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Economics Update

Economics Update (April-June 1996)

Venezuela Moves to Resolve Crisis
by Julia Holman, economic analyst

ne characteristic that nearly all Latin American countries share is a commitment to economic reform. After the 1982 debt crisis and the resulting collapse in foreign commercial-bank lending, most Latin economies performed poorly, experiencing steep contractions in economic growth and high inflation.

In an effort to stabilize their economies, almost all countries in the region began, in the mid- and late 1980s, overhauling highly regulated and inward-oriented economic structures by liberalizing capital markets, foreign trade, prices, and exchange rates. (Chile had initiated economic reform in the 1970s.) In many cases, stabilization succeeded in the short-term goal of ending hyperinflation and in the longer-term mission of improving the standard of living through sustainable growth and productivity.

Only recently has Venezuela moved to rejoin its neighbors on the road to economic reform after a decade of delays. Resisting market liberalization has hampered Venezuela's economy, which only five years ago was considered one of the most promising investment opportunities not only in Latin America but in emerging markets worldwide.

Apart from an abundance of oil reserves and buoyant economic performance at the time, Venezuela attracted international investors because of its progress under former President Pérez in opening the economy to market forces in the late 1980s.

In subsequent years, however, Venezuela significantly regressed from market liberalization. In 1989, popular resistance to deregulation and higher consumer prices culminated in violent demonstrations in which hundreds of Venezuelans reportedly were killed. The severity of the upheaval, known as the Caracazo, partially undermined the reform effort. Additional riots and the impeachment of President Pérez for misuse of public funds in 1993, however, effectively derailed economic reform.

Banking Crisis

On the heels of President Pérez's impeachment, a widespread banking crisis ensued, which compounded Venezuela's poor economic performance. In the first six months of 1994, the government bailed out more than half of Venezuela's banks after the failure of Banco Latino, the nation's second-largest bank, whose 1.2 million depositors accounted for more than 10 percent of Venezuela's adult population. After the government closed Banco Latino in early 1994, many depositors, losing confidence in the security of their deposits, withdrew their bolívars from other banks and converted them into dollars, of which substantial sums were transferred abroad. The Central Bank of Venezuela estimates that capital flight drained more than $3.5 billion from its total reserves in the first half of 1994. Total reserves, including gold, declined from $12.7 billion prior to the January 1994 crisis to $8.9 billion by the time the government imposed exchange controls in June 1994.

After the closure of Banco Latino, numerous other banks and financial institutions failed, resulting in an $11 billion government bailout. Fifty-six financial institutions were closed, and 25 were taken over by the government. Prior to the crisis, Venezuela had 47 commercial banks, 47 investment banks, 17 mortgage banks, and 36 leasing companies. As of March 1996 there were 39 commercial banks, 25 investment banks, 8 mortgage banks, and 21 leasing companies. According to the Central Bank of Venezuela, these failed institutions accounted for almost 50 percent of total deposits.

In fact, the severity of Venezuela's banking crisis, in relative terms, was much greater than that of the U.S. savings and loan crisis in the early 1990s. Whereas the cumulative cost of the savings and loans bailout represented 2.4 percent of the United States' 1994 gross domestic product (GDP) and 11.5 percent of the 1994 federal budget, the Venezuelan bailout amounted to roughly 11 percent of GDP and 75 percent of the government's 1994 federal budget.

By March 1995, 58 percent of all bank assets were under state control. To finance the bailout, the government had allowed the money supply, as measured by M2, to increase by more than half in 1994 alone. The inflationary effects of the bailout, along with the steep fallout in loans, exacerbated the crisis.

Economic Reform in Jeopardy

In June 1994, in the midst of the banking crisis and while confronting declining foreign exchange reserves, Venezuelan President Rafael Caldera authorized the state to set price and foreign exchange controls. Subsequently many businesses? deprived of access to dollars because of the controls, and thus to imports? could no longer operate, resulting in shortages of consumer goods. In November 1995, the entire Exchange Control Administration Board resigned after its task of exchanging bolívars for dollars had become increasingly difficult as the supply of dollars dwindled. Furthermore, the government maintained an official fixed exchange rate of 170 bolívars to the dollar? despite a parallel rate operating at the time in the Brady bond market of roughly 350 bolívars per dollar. Because of the mounting overvaluation of the currency and declining central bank reserves, on Dec. 11, 1995, the bolívar was devalued by 41 percent to 290 per dollar.

