Publish in Perspectives - Monday, September 26, 2016
Bolivar or dollar? Which is better for Venezuela's economy? (Latinvex collage)
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How to save Venezuela’s currency or dollarize outright.
BY MARÍA BELÉN WU
Since their independence, Latin American countries have displayed a common fervor for populist socialism. Whether it is a residue of three centuries of European imperial rule, or simply a fondness for charismatic leaders – and an extraordinary talent for producing them – the widespread formula of clientelism and cronyism disguised as socialism has proven to have devastating consequences for the continent’s economic, social and political development.
Nowhere is this phenomenon displayed more clearly at present than in the Bolivarian Republic of Venezuela. The country is suffering its worst humanitarian and economic crisis in history, which calls for an urgent solution.
The experience of a number of former socialist countries suggests that a key to [improving] Venezuela’s [economy] lies in forsaking monetary policy autonomy and in turn gaining a stable, fixed exchange rate and international capital mobility.
ORTHODOX CURRENCY BOARD
To undertake monetary reform in Venezuela through a currency board, the first stage of the process would be to convert the existing central bank (BCV) into a currency board. First, all functions of the central bank other than supplying the monetary base should be delegated to other administrative bodies. In the case of Venezuela, this can be the Ministerio del Poder Popular para la Banca y Finanzas. Commercial banks could operate the payments system and provide mutual deposit insurance protection.
Second, there should be a brief period of free-floating exchange rates for the domestic currency, which will indicate an appropriate exchange rate between the reserve currency and the domestic currency that can later become fixed. For instance, in the case of Bulgaria in 1997, after the announcement of the implementation of a currency board, the monetary base was frozen and the lev was floated for 30 days. After this period, the lev was fixed at the resulting rate against the German mark. However, considering the current state of crisis in Venezuela, this step could be omitted for a faster transition, as the black market exchange rates already provide a good indicator for a future fixed exchange rate under the currency board; more precisely, the average rate achieved in the last 90 days would under current conditions be suitable.
At the same time, the government should announce its choice of reserve currency and the date it will fix the exchange rate. This would prevent excessive currency depreciation due to uncertainty, and the announcement of a currency board system itself would probably push the black market rate down by a significant amount, as was the case of Indonesia, where the rupiah soared by 28 percent against the dollar in February 1998 with the announcement of a currency board. Still, official inflation will inevitably rise, presumably to the levels indicated by the implied inflation rate. This figure would then decrease drastically as the currency board was established and began its operations, allowing inflation rate to converge towards the anchor country’s rate.
The choice of reserve currency for Venezuela is obvious. Being a petro-economy, most of Venezuela’s foreign currency transactions are made in U.S. dollars. Realistically, shock asymmetry with the United States should not be a priority concern in Venezuela’s decisionmaking, simply because Venezuela bears no shock symmetries with any stable advanced economy. Even so, the dollar would represent a better choice than the euro or the yen since the United States is Venezuela’s largest trading partner.
An additional step in Venezuela’s case would entail the replacement of all BCV personnel as a sign of full commitment to the new monetary system. Ideally, this would take place swiftly if the administration were to fall into the hands of the opposition, which would also result in the substitution of most current government officials. Additional actions to increase the central bank’s transparency could involve publishing weekly or even daily statistics and balance sheets, or requiring the BCV to fully back any further increases in the monetary base with foreign reserves.
The next step would be to convert some of the required reserves of commercial banks into currency board notes and coins or into foreign securities at the banks’ disposition. This step would eliminate the deposit liabilities of the central bank. In addition, the BCV keeps excess reserves from universal and commercial banks, investment banks, savings and loan institutions, mortgage banks, and financial leasing companies. To prevent extra inflation, these could be converted into government bonds instead of currency board notes and coins. Despite being deep in crisis, Venezuela has kept a surprisingly disciplined commitment in meeting its billions of dollars worth of international debt obligations. This good record of repayment has contributed to an unexpected rally in Venezuelan bonds, especially since the recent rebound in oil prices. Prices for benchmark debt due in 2027 increased from a record low of 33 cents in the dollar in February to 46 cents in June. While the decision to prioritize foreign lenders as the population starves is highly controversial, it will contribute to faster economic rebound if there is a debt restructuring.
