The Venezuelan economy is diversifying, and next month’s constitutional referendum should strengthen confidence, according to president Hugo Chavez’s roving representative in Latin America. In an exclusive interview, Erick Rodriguez told Emerging Markets that non-oil growth reached 10.8% in the second quarter of 2007.
“This growth is not only because of oil revenues, as our critics maintain. We are incorporating people into the economy who have traditionally been excluded,” said Rodriguez, who is charged with explaining the president’s proposed constitutional reforms to the rest of the continent.
One of those changes prompting concern among investors is the proposal that central bank policies should be required by law to line up with those of the government. The credibility of monetary policy is already under pressure because the bolivar – for which the official exchange rate is 2,150 bolivars per U.S. dollar – is trading at less than half that official rate on the parallel market.
But the finance ministry has ruled out devaluation, and Rodriguez refuted the allegation that his government is eroding central bank independence.
“Our proposal is coherent. All we are saying is that the central bank cannot go one way if the government is going in the other direction. This would only cause conflicts,” said Rodriguez.
Analysts are not convinced, especially as the threefold increase in government spending over the past four years has led to a surge in the money supply, prompting banks to increase lending and driving up consumer demand. Consumer prices are expected to pick up steam in the final months of the year as the government has increased spending further to bolster its popularity ahead of the referendum on constitutional change – which could allow Chavez unlimited terms in office.
Shortages of basic goods such as milk, eggs and beef have helped keep annual inflation above the central bank's 12% target. In the year through August, consumer prices rose 15.9%, and CPI could top 20% this year. This is even higher than the 17% level recorded in 2006, which provoked a series of announcements by president Chavez and finance minister Rodrigo Cabezas aimed at keeping inflation in single digits this year.
A central pillar of Cabezas’ reforms, which he revealed exclusively to Emerging Markets in March 2007, is scrapping sales tax by 2009. “This is not only a policy to curb inflation, but is a political decision to benefit the poor,” Cabezas said at the time.
The tax, currently at 9%, has been cut twice this year. Its reduction caused a short-lived drop in inflation, but the fiscal easing could make things worse in the long run, according to Ana Maria Di Leo, an economist at the consultancy Veneconomia and longstanding critic of Chavez’s policies.
“If you are going to eliminate the VAT you are going to create demand and the prices will go up. The government is trying to counteract with controls, but it is not working,” Di Leo said.
“We are in a time warp. There are price controls, subsidies, state management of the economy. This experiment is destroying Venezuela’s economy despite the oil windfall,” she added.
Jose Luis Machinea, head of the U.N. Economic Commission For Latin America And The Caribbean (ECLAC), agreed that reducing tax is not the ideal solution to improve the economy. “We have not found that significantly reducing the VAT will eliminate inflationary pressures,” he said.
Instead, Machinea told Emerging Markets, ECLAC believes more efficient tax collection and a broader tax base would be beneficial.
But this is not the government’s approach, as signalled by plans to fill the hole in revenues that would be created if VAT were eliminated altogether. VAT generated 46.5% of non-oil taxes in the first eight months of 2007, amounting to 18 billion bolivars, compared with 15 billion in the same period of 2006. One of Cabezas’ plans is a new 0.5%-1.0% capital tax on luxury items, including second homes, boats, planes, jewellery and works of art. An additional proposal to tax national and international bank accounts held by Venezuelans appears to have been dropped for the time being.
These measures could deter investment in the non-oil economy, but the government says higher oil prices and the development of a new Venezuelan international natural gas industry will also offset the gap. Chavez has forecast that oil prices will reach $100 a barrel by the end of this decade – a forecast which now looks conservative. But more controversially, he also predicts that Venezuela’s hydrocarbon output will increase thanks to a new way of doing business in the Orinoco belt and plans to build pipelines to send natural gas to the Southern Cone (Argentina, Brazil, Paraguay and Uruguay) and an oil line with Colombia to satisfy Chinese demand.
Analysts believe that picture is far too rosy. The government maintains that oil production is 3.3 million barrels daily, but there are outside estimates putting the amount at around 2.5 million barrels and falling. Other sources say that Venezuela actually needs to double production just to keep pace with Chavez’s spending initiatives at home and abroad.
The government has spent more than $1 billion this year renationalizing telecoms and electricity companies that had been privatized by previous governments. It has also renegotiated contracts with foreign oil companies that will cut the role of the private sector, requiring much larger state investments if the administration plans to take full advantage of the heavy crude in the Orinoco belt. The state also has billions of dollars in commitments to other Latin American countries.
Di Leo said the forced purchases of the telecoms company, CANTV, and the Caracas electricity utility, together with pressure on oil companies, are driving away foreign investment and guaranteeing that Venezuelans do not invest locally either.
“The impact of these policies is very negative. Foreign investment has been declining for years and the drop will be steep this year,” she said.
The government’s price controls and subsidies are also distorting the economy, creating a problem with the balance of payments. Imports are climbing and could be above $40 billion this year, a trend that will create additional inflationary pressure. International reserves were $28 billion at the end of August, which is a solid number and above the basic formula that reserves should cover four or five months of imports. Venezuela’s reserves, however, are less than impressive when compared to other countries in the region. Peru, for example, has reserves close to $25 billion without the massive oil revenues.
“Imports continue to increase because the Venezuelan economy is producing less than it needs, because there is no respect for the laws of the market. The government is going to need more and more income to subsidize imports, which is not sustainable even with oil prices high,” warned Di Leo.