Serie Papeles de Trabajo 002-2016 - Una Agenda Económica para la Transición

 

25/09/2016

 

ACADEMIA NACIONAL DE CIENCIAS ECONÓMICAS, Caracas

 El presente documento es el resultado de un conjunto de reuniones de trabajo convocadas por la ANCE en las que han participado un grupo amplio y plural de economistas venezolanos. El ánimo de estas reuniones está centrado en deshilvanar y analizar la compleja crisis económica y social que atraviesa Venezuela despejando así el campo para proponer, desde la experticia y perspectiva profesional, una agenda para la transición y superación de la crisis.

 

In search FOR STABILIZATION AND RECOVERY: MACRO-POLICY AND REFORMS IN VENEZUELA

 

Leonardo Vera

 

UNIVERSIDAD CENTRAL DE VENEZUELA

 

FACES, ESCUELA DE ECONOMÍA

 

CIUDAD UNIVERSITARIA, CARACAS 1060

 

 

 

September 2016

 

 

 

Abstract: Venezuela is currently immersed in a severe economic crisis as a result of years of domestic mismanagement and the recent reversal in oil prices. This paper attempts to formulate a proposal for stabilization and recovery which includes upfront key policy actions to deal with the drastic foreign exchange constraint. We see the recovery of foreign currency liquidity of paramount importance. This will not only allow the lifting of the exchange control and the implementation stable and competitive real exchange rate (SCRER), but also the removal of shortages across the board and output recovery. The recovery of domestic activity will also require supply-side relief in the form of broad deregulation, institutional changes and a sensible policy to lift price controls. To maintain a stable and competitive exchange rate, we propose a whole set of policy measures for rapid suppression of inflation and the causal mechanisms built through the years. A monetary reform and the support of monetary and fiscal policy for successful stabilization and recovery efforts are also discussed.

 

 

 

 

 

Key Words: Venezuela, Stabilization, Recovery, Reforms, Foreign Exchange Constraint, Inflation

 

 

 

 

 

The author has greatly benefited from discussions with Francisco Saez and Maikel Bello on the subject matter of this paper. Jan Kregel and Mario Damill made constructive comments, as did seminar participants at the Potificia Universidad Católica del Perú. We also like to acknowledge the help rendered by Jorge Sarmiento, Jorge Corro and Frank Gómez.

 

1. Background

 

Venezuela is currently immersed in a severe macroeconomic crisis with bleak prospects of an economic recovery in the short-run unless a comprehensive program to deal with macroeconomic imbalances, relative price distortions and dysfunctional institutions could be undertaken in the near future. Despite the oil windfall that the country's economy registered over the past oil price super-cycle, macroeconomic mismanagement and a fragile governance of oil proceeds have led to a severe external liquidity problem. By the end of 2012, before the oil price started to drop, Venezuela was already in difficult economic straits. The country had already depleted almost all its liquid level of international reserves and lost access to international financial markets. Since then, the growing external debt servicing has made the foreign exchange constraint worse and has left Venezuela’s external and public finances in shambles.[1]

 

Forced to adjust through a reversal of the original expansion, the administration of President Maduro has decided to solve the external imbalance through import compression and a tightening of the existing exchange control. Foreign exchange rationing through a complex multi-tiered currency control system has increased pressures in the black market and weakened the parallel exchange rate. As very often happens with exchange controls, this parallel market becomes very significant and dominant. Thus, import compression and the very dynamics of the parallel exchange rate have led rapidly, and almost simultaneously, to drastic shortages of basic consumption goods and essential intermediate imports for the productive sector, a dramatic fall in domestic output, and skyrocket inflation. Moreover, since the model has moved the economy beyond market mechanisms for setting prices and regulating production and distribution of many goods, key incentives for domestic production have also disappeared.

 

To the extent that the economy has lost the capacity to import all the intermediate inputs that it needs, domestic output has ended up constrained by the availability of foreign exchange. Thus, in the current Venezuelan case, both the balance of payments and the supply-side of the economy are binding. In his Theories of Growth of Different Social Systems, Michal Kalecki (1970) associated this type of supply-constrained system with classical socialism. Though not building classical socialism, since 2005 the Bolivarian revolution, under the leadership of President Hugo Chavez, has called to build 21st century socialism. This ideal of 21st century socialism certainly remains rather undefined, but the Venezuelan economy, plagued of controls (invariably off-target), of large-scale State intervention, and with problem of shortages, excess demand and inflation, seems to be moving to a context that makes the conventional analysis of demand-constrained systems ill-suited.