The next step in establishing the currency board would be to fix the exchange rate with the reserve currency, by which point the government must have ensured that foreign reserves for currency board notes and coins in circulation equal 100 percent. Fortunately, Venezuela already meets this requirement, and is above the 110 percent ceiling at both the highest official exchange rate (DICOM) and the black market exchange rate. The ratio would probably decrease in the case that the bolívar gained back some value after the currency board announcement. However, as the black market ratio currently exceeds 800 percent, this might indicate that a lower exchange rate than the black market rate is suitable to adopt as the currency board fixed rate.
The final step in the process would be to transfer the remaining assets and liabilities of the central bank to the currency board and open the currency board for business. By then, the currency board would have replaced the BCV as the issuer of domestic notes and coins, and would assume all remaining assets and liabilities of the central bank. Experience indicates that a currency board system could be established in as little as 30 days; the faster, the better.
BOLIVAR VS DOLLAR
Some believe that the bolívar is already too far gone to be rescued. Venezuelan economist and author José Luis Cordeiro even proclaims a “second death of Bolívar” in his book advocating dollarization, or as he calls it, the democratization of money.
There are several reasons why dollarization is a more adequate option than a currency board system in Venezuela. To begin with, there are fewer steps, less bureaucracy and very small costs involved in dollarizing an economy. Ecuador’s dollarization cost around $800 million, a tiny fraction of the billions of dollars that have been smuggled through Venezuela’s fraudulent exchange rate systems. Additionally, the credibility of the currency would no longer be an issue, which would greatly reduce the country risk premium and interest rates, as currency risk would be completely eliminated. Furthermore, dollarization would serve the interest of the Venezuelan people by privatizing foreign reserves and distributing them to the population, so that consumers would finally be able to fully take advantage of the perceived superiority of the dollar. Lastly, dollarization provides the same monetary austerity measures as a currency board, by preventing lender of last resort activities, irresponsible money printing and high inflation.
Venezuela has already begun considering dollarization as a way to salvage the economy. The government has taken steps in the auto industry, where it has recently reached a deal with Fiat Chrysler Automobiles NV, General Motors Co. and Toyota Motor Corp. by allowing them to sell output in dollars. Auto parts will also be paid for in dollars and assembly will take place in Venezuela. Production lines should resume in August.
The auto industry aside, the reality is that the entire nation is informally dollarized through the black market. No Venezuelan would prefer holding bolívares over dollars. However, the popular saying “wages climb up the stairs while prices go up in the elevator” describes the frustrations of earning a living in bolívares and spending in dollar prices.
DOLLARIZATION & ECUADOR LESSONS
Normally, dollarization can take one of two paths: unilateral dollarization, which can occur without a treaty; or a limited treaty with the U.S. government under which Venezuela could retain some of the seignorage it would otherwise lose from dollarization. The latter would allow Venezuelan banks to gain access to the Federal Reserve System as a source of liquidity. In the interest of reforms taking effect rapidly, Venezuela would be better off choosing unilateral dollarization and forgoing seignorage. Furthermore, the absence of the U.S. Federal Reserve as a lender of last resort is in line with the objective of monetary discipline.
As soon as the government announces its decision to dollarize, the BCV can stop issuing bolívares at any time, and simply call in all bolivar-denominated liabilities and give out the equivalent value in dollars. The ratio of domestic currency liabilities to foreign reserves indicated on the BCV’s April balance sheet suggests an appropriate exchange rate would be as low as 9.55 bolívares per dollar for these transactions (see accompanying spreadsheets), although other considerations, discussed below, suggest a more depreciated rate.
To discourage future governments from reintroducing the bolívar or any other domestic currency, the bolívar should be abolished as legal tender and the BCV’s power to issue currency should be repealed. These are essential measures in Venezuela’s case, given the remarkable history of economic and political manipulation.
More important, if Venezuela truly wishes for successful dollarization, it should look to Ecuador’s experience. Ecuador is similar to Venezuela in many aspects; it is also a Latin American oil exporter, and adopted the Chavismo ideology under the leadership of Rafael Correa. Before dollarization, Ecuador’s now extinct currency, the sucre, was subject to rapid depreciation just like the bolívar. The sucre traded at 6,825 per dollar at the end of 1998, and by the end of 1999 the sucre-dollar rate was 20,243. During the first week of January 2000, the sucre rate soared to 28,000 per dollar. Dollarization on January 9 at 25,000 sucres per dollar created immediate stability and a large positive confidence shock in Ecuador.
