Colombo Telegraph

Rich Oil Income Is Not An Insurance Against Bad Economic Policies

By W.A Wijewardena –

Dr. W.A. Wijewardena

Lessons from Venezuela: Rich oil income is not an insurance against bad economic policies

Hugo Chávez: Hero to Sri Lanka’s nationalists

Venezuela’s popular President, the late Hugo Chávez, was, and is still, a role-model in many respects for nationalistic minded groups in developing countries. This was specifically true for similar groups in Sri Lanka. Their love and awe for Chávez were amply demonstrated by them when they made anti-American and anti-Western marches in the streets of Colombo waving placards featuring photos of smiling but defying Chávez to support their cause. They had all the reasons to hero-worship him.

Bad economic policies supported by rich oil incomes

Chávez confronted the mighty US face to face without showing any sign of retreat or fear. Backed by the rich oil income, he took over not only the businesses owned by Americans but also the businesses owned by his former colonial master, Spain. His justification of the move was purely nationalistic that he declared openly “those natural resources owned by Venezuelans should be placed under Venezuelans”.

He did not stop there, but began nationalising even the businesses owned by Venezuela’s private sector and his successor, Nicolas Maduro, took pride in completing Chávez’s unfinished job in January 2014 (available at: http://venezuelanalysis.com/news/9931 ). His nationalisation move covering industries such as oil, cement, rice processing, packaging, steel, glass and even supermarket chains was a bold attempt at establishing a socialist economy in Venezuela which he termed ‘socialism of the 21st century’ though many in other parts of the world continue to believe socialism as an ideology ‘dead and gone’ today.

He used the windfall oil income to undertake a massive infrastructure development program, support anti-American political leaders in Latin America and abroad and redistribute income among the poor in Venezuela which critics say a move by him to bribe voters at elections. The main beneficiary of his massive infrastructure development programme running into billions of dollars and covering the construction of houses, railways and power plants was Chinese companies which got the contracts for building the same. His annual support to anti-US sentiments the world-over exceeded $ 3 billion according to one estimate (available here ).

His redistribution of oil money among the poor reduced the head count poverty in Venezuela from 55% in 1998 to 28% in 2008. Thus, he was a hero at home; a hero abroad. This is shown by the dozen of honorary doctorates awarded to him by universities in many such radical countries like Iran, Libya, China, Russia, Syria and Nicaragua.

Slipping away of Venezuela’s economic growth rate

Chávez was able to do all this because of the high revenue which Venezuela got from its oil industry that accounts for slightly more than 10% of GDP, about 45% of government revenue and about 95% of export earnings. Hence, when oil prices go up in the international markets, so does his power base as well. He could continue to do it confidently because Venezuela had the largest oil reserve in the world and it was the fifth largest oil producer in the Organisation for Petroleum Exporting Countries or OPEC.

Thanks to high oil income and high government expenditure, Venezuela was able to maintain a super-high economic growth rate exceeding 9% per annum in the initial years of his rule. However, the growth rate has slipped in the last few years recording a decline in the output by 1.5% in 2010 but making a slight turnaround with an average growth rate of 5% in 2011 and 2012. This growth rate has receded to about 1% in 2013 and is projected to be negative in 2014 as it had been in 2010.

Failure to transform the Venezuelan economy

When Chávez became President in 1999, the most pressing need of the day was to transform the Venezuelan economy from a natural resource based economy to an industry cum services based economy. That could have been done easily with the massive oil revenue Venezuela was getting after the oil prices had increased to $ 140 per barrel in 2007-8 and continued remain above $ 100 per barrel since then. However, his biggest oil market was USA which absorbed about a third of his oil production. In addition, USA was its biggest trading partner buying about 54% of its exports and supplying about 45% of its imports. Hence, he was more or less dependent on USA for maintaining his lifeline despite his open war with USA and the declaration that he could bring USA to its knees by cutting oil exports and making it starve of energy.

This was only a one-sided threat because any trade war with USA would have resulted in retaliation by USA in the form of trade sanctions on Venezuela hurting him more than the US. Hence, his claim of getting the US on its knees did not go beyond a mere verbal threat. But his preoccupation with engaging USA and the West in a war and using the country’s resources for that cause denied him of an opportunity for initiating the needed measures for transforming the Venezuelan economy. So, his verbal battle with USA appears to have imposed a long-lasting cost on the domestic economy causing his successor to inherit an economy that had been infected with a number of incurable economic ailments.