 

Against this background and looking ahead, this paper formulates and evaluates a coherent set of macro-policies and reforms for the economy of Venezuela that can bring stabilization and solutions to several key imbalances. By stabilization this work implies, the restoration of the external balance (using a less damaging closure rule), the return to an environment of low inflation, the recovery of economic activity to normal levels, and the elimination of goods shortages.

 

The plan of the paper is as follows. A discussion of the external constraint and its unpleasant side effects are presented in section 2. Sections 3 and 4 discuss actions oriented in two directions: One on the introduction of a competitive and stable real exchange rate, and on the need to concentrate a critical mass of resources sufficient to lift the exchange control and handle exchange rate policy. Attempts to expand the policy space through debt relief and foreign lending are also discussed in section 5. In section 6, we are concerned with inflation control, a key factor for the success and sustainability all policies oriented towards the implementation of a workable exchange rate regime. Section 7, delineates and discusses a set of supply-side measures that may promote the recovery. Section 8 presents and discusses a stylized overview of the monetary and fiscal policy approach that can be consistent with the main policy targets.

 

2. Explaining Venezuela’s External Constraint and its unpleasant effects

 

During a prolonged period of strong oil prices the economy of Venezuela presented an exceptional situation among Latin American countries of huge and persistent surpluses in its current account. Indeed, while the average current account deficit for the region was nearly 1% of GDP between 1999 and 2013, Venezuela registered a current account surplus that averaged 8 percent of GDP during the same period.

 

 

 

As the oil boom developed, the progressive generation of huge current account surpluses also restored incentives to peg the domestic currency as a nominal anchor against inflation. However, inflation was out of control and the resulting exchange rate overvaluation instead of helping exacerbated policy inconsistencies. Eventually when the real appreciation (induced by chronic inflation) was no longer sustainable, the government made a modest concession to economic reality and devaluated the currency. The estimation of real exchange rate presented in Figure 1 suggests that despite partial interruptions occurred as a consequence of large and periodically maxi-devaluations, the bolivar was overvalued almost at all times since the early 2003. The theoretical prediction of this case of sustained overvaluation of the domestic currency is a deteriorating situation in the country’s degree of international competitiveness.

 

Table 1 shows that, over the period 2003-2015, this indeed was the case. The importers in the non-oil sector got a subsidy as non-oil imports skyrocket and stood at US$ 42.84 billion in 2013, more than 4.5 times the level reached in 2003. In contrast, non-oil exports went down 35% over the same period. In the meantime and despite the strict currency controls that the government had maintained since February 2003, Venezuela could not stop capital flight. The escalation of net capital outflows coincided with upswing of the current account surplus flows, illustrating the so-called ‘revolving door’ effect (Vera 2015).

 

 

 

In explaining the loss of control of the oil boom and the current external constraint basic questions concerning the explicit contract between the Central Bank and the state-owned oil company PDVSA on the surrender of foreign exchange proceeds, and concerning the adequate amount of international reserves, have been also particularly important. A reform of the country’s Central Bank charter undertook in 2005 changed the balance of power between these two public institutions, and since then the oil company gained more flexibility in meeting government claims for payments in foreign currency and in transferring foreign exchange resources to government funds and other public requirements. Figure 2 shows how PDVSA, over the years, gradually adjusted the portion (as a percentage of the oil bill) of the foreign exchange sales to the central bank.

 

 

 

Moreover, as part of the so-called “oil diplomacy” various asymmetric agreements with the People’s Republic of China and other countries Latin American countries were signed (in exchange for goods and services, and loans) with short-run effects on the cash flow of PDVSA.[2] Indeed, since 2007 through a series of oil-backed agreements Venezuela has received loan commitments from China upwards of U$ 50 billion. In exchange PDVSA has pledged to ship hundreds of thousands of barrels of oil to China per day for the life of the loan.

 

The sum of these institutional changes severely not only affected the sale of PDVSA’s foreign exchange to the Central Bank, but undermined the capabilities of the Central Bank to effectively manage its holdings of international reserves and to response to exchange market pressures. Indeed, international reserves, that reached US$ 42.0 billion at the end of 2008 (when Venezuela was close to confront the sharp oil price decline resulting from the global financial crisis) started to fall at a surprisingly fast pace and drawn down to about US$ 28.1 billion in just three months (in the first quarter of 2009). By the end of the third quarter of 2012 Venezuela had already depleted almost all its liquid level of international reserves (see Figure 3).

