Venezuela’s Descent Into Crisis

In my May monthly, I make the case that the crisis in Venezuela has intensified to the point where a chaotic default is a question of when, not if. Economic activity is falling sharply and the seeds of hyperinflation have been planted, a downward spiral reinforced by political paralysis, widespread electricity shortages, and a breakdown in social order. Reserves are falling sharply, driven by capital flight and a fiscal deficit that has swelled to over 20 percent of gross domestic product (GDP). Although the government has made enormous efforts to continue making debt payments, a default now appears likely sooner rather than later, and possibly even ahead of large debt service payments due this fall

Absent a dramatic change in the political environment, there would need to be a change in government, and a green light from the United States, before officials from the International Monetary Fund (IMF) would board a plane to Caracas to begin negotiations on a rescue program. By then, the chaos could be severe.

An IMF-backed adjustment program should include a float and unification of the exchange rate, as there will not be adequate reserves to allow intervention, and an extended period of capital controls to stem flight; a multistep increase in domestic energy price to world prices, allowing prices to be flexible going forward in response to market developments; a tighter fiscal policy consistent with available resources; a targeted safety net, replacing the pervasive and inefficient subsidies now in the system; a comprehensive restructuring of the banking system, which is likely to be quite costly given reports of deep-seated corruption; and broad measures to address corruption and rule of law.

In my base case scenario, debt would soar to unsustainable levels, and the cash flow needs of the country likely will outstrip what the official community was willing to provide. While new IMF lending rules provide a fair degree of discretion in highly uncertain, high-access cases (“grey zone”, in Fund-speak), it looks increasingly likely that a comprehensive restructuring, with significant cash flow relief, ultimately will be needed.

China’s role in Venezuela’s debt restructuring will be critical and precedential. As Venezuela’s largest creditor, China has extended nearly $60 billion in loans over the last ten years, mostly backed by oil. China has reportedly already provided material cash flow relief to Venezuela, but would need to be a part of any debt restructuring effort both because its claim is so large and because private creditors would want China to share the burden if asked to restructure. In an earlier blog post, I argued that restructuring the Chinese debt owed by Venezuela is best done by China joining the Paris Club of official creditors, and agreeing to restructure on comparable terms to other official creditors. But short of such a decision, China could still participate in a financing package in parallel to other creditors. Whatever China decides in Venezuela will likely set a precedent for other countries that owe China much debt and have been battered by low commodity prices and slow global growth—countries that will seek restructurings in coming years. The decisions made in this case will be consequential.

Markets are too sanguine about the risk of a disruptive default in Venezuela. If it happens, the IMF will need to move quickly to assemble a comprehensive financing package. China’s support for that package, and any related debt restructuring, will be critically important for the package to be credible and to provide appropriate incentives for participation by other creditors.