LATIN AMERICA FOCUS

Is Venezuela approaching crunch time?

While the rest of Latin America is experiencing bumper capital inflows, Venezuela is gripped by a dollar drought. With President Chavez seeking re-election in December 2012, there is a growing risk that the government will default on its foreign debt. Some form of restructuring already appears to be priced into the market, so the threat of contagion should be limited. But while the market expects there to be some kind hiccup, we think that there is a chance that debt repayments will be halted altogether. Venezuelas dollar drought has stemmed from two factors. First, although oil prices have rebounded by around 30% in the last 12-18 months, there has been a fall in export revenues. This is because years of underinvestment by the national oil company, PDVSA, mean that oil production has been in long-run decline. At the same time, oil-for-loan deals with China have cut oil export revenues by around 20%. The second factor is that the governments policy program of expropriations has alienated the private sector and the increase in political risk has triggered capital flight. To compound matters, demand for dollars has increased. The bout of nationalisations has led to a hollowing out of the industrial sector, making the economy more dependent on imports. Moreover, the flurry of external debt issues in recent years to raise foreign currency funds is coming back to haunt the government. Debt service alone looks set to total over $6bn this year. So far, Mr. Chavez has tackled the problem by running down foreign currency reserves and cutting imports of non-essential goods. As a result, living standards have dropped and inflation has remained in double-digits. But this approach is ultimately unsustainable: FX reserves are now sufficient to cover only two months of imports. Accordingly, the government is approaching crunch time. With his popularity on the wane, Mr. Chavez will be eager to ease the dollar drought and its consequences for ordinary citizens ahead of the election next December. The question is how can he do it? We think that there are three possible escape routes. The first is via higher oil prices we suspect that an oil price of $120 per barrel could ease the drought. But while prices may remain elevated in the near term, we still expect them to fall over the next year or so. The second is via bilateral loans from the likes of China in return for preferential oil supplies. This appears to be very likely. Finally, with an additional $5bn of debt servicing due in 2012, there is a growing risk that the government will default on its obligations in 2012. The good news is that it would probably be well contained: the market expects there to be a default in the next five years and so the risk of a spill over effect to other, stronger, emerging markets should be limited. David Rees Tel: +44 (0)20 7811 3907 North America 2 Bloor Street West, Suite 1740 Toronto, ON M4W 3E2 Canada Tel: +1 416 413 0428 Chief International Economist Senior Emerging Markets Economist Emerging Markets Economist Europe 150 Buckingham Palace Road London SW1W 9TR United Kingdom Tel: +44 (0)20 7823 5000 Asia #26-03 16 Collyer Quay Singapore 049318 Tel: +65 6595 5190

Julian Jessop (julian.jessop@capitaleconomics.com) Neil Shearing (neil.shearing@capitaleconomics.com) David Rees (david.rees@capitaleconomics.com)

Latin America Focus 1

17th Feb. 2011

Is Venezuela approaching crunch time?

While policymakers in almost every other country in Latin America are struggling to manage rapid capital inflows, their counterparts in Venezuela face an entirely different problem. President Hugo Chavezs drive towards a so-called 21st century socialist revolution has hit the buffers. A shortage of dollars has caused economic activity to stall, while the Presidents popularity has nose-dived. With presidential elections on the horizon, Mr. Chavez has to solve the dollar drought. In this Focus we examine how he might do this. What oil wealth? At first sight, Venezuelas current predicament is hard to comprehend. With interest rates in the developed world at rock bottom, a wall of money has crashed into emerging markets. Whats more, the Venezuelan government has recently boasted that it now presides over the worlds largest oil reserves, greater even that Saudi Arabias. On the face of it, then, the economy should be awash with foreign currency. Instead, it is being crippled by a shortage of dollars. So what is causing this? Dwindling oil production The first reason is that export revenues have fallen. There appear to be two factors behind the slump. First of all, oil production, which accounts for around 95% of exports, appears to be decline: while the government insists that it has remained at around 3.1 million barrels per day, those figures are widely disputed following years of underinvestment by the national oil firm, PDVSA. Indeed, independent estimates from the International Energy Agency (IEA) show that oil production has been in long-run decline and that output fell by around 5% last year (See Chart 1.) Secondly, the fall in production volumes has been exacerbated by the recent oil-for-loan deals with the likes of China. Following a bilateral loan from China worth $8bn in 2009, President Chavez claimed that the government was repaying the debt via oil shipments of 460,000 barrels per day. This accounts for around 20% of total oil production and has greatly reduced the amount of oil that PDVSA can sell on the open market. Thus, such deals have reduced the regular inflow of dollars. Moreover, with continuing concerns about corruption and poor management in the country, the incoming money from China does not appear to have boosted the economys productive capacity.
CHART 1: OIL PRODUCTION (000S BARRELS PER DAY)
3600 3400 3200 3000 2800 2600 2400 2200 2000 1997 1999 2001 2003 2005 2007 2009 3600 3400 3200 3000 2800 2600 2400 2200 2000