 

 

 

Victims of their own practice of state-led socialism and of their myopic viewpoint regarding the future of oil prices, government authorities fell into the trap of relying on unlimited access to international capital markets but with limited concern for the pro-cyclical bias of fiscal policy. As a result, between 2007 and 2012, Venezuela’s external debt stock increased significantly. In the case of market debt, PDVSA saw its debt stock grow almost 260% to over US$ 43 billion between 2008 and 2012; while the Central Government external debt grew 50% in the same period to almost US$ 45 billion. China started to lend massively to Venezuela in 2007.

 

Since 2011 the substantial run up in debt by the government started to affect government finances. Not only PDVSA’s bond maturities and interest payments started to rise, but repayment of the Chinese loans implied on average US$ 6.4 billion in debt service to Chinese banks. Figure 4 shows how the debt service, that represented less than 15% of oil revenues in 2012, increased systematically after 2013 to reach levels of 27% in 2014 and 53% in 2015. This, of course, started to raise concerns among international investors who now wonder whether Venezuela will choose a partial or total default of its external obligations. 

 

  

 

Without access to international capital markets, with a very limited level of cash reserves, and unwilling to make the corrections in the exchange rate regime, the Venezuelan government imposed quantitative restrictions to contain the deterioration of its hard currency cash flow. This not only  promoted a contraction of domestic activity, but also put further pressures on the parallel exchange rate market and inflation expectations. Figures 5 and 6 show developments of these key macro variables. As inflation accelerated the overvaluation of the currency got worse. Self-fulfilling bubbles in the domestic price of foreign money developed and expectations were revised leading to further domestic price increases and to a process of inflation/overvaluation dynamics.

 

Thus, when oil prices started to fall in the second half of 2014 the Venezuela’s economy was poorly placed, and when President Maduro came to power, a year before, he indeed inherited a country in economic disarray.

 

 

 

 

 

3. Towards a New Exchange Rate System: A Stable and Competitive Real Exchange Rate (SCRER)

 

One of the causes of Venezuela’s unsatisfactory economic performance is to be sought in the combination of a hard exchange rate peg with exchange controls and the fallacious premises on which this system is predicated. The system yields a persistently overvalued exchange rate and a permanent insufficiency of intermediate imports, with devastating output effects, especially when the foreign exchange gap is acute.

 

Since output recovery and the elimination of the import constraint must be seen as an undeniable priority, the liberalization of exchange controls on all commercial transactions is rapidly needed. Liberalization of the pervasive exchange controls on the remittances of dividends should also be welcome and evaluated. This may have a positive effect on foreign investor’s confidence. By contrast, to avoid large and potentially destabilizing capital flights, in a transitional period controls on financial transactions should be removed only gradually as the pace of the whole stabilization program shows results in progress.[3] This was the approach successfully employed in South Africa to lift the control in the early 1990s (see Aron and Muellbauer, 2009).

 

In addition, the Venezuelan economy requires a different exchange rate regime, whereby the Central Bank, as a mayor player in the market, can formulate a strategic target. It also needs a rationalization of the foreign exchange markets whereby the premium is lowered and the official and the parallel rates are gradually brought closer. We argue that a stable and competitive real exchange rate (SCRER) as recently justified by Frenkel and Taylor (2006), Frenkel y Rapetti (2007 and 2008) and Frenkel (2006), is a much better alternative for the Venezuelan economy than the current regime.[4]

 

To achieve this intermediate target the Central Bank may initially let the nominal exchange rate to float and later intervene more or less strategically in the currency market to achieve a competitive real exchange rate and provide its stability. Thus, once the initial move to a flexible exchange rate system is adopted, the nominal rate should move to hold the real exchange rate in the vicinity of a competitive level.

 

A stable and competitive real exchange rate not only may contribute to avoid the risk of currency overvaluation and the danger of running increasing deficits in the non-oil sector, but also reduces uncertainty and thus encourages investment in the tradable segment of the non-oil economy.  Furthermore, the free convertibility is fully in place, this policy does not give rise to rent-seeking, arbitrage or speculation.

