Venezuela's oil: From the Devilís Excrement to The Politicianís Trap
By Miguel Octavio
Caracas, 11.09.06 | The term Devil’s Excrement, was created by Juan Pablo Perez Alfonso to dramatize the difficulties that a country may have in implementing the necessary economic measures for its development when a natural resource exists which strengthens the currency and allows policy makers to postpone unpopular measures because their urgency can be hidden by the wealth itself. In The Netherlands it is referred to as the Dutch Disease, because of the effect that natural gas prices had in that country’s economy in the 60’s.
Venezuela’s case is one of the best examples of this. Politicians past and present, have always believed that they could innovate on economic matters and that the surge in prices and/or steady stream of income from oil could support their ignorant creativity on the economy. Somehow they knew the day of reckoning would come, but by then they would likely not be around and somebody else would be blamed.
Any Venezuelan who was an adult in 1982 likely remembers the calls by the then President of the Venezuelan Central Bank Diaz Bruzual for people to take their money abroad, as that would reduce the pressure on inflation. Six months later, the country lived through its first maxi-devaluation. (The same policies are being encouraged today) It was no different when Jaime Lusinchi was President. He imposed exchange controls and Venezuelans began importing cars (remember the Ford Sierra?) as Lusinchi’s popularity remained above 60% up to the last day of his Presidency, except that the incoming administration found liquid international reserves of less than US$ 300 million and the economic adjustment that followed was one of the worst in our country’s history.
Rafael Caldera in his second Government was no different. He thought he could impose his ignorant economic policies and his will on the country. He began by firing a well respected Central Bank President, which drove the currency down, created a financial crisis and within months, Caldera imposed exchange controls and price controls which eventually began blowing up. When Caldera realized that inflation was running at a 100% clip if you annualized it, in December 1995, he got rid of his economic team full of friends with little economic knowledge and appointed Teodoro Petkoff as Minister of Planning. Petkoff imposed the second economic adjustment in the three years of the Caldera administration and things began to improve until oil prices went down, derailing any attempt at changes.
In each and everyone of these cases, the imposition of exchange controls, price controls or creation of economic rules which are simply outside the realm of economic theory, created distortions which eventually led to a big adjustment, as they could not be sustained. In each and every case, it is the poor that pays for these adjustments and devaluation is typically the simplest solution to solve most of the problems, remove the distortions and deflate the pressures that have been built into the system. It is a the Politician’s Trap.
The laws of economics are not too different than the laws of other sciences, except that in those one can isolate a system, do an experiment and reduce the problem to a couple of variables that you can use to prove these laws. In economics, there are so many variables and the system takes time to react in such a way, that the distortions and causes may take some time to manifest themselves.
The Chavez Government has not been any different. We can divide its economic policy in two stages, before the devaluation in 2002 and afterwards. Before the large devaluation in 2002, the Government ran contradictory and distortionary policies that were trying to contain inflation, save excess funds into the Macroeconomic Stabilization Fund (FIEM) and borrow money internally while holding the currency stable to reduce inflation, It did not work. The moment oil prices dropped, the FIEM was used, rather than saved and then discarded and the weight of the ballooning local debt was too much for the Government to sustain its constant exchange rate policy. In February of 2002, Chavez was forced to allow for a maxi-devaluation which together with the strike in 2003, induced a crisis which was once again paid by the poor via inflation and devaluation.
The second stage began in February 2003 with the imposition of exchange controls which combined with high oil prices has allowed the Chavez administration to introduce what is likely to be the biggest distortions in the country’s economy ever and which eventually will lead to a huge crisis which will be once again paid by the poor via inflation and devaluation. Up to now, these distortions have been covered up by the sharp increase in oil prices, but are now beginning to be felt as a sharp increase in consumer prices. The seams are beginning to show some rips, and they are ugly.
Let’s look at some of the major distortions on the Venezuelan economy today:
Exchange Controls: Exchange controls have always proven to be damaging in the long run. They create numerous problems from corruption surrounding approvals, to all sorts of gimmicks to buy dollars at the official rate. When first imposed, the Government claimed it would stop any possibility of a black market, but then it took two and half years to approve the law punishing it. By then, the Government had not only realized that it needed a escape valve, but it had become the biggest supplier of dollars to the parallel market via the Argentinean bonds, another one of the biggest corruption scams in the Chavez administration. By now, CADIVI, the exchange control office, has become a bureaucratic office, which approves anything from foodstuffs to luxury cars, as few things are actually banned. But at the same time the criteria for approval are somewhat mysterious. Individuals get an allotment to travel, which also began with lots of controls, but by now, they have realized how difficult it is to monitor it. Thus, you only need to prove you are traveling once, after that you can request your $4,000 annually without proving you are going abroad. But the mian problem is the corruption it generates and the burecracy imposed on everyone.
