Macro and Markets

In my May monthly, I make the case that the crisis in Venezuela has intensified to the point where a chaotic default is a question of when, not if. Economic activity is falling sharply and the seeds of hyperinflation have been planted, a downward spiral reinforced by political paralysis, widespread electricity shortages, and a breakdown in social order. Reserves are falling sharply, driven by capital flight and a fiscal deficit that has swelled to over 20 percent of gross domestic product (GDP). Although the government has made enormous efforts to continue making debt payments, a default now appears likely sooner rather than later, and possibly even ahead of large debt service payments due this fall Absent a dramatic change in the political environment, there would need to be a change in government, and a green light from the United States, before officials from the International Monetary Fund (IMF) would board a plane to Caracas to begin negotiations on a rescue program. By then, the chaos could be severe. An IMF-backed adjustment program should include a float and unification of the exchange rate, as there will not be adequate reserves to allow intervention, and an extended period of capital controls to stem flight; a multistep increase in domestic energy price to world prices, allowing prices to be flexible going forward in response to market developments; a tighter fiscal policy consistent with available resources; a targeted safety net, replacing the pervasive and inefficient subsidies now in the system; a comprehensive restructuring of the banking system, which is likely to be quite costly given reports of deep-seated corruption; and broad measures to address corruption and rule of law. In my base case scenario, debt would soar to unsustainable levels, and the cash flow needs of the country likely will outstrip what the official community was willing to provide. While new IMF lending rules provide a fair degree of discretion in highly uncertain, high-access cases (“grey zone”, in Fund-speak), it looks increasingly likely that a comprehensive restructuring, with significant cash flow relief, ultimately will be needed. China’s role in Venezuela’s debt restructuring will be critical and precedential. As Venezuela’s largest creditor, China has extended nearly $60 billion in loans over the last ten years, mostly backed by oil. China has reportedly already provided material cash flow relief to Venezuela, but would need to be a part of any debt restructuring effort both because its claim is so large and because private creditors would want China to share the burden if asked to restructure. In an earlier blog post, I argued that restructuring the Chinese debt owed by Venezuela is best done by China joining the Paris Club of official creditors, and agreeing to restructure on comparable terms to other official creditors. But short of such a decision, China could still participate in a financing package in parallel to other creditors. Whatever China decides in Venezuela will likely set a precedent for other countries that owe China much debt and have been battered by low commodity prices and slow global growth—countries that will seek restructurings in coming years. The decisions made in this case will be consequential. Markets are too sanguine about the risk of a disruptive default in Venezuela. If it happens, the IMF will need to move quickly to assemble a comprehensive financing package. China’s support for that package, and any related debt restructuring, will be critically important for the package to be credible and to provide appropriate incentives for participation by other creditors.

Five things we learned from this weekend’s G20 meeting of finance ministers and central bankers.           A desire for better. The communiqué candidly acknowledges growing threats to the global economy, and signals a desire for stronger growth at a time when “downside risks and vulnerabilities have risen.” There also was recognition that monetary policy has carried most of the load in recent years, and going forward more responsibility rests on governments to accelerate long-promised fiscal and structural reforms.             Other people’s money. The problem with a full-throated call for growth is that there is no evidence that any major country leaves the meeting with different policies than they entered the weekend with. The U.S. government would like to see more demand, but Congress is unlikely to go along with new spending proposals. German finance minister Schauble threw cold water on the idea of new debt financed spending ahead of the meeting, and Japan remains committed (for now) to future fiscal consolidation. Only China seems focused on fiscal expansion, though its unclear the extent to which the boost to demand from the budget goes beyond allowing the automatic adjustment of spending to the slowdown. One area of coordination was on infrastructure, where the G20 again called for more spending by the World Bank and other international financial institutions, but the amounts involved are likely to be small.             China gets the benefit of the doubt. One question prior to the meeting was whether there would be an effort, led by the United States, to press the Chinese for stronger and more explicit commitments to support demand and avoid further depreciation. While Chinese officials did embrace these objectives and reportedly made strong statements in the meeting that they did not intend further devaluation, the communiqué largely avoided the type of specific commitments markets were hoping for. With China continuing to lose $100 billion in reserves each month, some will see this as opening the door for further depreciation against the dollar.                 