 

4. Expanding the Breathing Space: Sources of foreign exchange liquidity

 

The benefits of a more workable exchange rate system for the Venezuelan economy cannot be reached before some critical intermediate steps are undertaken. The country needs adequate and readily available defensive assets as well as foreign currency liquidity not only to maintain confidence in the policies for exchange rate management (including the capacity to intervene in support of the SCRER); but to really lift the exchange control, remove shortages and promote the recovery in economic activity. Liquidity also limits external vulnerability, provides a level of confidence to international markets (that the country can meet its external obligations). In essence the Central Bank needs the return of its capabilities to effectively manage its holdings of international reserves and conduct monetary and exchange rate policy. We argue that the model of governance around oil export proceeds should return to a situation already common in many oil dependent economies, in which oil revenues accrue in the form of foreign exchange is surrendered to the Central Bank and this, in turn, credits the State-owned oil company with the domestic currency equivalent at the new official market rate.

 

The scheme has several advantages. First, by increasing the purchases and holdings of foreign exchange, the Central Bank can de facto provide the required unconditional liquidity that would be initially needed to lift the exchange control. Secondly, in view of the large uncertainties that the Central Bank will initially face under a liberalization of commercial transactions, the authorities may well require substantial amount of reserves to attend the unexpected component of the demand for currency exchange and to support the new system of managed float, once the exchange rate has achieved its real target level.[5] Finally, in the medium to long-term, the hoarding of oil export proceeds in the form of international reserves represents a potent self-insurance mechanism against reversals in the terms of trade, sudden stops and deleveraging crises.[6] 

 

Breathing space can also be gained if the oil agreements that Venezuela maintains with several Latin American and Caribbean countries are revised. These agreements have been a heavy burden for Venezuela. The oil agreements do not have to cease. In the case of PetroCaribe, for instance, all that is needed is a reform in the referential discounted price used so that as oil prices fall below certain level the size of the facilities declines or disappeared. The reform is easy to do because agreements are ad-hoc and bilateral PetroCaribe supply contracts are renewable annually. .

 

5. Debt Relief and Multilateral Financing

 

In implementing and promoting stabilization and recovery in the current Venezuelan situation policy changes to deal with the external constraint have better chance to succeed and be sustained with the help of debt relief and foreign lending.

 

With a weak external asset position and no access to international capital markets debt servicing due in 2016 and 2017 will be challenging. To keep the debt services on track, the willingness to pay has already submitted the country to big efforts. Venezuela will have to disburse US$ 42.13 billion from 2016 through 2019 to pay maturity of PDVSA and sovereign bonds. In addition the country has an outstanding debt with Chinese banks estimated around US$ 17.9 billion. Thus, faced with huge debt payments to international creditors for the next four years and with further payments to China’s development banks, Venezuela cannot rule out a credit event, which means that authorities should consider to request rapid conversations with creditors and the international financial community and to organize debt relief and financing.

 

Already in June 2016 the Venezuelan and international press informed that Venezuela and China had amended the oil-for-loans agreement to provide Venezuela better conditions on mandatory volumes and timeframes, stipulating that both parties would agree mutually on volumes and timing of payments.[7] At the current oil price Chinese debt restructuring could free up cash equivalent to about 650,000 barrels of oil per day, thereby alleviating Venezuela’s cash flow needs, which might help authorities to improve the allocation of foreign exchange liquidity in the foreign exchange market.

 

However, renegotiation with Chinese banks looks insufficient. To avoid a messy default, preemptive restructuring should be considered as the best strategy. It should be clearly understood that a refinancing is very often preferred than restructuring (because it is a quicker process, and impacts credit score positively); however, Venezuela can get much more relief if the Central Government and PDVSA bond maturity gets restructured on time. As recently showed by Asonuma and Trebesch (2015), preemptive defaults, compared to post-default cases have a much shorter duration of debt renegotiation (1 year vs. 5 years) and significantly lower output losses (post-default cases see a protracted decline in GDP after crisis start, while preemptive cases do not). Furthermore, they show that preemptive restructurings see a quicker re-access to international capital markets, as measured by the placement of bonds or syndicated loans with external creditors.

 

In this logic, the restructuring of the country’s debt should also involve the approval of new loans. Bridge loans provided by the international community to ride out temporary strains in foreign currency management should be the first option to explore. However, IMF’s early involvement and rapid financial assistance is also important because the support of the IMF and of the international community, in general, reduces the chances of holdout creditors to credibly threaten the restructuring agreed to by a supermajority of creditors.  IMF’s financial support should also be present when it is more necessary; as a further support to the short-run policy space gained through better management of oil exports proceeds.

