Venezuela Currency Devaluation

Venezuela’s economy is in dire straights. Its productivity has plummeted, its debt has skyrocketed, its currency is the weakest it has ever been as far as available data shows. And it's about to take another hit in March of next year in an emergency effort to bring runaway inflation under control and draw foreign investment into its ailing oil industry.

Venezuela on the Brink

Strict currency controls at Venezuela’s central bank limiting the amount of USD allowed to circulate within its borders have lead to a shortage of dollars, strengthening the value of the USD and weakening Venezuela’s bolivar, resulting in skyrocketing inflation from 17.2% in November of 2012 to 46.85% in October this year.

To combat such high inflation, Venezuela needs to keep its interest rates high, currently straddling the 16% mark for some two years already. Yet this has made it much more costly for the government to raise money, which it desperately needs to finance a growing budget deficit projected to reach 10.75% of GDP, while GDP itself shrinks from 4.73% in 2012 to 1.43% this year.

To finance this deficit, the nation has been tapping into its reserves, depleting them by some 29% this year alone, from $29.9 billion USD at the start of 2013 to some $21.3 billion last month. It has also been forced to borrow heavily, with combined internal and external debt growing by over 39% in the last two years to $110 billion USD.

Rising consumer prices, depleting foreign reserves, high interest rates, and spiralling debt accumulation have prompted Standard & Poor’s Rating Services and Moody’s Investors Service to cut Venezuela’s credit rating to Caa1 — just four steps above default — with Moody’s citing “increasingly unsustainable macroeconomic imbalances and materially higher risk of an economic and financial collapse.”

Fighting a losing battle to keep its currency propped up, the government decided to release some pressure by devaluing its money effective March of 2014 — but not for the entire nation; only for incoming foreign investments.

New Targeted Exchange Rate

For years, the Venezuelan central bank has pegged the bolivar to the USD through auctions of dollars at its CADIVI exchange rate, currently set at about 6.3 bolivars to the dollar. Yet its tight currency controls limiting the amount of USD in circulation have led to a dollar black market, which has pushed the value of the dollar to a staggering 55 to 60 bolivars — some 10 times the official government exchange rate.

This has been the main driver behind the soaring inflation, with market forces automatically adjusting the bolivar’s real buying power even as the government clings to its own official rate. The shortage of USD has created a severe shortage of imported goods which the nation depends on due to limited domestic manufacturing.

The new leadership after the death of former president Hugo Chavez has thus decided to increase the flow of dollars into the country through its new currency auction exchange system introduced earlier this year — SICAD.

Only its not intended for everyone. While the general populace will still exchange their money using the CADIVI rate of 6.3 bolivars per dollar, foreign investors and tourists will be using an adjusted SICAD rate set for March — currently undisclosed but believed by analysts to be 12 bolivars per dollar — effectively cutting the value of Venezuela’s currency in half for foreigers.

Oil For Cash

After years of mismanagement under the previous regime, Venezuela’s new administration under President Nicolás Maduro desperately wants to increase revenue, and it is turning to the nation’s crown jewel — its oil industry — where there is plenty of room for improvement.

While sitting atop the world’s largest oil reserves of 297.6 billion barrels of oil (CIA World Factbook) ahead of Saudi Arabia’s 267.9 billion, Venezuela ranks only 8th in oil exports and 13th in oil production. Since it lacks the money needed to upgrade its facilities and infrastructure, the government has decided to attract foreign investment to help expand its oil industry by lowering the value of its currency through SICAD, specifically targeting oil sector investments.

In an interview with the Wall Street Journal, Russ Dallen of Caracas Capital Markets calls it “a back door way to devalue” and “a nod to reality.” It is a roundabout way of depreciating its currency for a targeted few without upsetting the Bolivar’s value in other parts of the economy. Remember, inflation is bad enough as it is. A general devaluation of the currency for everyone would send an already sky-high inflation rate to the moon.

Much better than the gold-for-cash scheme with Goldman Sachs (NYSE: GS) rumored earlier, this is a plan that is very much in Venezuela’s favor today as it will be for the future. It is effectively an oil for cash plan that will revitalize the nation’s oil industry and increase its revenue stream for decades to come.

Oil Minister Rafael Ramirez indicated in a news conference Monday that the SICAD auctioning system could be altered by exchange rate and by targeted industry “for the sectors that want to bring dollars into the country for increasing production,” he noted. The nation’s gold industry is also expected to be made eligible for the special exchange rate.

Balancing on a Fine Line

However, Dallen remains a little less optimistic that these special industry-specific exchange rates will be enough to solve Venezuela’s financial woes, as he foresees a full currency devaluation in the near future as being inevitable, leading to further inflation and higher interest rates.

A good deal of damage was dealt by Venezuela’s previous president Hugo Chavez, who believed a little too unrealistically in ‘giving to the people,’ choosing to subsidize gasoline prices, of all things.

For the same price as one liter of bottled water, Venezuelans “can buy 72 liters of gasoline,” Ramirez astounded. “Venezuela is the country with the cheapest gasoline in the world. It's not a point of pride…it makes no sense,” he denounced.

Some $12.5 billion USD are lost every year by selling gasoline internally at the subsidized rate. And all it does is encourage people to use fuel less responsibly, adding to the internal consumption of a valuable product that could fetch much higher prices if sold externally.

As a result, Venezuela’s consumption of refined petroleum products has jumped from 571,000 barrels of crude oil per day in 2011 to some 700,000 barrels per day currently — an increase of 22.6% in two years.

But it will take a lot more than simply raising gasoline prices to turn Venezuela’s economy and finances around, as higher gasoline prices will reduce consumer buying power, which has already weakened considerably through 16-year high inflation.

Investment Potential

It will be a difficult act to juggle to increase revenue without slashing the currency’s buying power which only hurts the populace. But the dual exchange rate system seems like clever way of playing two chess games at once — attracting foreign investment by lowering the cost of doing business in Venezuela’s rampant inflationary environment, while preventing the buying power of the locals from sliding ever lower.

At the same time, the government would effectively receive more bolivars for each dollar of oil it sells abroad through the SICAD rate. (It collects USD for its oil; the central bank then sells USD to businesses at the SICAD rate, receiving back a greater number of bolivars than it would through the normal CADIVI rate.)

This allows the central bank to gradually reduce the amount of its own currency in circulation, while at the same time increasing the supply of USD, resulting in a lifting of the value of its money while lowering the value of the dollar, cooling both the black market and inflation. If it works, it will be one of the greatest economic turnarounds in decades.

Entrepreneurs looking to invest in a foreign market might want to keep an eye on Venezuela’s experiment with a dual exchange rate system. Cuba has had one in place for some time, but its effectiveness is difficult to judge given the island nation’s limited trade prospects under the U.S. embargo.

Venezuela will give the world a chance to see the dual exchange rate system in play under a freer system of international trade with unlimited access to foreign investors. Factoring in Venezuela’s massive oil reserves and potential for doubling its export growth, a bet on the Venezuelan bolivar might be something to seriously consider as a long-term foreign currency investment.

(Note: As a contrast to Iraq, there are no rumors of a sharp, overnight currency revaluation of the Venezuelan bolivar as there have been for the Iraqi dinar. Investing in the Iraqi dinar may prove just as valid as investing in the Venezuelan bolivar as far as growth in oil revenues would imply. But deciding to invest in either country should be done with the right objective — slow, long-term appreciation, not an overnight revaluation bonanza. Given Iraq’s less developed economy, of the two nations, Venezuela would offer a healthier return potential.)

Joseph Cafariello