Venezuela's Economic Fractures

Author: Brianna Lee
April 24, 2014

Carlos Garcia Rawlins/Courtesy Reuters
Introduction

Hugo Chávez's transformative presidency left behind an economic model that has sowed deep, heated divisions within Venezuelan society. The country's oil reserves—among the world's biggest—largely sustain the economy, which is state-controlled and prioritizes social development and affordability for the poorest sectors of society. But stringent currency and price controls and a thriving black market for dollars have contributed to inflation, stagnant production, and frequent goods shortages, catalyzing vocal discontent against the government's economic management.

Mass protests erupted in February 2014, a year after Chávez's death and election of his hand-picked successor, Nicolás Maduro. Economic frustrations are a major undercurrent of the unrest, exacerbating grievances over crime rates, governance, and the administration's violent crackdown on protestors. The demonstrations—Venezuela's most severe in more than a decade—resulted in more than thirty deaths as of April 2014. The Maduro government has scrambled to make economic adjustments, but analysts say these moves alone are not enough to stabilize the economy. Meanwhile, Venezuela's volatility threatens its regional relationships with oil beneficiaries and trade partners.

An Oil-Based Economy

Venezuela's powerful oil industry, helmed by state-run petroleum company Petróleos de Venezuela, S.A. (PDVSA), is the economy's main life source. The industry, which sits atop the world's largest oil reserves (surpassing Saudi Arabia in 2012), accounts for about 50 percent of government revenue, 25 percent of GDP, and 95 percent of all exports—figures that Chávez's presidency had achieved.

Chávez famously used this oil wealth to cement international relationships, selling petroleum at steep discounts to members of the eighteen-member Petrocaribe alliance, including the Dominican Republic, Nicaragua, and Haiti, as well as longtime ally Cuba. Under barter agreements, many of these countries export agricultural and food products to Venezuela. Oil exports also sustain the eight-member Bolivarian Alliance of the Americas (ALBA), founded by Chávez and Cuba's Fidel Castro in 2004. Oil is also used in some cases to repay Venezuela's external debts, as is the case with China, which has loaned it more than $40 billion since 2008. Domestically, oil subsidies result in the world's cheapest gasoline at about 6 cents a gallon for the population of 30 million.

Oil has been central to the trajectory of Venezuela's political economy and underpinned Chávez's political power. In their 2011 book Dragon in the Tropics, analysts Javier Corrales and Michael Penfold write that "institutional changes, both prior to Chávez and in the first years of the Chávez administration, allowed Chávez to seize control over the political system and the oil industry. The subsequent oil windfall allowed him to save his government and consolidate his control."

PDVSA controls all operations in exploration, extraction, processing, and exporting, and is the world's third-largest oil company behind Saudi Aramco and ExxonMobil. But as Chávez expanded his control over the oil giant, it became a highly politicized body. Following a devastating general strike in December 2002 through February 2003, Chávez dismissed nearly 20,000 oil sector workers and dramatically expanded PDVSA's mandate to include the government's social priorities. This effectively turned the company into a "checking account" that has bankrolled food and housing subsidies, medical services, and educational programs for the poor.

Critics point to PDVSA as an example of gross mismanagement, citing an 18 percent decrease in oil production, a string of refinery accidents, and the addition of around 100,000 employees to the company's bloated payroll during Chávez's fourteen-year presidency. Nationalizations of multi-billion dollar oil projects in the country disrupted the economy, and delayed payments by PDVSA to oil contractors have driven away workers. Some argue that diverting oil revenue into social programs at the expense of reinvesting the funds in oil operations has weakened the industry. Others say Venezuela's oil discounts and barter arrangements further block cashflow back into PDVSA. Former board member Gustavo Coronel has described PDVSA as a "toothless tiger resting on its haunches before a huge slice of raw meat."

Because the oil industry is so central to Venezuela's access to foreign currency, particularly dollars, oil prices and production greatly affect the production capacity of the country's other industries—a problem that is exacerbated by a warped currency market.