 

6. The Control of Inflation

 

In an unfavorable environment of inflation acceleration as Venezuela is living today, to maintain a stable and competitive exchange rate will look more and more incredible and therefore a wave of pessimistic expectations may ruin stabilization efforts. This implies that policies to control inflation require a very rapid suppression of the causal mechanisms built through the years. This is not an easy task since the behavior of domestic prices seems to be dominated by multiple factors.

 

Perhaps one of the most important factors affecting the overall price level in is relative price variability. In a country plagued of price controls this may not be surprising.[8] Typically, the adjustment of relative prices of this highly distorted structure of controlled prices may contribute to inflation if other prices are sticky downwards.[9] One of the main practical problems is that as inflation goes on, profitability ratios in the production of those goods and services under regulations and controls are negatively affected and from time to time. To avoid deep shortages, the government authorizes periodic but random upward adjustments, which prolong the price inflation dynamics.

 

From an economic policy perspective the transition towards a non-inflationary vector of relative prices is then crucial. The need of rapid disinflation primarily supports a rapid shift toward market prices. This implies a rapid removal of the Law of Fair Cost and Prices, which currently establishes the standards to determine prices of goods and services, profit margins, and commercialization mechanisms. An initial price jump resulting from the comprehensive price liberalization is very likely or inevitable, but once distortions in the structure of the relative price system disappear, pressures on average inflation coming from relative price changes should be lower. 

 

However, widespread and rapid removal of price distortions may inevitably generate downward adjustments in real wages and growing discontent of fixed income recipients.[10] A substantial increase, in advance, of the minimum wage looks as a necessary compensatory measure. The private business sector would be able to accept it if they discount the compensatory effects of the liberalization of prices. In addition, a safety net of direct subsidies that substitute the indirect subsidies, inextricably linked to the system of price controls, could provide much needed relief for poorer and support for the program.

 

A second aspect of anti-inflation program should deal with inflation expectations. Anchoring inflation expectations may require a credible commitment of monetary authorities with an exchange rate policy that avoids currency overvaluation. Because overvaluation breeds anticipations of large depreciations in Venezuela, it can be identified as one important determinant of inflation acceleration. While at the start of the stabilization program the decision to let the nominal exchange rate to float may trigger inflationary pressures in the very short-run; with a movement in a direction of a SCRER, devaluation risks will diminish so as to positively reorient inflation expectations.

 

Fiscal and monetary policies should also be consistent with the target of maintaining inflation pressures under control. One mayor problem in an economy in which inflation is already accelerating and the demand for money is falling, is that an unrestrained expansion of domestic credit by the Central Bank will face people’s increasing desire to hold alternative assets and durable goods, most of which are, in the case of Venezuela, in short supply. Thus, supply-constrained markets will respond to a non-programmed increase in the money supply with sharp price increases. In some cases the food market is, for the poorest people, the alternative asset market.  In other cases, for those who have higher access to hard foreign currencies, the attack is against the domestic currency. Thus, from a policy perspective, it seems clear that while reforms do their work to remove some of these bottlenecks, monitoring of monetary aggregates and monetary policy in general has a prominent role to play in the fight against inflation.

 

Chronic inflation is a main feature of the Venezuelan economy. In the last 35 years the country has not faced a single year with one-digit inflation. The persistence of inflation arises as a result of several defensive mechanisms on the part institutional agents. The most common is informal indexation through desynchronized adjustments. Recent empirical studies conducted by Guerra, Olivo and Sanchez (2002), Alvarez, Dorta and Guerra (2002), Zambrano and Lopez (2003), Maldonado (2011), and Contreras and Guarata (2013), show that the inflation rate  in Venezuela moves largely in response to lagged inflation, a strong evidence on the presence of inertial components in the process of inflation.  Hence, in this situation a monetarist diagnosis/program to curb inflation is insufficient. Other simplistic attempts through as exchange rate pegs or price controls could be disappointing and very costly, as the recent case of Venezuela demonstrates. We think a much better idea for countries suffering indexation and desynchronized price adjustments is to move the economy into a mechanism of perfect contractual indexation pegged to a standard of value. This was the path followed, for instance, in Brazil when Fernado Henrique Cardoso presented to the country the Real Plan, on December 7, 1993.[11]

 

