Caracas Chronicles

In recent weeks, we’ve heard plenty of rumblings about how the Chinese government has run out of patience with Venezuelan shenanigans and is ready to turn off the money-spigot. What’s been harder to find is a real insider’s look at the way the Chinese elite thinks about these issues. The Chinese Communist Party isn’t exactly known for its transparency, so for a long time the thinking behind their Venezuela Strategy has remained a bit of a black box.

Wang and Li advise the Chinese Government avoid lending fresh money to Venezuela.

Until now. In an exquisitely well fleshed-out paper, this past summer Qiang Wang and Rongrong Li of the China Energy Think-Tank at the China University of Petroleum give us the closest outsider’s look yet at how Official China talks about us. Actually using the D-word to describe Venezuela’s failure to comply with contractual commitments under the Fondo Chino, they predict that Venezuela’s financial default is practically inevitable.

Wang and Li advise the Chinese Government avoid lending fresh money to Venezuela, suggesting the country should “turn to the IMF for assistance to reform its oil industry model of Socialism of the 21st Century”. Communist China ain’t what it used to be. 

Now, let’s pause for a moment to understand what this means.

What the paper says

According to the research, the story goes something like this:

A high-rank Chinese communist party bureaucrat learned back in the early 2000s that Venezuela had “surpassed Saudi Arabia to become the world’s largest holder of proven oil reserves”. Little barrels of oil shone in his eyes, as he realized it would be strategic for China –the world’s most energy-hungry economy– to secure of some of that good ol’ black stuff from the Orinoco Belt.

The deal seemed almost too good to be true. Venezuela would get fresh cash without any policy conditions to invest in development activities, while China would secure long-term energy supply in the form of crude oil.

In 2007, then VP of China, Xi Jinping, and the Comandante Eterno signed 11 bilateral cooperation agreements. The most important one: the creation of a US$6Bn Chinese-Venezuelan Joint Fund.

The deal seemed almost too good to be true. Venezuela would get fresh cash without any policy conditions to invest in development activities, while China would secure long-term energy supply in the form of crude oil. Of course, in return for China’s kindness, Venezuela would prioritize awarding contracts to Chinese enterprises without the need to go to public tenders. Also, Venezuela pledged to prioritize repaying the Fondo Chino liabilities over bondholders.

The key here is that the oil investments would come with two major risk mitigation strategies. On one hand, PDVSA had already certified the resources, which means exploration risk was significantly lowered. And on the other, Venezuela’s Hydrocarbons Law obliges PDVSA to take at least a 50% interest in every venture, with the practice being that PDVSA took from 60 to 80%. This means that 60 to 80% of capital investment would be financed by quasi-sovereign investment, so if everything were to go wrong with a particular project, the government would still pay for most of it. Theoretically, this made the investment “safer” for private partners.

Inevitably, Venezuela came to use the Fondo Chino as a big external piggy bank to bankroll populist spending sprees.

What the Chinese failed to realize is that, although this was a government-to-government long-term agreement, short term incentives for both parties were entirely misaligned. The Chinese Communist Party is well established as the ruling power elite in China, and therefore, Communist Party officials have incentives to comply with long-term agreements. But Venezuela’s government is weak, consistently driving officials to operate with much shorter-time horizons to ensure the incumbent party remains in power, even at the sacrifice of long-term well-being.

Inevitably, Venezuela came to use the Fondo Chino as a big external piggy bank to bankroll populist spending sprees. The fund was used to finance –alongside windfall revenues from oil exports– the great misiones and all sorts of socialist extravaganzas, failing to re-invest sufficient capital in the oil industry. You know, classic “we forgot to sow the oil” type thing.

This resulted in a production decrease of 500k bpd between 2008 and 2015, plus some 230k bpd in the first half of 2016 (if you want some technical details check out Carlos’ article on El Furrial and Luisa’s paper on Venezuela’s supply risk).

Wang and Li note that since the beginning of the agreement Venezuela has fallen short providing the contracted number of barrels. According to the paper, by 2014 Venezuela should have been sending China 600k bpd, but was instead sending 276k bpd.

Discrepancies always arise from the figures that account Venezuela’s oil shipping to China. For instance, that same year PDVSA reports to have exported 323k bpd to China. The reason for this is that some of the shipments are sent to repay the loans in kind (both for capital and for interests) and others are sent as commercial exports, and it is not publically available which are what.

