Wednesday, 25 February 2009

Inca Kola News Again: Readers Wll Find Its Morning Piece on Venezuela's Currency Insightful and Very Solid

Inca Kola News ended third in last year's
Web Log Awards for best Latin blog

Inca Kola News does it again. After admitting IKN's latest postings were too mining-focused and perhaps they were becoming too much a sleeping material, the author decided to write about Venezuela's (beleaguered currency, my comment) bolivar fuerte. Excellent decision! Click here for the link to the story.

IKN argues that a devaluation might be on the cards, that dollar assets remain strong and that market worries of a collapse of the currency system might be overstated. True. IKN also defends Hugo Chávez's decision to seize $12 billion from international reserves for his off-budget Fonden fund -- the least transparent Sovereign Wealth Fund in the world, -- saying it doesn't hurt the country's financial position. Plausible thesis, but hard for some of us to swallow:
We've recently had a whole bunch of blog-based Venezuelan 'experts' doing mutual handwringing sessions over that supposedly polemic withdrawal of reserves. These people seem to miss entirely the real point while preaching to their own little choirs. Venezuela's reserves are in good shape.
We at MM may form part of that selected group of blog-based Venezuelan ''experts,´´ -- as IKN dubs skeptics on the country's currency system, -- and we are happy to contribute ideas to the debate. Our purpose is not siding a priori with any party on this but bringing elements for a further discussion of the issue that you can judge a posteriori. In a recent chat with Samuel Malone, a U.S.-born economist now at Universidad de los Andes in Bogotá, I realised how dogmatic has this issue of the bolivar became among markets people -- investors, company executives, analysts, journalists, professors, politicians.

Malone developed a very interesting model for the Venezuelan black market currency in the stock-flow tradition of Rudi Dornbusch, the late MIT professor; Malone compares his findings with a group of five other models in finding the determinants of the black market dollar in Venezuela. The model (obviously no model is perfect) has the lowest RMSE (root mean square error) of all the sample of different models he picked for his paper. He found strong correlations between the trend for the black market dollar and the level of international reserves (or government dollar assets), the pace at which the black dollar exchange rate depreciates and the lagged premium. The model also shows the black market rate is very sensitive to changes in the differential rate of expected profits from purchasing black market dollars.
Shortcomings of the model include the lack of a PDVSA cash holdings proxy (in general, my experience covering this market suggested that people were very attentive to the financial situation of PDVSA and such worries affected the quotation of the black market rate.) I assume its inclusion would just make the model too complicated for the author's purposes.

I apologise to readers because Malone's speech and our chat took place the same day, almost a month ago, and I lost track of key details. Nevertheless, I took down some notes and managed to piece them together.

Malone identifies a few policy dilemmas: 1) Money creation has caused inflation. However, the Hugo Chávez administration has committed to transfer programs (the so-called Misiones) that keep the oil windfall flowing into the economy. Soaring money supply coupled with a fixed exchange rate stoked excessive growth in imports. 2) Growing demand for imports ''creates a drain on the government’s international reserves, especially as seen during 2007´´ and 2008, he says. 3) The government has sell debt (remember the famous and almost no transparent colocaciones especiales, or the at-some-point very successful PDVSA bond sale) to soak up excess bolivares from the domestic market. While this worked temporarily to lower the parallel market rate, it hasn't lowered the drain on foreign reserves. Venezuela keeps wasting too much money in imports -- no matter how fast reserves growth, now with the oil price decline that situation will tend to worsen unless demand is put the brakes effectively.

Yet, 4) the increased debt sales boosts government liabilities. This translates into higher spreads on both domestic and foreign debt -- no matter whether the oil price is high or low. The higher borrowing costs are then passed on the domestic firms and individuals, Malone says, which discourage the undertaking of investment. Then add the impact of the price controls and the exchange rate system shortcoming and you will have what you have now: under- or simply dis-investment (I know this word doesn't exist in the dictionary, but it exists in mine and you should be able to understand it as destruction of value.) Thus, volatile reserves and exchange rates, including the parallel market rate, contribute to high spreads. Also, volatile oil prices contribute to volatile base money, which implies a volatile sovereign asset. In Malone's opinion, the government’s goal of keeping the fixed exchange rate regime and capital controls is unsustainable in the medium term. That oil bought Chávez some extra time is different. Common sense, which doesn't necessarily goes hand in hand with economics thinking, tells us there is something wrong happening there, not simply the tantrum and unwillingness of the opposition to work for the country. Malone likens Venezuela to a Dutch Disease economy combined with an unsustainable exchange rate regime. The element of indebtedness and sovereign risk creates the conditions for high inflation, low investment, and falling productive capacity in the non-oil traded sector. He said this crisis can morph into one of increasing probabilities of default. I disagree with that -- Venezuela still has $70 billion in dollar assets at disposal. Professor Malone says there is still room left to correct these imbalances, but the room to maneuver is falling dramatically now that oil is on the low $40 a barrel.

When I asked him why the government kept the controls in place, he said this: ''There are a number of political economy reasons to do this. Macro economically speaking, I am afraid I don't know them.´´


  1. I'll take issue with one part. I kept my post deliberately non-political and simply noted the financial moves that were going on. I'm not defending NOR attacking Chávez on the Fonden move.

    There's plenty of solid economic theory out there that says $30Bn in reserves for a country the size of Vzla is plenty. My issue is the fact that nobody looks at the real problem, that of money supply/velocity. The commentators and the normal wafer-thin analyses on the subject are all about the dollar reserves and nothing about the VEF M2.

    If someone wants to look at Vzla finances, look at the finances and stop throwing the first available political brick in the direction of Chavez.

  2. Es muy cierto amigo ... nadie dice aqui que vos tenes una agenda politica. pero es cierto que las criticas que se le hacen al modelo tienen mas un fondo politico que formal. we all tend to fall into that trap -- that is why we need to avoid it ... en mi caso trato de agregar la mayor cantifdad de opinoones expertas posibles. but my opinion remains the same ... the system there is unsustainable.

    but i loved your piece and i thin the argument is quite strong. READ THE HEADLINE!!! HOMBRE, NO TE PONGAS BRAVO! the posting of yours is so goog it gave me the idea of writing about prof. malone's model and our chat the other day.

    thanks a lot ... un abrazote amigo ...