Potential Future Consequences for Venezuelan Spending Spree

Sources:

Bloomberg: P&G Bracing for ‘Large’ Venezuela Devaluation After Election

Reuters: Venezuela Inflation Slows in July for Seventh Month

WSJ: Venezuela Faces Economic Hangover

Over the past year, Venezuelan President Hugo Chávez increased spending in various social programs, including free government housing and cash stipends for the elderly and pregnant women. According to government officials, these spending tactics contribute to the nation’s forecasted 5% gross domestic product (GDP) for 2012—generally, government spending boosts economic activity because when the government spends, it purchases good and services, which raises the demand for such goods and services. To meet this demand, companies create more jobs, which leads to more income for consumers, and thus, more economic activity. President Chavez encourages spending for social programs in hopes of rallying support for his campaign before the country’s October election. However, analysts such as Boris Segura—of the international financial consulting firm Nomura—are skeptical of the future repercussions that this spending spree could have on Venezuela’s economy.

Analysts like Segura are concerned that President Chávez’s spending spree will affect the country’s debt as well as currency valuation. Although the exact allocation of government spending is unknown due to a lack of transparency in the government, analysts recognize that the recent spending spree increased Venezuela’s debt. Analysts expect the debt-to-GDP ratio to reach 52% by the end of the year, which is almost double the 23% debt-to-GDP ratio from 2008. Even though Venezuela never defaulted on its debt obligations under President Chávez’s leadership, the growing debt harms Venezuela’s credit rating—credit ratings affect how much an entity must pay in interest on their issued debt—because an entity with a large amount of accumulated debt is generally less able to repay that debt. According to both Standard & Poor’s and Fitch,—credit rating agencies—Venezuela’s current investment grade is a B+, meaning that adverse circumstances such as poor economic conditions could affect the country’s ability to meet debt obligations. Due to the country’s recent spending spree and increased debt, Fitch put Venezuela’s rating on review for a potential downgrade. A lower credit rating would hurt the country’s ability to obtain more money (debt) because investors would consider Venezuela to be a riskier investment and the country would have to offer investors higher interest rates (pay more money to investors) to be able to continue borrowing.

Due to this growing debt, Venezuela may need to devalue its currency—lower the value of the currency—to help the country service its debt; that is repay the interest and principal of a debt, . According to a group of fourteen analysts surveyed by Bloomberg, Venezuela will devalue its currency in January 2013 from 4.3 bolivars per dollar to 6.2 bolivars per dollar. By devaluing its currency, Venezuela will earn more bolivars for its exports (instead of selling its goods and services for 4.3 bolivars per dollar, the country now sells its goods and services for 6.2 bolivars per dollar). With more bolivars, Venezuela will improve its ability to pay its debt obligations. However, devaluing the currency will also likely increase inflation— a general rise in the price levels of goods and services. This is because imports become more expensive—more bolivars are needed to purchase the same quantity of dollar-denominated goods and services (instead of paying 4.3 bolivars per dollar of goods and services, the country now pays 6.2 bolivars per dollar of goods and services). Since Venezuela imports about 75% of its consumption, devaluing the currency would likely raise the country’s inflation rate.

Based on Venezuela’s growing debt and likely devaluation of its currency, some analysts suggest that Venezuela will experience a lower GDP in 2013. Normura’s analyst Boris Segura predicts a 1% GDP loss for the country, while Bank of America Merrill Lynch expects a 3.5% GDP loss. Other analysts like Russell M. Dallen Jr., managing partner at a local brokerage and research firm named Caracas Capital Markets, do not provide a GDP prediction as the country’s spending tactics could change after the October election. Nonetheless, most analysts will agree that the current spending tactics are not sustainable because of the potential lasting effects on the country’s debt obligations and inflation rate.

