F-Rod Pitches a Rabo’e’Cochino

“Not me, the other guy…”

Every few months, Francisco Rodríguez lobs a conceptual hand-grenade at the center of the opposition Conventional Wisdom about the Venezuelan economy.

The series of papers he’s written for Bank of America are growing into a corpus of contrarian analysis of the Venezuelan economy that’s not quite like anything else out there.

His writing is not for the faint of heart: jargonny, data-driven, and wonky, F-Rod writes for Wall Street fund managers, and doesn’t much seem to care whether anyone else gets it.

The jargon tends to obscure an analytical playfulness I’ve always found really appealing, though. The real wonder is that the guy manages to draw a quince-y-último for having this much fun.

His latest effort is once again aggressively at odds with what everybody thinks they already know about the Venezuelan economy. If you speak even basic macro, it’s well worth a read. If you don’t, well, that’s what Caracas Chronicles is for, isn’t it?

The roster of sacred cows he barbecues is rather long, so let’s start with the headline idea:

The hardest part is over. For Rodríguez, what’s hardest is external adjustment – shifting from the crazy rate of imports we had in 2012 to a more sustainable level.  But that part is basically done. The painful, wrenching switch away from a higher to a lower consumption plane was achieved in 2013. It sucked. You saw it in your daily life in the form of bare shelves and enormous queues to buy the basics. But something like it was inevitable. In 2012, Venezuela was consuming way beyond its means. Now it isn’t.

Sure, our chavista overlords didn’t adjust in the normal way. The textbooks say if you want people to consume less, you do that by raising prices. And yes, higher prices were a feature of adjustment, but not the main feature. The main feature was scarcity. “Instead of being frustrated at not being able to afford the goods they could find, Venezuelans were frustrated at not being able to find the goods they could afford.” To a macroeconomist’s way of looking at the world, it’s six of one, half a dozen of the other.

So that’s the first big, bold claim he makes: the tiger of external adjustment is well and truly slayed. Now we’re just having a bit of a fright over the hide.

Internally, though, the economy is still very far from balance. This turns up in the form of a still sprawling public sector deficit that the government is financing in the most irresponsible way imaginable: just printing up money.

But here comes the second big bold claim Rodríguez wants to make: in fact, reaching internal balance isn’t as hard a problem as people think it is. They just need to end the control the cambio – Venezuela’s crazy-dysfunctional forex control regime – and really devalue, across the board.

Such a devaluation would not, as I mistakenly argued, need to be followed by a painful fiscal adjustment because devaluation is a painful fiscal adjustment: by yielding more bolivars for the government per dollar of oil exports, devaluation itself balances the government’s books.

“But, but,” you’re thinking, “the inflation!”

And here comes the third big bold claim Rodríguez wants to make: the inflationary cost of devaluation is one the government already paid because – big bold claim number four coming up – they already floated the bolivar last year.

This last one is especially counterintuitive, and showcases Rodríguez at his most provocative. Since yesterday, oppo types have been saying SICAD II amounts to a major devaluation. But that’s not quite right: all the government really did yesterday is publicly acknowledge the enormous devaluation in the black market rate that has taken place over the last year.

For F-Rod, what we saw in 2013-2014 was a highly unorthodox partial flotation. From 2009 until early last year, the government had played a bizarre game of both refusing to acknowledge a dollar black market existed but then also intervening in that market, sporadically flooding it with dollars to bring back the parallel exchange rate.

Early last year, though, the government stopped supplying dollars to the black market on the sly and just letting the black market exchange rate go as high as it needed to go to match supply to demand. Meanwhile, its decision to monetize the deficit vastly expanded the pool of bolivars out chasing the tiny number of private dollars on offer in the black market. That, and not SICAD II, was the real devaluation: all SICAD II does is make an honest woman out of the black market.

The result was a tiered system – Tier 1: CADIVI, Tier 2: SICAD, Tier 3: the black market – with just one of the tiers absorbing the entire burden of adjustment. As the black market skyrocketed, inflation passed through the system, though concentrated in markets that use Tier 3 as a marker. That’s not like any kind of flotation they’ll teach you about in grad school, but Rodríguez wants to argue it has many of the same effects as a flotation, at least from a macro-point of view. In particular, the big inflation spike you expect from flotation is now in the past, not the future.

This week, the government already decided to “sincerar la flotación” on tier 3 by opening a legal alternative to the black market – Sicad 2. A much more significant step, though, would be to “sincerar la devaluación” by announcing big devaluations in tier 1 and 2, with a view to unifying the three tiers in the not-too-distant future. It’s that move that would really move the needle as far as internal balance goes: by turning the same number of petrodollars into many more bolivars, it could wipe the fiscal deficit out almost completely, ending the need to keep printing money.

For Rodríguez, such a move is all gain no pain by now, because, remember, the bulk of the “pain” is in the past. Sure, there would be a brief upward spike in prices right after the measure is implemented, but he sees no reason to think that would shift the economy into a permanently higher inflation trajectory, or even a medium-term one.

So far, so good: Rodríguez has told a contrarian tale and told it with unusual flair.

