A Roadmap Out of Cadivi

A shorter version of this post appears in Foreign Policy’s Democracy Labs blog. 

Say “macroeconomic adjustment” and Venezuelans immediately cast their minds back to 1989. That year, an IMF-inspired shock therapy program pushed through by President Carlos Andrés Pérez set-off serious rioting throughout the country, costing hundreds of lives and undermining governability for a generation to come. The memory of those traumatic events still colors policy discussions today.

As October 7th draws near, the opposition is thinking through its macroeconomic approach to transition.

At first blush, the parallels are jarring. Just as in 1988, the country faces a fixed, severely overvalued exchange rate; a structural budget deficit fed by a sprawling, loss-making state-owned enterprise sector; rigid price controls; and ruinous gasoline subsidies. It’s enough to give any Venezuelan macro-economist the heebie-jeebies.

So is the country is on the verge of another massively disruptive adjustment experience?

Not at all, for two reasons: the economic fundamentals of 2012 are nothing like those of 1988, and the opposition’s presidential candidate now is nothing like the one we had back then.

Barring an unexpected collapse in oil prices, Venezuela will face next year’s adjustment from a position of strength this time. It’s one thing for a petrostate to undertake structural adjustment with oil trading at $16 a barrel, and quite another to do it with a barrel selling for $110. Masses of petrodollars will be flowing into state coffers every day, and while the incoming government in 1989 found the cupboard almost completely bare, Venezuela’s net foreign asset position is now estimated at $72 billion.

Economist Miguel Angel Santos stresses another key difference between then and now: private sector firms had been accumulating dollar denominated debt fast in the years leading up to 1989, which amplified the impact of adjustment on the real economy. In recent years, by contrast, Venezuelan private firms have been deleveraging abroad.

If starting conditions are different, so is the approach of adjustment advocates. Henrique Capriles Radonski has explicitly rejected shock therapy, committing instead to a gradual approach that could make 2012’s experience – dare one say it? – nearly painless.

Here’s how:

The first order of business will be unwinding CADIVI, Chávez’s foreign exchange control mechanism slash corruption cesspool.

CADIVI is charged with administering a massively over-valued exchange rate fixed at a ridiculous 4.30 “Strong” bolivars per dollar. That rate is available only for priority imports of food, medicine, and public procurement goods, all under supposedly-tight bureaucratic supervision.

In practice, 4.30 dollars are the unicorns of Venezuelan political economy. The supply of dollars at this lower rate has been contracting for years, pushing more and more importers into more expensive, often illegal ways of obtaining hard currency.

One way to cut this Giordanian knot would be to combine a more prudent approach to public spending with a switch from a static peg (Bs.4.30:$) to a crawling peg. That would allow for gradual, controlled nominal devaluation on the official market, clawing away at real over-valuation little by little. This crawling peg would be complemented by an overhauled SITME alternative exchange market, one that’s more flexible and openly accessible, and especially far more transparent.

This new, improved SITME would allow market forces some scope to settle on a reference price for the dollar – which is critical, because at this point the black market is so opaque, thin and dysfunctional, there really isn’t a reasonable market-driven reference price that would allow us to know what the “real” cost of a dollar is.

Creating market information on the real value of the bolivar is, therefore, step one.

This dual exchange rate strategy is Alejandro Grisanti’s preferred approach. The Barclays Capital economist – and key advisor to Capriles Radonski – foresees an initial spike in the parallel market rate, as some of the built-up demand for foreign exchange is met. If this initial spike threatened to overshoot, however, the new government could mitigate the jump by fixing a top price to the parallel dollar, leaving part of the pent up demand initially unmet.

What few in Venezuela seem to appreciate is that following that initial spike, the parallel dollar rate would likely face the same pressures towards appreciation that now face so many emerging commodity exporters. That’s been the experience in Peru, Chile, Brazil and almost every resource-dependent emerging economy over the last few years.

