Caracas Chronicles

Four years into this catastrophe, to say the Venezuelan economy is in shambles just doesn’t cut it anymore. The dominant narrative is intellectually lazy: just repeating the same negative trend on the same main drivers every year (low oil prices, dollar shortages, deepening controls), adding very little substance to the public policy debate. The main questions – what to do to fix this mess and how to do it – remain untouched.

One of the brave academics looking for answers is Leonardo Vera, PhD. Vera is a full-time Professor and researcher at Universidad Central de Venezuela (UCV), and one of the most respected voices in Venezuelan economics today.

The 30% contraction in GDP in Venezuela during 2013-2017 makes sense when you pinpoint the most recurrent feature of the Maduro administration: there are no dollars for the private sector.

I know how brilliant he is first hand: he taught me Macroeconomics I in my fourth semester and Advanced Macro II in my final semester, and soon became one of the biggest influences in my economic thinking. He’s just one of those gifted teachers who opens whole new vistas in your intellectual horizons: a proper expert in development economics and Post-Keynesian thinking, he helped me understand complex phenomena all around me.

Professor Vera recently published In search of stabilization and recovery: macro policy and reforms in Venezuela, in the Journal of Post-Keynesian Economics.  It sets out a series of reforms needed to bring the Venezuelan economy back into balance. We met last Friday afternoon to discuss it over pastries and tea.

He starts in vintage form,

Stabilization —in the Venezuelan context— must take on more than what’s in the orthodox view of stabilization, which focuses only on bringing inflation and nominal variables down to normality. Given our domestic economy’s huge dependence on access to foreign exchange, bridging the gap in the Balance of Payments should be the cornerstone of a stabilization plan looking to reactivate the productive apparatus.

In his view, the most binding constraint facing the economy now is the huge gap in the nation’s external accounts, brought upon by the double-whammy of lower oil prices coupled with a growing external debt burden. The government’s response to the new reality of slimmer Current Account surpluses has consisted in a near-shutdown of access to foreign currency to the local private sector and an inefficient centralization of imports (final goods, mostly) in detriment to the intermediate inputs local industry needs to operate.

Their practice of big-spender populism and their shortsightedness regarding future oil prices led government authorities to over-rely on external borrowing to cover growing budget deficits and to defend – foolishly – the official exchange rate from an unmitigated wave of capital flight.

“The 30% contraction in GDP in Venezuela during 2013-2017 makes sense when you pinpoint the most recurrent feature of the Maduro administration: there are no dollars for the private sector,” Vera adds with gloom.

“How did this happen?”  I ask, perplexed. “How could Venezuela go from surfing the commodities super-cycle with eleven-figure current account surpluses to a near-crisis in its Balance of Payments?”

“It’s a combination of factors,” Vera explains. “Their practice of big-spender populism and their shortsightedness regarding future oil prices led government authorities to over-rely on external borrowing to cover growing budget deficits and to defend – foolishly – the official exchange rate from an unmitigated wave of capital flight.”

The strain on the government’s finances began before the oil price crash. If you count items such as Chinese Fund repayments, bilateral loans and PDVSA bonds, external debt service already ran well over $15 billion per year in 2011: about a sixth of exports.

The collapse in Brent futures and the debt buildup have worsened both sides of the equation: by 2015, more than 50% of exports went to repay external debt.

“The concern among investors now,” Vera says, “is whether Venezuela will choose a partial or total default on its external debt obligations. Something’s got to give, and there’s no more room for import cuts.”

“But, professor,” I press him, “what do you make of the established view that maintaining debt service is essential for long-term market access? How do you solve the paradox of trying to ease a foreign-exchange constraint by imposing yourself one of its own?”

I’m a bond-trader now, remember — the to-pay-or-not-to-pay debate consumes my work days.

It’s as simple as this: If your economic plan is sound, if the numbers round out (si las cuentas dan), if you show discipline in hitting your fiscal targets, then the market will reward you with sustainable borrowing costs and access to foreign currency. This government hasn’t met any of those criteria; as a result, it doesn’t have access to the capital markets, and ends up in the worst of all worlds: a nation that keeps on paying, but can’t borrow a dime.

Treading carefully into the realm of political economy, I ask about the conflicting interests among government power-players. He dives into my question:

Well, the foreign-exchange constraint needs to be understood in the broader context of the country’s economic institutions. The 2005 reform of the Central Bank Law completely rewrote the explicit contract between PDVSA and the BCV. Since the oil giant has no obligation to send back all proceeds from oil sales to the Central Bank’s reserves, it has become a powerhouse of its own. PDVSA’s oil income distributions, debt service and cash flow from operations have effects that are equivalent to traditional fiscal, monetary and even exchange-rate policies, given its size and strategic relevance. Predictably, it’s possible that the BCV’s policy objectives and PDVSA’s actions are out of sync, or even in straight-up conflict. If there’s any piece of legislation that requires immediate rewriting for the stabilization plan to work, this is my number one pick.

Trying to spin the conversation onto more optimistic terrain, I encourage Vera to go into detail on the last part of his paper, where he proposes a how-to guide to reanimate the economy.

