Tuesday, December 30, 2008

It will take more than a slight of hand to fix this. 

Recently I reviewed an economic report by Mark Weisbrot on how the recent fall in oil prices might impact Venezuela. Despite some differences our conclusions were generally similar.

However, Dr. Weisbrot's article focused exclusively on Venezuela's ability to earn enough dollars to pay for its imports and other dollar denominated expenses. He did this because he viewed being able to cover expenses in dollars as a potential problem while expenses in Bolivares (ie, the governments own budget) could presumably be covered without an major problem. Quoting Dr. Weisbrot:

The relevant question for Venezuela is therefore how far oil prices would have to fall before the country would begin to run an unsustainable current account deficit. This is the binding constraint for developing countries. In other words, the United States, Europe, and Japan will – inasmuch as they choose to do so – pursue expansionary monetary and fiscal policies, including deficit government spending, in order to counteract the current recession. Developing countries can and
ideally should do the same, but unlike these rich countries, they face a constraint due to the fact that their national currencies are not “hard” currencies. Therefore they cannot count on being able to borrow nearly as much, relative to GDP, or for so long a period of time, as countries with hard currencies, to cover their import needs. For this reason, the current account5 – not the central government budget, which can be covered in local currency [emphasis mine] – is the most important and binding constraint on developing countries such as Venezuela in the present situation.

Unfortunately, I have to disagree with the short shrift being given to this problem by Dr. Weisbrot. I think the Venezuelan government faces a very significant problem with its budget in the form of a enormous deficit if oil prices continue at anything approaching current levels, and this problem has no simple or painless solutions.

The Venezuelan government's budget counts on 155 billion Bolivares in revenue of which almost 78 billion comes directly from oil revenues. Getting that amount of oil revenue was dependent on the country producing 3.6 million barrels per day of oil and that oil selling for $60 per barrel. At this time neither of those numbers seems likely to be met. My calculations of how much of a hole the Venezuelan budget might have can be found here (note things have become appreciably worse since that post was written).

Now, the first question is how is a budget in Bolivares effected by oil revenue that is in dollars. Simple. The oil revenues that Venezuela receives and that are paid in dollars are converted into Bolivares by the Venezuelan central bank at 2.15 Bolivares per dollar which is the official exchange rate. It is the Bolivares that result from that exchange of oil dollars for Bolivares that fund the 78 billion Bolivares in oil revenues that the government is counting on for 2009.

Weisbrot implies that because those 78 billion Bolivares are just pieces of paper printed by the Venezuelan government itself this doesn't present a major problem itself. [completely off topic for this blog but gringo economists referring to the U.S. economy have made similar points recently - much to the discredit of economists in general].

However, in looking over the situation I am not so sure. Lets go one by one and look at the ways the government could cover a large deficit in its Bolivar dominated deficit.

First, as pointing out that Bolivares are nothing more than pieces of paper printed by the Venezuelan government implies, they could just print more Bolivares to cover the deficit. Of course, just printing more money without having some concomitant increase in goods and services for those Bolivares to chase is the very definition of what creates inflation. So while they could inflate their way out of this deficit I assume the government, especially one that uses the reason of fighting inflation to justify half of what it does, won't do that.

Second, they could raise other tax revenue by doing things such as increasing the IVA or reinstating the financial transactions tax. However, this is hardly a painless measure as these taxes will be felt by a large number of Venezuelans. Moreover, the deficit that Venezuela is facing is so large it would seem unlikely that it could be made whole by these taxes increases, especially when one considers that if the Venezuelan economy enters a recession tax revenues as a whole are likely to drop (and I won't even get into the fact that raising taxes is known as a pro-cyclical action which is considered a no - no by some economists, Weisbrot included). So taxes don't seem to constitute anything more than a part of the possible solution and they are definitely not painless.