Paraguay’s Suspension Clears Way to Mercosur for Venezuela

Sources:

Reuters: Mercosur Welcomes Venezuela, Suspends Paraguay

Rio Times: Mercosur Members Suspend Paraguay

WSJ: Venezuela To Join Mercosur Trade Bloc

Washington Post: Paraguay Suspended from Mercosur for Lugo's Impeachment, but Will not Face Economic Sanctions

On June 29, Argentina, Brazil, and Uruguay suspended Paraguay from Mercosur, a trading bloc that consisted of those four countries as voting members. Shortly after, Argentina, Brazil, and Uruguay also voted to make Venezuela a full member of the trading group.

The shakeup of Mercosur followed the Paraguayan Senate’s decision to remove leftist President Fernando Lugo. The Senate, which Paraguay’s right-wing opposition party controls, believed President Lugo did not appropriately handle a forced land eviction that killed nine farmers and seven police officers on June 15 of this year. Leaders of countries throughout South America condemned this impeachment. Argentina, Brazil, and Uruguay withdrew their ambassadors and claimed the impeachment violated due process (the legal procedures required to make a decision valid) because the Senate provided President Lugo less than 24 hours to present his defense at trial.

The decision by Argentina, Brazil, and Uruguay to suspend Paraguay from Mercosur opened the door for Venezuela, whose full-member status in Mercosur had been blocked for six years by the Paraguayan legislature (but favored by former President Lugo), to join Mercosur. Paraguay’s right-wing legislature had questioned whether Venezuela’s President Hugo Chávez was operating a democratic regime. However, with Paraguay no longer eligible to vote in Mercosur meetings due to the suspension, the three remaining countries quickly agreed to grant Venezuela its long-awaited full-member status.

Venezuela will officially become a voting member of Mercosur on July 31, and its addition will increase the trading bloc’s global influence. Although Mercosur is already a major global grain provider, Venezuela will bring in the world’s biggest crude oil reserves into the trading bloc. Potentially, the addition of Venezuela’s crude oil could give Mercosur leverage in long-discussed free-trade negotiations with China as it will now have energy supplies on its side of the bargain.

Although Argentina, Brazil, and Uruguay decided to suspend Paraguay until it votes for a democratically elected president in April 2013 (the interim President, Federico Franco, had served as Lugo’s vice president and had been critical of former President Lugo), the countries did not decide to impose economic sanctions on Paraguay. The land-locked country of 6 million is already one of the poorest in South America, and economic sanction by Mercosur, such as imposing tariffs (a type of tax) on Paraguayan goods, could have devastating effects because half of its trade is with other Mercosur countries. Moreover, the country has already suffered economically this year because a drought destroyed its soy exports and farmers have slaughtered hundreds of cattle due to the outbreak of foot-and-mouth disease. According to Argentina President Christina Fernandez, who has called the removal of President Lugo a “coup,” economic sanctions would not be productive because “they never hurt governments. They always hurt the people.”

The right-wing members of Paraguay’s Senate did not expect a suspension from Mercosur after impeaching and removing President Lugo. Despite their expectations, Paraguay’s suspension is Venezuela’s gain, and the legislators’ six-year efforts to prevent Venezuela from gaining full-member status have finally been thwarted. However, it is too soon to determine what these developments mean for South America’s economic and political landscape.

Venezuela Moves to Return Gold Reserves Home

Sources:
Bloomberg: Chavez Emptying Bank of England Vault as Venezuela Brings Back Gold Hoard
Bloomberg: Chavez Preparing Government Takeover on Venezuela’s Gold Mining Industry
FT: Venezuela to Nationalize Gold Industry 
WSJ: Venezuela Moves to Take Over Gold Sector

Earlier this month, Venezuelan President Hugo Chavez announced a plan to return the country’s gold reserves to Venezuela. The price of gold has skyrocketed in the last few years in the wake of the global financial crisis, thereby increasing the commodity’s importance in global finance as a haven in rough economic times. Venezuela is the 15th-largest holder of gold in the world, with approximately two-thirds of its international savings held in the form of gold. Currently, however, 211 of Venezuela’s 364 tons of gold—approximately $11 billion worth—are stored in institutions located abroad in global economic centers such as London and New York.

