A long term view of monetary liquidity and international reserves in Venezuela

January 31, 2009

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A couple of weeks ago, Quico showed a plot I sent him of monetary liquidity (M2) in US$ divided by Venezuela’s international reserves going back to 1994. M2 is a measure of all of the bolivars in circulation in Venezuela at the official rate of exchange. Because the results were so interesting I decided to go back even further to the 70’s when Carlos Andres Perez was President and the exchange rate was held constant at Bs. (old ones) 4.3 per US$.

Getting all of the data was not easy as the Central Bank had gaps on the exchange rate but I managed to fill all of the holes and the result is shown above.

One can think of this plot as how much backing the Bolivars in circulation have. A value of 1.0 simply says that for each dollar in international reserves there is one dollar in Bolivars in circulation. Thus, at a current value of 3, the plot says that only one third of the Bolivars in circulation are backed by the country’s international reserves.

As you can see the value of 3 has only occurred once in the country’s history, right before what is known as the “Viernes Negro” or Black Friday when Luis Herrera Campins had to do away with the Bs. 4.3 per US$ and the currency devalued dramatically in the ensuing months.

I have noted with red arrows the big devaluations that occurred during this time period and as you can see, except the devaluation by Chavez (more the release of the band system in place at the time) in 2002, all of the other large devaluations were preceded by a sharp rise of the ratio (M2/International Reserves). (Some people like to plot the “implicit” exchange rate, that is how many Bs. in circulation there are for each dollar at the Central Bank, the problem is that this gives you no standard measure due to devaluations to compare things in time, thus looking at this ratio makes historical comparisons better, in any case this “implicit rate today is Bs. 6.56 per US$)

However, as you can see, a sharp rise in M2/Reserves does not suggest a devaluation is imminent, just that it is coming. My sense is that the graph says that Government’s should not let this ratio get so large so as not to get in trouble, but they usually do and eventually there is some crisis that forces devaluation. Luis Herrera held off the crisis and the ratio got so large, because the Fondo de Inversiones de Venezuela had some US$ 30 billion abroad and PDVSA was allowed to keep its excess dollars abroad. As the crisis ensued the Government grabbed the FIV’s money first and later forced PDVSA to send all its dollars to the Central Bank. Once the Government went through those, it was just a matter of time before the currency collapsed in the worst devaluation ever. (The size of the drop each time tells you how large the devaluation was)

Lusinchi on the other hand, left the second Carlos Andres Government essentially no international reserves forcing it to devalue, it was a case of the denominator going to zero, rather than too many Bolivars chasing too few dollars, there were simply no dollars to be had.

Caldera on the other hand had dollars, but inflation was getting out of control, as too many Bolivars were chasing too few goods. When Caldera decided to devalue, inflation was running at over 100% when you annualized the monthly inflation of December 1994 and January 1995.

This is what we are seeing these days. Inflation is accelerating as M2 grows and the sustainability of such a large M2/Reserves has been made possible by the large oil income that has kept reserves large, as M2 has grown excessively. But now, oil is not only sharply down, but the Government just removed another US$ 12 billion from reserves. The Government does have US$ 20 billion in various savings accounts like Fonden, Bandes and PDVSA, but in reality the “real” rate of exchange is not Bs. 2.15 per US$ as the graph assumes, but much higher.

Because what the Government has done is implement a “stealth” devaluation in which fewer and fewer items are given foreign currency at the official rate of exchange. At the same time PDVSA now, Fonden in the first half of 2008, intervene in the parallel swap market selling US$ at the swap rate which is over 2.5 times the official rate. This large arbitrage distorts things in the economy and commerce, drives inflation up and eventually will force the Government to devalue.

And the ratio will go back down to its normal levels…

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