Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

International Report: Venezuela

by Jim Hurson

 

Image via Yahoo News.

Image via Yahoo News.

Venezuela’s recent economic and political tribulations have garnered international coverage, and have underscored the need for serious reform in the oil-rich Latin American nation. The country’s convoluted system of foreign exchange, combined with the collapse of its currency, the bolivar fuerte, have contributed to triple-digit inflation, encouraged capital flight, and birthed a black market currency exchange. The petroleum sector, which was once the nation’s key source of revenue and one of the strongest sources of production in OPEC, has suffered from falling oil prices and poor management by its state affiliated directors. Corrupt government institutions, a lack of investment in diversified industries beyond petroleum, and high crime have strained the country’s economy and left the government in billions of dollars in debt.

Venezuela’s problems are largely institutional and come from an outright rejection of Washington Consensus policies. Expropriation of the petroleum sector and manipulation of the bolivar’s exchange rate has piqued social protest, industry failure, and general economic disaster. In order to revise its broken system, Venezuela must first launch a full-scale war on internal government corruption, starting with a purge of Maduro and his cronies. The Central Bank of Venezuela must stabilize the bolivar, simplify the foreign exchange system, and implement a floating or free exchange rate. Aditionally, free market policies must be implemented across Venezuela, in order to fix currency woes, strengthen the petroleum sector, and make the country more attractive to foreign capitalists.  

In order to understand the significance of the petroleum industry in today’s Venezuela, one must understand the history of oil in Venezuela. The drilling of the first oil reserve in 1912 attracted the attention of industry giants from the United States and the Netherlands. By the time Rockefeller’s Standard Oil and Royal Dutch Shell had secured drilling contracts with the Venezuelan government, oil was a major source of revenue. Between 1920 and 1935, oil revenues flooded the country with foreign currency, mainly from the United States, and though oil now made up 92.3% of exports, the influx of so much foreign capital caused a rash of Dutch disease.

Inflation was not the only effect of Dutch disease. In “Booming Sector and De-Industrialization,” Corden and Neary investigate the resource movement effect and the spending effect, which come out of energy booms in oil rich countries like Venezuela). For Venezuela, this early influx in oil production raised the marginal products of mobile factors in the agriculture sector and “drew out” resources from it and other competing sectors. Exchange rate fluctuations resulted, and interest rates rose. With higher incomes, more spending occurred, driving up the prices of goods and services across industries, thereby motivating the “spending effect.” Administrations from Medina to Chavez did little to curtail the “drawing out” effect from non-petroleum industries. Instead, they wagered that the world price for oil would rise, and the domestic petroleum sector would funnel more revenue into government coffers, which could then be redistributed to political constituents.

The future of economic performance in Venezuela was thereby tied to the performance of oil prices. The below chart tracks Venezuelan GDP over time.

 

The above confirms much of this article’s coverage of Venezuela's economic history. Oil exports buoyed the country’s GDP and made it one of the most dominant in Latin America for nearly 60 years. The first boom, which occurred from 1912-1958 was the result of high world demand for oil. The second boom occurred in the early 1970s, when fellow OPEC nations in the Middle East enacted an embargo with Venezuela’s main trade partner, the United States, thereby increasing US demand for Venezuelan oil. By the late 1970s, OPEC nations were producing beyond stated quotas, and the world price for oil dropped drastically.

Fraga explains the woes of the “lost decade” of the 1980s in “Latin America since the 1990s: Rising from the Sickbed?.” The debt crisis that shook Latin America affected Venezuela especially, with rates of inflation averaging 176.9 in the 1980s. However, while many of Fraga’s model countries (i.e. Chile, Brazil) employed Washington Consensus style policies, Venezuela failed to adjust, instead implementing a series of “heterodox policies,” including tightening fiscal policies, implementing price and wage controls, and setting a fixed exchange rate (Harvard Review of Latin America, Javier Corrales, 1999).

