Investors regard the inclusion of a variable rate instrument (VRI) in Venezuela’s upcoming debt restructuring as a near certainty. While they are right to expect a piece of the pie should Venezuela enjoy economic revival, they should not hoover up cash that Venezuela could better spend at home.
Economic mismanagment, slumping oil production and lower prices led to a crisis that pushed Venezuela into default in 2017, as well as its national oil company, Petróleos de Venezuela (PDVSA). There has been no prospect of a debt restructuring due to the country’s inability to earn enough foreign currency and a hostile relationship with the US under former president Nicolás Maduro.
But the likelihood of a debt restructuring ramped up with Maduro’s removal in January. Venezuela is carrying out reforms to open up its oil industry to foreign firms again, raising the hope that it can revive its ailing hydrocarbons industry. Oil production could go up again, leading to economic recovery and much greater dollar revenues. The potential in Venezuela is enormous: it has some of the largest oil and gas reserves in the world.
Venezuela’s plan to restructure its debt is based on an expectation it can better exploit those resources. But predicting long-term oil prices and Venezuela’s success in revamping its energy industry is very difficult, meaning investors expect a VRI to be included in the restructuring.
VRIs are instruments in which the payment terms can change, depending on whether the issuer hits agreed metrics. In Venezuela’s case, this would almost certanintly be based on oil production, exports or foreign currency generation — all of the latter would come from the former, anyway.
The principle would be that if Venezuela can hit a given target by a certain time, then investors would receive bigger payments than if it did not. Those payments could also fall if Venezuela does not perform as well as hoped.
This is a good thing. Investors will not lose out if Venezuela’s economy does enjoy a recovery, while the sovereign would be protected if that did not happen.
But investors should not ask for too much upside when it comes to agreeing the terms of a VRI with Venezuela, for two reasons.
First, there is not always a direct correlation between dollar earnings and the ability to repay debt.
And second, Venezuela is in a torrid state. The country has suffered hyperinflation, food shortages, disease outbreaks and rising crime, leading to the exodus of millions of people from the country.
To get back on its feet will require enormous investment. Much of the money that Venezuela would generate from a recovery in its oil industry will need to stay in the country, rather than go to foreign investors.
Investors would be correct to want to benefit from such a recovery. But they will need to accept that Venezuela’s government will have to prioritise domestic spending over paying overseas creditors.
It can do both at the same time. But to truly recover, the former is more important. And prioritising domestic spending will, in the long run, benefit investors, as they would be lending money to a stronger, more productive country.
The purpose of a sovereign debt restructuring is not to make sure foreign investors get as much money back as possible. The process is to give a country enough debt relief so it can keep on investing in economic growth, while at the same time giving creditors a reasonable payout.
Ukraine’s GDP warrants, created in 2015 as part of a debt restructuring, are an example. Bondholders got plenty of money back, but the variable payment structure ended up hurting Ukraine even more in the long run than if it had not bothered restructuring in the first place.
If bondholders demand too much upside in any VRI included in Venezuela's restructuring, they risk the former to satisfy the latter, which will cost everyone in the long run.