The destruction of markets and private initiatives

Venezuela’s trade account was in surplus due mainly to high oil income. For instance, in 2012 its exports amounted to $ 96 billion; but its imports were much lower at $ 56 billion generating a trade surplus of $ 40 billion or 12% of GDP. Many who would just look at the trade surplus only may view that Venezuela’s economy is in good shape without problems for its balance of payments or the stability in the exchange rate.

But the seeds of the economic crisis were sown by the profligate fiscal policy which was subserviently approved and supported by its central bank by having a loose monetary policy to support such policies. The central bank, instead of providing economic wisdom to Chávez, openly justified his economic policy of destroying the markets and private initiatives and isolating Venezuela from the rest of world. The outcome was totally predictable: The setting of the ground conditions for an unparalleled macroeconomic crisis bringing the defiant oil rich giant to its knees instead of its rival, USA.

Profligate fiscal policy and loose monetary policy create a shortage of dollars

Despite the high oil revenue, Venezuela has had a large budget deficit due mainly to the lavish expenditure programmes adopted by Chávez government. In 2012, its total revenue amounted to $ 116 billion while expenditure stood at $ 175 billion. The almost entirety of this expenditure amounting to $ 172 billion consisted of current or consumption expenditure of the government. Thus, the revenue account was in deficit to the tune of $ 56 billion or 17% of GDP.

This huge fiscal deficit put pressure on the Venezuela’s central bank to finance the government expenditure programmes leading to an increase in money supply on the one hand and a deficit in the overall position in the balance of payments on the other. Thus, there was an acute shortage of foreign exchange that prevented Venezuela to maintain an adequate import programme to meet the demand for consumer goods by its people. The result was a shortage of almost all consumer goods in the market.

Acceleration of inflation due to loose monetary policy and scarcity of goods

The increase in money supply coupled with a shortage of consumer goods led to high inflation in the Venezuelan economy. During 1999-2012, it had on average an annual inflation of 22%. But in 2013, inflation rate accelerated to 56% according to official sources and to more than 250% according to private sources.

The high inflation throughout the first decade of 2000 put pressure on the Venezuelan currency – Bolivar – to depreciate. Its exchange rate in 2003 was 1300 Bolivar to US dollar. However, since there was no sufficient supply of dollars in the market, no dollars could be purchased at this rate. The result was the development of a massive black market for US dollars where the exchange rate was two to three times higher than the official rate.

Cosmetic removal of three zeros from Bolivar

High inflation, the pressure on Bolivar to depreciate and the shortage of dollars in the market led Venezuelan authorities to go for a currency reform programme which only a country hit by hyperinflation would have undertaken. Venezuela’s official inflation rate was not yet at hyperinflation level in 2007. Yet, it decided to change the base value of Bolivar and call it ‘strong Bolivar’.

Accordingly, from the beginning of 2008 at a time when the oil prices were at their peak at $ 140 a barrel, the last three zeros of Bolivar were removed making a 1000 Bolivar old note equal to 1 Bolivar new note from that date. The official exchange rate per dollar at that time was 2150 Bolivar to a dollar and after the currency reform, the exchange rate was also fixed at 2.15 Bolivar to a dollar. The black market rate also settled at 3.50 Bolivar to a dollar.

This currency reform was just a cosmetic change resulting in an accounting decline in prices, wages and incomes by one thousand times; its only benefit was for calculators and cash registers which could now accommodate more digits on their display screens. But it did not solve the problem of shortage of dollars or the shortage of consumer goods in the market.

International conspiracy theory to explain away the crisis

This led to acceleration of inflation rate, slowing down of the economic growth and the development of a thriving black market for dollars. As expected, the operators of the black market were alleged to be government servants and criminal groups connected to Chávez administration and therefore, the central bank had to keep a blind eye on their operations. Chávez began to complain of ‘an international conspiracy’ to destroy his ‘socialist economy of the 21st century’ but the conspirators were not from abroad but from his own political party who took advantage of the emerging economic difficulties.

