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Sunday, 19 November 2017

Cause for optimism?

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Venezuela’s economy is in a desperate mess. Yet it has defied expectations of a default in 2015, and few would deny the possibility it could do so again in 2016, despite economic problems that have festered for many years. The recent election victory for the opposition coalition gives further grounds for hope, but even the most dedicated politicians will struggle to deliver a swift turnaround.

The recent history of Venezuela has been a tale of tragic economic mismanagement and unfulfilled potential.

“Recent years have seen the biggest oil boom in history, and yet Venezuela has suffered from perhaps the most wasteful economic management in the world. Its population should enjoy the same living standards as Norway,” said Jan Dehn, head of research at Ashmore.

Instead, the population is struggling against violent and relentless economic headwinds that threaten to sink the economy at any time. Real GDP in Venezuela contracted by 4% year-on-year during the first three quarters of 2014, the latest data available in a country where reliable information is hard to come by.

Unwilling to significantly cut spending and unable to increase revenues, Venezuela has largely closed its financing gap via a stealth devaluation of the bolivar. The official exchange rate is 6.35 bolivars to the US dollar, but on the black market it trades for as low as 1% of the official figure. This has suppressed domestic demand by discouraging imports.

Optimists have long anticipated the recent elections, seeing in them Venezuela’s opportunity to chart a new economic course. The opposition party, Mesa de la Unidad Democratica (MUD), was still tainted by the reputation earned before Hugo Chavez seized power, with leading figures held responsible for the extreme poverty and inequality that paved the way for Chavez’s rise. Yet the scale of its victory – it won a two-thirds majority in the country’s legislature – proves the electorate was willing to put such reservations aside.

MUD must now make the most of its new mandate. Despite winning control of Congress for the first time in 16 years, MUD is likely to be cautious. It will want to maintain the social programmes that Chavez put in place and will therefore be desperate to increase government revenues. The obvious solution is to attract foreign investment and, crucially, ramp up oil production.

Dehn said: “The opposition party’s priority will not be to oust [current president] Nicolas Maduro, it will be to secure the release of various political prisoners. Once it has achieved that, it will want to push through reforms to increase transparency, for example forcing Maduro to explain where all the money has gone.

“They will want to expose corruption in order to undermine the credibility of the Chavistas, who are still seen by many as being on the side of the poor. Then a moderate, centrist leader can emerge.”

With a majority of 112 seats out of 167, the opposition will have the option to change institutions, including the courts, and could even pass motions for recall referenda, Dehn said. “Change requires several conditions to be satisfied: political change and then economic and institutional change. The former has now happened. We now look forward to the latter two,” he said.

Yet some still worry that the election result will not lead to a substantive change.

Ben Ramsey, an analyst at JP Morgan, said: “Institutional clashes between the different branches of government can lead to uncertain outcomes, and stability is not taken for granted. As such, with Venezuela facing another large external funding gap next year (we estimate US$16bn), default concerns will remain elevated.”

To default or not to default?

There is considerable debate around the possibility of default in 2016. Many predicted 2015 would be the year it happened, but Venezuela defied these expectations. Capital Economics, for example, predicted Venezuela would probably default around October or November this year. Thus far it has been kept afloat in large part thanks to deals with China.

Some have concluded that 2016 will see Venezuela continue to muddle through, making repayments to avoid default, despite the rapid deterioration of its economy. The government depends on its oil output to remain solvent, but cannot keep the oil pumps on without maintaining access to markets for working capital. Any government that was unable to keep the oil flowing would be unlikely to hold on to power. That, at least, is the theory.

The government until now has given indications that it intends to manage the economy as responsibly as possible, budgeting for 2016 on the assumption that oil will fetch, on average, US$40 per barrel. This relatively conservative estimate should insulate it against continued volatility in the oil price.

