Venezuela: Inflation – The Calm Before The Storm
Venezuela’s headline consumer price inflation edged down for a fourth consecutive month in January, falling to 30.7% y-o-y from its peak of 36.0% y-o-y in September. Despite the decline, Venezuela’s inflation outlook remains grim. In fact, since the headline rate hit its peak, the month-on-month inflation figures have actually pushed higher. In short, don’t be fooled by the headline figures, inflationary pressures in Venezuela are still on the rise.
Taking The Easy Way Out
I’m still targeting 40.0% inflation by year-end, and think hyperinflation (for example, rising above 100% per year as seen in 1996/97) is a real threat if the current policy mix is not reversed. President Hugo Chávez withdrew US$12.5bn in excess reserves from the central bank in January, which will be used to finance government spending ahead of the election. This monetisation of the government’s fiscal deficit is highly dangerous, and will have direct inflationary consequences over the coming months. The government appears to be taking the easy way out regarding its fiscal deficit, by opting to use its scarce reserves to maintain an unsustainable budget in the short term. However, there will be no free lunch. Eventually, failing a substantial and sustained bounce in oil prices, the government will be forced to cut expenditure or raise taxes to avoid spending its way into bankruptcy. A successful result at the February 15 referendum on presidential term limits would give Chávez some breathing space to implement such austerity measures, but there has been little indication that this policy will be embarked upon any time soon.
Official Exchange Rate Peg Being Phased Out
Clearly, with oil revenues declining and the government monetising its reserve holdings, a weakening of the bolivar is unavoidable. I’ve been calling for an official devaluation of the fixed peg for some time, suggesting that an adjustment to VEF4.0000/US$ from VEF2.1500/US$ would be needed to shore up the fiscal accounts. However, while I still expect an adjustment of the peg, the authorities seem to be approaching the problem from a different angle, by gradually phasing out the use of the official rate, thus allowing the parallel exchange rate to act as the main exchange rate. CADIVI, the country’s foreign exchange board, has gradually been cutting back on its dollar allotments to businesses, forcing them to go to the black market to access dollars. Moreover, state-oil firm PdVSA is reported to have been selling its dollars in the parallel market. I think it’s likely that we will see a gradual move towards an almost total phasing out of the fixed peg, with only food and medicine importers allowed access to dollars at the official (preferential) rate.
Stealth Devaluation Second-Best Policy
While this ‘stealth devaluation’ would continue to create distortions in the market for food, I actually think it would represent a second-best policy for the government at this juncture. It would allow the parallel exchange rate to act as a valve to reduce the pressure on the country’s foreign reserves as domestic money supply is expanded, by making imports more expensive and non-oil exports more competitive. Many of the distortions in the economy, particularly the build up of inflation pressures, have been caused because of the overvalued exchange rate. Devaluing the rate slowly and in a controlled manner, rather than gradually turning people to the black market for dollars, would prevent the need for a major one-off devaluation that would raise import costs suddenly and disruptively. As such, I think import prices will rise substantially over the coming months regardless of what happens to the official exchange rate, as fewer and fewer agents will have access to dollars at the fixed rate.
Food Production Key To Preventing Hyperinflation
While a depreciating exchange rate will squeeze the demand for most imported goods as the domestic money supply rises, food imports may continue apace in the absence of a resurgence in domestic supply. The country is still heavily dependent on imported food (approximately 60% of all food consumption) due to the overvalued exchange rate and distortionary price caps (not to mention the growing threat to property rights in the country). With the government taking an increasing role in the agricultural sector, we could see domestic food production come under further pressure. Accelerating food prices (which rose at a rate of 2.7% m-o-m in January, and 43.7% y-o-y) could lead to further hoarding, which could create an inflationary spiral.