Price Controls: A number of basic staples have had their prices controlled. Periodically producers have a battle with the Government and the controlled price is increased. Controlled items are typically the ones that you can’t find at the markets, with chronic shortages in many staples, with sugar being the predominant one, since its retail price is below production price. The solution? The Government imports some of these products when shortages intensify. But the consequences are clear, producers, when they can, migrate to other unregulated crops or simply don’t produce. Add to these controls the threat of expropriation of farms under the Land Bill and what you have is less local production and higher prices. Consider the case of meat. Between price controls and the actual confiscation of farms (few cattle ranch owners were paid, but they don’t have their land) the number of heads of cattle is down by two million since Chavez took over. Just last week, the price of meat went up by 10% (yes, in one week).
Interest rate controls: The Government is regulating the minimum amount you can be paid and the maximum amount you can be charged. It has also created multiple subsidies to various sectors like agriculture, mortgages, tourism and micro credits. Some are not Government sponsored subsidies but rates are fixed and it is banks that have to make up the difference, which is obviously paid by the rest of the depositors and/or creditors. It reaches the point that this week the Government lowered, for no reason, subsidized mortgage rates to 4.9% and 9.7% for the two lowest levels of loans, while it increased the minimum amount that banks can pay on either savings rates or CD’s for banks. How can it justify interest rates moving in two different directions?
Gasoline subsidy: Gasoline is sold at 4.46 US$ cents per liter or 17 US$ cents per gallon, with the total subsidy at 14.5% of the National Budget as proposed last Fall or three times what is spent on the "Misiones". This is a very unfair subsidy as those that have cars receive the largest share. My share of the subsidy as one that is in the top 25% of the population by income is ten times larger than that of those in the bottom quartile. In fact, while I strongly disagree with Rosales’ proposed “Mi Negra” card to distribute people money, if the oil subsidy were to be removed, the card would certainly be more just and cost about the same.
Removal of Central Bank excess reserves: The Government has decided that there is an “optimum” amount of international reserves at the Central Bank and any amount over it is periodically removed and given to thee Development Bank Fonden. This idea is simply nuts and would one day come to haunt the Government. If you don’t consider the liability side of the Central Bank (It’s debts!), there can be no “optimum” level and if the Central Bank creates liquidity every time they get dollars from PDVSA and give it Bolivars, when you remove those dollars from the Central Bank, those Bolivars have less backing that they did before.
All of these distortions can last a while, as long as the price of oil continues to go up, but behaving like a good Devil’s Excrement, as time goes by each of them becomes harder to remove from the system and the different combinations of them will eventually lead to the economic system coming apart at the seams. The entrapment begins and nothings is done about it. And it is beginning to happen again.
Effects of the distortions: Inflation
The most important effect that can already be seen is inflation. Particularly rapidly rising prices on essential items that are produced in Venezuela. During the last four months inflation, only in those months, for foodstuffs has been 19.9% (4.7%, 5.5%, 5.1% and 4.3%). This is not annualized, this is what the official level of inflation has been for food prices, including controlled prices and all of the tricks the Government uses to convince us that inflation is not as high as we feel it on a day to day basis. Given that people in the C and D levels of the population spend 70% of their income on food, this means that the impact on their daily lives since May of this year has been huge! So huge, that it has eaten away 14% of the other 30% that they had to spend on other things.
The problem is that this increase in inflation will be really hard to fight. First of all, it is simply a result of the laws of economics: The Government has increased liquidity by 100% in 12 momths and its own spending by 85% so far in 2006, but local production of food is barely up and imports by the Government can not be planned sufficiently ahead of time to compensate. Thus, by the time a shortage occurs and prices go up, it takes at least two months for the Government to approve the foreign currency and import the foodstuffs to have an impact. Thus, prices will continue to go up at similar levels and inflation for the year for foodstuffs could reach unmanageable levels. (Add to this the fact that the minimum salary was increased this week by 10% and that September tends to be the worst month of the year for the CPI and you get the picture). If the rate of inflation for food stays constant between now and the end of the year, prices will go up another 20% by Xmas time.
The problem is that there is no short term or simple solutions to this. This week we heard supposed experts on economic matters from the National Assembly blame CADIVI for the jump in prices. Their logic went something like this: CADIVI has been reducing foreign currency outflows by some US$ 500 million in the last three months. What he means is that by not removing US$ 500 million in Bolivars from the system, inflationary pressures were unleashed. Well, not in their wildest dreams can a 10% reduction in foreign currency approvals create such a problem. They are trapped in their own inconsistencies by now.
What all these "experts" refuse to accept and admit is that it is the excess liquidity and 85% increase in Government spending this year which is responsible for the inflationary pressures. It is a textbook case of too much money going after too few goods, the laws of the markets at work!