President Chavez decided to bring Venezuelan gold “home” as a way to ensure its security. The Venezuelan Finance Minister clarified that recent events like the weakening of the U.S. dollar, the U.S. government’s near-default on its debt obligations, and the European sovereign debt crisis have exposed instability in the developed world that makes Venezuela’s savings safer elsewhere.
President Chavez claims that he wants to defend Venezuela’s assets from those whom he believes might take Venezuelan wealth for their own purposes, including the U.S. and U.K. In addition to returning some of the gold to Venezuela, the government will also send some to emerging markets, such as Brazil, Russia, India, and China, that it views as more friendly to its government.

In a parallel move, President Chavez also decided to nationalize the gold mining industry, which further increases the government’s control over the gold supply. Nationalization has been common in Venezuela during Chavez’s term as president, so the decision came as no surprise to many observers. However, unlike its sizeable oil industry (infamously nationalized early in Chavez’s presidency), Venezuela is not among the top gold producers in the world, producing only 100,000 ounces of gold per year. Furthermore, legal production of gold pales in comparison to the approximately 400,000 ounces illegal miners extract each year. Although Chavez cites this extensive illegal mining as a pretext for the nationalization, critics see foreign mining companies as targets as well. The Venezuelan government does have a history of intervening in foreign gold-mining operations. In February of this year, for instance, it terminated a Canadian company’s contract to develop one of Latin America’s largest gold deposits located in the southeastern part of the country. Many of these foreign companies are now seeking redress from the Venezuelan government through international arbitration.

Skeptics of the two moves believe that Chavez’s intentions go beyond mere security concerns. Moving gold to “allied” countries may be an attempt to prevent the U.S. or U.K. governments from seizing the gold to satisfy foreign investors if and when they succeed on claims against Venezuela in international arbitration. It may also be an attempt to improve economic ties with emerging economies as the Venezuelan economy continues to struggle. However, some experts believe Chavez’s decision may leave the country even more economically vulnerable than it already is. The lack of transparency resulting from Venezuela’s relocation and increased control of its gold reserves (essentially its savings) will make it difficult for outsiders to know the state of Venezuela’s finances. If investors come to believe that investing in Venezuela is even more risky than it already is, they will demand more protection for their investment in the form of a higher interest rate on Venezuelan bonds, or they might refuse to invest in Venezuela entirely. Rising interest rates would increase Venezuela’s borrowing costs and, therefore, its already large debt. Increased debt would cause more investor uncertainty, which would further damage the Venezuelan economy. As a result of this economic reality, Chavez’s decision may do more harm than good.

Venezuelan Exchange Policy Troublesome for Many

WSJ: In Venezuela, Popular Websites Track Black Market in Currency

NASDAQ: Venezuela Formally Charges 10 Brokers for Parallel Currency Trading

Bloomberg: Policy Sends Venezuelans on Cross-Exodus for Cash

Many Venezuelans are unable to exchange Venezuelan bolivars for United States dollars to import necessary American products. In May 2010, in a move to encourage domestic production and consumption, Venezuelan president Hugo Chavez banned private currency trading and required banks to use a state-run exchange market. Since then, individuals have to apply to the government to exchange currency, but most are turned down because Chavez wants Venezuelan money to stay within Venezuelan borders. Trading outside of the government system is illegal. In a country that relies heavily on imports, many Venezuelans are trying to find ways around this strict and troublesome exchange system.

Some Venezuelans travel to neighboring countries, like Colombia, to exchange their money. They often travel hundreds of miles every week to exchange currency and purchase supplies from the United States for their businesses. However, through this system, Venezuelans only get about half the dollars for what the bolivars are supposed to be worth according to the government’s official exchange rate. The Venezuelan government offers 4.3 bolivars per dollar whereas the exchange rate in Colombia is around 8.3 bolivars per dollar. Venezuelans accept the low value in Colombia because the government almost always denies applications for currency exchange. In fact, numerous websites have been designed specifically to track the exchange rate of bolivars in nearby countries. These websites are based in other countries so that Venezuelan governmental control is nearly impossible.

