According to international statistics, Venezuela has the largest proven oil reserves of the world. So, one has to ask, why experienced Venezuela a freefall in its economy, although it was at the beginning of this century the richest country of South America. Hugo Chavez, the president of Venezuela between 1999 and 2013, was always very popular among the poor and the middle class. One of the reasons was his promise to make the life of the poor better, by sharing the country’s oil revenues with the poor. Billions of dollars were spent on building houses, hospitals, providing food and other projects with broad support from the poor. Although he promised to also diversify the economy and invest in new industries, oil revenues accounted for 96 percent of the export in 2012, compared to 80 percent 10 years before.
Having an export that mainly depends on oil is not new for Venezuela, since the oil industry really developed in 1929, it started to dominate other industries. If a government mismanages such a natural resource, it creates a “Dutch disease” problem. This problem arises if the revenues of the oil industry only increases domestic demand. Meaning that demand for tradable as for non-tradable goods expands. This demand expansion causes an increase in the price of non-tradable goods, as the price is set domestically, yet the price of tradable goods does not experience a large change, as prices are determined in the international economy. The decrease of the relative price of the traded good in terms of the non-traded good is also known as a real exchange rate appreciation, this causes a problem because labour reallocates from the traded good sector to the non-traded good sector. Yet other reasons may also cause fluctuations in the real exchange rate.
The IMF performed a study to analyse the determinants of the real exchange rate for Venezuela between 1950 and 2004. They found the oil prices had a significant effect on the time varying real exchange rate, as a higher price allows to spend more on tradable and non-tradable goods. Besides the oil price, the paper emphasizes that policy choices and productivity differentials with other countries are an important determinant of the real exchange rate. Which illustrates that the latest economic crisis of Venezuela, isn’t caused by a sole factor.
As the oil price had a significant effect on the real exchange rate between 1950 and 2004, it is expected that the rise in the oil price between 2008 and 2015 also had an effect on the real exchange rate appreciation for Venezuela for that same period. Without doing a time series estimation for the effect of the oil price, observing from figure 1 and 2, one can see there is a clear correlation between the oil price and the real exchange rate after 2004. Yet, there may be again other determinants that also explain the real exchange rate appreciation after 2014.
Figure 1: Brent crude oil price (2010=100)
Figure 2: Real exchange rate index Venezuela (2010=100)
One of these other determinants that also explain real exchange rate appreciations according to the same study of the IMF in Venezuela between 1950 and 2004 is government spending. The study found that a higher government spending, causes a real exchange rate appreciation and that periods of oil price increases go along with a higher spending level. Furthermore, the paper states that during oil price booms the government also spent more. Yet as government spending, increases the real exchange rate, this policy amplified the effect of the rising oil price. And just like in the past the government under Chavez kept on financing their social program with oil revenues during the boom of the oil price. Besides the revenue coming from oil, Chavez could also rely on enormous foreign loans to pay for the social program. Foreign countries were very willing to lend to Venezuela, since the price of oil was still going up. Although many economists would recommend to save in good times and to spend the savings in bad times, Venezuela decided to spend its oil revenues…
Besides the oil price increase and government spending, that led to an exchange rate appreciation and correspondingly the “Dutch disease”, other factors also contributed to a further de-industrialization of the Venezuelan economy. In accordance to the social program of reducing inequality, the government took over hundreds of private companies, with the goal to redistribute the wealth among the poor. Yet these companies were badly managed, causing production to fall further. Additionally, since 2003, the government imposes currency exchange controls, meaning that the dollars companies needed to import goods could only be bought from the government. Which contributed to a further decrease in local production. The exchange control originated as a reaction to the strike of the oil industry, which threatened Venezuela’s ability to repay its foreign debt. As long as Venezuela was able to borrow from other countries, the government could sustain this deficit and buy all the necessary imports. E.g. the government imported goods and sold them at a subsidized price to make food affordable to the very poor. However, this does not mean this was a healthy situation for Venezuela’s economy, because of its high spending and overall scarcity of goods, the average inflation before 2012 was around 15%.
However, from 2013 onwards, the situation changed dramatically. When Chavez died in March 2013, Venezuela experienced a sudden stop of capital inflow as foreign countries were not willing to give any more loans. And late 2014, oil prices dropped to half the price, making it even harder for Venezuela to repay its debt. The Venezuelan government responded by tapping its gold reserves and printing money. This allowed them to pay off some of its debt and import some basic goods. But with the reserves declining, the government gave priority to paying off its debt over importing goods. They namely assumed a default would be too costly as many of their assets would be seized by creditors (e.g. oil refineries). As a result, subsidies for food had to decline. To compensate, the government implemented the fair price law. This regulated the production and pricing of products, making companies less profitable and forcing them to stop production. The combination of money creation and goods that became even more scarce, led to a hyperinflation, with rates hitting 800%.
To get out of this situation, Venezuela has to move from an external deficit to an external surplus. It should try increasing its industrial activity and hereby reinstating an economy that is not only focused on oil revenue. Instead, it should focus on the export of other goods than oil. To establish a bigger workforce in the export or the traded good sector, Venezuela needs a real exchange rate depreciation. Which means either an increase in the price of tradable goods or a decline in the price of non-tradable goods or a combination of both. When wages and prices are flexible, such an adjustment can easily be achieved. Yet, the seating government, led by president Maduro has been repeatedly increasing the minimum wage in order to protect people against the high inflation rate. If the country allowed the nominal exchange rate to depreciate it would still be possible to have a real exchange rate depreciation. Such a nominal exchange rate depreciation would support the traded good sector, since it makes products cheaper for those countries with other currencies. Yet Venezuela’s government is holding the value of the bolivar fixed against the value of the US dollar. The argument is that a depreciated bolivar would make it impossible to repay its debt and imports for the country would become much more expensive. With the two instruments to achieve a real exchange rate depreciation being fixed, the only way for the economy to meet external balance is through a contraction of demand. Which implicates there will be unemployment. According to the IMF, Venezuela had an unemployment rate of 17 percent in 2016 and it will grow to more than 36 percent by 2022. Even without these nominal rigidities, for Venezuela to achieve labour moving back to the traded good sector may be difficult due to structural rigidities such as a loss of skills, delay in investments due to uncertainty, borrowing constraints, …
This overview showed how the Venezuelan government badly managed the natural resource and how difficult it will be to get out of this current situation. As part of the economic recovery, current president Maduro, announced a devaluation of the currency in 2016. Yet analysts claim this devaluation is not yet sharp enough. And very recently, president Maduro announced the creation of a virtual currency, the Petro. He said that the currency will allow Venezuela to repay its debt and to overcome the financial blockade of the US. Future will tell if this is the measure Venezuela was waiting for.
Jef Jamaer (31338)
Figure 1: Brent crude oil price (2010=100). TRADINGECONOMICS. Accessed Nov 2017.
Figure 2: Real exchange rate index Venezuela (2010=100). International Monetary Fund, International Financial Statistics. Accessed Nov 2017.
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Borger, J. (2016, June 22). Venezuela’s worsening economic crisis – the Guardian briefing. Retrieved from: https://www.theguardian.com/world/2016/jun/22/venezuela-economic-crisis-guardian-briefing
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Zalduendo, J. (2006). Determinants of Venezuela’s equilibrium real exchange rate. IMF working paper, Vol., pp 1-19.