Counting Pennies In Venezuela

It was a gloomy, rainy night in Boston last week where emerging market analysts and portfolio managers huddled together before an audience of 75+ people to discuss an equally gloomy situation in Venezuela, specifically whether or not the nation, with the biggest proven oil reserves in the world, is on the precipice of defaulting on its debt.

Trying to figure out what economic and fiscal policies the administration of President Nicolas Maduro will follow to alleviate rampant inflation and shortages is akin to trying to read tea leaves. But a panel put together by EMTA laid out the scenarios and discussed the implications of any potential default. The talk of default really kicked off Sept. 5, 2014 after an article published by former Venezuelan planning minister Ricardo Hausmann and Harvard research fellow Miguel Angel Santos asked whether or not Venezuela should default.

Maduro is the hand-picked successor of former President Hugh Chavez, who launched and nurtured his leftist Bolivarian Revolution with government subsidies for food, health, education, fuel and more out of the oil receipts of the national oil company Petroleos de Venezuela (PDVSA). In the process Venezuela has run up an increasing debt load to help pay for his vision even as oil production started to slip.

But Venezuela has a reputation for being a consistent and strong payer of its debts, earning Wall Street’s confidence even when the now deceased Chavez was rattling his sword, denouncing the United States and capitalism in general. Maduro insisted that the country has no intention of defaulting on its debt and that’s been recognized by the market.
“The government has been pretty adamant about its intention to service its debt since they appear to believe very strongly that to do otherwise, to default, would really compromise their ability not just to export oil but to also import goods. I think they see the downsides to a default as quite significant,” said Matt Ryan, portfolio manager at MFS Investment Management.

Chavez arranged for subsidized oil to be sent to Cuba in return for doctors and created Petrocaribe in 2005 where member states buy oil and fuel on favorable terms. But the price of that oil is plunging on world markets. West Texas Light Sweet Crude prices are down 21 percent year-to-date, and trading below $80 a barrel since late October at four-year lows. One panelist cited the lost revenue at $770 million for every $1 drop in the price of oil.

Walking past the Boston Tea Party museum on the way to the panel discussion, I couldn’t help but be reminded of the timing between the dumping of the tea into Boston Harbor and the official start of the American Revolution. It might be a stretch to equate that to what’s happening in Venezuela but in purely time-terms, there could be something to it. The Colonists threw the tea overboard in December 1773 and the start to the War of Independence was marked in April 1775, roughly 16 months of skirmishes, wrangling, shouting, and hand wringing.

(Boston Tea Party Museum, Nov. 6, 2014 – Photo by Daniel Bases)

“Analyzing Venezuela has become an exercise in counting pennies and trying to figure out the behavior aspects of the administration when the only thing we really know for sure is that preserving the revolution is paramount in the objective function of the policymakers,” said the moderator Carl Ross, who works in fixed income research at asset manager GMO.
So far it has been five months since investors really started to dump Venezuelan debt, sending it to levels normally associated with default. The yield on the benchmark 2027 Venezuelan sovereign bond is around 18 percent, almost double the coupon on the bond when it was issued of 9.25 percent.

The yield on the Venezuelan 2027 Global Bond is up to nearly 18.40 percent. The bond was issued in 1997 with a coupon of 9.25 pct.

