Venezuelan Currency Reform: Pragmatic Policy or Misguided Gamble?

Predictions about Venezuela’s economy spawn prolifically. In light of Venezuela’s major oil reserves and president who is increasingly outspoken against the U.S., many wait impatiently to see how the country will fare in the wake of its ongoing recession. Will Chávez lead the economy downward to disaster, or will he surprise all with economic resilience?

On Wednesday, June 9, Venezuela’s bond market reopened after President Hugo Chávez had shut it down on May 19. Chávez blamed the bolívar’s fall to almost half its previous value on currency speculation in the parallel market for dollar bonds, which he proceded to suspend until a new market system could be put into place. Newly reopening with a devalued bolívar, the new bond trading market will give the government full control of the exchange rate by requiring that companies buy dollar-denominated bonds rather than conduct direct sales of bolívars for foreign currency. This system follows the trend of Chávez’ leftist recession-fighting policies such as nationalization of industries, controls on prices, and high rates of government spending on social programs. Lauded by some and assailed by others, Chávez’ policies are often seen as indicative of a worldwide trend against the 1990s’ globalization, market economics, and neo-liberalism. The question that now remains to be answered is: what does this new policy portend for Venezuela’s economy?

Venezuela’s New Market for Bonds

In the new system, Venezuela’s central bank will announce a trading band each morning within which banks, savings institutions, and authorized exchange houses will be able to trade bonds for currencies. The bonds used for trading will come from government reserves as well as from private banks. According to Chávez, if the country’s banking institution does not respond to his request for dollar-denominated bonds, the government will force them to do so. The creation of this new system comes at the heels of currency reforms introduced earlier this year. In January, Chávez created a multi-tiered exchange rate system, setting one priority rate for necessity imports and another one for all other transactions. The official rate was around 4.3 bolívars per dollar, with the rate for necessities at 2.6 bolívars per dollar. The thriving black market in foreign currency that has arisen as a result of this system ranges anywhere between 6.25 – 9 bolívars per dollar.

Effects of Chávez’ System on Inflation

According to Chávez’ officials, the main purpose of the new system is to prevent the speculative trading that fuels rising inflation. At 31.2%, the highest rate in Latin America, Venezuela’s inflation discourages investment and prevents growth. However, according to Finance Minister Ali Rodriguez, the new system might actually increase inflation by 5%. The Royal Bank of Scotland (RBS Securities Inc.), one of the largest providers of liquidity to the U.S, has announced that Venezuela could potentially face a rise in consumer prices of 40% this year. Thus, while Chávez believes that his economic policies will strengthen the economy by decreasing inflation, current conditions and multiple predictions could indicate otherwise.

Effects on Competitiveness of Venezuelan Goods

However, Chávez’s new system could enable Venezuelan goods to be more competitive on the world market. By increasing Venezuela’s competitiveness, this week’s de facto devaluation might help boost exports and lower imports. Such improvements might help the country become more independent; during Chávez’s presidency, Venezuela has become dependent on imports of many products. Increased import prices and decreased export prices would encourage development of the country’s commodities industries. Similarly, a fixed exchange rate usually encourages international trade and investment by making investors confident in exchange rate stability. Nonetheless, the probable escalation of inflation will likely prevent any improvements in investment confidence in Venezuela because investors will be averse to volatile economic climates. Venezuelan goods could also gain competitiveness with funding deriving from foreign direct investment (FDI). According to James Painter of BBC, “total foreign investment in Latin America last year was worth about 126 billion USD. Only 600 million USD were invested in Venezuela, compared to more than 8 billion USD in neighboring Colombia, and 15 billion USD in Chile.” It would be in Venezuela’s interest to stabilize its economy so as to attract FDI, which might make its products more competitive.

Problems in Demand for Bonds

In addition to improving competitiveness of its goods, Venezuela should also address its current issue of potential bond shortages. Though the central bank’s president Nelson Merentes said Tuesday that the government currently has enough bonds to meet demands, several economists believe this is not the case. Some estimates predict 15-17 billion USD in bonds will be needed for the new system, but according to the government, the central bank falls short of this amount with only 5 billion USD. According to Fabiola Sanchez in an article for The Washington Post, the government only has 2 billion USD. This lack of liquidity is a particular cause for concern because of the government’s poor history of supervising the exchange rate system. If banks have insufficient bonds, businesses cannot trade bonds for the dollars they require for international trade, and shortages arise. Also, because bonds are undersupplied, black markets develop in order to fulfill excess demand.

Critiques of Chávez’ Economic Policies

The problem with bonds is only one of the negative aspects of Chávez’ economic legacy. Inflation, black markets, and corruption are also issues. After Venezuela’s 2002-3 recession, the country recuperated after benefiting from rising international oil prices that boosted GDP. In 2007, for example, economic growth reached 8.4%, according to the IMF. As a result, Chávez’ economic policies were aimed at trying to deal with these economic struggles.

Chávez’ Social Policies: Effective Cure or Temporary Bandage?

Chávez’ newest policy is one of many that have engendered mixed assessments among economists. Some are optimistic, pointing out that the immense increase in social program funding has brought unemployment down to below 10% and reduced poverty by two-thirds according to the Venezuelan government. However, other economists fear that Venezuela’s inflation rates, among the world’s highest, as well as shortages of food products like sugar and milk, do not bode well for the country’s commercial future. Such policies have faced mixed acclaim worldwide, as well as in his country. Chávez’ anti-elite and populist rhetoric and policies have launched him as a highly inspiring figure among much of the largest sector of Venezuelan society, the poor and marginalized peoples of Venezuela. However, despite Chávez’s popularity, he still has failed to address Venezuela’s main problem: the curse of oil.