Source Thomson Datastream

So while oil prices have rebounded by approximately 30% over the last 12-18 months, around 5%-pts of the price increase has been offset by falling production and an additional 20%-pts or so has been offset by essentially free shipments to China. That leaves a net benefit of only 5%-pts. Of course, given the huge importance of oil to the economy, policymakers have been reluctant to admit this apparent reality. But the official trade figures just do not stack up. A simple calculation, assuming that all of the oil which is produced according to the IEA is exported at the price of the Venezuelan basket, suggests that total oil exports in 2009 were worth $45bn. That is around $10bn short of the governments official figures which show that total oil exports were over $55bn. (See Chart 2, overleaf.) The situation becomes much worse if the effect of the shipments to China, along with anecdotal evidence that around one-third of oil production is

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retained for domestic use, is included. Oil export revenues then slump to just $27.5bn.
CHART 2: OIL EXPORT REVENUES (US$BN)
12 Official Oil Exports 10 8 6 4 2 0 2000 2002 2004 2006 2008 2010 CE Estimate Value of Oil Production Overreporting? 12 10 8 6 4 2 0

This has had several effects. For a start, in instances where foreign owned firms have been taken over, the government has been left with foreign currency liabilities in the form of compensation to the previous owners although they would contest that compensation is rarely paid.
CHART 3: CURRENT ACCOUNT BALANCE (% GDP)
20 15 10 5 0 -0.1% GDP 20 15 10 5 0 CE Current Account (% GDP) IMF Current Account (% GDP) 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10f -5 -10

Sources Thomson Datastream, CE

-5

As a consequence of this apparent over-reporting of export earnings, the Venezuelan current account position is much weaker than official data and estimates by the IMF suggest. Our calculations indicate that it was actually in a slight deficit in 2009 rather than the surplus worth 2.6% of GDP that was reported by the IMF. Moreover, despite the rally in oil prices last year and the sharp reduction in imports, the current account surplus probably only rebounded to 1% of GDP in 2010. This is far below the huge surplus worth 7.8% of GDP that has been forecasted by the IMF. (See Chart 3.) The upshot is that there has been a sharp decline in foreign currency earnings over the past five years on the current account side of the balance of payments. Withdrawal of the private sector The second reason for the dollar drought comes from the capital account side of the balance of payments. Persistent political risk, stoked by Mr. Chavezs provocative attitude towards the US, neighbouring Colombia and capitalism in general, has triggered a sustained withdrawal of capital from the country. As part of his Bolivarian revolution, Mr. Chavez has nationalised many firms which he regards as being crucial to national interests firms involved in food processing plants and basic materials have been particular targets. Indeed, last year alone he expropriated well over 200 private enterprises.

-10

Sources Thomson Datastream, IMF, CE

More importantly, however, the threat of nationalisation, along with the general deterioration of the business environment and violation of property rights, has been sufficient to spark capital flight and also repel any further inflows of foreign capital. Capital outflows totalled nearly 5% of GDP in 2009. (See Chart 4.)
CHART 4: NET CAPITAL FLOWS (12M SUM, US$BN)
10 5 0 -5 -10 -15 -20 -25 -30 -35 -40 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 10 5 0 -5 -10 -15 -20 -25 -30 -35 -40