Briefly, the idea would be to institute a monetary reform process in which government authorities introduce, for a short period of time (the transition period), a domestic unit of account or Unit of Indexed Value (UIV), with a virtual exchange rate value of 1 UIV = US$ 1.00. Though for the transition period the old currency will continue to be the mean of payment, its value in terms of the new unit of account would be devalued every day in tandem with the ongoing rate of inflation. It essentially means that all previous existing contracts, which were set according to different price adjustment rules, overlapping periods, and time frames, will be replace by a new coordinating mechanism. Thus, the move involves an increasing use of a stable unit of account (pegged to the dollar) through a process of full indexation that asymptotically reduces asynchronic price adjustments. In essence, an indirect process of dollarization takes place without using the dollar as a mean of payment. When the stabilization formally begins and inflation gradually converges to one digit, the unit of account (linked to the dollar) becomes the new currency at a parity of one to one with the dollar. This pillar of the plan finds then a devise to align the adjustments of the most important relative prices in the economy and to perform a coordinated price/contract conversion to a new stable currency.

 

In sum, to control inflation we propose a plan that comprises three steps: (i) a rapid move oriented towards removing all relative price distortions, including the overvalued real exchange rate. This process of relative price correction should be preceded by measures that can provide income support for the poor; (ii) a fiscal and monetary strategy centered on the correct monitoring of the demand for money to avoid unrestricted expansions of the money supply, and (iii) a monetary reform process that through an indexed unit of account allows a coordinated price/contract conversion and the transition to a new stable currency.

 

7. Challenges for Economic Recovery

 

Extremely high inflation, rising constraints on government spending, and a poor business environment combined with severe supply-side constraints will see Venezuela’s recession stretch into its third year in 2016 and persist into 2017. We already argued that output recovery will require the liberalization of exchange controls on all commercial transactions and the elimination of the import constraint. Efforts to unify the exchange rate and allow current account convertibility in an environment of a competitive exchange rate regime should be seen an opportunity for the production of tradeables at least in the medium term.

 

Massive state intervention in the economy and a volatile legal and regulatory framework also make Venezuela a difficult climate for local and foreign firms. The government’s project of institutionalizing “socialism” has relied on heavy, if uneven, regulation of the economy, affecting property rights, degrading the operating environment and increasing risks for private-sector businesses.[12] The Venezuelan government has nationalized businesses in diverse sectors over the past several years, using such expropriations as a pillar of its project. However, most of these ventures not only brought these new state firms to the brink of bankruptcy but also undermined the nation’s production of basic goods and services. Addressing all inadequacies of the business climate at the same time is obviously impossible, but the country and government authorities, in particular, need to sustain a major effort to promote structural reforms, improve incentives and overcome this economic climate in order to address social demands without serious conflicts.

 

Addressing the supply-side means not only broad deregulation and institutional changes to reduce supply constraints, but also a sensible policy to lift price controls. We already argued that the policy of price controls and profit caps is likely to magnify relative price variability, but price controls also discourage much-needed output growth and investment. In general, the overall gains from price liberalization are positive. It is certainly true that lower welfare effects can be computed when indirect subsidies through prices controls are eliminated, but there are two beneficial effects of price liberalization: lower queues and more output.

 

8. The Support of Monetary and Fiscal Policy

 

The stability of the competitive real exchange rate, the voluntary conversion to the UIV (and all efforts to contain inflation), and a successful program of economic recovery, depend very much on the program credibility, with economic agents being convinced not only that there is a plan to solve the Venezuela’s complex economic situation, but also that monetary and fiscal policy will be consistent with the main policy targets.

 

Two aspects of monetary policy may be considered crucial from the perspective of a stabilization and recovery program. First, that monetary policy under the new exchange rate and currency regimes should not be used as an accommodative mechanism for fiscal deficit financing. Secondly, that the capacity of the Central Bank to control monetary policy may decline abruptly as soon as the monetary reform brought inflation to a sudden halt and the demand for money increases.

 

The first aspect implies a revision of the Central Bank operations of monetary financing of the public sector. This in turn implies that the main cause of the expansion in the monetary base in recent years, the continuous financing of the state-owned company PDVSA and other state enterprises, should be revised and solved.[13] Sustainable fiscal adjustment will likely require a durable reorganization and restructuring of PDVSA and other state-owned enterprises. Though the Venezuelan government is not providing information on public sector revenues and outlays, reconstructed statistics for the consolidated (or restricted) public sector provided by BoAML (2016) indicate that Venezuela’s fiscal deficit has been growing steadily for the past decade (see Table 2).[14] The data shows that the major problems are not located at the Central Government level but in PDVSA, which bad financial shape is precisely what explains the continuous monetary financing of the state-owned company (Monaldi 2015). The financial situation complicates when PDVSA’s financial gap is calculated in domestic currency. Hernandez (2016) correctly argues that while PDVSA’s spending increases with inflation, revenues in domestic currency are tied to the fix currency exchange.