The Curse of Oil?

Some believe that Venezuela has limited oil revenues by spending too little on rejuvenating the country’s capacity to rebuild oil stock production and recapacitation of oil production infrastructure. These economists argue that his government spends too much money on military expenditures rather than on infrastructure for the oil industry. For example, the Wall Street Journal has written that exploration, which could lead to new oil production by PDVSA, Venezuela’s state owned oil corporation, has decreased from $174 million in 2001 to $60 million in 2004. However, not all agree with this analysis. Vicente Frepes-Cibils, lead economist for Venezuela at the World Bank, believes that investment is increasing and that the country has accumulated $10-15 billion that it plans to use for oil infrastructure modernization in its uncertain future. Furthermore, Chávez has said that he will increase oil production this year.

Paradoxically, many economists believe that developing countries with large oil endowments are actually “cursed” in that large oil revenues discourage them from diversifying production of other non-petroleum goods. This tunnel vision makes countries such as Venezuela dependent on other countries for basic necessities like food. However, it does not seem that Venezuela is fully suffering from this curse: Chávez has been somewhat successful in diversifying the economy, with a collective growth rate of 10.6% in the mining, manufacturing, and agriculture sectors in 2005. However, according to Miguel Tinker-Salas, a professor at Pomona College, “oil still predominates.” This dependency is problematic because it may leave Venezuela vulnerable to oil price collapses. Thus, some believe that Venezuela should allocate more funds to oil extraction whereas others argue that diversifying the economy would be far more beneficial. A balance of both solutions would be ideal: if Venezuela encouraged a broader range of economic production while also investing in oil, the oil could provide revenue for further investment in diversification.

Chávez’ Macroeconomics

It is likely that Chávez’ inadequate macroeconomic and exchange rate policies have worsened the recent recession: instead of boosting spending, he made cuts to the government budget, and instead of devaluing the currency, he let it stay overvalued. Many of Chávez’ programs have been less than successful because they have been unaccompanied by focused macroeconomic policy. For example, in 2004, Chávez should have instituted fiscal and monetary expansion alongside the institution of the bolívar in order to stave off inflation. Even now that the currency has been devalued, some economists such as Mark Weisbrot believe that it is still overvalued.

However, Chávez does not believe inflation is caused by any weakness in his economic policies. Rather, he blames the private sector for Venezuela’s high inflation. With congressional elections upcoming in September, he seems eager to escape any personal blame for inflation. Chávez has said his government has been unable to lower inflation because private companies’ price increases outpace his annual minimum wage adjustments, and he blames the former for not doing enough to stabilize the inflation rate. He intends to solve the problem of inflation by approaching manufacturers and offering to set up joint venture businesses as a way to guarantee low prices and give workers more control over production. At that stage, companies might not have the option to turn down this offer: companies that refuse to cooperate may be expropriated. Whether this is a prudent policy remains to be seen.

“Is Venezuela Another Greece?” An Inaccurate Comparison

Recent articles in Bloomberg, The Washington Post, and other sources suggest that Venezuela is on the verge of economic collapse. Though Venezuela has been compared to the PIGS (Portugal, Italy/Ireland/Iceland, Greece, and Spain), this is not a fair comparison. As Mark Weisbrot points out, Venezuela does not have the debt burden that beleaguers the PIGS. With debt at 20% of GDP, Venezuela is better off than Greece, which compares at115% and is expected to rise to 149% in 2013. Though the cost of insuring Venezuela’s debt is high (the cost of credit default swaps reaching 1,448 basis points from 897 basis points on May 3), Frank Jack Daniel writes for Reuters that many economists believe these figures are overestimated and that Venezuela’s debt is in reality quite solvent.

Furthermore, unlike indebted European nations, Venezuela’s control of its own monetary policy affords it the ability to correct an overvalued currency. Thus, fears of a Venezuelan default are most likely unfounded. This ability to control monetary policy is extremely significant, for the overvalued exchange rate is a main hurdle in Venezuela’s path to growth. In other words, Venezuela has the means to securing a lower exchange rate and to thereby diversify beyond oil, as this has been found to be the best approach to development.

Future Prospects for Chávez’ Policies

Chávez’ inadequate macro policies have left him in need of solutions to help patch up the Venezuelan economy. Perhaps this is much of the cause for his decreasing popularity ratings. Of course, these ratings contain some inherent bias, because more middle to upper class citizens were surveyed than those in the lower strata of society. Until Chávez lets the overvalued bolívar fall, however, he will prevent the economy from reaching its full potential. With not only oil reserves but also other primary materials, the Venezuelan economy’s full potential is vast.

In addition, there are high levels of corruption which there have been few efforts to correct. Venezuela’s corruption is demonstrated by Transparency International’s index ranking of 162 out of 179 countries. Moreover, even if Chávez’ policies do experience some economic success, current corruption levels indicate that funds would be inefficiently allocated. However, Chávez does not systematically evaluate his own social programs which he so energetically launches. His penchant for developing new plans instead of improving those currently in place is inefficient in most cases. Chávez’s new policy was only instituted on June 10; it is perhaps still too early to predict with certainty whether it will have a generally positive or negative effect on the economy. However, it seems that Venezuela’s strategy to deal with oil diversification and combat corruption, poverty, and inflation, are likely to prevent Chávez’s policies from successfully boosting the economy any time in the near future.