The Trouble With Venezuela, Part One

“Formula for success: Rise early, work hard, strike oil.” (John Paul Getty)

This is the first of a two part look at aspects of the Venezuelan economy. Your author would like to point out that this is not a case of criticizing just for the sake of it, as we have been among the first to applaud the positive changes the present administration has made. This note (and part 2 to follow) is simply an attempt to recognize potential economic problems that might upset the good progress made these last few years. Today’s point is this; despite rumours to the contrary Venezuela is still a petrodollar junkie and other parts of the economy are as lacklustre as ever.

In a recent publication from the Center for Economic and Policy Research (CEPR), “The Venezuelan Economy in the Chávez Years”, Mark Weisbrot and Luis Sandoval present the case that Venezuela is not simply in the upside phase of its oft-repeated oil boom/ bust scenario. To quote from their executive summary;

“The most commonly held view of the current economic expansion is that it is an “oil boom” driven by high oil prices, as in the past, and is headed for a “bust”…//…There is much evidence to contradict this conventional wisdom.”

Weisbrot and Sandoval highlight the various strengths of the Venezuelan economy away from oil (as well as making fair mention of shortcomings). They rightly point out that although government spending has risen strongly (from 17.4% to 30% of an ever expanding GDP), said spending is still less than revenues received; i.e. Venezuela runs a balanced budget. They emphasize the tradition of planning annual state budgets conservatively (example, the 2007 budget is based on oil at U$29/bbl), which then allows spending increases if oil brings in more than budgeted revenues. They point to the impressive GDP growth in the last few years. They also argue that the cushion of reserves accrued coupled with low foreign debt will allow the economy to weather any future storm more successfully than in previous downturns. Their implication is clear: Venezuela’s fate is not just in the hands of WTI spot.

It is somewhat unfair to condense Weisbrot and Sandoval’s well-presented argument into a few short lines as the report should be read as stands. It also contains a lot of information about the significant improvements the Chávez administration has brought to Venezuela as a whole. They are absolutely right when they argue that headline statistics are not enough to understand the Venezuela of today, as the rise in living standards via “invisible” social policies, particularly for the poorer sectors, must also be taken into consideration. But as well as the present administration might distribute the bonanza oil revenues, we must argue that when it comes to the boom/bust oil question conventional wisdom is correct and that Venezuelan good times do still depend on continuing high oil prices. In other words, it really is about oil. Sorry guys.

First some background. Below are two charts showing Venezuela historical oil production and oil prices. In the last 3 years, oil exports have fluctuated around the figure of 2.2mbbl/d once local consumption is subtracted.

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Source: BP statistical review.

When one considers that the tax burden has increased from the peppercorn rates of the early 1990’s to 83% today (including all fiscal and state demands on production), it’s easy to see how oil has added considerably to government coffers. In fact state company PdVSA contributed $40.7Bn to state coffers in 2006 (for context, Venezuela’s 2006 GDP is estimated at U$180Bn). This is aside from any taxes paid by other oil companies operating in the country.

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Source: BP statistical review

To add a little more flesh, below is a chart showing Venezuela’s imports and exports over the last decade. Looking at exports, we see a figure that fluctuates around U$6bn per quarter until 2003, and then takes off with the advent of higher oil prices. In 2q07, exports were U$16.8Bn….a pretty penny indeed. We also see that Venezuela is still running a very healthy trade surplus even though imports have risen sharply in recent times. 2q07 imports were worth U$10.9Bn (more on imports later).

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So how much of those exports is oil? Answer; a lot. In 2q07, hydrocarbons exports accounted for U$15.1Bn, 90% of total exports (a pretty typical percentage historically). If this doesn’t make it clear that Venezuela is an oil revenues junkie, let’s look at a detail or two.

This next chart breaks down imports and exports a little further. We clearly see that imports are generated by private sector demand, whilst exports are public sector driven. Private sector imports make up around 90% of historical demand, while private sector exports have languished for the last 10 years at a stubbornly static U$1bn per quarter.

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Source: BCV

Thus foreign trade can be summed up as “Venezuela supplies oil, population demands goods”. But what of the internal economy? Here we have a chart showing wholesale and retail combined sales in Venezuela. It’s easy to spot the slump caused by the attempted coup d’etat and subsequent oil strike in the 2002 to 2003 period, but since then the internal economy has been in full party mode.