As a simple comparison, the table (above, under the photo) shows the comparison between Ecuador and Venezuela’s real GDP, converted into dollars, shortly before and since Ecuador’s dollarization. The difference is staggering
In addition, Ecuador’s inflation rate declined from a high of 96.09 percent in 2000 to an all-time low of 2.41 percent in 2005, and has been steady at single-digit figures ever since. A similar rapid drop in inflation over a span of no more than five years could be achieved in Venezuela, if dollarization is implemented
In addition, it is important to note that Ecuador deliberately chose an undervalued exchange rate of 25,000 per dollar, whereas 20,000 would have been feasible and possibly even 15,000.
A crude estimate of the effect of an exchange rate of 20,000 is that inflation would have been only 80 percent (0.8) as much, giving inflation of approximately 77, 30, 10, and 6 percent, meaning that approximate inflation convergence with the U.S. would have occurred a year earlier, and the price level at the end of the period would have been only 2.68 times the pre-dollarization level.
Therefore, Venezuela should set its dollarization rate based on free market exchange rates, instead of choosing an undervalued rate in order to avoid an inflationary burst. Essentially, it is easier to adjust to a one-shot burst of inflation than to endure the depression that can occur if the exchange rate is too depreciated and have to rely on falling prices to equalize local purchasing power with purchasing power in the rest of the world.
INTEREST RATES, PRIVATIZATION, FISCAL TRANSPARENCY
Another issue is the adjustment of interest rates when converting from the high-inflation bolívar to the low-inflation dollar. Keeping interest rates the same in nominal terms would bankrupt borrowers, since they expect to pay back in depreciating bolívares and not stable dollars. What is needed is an interest rate conversion, or desagio as it has been called in some Latin American cases.
Lifting currency controls is an essential precondition for establishing a currency board system, while with dollarization it ceases to be an issue at all. In contrast, lifting price controls is not a technical prerequisite for the enactment of either monetary reform. However, failure to do so would inevitably compromise the entire reform effort.
Next, as a measure to reduce the costs of goods and services and enhance Venezuela’s competitiveness, state-owned enterprises should be privatized, particularly in the energy sector. The privatization of PdVSA would dramatically increase efficiency, productivity and minimize corruption.
Finally, monetary and fiscal reform must go hand in hand. The Venezuelan government should be subject to a fiscal reform in order to ensure transparency. This is easier said than done.
Ideally, such a fiscal reform would require the government to publish a national set of accounts, which would include a balance sheet of its assets and liabilities and an accrual-based annual operating statement of income and expenses. These financial statements would be required to meet International Accounting Standards and they would be subject to an independent audit.
As mentioned previously, a big advantage of the currency board system is that it imposes fiscal discipline, by eradicating “lender of last resort” activities and central bank credit to the fiscal authorities and state-owned enterprises. This would put an end to the Venezuelan government’s rampant fraud and expenditure.
The monetary reforms of an orthodox currency board system and dollarization both represent efficient and feasible solutions for Venezuela. On the one hand, they address the problem of political intervention and inflation by imposing monetary discipline and rule-based monetary policy. On the other hand, they restore credibility and investor confidence by lowering exchange rate risk and interest rates. Finally, it is necessary to ensure that monetary reforms are accompanied by complementary structural reforms, in order to prevent the collapse of the newly established system. It is up to Venezuela whether to let the bolívar perish, or perish with the bolívar.
María Belén Wu is a junior at Johns Hopkins University double majoring in International Studies and Economics. She wrote this paper during her time as an undergraduate researcher for the Institute of Applied Economics, Global Health, and Study of Business Enterprise. She is a BA/MA candidate with the Johns Hopkins School of Advanced International Studies and will graduate in 2019 with an MA in China Studies and International Finance.
This column is excerpted from “Issues in Venezuelan Monetary and Economic Reform,” a new report from the Studies in Applied Economics, under the general direction of Professor Steve H. Hanke, Co-Director of the Institute for Applied Economics, Global Health and the Study of Business Enterprise (email@example.com).