Ramsey argues that Petroleos de Venezuela (or PDVSA), the state-owned oil company, remains committed to keeping up coupon payments and reserved cash to meet the October–November maturities of US$1.413bn 2015s and is doing so again to meet the US$2.05bn first tranche of sinking 2017s, having been acquiring much of the former at a discount in the secondary market.

“While it is hard to see how the balance of payments closes next year without additional import contraction and economic pain, a credit event is still not written in stone,” he said.

Reports that Finance Minister Rodolfo Marco Torres told investors in New York that government institutions own around 25% of Venezuela’s foreign currency bonds have also fuelled hopes that the sovereign can remain solvent.

Survival is the priority

Dehn said: “To increase oil output the next government may take away PDVSA’s monopoly and grant concessions to foreign companies. It could do a deal with China that could increase production quickly and meaningfully. Venezuela is still an attractive place for oil companies to do business because its fields are onshore and near the surface, making it cheap to extract. It used to pump around five million barrels a day, and it is now around half of that, so there is potential for it to increase quickly.”

But Edward Glossop, emerging market economist at Capital Economics, is less sanguine. “Attracting investment to stimulate oil production is probably the last thing on the government’s mind,” he said. “Although investment has collapsed and oil production is in long-run decline, there isn’t much the government can do about that right now. Venezuela needs dollars to keep the country functioning. Survival is the priority.”

Glossop added: “When an emerging market defaults it usually isn’t just a question of ability to repay debt, but a willingness to pay. There is always a way to find the money if the will is there: Venezuela can beg, steal or borrow the money – it has more gold it can sell and China will probably lend more. But using this money to pay down debts could have knock-on effects. It means the funds are not being spent on importing basic goods, which means more shortages, recession, and likely social unrest.”

The country’s deals with China are also a mixed blessing. The loans see Venezuela receive cash in exchange for future deliveries of cheap oil. But while such an arrangement is helping stave off default in the short term, selling off its most valuable asset at a discount is not in Venezuela’s long-term economic interests.

Short-term solutions

China’s loans have supplemented emergency measures, such as agreeing to significant haircuts of up to 50% on debts owed to it under the Petrocaribe deal, in which it provided neighbours with cheap oil on credit, in return for early payment. Reserves have crept up from around US$15.5bn in July to around US$16bn in October.

Such solutions, just like the China loans, buy short-term solvency at the expense of longer-term health. The question is whether Venezuela’s new government wants to try repeating the same trick. Eventually, even China may balk at lending more, especially if its own economy is under pressure, or if it begins to doubt Venezuela’s ability to deliver the oil it uses as payment.

Even a sleight of hand in the currency markets may not provide the respite it has in the past.

“In the absence of a structural policy approach aimed at correcting the numerous macroeconomic imbalances, resorting to a solitary devaluation, a measure used in the past, would not suffice to take the economy onto a sustainable macroeconomic path,” said Goldman Sachs in a research note.

With this in mind, the newly elected opposition politicians may be willing to risk their reputation on a longer-term play.

To fundamentally turn things around, it needs to aggressively tighten fiscal and monetary policy, with inflation believed to be running into three digits; rebuild the supply side in the economy, particularly oil production, to increase growth potential; and radically devalue the currency and reform its dysfunctional multi-tiered exchange rate system.

Glossop said: “Even if they did all those things, recession would certainly get worse in the short term, it would take two to three years before the benefits were felt. It is highly unlikely any Venezuelan government will be able to do all this over our forecast horizon of two to three years.”

It seems more likely, therefore, that Venezuela will continue to find the money to keep up with repayments, without addressing the underlying weaknesses in the economy, meaning more suffering for its people. Or, as many predict, that relatively rare thing: a sovereign default. Venezuelans are entitled to a real sense of optimism following the decisive election result, which could yet deliver the change the country so badly needs. All eyes will now be on the new political dispensation to see how it responds to the challenge.

To see the digital version of the IFR Americas Review of the Year, please click here .

To purchase printed copies or a PDF of this report, please email gloria.balbastro@tr.com .

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