Fixing Venezuela's economy #1: Dollarization
01.12.04 | Things have been hectic, I want to write about the muzzle bill (also known as the media Bill), I want to write about the mortgage bill, a tribute to financial stupidity and I want to write about the new bond, but there has been so much going on that I have not had time to do any of it. Moreover, last weekend I wrote my list of “fixes” for the Venezuelan economy but have not had time to talk about them and I don’t want to delay staring that thread, so here is the first installment.
First I will clarify: I am not an economist nor trained in economics, but the last twelve years of my professional life have been in the finance sector where I have become an amateur practitioner of a field that I was always interested in. I will start with dollarization; a measure that I believe will have a wide and very positive impact on the Venezuelan economy, benefiting everyone. But let’s start at the beginning.
I am not advocating for a currency board by which a central authority will decide how many bolivars to have outstanding based on how many dollars are in the Central Bank. I am advocating doing away with the Bolívar and making the US dollar the official currency of circulation in Venezuela.
First of all, I choose the US dollar for practical reasons. Venezuela imports more from the US than any other country and exports to that country more than to any other country. The ideal solution would be to make a basket of the dollar and the euro, in proportions similar to the economic activity withy each currency, but this would be impractical, you need coins and bills to circulate and the relationship between the euro and the dollar is changing constantly, so having both would also be impractical. The US dollar wins hands down in terms of trade, savings by Venezuelans abroad and geographical proximity to countries that also depend on the US dollar.
The benefits of dollarization are quite evident. Countries like El Salvador, Ecuador and Panama have implemented and it brings the following benefits from a macroeconomic point of view:
-End of twenty one years of instability: The first benefit is stability; the value of the currency will no longer be dependent on mishandling of the economy by the Government. Salaries will be stable, purchasing power will be stable.
For those who don’t know the country’s history of currency instability, Venezuela had a de facto currency board in the 50’s, 60’s and early 70’s, inflation was low and the Bolívar was only affected by oil prices, the exchange rate ranging from Bs. 3.35 to 4.30 per US$. The accumulation of bad policies in the 70’s and early 80’s led to the first maxi-devaluation in 1983 when the currency was devalued from Bs. 4.30 per US$ to approximately Bs. 8.50 per $ on the first day, as the currency was allowed to float.
By the time the Luis Herrera Campins presidency ended in 1984, the currency stood at Bs. 13 per US$. Jaime Lusinchi was elected President and he experimented with exchange controls and more than one exchange rate, one for “essentials” and another a free market rate. When Lusinchi left power, the “official” rate was at Bs. 15 per US$ and the parallel rate was at Bs. 40 per US$.
When the Carlos Andres Perez Government came to power in 1988, it removed controls and unified the exchange rate at Bs. 40 per US$. Carlos Andres was impeached, Ramon J. Velasquez took over and by the time Rafael Caldera became President the exchange rate was near Bs. 100 per US$. Within a couple of months, the exchange rate started ballooning as Caldera faced a banking crisis, removed the President of the Central Bank, and attempted to implement his own economic ideas. By June, exchange controls were in place with the “official” rate at Bs. 170 per US$ and a parallel market above Bs. 300 per US$. After two years of erratic economic policy, inflation was threatening to reach 100% per year and Caldera reconsidered his policies, he fired his economic team and named Teodoro Petkoff as his Planning Minister. One of the first measures was to remove exchange controls, letting the Bolivar float. At that time the parallel rate was around Bs. 530 per US$ and letting the currency float drove it down to around Bs. 460 per US$.
When Hugo Chavez got to power the currency was around Bs. 650 per US$, Minister of Planning Giordani insisted in a policy of stability of the currency, but borrowed heavily internally, while holding the currency constant. This led to a crisis in February of 2002, with the currency devaluing and reaching close to Bs. 1,100 per US$. After the general strike of December-January 2002-2003, the parallel market rate reached Bs. 1800 per US$ which led the Government to impose exchange controls with the “official” rate fixed at Bs. 1600 per US$. In January 2004, the currency was devalued to Bs. 1920 per US$. The parallel exchange rate reached Bs. 3,400 per US$ and is currently around Bs. 2,400 per US$, a devaluation to Bs. 2,150 is part of next year’s budget.
Thus, the last twenty one years have been nothing but stable with each of these devaluation cycles increasing inflation, killing the purchasing power of Venezuelans and controls generating distortions and corruption around them. Dollarization would eliminate these cycles and provide stability. A dollar would be a dollar. Salaries would keep their value. Purchasing power would be sustained.