Source Thomson Datastream

Rising demand for dollars Another effect of the expropriations has been a hollowing out of the manufacturing sector. Simply put, the economy does not produce as much as it used to as the productivity of firms has fallen as a result of nationalisation. Accordingly, the economy has become more reliant on imports

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and industrial production is still more than 10% lower than it was in 2008. (See Chart 5.)
CHART 5: INDUSTRIAL PRODUCTION (1997 = 100, S.A.)
140 130 120 110 100 90 80 2004 2005 2006 2007 2008 2009 2010 140 130 120 110 100 90 80

Admittedly, the central banks own data place the level of reserves much higher at $30bn down from a peak of over $40bn. But it seems that the discrepancy can be explained by holdings of liquid assets. The IMF use liquid reserves which could quickly be mobilised to meet obligations, whereas the central bank includes illiquid assets. (See Chart 6.) We suspect that the IMFs figures are a more accurate reflection of the current situation. The second response has been to limit the provision of foreign exchange to the private sector. For a start, the string of devaluations to the official exchange rate since last January has reduced the demand for foreign currency by increasing its price. The official exchange rate has been cut by 50% from 2.2/$ to 4.3/$. While another rate, called the SITME, replaced the oil parallel exchange rate in June last year and trades at an average rate of 5.3/$. (See Chart 7.)
CHART 7: EXCHANGE RATES VS. US$
9 8 7 6 5 4 3 2 1 0 2008 2009 2010 2011 Essential Items Exchange Rate SITME Exchange Rate Official Exchange Rate Parallel Rate 9 8 7 6 5 4 3 2 1 0

Source Thomson Datastream

Meanwhile, the governments demand for dollars has also increased. As part of its attempts over the last couple of years to control the old parallel exchange rate, which was an unofficial floating exchange rate that was generally tolerated by the government, the authorities issued a flurry of external debt. As a result, the governments foreign currency debt servicing costs have also risen, and they will total at least $6.2bn this year. FX transactions suppressed The government has responded to the dollar drought in two ways. The first has been to run down the foreign exchange reserves which were accumulated during the oil price boom between 2003 and 2008. According to data from the IMF, foreign exchange reserves have tumbled from $32.5bn at the end of 2008 to just $7.5bn by November last year.
CHART 6: FOREIGN EXCHANGE RESERVES (US$BN)
35 30 25 20 15 10 5 0 90 92 94 96 98 00 02 04 06 08 10 10 0 30 20 IMF FX Reserves BCV FX Reserves 40 50

Sources Thomson Datastream, Venezuela Blogspot, CE

Whats more, the government has also reduced the supply of foreign exchange. The delivery of foreign exchange has been suppressed at the official exchange rate, while the authorities have also kept a tight grip on trading volumes via the SITME mechanism. FX injections used as populist tool The governments initial response had caused imports to plummet, created shortages of goods and caused economic activity to stall and inflation to rise. Rampant inflation hit the poor, who make up the core of President Chavezs support, hardest and his popularity nose-dived. However, in the run

Source Thomson Datastream

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up to last Septembers Legislative elections the government ramped up the supply of dollars via the SITME exchange rate. (See Chart 8.)
CHART 8: DAILY SUPPLY OF DOLLARS VIA SITME ($MN)
60 50 40 30 20 10 0 15-Jun-10 15-Aug-10 15-Oct-10 15-Dec-10 60 50 40 30 20 10 0

both this year and next just to sustain the current situation. But in order to boost the level of imports, he will need to find closer to $80bn (imports totalled $60bn in 2008). We think that there are four ways in which he could increase the supply of dollars, and thus ease shortages, ahead of the elections.
TABLE 1: FX REQUIREMENTS
US$ bn Requirements Debt Service Capital Flight Imports (G&S, 2010e) Additional revenues to reach 2008 Imports ($60bn) Income ($120p.b. Oil) Exports Potential imports Income (Oil Remains at $100p.b.) Exports Potential imports Income (CE Oil Forecast) Exports Potential imports 65.0 45.0 55.0 35.0 70.0 50.0 70.0 50.0 2011 80.0 6.0 14.0 50.0 10.0 2012 79.0 5.0 14.0 50.0 10.0

