government is running out of tools to control the


It is somewhat ironic that by threatening to withdraw from
the multilateral agencies, the Chávez Government has exchanged institutions
that do show some degree of solidarity with countries, for the biggest
investors and speculators on the planet, who are the primary investors in the
country’s debt. These investors could care less about Venezuela and
are always looking to make an extra amount using a variety of complex


At the current clip, there is only so much longer that the
country can continue to spend, create monetary liquidity without something
yielding and creating a crisis. The obvious solution would be to slow the
spending rate, but it is clear that this is not being contemplated.
Unfortunately, the longer this continues without any adjustment, the bigger the
crisis that will take place in the end. There is, of course, the perverse
obvious solution, which is simply to devalue. When this type of adjustment
comes, it will be the average Venezuelan that will be hit, inflation will
accelerate, consumer loans will default, imports will become very expensive helping
local industry temporarily, but given the distortions the adjustment may have
to be so large, that its consequences may be simply unpredictable.

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