Parallel universe

Venezuela’s parallel government, led by Juan Guaido, the president of the country’s National Assembly, must consider a long-term debt restructuring that does not penalise foreign bondholders in a draconian manner.

Otherwise, a new administration could be mired in litigation and cut off from international capital markets for more than a decade, warn experts.

The country is still nominally led by Nicolas Maduro, who took over the presidency in April 2013 upon the death of Hugo Chavez, but Guaido declared himself the interim president on January 23. His parallel administration has now been recognised by more than 50 countries.

Until now, the country’s generals have backed Maduro but the appalling economic meltdown is having a dramatic impact on the army’s rank and file and their family members. A coup d’etat against Maduro is a possibility.

Furthermore, the US government has tightened the sanctions screw on the Maduro regime. On February 1, the US Treasury limited the sale of Venezuelan sovereign bonds to non-US entities only, following a similar move on debt issued by state-owned oil firm PDVSA. Trading in the sovereign and PDVSA bonds has now ground to a halt.

Other US sanctions have made it hard for countries that use the US banking system to purchase Venezuelan crude, which used to account for 95% of Venezuela’s exports.

The Trump administration has also frozen Venezuela’s assets, including PDVSA’s US refining arm, Citgo Petroleum Corp, the country’s most important foreign asset. Almost all the Maduro government’s sources of hard currency have now been shut off.

Restructuring planning

There is speculation that the US president could order an invasion of Venezuela if Guaido is jailed or harmed. One way or another, most financial analysts now expect regime change within the next year, so the parallel administration must plan for a debt restructuring in case this happens.

The country’s total debt load is around US$130bn, including sovereign and PDVSA debt. Nominal GDP stands at around US$75bn, giving a total debt-to-GDP ratio of 173%, according to Andean Capital Management, a New York-based hedge fund. This indicates that bondholders could face a hefty haircut north of 80% on Venezuela/PDVSA debt once a restructuring finally occurs.

However, experts warn that a restructuring of this magnitude could lead to an avalanche of litigation by foreign investors and the sovereign/PDVSA could suffer Argentina’s fate, being cut off from international capital markets for 15 years.

“The challenge is to establish a sustainable sovereign risk-free rate of return that incentivises existing creditors to remain invested in Venezuela, increase their investment in Venezuela and not hold up the reorganisation of the country’s liabilities in domestic and foreign courts,” said Daniel Osorio, chief executive officer at Andean Capital Management.

“Few things will impede the normalisation of Venezuela’s economy like a long litigious process that will prevent the country from re-establishing its relationship with the international capital markets. On the flip side, existing creditors will have to afford Venezuela a critical commodity, time.”

He says that a ‘patient capital bond’ structure could be the solution. It would allow the Guaido administration around 18 months to market it to creditors and prepare the issuance. It would roll up all of Venezuela and PDVSA’s liabilities into one long-dated bond. Its amortisation schedule would have a grace period for the first few years of its life, then amortisations would gradually increase in the intermediate years, and amortisation payments would decrease as it gets closer to maturity.

Bondholders would face a haircut, but not at the top end of the range, and it could avoid the scenario of a new administration being bogged down in litigation for many years.

This structure would enable a new administration to focus on quickly ramping up oil production, which has fallen to a little more than 1m barrels per day from 3m at the start of the century.

Since November 2017, the Maduro regime has presided over a series of defaults on various debt instruments that reached US$10bn by the end of March, according to Capital Economics. Around half is in coupon payments and the other half in principal.

The country is in default on almost all of its international bonds, which Capital Economics estimates at around US$70bn. Furthermore, it has bilateral debt owed to China and Russia of around US$30bn–$40bn and $10bn, respectively. Combined with loans from other countries and international organisations of around US$10bn, total public sector external foreign exchange debt is in the region of US$120bn–$130bn.

