Thursday, June 23, 2005

What to do with all the money - II 

I previously posted about Venezuela’s large foreign reserves, how good it was that Chavez had built them up and that the government had a bunch of good options as to how to use them. The Venezuelan Assembly is currently discussing a new law that would allow the government to tap into these reserves. But as usual, the obstructionist opposition is doing the one thing it knows how to do - objecting.

Before getting into the objections lets first lets take a step back. Venezuela keeps reserves of foreign currencies, as do most poor countries, as sort of a savings system to ensure that even if they have a economic crisis or their exports are somehow reduced they will still have money to keep importing what they need and honor their financial obligations. The importance of this was demonstrated during the opposition led “strike” of 02/03 where they tried to shut down the country and did manage to shut down Venezuela’s primary source of income – the oil industry. If not for the fact that Venezuela had large amounts of foreign reserves they would not have been able to import crucial supplies such as food and gasoline nor honor their financial obligations such as making payments on the foreign debt. So these reserves serve as a safety net just as an individuals bank savings may serve as a safety net in case they lose their job.

Under Chavez Venezuela has had very high levels of foreign reserves. Right now they are about $28 billion dollars. Chavez has argued that this is a higher level of reserves than is needed and that a portion of them should be turned over to the government to be utilized for its needs. This is certainly a very rational thing to do.

However, the obstructionist Venezuelan opposition has been fighting this tooth and nail. The reason they give is that these foreign reserves somehow “back” the local currency, the Bolivar, and if they are reduced the value of the Bolivar will be reduced. Also, they argue that turning over these dollars to the government would be inflationary.

Lets look at these assertions. The first thing is just a complete lack of understanding of economics. Foreign reserves don’t back the local currency - nothing backs the local currency. The Venezuelan Bolivar, like almost all currencies these days, is a fiat currency. That means that it is just a piece of paper that has value as a means of exchange because the government tells people to accept it as such and they do. With fiat currencies the value is not determined by what is “backing” it but simply how much of the currency is in circulation. But that is independent of the foreign reserves that the country maintains and therefore this first assertion by the opposition is without merit.

Then there is the question of whether allowing the government to spend these reserves will be inflationary. The answer to that is it depends. If the government takes the dollars, converts them to Bolivars and spends them within Venezuela, then yes it will be inflationary and the oppositions objection would be correct. The reason is that a currencies value is determined by how much of that currency is in circulation. If the government increases the amount of money abruptly it will probably be inflationary as an increased amount of money would be chasing the same amount of goods and services.

If however, the government takes the reserves in the form of dollars and doesn’t spend it within Venezuela, but rather uses it to pay down the foreign debt or purchase items abroad to import into Venezuela, then it wouldn’t be inflationary at all. Why? Because the amount of Bolivars in circulation wouldn’t have changed at all.

So what does the Venezuelan government actually plan to do? You guessed it – pay down the foreign debt and spend the money abroad to import needed goods. Witness this article:

CARACAS, Venezuela - Venezuelan lawmakers gave initial approval to a bill that would allow President Hugo Chavez to tap as much as $5 billion in reserves held by the Central Bank and use it for government spending or paying off debt.

Opposition leaders on Wednesday criticized pro-Chavez lawmakers for voting late Tuesday in favor of the proposal, which still requires a final vote before going into effect. Government opponents say the reform would spur inflation and permit Chavez to freely spend billions ahead of presidential elections next year.

"The government wants to create a kind of secret coffers to be used without control," opposition lawmaker Salomon Centeno said.

Under the proposed reform, officials would determine an "optimum level" of reserves each year, with any excess transferred to a government-controlled development fund for overseas purchases and paying off foreign debt.

Government and bank officials together would be expected to agree on the method for determining how much should remain in reserves — a topic that has put Chavez at odds with Central Bank directors in recent months.

Centeno, vice president of the congressional finance committee, said the spending of some $5 billion reserves by the Chavez administration could greatly increase inflation.

Centeno said he expects Chavez to use some of the bank's reserves on programs that would help maintain his popularity ahead of presidential elections next year. Chavez has predicted victory by a wide margin in the elections tentatively set for December.

National Assembly President Nicolas Maduro downplayed the criticism and said most Venezuelans favor such a change.

The Central Bank currently holds about $28.3 billion in reserves. Chavez has repeatedly said his government should have access Central Bank reserves for social spending to benefit the poor.

"I propose that we grab part of the excess international reserves, at least $5 billion, and we use it to import agriculture machinery," Chavez said in a speech last month.

Chavez, a former army officer elected in 1998, says his administration is gradually establishing a socialist economy in Venezuela, the world's No. 5 oil exporter.

So there we have it, the government plans to use the money for the very sensible purposes of paying down debt and importing agricultural machinery to go with their land reform program. They sound like excellent ideas.

Of course the opposition will still object. But what they are objecting to isn’t to any type of bad policy as there clearly isn’t one here. And it doesn’t come from any genuine concern about the lever of foreign reserves – lets not forget the opposition spent 2002 and 2003 deliberately trying to bankrupt the country and wipe out its reserves. What they really are objecting to is Chavez’s continued success with the economy which pushes them ever closer to political oblivion.


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