The Plaza is still just a hotel. Prior to the meeting, there were a surprising number of analysts talking about the prospect of an agreement on currencies similar to the Plaza Accord of 1985. Such ideas were always fantastical. The G20 called for countries to refrain from cheapening their currencies to gain a competitive edge. They reaffirmed their policy that exchange rates should be market determined, and that governments should adopt policies aimed at domestic macro balance and not intervene in foreign instruments. This formulation has been in place since the yen weakened in the spring of 2013 following the introduction of Abenomics. There was a mild hint at future possible action in their commitment to consult closely on exchange markets and their reminder that markets can get it wrong, but no binding commitments. A possible new sovereign debt initiative. Among the issues for further action (buried at number 12) is to explore “market-based ways to speed up” the strengthening of existing sovereign debt contracts. Recall that last year, in the wake of Argentina litigation and concerns about holdouts in the Greek debt restructuring, the G20 endorsed the inclusion of new clauses in debt contracts that would make it easier to get broad participation in debt deals. That was a significant step, but there was always a question about what to do with the nearly $1 trillion in existing bonds that didn’t have the new clauses. In a paper I did with Greg Makoff, we argued that the G20 should take the lead in encouraging market-based transactions to swap old debt for new debt, and it now seems the G20 is open to going in this direction. This could be a meaningful step toward a better functioning debt market (but it wouldn’t help Venezuela).   In sum, the communiqué is about as much as can be expected in the current environment—a commitment to stay the course, combined with a recognition of the risks and a promise to do more if needed. Tomorrow, we will see if markets take confidence from such commitments, or were hoping for something a bit bolder.  

The Venezuelan government has a $2.3 billion debt payment due this Friday. Most believe the government has the resources to make the payment, though it is hard to see a coherent economic reason to do so. The economy is descending into a deep and profound crisis—reflected in severe shortages, hyperinflation, and a collapse in economic activity. It faces a widening financing gap, and has imposed highly distortive foreign exchange controls. Debt service far outstrips dwindling international reserves. Recent policy measures by the government, including a rise in gasoline prices, fail to meaningfully address the imbalances. A default increasingly appears to be a question not of “if,” but “when.” But whether through a stubborn unwillingness to accept this reality, fear of litigation and asset seizures, or simply an effort to kick the can in the face of powerful political and economic pressures, the government has shown a strong commitment to pay as long as they can. The current regime will refuse cooperation with Western governments, but it is not too early to begin planning for a time when a future Venezuelan government is willing to take the hard measures that warrant strong and broad international support. The Numbers Are Daunting There is no doubt that the dramatic decline in oil prices has hit Venezuela hard. At $30 per barrel, oil exports will be around $26 billion this year, down about three-quarters from 2012. Subtract around $8 billion for oil-related imports, and you have export revenue woefully inadequate to meet debt service this year of nearly $20 billion on $125 billion of debt (that includes substantial oil payments due on assistance provided by China in recent years). Altogether, market commenters have estimated a financing gap of around $30 billion. Meanwhile, reported reserves are only $15 billion, and there are serious questions as to whether all of those reserves (especially the gold) are freely useable. In sum, it will take extraordinary measures to make it through the year without a default. And if the government responds by further compressing imports, popular support for the government could collapse. Change could come quickly, not because of a debt payment due but rather because of domestic conditions. Meanwhile, the economy likely declined by around 10 percent last year, and according to the International Monetary Fund (IMF) is expected to decline by an additional 8 percent this year. Inflation was officially 180 percent in 2015, though the actual number was probably closer to 250 percent, and accelerating rapidly this year. Following years of mismanagement and low investment, the state oil company Petroleos de Venezuela, S.A. (PDVSA) has seen a sharp decline in production, and while reserves in the ground are substantial, there would be material hurdles to a significant increase in production. In response, the government has invoked emergency powers through mid-March, devalued the primary official exchange rate by 37 percent, and adjusted some domestic prices—but this has done little to address widening imbalances and shortages. After this Friday’s payment, the government does not have a major international bond maturing until 2018.  