Until now, the Maduro administration has been current on interest and principal payments for only one bond: the PDVSA 2020. It is a key note, as it is secured by 50.1% of the shares of Citgo (the other 49.9% is pledged to Russian state-controlled oil company Rosneft for an oil-backed loan of US$1.5bn).

A US$71m interest payment on those notes is due on April 27 but Guaido has appointed a new board to Citgo and the Maduro administration now has little incentive to make the payment. The US authorities have set up an escrow account for refiners that purchase Venezuelan crude. At the end of February, it was estimated to have US$560m in assets. Some experts believe that it could be used by Guaido to service the debt if he is granted special permission from the US government.

Escalating tension

“Tension in Venezuela is clearly escalating,” said Siobhan Morden, head of Latin America fixed income strategy at Nomura. “Russia has been sending military personnel to the country. The Maduro administration is under extreme cashflow stress. Regime change is now inevitable.

“Maduro could try to make the PDVSA 2020 payment if he thinks he can remain in office in the long term, but in practice it is not clear how PDVSA could wire the money. It is completely cut off from international financial markets. Guaido would clearly like to safeguard Citgo for the future Venezuelan people and has every incentive to make sure that payment is made.”

The debt writedowns in Greece in 2012 and in Argentina in 2001 were both in the 70%–75% range, according to Moody’s. Edward Glossop, an emerging markets economist at Capital Economics, said there are two reasons to think Venezuela’s would be on a similar scale.

“First, the country will need all the hard currency it can get to pay for a surge in imports needed to rebuild the economy,” he said.

If Venezuela’s economy expands by around 5% annually once the crisis ends, as seems likely given the country’s huge negative output gap, that would imply nominal import growth of 30%–35% a year. By 2025, that would push the annual import bill to US$100bn.

“The negotiating government will also be keenly aware of this, so is likely to be less willing to cede ground to investors,” said Glossop.

“Second, restructuring bilateral debts with China and Russia might prove more difficult, so bondholders might need to shoulder more of the pain. In particular, China is not a member of the Paris Club, which helps countries to restructure bilateral debts, so there’s nothing stopping it from simply refusing to restructure.”

Traders have been snapping up defaulted Venezuela sovereign/PDVSA bonds on the cheap (some have been trading as low as 20 cents on the dollar), on a bet that they can cash out at much higher prices during a restructuring.

However, recent comments by Professor Ricardo Hausmann, director of Harvard’s Center for International Development, suggest this unlikely. At the start of March, Guaido named him as Venezuela’s representative to the Inter-American Development Bank.

Hausmann believes that key to any economic turnaround in Venezuela is a swift and massive injection of cash from the IMF to the tune of US$60bn. He says creditors also need to brace themselves for significant pain.

“Venezuela is the most over-indebted country in the galaxy,” he said in an interview in January. “First, second and third priorities have to be the recovery of the country. There’s a humanitarian disaster. There are millions of Venezuelans flooding into other countries. If you want to fix the problem, you can’t take money out of the system to pay yourself back. It will take years to start servicing debt.”

Venezuela’s economy is in appalling shape. Hyperinflation is forecast to hit a whopping 10,000,000% this year, up from 3,700,000% in 2018, according to the IMF. GDP declined by a total 58.5% between 2014 and 2018, and the IMF predicts it will fall a further 5% this year.

Rafael Klemprer, a property developer based in Caracas, said: “I cannot see Trump ordering an invasion of Venezuela, as he plans to stand for re-election as president in 2020. He would not want a war on America’s doorstep in the run-up. Regime change must come about from the inside; things could get very radical. Maduro will glue himself to the table in the presidential palace but the military could eventually say ‘enough is enough’.

“The economic situation is truly horrendous. We are getting used to a new reality of rolling power cuts. If there is no electricity, water pumps do not work, so there is no water either. The hyperinflation will only get worse, as the government has very limited access to hard currency; it relies totally on the central bank keeping the printing presses rolling.”