Where he gets into trouble is in trying to account for the final anomaly: if devaluation is such a panacea, why haven’t they done it already? As he admits, it’s easy to see why they didn’t do it before December: nobody wants to devalue just before an election. But it’s the end of March now. It’s been three months. What’s the hold up?

One possibility is that they’re just wrong, and are failing to calculate the almighty inflationary mess they’re going to get themselves into if they keep printing money instead of devaluing.

Another possibility is that they like the tiered system and are determined to keep it.

The adjustment through a multiple tier system could help minimize the distributive costs of price adjustments, shifting the burden of the devaluation to non-essential goods, though at the cost of maintaining sizable differentials between tiers with the associated perverse arbitrage opportunities.

This, however, is not a preference Rodríguez thinks they’ll be able to hang on to for long. In a paragraph that is, I think, the lynchpin to the whole paper, he says,

Nevertheless, even if the government chose not to devalue (…) we believe that sooner or later it will be forced to do so. As inflation accelerates, the costs of deficit monetization are easier to see, and the error of choosing monetization over devaluation becomes increasingly evident. The fiscal sacrifice from the subsidy and the associated transfer of rents to importers at the cost of lower revenues for government expenditures also becomes greater. Arrears of the FX control agency continue to grow, introducing a strong incentive to erase them by paying them at a depreciated rate.

It’s too bad this argument is so central to his thesis, because it’s the least convincing thing in the paper. Why? Because the political economy of chavismo is heavily stacked against this kind of reform.

The tiered system isn’t something chavismo is free to walk away from when it stops serving its fiscal purposes, because the tiered system embodies the deep structure of chavismo’s distributive model.

Not for nothing is this a leitmotif in Simón Andrés Zuñiga’s writings in Aporrea. Exchange controls are central to the way chavismo channels petrostate resources at the two key constituencies that keep it in power: the enchufado elite of importers and arbitrageurs – many of whom dress in olive green – and a mass constituency of barrio voters whose livelihood strategies depend on the deep CADIVI discount on imported food and medicines.

Is the tiered system an even vaguely efficient way of channeling resources towards these groups? Come, now, this is chavismo we’re talking about: they don’t speak efficiency.

But in its own messy, scattershot way, the tiered system does shift resources – lots of resources – into the pockets of those whose support chavismo depends on to hold power. The system has lots of dolientes. And some of those dolientes are very well positioned to stymie any attempt at reform.

Even if devaluing and unifying (or almost unifying) the tiers doesn’t have much of an inflationary impact overall, shifting relative prices can have serious political consequences. Remember: unifying the tiers amounts to devaluing the exchange rate for CADIVI-eligible imports while you revalue the exchange rate for stuff that gets imported with parallel dollars.

In Rodríguez’s words, “although there may be changes in relative prices, the absolute price level will not increase as the average cost of buying imported goods for consumers will not increase” (emphasis added.) But this comes perilously close to arguing that there’ll be no political price to pay because the rise in the price of canned sardines will be offset by the fall in smoked salmon prices.

The more important relative price adjustment is between domestic and imported goods, though. In fact, to make the framework work, Rodríguez has to “assume that the government will substitute domestic for imported goods in order to leave the provision of public goods and services constant.”

Assumptions don’t come much more heroic than that one. After 12 years of deepening overvaluation, the domestic economy’s capacity to produce tradable goods is in tatters, and to bring it back you need to do more than click your ruby shoes three times and say there’s-no-place-like-devaluation. The public sector has shown itself useless when it comes to production, and to get any kind of private sector response the government would need to undo much of its micro policy framework – starting with a politically damaging U-Turn on the highest profile policy initiative of Nicolás Maduro’s short tenure. In short, if our strategy for ending food shortages hinges on substituting domestic production for the no-longer-affordable imported stuff, we’re going to be waiting a good long time.

But the logic of devaluation doesn’t just depend on persuading people to buy from domestic producers that no longer exist. It also hinges, crucially, on screwing over the enchufado elite, which has made a living for years now from the fat arbitrage profits that tiers build into the system.

This is the reason it’s proven so hard for the government to agree a policy that to a guy like Francisco Rodríguez looks like such a no-brainer: there is a powerful, extremely well-connected constituency of enchufado businessmen – not a few of whom moonlight as military officers – actively resisting the end of the tiered system for the same reason the Sicilian mafia lobbied hard against the end of prohibition: they’re uniquely positioned to capture the rents.

To devalue with a view to ending the tiered system, then, would mean filling up the coffers in Carmelitas by picking pockets in Antímano and in Fuerte Tiuna.

Worse still: the pockets they’d be picking in Fuerte Tiuna belong to the very same officers they’re going to have to call on to repress the protests that are sure to break out in Antímano when those pockets get picked as well. And this is the solution that’s being sold to us as not having much of a political cost!

To sum up: is ending the tiered system the technocratically correct solution to the government’s fiscal woes?

I’m sure it is.

Are there good reasons for chavista policy makers to fear going down that path?

There sure are.

Ending the tiers will set off a political crisis for the government. That’s why they’re going to wait until the last imaginable minute before they act.

Reality might just drag them kicking and screaming towards a saner exchange rate system, but the kicks are going to be hard, and the screams ear-splitting.