Source Banco Central de Venezuela

The move eased shortages of essential goods and bolstered his popularity. This helped to ensure that his party retained its majority in Congress. This may have set an important precedent: with presidential elections set to be held in December 2012, Mr. Chavez will probably try to boost dollar supply again to have a better chance of reelection. As things stand, however, he appears to have very limited resources at his disposal. For a start, foreign exchange reserves are only sufficient to cover two months worth of imports, below the standard benchmark of three months coverage. (See Chart 9.) This suggests that the current level of imports is still unsustainable.
CHART 9: FX RESERVES COVERAGE OF IMPORTS (MONTHS)
25 20 15 10 5 0 Benchmark = 3 month coverage 25 20 15 10 5 0

80.0 60.0

80.0 60.0

Sources Thomson Datastream, Bloomberg, CE

Higher oil prices would relieve pressure The first, and most obvious, way out of the situation is for oil prices to continue to rise higher. Based on the IEA production figures, our calculations suggest that if Brent crude were to edge up to $120 per barrel1, and crucially stay there, then the large trade surplus would be sufficient to allow the government to cover capital flight, meet its debt obligations and also boost imports substantially. With oil already around the $100 per barrel mark this outcome cannot be ruled out altogether. And if oil were to simply stay at its current level, then books would just about balance (but the government would not be able to boost the level of imports). Nevertheless, we think the current price

Sources Thomson Datastream, CE

As Table 1 shows, our calculations suggest that Mr. Chavez will need to raise around $70bn in

This is consistent with the Venezuelan oil basket, which trades at a discount to Brent crude, rising to around $100 per barrel.

Latin America Focus 5

level is only temporary and still expect oil prices to fall later this year. Our baseline scenario is that, with the global recovery ultimately set to disappoint, oil prices will fall back to $85pb by the end of this year and to $75pb by end-2012. Based on this forecast, the authorities will face a shortfall of around $5bn this year which they will probably be able to offset by cutting imports back again. But if oil falls further next year, as we expect, they could be forced to cut imports by another $15bn (around one-third of 2010 imports) next year. (Again, see Table 1.) Capital markets and bi-lateral loans Clearly that is simply not an option in an election year, so Mr. Chavez will look to fill the void in other ways. The second option available to him is for the government to go to the markets. The authorities still have access to international capital markets and could issue new dollar denominated debt to meet the requirements. But even so, ongoing concerns about Mr. Chavezs policies mean that while the cost of borrowing for emerging economies has generally been falling, the required yield on Venezuelan debt has trended upwards. (See Chart 11.) The consequence of this is that the cost of plugging the gap with debt may be prohibitively expensive.
CHART 11: EMBI GLOBAL BOND SPREADS (BPS)
2000 1800 1600 1400 1200 1000 800 600 400 200 0 2000 2002 2004 2006 2008 2010 Venezuela Global Composite 2000 1800 1600 1400 1200 1000 800 600 400 200 0

cost of capital is even more expensive. The reality, though, is that PDVSA has simply become another arm of the government and with the markets concerned about the outlook for the company, yields have risen. At present, there appears to be sufficient demand for PDVSAs paper. However, the company has been issuing on average $4.5bn of bonds per year in recent times and it is perhaps unlikely that there would be sufficient demand for debt totalling $25bn ($15bn to cover the potential shortfall if oil prices fall and $10bn to boost imports) - especially if risk appetite wanes next year as oil prices fall. The third way to boost FX inflows, which the government has pursued in the past, is bilateral loans. As we noted earlier, Mr. Chavez has previously agreed oil-for-loan deals with China. With the Chinese eager to secure energy supplies, and given Beijings huge pot of reserves, more loans are likely to be forthcoming. Such deals could help solve the dollar drought in two ways. First, any loans would instantly boost FX liquidity and allow the government to provide more funds for imports. Second, and perhaps more importantly, any deals which involve investment aimed at increasing Venezuelas oil production volumes could potentially increase dollar inflows over the medium-term. Nevertheless, there are also grounds for caution. While deals between Chinese oil firms and Venezuela to develop the oil-rich Orinoco Belt are highly likely, it is not entirely clear that any increase in production will actually translate into greater dollar earnings. Assuming that any loans are made on similar terms to those in the past, the loans will be repaid via oil shipments. These could be over a period of decades depending on the size of disbursements, and so Venezuela would gain little or no increase in regular dollar inflows until the governments debts to China are repaid in full. But there is clearly a reasonable chance that such a deal could be sufficient to help Mr. Chavez win reelection before dealing with the loss of export revenues at a later date.