 

 

 

Though financial reorganization takes time to achieve, actions should not wait if policymakers want to establish confidence in the new economic policy stance. Several types of expenditure measures can be adapted quickly to contain a deteriorating financial situation of PDVSA. A profitable expenditure reduction involves tackling the current spending in foreign currency, specifically spending in foreign currency to feed off-budget funds and social spending programs, which are not the best example of transparency and good governance.[15] Preemptive foreign debt restructuring or refinancing should also be among the menu of early actions.

 

PDVSA can support public finances by consolidating its own budget, but a fiscal strategy for the Central Government is also needed.  Though structural problems in the tax system may well be a mayor contributor to fiscal deficits in Venezuela, the current ability to generate revenue by raising tax rates may be limited and counter-productive, particularly because the economy is undergoing a severe recession. A better strategy may involve asset divestiture, deregulation, elimination of rent-seeking entitlements and preemptive debt restructuring (domestic and foreign). But the tasks behind these public sector actions and reforms, take time.

 

There is a key point regarding fiscal adjustment that deserves further attention. Efforts in the fiscal realm may run into trouble when the conventional budget deficit is used as a single and fundamental measure of the required fiscal adjustment. This is especially relevant in economies such as Venezuela, subject to enormous exchange rate distortions, high inflation and deep downturns. If the effects of the exchange rate lag, the rate of inflation and the size of the downturn are not taken into account, the deficit as well as the magnitude of the adjustment will be overstated. These non-discretionary factors beyond the control of fiscal authorities can be critical, specifically during the transition towards a more stable economy. For instance a rapid return to lower inflation as well as towards a unification of the exchange rate, two key components of the stabilization program, could change the fiscal situation dramatically. Indeed, under certain specific circumstances, when government spending is inflation-adjusted and when the real interest payment on net external debt is below the noninterest budget surplus relating to tradables, both lower inflation and a real devaluation will close the fiscal gap (Reisen 1989). Of course, though these macroeconomic factors have a significant impact on the budget balance, it is difficult to assess their quantitative effects as they may depend very much on unknown specific parameters and institutional realities. What we certainly know is that to the extent that the public sector deficit can positively adjust to these macroeconomic changes, the central bank will face less pressure to print money. 

 

The second aspect of monetary policy that may be considered is that with a rapid fall in the rate of inflation and the further introduction of the new currency, real money demand would increase significantly.[16] This, in turn, implies that the banking system and the Central Bank have to be willing to provide the needed liquidity to match any growing demand for money. Prefixing monetary expansion targets under these circumstances would be difficult if not impossible.

 

Complex is the answer then to the question of what exactly should be the operational targets of monetary policy. Initially, for confidence building purposes and to avoid undue pressures on prices and the exchange rate, the authorities can be committed themselves to strict targets for the monetary base, but this may prove futile later, in face of a much higher than expected acceptance of the new currency.

 

 9. Some Concluding Remarks

 

Since the Venezuelan economy is today supply-constrained (specifically by a lack of intermediate imports and raw materials) the lifting of the foreign exchange constraint and the restoration of the system of price incentives should be seen as instrumental to the solution of the output growth problem. Other non-price reforms that remove massive state intervention in the economy and the volatile legal and regulatory framework, may substantially improve the business climate for local and foreign firms.

 

An economic strategy to deal with the foreign exchange constraint requires an increasing space of currency exchange to facilitate the removal of the exchange control and the initial transition towards a SCRER target. Policy changes in this area have also better chance to succeed and be sustained with the help of debt relief and broad multilateral or foreign lending.

 

Inflation control is important for the success and sustainability of the new foreign exchange regime, and we have expressed concerns over the multiple factors that affect the behaviour of domestic prices in Venezuela. A comprehensive approach rather than a simplistic monetarist rule seems to be the best option. We have evaluated the convenience of a rapid removal of all relative price distortions, including the overvalued real exchange rate, a fiscal and monetary strategy centred on the correct monitoring of the demand for money to avoid unrestricted expansions of the money supply, and a monetary reform process that allows the adoption of a fully indexed unit of account (pegged to the dollar) later to become the national currency.