The stabilization plan has to begin way before going into effect; you need money to kickstart any serious effort to fix this mess. You definitely want to secure the support of the multilateral lenders for financing, as the foreign exchange needed in the order of tens of billions of dollars. I suggest asking the IMF for a $20 billion loan to operate the currency market, and sourcing another $10 billion or so from the World Bank, IDB or CAF, specifically towards funding a programme of direct, conditional cash transfers.

And what should be done with the current stock of external debt?

A friendly restructuring should bring the optimal outcome for both the country and its creditors. A five-year extension to allow the government the necessary wiggle-room as it gets its house in order – implying a haircut on current debts, but lower than what’s implied on current bond prices – will work a long way towards easing the foreign exchange constraint.

Research shows that preemptive credit events are usually shorter in duration and entail lower welfare losses

I imagine day one of the stabilization plan combining three key announcements: immediate, overnight liberalization of all prices of goods and services; a well thought out plan to liberalize the foreign-exchange market, aiming for a stable and competitive real exchange rate or SCRER (a stable and competitive real exchange rate — i.e., a managed float of the local currency, aiming to keep it undervalued versus the dollar); and a preemptive debt restructuring plan.

After asking him about the rationale behind the three-legged plan, Vera answers without hesitation,

Research shows that preemptive credit events are usually shorter in duration and entail lower welfare losses; besides, a new government has to take swift action if it wants to establish credibility. Gradualism is uncalled for in this context given the magnitude of the loss in economic activity already suffered. In fact, there’s the likelihood of an ‘expansionary adjustment’, in which the pros of easing the foreign-exchange constraint and reigniting local industry in a competitive environment far outweigh the cons of unwinding the system currently in place. Venezuela is a prime candidate for experiencing such a macroeconomic rarity.

“OK, that makes sense,” I say, perplexed at the thought yet convinced at the explanation.

“Tell me a bit more about how to make the FX market work again,” I press him. “It seems like a very tall order, given our 14-year-old history of rigid price controls and that the official market structure has been dismantled. Not to talk about the immense disparities between the official and the black-market rates. What’s the key for success?”

First of all, you need ammo. This’s what the $20 billion IMF loan is meant for. Remember, swift action: it’s as simple as determining the current value of the SCRER (somewhere between the official and the black-market rate) and directing the BCV as the sole government source of foreign exchange to commit to sell dollars there in potentially unlimited quantities. You need a strong-enough buffer of hard currency to fight against speculators, but you also need to be realistic in the ‘opening’ market rate, and allow the rate to float in line with inflation dynamics to avoid currency overvaluation.

“Of course, there also needs to be a reason to own bolivars other than for transaction purposes,” I chip in, remembering the finance side of the question.

“Bank deposits with liberalized rates can do the trick in the short term,” he shoots back. “You’d need to develop capital markets to attract a greater flow of FDI and portfolio investment, but that’s a long-term goal and beyond the scope of a stabilization program.”

All moving parts start to click together in my head. There’s just this one pending issue.

Professor, these measures make a lot of sense. But what about inflation? You’re talking about a sizeable one-off shock, plus the impact of inertial inflation and a persistent fiscal deficit that doesn’t look as easy to fix. What has to be done in that front?

Vera actually cracks a smile as he explains the next bit.

“Here’s when the plan gets tricky,” he says.

In theory, you can kill two birds with one stone: if the government dramatically increases the price of dollars sold in line with the SCRER, fiscal revenues will jump likewise, getting rid of the main reason why the government’s been printing money so aggressively in recent years. However, devaluing the official rate will only improve the fiscal balance if we manage to get an external surplus (ie. Greater dollar revenues than dollar outflows); that’s where the 5-year loan extension comes in. Each part helps towards improving the external and fiscal balances in the short term will reduce the need for monetary expansion to plug the holes in the government’s books.

This new currency plan needs to be thoroughly explained and discussed with the public; it requires a massive change in the way Venezuelans think about their currency, the economy and their role in it.

About inertial inflation: it’s true, that’s a tricky issue to deal with. In Venezuela, persistence in inflation is mostly due to staggered price adjustment mechanisms. Prices of goods and services change at different points in time, mostly as a response of price hikes by other market participants in a sort of distributional conflict. The Law of Fair Costs and Prices made the situation worse by adding an explicit indexation mechanism; ironically, setting a cap on profit margins at a flat 30% means any price increase in an intermediate good is reflected tit-for-tat in the price of the final product, without the cushion provided by changing profit margins.

That right there is Professor Vera’s number two pick for legislation that needs to be changed ASAP. But number three is the trickiest:

Venezuela can apply the Brazilian experience of the 1990s under Fernando Henrique Cardoso and adapt the Plan Real. The idea would be to create a new currency, but first using it only as a unit-of-account and pegging it to the dollar, in order to guide expectations towards the SCRER. This new currency plan needs to be thoroughly explained and discussed with the public; it requires a massive change in the way Venezuelans think about their currency, the economy and their role in it. It’s going to test the resilience of the new government undertaking the plan, but with a potential upside: if successful, it will result in a massive boost in political capital. Cardoso easily won his presidential bid after the Real seamlessly entered the economy under his watch, bringing inflation to a screeching halt, down from four to single digits in little over a year. This is the kind of victories that shape the political landscape forever, for good.

Professor Vera, deep down, is an optimist: and to hear him talk about his stabilization plan in this way gave me a lot of hope for the future. There’s a way to bring the country back from the abyss.

All we need is a change of heart.