The black market rate for dollars gradually started to move up and eventually settled around 70 Bolivar a dollar by end 2012. The reaction of the central bank to this unhealthy development was too late and too short. It went for a second official currency depreciation making Bolivar equal to 6.30 a dollar, but given the very high black market rate of the dollar at around 70 Bolivar, the new adjustment was a peanut. Thus, it still provided huge profit opportunities for black market traders of dollars who were alleged to be inside supporters of the ruling party.

One mistake leading to another mistake

Meanwhile, shop shelves were empty of essential consumer goods like toilet papers. This situation was similar to the present day Sri Lanka where shop shelves are empty of powdered milk-foods. It was reported in international media that people in Venezuela were stockpiling toilet papers because they did not know when the next stock would come to the market. Chávez angrily reacted by nationalising the supermarket chains and promoting the establishment of cooperatives to distribute essential goods.

He set up a state owned national supermarket chain called ‘Mercal Network’ with some 16,000 outlets and 85,000 employees to distribute essential food items. It provided more employment opportunities and economic power to his supporters. But the state performance in distributing goods was not a match for the private sector efficiency and, as a result, there were long queues in front of the Mercal outlets for essential consumer items. Thus, in Venezuela, one mistake led to another mistake.

This was similar to the policy package in Sri Lanka in 1970s where the private consumer goods market was replaced by state-owned entities. In that system, the common characteristic was the long queues in front of state owned entities or underhand transactions behind the doors or long waiting lists to make available some manufactured items.

Return to a dual exchange rate system

Chávez’s successor and protégé, Nicolas Maduro, inherited this economy which was in an explosive state in March 2013 after his death. Instead of dismantling the state-run socialist economy and returning to a free market economy system, he continued with the same policy of state expansion and control. The situation became acute by the end of 2013 when inflation accelerated to hyperinflation level, economic growth slipped away into negative range and the black market for dollars thrived unprecedentedly.

Maduro’s reaction was going for another mistake which Sri Lanka too had tried in 1970s. That is to have a dual exchange rate regime where the official rate of 6.30 Bolivar would apply to essential goods but for non-essential goods, the rate applicable would be 11.30 Bolivar, an effective partial devaluation of Bolivar by some 45%. The same attractive higher rate was offered to tourists who would bring in dollars to the country (available here ).

This was similar to the Foreign Exchange Entitlement Certificate or FEEC system that was in use in Sri Lanka during 1970 to 1977.  In this system, importers of non-essential items had to pay a premium of 65% over the official exchange rate to buy dollars; similarly, the non-traditional exporters were rewarded by the same premium.

When a black market is run by party supporters, economic adjustments cannot eliminate it

The objective of the dual exchange rate system, as announced by the Minister of Finance, has been to eliminate the black market for dollars. However, it is a partial devaluation and a too short economic policy given the very high black market rate of 70 Bolivar to a dollar. Since the black market is run by government supporters with impunity it does not go out of business on its own. Hence, it thrives without penal action by the central bank and there is no reason for any rational tourist to exchange his dollars at 11.30 Bolivar at a bank when he can exchange the same for 70 Bolivar in the black market.

The importers on the other hand will flock to banks to get dollars at the better rate of 11.30 Bolivar to a dollar but the banks are short of dollars to supply to them. The banks have demanded that the central bank should supply dollars to them, but the central bank could do so only by running down its foreign exchange reserves which will exacerbate the current economic crisis.

Even if the central bank borrows dollars and supplies dollars to the market, those dollars will eventually end up in the unchecked black market. Hence, the analysts have predicted that a full scale devaluation of Bolivar is unavoidable though the central bank has repeatedly denied it. But will it eliminate the black market? No, unless the Maduro government is ready to put a large number of party supporters who presently run the black market behind bars.

Lesson: Bad economic policies can bring down even a mighty elephant

The experience of Venezuela has provided a good learning lesson to countries like Sri Lanka. That lesson is that even if a country is rich with natural resources, it is not immune from economic crises if it continues to follow bad economic policies.

*W.A Wijewardena –Formerly Deputy Governor of the Central Bank of Sri Lanka and presently Visiting Lecturer at PIM, University of Sri Jayewardenepura, Asian Institute of Technology, Bangkok and Naresuan University, Thailand. He can be reached at waw1949@gmail.com

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