Monthly Macro Outlook: Rebuilding Venezuela's economy

Democratic transition is a matter of time

For the first time since 2016, when massive demonstrations against the regime began, a transition to democracy seems at hand. My assessment of the political situation is that it is only a matter of time before President Nicolás Maduro is forced to step down and an interim administration with representatives from the opposition, pro-government leaders, armed forces and business groups is created to deal with the humanitarian crisis, request international financial help and conduct a free election.

There is little doubt that we are at the final stage of the Chavist experiment that has been a total failure at the economic level. The economic and political cost of maintaining the status quo is increasing every day. The balance between the various factions that belong to the governing coalition is very fragile and the current tensions, both from US sanctions, massive demonstrations and blackouts, could serve as a catalyst for a split within the government that could pave the way for a transition. 

Impact of US sanctions and structural underinvestment on the country’s output:

The inaction from armed forces mostly reflects coordination problems and the historical tendency to avoid conflict, rather than loyalty to Maduro. Oil ties between Venezuela and Cuba could generate tensions within the army ranks. Due to the decline in oil production, the weight of oil transfers on preferential terms to Cuba as a percentage of total oil exports has doubled to 10%. According to my calculations, based on available data, it may reach 20% in coming weeks as Venezuela’s oil production is expected to fall from 1m/barrels per day to 0.5m/bpd because of US sanctions and blackouts that halt operations at the country’s main oil port of Jose. These transfers are essential for both countries since they cover up to 80% of Cuba’s energy needs and, in return, Cuba sends doctors, security experts and other operatives in Venezuela, but this privileged relationship could fuel anger within the army as the economic situation deteriorates fast. 

Four priorities to rebuild the economy

When Maduro eventually steps down, a massive international recovery package will be needed to help rebuild an economy that has gone from plenty to scarcity in the space of twenty years. As soon as the regime change becomes reality, foreign capital will flow into the country’s oil sector, with real impact on the wider economy at best three to five years later. The oil infrastructure is in such a bad shape that it will take time and tens of billions of dollars a year to return oil production to 3m/bpd. On the other hand, it will be necessary to ensure that petrodollars really benefit the population and efforts must be made to avoid the pitfalls of other Latin American countries that requested the IMF support in the 1980s and implemented structural reforms without much consideration for their negative social impact. 

I identify four main economic priorities for the future interim government.

(1) The restructuring of the oil industry

As pointed out by the roadmap document published by the opposition formally called “Plan For The Country: The Coming Venezuela”, one of the top priorities will be the restructuring of the oil industry. Before even injecting cash into the national oil company, PDVSA, which is in default, the interim government will need to conduct a deep internal audit to evaluate its corporate governance and accounting.
PDVSA’s financial statements are widely considered as incomplete or even misleading. It is well-known that the company’s top and middle management have committed serious misconduct over the past years, notably embezzlement, fraud and negligence.

The second step will consist of opening the oil industry to foreign investors and allowing them to have majority share in oil projects. Venezuela’s oil sector is suffering from structural underinvestment. Oil production methods, mostly water-flooding and chop cold heavy oil production, are inefficient to extract local heavy oil situated in the Orinoco belt (around 652 billion barrels are technically recoverable according to the USGS). It largely explains the poor amount of oil recovery (often less than 10%) and the long-term decline in oil production. The use of the most modern technology, especially thermal and solvent-assisted in-situ recovery, would constitute a game-changer for Venezuela’s oil industry but, due to the very high cost linked to infrastructure modernisation, it is therefore essential to share the financial risks with private investors.

(2) A deep restructuring of the country’s debt

Venezuela’s outstanding debt is estimated to be around $140bn which comprises: $40bn contracted from Russia and China as part of the oil-for-loans agreements, $60bn owned by foreign investors, such as hedge funds, and tens of billions of dollars for foreign companies as compensation for expropriations. External debt service accounts for around 100% of exports, which means that the country is not able to repay its creditors in the coming years.

A massive injection of hard money from the IMF, that could be at a minimum of $20bn per year for many years, and a large debt haircut, that could be as high as 80%, are required. Compensation for bondholders could consist of giving them long-term oil warrants that would pay out as oil production increases. It would allow the government to focus on economic recovery instead of debt servicing and it would give bondholders a good reason not to add Venezuela to their investment blacklist.  

(3) The bailout of the banking sector

Venezuela’s banks are the weakest in Latin America and one of the most dysfunctional sectors in the country. A restructuring is necessary to ensure that any fiscal and/or monetary stimulus will really fuel the whole economy. History has taught us the hard way that a stimulus program is doomed to fail if the banking sector is too fragile (I have in mind the example of Japan at the beginning of the 1990s).

Except for liquidity ratio, most of the other banking sector’s ratios, such as capital adequacy, profitability and NPL, are not that bad. It is explained by the fact that banks are evolving in a very captive market, characterised by high level of state interventionism, and controls. But, in fact, over the past years, credit has disappeared in Venezuela, due to capped interest rates that led to extreme negative real interest rates in the context of hyperinflation, and discouraged lending and saving. The banking sector faces an elevated risk of liquidity crunch when the transition period starts. On this occasion, favoured by the temporary political vacuum, a massive capital outflow from the country’s banking sector to safer and more profitable sectors abroad could happen, thus weakening further local banks. Therefore, a massive bank bailout, as part of the IMF financial package, along with capital controls maintained for many years and sector consolidation will be needed for recovery.   

(4) A monetary reform to stop hyperinflation

The last and probably more complicated task will be the implementation of a monetary reform to stop hyperinflation and rebuild trust in the currency. So far, the “Plan For The Country” that has been recently unveiled does not give many clues about what the opposition favours as monetary policy options. Considering the importance of the black market in daily life, Venezuela is de facto a dollarised economy.

It would be an easy move to officially dollarise the country. Based on the previous experience of Ecuador, dollarisation is a strong factor of stability and is the right way to halt capital outflow and hyperinflation quickly. It would also make sense to use the US dollar as revenue brought in is mostly linked to oil exports in USD.

However, dollarisation is not all good. In Zimbabwe, it caused higher dependence of the local financial market on foreign investors funds, which are prone to exit when economic downturn happens, and the central bank is not able any more to carry out its duty as lender of last resort of the banking sector.

Dollarisation could serve as emergency measure to stop hyperinflation but, in the long run, I personally favor the implementation of PEP (Peg the Export Price). The idea behind PEP, as described by the economist Jeff Frankel, is that commodity exporting countries should peg their currency to the price of the main export good; oil for Venezuela. For more insights, I advise you to read this academic paper. Simply stated, the bolivar would be pegged to a basket composed of US dollar and oil prices. It would be necessary to do the maths to assess the optimal percentage of each components but the main advantage of PEP, contrary to dollarisation, is that the bolivar would be automatically adjusted to any oil price shock. It could be a better factor of exchange rate and financial stability, as we all know that oil prices are hardly predictable in the medium and long term, and are very volatile. Such a monetary set up obviously involves an independent central bank. 

Despite all the challenges, I am very optimistic for the future of Venezuela. There are indications that change is in the air. The residential real estate market, which was left for dead, is slowly showing signs of life as Venezuelan expatriates are looking to buy properties in their home country again. Due to absence of buyers, real estate prices have been divided by four or even by five in the past four years in the main Venezuelan cities. Buyers are coming back. Things are starting to get better.