A Two-Tiered Currency System

High oil prices, in addition to expansionary fiscal and monetary policies, led to average annual GDP growth of about 5 percent from 2005 to 2012. But growth slowed dramatically in 2013 to about 1 percent, reflecting increasingly binding exchange controls and supply constraints.

Many barriers to increased production and investment can be traced back to strict currency exchange controls, which Chávez implemented after the 2002-2003 strike in order to stem capital flight and curb inflation. Under this system, U.S. dollars are heavily restricted to the general public. Venezuelans can access dollars only through the central bank and only for certain purposes, such as travel or importing, and must go through a string of bureaucratic steps before the exchange is completed. Maneuvering through the red tape has hampered the efforts of many businesses to pay back debts and import goods and raw materials for production.

In a March 2014 roundtable discussion at the Americas Society/Council of the Americas, Luisa Palacios, head of Latin America Macro and Energy Research at Medley Global Advisors, said the deprivation of dollars was central to Venezuela's current economic stagnation. "The government decided to starve the private sector of dollars [used to] import basic raw materials and different components," she said. "What we're seeing is that that has led the economy into kind of a standstill."

The scarcity of U.S. dollars has made them extremely valuable and contributed to a thriving black market for the currency, where they have at times traded for up to ten times as many bolivars as the official rate offers. These economic distortions have provided a conundrum for businesses in calculating costs and profits, and there are stark differences in purchasing power depending on what type of currency one holds.

The scarcity of U.S. dollars has made them extremely valuable and contributed to a thriving black market for the currency, where they have at times traded for up to ten times as many bolivars as the official rate offers.

Manipulating the system through arbitrage schemes, known as raspao, or "big scrape," has introduced lucrative opportunities for those with access to dollars. A person may travel abroad, exchange money at the government rate of 6.3 bolivars to the dollar, then return to Venezuela and sell back the dollars on the black market for 60 bolivars each. Economy minister Rafael Ramirez said in February 2014 that one in three dollars circulating in Venezuela was misused or stolen.

Scarcity and Shortages

Price controls compound the distortions. Many consumer goods, including food, personal care items, and appliances have government-mandated prices that are artificially low to make them more affordable for the poor. Maduro has expanded the list of price-controlled items and imposed a 30 percent cap on all businesses' profit margins to prevent overcharging.

Low consumer prices, minimized profits, and the difficulties involved with accessing dollars and importing goods have caused businesses to halt or cut back on production and supply, resulting in shortages across industries. Several newspapers have struggled with paper shortages, leading to an emergency loan of paper from Colombia to three Venezuelan dailies in April 2014. Car manufacturer Toyota announced it was stopping assembly operations in Venezuela in early 2014 because of difficulties in importing materials. Grocery shortages of items like milk, cornmeal, and toilet paper are frequent, and shipments of rare items have resulted in notoriously long lines at supermarkets.

In many cases, the system makes it far more profitable for importers to take government-issued dollars and trade them on the black market instead, or smuggle imported goods out of the country to fetch a higher price. On the consumer end, those who can get early access to rare goods have higher incentives to hoard them, exacerbating the scarcity.

Venezuela's scarcity index, which measures the amount of basic goods that are out of stock at a given time, reached a record 28 percent in January 2014 (since then, the Venezuelan Central Bank has stopped publishing scarcity index figures). These shortages and ever-present high demand have also drastically pushed up inflation, which reached an annualized 57.3 percent in February 2014.

"The only way for Venezuela to grow out of this is to produce more dollars," said Palacios at the Americas Society discussion. "But they have limited capacity to produce more dollars because it is a function of oil production and oil prices, both of which have very serious challenges."

Support for the Poor

Despite the economic disruptions to daily life that Venezuelans experience, the chavista economy has been heralded for its emphasis on social spending for the poor. A hallmark of Chávez's presidency was the implementation of Bolivarian social missions, which stressed human development in poor communities and provided doctors, teachers, and social workers free of charge. With Latin America's lowest rate of inequality, Venezuela has led the region in reducing poverty, which has curried strong support for the government among the working-class and poor. Between 1998 and 2012, the poverty rate was reduced from 50 to 25 percent.