 

One critical juncture in the design of a stabilization and reform effort relates to fiscal and monetary policy. Venezuela has a huge fiscal gap and the data shows that the major problems are located at PDVSA. The problem is that the Central bank has been funding the oil company in a context plagued of productive bottlenecks. Against this unpleasant situation we have pointed out several types of expenditure measures that can be adapted quickly to contain the deteriorating financial situation of PDVSA. We have been more cautions with respect to the Central Government gap.

 

But neither the capabilities of budget planners nor the extent of discretionary fiscal policies should be overstated. During a successful stabilization process some new forces take over and determine a new path towards lower inflation, output expansion and a less distorted exchange rate regime, and the fiscal gap will not be immune to those developments. Moreover, with a rapid fall in the rate of inflation and the further introduction of the new currency, real money demand may increase significantly, which will make strict monetary targeting a difficult task.

 

 

 

References

 

Alvarez, F., Dorta, M. and J. Guerra (2002), Persistencia Inflacionaria en Venezuela: Evolución, Causas e Implicaciones,  in Guerra, J. (editor), Estudios sobre la Inflación en Venezuela, Banco Central de Venezuela, Caracas.

 

Asonuma, T. and C. Trebesch (2015) Sovereign Debt Restructurings: Preemptive or Post-Default, CESifo Working Paper No. 5605.

 

Aron, J. and J. Muellbauer (2009) Monetary Policy and Inflation Modeling in a more Open Economy of South Africa, in Hammond, G., Kanbur, R. and E. Prasad, Monetary Policy Frameworks for Emerging Markets, Edward Elgar Publishing Limited, Chetelham.

 

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[1] Elsewhere (in Vera 2015) we have presented an analysis and description of the recent evolution of the Venezuelan economy.

[2] In the case of PetroCaribe, the mayor energy program with the region, a group of countries from Central America and the Caribbean purchase oil and oil products from Venezuela and the differential between the market price and a referential discounted price is turned into a 25-year loan at concessional terms. 

[3] Though this arrangement will imply the existence of parallel exchange rate market, its behaviour will depend on a number of factors, in particular the behaviour of expectations regarding the credibility and the sustainability of the SCRER system.

[4] All these authors understand a ‘competitive’ real exchange rate as one that is above its equilibrium level.

[5] Here is critical to know or have an idea of the elasticity of the demand for reserves with respect to an increase in the exchange rate system flexibility.

[6] If the exchange rate changes rapidly, up or down, traders and investors will become more uncertain about the profitability of trades and investments and will likely reduce their international activities. As a consequence, international traders and investors tend to prefer more stable exchange rates and will often pressure governments and central banks to intervene in the foreign exchange (forex) market whenever the exchange rate changes too rapidly.

[7] With no updated official figures of Venezuela’s oil deliveries to China it is difficult to confirm these speculations.

 

[8] Contreras and Guarata (2013) confirm this causality from relative price variability to inflation in Venezuela using monthly data for the period 2000:1-2011:10.

[9] As the new “supply-side” theory of inflation contends when the distribution of price changes is positively skewed and downward price inflexibility prevails, large o even small increases in the prices of few goods may be associated with an increase in average inflation. The theoretical proof belongs to the works of Olivera (1960 and 1964) though Ball and Mankiw (1995) later provided an explanation in a statistical sense.

[10] We should not underestimate, however, the positive welfare effects that radical elimination of shortages and queues and a broader variety of goods and services may have on the general public.

[11] The Real Plan was in essence a three-pillar and three-stage stabilization program with a budget balancing mechanism, the introduction of a stable unit of account to align the most important relative prices in the economy, and the conversion of this account unit into a new currency at a fixed par rate with the US dollar.

[12] Venezuela is ranked 186th out of 189 economies in Doing Business 2015.

[13] In Vera (2015) we show that this accumulated stock of liquid resources (whose counterpart comes as short term debt instruments) is highly correlated with the ratio of M2 to international reserves. Hence, more liquidity chasing the same restricted volume of output, and chasing the same amount of dollars, has a potential impact on both inflation and exchange rate depreciation dynamics.

[14] Definition of the consolidated public sector covers only the central government and the state-owned oil monopoly PDVSA. No data are available on the social security system, or other state-owned enterprises. None of the series includes off-budget funds such as Fonden or the Chinese Funds.

[15] Manzano and Scrofina (2011) argue that these vehicles have been used to bypass the formal budget and have provided the government discretion and flexibility because they are not bound to the same legal entitlements and earmarks as the formal budget.

[16] Both households and firms will not only continue to hold domestic currency, but also to hold it in growing amounts because they will feel that through full indexation they are protected against inflation.

 

   
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