Venezuela Devaluation Does Nothing to Address Its Structural Problems

Venezuela has devalued the bolivar and somehow tied it to its sovereign “petro” cryptocurrency. We think this is yet another gimmick that does absolutely nothing to address the nation’s deep structural problems as its struggles with default. Like Turkey, Venezuela is an idiosyncratic disaster that poses little contagion risk to wider EM.

POLITICAL OUTLOOK

The official rate for the bolivar was devalued from about 285,000 per dollar to 6 mln per dollar. This represents a 95% devaluation and comes at the same time that the currency was redenominated by lopping off five zeros and renamed the “sovereign bolivar.” This new redenominated currency is now worth 60 per dollar. As if that weren’t confusing enough, the value of the new currency will somehow be tied to the Petro, the sovereign cryptocurrency introduced earlier this year.

President Maduro is on an increasingly unsustainable path. In a paltry effort to lessen the pain for ordinary Venezuelans, the government raised the minimum wage by 3500% to the equivalent of $30 per month. However, it also hiked the VAT four percentage points and will end some gasoline subsidies.

Note that the exchange rate is the symptom of Venezuela’s poor fundamentals, not the cause. Liberalizing the exchange rate without a serious orthodox restructuring of the economy simply suggests more of the same in the months ahead. If the government continues printing money to finance its deficit spending, then hyperinflation will continue.

Maduro was just reelected in an election that is widely viewed as rigged. Three major opposition parties were prohibited from participating in the election, while other opposition parties boycotted it.  The new 545-member Constituent Assembly, which banned those parties, is stacked with Maduro supporters that include his wife and son. Note that the duly-elected (and opposition-controlled) National Assembly was rendered toothless last year by a Supreme Court ruling.

Maduro survived a drone attack earlier this month. He used it as an excuse to crack down further on opposition lawmakers. In a videotaped confession, an unidentified man accused Juan Requesens of the opposition Justice First party of ordering the attack on Maduro. The government said it had connected 19 others to the attack and would seek extradition from Colombia and the US.

Recall that back in 1989 Venezuela coped with collapsing oil prices by raising gasoline costs, lifting FX controls, and letting the currency weaken. Inflation spiked, with the resulting economic chaos leading to the violent riots known as the “Caracazo” that killed hundreds. The economic mismanagement eventually paved the way for Chavez’s rise to power. Obviously, the big question now is whether this weekend’s devaluation is the beginning of the end for Maduro.

The business environment is deteriorating. Venezuela scores poorly in the World Bank’s Ease of Doing Business rankings (188 out of 190). The worst components are starting a business and paying taxes, while the best are getting credit and registering property. Venezuela also does poorly in Transparency International’s Corruption Perceptions Index (169 out of 180 and tied with Iraq).

 

A BRIEF HISTORY LESSON

Venezuela launched an oil-backed cryptocurrency called the petro back in February. The deal was first announced in December. Details still remain sketchy six months later, but the petro is meant to represent a claim of some sort on Venezuelan crude oil. President Maduro has at times said that the petro is backed by the country’s oil reserves, at other times that it reflects the price of a barrel of oil. However, there is no specific pricing mechanism in place. Neither have traded prices ever been posted.

That this government has little credibility and can seemingly do no right simply compounds the confusion. The Superintendency of Cryptocurrency will be the sole regulator of the petro. A senior member of the constituent assembly was put in charge of this Superintendency despite having no experience with cryptocurrencies. What could possibly go wrong?

The government reportedly put 38.4 mln petros on private pre-sale that ran through March 19. After that, another 44 mln units were reportedly sold in a public Initial Coin Offering (ICO). A total of 100 mln units were sold, with the government reserving the remaining 17.6 mln units. Officials say that no more petros will be created unless approved by the Superintendency for Cryptocurrency.