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Source: BCV

Imports feed this rise in sales. In fact, the inertia shown in non-oil industrial sectors of Venezuela is not confined to the sectors that export (as seen above). This is not an academic paper (and your author is not an academic by nature) and in a medium such as this there’s no place for deep, detailed industry-wide examinations, but a tried and tested benchmark of LatAm economic activity is the auto sector, and in that Venezuela is no exception.

According to sector watchdogs CAVENEZ, way back in July 1997 Venezuelans bought 15,329 vehicles, of which 14.205 (93%) were manufactured locally. Fast forward a full ten years, and in July 2007 the number of units sold had nearly tripled to an impressive 43,007, but only 13,971 (32%) of those were manufactured locally. In other words, sales nearly tripled, but local sales have actually dropped in absolute terms! There are many reasons to explain the stagnant smell around Venezuelan manufacturing, but the bottom line is that Venezuela has a nasty case of Dutch disease, the lack of growth in non-oil sectors leaving the country rather exposed to any future downturn in crude prices.

So to recap, we have an economy that depends on government spending and retail sales for continued growth. Retail sales are largely fed by a rise in imports. The imports are paid for by rising exports. Export revenues are almost totally oil revenues. Oil revenues are also directly responsible for the rise in government spending. And as much lip-service the government pays to promoting investment and growth of the manufacturing base in Venezuela, the lack of growth in the sector is plain to see.

The consequences are simple: If the price of oil suffers significant world decline, the retail sector will not be able to support the current level of imports without the country sliding into immediate trade deficit. The U$25Bn central bank reserves would not last long under such pressure, and recession would be a real threat to the economy as well as the administration running it.

As a matter of opinion, I believe that oil prices are not about to fall through the floor and the present range will be sustained into the indefinite future, thus ensuring Venezuela’s prosperity for the time being. Then again, I’m not the one betting the future of an entire country’s economy on that outcome (with power comes responsibility, and there are plenty of advantages in being insignificant). On that thought, part one of this look at Venezuela comes to a close. Part two will expand on the “oil base” put down here and will also try to answer this reader’s question from a previous post:

“How is the foreign exchange rate policy the greatest problem facing Venezuela’s economy? Can you flesh out this point? Not clear to me.”

A good question. It remains to be seen if we can cobble together a half-decent answer.

10 Responses to "The Trouble With Venezuela, Part One"

  1. Qingddao   August 22, 2007 at 7:21 pm

    I can very easily imagine a scenario where the Chinese economy falters for either domestic or non-domestic reasons (26% tariff), neighbring Asia slows, commodity producers – Brazil – slow, future expectations change and down goes the price of oil.

  2. Nicolas   August 23, 2007 at 1:02 am

    Venezuela is a banana republic with petroleum and has been mismanaged in the past and is still mismanaged. The problem is demographics whereby the vast majority are poor indigenous people who voted for Chavez. People who own buildings in Caracas have had the properties sequestered and occupied by the masses. You can be killed for a dime. People laid out on the street. One old man I know was peacefully dining in a restaurant when a complete stranger sits next to him and orders a meal, finishes the meal and leaves. Naturally the old man pays.  That is Venezuela today.

  3. Guest   August 23, 2007 at 4:38 pm

    Mr. Turner: excellent piece of analysis. At which low levels of oil prices would Venezuela start to suffer? and at which oil prices would Venezuela default on its foreign debt?

  4. John Hofer   August 23, 2007 at 8:15 pm

    There is no doubt that Venezuela’s fortunes depend on oil. It is a fact of life that the petroleum industry represents a disproportionate share of national wealth and income. But Venezuela’s economic growth, roughly 10% per year in real terms, has not come from growth in oil production, as your graph shows. (Actually oil production is much higher if you include heavy oil.) So this does not look like a case of Dutch disease. What is growing are non-tradables sectors, exactly what economists recommend as the remedy for Dutch disease. As such, Venezuela’s growth seems highly appropriate for its circumstances.  The dilemma facing any resource based economy is that the resource is the nation’s comparative advantage in international trade. Economics suggests that it is folly to deny or to try and overcome the comparative advantage as some mixed economy advocates recommend. Instead, it makes sense to exploit that comparative advantage to the fullest. Venezuela seems to be doing that by trying to develop a vertically integrated petroleum industry from exploration and development (manufacturing oil rigs) to distribution (owning and maintaining oil tankers). All that makes sense and is similar to the path followed by Norway, the model petro state.  The risk lies in the boom-bust nature of oil markets and how to prepare for the bust. As Weisbrot and Sandoval point out, Venezuela has foreign reserves and borrowing capacity to carry it for some time during a bust. In addition, Venezuela has been investing in education and public infrastructure, basic building blocks for any prosperous economy. Plus, the broad dynamism of the domestic economy bodes well for future flexibility and adaptability, despite the current lack of export markets, which have been stifled by the nation’s comparative advantage