The advantages would be:
-Inflation: It would immediately drop to single digits as it equilibrates with that of the outside world. While there will be a lingering inflationary effect initially, since the dollar monetary base is not under control of the local Government, prices in dollars should stabilize, if they keep rising, foreign goods would be cheaper for the population.
-Credit: Local interest rates would drop, they will not go down as low as US rates because there will be a small country risk premium, but they will likely go down to single digits or low double digits as the country’s credibility incraeses. The availability of cheap credit and stability will be an economic driver; employment should grow, benefiting the unemployed. Typically, dollarization should also reduce the risk premium, making it cheaper for the country to borrow. Local companies will also be able to borrow abroad at rates similar to the local ones. Just the availability of cheap credit should create a housing and construction boom.
-Fiscal Responsibility and discipline: Dollarization imposes responsibility on Governments. The Government will only have a certain amount of revenues and it will know it can not spend beyond its means. It may be able to borrow as long as the perception of ability to pay is positive.
-Transparency: Currently, the country’s budget is an exercise in fantasy. It is proposed at one exchange rate the year before, which may later turn out to be different and all sorts of accounting tricks can be used to hide or make problems seem less important than they are. With dollarization, there will be not conversion tricks, inventory tricks, foreign exchange gains. The whole budget would be in US dollars, no conversions involved.
-A savings pool: Currently, most Venezuelans simply save in US$ and they do it abroad. Why? Because with all of the devaluations cycles they prefer to have their savings in foreign currency, even if they do not get much of a return just because the capital is protected by the instabilities of devaluations.
-Little Capital Flight: While there still be some people that prefer to take their savings abroad the “urge” to take your money away from instability will disappear. In fact, the more than US$ 100 billion that Venezuelans have abroad will no longer have a reason to stay away. Most of it may never come back, but even a fraction coming back looking for opportunities will act as a driver of economic growth.
-Corruption: Eliminating exchange controls or the need for them eliminates the opportunity for payoffs and commissions from government officials to obtain approval.
-Distortions: A whole range of distortions would be eliminated. Let me give you just one example: If you place your money in a local bank, you may get today no more than 13% and likely less than 10% for your Bolivars (inflation is running around 24%). But if you go to the black market, buy dollars and buy a bond from Electricidad de Caracas, you will get a yield in US dollars of 9.4% and a coupon of 10.25%. Does that make sense to anyone?
-Development of a merit system at work: Currently in Venezuela, salary increases reflect mostly inflation and not merit, since the largest share of the increases is used to compensate for the devastating effects of inflation. This reduces competitiveness and helps develop the culture that individual effort is irrelevant.
Of course, there are negatives, among the most important ones:
-Loss of sovereignty: The Venezuelan Central Banker will now be Alan Greenspan of whoever is at the helm of the US Federal Reserve. His decisions on monetary liquidity, interest rates and the like, will directly impact the Venezuelan economy. My reply: They do anyway. Greenspan is more responsible than our Central Bankers have been. What good is sovereignty if it only benefits politicians?
-Loss of lender of last resort: If the price of oil drops and revenues drop significantly, the Government would simply have to cut down expenses as there is no lender of last resort. Currently, if the Government needs more money, it issues debt on local currency and the problem is solved. If foreign sources are not willing to lend to Venezuela, then there will be no solution for the Government but to cut spending or…create a well managed macroeconomic stabilization fund for these times. This is a separate part of my discussion and the discussion that I will propose in the next few weeks.
-Bad for the banking system: the Venezuelan banking system is used to functioning with huge spreads between savings and lending rates and extremely high overhead costs (Due in part to low penetration of the banking system and a strange banking culture). This would have to change or many of the banls could face bankruptcy, Moreover, they would have to adjust to a new reality in which they will have to be competitive with foreign banks or lose business. Many would have to disappear to adjust to the lower spreads. Profits would go down dramatically at the beginning!
-Country more Susceptible to external shocks.
-Competitiveness becomes a problem: Government will no longer be able to have local products become competitive by simply devaluing. They will have to be truly competitive at the international level. This implies the reform of labor regulations that limit hiring part time workers, workers by the hour and guarantee a salary at least 16 times the monthly basic salary. This maybe a moot point, Venezuela is mostly competitive on the basis of natural resources, not on manufacturing or agriculture.
These are my thoughts on dollarization to start with. I believe the benefits outweigh the drawbacks.
Who benefits the most? In my mind, the poor who are employed as their salaries become stable and protected. The unemployed because there should be economic growth and job creation. Those that recognize early the benefits will certainly make a lot of money.
Who loses the most? First and foremost, politicians who would be subjected to a discipline they never had. Second of all the banking system.
What do you think? Sorry for the length…
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