US sanctions will remain in place for the foreseeable future. Besides targeting various individuals in the Maduro administration, the sanctions have also effectively prevented Venezuela from raising money in international markets by banning any US trading in new Venezuelan bonds. This has contributed greatly to its inability to service its external debt. The US Treasury has warned that the petro “would appear to be an extension of credit to the Venezuelan government” and due to sanctions in place, could “expose US persons to legal risk” if they invest in the scheme.

 

ECONOMIC OUTLOOK

Most official economic data are no longer being released. As such, the country’s outlook is based on little more than educated guesswork. While the current economic crisis has its roots in the oil price collapse, it has now taken on a life of its own thanks to ongoing official mismanagement.

The economy remains in deep recession. The IMF now forecasts GDP will contract -18% (vs. -15% previously) in 2018 after an estimated -12% in 2017. This latest leg up in oil would normally point to upside risks to the growth forecasts, but the broader economic performance remains decoupled from oil prices.

Hyperinflation is in place and largely caused by the central bank printing money to finance the budget deficit. The IMF just increased its forecast for inflation this year to 1,000,000% (yes, that’s one million percent) in 2018 from “only” 13865% previously forecast and 653% in 2017. Indeed, the IMF just compared the current crisis in Venezuela to Germany in 1923 or Zimbabwe in the late 2000s.

The devaluation will put further upside pressure on prices. Widespread price controls have done nothing but create shortages of those goods. M2 rose 10555% y/y in July and is still accelerating. Until the government stops monetizing its deficit, nothing it does will address this hyperinflation. Bloomberg consensus sees that deficit at -11.5% of GDP this year and -14.3% next year.

Despite buoyant oil prices, foreign reserves continue to fall. At $8.7 bln in July, they barely cover 2 1/2 months of imports and are less than third of its stock of short-term external debt. Also, dropping from $9.9 bln in April suggests that the supposed sale of petros has had little beneficial impact on its reserve position. Lastly, reserves excluding gold were last reported by the IMF at $3.3 bln in April. On other words, the bulk of its reserves are held in fairly illiquid gold.

 

INVESTMENT OUTLOOK

The longer the crisis goes on, the more likely that some sort of shock therapy is needed. That’s what Argentina chose when it introduced a currency board to address hyperinflation. But that requires technocratic expertise and a willingness to put faith in market mechanisms. That won’t happen under Maduro. Until we see a regime change in Venezuela that opens the door to market reforms, Venezuela will not follow Argentina’s lead under President Macri.

For now, expect further band-aid measures that address the symptoms of this crisis but not the cause. No one should be surprised when the “sovereign bolivar” eventually joins the trash heap of worthless Venezuelan currencies in the coming months.

Venezuela still has not clarified what it plans to do with regards to its $6.1 bln in debt arrears. It just missed a principal payment for the first time, to the tune of $1 bln. Those bonds were trading at 28 cents on the dollar, so markets clearly were not expecting to get paid. The World Bank estimates Venezuela’s external debt at $113 bln at the end of 2016. According to Bloomberg data, the nation is facing $12.1 bln of debt servicing needs in 2018, peaking at $13.7 bln in 2019.

While Maduro has tossed around notions of restructuring, there have been no concrete talks so far.  Maduro has put Vice President El Aissami and Finance Minister Zerpa in charge of the debt negotiations with its bondholders. Both men are on a US sanctions list, and so most US investors are not willing to meet with them.

S&P moved Venezuela to Selective Default last year on November 13. It noted that Venezuela had “failed to make $200 mln in coupon payments for its global bonds due 2019 and 2024 within the 30-calendar-day grace period.” Fitch was next and moved Venezuela to Restricted Default last year on November 14. Inexplicably, Moody’s had kept its rating at Caa3 since January 2015 before downgrading Venezuela to C this March.

Our own sovereign ratings model shows Venezuela’s implied rating at D. What will Venezuela do with its dwindling reserves? How can it resume servicing its external debt when its own citizens are facing chronic shortages of food and medicine? Will the money be used to buy basic goods for the impoverished populace? Only time will tell but it surely won’t end well for anyone involved.