But payments of around $6 billion are due later this year on debt owed by PDVSA. While the government does not explicitly guarantee PDVSA debt, the companies’ creditors have substantial remedies which provide protection (and a degree of effective seniority) in times of distress. There are assets in the United States that could be seized (e.g., Citgo), efforts could be made to disrupt if not to seize oil tankers and the oil in transit, and there will likely be litigation as to whether the government exercises explicit control over the company (which could expand the range of assets that could be attached by creditors to include sovereign assets). Any debt restructuring would be made more difficult by the large amount of bonds, in excess of $40 billion (mostly PDVSA debt but also some sovereign bonds), that do not have the collective action clauses now common in international bonds to bring in holdout creditors. In sum, the legal environment is complex, the interest of creditors may diverge sharply, and there are strong reasons to expect that a default on debt would be hugely disruptive. It is hard to imagine international support for a restructuring of debt by the existing government. The strong frictions between the Maduro administration and the opposition-led National Assembly pose additional political risks. The new economic czar, Miguel Pérez Abad, reportedly was named to the job when his predecessor advocated default. He may have a mandate to sell energy stakes and try for market deals that buy some breathing space for the country by pushing back debt payments. It is difficult to assess whether it is in the interest of creditors to do so when a more difficult restructuring likely lays ahead with a different government that may be quite critical of today’s deals. In any event, given the fundamental downward trajectory of the country, maturity extensions are unlikely to catalyze new private money. The China Factor China has been the primary provider of financing to the government in recent years, and while there is low transparency to these deals, it is thought that net claims are on the order of $30 billion. Many of the contracts require payment in oil, and currently Venezuela uses about one-third of its daily crude oil export to China to repay the debt. But the decline in the price of oil has dramatically increased the quantity that needs to be provided. By some estimates, full payment of the Chinese claims could consume 80 percent of the country’s daily oil export to China. Venezuela needs continuing relief from that amount, but at the same time it is not in China’s interest to be seen as providing loans under the guise of commerce that serve solely to extend the life of the current government. Even today, China’s message needs to be that it will be a critical player in a rescue package, and to that end cannot be too closely associated with the current government or policies. What International Policymakers Can Do Now For now, there is not much that international policymakers can do.  The current government is unlikely to seek help from the international financial institutions. Indeed, the IMF is operating largely in the dark. The last IMF review of the economy was in 2004, and Venezuela ceased all cooperation with the Fund in 2007. In any crisis scenario, they would be scrambling to catch up and—if past post-crisis programs are any guide—an IMF program team putting together a rescue package is likely to find that the economic crisis, the financing gap, and the damage to the financial sector are much worse than we now understand. Reserves also will need to be replenished. There does need to be a close watch for contagion to its neighbors. In recent years, trade and financial links between Venezuela and its neighbors have dropped sharply, and so one could hope that there would be limited spillovers. But the risk of domestic political and social unrest affecting its neighbors is a concern, as is the broader fear that a crisis in Venezuela would weaken market confidence in other oil-exporting countries such as Nigeria that will need to be watched. When conditions warrant, international policymakers should move fast rather than let the crisis fester. Short-term bridge financing, perhaps linked to oil, may be needed once agreement is reached on a comprehensive adjustment program. Given the likely financing needs, any future IMF package will need to include at a minimum a debt reprofiling (an extension of maturities with limited net present value loss) to provide breathing space. Whether the IMF goes further, and demands a deep restructuring because the debt is unsustainable, is hard to know given the current uncertainties. Certainly, extraordinary high debt as a share of exports suggests the need for restructuring, as would the ratio of debt to GDP (the Fund’s preferred metric) if a unified exchange rate settles near the black market rate. Further, because Venezuela’s quota is low (around $3.5 billion), the Fund’s program will require exceptional access, which under its rules calls for a high degree of confidence that the debt is sustainable if a restructuring or reprofiling is to be avoided. That seems unlikely. But any restructuring will present the difficult challenge (even more difficult than Ukraine in 2015) of deciding on the relative treatment of bilateral creditors, bonds and other creditors. China will need to contribute, through transparency about its claims on the government and a willingness to provide relief through a negotiation that leaves other official and private creditors with a sense that there is fair burden sharing.  That will be a change in how China has been operating in emerging markets, but would go a long way toward becoming a responsible part of the global rescue architecture.