In any case, Wang and Li use the figure to claim the oil-for-loan scheme had failed even before the drop in oil prices. Some may argue the difference could be the result of a non-declared negotiation between the two governments. After all, the Chinese-Venezuelan agreement valued every barrel at US$ 60, back when prices were close to US$ 100 per barrel.

Earlier this year Venezuela negotiated a two-year grace period during which China will not disburse new resources, allowing Venezuela not to make any capital payments (in kind, remember), only interest payments – a massive debt restructuring exercise that leaves Eulogio’s puny reprofiling en pañales.

But given the commodity nature of the payment mechanism, Wang and Li calculate that after Venezuelan crude price dropped over 2/3rds in the second half of 2014, Venezuela should have increased its oil exports to China three-fold, in order to service the amounts due in the multiple oil-backed loans. According to PDVSA, Venezuela sent 400k bpd to China in 2015.

Earlier this year Venezuela negotiated a two-year grace period during which China will not disburse new resources, allowing Venezuela not to make any capital payments (in kind, remember), only interest payments – a massive debt restructuring exercise that leaves Eulogio’s puny reprofiling en pañales.

In the light of events, authors give three policy recommendations to the Chinese government:

1.    Delegate to the IMF the macroeconomic assessment of Venezuela before loaning money to Venezuela in order to avoid unsustainable investments
2.    Avoid to increase lending to Venezuela before it conducts a trustable economic reform
3.    Renegotiate deals and get the National Assembly to ratify the Chinese oil-for-loan debt

Also, it recommends Venezuela to:

1.    Allow China to access more oil resources on favorable terms in order to honor its compromises
2.    Turn to the IMF to obtain assistance as to reform its economic policy and oil industry

Why this matters

China University of Petroleum has a documented track record of influence over Chinese policymakers. Although this isn’t an official policy-paper per se, it does play a role in providing technical expertise on policy matters, to which politicians may choose to listen. Word has it this is not the only Chinese study to find the oil-for-loan scheme an unambiguous failure. Wang and Li peel back the curtain on the way the Chinese state elite thinks about us.

Above all, it means that we may have arrived to the end of an era.

Their paper also reveals shifting attitudes in China towards the IMF. Back in 2007, China showed pride in acting as an alternative financing mechanism in the international arena. However, in 2015 China’s renminbi was included in the privileged club of currencies belonging to IMF’s special drawing rights basket, which may have fundamentally changed China’s attitude towards the international organization for the better, meaning a more institutional approach could be expected in the future.

Above all, it means that we may have arrived to the end of an era. If China does stop acting as one of Venezuela’s main external financiers, the void they’ll leave may be impossible to fill under Nicolas Maduro’s government because financial markets and private creditors have already shown they don’t trust his regime. That doesn’t mean they won’t still lend — it’s just that, as the PDVSA Swap episode shows, they’ll demand dizzyingly high yields to match the dizzyingly high risks involved. Venezuela’s already in a credit cost-risk deathspiral. This makes it worse.

The forth-mentioned grace period with China is meant to allow Venezuela to muddle through 2016 and 2017’s maturities. But without cash injections into the oil and gas industry, Venezuela has little chance in the short term to increase its cash flow generation. Natural Gas could be an option, as Guevara de la Vega explained, but this is not nearly enough to close the fiscal deficit, nor the trade balance.

Of course, OPEC’s possible decision to finally cut production after eight years of defending-market-share strategy could be of great help. But as you know, Venezuela is a price taker, not a price setter, so it is not something Venezuela can control.

Without a sustainable external financing mechanism, it’s no surprise Venezuelans have been reliving Cuba’s Special Period, which is not surprising since the island is the model the government has tried to copy for almost two decades.

If China really does stop pumping cash into Venezuelan state coffers —which according to some analysts has already happened and that is why we’ve been seeing PDVSA trying to get bondholders to do a voluntary swap— the government can forget about achieving governability through handouts.

This would shortly leave the government with two options: hold to power by means of force –leaving behind any façade of democracy– or die. Of course, the radical Chavismo-sin-Chiabe we’ve seen so far could try to get rid of the chavistas-de-convicción and go begging to the IMF for assistance, but that… that’d be just the greatest irony of all.