Other Venezuelans participate in a black market exchange of bolivars. In fact, about 11 percent of the country’s imports are purchased on the black market. Exchange of currency used to occur legally through electronic transfer by banks. In this system, Venezuelan importers sent bolivars electronically to traders. The traders then sent the dollars to the American companies to export the products to Venezuela. Chavez banned this trading, but the electronic transfers did not necessarily stop. However, the government is cracking down on the black market. In April 2011, the Venezuelan Attorney General charged 10 brokerage houses with participating in the black market.

While there are methods of getting around the government exchange system, many Venezuelans are finding it too difficult. One Venezuelan who owns a medical clinic and imports equipment from the United States is thinking of selling his clinic and moving out of the country instead of continuing to take trips to Colombia to exchange currency. Although Chavez’s policy attempts to encourage domestic consumption, it appears that it may have the opposite effect and push some to take their business out of Venezuela.

Latin America Surges Forward in the Face of the Continued Global Recession

Sources:
Elcomercio.pe: La economía peruana crecerá más de 6% este año, aseguró la ministra Mercedes Aráoz
WSJ.com: Mexico’s Economy Expands in Second Quarter
Estadao.com.br: Serasa: economia brasileira desacelera no 2º trimestre
Mercopress.com: Peru and Chile Will Lead Latam Expansion in 2011 with 6% Growth Each
Mercopress.com: Argentine Economic Activity Expands 11.1% in June Over a Year Ago
Businessweek.com: Venezuela Economy Down 3.5 pct in First Half 2010

Despite the fact that most of the world has still not completely shaken off the global recession, Latin America has clearly set itself apart as countries across the region are experiencing their best growth rates in years. The International Monetary Fund (IMF) is predicting that Chile’s economy will expand by 6% this year (in terms of Gross Domestic Income). This growth is thanks to effective reconstruction spending following the massive earthquake on February 27 of this year and a rise in commodity prices. This growth will far outstrip the IMF’s prediction for global expansion of only 4.2% for the year.

Peru and Mexico are experiencing equally impressive levels of growth as well. Standard & Poor’s is predicting growth of 7.5% (in terms of Gross Domestic Product) for the year in Peru, though the Peruvian government is predicting only 6%. Peru is also benefiting from high commodity prices, but the Minister of Economy credits higher domestic demand and private investment as the main source of growth. The Bank of Mexico is predicting an annual growth rate between 4-5% (GDP) this year driven by a strong recovery in the country’s manufacturing sector. Mexico’s economy expanded at the fastest rate in over a decade in the second quarter this year.

The industrial sector pushed Brazil’s growth to 8.4% (GDP) in the first half of 2010 compared to the first half of 2009, and the IMF is predicting a growth rate of 4.1% (GDP) for the year. Ironically, like most of Latin America, second-half growth rates will likely decline in Brazil due to the fact that the country had already exited the recession and was again experiencing growth by the end of last year, making the year-to-year comparison less favorable. Even Argentina, a country with a less-than-stellar economic record since its 2001 economic collapse, saw growth of 11.1% (GDP) in June 2010 as compared to June 2009 after an excellent agricultural harvest.

One country bucking the growth trend is Venezuela. The Venezuelan economy shrank 3.5% (GDP) in the first half of 2010 after shrinking 3.3% in 2009. The government blames its financial woes on low global oil prices (oil makes up 95% of Venezuela’s export earnings), while government critics blame the country’s socialist economic policies and low consumer demand and investment for the poor showing.

Discussion:
1) After famously suffering through the “Lost Decade” of the 1980’s many Latin American countries have shifted to more democratic governing systems and have experienced subsequent economic growth. Does the fact that Latin America appears to have already exited the global recession and returned to the excellent growth rates it had been experiencing in recent years signal that the region as a whole is on a path to first-world status, or should the world continue to be wary of the historically troubled region?