Why the Markets Are Betting Against Venezuela

If we are to believe the bond markets, Venezuela is the riskiest country in the world. It is riskier than Greece, riskier than Argentina, and only slightly less risky than the bankrupt U.S. commonwealth of Puerto Rico.

In spite of Hugo Chávez's death and the uncertain political situation left in its wake, this is surprising. Venezuela is a major oil exporter, and bond yields should, in part, reflect a country's ability to pay its international obligations. In a period of high oil prices, why are markets so down on Venezuela?

The answer lies in the country's unsustainable fiscal situation, and its government's unwillingness to face reality.

Venezuela had a fiscal deficit of around 11 percent of GDP in 2012. The International Monetary Fund (IMF) projects it will reach 12.6 percent of GDP this year. Both figures are among the highest in the world. Not surprisingly, the country's rate of inflation has shot up to almost 50 percent per year. The Central Bank has practically run out of liquid foreign exchange reserves. Meanwhile, oil prices have embarked on a slow, but apparently steady, trend downward.

Why has it come to this? Two insane policies are (mostly) to blame: foreign exchange controls and the enormous gasoline subsidy.

More than ten years have passed since Hugo Chávez established foreign exchange controls in Venezuela. What began as a policy to control capital flight has evolved into a massive scam, transferring the government's enormous wealth to politically-connected sectors that benefit from subsidized dollars.

The government sells dollars at a rate of BsF 6.30, while the black market rate is upwards of BsF 47, seven times the government rate. Not surprisingly, demand for government dollars has shot up, and people who manage to get them simply save them or exchange them in the black market. Cheap dollars are supposed to finance the import of basic staples. In practice, they are fattening the bank accounts of the local elite, colloquially known as the "bolibourgeoisie."

The other reason for Venezuela's unsustainable fiscal situation is the policy of giving away gasoline for free. In Venezuela, filling up a 40-liter tank of gas costs less than 8 cents in U.S. dollars when one converts using black market rates. The retail price of gas has been fixed for 17 years, and the government has no intention of changing it. After Venezuela's refineries began malfunctioning, Venezuela actually increased its imports of gasoline. The bottom line is that the government is giving away something that it needs to buy at market prices. This has caused a tremendous dent in public finances. Meanwhile, the government denies there is even a problem.

Deep down, however, the government understands it is in a bind. It is simply unwilling to remedy the situation. Just last week, President Nicolás Maduro announced that the government would increase the sale of dollars, partly by issuing new debt. At the interest rates the market is charging, this constitutes an expensive transfer of wealth from future generations of Venezuelans to the well-connected elites of today.

It has also resorted to hunting down no-shows for flights out of Venezuela, looking for those wanting to take advantage of currency controls. And instead of promoting the few pragmatists in his administration, he has sidelined them, instead giving more power to the military and the radical Marxists. The government has also blasted private companies ("parasites" in chavista lingo) for demanding cheap dollars while not exporting enough. President Maduro has publicly lamented that the private sector is still a large portion of the country's GDP, a sign that his dream of "socialism" has not yet been fulfilled.

One of the things that most trouble investors is Venezuela's seeming inability to increase oil production. During the 1990s, previous Venezuelan governments attracted foreign investment thanks to a generous royalty and tax regime. Chávez, upon seizing power, denounced this and proceeded to nationalize the oil industry, later raising taxes on the few multinationals that remained in the country. This has resulted in steadily declining production levels.

The outlook for Venezuela's economy is bleak, and bondholders are worried. Just this week, the IMF warned of growing imbalances in its economy. Everyone outside the government seems to understand that an adjustment is inevitable, and that postponing it will only make it more painful.

Regardless, the government is intent on staying the course. If it continues on this path to "implosion," as the Washington Post has labeled it, alarm bells will continue to ring in the international banking community.

Juan Nagel is the Venezuela blogger for Transitions, co-editor of Caracas Chronicles, and author of Blogging the Revolution. Read the rest of his posts here.



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