Because these countries export natural resources whose prices have been rising over the last few years, that has been the norm, and nothing suggests it is going to change in the near future. As the price of export commodities rise, more and more dollars flow in chasing the same number of local currency units. When that happens, the value of the local currency rises – simple supply and demand.

So long as government spending is kept within reasonable limits and Capriles gains investor confidence, there’s no reason to think the price of dollars would rise inexorably after Cadivi is brought to an end. In the medium term, we would tend towards convergence between a depreciating official rate and an appreciating parallel rate.

In time, the two would meet, spelling the end for exchange controls, imaginably in the not too distant future. This wouldn’t necessarily mean an end of government intervention in the currency market, however.

“In a country where the government supplies 95% of the dollars in the currency market,” Grisanti says, “there’s no such thing as a clean float.”

In practice, then, the Central Bank would retain plenty of tools to keep the exchange rate from gyrating too wildly this way or that – nobody, after all, can force BCV either to supply or withhold dollars from the market.

The real challenge in this scenario would be the opposite of what we’re used to: keeping the bolivar from strengthening too much. For Grisanti, that old bugbear of petro-exporters – Dutch Disease – is a much bigger threat to Venezuela’s economy in the medium term than the sharp, adjustment-induced devaluation Venezuelan economic agents fear so much.

How you achieve this is, again, a subject for debate. Plenty of Venezuelan economists favor a FIEM style stabilization fund, where excess oil profits are deposited in dollars to hold in reserve for a downturn. With Venezuela (and PDVSA) now owing tens of billions of dollars in high-interest bonds, though, saving at 2% while borrowing at 12% doesn’t seem like a very smart move.

Grisanti’s approach would divert excess dollars away from FIEM and into paying down Venezuela and PDVSA debt, i.e., retiring Venezuelan and PDVSA bonds. Only once debt has come down quite near zero would any kind of savings fund be favored.

Grisanti’s determination to keep the bolivar from rising in value too much is by no means a consensus view, though. Economist Omar Zambrano sees appreciation as an inevitable outcome of normal exchange market operations in a natural-resource rich Latin American economy, whether it’s Venezuela or Chile or Peru. In his view, appreciation need not be a binding constraint on the tradable goods sector, which can still flourish as the business climate is improved through microeconomic reforms.

Zambrano – who is not a Capriles advisor – focuses instead on the political attractions of currency appreciation. As a currency appreciates, it buys more and more in international markets – which isn’t good for local industry, but sure is great when you go shopping. By transferring purchasing power directly into consumers’ pockets, an appreciated currency could be a powerful force for maintaining political stability in what is sure to be a politically dicey transition – in effect, it acts as an across the board subsidy on everything foreign.

When that happens to Greece, or Japan, it’s just terrible: too many jobs in those countries depend on exports, whether it’s of electronics or of vacations, and those sectors suffer as the currency appreciates. In Venezuela, though, 13 years of Bolivarian socialism have decimated the tradable goods sector – most of the industries that would stand to lose from appreciation have shut down, been expropriated, or shrunk beyond recognitions.

The political economy “losers” from appreciation, in other words, are likely to be marginal players in the politics of the early Capriles administration. For Zambrano, now that Chavismo has given us lemons, we better appreciate the lemonade.

Zambrano’s point of view is provocative, but clearly a minority view among Capriles’s advisors. For an administration coming into power with a strong focus on job creation, allowing runaway appreciation to ensure short-term governability would look short-sighted. By gradually – but preferably quickly – phasing out currency controls and then seeking to balance exchange rate competitiveness with an effort to bring inflation under control through fiscal discipline, an incoming Capriles government could begin to clear the mass of economic imbalances of the Chávez era in an orderly manner.

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I’m convinced that, if anything, the lessons of 1989 have been over-learned, building a strong anti-adjustment bias into Venezuela’s policy debate that inhibits even reforms everyone agrees are needed.

But 2012 is not 1988. In a context of triple-digit oil prices, Capriles’s commitment to gradualism could help accomplish adjustment without the costly social dislocations that accompanied an earlier vintage of reform.