Most of the analysts and portfolio managers at the Boston meeting gave Venezuela at least another 12+ months before they consider default with a high level of probability. They all pointed out the subjective nature of such a prediction and all asked not to be cited directly to any specific number because they were fearful of it being taken out of context.
As the discussion moved along from outlining policy prescriptions to the political landscape to default scenarios to recovery values, there were consistencies between the panelists, including the recognition that Venezuela’s economy is in a shambles.
“I don’t think it is a stretch… to say that Venezuela is probably the worst managed economy in the world right now, and I’m taking into account Zimbabwe,” said Ryan.
Reuters was unable to obtain comment from the Venezuelan Finance Ministry on its debt position.
The economic situation in Venezuela grows more and more dire as financing is getting tighter, the availability of U.S. dollars is becoming scarcer as the value of the local currency, the bolivar, plummets against the greenback and causes a severe cash crunch for everyone, whether they be the man on the street or a business trying to conduct operations.
Venezuela now has three official exchange rates. The strongest rate is 6.3 bolivars per U.S. dollar. The black-market rate is over 100 bolivars to the dollar.
So I rang up Mark Weisbrot, the co-director of the liberal-leaning Center for Economic and Policy Research, based in Washington, D.C. He’s not shy about criticizing media coverage of Venezuela, including how Reuters covers the nation. He believes there will be no default on Venezuelan debt because the nation doesn’t have a balance of payments problem.
“When you get past the ideology and you look at why would they default, it doesn’t seem there would be a reason for it. It is not like they cannot make their debt service payments,” Weisbrot said from Washington.
Instead, he said the country needs to address its “dysfunctional exchange rate system.” In other words, let the currency float and switch to a unified exchange rate system. 
Venezuela annualized inflation rate reached 63.4 percent in August, with consumer prices rising by 3.9 percent that month, according to the latest data from the central bank. The minimum wage was raised 15 percent earlier this month, and takes effect in December. 
Maduro blames outsiders for Venezuela’s economic problems while critics say he is doing nothing to reverse the problems caused by 15 years of socialist economic policies that were started by Chavez and collectively referred to as Chavismo.
The panelists agreed the government needed to make real economic changes in order to halt a crisis, but when asked if there was a chance of some positive policy moves taking place, without fail the five speakers all said it was highly unlikely that would happen.
A short list of actions included devaluing the currency, selling state assets such as U.S.-based refineries and the retail gasoline operation, Citgo. Other ideas included cutting fuel subsidies, reducing the Petrocaribe subsidy, combating the smuggling of subsidized fuel over the borders to neighboring countries, and changing the investment climate for foreigners who have been largely driven out of the country through nationalizations.
Venezuelan Finance Minister Rodolfo Marco said in an interview broadcast a few days after the panel that Venezuela is not planning to devalue its currency or make changes to the existing foreign exchange system.
One example of the deteriorating conditions is in air travel. Major international airlines have severely reduced the number of flights in or out of the country because currency controls have prevented them from repatriating ticket revenue. The International Air Transport Association this year has said airlines have some $4 billion trapped in Venezuela because they cannot exchange enough of the bolivars used to pay for seats into U.S. dollars .
“I’ll believe it when I see it,” Cem Karacadag, portfolio manager at Babson Capital, said in summing up what the other panelists felt about fundamental economic reforms being implemented by the Maduro administration.
“Some of the fixes we talked about… exchange rate devaluation, for example. They can do that with a stroke of a pen. It is so easy to do. Why is it not happening? That’s the depressing part of all of this, is it is not happening because clearly the vested interests are not making it happen, which means the system has to break,” Karacadag said.
So if a default were to come, in what form would it appear and could investors expect a high recovery value?
“The cost of default? Obviously loss of confidence, more capital flight than they already have, risk of attachment of offshore refineries, risk of attachment of oil delivery…. It seems the obvious conclusion is the case against default is very strong or the case for default for this government doesn’t look good,” said Karacadag.
Ben Ramsey, who heads economic coverage and sovereign debt strategy for the Andean region at JPMorgan pointed out that lower oil prices going into 2015 will make debt servicing even more difficult, limiting their ability to find financing sources.
“In my mind the type of scenario in which Venezuela is going to default is going to be one in which we have a governability crisis. It could also certainly coincide with a dollar liquidity crisis,” Ramsey said, adding: “In terms of whether they would be hostile and how low recovery would be, I certainly think if you have a default under conditions of chaos and disarray and lack of governability, bonds are going to trade much lower.”
Ramsey said he believed if there were a default, whoever was in charge would attempt to address it quickly rather than imposing a big cut in principal for investors because they don’t want to have the situation drag on for years as is the case in Argentina. Buenos Aires is still fighting investors in the U.S. courts since its default in early 2002.
Siobhan Morden, head of Latin America strategy at Jefferies highlighted that the economy has never been so bad, but that politics will be critical with national assembly elections coming in 2015. 
“The polls, Maduro, and the party have never looked so bad. So what’s really at stake is how far they will break the rules. I don’t think they will accept losing a branch of the government,” Morden said, referring to Maduro and the Chavista movement. “I don’t expect real economy reform under Chavismo. I think that is clear. I also don’t expect a true democratic transition either,” she said.
Morden argues that Venezuela is not heavily leveraged from a debt servicing standpoint. Between the sovereign and PDVSA, there is roughly a notional $67 billion in U.S. dollar denominated debt with debt servicing costs of about $10 billion a year for the next year or two.
“When you look at their balance sheet in terms of their external accounts, they are not heavily leveraged on debt. What is their leverage? It is import leverage, capital flight leverage…. So what do you benefit from the default? You have to reach a point where you are so desperate. I think this oil price shock hits them hard. It is sacrificing about $17 billion in revenues and they don’t have any extra cash to adopt import populism,” she said. Import populism is another way of saying the government floods the market with cheap consumable goods.
“I don’t see it as being an accidental default. I think the problem with Venezuela and the Venezuelan’s know this, PDVSA is so integrated with global financial markets, that naturally they would want to assess the legal risks first,” Morden said.
Recovery values would be dependent upon what kind of default occurs, the panelists said. If a default occurs in a haphazard way, perhaps due to political infighting or because there has been a breakdown in governability, then recovery values could be higher. The reasoning being the government may not have gone through the methodical process of selling off assets ahead of time to raise capital to meet its financing needs. If they have done those sales, then in the event of default, investors will have fewer assets available to go after as they attempt to recover their investment.
The government has been running hot and cold on selling off Citgo, its U.S. refining unit. It put the business, which has 3 refineries, on the auction block in September only to withdraw it in October with one source telling Reuters the bids were well below the $10 billion asking prices.
MFS’s Ryan said he does not expect the government to undertake any coherent macroeconomic adjustment program.
“What we are likely to see is a piecemeal approach by a weak and somewhat radicalized government that is really scrambling to plug holes in a sinking ship.”