  5. mark turner   August 23, 2007 at 11:56 pm

    John, a few questions for you:  What % of Norway’s GDP comes from hydrocarbons? What % of Norway’s export revenues comes from hydrocarbons? How do these numbers stack up against Venezuela’s? Why does Venezuela seemingly drag its heels on all sectors bar petroleum and social welfare (which explains much of the recent construction boom?) Can you address the inertia its manufacturing industry shows (my example being autos)? Its tourism industry?  I am absolutely not discounting the significant steps that Venezuela has taken in improving living standards, especially amongst the lower income brackets. But does this mean that it cannot develop its mining industry faster than the current snail’s pace? I’d appreciate your insight.  Mark  PS: nearly forgot: the banking sector is a fabulous growth success story. Due credit!

  6. mark turner   August 24, 2007 at 9:14 am

    http://www.ft.com/cms/s/0/d83b3294-51b4-11dc-8779-0000779fd2ac.html  Chávez’s iron grip on economy ‘unsustainable’  By Benedict Mander in Caracas  Published: August 23 2007 22:36 | Last updated: August 23 2007 22:36  President Hugo Chávez’s tightening grip over Venezuela’s economy is generating distortions that economists fear could, paradoxically, eventually lead to a loss of control.  Price controls, currency controls and negative real interest rates are just some of the elements that have contributed to one of the highest rates of inflation in the world and a substantially overvalued exchange rate.  “This regime is not sustainable. It is only propped up by the high price of oil,” says Jose Guerra, a former director of research at the central bank.  “Venezuela has already experimented with these policies in the past and it ended up going broke.”  The controls introduced by Mr Chávez are, in part, an attempt to offset the inflationary effects of large-scale government spending, afforded by record oil prices, to boost economic growth.  In this, the government has succeeded: growth has averaged 12 per cent in the past three years, leading to a drop in the rate of poverty from 43.9 per cent when, Mr Chávez was first elected in 1998, to 30.4 per cent in 2006.  This has won Mr Chávez increasing levels of support from the electorate, who are expected to vote in favour of his proposed reforms to the constitution in a referendum that would allow him to be re-elected indefinitely.  But his economic policies have triggered high levels of consumer demand that now far outstrip the economy’s productive capacity, with negative real interest rates providing consumers no incentive to save their cash.  Unbridled spending combined with price controls that are intended to check the inflationary effects of such policies has lead to scarcity of basic goods such as milk, eggs, beans and beef.  To counter this, imports have tripled in the past three years in an effort to make up for the economy’s inability to support demand. But rising inflation and an increasingly overvalued exchange rate will continue only to make imported goods even more attractive, just as non-oil exports become too expensive on world markets. This would make Venezuela ever more dependent on oil, which accounts for almost 90 per cent of exports.  Ironically, one of Mr Chávez’s key policies is to stimulate “endogenous de­velopment” to steer Venezuela away from its dependence on oil.  “If the price of oil suffers a significant world decline, the retail sector will not be able to support the current level of imports without the country sliding into immediate trade deficit,” says Mark Turner, an analyst at Hallgarten, who adds that central bank reserves would not last long under such pressure. “Recession would be a real threat to the economy as well as the administration running it.”  But Mark Weisbrot, an economist at the Centre for Economic and Policy Research, argues that the Venezuelan economy “does not fit the mould of an ‘oil boom headed for a bust’.”  He says that a large current account surplus, rising foreign exchange reserves, and low levels of external debt are enough to insulate the economy from any imminent danger, although he concedes that the currency is at least 30 per cent overvalued in relation to the dollar.  “This is something that will have to be remedied if Venezuela is going to pursue a long-term development strategy that diversifies the economy away from oil,” he says. However, he concedes that the government is reluctant to devalue due to the effect this would have on inflation.  Copyright The Financial Times Limited 2007

