Sovereign Risk: Will Venezuela Default on Its Debt?

On Wednesday, February 21, 2007, I delivered a speech entitled "Venezuela Under Chavez: Socialist Construction and National Chaos" at a conference sponsored by the Global Interdependence Center (www.interdependence.org). The event was held at the Federal Reserve Bank of Philadelphia. You may read the full text of my remarks by clicking here.

The reason why I chose to present this topic in such a provocative way is the lack of understanding by many risk managers for the nuances of political and economic developments in Latin America. An excerpt from my remarks follows below. Please let me know if you have any questions or comments. Will Venezuela Default?

Perhaps the biggest threat to Hugo Chavez' continued rule is internal, namely the rapidly deteriorating Venezuelan economy. But this trend holds potentially ominous implications for domestic and foreign investors who currently hold Venezuelan debt instruments.

When oil prices spiked last year to more than $70 per barrel, the political currency of Hugo Chavez soared even as the nation's currency, the Bolivar, sank to all times lows vs. the dollar. Despite the vast increase in Venezuela's export income last year, Chavez has managed to alienate foreign investors and accelerate both inflation and the rapid deterioration in living standards among his country's poor - once his most powerful and reliable base of political support.

Decades of inflation have done enormous damage to the economic psychology of Venezuelans, who instinctively horde dollars and physical assets such as automobiles and consumer durables to protect themselves from the ravages of inflation, which is now the highest in Latin America. Last week President Chavez said he will chop three zeros off new bolivar currency bills to bolster Venezuelans' perception of a strong currency in a bid to curb inflation, The bolivar, named after Chavez's 19th century hero Simon Bolivar, trades above 4,000 bolivars to the dollar on the parallel market, around double the official fixed exchange rate is 2,150 bolivars.

Almost half of all private sector jobs in Venezuela have disappeared since the rise of Chavez. Oil is now everything in Venezuela and the country is increasingly dependent on oil income, but there is little in the way of new investment, or even new contracts, in the oil sector. As a February 15, 2007 article in the Wall Street Journal noted, those professionals from the oil industry and other sectors who can leave Venezuela are doing so in growing numbers, driven out by inflation and the radical political course taken by Chavez.

Although Chavez won the 2006 presidential elections, he remains extremely fragile, even with the full protection of his Cuban security apparatus. Though Venezuela has sharply increased public sector spending in the past several years, the private economy is in dire straits and it is from this fact that Chavez faces his greatest hazard. The country's over-dependence on oil, the recent plunge in energy prices and the operational problems at PDVSA are forcing the Chavez administration to look for alternative economic resources.

At the start of 2007, Chavez announced the decision to nationalize the electricity and telecommunications sectors, underscoring the political risks facing foreign investors from all of the populist governments in the region. In an effort to stabilize the economy and forestall any future political challenges, Chavez is trying to consolidate his power base and at the same time deprive his enemies of independent bases of economic and financial influence. This includes nationalizing the state electricity and telephone companies, and closing down a television network that was supportive of the anti-Chavez movement. Foreign investors such as AES Corp. (NYSE:AES) and Verizon (NYSE:VZN) have been forced to accept steep discounts on their investments from the Chavez government.

In April 2002, Chavez was almost removed from office by a coup that was supported by a broad segment of the population, particularly the professional managers in the oil industry. Only a few months later, Chavez faced a strike organized by PDVSA management who sought to force Chavez out of office by removing his access to oil revenue. The strike, led by a coalition of labor unions, industrial magnates, and oil workers, sought to halt the activities of the PDVSA.

As a result, Venezuela ceased exporting its former daily average of 2,800,000 barrels (450,000 m³) of oil and oil derivatives. Shortages soon erupted throughout Venezuela and gasoline imports were soon required. Chavez responded by firing PDVSA's upper management and dismissing 18,000 skilled PDVSA engineers and other employees. Chavez justified this action by alleging their complicity in gross mismanagement and corruption in their handling of oil revenues, while opposition supporters of the fired workers stated that his actions were politically-motivated.

Chavez is also dealing aggressively with the foreign oil companies. In 2005, Venezuela's energy ministry gave private firms one year to eliminate 32 operating service agreements that governed mostly marginal fields accounting for about one-fifth of the country's production. None of the contracts were due to expire until 2012, at the earliest.

Since last year, the Venezuelan government sought to form state-controlled "mixed companies" with British Petroleum PLC, Exxon Mobil Corp., Chevron Corp., ConocoPhillips Co., Total SA and Statoil ASA to upgrade heavy crude in the Orinoco. Such joint ventures have already been formed in other parts of the country. These changes have been made as Chavez has systematically removed officials of PDVSA who are not entirely loyal to his socialist agenda.

The key thing to understand about Chavez, however, is that he cares nothing about economic statistics or trade or even the ability of PDVSA to produce oil efficiently, the currency of modern politicians. His goal is power, the legacy of a life spent as a soldier and a political demagogue.

As Chavez said in a televised address after swearing in his new Cabinet in January: "We're moving toward a socialist republic of Venezuela, and that requires a deep reform of our national constitution… We are in an existential moment of Venezuelan life. We're heading toward socialism, and nothing and no one can prevent it."

Because of the fragile dynamic between Venezuela's government and the large proportion of the population who depend upon government subsidies for their subsistence, foreign investors would do well to consider whether, if given a choice between cutbacks in public spending and making foreign debt payments, Venezuela won't choose the former.

Venezuela's foreign debt only totals about $40 billion, including about $10 billion in short-term debt, but if confronted with a choice between staying in power and defaulting on his country's financial obligations to investors in the US, Europe and elsewhere, you should have no doubt that Chavez would immediately choose default - and would do so gladly.

When you add together the cost of rapidly rising public sector expenditures, support for Chavez allies in the region and around the world, weak oil prices and mounting operational and management problems at PDVSA, the financial outlook for Venezuela seems increasingly problematic. Then consider the action of Ecuadorian President Rafael Correa, who last month proposed a haircut of 60% on the country's foreign debt, an action taken with the advice and active encouragement of Hugo Chavez.

While it has been almost two decades since Venezuela insisted on a 50 percent debt reduction under Treasury Secretary Nicholas F. Brady's strategy for reducing third world debt, there should be no doubt that so long as Hugo Chavez remains in power, Venezuela's economic situation will continue to deteriorate. In that event, do not be surprised in a few months to see Chavez himself calling anew for foreign debt reduction to lighten the economic worries of his captive countrymen.