Consequently, the 2014 protests saw less participation from the lower classes. In an interview, Javier Corrales of Amherst College pointed out that the government has expanded its political presence in lower-income neighborhoods to perpetuate political and economic dependence on the administration. "In populist governments, the state creates restrictions on the business sector that produces shortages, but then the state emerges as the one actor that's going to help you with those shortages," he said. "It is true that low-income groups are not seeing protests, but they're also not out there defending the government."

Regional Tremors

Economic instability in Venezuela poses concerns for its regional and international trade partners as well. Venezuela is a member of regional trade bloc Mercosur, which includes Brazil, Uruguay, Argentina, and Paraguay, and its economic woes may foster further divisions within the already fractious group.

The United States also remains one of Venezuela's most important trade partners, despite the antagonistic rhetoric lobbed between Washington and Caracas. Venezuela's exports to the United States have slowed in recent years, from $43 billion in 2011 to $31 billion in 2013.

Chávez's death and the country's economic woes have prompted questions over the future of regional bodies like the Bolivarian Alliance of the Americas (ALBA) bloc, as well as the Petrocaribe alliance, both of which Venezuela has heavily supported with funds and discounted oil. Falling oil production has put Venezuela's oil commitments to the Petrocaribe member states on shaky ground, leading to delayed shipments and readjustments of exchange rates, the latter of which eventually led to Guatemala's withdrawal from the alliance in November 2013.

Piecemeal Reform

Sluggish growth, high inflation, scarcity, skewed currency markets, and stagnant production and investment have culminated in the torrent of economic grievances that fueled the early 2014 unrest. For its part, the Maduro government has acknowledged that economic reform is a necessity. "We can't hide the reality: the economy has inflation, shortages, and growth is not robust," admitted central bank president Nelson Merentes in a March 2014 television interview. "But Venezuela has the ability to get out of this moment which is not so good. Indeed, the government is taking measures that will help us get out quickly."

One of the high-profile measures that the Maduro government has undertaken is the introduction of a new currency market, dubbed SICAD II. Alongside the government exchange rate and the SICAD I system, an exchange market targeting state-owned enterprises, SICAD II most closely resembles a free market for foreign currency and allows individuals and private businesses to trade for dollars at a higher rate. As of its opening in April 2014, a dollar on the SICAD II market traded for 50 bolivares—far higher than the official government rate (6.3 bolivares to the dollar), though not as high as the black market rate (68 bolivares to the dollar). The Maduro government also took steps in April 2014 to introduce an identification system for people buying groceries in order to prevent food hoarding.

But critics of the government's approach say its crackdown against opponents has complicated reforms and that is has to move beyond exchange-rate fixes.

But critics of the government's approach say its crackdown against opponents has complicated reforms and that is has to move beyond exchange-rate fixes. Palacios, speaking from the April 2014 Americas Society roundtable, said that the government's crackdown on protestors exacerbates obstacles to economic reform. "You cannot be talking to the private sector and then using repression and censorship to the opposition as if they were two different actors," she said. "A lot of the private sector is in the opposition; there is a reason why that is the case."

To avoid exacerbating problems, analysts say, the liberalization of exchange controls needs to be accompanied by tighter macroeconomic policies, meaning higher interest rates and lower government spending. These moves may entail politically risky decisions, such as raising gasoline prices (Venezuela has the world's cheapest gas rates), at a time of heightened tensions in the street. But the longer the government waits to act, analysts warn, the more severe the pain will be felt down the road.

Additional Resources

Javier Corrales and Michael Penfold's 2011 book Dragon in the Tropics dissects the trajectory of Venezuela's political economy during Hugo Chavez's presidency.

Sarah Ladislaw and Frank A. Verrastro of the Center for Strategic and International Studies discuss the outlook for Venezuelan oil production in the post-Chavez era.

Experts Luisa Palacios, Alejandro Grisanti, and Javier Corrales discuss Venezuela's economic outlook amid antigovernment protests in this March 2014 panel discussion at the Americas Society/Council of the Americas.

The Americas Society/Council of the Americas provides a timeline of the 2014 protests and rounds up expert analysis on the crisis.

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