Even worse is how short term solutions are searched for: Three months ago Chavez told CADIVI to reduce outflows because too many luxury goods were being imported with CADIVI dollars. This week, exactly the opposite was told to CADIVI: Please give out foreign currency more efficiently so that inflationary pressures are removed.
The Central Bank distortion: There is no optimum level of international reserves, just their management
At the same time that the Government was pushing CADIVI to increase outflows to reduce monetary liquidity, the Central Bank changed conditions on its CD’s this week such that it will promote excess monetary liquidity in the system, because it reduced the interest it pays on excess liquidity to the banks.
In plain terms, the Central Bank issues CD’s so that there are fewer Bolivars in the economy, going after more goods, which helps reduce inflation. But all its decisions this week go in the opposite direction. Why?
Simple, the Central Bank is worried about the Central Bank’s balance sheet, which has its own distortions, mostly created by the removal of its own reserves.
When the Central Bank makes operations in order to absorb excess monetary liquidity, it pays banks interest on these funds. Where does the Central Bank get the money to pay the interest? Easy, from the interest it gets from the international reserves. A few years ago, these operations did not amount to more than one or two billion dollars and the Central Bank could easily pay for the interest. But as more and more money was created, the Central Bank issued more CD’s so that today there are more than US$ 18 billion of them! Unfortunately, the Central Bank does not get that type of interest on its current international reserves which amount to US$ 35 billion. So, the Central Bank is actually losing money now and it has to restrict these absorption operations, so it can not help fight the Government’s inflation battle, it has to do exactly the opposite of what is required!
This is a good point to look at the magic “optimum” level of reserves. The Government is quite proud of the current level of international reserves which are near US$ 35 billion. Reportedly Chavez wants them really high. But what good are they if the Central Bank has liabilities of US$ 18 billion? Moreover, what good are they if the country’s debt has also increased sharply as it has gone from US$ 22 billion in 1998 to US$ 45 billion in 2006?
The difficulty is the same as with other distortions, it is not easy to solve the Central Bank’s problem. Either you let reserves go up soon, or you reduce spending or the price of oil doubles. In fact, this will get worse, the Government is already talking of taking away US$ 6 billion in reserves in early 2007.
Of course, there is always the magic solution: Devalue, you reduce the Central Bank’s debt by that amount and the problem eases. Until the next time.
Financial Distortions: Something has to give!
There are so many of these that I don’t even know where to start. Let’s simply make a list:
Banks mostly make money on commissions they charge clients and their investment on Government bonds, not spreads.
It is possible to borrow money at rates lower than inflation.
Despite high oil prices, the Government is running a deficit.
If exchange controls are removed, banks would lose half their deposits
Interest rates are negative, that is, people lose by having money in the bank. Thus, they spend.
If interest rates ever become positive, going to the current levels of inflation, all banks but maybe two or three, would lose all their equity. Will the shareholders replace it?
Banks have so much excess money that they are giving people credit without checking any credit history, salary or record. It is better to lend it with risk, that not have it doing anything. Just today someone told me that getting such a loan was so easy, that she got it within a day and would be unable to pay it based on her cash flow except that her insurance company owes her the money. Perhaps the funniest gimmick is the “Surgery with your plastic” campaign. Yes, it is simple, get an instant loan to have your plastic surgery done. Billboards even show which part of your body you may want fixed, sort of obvious, no?
People who can get an agricultural loan, borrow from a “good” bank at the preferential rate and deposit it at another “bad” bank at a higher rate.
Others borrow Bolivars, buy dollars in the parallel market, invest the dollars and wait for the devaluation to come. Pay 10-12% per year for an upcoming 100-200% devaluation, not bad, no?
Imports will likely reach US$ 30 billion this year. (Whatever happened to endogenous development?)
Foreign investment was US$ 65 million (no typo) in the fist six months of the year (From the US all of $200, yes two hundred dollars, no typo)
Growth in the first half was 9%, but Government spending was up by 85%, not very efficient, no?
I could go on and on, but you get the picture. If the price of oil stays constant or drops even a little this will all come apart at the seams. Only higher prices can sustain this. Unfortunately, in the lower oil prices scenario, the easiest solution to patch things up will be the usual one: Devalue and you know who gets hurt the most with that, simply the poor.
And that is why the Devil’s Excrement becomes the Politician’s Trap. Nothing will be done on any of these distortions until it is too late. In fact, this Government has created most of them, even if some are simply exaggerated replicas of things we have seen before.
Unfortunately, if the price of oil drops by a significant amount, the consequences will be simply catastrophic. We will see a financial crisis, the largest devaluation in history and poverty levels never seen before in the country’s history.
Makes you wonder why anyone would want to be President, let Chavez get out of his own trap first! No?
Source The Devil's Excrement
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