Sat | Jun 15, 2019

Walter Molano | Venezuela: The day after

Published:Friday | May 24, 2019 | 12:13 AM
An aerial view shows PDVSA’s Puerto La Cruz refinery complex in the state of Anzoátegui, Venezuela.

Venezuela is a mess. The economy has collapsed. And with an inflation rate that is expected to top 10 million per cent, it is now among the highest episodes of hyperinflation.

The hyperinflation record is currently held by Hungary, after the end of World War II. Prices, which doubled every 15 hours, rose almost 42 quadrillion per cent in July 1946. Zimbabwe’s inflation rate reached almost 80 billion per cent in November 2008, with prices doubling every two days.

Hyperinflation destroys economic systems, wiping out savings, pricing mechanisms and supply chains. It coincides with the breakdown of social and political order. Hyperinflation has accompanied military defeats, as well as the breakdown of national institutions.

This is how Venezuela entered into hyperinflation. Not only was it a classic mono-producer, where a single product – oil – accounted for 92 per cent of its exports, it witnessed a devastating plunge in prices in 2014. It also lost its access to the capital markets, thanks to the sanctions introduced by the Trump administration.

Moreover, Venezuela was a country that witnessed the systemic dismantling of the country’s institutions in order to increase the dictatorial powers of Hugo Chávez. Upon his death, the reins of power were usurped by his successor, Nicolás Maduro. Given the economic devastation, it is only a matter of time until the regime crumbles. At that time, the country will have a unique opportunity to re-engineer itself into a new and more prosperous nation.

The first thing the new government will need to do is stabilise prices. Given that hyperinflation occurs when there is no confidence in the currency, it will need to introduce a new unit that is trustworthy. Some countries dollarise or introduce currencies that are backed by hard assets. In the case of Germany, it was land. In Venezuela, it could be an oil-backed security.

Stabilisation programmes also tend to move through phases. Given that there is a great deal of inflationary momentum that persists, the new currency will quickly appreciate, in real terms. Therefore, countries typically cycle through a series of exchange regimes or modifications until they have fully stabilised domestic and relative prices.

Once Venezuela has commenced its monetary stabilisation programme, it will also need to focus on reactivating its oil sector.

The remaking of PDVSA

Some pundits claim that Venezuela will need a decade to repair PDVSA. However, that estimate may be overstated. Kuwait took two years to return to its pre-war production, following the war with Iraq in 1990. This was despite the fact that many of the oilfields were destroyed and set ablaze by the departing Iraqi troops.

Iraq took five years to return to its pre-war oil production, following the 2003 coalition invasion, even though it was in the midst of an ongoing civil war. The Venezuelan situation is different. Oil production has been steadily declining since the PDVSA strike of 2002/2003. The decay turned into a rout following the introduction of sanctions in 2015.

The main problems facing the sector have been the departure of most of the country’s oil workers, lack of maintenance, scarcity of replacement parts and the theft of machinery. However, the Venezuelan oil sector has not suffered the type of physical damage that was prevalent in Kuwait and Iraq, at least up to now. Undoubtedly, some oil wells will need to be redrilled, but the restoration of peace should allow a rapid – two to three years – recovery of the sector. It is important to stress that Venezuela has the largest oil reserves in the world, and most of the sector’s energy infrastructure, such as pipelines and terminals, remain intact.

The main hurdle after the restoration of peace will be the creation of an economic system that will end the country’s polarisation. Venezuela enjoys a cornucopia of natural resources, from energy to metals to mining to agriculture. However, the easy spoils produced by the oil sector provided an incentive to ignore the other sectors. In economics, this is known as Dutch disease.

Moreover, given that Venezuela nationalised its oil sector in 1976, whoever controlled the government also controlled the economy. This created a clientalistic arrangement, whereby lucrative oil contracts were awarded in exchange for political support. It also created a small and very wealthy political class that basically disenfranchised the rest of the society, creating widespread resentment, and it became the basis for Hugo Chávez’s political movement.

Unfortunately, the simultaneous concentration of wealth creation and power, along with the dismantling of the country’s institutions, created the perfect condition for the establishment of a kleptocratic dictatorship.

The challenge is to not repeat the situation. This will be difficult due to the relative strength of the oil sector, but Venezuela will need to develop other sectors in order to provide more economic opportunities for the rest of the population. It may also be prudent to privatise PDVSA in order to break the natural tendencies towards clientalism by separating the role of governance and wealth creation.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.wmolano@bcpsecurities.com