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Market Laws Could Spell Defeat for Venezuela's President

By Stratfor January 22, 2004

Summary - Efforts by Venezuelan President Hugo Chavez to block a presidential recall referendum and neutralize a divided political opposition are succeeding. However, his success in containing the opposition could be undermined by the economy's deepening crisis.

Analysis

If Venezuelan President Hugo Chavez can keep inflation and devaluation pressures in check for the next six months, he has a good chance of surviving opposition pressures to force him into a presidential recall referendum that could drive him from power. However, if inflationary pressures spike significantly in the first half 2004 and the bolivar's depreciation accelerates in the so-called "parallel" or "black" market -- where individuals and companies now buy over two-thirds of their foreign currency needs -- it could result in a more rapid erosion of Chavez's popularity among the mainly poor Venezuelans who make up his core political base.

Historically, the double-whammy of inflation and devaluation has been a political killer in Latin American elections, with voters turning against leaders and parties they perceived as responsible for the social and economic woes created by soaring prices and tumbling currencies. If an inflation-devaluation spiral takes hold in Venezuela over the next six months, it could cost Chavez much of his remaining popular support and speed the end of his government.

The argument that Venezuela's economic crisis will grow worse in 2004 might not appear credible at first glance. After all, it is likely that world oil prices will remain high throughout the year, assuring the Chavez government of a substantial revenue stream. The Central Bank's foreign exchange reserves total more than $21 billion, which means the government has plenty of cash on hand to spend -- if it can tap into those reserves despite the Central Bank's objections. Also, the economy is expected to grow more than 7 percent in 2004, according to the most recent government projections.

However, this year's projected economic growth would come on the heels of a cumulative economic contraction of over 20 percent in 2002 and 2003 and would be driven primarily by the state-owned oil sector. It will not be accompanied by new job creation in the oil sector. It also is likely that private-sector investment and job creation in what Venezuelan economists call the "non-oil economy" will remain stagnant in 2004.

Moreover, the Central Bank's foreign exchange reserves have doubled in the past year, due to tight government exchange controls that crippled private economic activity, drove thousands of companies out of business and raised unemployment to between 17 percent and 22 percent of the population, according to different official and private estimates. In effect, Venezuela's economy has become significantly weaker in the past year.

Chavez blames the economy's troubles on an oil strike in December 2002 and January 2003 that cost the country between $10 billion and $15 billion in losses. However, though the strike hurt Venezuela's economy badly, the tough foreign exchange controls imposed a year ago by Chavez in retaliation against his private-sector opponents has made a bad economic situation much worse. Ironically, Chavez's exchange controls have set the stage for the inflation-devaluation spiral in 2004 that could hurt his popularity among poor voters and increase pressures on the Electoral National Council, Supreme Court and other government entities to force the president to face a recall referendum.

Chavez also has compounded the economic dangers by picking fights with the Central Bank and the privately owned Italcambio exchange house. Chavez wants the Central Bank to hand over up to $2 billion of its foreign exchange reserves so the government can directly fund agricultural spending programs. However, the Central Bank rejected the president's demand as illegal, warning that compliance would threaten price and exchange stability and destroy Venezuela's international creditworthiness because it would be interpreted as a sign that the government has seized control of the Central Bank.

Chavez's recent intervention in Italcambio also apparently was motivated by his desire to retaliate against its owner, Carlos Dorado, one of the government's most acerbic critics in the private sector. However, the intervention had the unintended consequence of drying up the parallel market's dollar supply. As a result, since the start of 2004, the bolivar's exchange rate in that market has risen above 3,200 bolivars per dollar, compared to the official exchange rate of 1,600 bolivars per dollar.

Moreover, money traders in Caracas told Stratfor on Jan. 21 that everyone is buying dollars at any price they can get, which is placing even more pressure on the parallel market exchange rate. If the government were to loosen its exchange controls to inject more hard currency into the economy, Venezuelan buyers likely would flock into dollars massively, causing the bolivar to depreciate faster and possibly create a liquidity crisis that could hurt bank deposits.

Venezuelan government finance officials claim that exchange rate movements in the parallel market do not matter because all foreign exchange authorizations are calculated by the government agency (CADIVI) that issues foreign exchange to private companies. This might be true if CADIVI were fully supplying the private sector's foreign exchange needs, which totaled more than $48 million a day before exchange controls were imposed a year ago. However, CADIVI has been approving about $10 million a day on average and has disbursed only a fraction of that amount.

Venezuelan producers import more than half of their component needs. Also, most of the country's food is imported, including basic commodities. The government's tight exchange controls have forced private companies either to shut down -- as thousands have done -- or supply their foreign exchange needs from the parallel market. Consequently, the parallel market exchange rate determines real wholesale and retail prices in the non-oil economy -- where over 95 percent of the country lives and works -- while the official exchange rate determines the nation's wages.

This was not apparent to Venezuelan consumers in 2003, since wholesalers were unable to fully transfer higher costs to retailers due to price controls and declining consumption when Venezuelans tightened their belts. Also, many wholesalers were able to offset higher prices by slashing costs -- mainly by negotiating voluntary severance packages with over a quarter of their workers, on average, to get around a government freeze on firings. These 2003 cost-cutting strategies allowed wholesalers to absorb price hikes of 70 percent to 80 percent, while the retail price index increased only 27 percent, according to the Central Bank.

However, wholesalers do not have any more leeway to absorb even higher costs in 2004 resulting from the parallel market bolivar's accelerating devaluation. This means they will soon begin to pass cost increases to retailers and, ultimately, consumers. When consumers start feeling the bite more sharply, demands for wage increases will multiply quickly in the public sector. State-owned Caracas Metro workers called a snap strike Jan. 21 to demand fare hikes that would generate more cash flow to finance higher wages and salaries. The government is resisting the demands because caving in likely would trigger similar demands by other unions representing 1.2 million public-sector workers.

If wage pressures become too great, Chavez might seek to generate additional bolivar revenues for the government by accelerating the bolivar's devaluation. The central government budget for 2004 contemplates currency devaluation throughout the year to 1,920 bolivars per dollar. The government could accelerate this devaluation schedule and perhaps even take the official exchange rate to 2,150 bolivars per dollar, a Caracas-based economist told Stratfor recently. This would generate cash flow to finance public-sector wage increases and likely would bring the parallel market exchange rate down closer to the official rate -- at least for a few weeks or even a couple of months. A more rapidly devalued official exchange rate also would reduce the size of the government's debt to private Venezuelan banks if such debt were measured in dollars.

However, the gap between the official and parallel exchange rates would widen again quickly as prices and interest rates rose in response to the bolivar's faster devaluation -- particularly if the government keeps the current official and parallel market dual-exchange rate systems in effect. In turn, higher prices and interest rates would place more pressure on the parallel market exchange rate, which could easily top 3,500 bolivars per dollar before mid-2004.

Moreover, the apparent advantages to the government of reducing debt to private banks through devaluation would be more than offset by the harm many banks would suffer -- especially if a liquidity crisis were to develop. Banking sources in Caracas told Stratfor on Jan. 21 that a liquidity crisis could bankrupt at least six financial institutions that together hold over one-third of the financial system's assets and deposits.

Chavez has been a formidably astute political infighter who has survived in power for five years despite military rebellion, an oil strike and an economic crisis that would have toppled any of his predecessors in the past 15 years. However, his government has shown little competence in areas of financial and economic management. It is possible that market laws could weaken his hold on power to the point that he loses a recall referendum should he fail to stop it.



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