Thursday, June 23, 2005

The Central Bank Reserves takeover

One of the benefits of beeing a blogger is to meet through comments many interesting people. And some time you atually get to use them shamelessly. As I am very busy these days and as the Central Bank reserves are been taken over by the government, robbery style, I asked AIO to write a note to explain what is going on with the reserves move. Money Grab? Priming of the inflation machine? Grand robbery? The reader at least will get some info from AIO to make up his/her own mind while this blogger is out playing.

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Daniel asked me to write a summary of one of the biggest economic themes of the week: the proposed new Central Bank law. I’ll start with a brief autobiography, and continue with some recent Central Bank history, then talk about what the new law would mean.

I am a U.S. citizen, living in Venezuela, working as an economist. A large part of my job is studying and understanding the economy, and trying to figure out whether the changes are good or bad, for Venezuela and for others. My own opinion plays a role, but I try to talk to as many people as possible about things: private businesspeople, bankers, consultants, even Venezuelan government officials, though it’s often hard to get time with the last group.

As for the history, I’ll start in late 2002. During the general strike, the Venezuelan Central Bank (the BCV) was expending reserves in an attempt to keep the value of the bolivar from falling. Despite their efforts (reserves – counting the Emergency Macroeconomic Stabilization Fund – dropped from $15.8 billion on December 1, 2002, to $13.7 billion on January 23, 2003) the floating exchange rate went from 1323 bolivars to the dollar to 1853 in the same period.

On January 22, 2003, the BCV suspended all foreign currency trading. This was not an unreasonable action at the time, in order to stabilize things. The Ministry of Finance promised new rules to govern foreign exchange by January 29, though they were not announced until February 18, with the creation of the Foreign Exchange Administration Commission (CADIVI). Foreign exchange was again obtainable, though in limited amounts. (See this VenAmCham study,
especially page 4, for amounts of forex CADIVI has approved.)

As a result of the exchange controls, international reserves have grown tremendously. Still including the emergency fund (which now has $2.64 billion less than in December 2002, but that’s another story), the reserves stand at $28.3 billion as of June 20, more than doubling since exchange controls were imposed. Despite indications that the controls would be temporary (and consultants I’ve seen recommending that they be done away with now, while in a position of strength, rather than waiting until problems arise, as famously occurred in Argentina), there is reason to believe that such controls are permanent, or at least will remain as long as Chavez is President.

However, with all that money in the reserves, and government spending growing rapidly, Chavez began to pressure the BCV to turn over some of the reserves for spending. Beginning on November 9, 2003, Chavez repeatedly requested a billion dollars (“un millardito”) from the reserves, usually stating that they would be spent on agricultural development. The BCV leadership refused, citing the BCV law. (Then-Finance Minister Nobrega agreed.)

In late January, 2004, an alternative plan was found. The BCV law allows PDVSA to maintain funds outside of Venezuela in foreign currency for “operating expenses.” The BCV agreed to let PDVSA divert a total of $2 billion to an offshore account, supposedly to finance development projects. This agreement was not made public until June, a month after reserves began dropping, which made no sense while oil prices – the main source of reserves – were rising rapidly. PDVSA officials have admitted that they have continued to divert funds in 2005 while BCV officials state that the agreement was a one-time deal, and such diversions are not authorized.

Which brings us to the present. Reserves continue to grow, thanks to record oil prices, and President Chavez is dissatisfied that such quantities of money can belong to the country, yet be out of reach. Although they are already circumventing the agreement reached last year, $2 billion a year appears to simply not be enough funds. The new law would immediately put $5 billion of the reserves into a special fund, which will be at the discretion of the “Ejecutivo Nacional” to spend. Not only that, but the new law will require an estimate of “the adequate level of international reserves.” It’s not clear whose authority will be final in that regard; in one section, it is assigned jointly to the BCV and the Executive, while in another, the BCV has only an advisory role.

So what will the effects of this change be? I won’t talk about how the money will be spent, partly because it hasn’t been announced, and partly because it’s not clear if that would be the answer anyway. No accounting has ever been given for the $2 billion from 2004, any of the funds for 2005, including evidence that no more than those amounts were even transferred to the funds. Additionally, many of the projects announced as being funded with the money already had financing from other sources, e.g. metro extension financed by the CAF, Tocoma dam financed by the IDB.

The first potential effect of the transfer would be inflation. This would depend largely on how the money is spent – domestically or not. There is some talk of using the money to pay down external debt, though it doesn’t seem likely that will be more than a token amount, and is contradictory while issuing new debt anyway. If the money were to be spent domestically, the government would have to sell the funds back to the BCV to obtain local currency. This was already done once, as is true for all of the Venezuelan international reserves, so to sell it back would mean that twice as many bolivars were put into circulation as should have been for that dollar. It would be the same as printing new money (increasing the money supply), which economists consider the primary cause of inflation. (See this, as well as Venezuelan economic history and present.) $5 billion would increase the money supply by over 20%. Inflation would likely not jump quite as much (money supply has increased nearly 50% in the last year, while inflation was only about 17%), but the economy may be maxed out on its ability to absorb more liquidity, so the impact should be proportionally greater.

The second effect would be felt internationally, but with long-term effects for Venezuela. One of the purposes for reserves is emergencies. The money is available for purchasing essential products for imports, intervention in the exchange market, or other unexpected circumstances. This could be necessary in case of a large drop in oil prices, for example. (This isn’t likely in the near future, but is it responsible to bet the nation’s insurance policy on that speculation?) With fewer reserves, Venezuela would be less able to face up to an emergency, and would be more likely to someday have to choose between importing essential products and paying its debts. That choice is obvious, but since it becomes more likely, then lending to Venezuela will become more risky. Venezuela will be forced to pay higher interest rates when borrowing, costing more money in debt service, and perhaps find it harder to find lenders at all.

It’s impossible to say if this is a good idea overall for Venezuela without knowing exactly what the benefits will be. However, the costs will not be small. In the short term, there will be inflation, and in the long term, greater finance costs (as well as the lasting effects of inflation). Not only that, but with the volatility of the Venezuelan economy, there is a very real chance that any reserves taken away and spent will be needed some day in a crisis, perhaps for spending or simply to provide assurance during a crisis. Taking them away places Venezuela’s future in jeopardy.

An Interested Observer (aka AIO)


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