 

With present levels of inflation at around 400%, the value of the bolivar fuerte has tanked against the US dollar. Analysts from the International Monetary Fund (IMF) predict levels of inflation in Venezuela will reach quadruple digits by 201. The above chart indicates the volatility of the inflation rate in Venezuela; it also illustrates the inaccuracy of government reporting in producing reliable economic data. This combination of factors incentivizes firms--particularly those that deal in foreign currencies--to convert their cash assets into inflation resistant assets.

In “Construction and Inflation: A Critical Scrutiny,” Bailey provides some justification for this kind of spending. In general, real estate, much like gold, holds its value during periods of inflation, earning income for landowners as prices rise. A valueless domestic currency only increases the demand of foreign firms for real estate. The power of the US dollar against a worthless bolivar ensures that US firms can keep labor costs low, and the dollar’s strength makes purchases cheap.  

Venezuela’s burgeoning real estate sector is less a sign of economic growth than it is of corporate opportunism. Since financing for high end real estate projects comes directly from private investment by mostly American and European firms, including giants like DirecTV and Avon Products, projects and properties are typically centered in the wealthier parts of Caracas, such as in the Las Mercedes neighborhood, or along the “the Golden Mile,” a stretch in the capital city’s business district. In fact, housing for middle and lower-income families in Venezuela is scarce, and borrowing at current interest rates is expensive. Although high-end construction is booming, Venezuela’s poor bear the brunt of the price increases, waiting in breadlines as luxury buildings go up around them (Reuters).

This paradox of construction growth in Venezuela is explained by Albanesi in “Inflation and Inequality.” Albanesi finds a positive correlation between inflation and the GINI coefficient, concluding that low income households are most vulnerable to rising price levels. Commenting on the political economy of socialist countries like Venezuela, Albanesi asserts that cash transfer programs put the poor at a greater risk of losing during periods of rising price levels, as they are least likely to have non-cash assets.

In “Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution,” Acemogulu, Johnson, and Robinson discuss the importance of economic freedom and uncorrupt institutions, and highlight the negative influence of “extractive institutions.” The below chart characterizes economic freedom in Latin America as a region and in Venezuela in particular.

 

 

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NB: The above chart corresponds to a scale of 0-100, with 0-49.9 → repressed, 50-59.9 → mostly unfree, 60-69.9 → moderately free, 70-79.9 → mostly free, 80-100 → free

The above chart defines Venezuela as a mostly unfree nation, with levels of freedom, as measured by the Heritage Foundation’s economic freedom index, declining rapidly during the administration of Hugo Chavez, who was in office from 1999-2013, and declining further during the administration of current president Nicolas Maduro. The expropriation of private firms, combined with intense government manipulation of currency values, have contributed to Venezuela’s enduring hyperinflation and loss of faith in the soundness of the country’s institutions. Additionally, with so much popular angst surrounding economic uncertainty, civil unrest has broken out across the country, with violent protests concentrated in large cities, including Caracas.

The failure of government in Venezuela under the administrations of Hugo Chavez and Nicolas Maduro shows the failed experiment of “Bolivarian socialism.” The below chart characterizes the major components of Venezuela’s economy, and provides reference for this article’s further discussion of Dutch disease in Latin America’s most troubled economy.

 

The “drawing out” effect mentioned by Cordon and Neary in “Booming Sector and Deindustrialization” explains underperformance in the agricultural sector and strong performance in the industrial sector. The chart quantifies the Venezuelan reliance on the industrial sector, which is based almost entirely on petroleum. During periods of low world oil prices, the Venezuelan economy had only its weak service sector to fall back on.

Corrupt institutions and a lack of sector diversity are the fundamental reasons for Venezuela’s economic failure. Venezuela seems to be unwilling to seek advice from the International Monetary fund on how it can reform its broken system, and with elections not up until 2019, the immediate future for Venezuela looks grim. Venezuela needs Washington Consensus reforms: it needs a free exchange rate; it needs less government intervention in industry. But before Venezuela can alleviate its dependence on oil--here, it should look towards Norway and the United Arab Emirates, which have both established state investment engines for oil rents--it must correct its problem of political corruption.

 

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