  7. John Hofer   August 24, 2007 at 9:18 am

    Mark: I don’t get your point. Norway’s energy sector produces more the 2/3 of its exports, followed by a bunch of other primary goods: fish, aluminum and nickel.  Also, if you look at Table 1 in Weisbrot and Sandoval’s report, it’s not just construction. Finance and insurance, communications, transport and storage have been growing extremely rapidly. Is there something wrong with strong growth in the service sector? Even manufacturing has shown very strong growth, though not as fast as the non-petroleum part of the economy. If anything is dragging, it’s the petroleum sector.   As I said earlier, growth appears to be concentrated in the nontradables sectors, which is perfectly understandable given Venezuela’s comparative advantage in petroleum, which stifles trade in other sectors.

  8. mark turner   August 24, 2007 at 10:04 am

    John, You brought up the example of Norway and rightly mention the approximate exports percentage, but fail to mention Norway’s total percentage of GDP to oil. You might see this as nitpicking, but i personally believe that it’s very important to get a fuller context.   The lack of expansion in its industrial base is not a problem when times are good, but it does leave them dangerously exposed to declines in oil prices. I really think it’s tough to find an argument against this conventional wisdom, and that was what the note is all about (so far).   You should indeed play your strongest card, and for VZ that’s oil. I applaud the PdVSA plan to invest $80bn from now to FY12, and although they may be optimistic with their 5.8Mbbl/d target once OPEC relaxes quotas they will be pumping plenty more oil by then. But that said, it certainly is a case of Dutch disease as the efforts made by Venezuela to promote growth in other areas have been at best patchy and at worst failures. Large contracts from the govt to build hospitals are welcome, but where does that money come from? And will it leave a construction industry once the contract is completed? I honestly don’t know the answer to that one. And of course, this is not something confined to the present administration. Bottom line is: oil goes down, VZ goes down. As true now as it was in 1986.   You’re right, there’s nothing wrong with strong growth (and this argument put forward by the FT today is rather too catch 22…no growth = bad, growth = bad). Yes there is strong growth in financial and service sectors. But fuelled directly by petrodollars! Transport…that’s something to do with imported vehicles, isn’t it? I repeat (and i apologise if i bore), why hasn’t VZ’s auto-making facility grown at all in the last 10 years? Building a factory or two would be better for the future of the country than building yet another car showroom, would it not?

  9. John Hofer   August 24, 2007 at 4:42 pm

    I raised the example of Norway because it is often regarded as a model petro state–something Venezuela might choose to emulate. The salient features about Norway are a large petroleum sector and a large public sector. The service sector, obviously fueled by petroleum, accounts for 51% of GDP; manufacturing only 9%.   As for investing in the manufacture of cars, or any other goods traded on international markets, I think it would be a gross misallocation of resources. Do you think Venezuela has a prayer of competing with China? I don’t. But Venezuelans sure can produce oil, provide services for domestic consumption, and even manufacture specialty products targeted at the Venezuelan market. They have to go with the flow of their comparative advantage. As long as oil continues to flow, manufacturing will not be part of their comparative advantage.

  10. mark turner   August 26, 2007 at 11:17 pm

    John,  As a matter of fact i do not think it would be a gross misallocation of resources and i do think that Venezuela has every chance of competing with China (a simple comparison perhaps, but your point is clear). For example, Argentina has successfully expanded its industrial base in the last 4 to 5 years via the precise kind of investment that would benefit Venezuela’s secondary sector. At least part of the U$8.8BN that Venezuela has reportedly pledged to neighbouring states this year could have been used to create value-adding industries inside its borders.   But perhaps this is not the point, because like it or not there comes a moment when today’s Venezuela turns into a subjective and political issue…we both know that. To recognize that VZ might not implement the most efficient economic strategies for political reasons and prefer to direct energies to other ways of benefitting its people doesn’t necessarily mean it’s doing anything wrong as long as the govt really has the best interest of its people at heart. Is that too flighty?  I personally would like to keep this debate on a economy-only level. Rather Utopian, perhaps even naive on my part. But all the same, it’s “interesting” to watch an esteemed medium such as the Financial Times cherry-pick quotes from the Weisbrot/Sandoval paper and well as from this less substantial blog in order to put together its story for a much wider world. As mentioned before, there are already far too many people that want to influence votes. I’m still not one of them.