Source Thomson Datastream

The government has tried to get around this by issuing debt via PDVSA. Given that the company claims to preside over the worlds largest oil reserves, it is perhaps surprising that the companys

Latin America Focus 6

Default increasingly likely... In the past, Mr. Chavez has coped with any shortfalls by taking bilateral loans, issuing debt and cutting the supply of dollars (and imports), while accepting high inflation, a shrinking economy and a lower approval rating as the consequences. We suspect that this approach will suffice this year. However, he is unlikely to risk taking that approach next year ahead of the elections. This leaves a fourth, and final way, out of the situation: default on external debt obligations due in 2012. The wisdom of such a short-sighted move is questionable. But if oil prices fall in line with our forecasts, and the government is unable to finance itself via the markets and China, then there is a clear risk of default since it would free up around $5bn to be channelled into the wider economy (equivalent to 10% of imports). ... but a domino effect is not On the face of it, given that Venezuela is the fourth largest economy in Latin America at market exchange rates, a default could have widereaching implications for the region and for emerging markets in general. It would be big news and, given that Venezuela accounts for around 6% of the EMBI Global bond index, there could be a general widening of the EMBI spread. Nevertheless, we suspect that any market reaction would soon be reversed, not least because some kind of default on both sovereign and PDVSA debt appears to be fully priced into the market. (See Chart 12.) Indeed, based on an assumed recovery rate of 40%, the probability of default over the next five years, as implied by credit default swaps, is currently 57% for the government and 65% for PDVSA. One point worth noting, though, is that the market is probably expecting some form of hiccup or rescheduling along the lines of Ecuadors default in late 2008. This is perhaps the most likely outcome. But the unpredictable nature of Mr. Chavezs policymaking means that there is a risk that something more serious unfolds. It is quite

plausible that what may start as a minor rescheduling could snowball into a complete halt of debt repayments all together. After all, many incidents of default boil down to the debtors willingness to pay rather than their ability to pay.
CHART 12: PROBABILITY OF DEFAULT IMPLIED BY CDS MARKET ASSUMING A 40% RECOVERY RATE
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0.5 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 4 5 Years 7 10 20 30

Government PDVSA

Sources Thomson Datastream, CE

Either way, Venezuelas is very much a special case and the rest of the regions fundamentals remain very good. Accordingly, we think that there is very little threat of any Venezuelan default triggering a systemic emerging market crisis. Given its fairly recent default, Ecuador will be the most exposed country in the region and any default could trigger capital flight which would hit the dollarised economy hard. But the wider implications of this should be short lived. Conclusions Falling export revenues and sustained capital flight have forced the Venezuelan government to slam the capital account shut and reduce the supply of dollars to the wider economy. The subsequent drop in imports has brought about shortages in the economy and has been one of the contributing factors to double-digit inflation. That has hit the poor, who are President Chavezs core supporters, hard and his popularity has dwindled. As a result, his United Socialist Party struggled to maintain its majority in last years Legislative elections. Accordingly, the dollar drought looks set to have a big say in the outcome of next years presidential

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elections. If our forecasts are right, then the elections will coincide with a fall in oil prices and a dip in risk appetite. Clearly, Mr. Chavez will seek bilateral loans from the likes of China to try and maintain dollar liquidity. But failing this, there is a growing risk that the government will elect to default on its $5bn of external debt obligations which are due in 2012. Given that Venezuela is the fourth largest economy in Latin America, this would be big news. It could dent risk appetite in general and have a negative effect on emerging markets as a whole. The good news, however, is that some kind of default already appears to be broadly priced into the market over the next five years. Accordingly, any impact on other markets is likely to be short-lived and we see little risk of a domino effect. Nevertheless, there is a risk that rather than the default taking the form of a minor rescheduling of debt repayments, Mr. Chavez could elect to halt debt servicing all together.

Latin America Focus 8