Third, they can just cut expenses and try to balance the budget that way. However, Venezuela, of all countries, will have real problems trying to do that. The reason is that in Venezuela government spending has been more than just something that provides services to the general population - government spending is widely accepted as having been the motor pulling propelling the Venezuelan economy forward.

This is an important point so lets review it for minute. Venezuela really only has one important wealth generating industry - the oil industry. That brings in well over 90% of the countries foreign currency and its spending underwrites most other economic activity either directly or indirectly. Investment, social spending, consumer spending, are all to a large degree funded by government spending. Given that there is not much of any independent wealth generating segment in the economy - not manufacturing, not agriculture, not services, not even speculative real estate bubbles - if the government spending that is funded by oil revenues drops so too will the Venezuelan economy.

Worse still, the Venezuelan economy needs more than just a stable amount of government spending - it needs that spending to being increasing in order to create growth. But that will be a tall order for 2009. The reason is that government spending this year was actually HIGHER than what next years budget is - it was 189 billion Bolivares versus the 167 billion in expenses budgeted for 2009. The reason is that in prior years the budgets were later added to as additional oil revenues that were higher than the budgeted amount came in. Given that next year they are facing a deficit on their base budget how likely is that kind of supplemental spending?? The answer is it is not likely at all.

That means that they are likely stuck with the budget that they have which itself represents a decrease in spending and would therefore likely bring about a dramatic slowing of economic growth. If they now cut that budget even more in an attempt to balance it... I think you can imagine the result.

So clearly budget cuts will not be painless and will have a very significant impact on the economy as a whole.

Fourth, they can start cashing in their rainy day savings to fund the budget. That is they have dollar denominated savings such as their foreign currency reserves and the national development fund, FONDEN, which they could convert to Bolivares as needed to cover the deficit.

In certain respects this is the least painless of all the options so it will be tempting to do it. However, there are a few downsides to this too. First, with the size of the deficit they are facing they will burn through that money pretty fast. They may be good for 2009, but then what about 2010? Moreover, they actually owe a fair amount of those dollars to other people for various nationalizations that they have made but not yet paid off. Those in and of themselves could eat up between $5 and $10 billion dollars. Also, if they dip into the foreign reserves they are spending money meant to cover imports and by doing so they may jeopardize their ability to finance future imports. And last but not least, funds like FONDEN were meant to finance the development projects a country like Venezuela needs if it is to progress NOT cover a deficit in a regular government budget. So spending them this way would represent a major blow to Venezuela's development plans (more on this in a future post).

Fifth, they could try to borrow money either internally or externally. This will be tough for reasons not the least of which are the worlds financial crisis and Venezuela's declining credit worthiness. Honestly, I really don't know if Venezuela could raise money at all this way given the current circumstances. At the least it would prove VERY expensive and would certainly hurt future budgets.

Sixth, the final option I can think of, is to devalue the currency. What this means is that instead of paying themselves 2.15 Bolivares for every dollar they would now pay themselves 3 or 4 Bolivares per dollar. Depending on how much they devalue this could conceivably solve the entire budget problem. Also, it could also solve their balance of trade problems which means it would be killing two birds with one stone. However, it also involves pain. There would be a temporary spike in inflation with imported goods now more expensive. Also, Venezuelans would be able to consume fewer imported goods so they, particularly the middle class, would feel much poorer. A devaluation may be salutary and necessary but it is certainly not painless.

Those are the six options that I can think of for them to solve this problem. As you can see it is a very real problem with no easy nor painless solutions and certainly a problem that is much more serious than Dr. Weisbrot's passing mention of it would imply.

What do I think the Venezuelan government will do in order to respond to this problem? I imagine early in the year they will mainly spend down savings to buy time and see what happens with the price of oil (ie, see how bad the problem will be). Then they will probably implement some combination of tax increases, spending cuts, and devaluation (even if it only take the form of selling oil revenues on the black market) to try to cover the breach.

What would I recommend they do? That will be the subject of the next post.


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