Although market analysts commended the devaluation, the fact that price and exchange controls remained in effect suggested to some analysts that Venezuela's economic reform program was, at best, incomplete. Access to dollars at the official rate remained limited to emergency import transactions until exchange controls were lifted in April 1996, although some large companies were granted partial dollar access for current account transactions earlier in the year. The only other way Venezuelans could obtain dollars was by buying Brady bonds with bolívars on the local market and selling them on international markets for dollars.

Official backtracking on economic reform coupled with the extremely costly banking crisis had a notable effect on economic performance. Given its endowment of natural resources and its well-educated work force, Venezuela's economic performance has been disappointing. Real (inflation-adjusted) GDP growth slowed from 7 percent in 1990-92 to just over 2 percent in 1995 (see Chart 1), while inflation accelerated from roughly 33 percent per year in 1990-92 to an annualized rate that exceeds 100 percent in 1996 (see Chart 2). Furthermore, foreign investment declined by an estimated 60 percent in 1995 compared with 1994.

The Irony of Oil

Paradoxically, the success of Venezuela's oil industry may have contributed to the postponement of economic reform. Oil directly accounts for 75 percent of exports and 25 percent of GDP, providing a large, stable revenue base for the country. With such a cushion, a number of inefficiencies, such as subsidies and a large state sector, could be sustained. Apart from using oil revenues to finance unprofitable state-owned enterprises, the government subsidized domestic gasoline prices to such an extent that in 1995, Venezuelans were paying only 7 cents a gallon for gasoline. Despite the lucrative nature of the oil industry, however, the continued deterioration of Venezuela's public finances and balance of payments position necessitated a modification of fiscal and monetary policy.

Current Developments

Although experts on Latin American economies recognized that free-market reforms were an appropriate solution to the nations' particular crises, Venezuela resisted enacting such policies for two years. Finally, faced with no other option, the Venezuelan government introduced a comprehensive economic reform package and on June 3 signed a letter of intent for a one-year, $1.4 billion loan agreement with the International Monetary Fund (IMF) expected to be finalized in mid-July. IMF approval in turn paves the way for $1.9 billion in loans from the Inter-American Development Bank (IDB) and the World Bank, bringing the total in multilateral loans to more than $3 billion. Whereas the $1.4 billion IMF loan will shore up Venezuela's foreign exchange reserves and help to reduce the federal deficit, funds from the IDB and the World Bank are earmarked for strengthening the social security system and lessening the burden of the austerity plan on the poor.

Included in the "Agenda Venezuela," as the set of economic reforms is known, are a free-floating exchange rate, renewed access to foreign currency, elimination of price controls, tax hikes, a steep increase in gasoline prices, and a gradual return to positive real interest rates.

On April 22, the bolívar floated freely on currency markets for the first time since June 1994, when President Caldera restricted access to foreign currency and initiated a fixed exchange rate regime. In its first weeks of trading, the bolívar declined by more than 40 percent from 290 to 500 per dollar, and stabilized, at least temporarily, around 465 per dollar. The new value of the bolívar roughly corresponds to the parallel rate established on the Brady bond market, which until the elimination of exchange controls, was the only mechanism widely available to Venezuelans for accessing dollars.

Aside from liberalizing price and exchange controls and moving toward positive real interest rates, the Venezuelan government agreed to reduce the fiscal deficit from nearly 7 percent to 2 percent of GDP by year-end 1996. To do so, sales tax will be raised from 12.5 to 16.5 percent, and the government has allowed the price of domestic gasoline to rise by about 500 percent. To contain domestic dissent?such as occurred in 1989 and 1993, the government initiated a subsidy to prevent higher gasoline prices from significantly raising the cost of public transportation.

Conclusion

The next few months will prove crucial to Venezuela's economic prospects. Although polls show that the majority of Venezuelans believe economic reform is long overdue, macroeconomic stabilization will likely involve a painful transition. The success of economic reform in other Latin American countries, however, may provide sufficient incentive for the Venezuelan government to stay the course.

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