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Venezuela's new exchange rate mechanism unlikely to curb price distortions: Moody's

Venezuela's new exchange rate mechanism is unlikely to materially curb relative price distortions in the economy, Moody's Investors Service said in a note Friday (February 27, 2015).

Giving the background, Moody's said: "On 18 February, the central bank of Venezuela (Caa3 stable) notified the country’s banks and exchange houses that they could begin submitting bids to purchase and sell foreign currency under the new Marginal Foreign Exchange System (SIMADI)."

Moody's explained: "The new exchange market is designed to create incentives for economic agents to abandon trading foreign currency in the parallel (illegal) market; its rates will be determined through supply and demand. The launch of SIMADI could give Venezuela’s multi-tiered exchange-rate regime more flexibility. However, the small size of the initial allocation of foreign currency that the government seems willing to move to this market is unlikely to be enough to curtail relative price distortions in Venezuela’s markets or lead to a significant adjustment in Venezuela’s external finances."

Dwindling oil revenues because of lower hydrocarbon prices have been exacerbating hard currency shortages in the country, generating a shortfall in the external payments position, Moody's said. "We expect Venezuela’s 2015 external financing gap to reach almost $40 billion if low oil prices persist through the end of the year," said Moody's.

The analysts said: "The SIMADI mechanism becomes the third official foreign-exchange market operating in the country and replaces the old SICAD II system. The Venezuelan bolivar has been trading in the range of 170-174.5 to the dollar on the new system, compared with 52 per dollar at which it traded on the previous alternative market. The declining availability of hard currency and growing distortions in the country’s exchange markets have led to a sustained increase in the parallel exchange rate to almost VEF190 per dollar.

"The strongest official rate, known as the CENCOEX, remains in place for food and medicine imports at VEF6.30 per dollar. The second rate, the SICAD I, is likely to be progressively adjusted from its current level of VEF12.0 per dollar (see Exhibit 1)."

Finance Minister Marco Torres announced that the public sector would allocate 70% of its dollar sales to the strongest official rate of VEF6.30 per dollar, with the remaining 30% going to the other two markets (see Exhibit 2), Moody's said.

"Based on anecdotal evidence, we estimate that approximately 10% of all dollar trades are conducted on the black market. We believe that the resulting volume of dollars allocated to the new market is likely to remain relatively unchanged from volumes traded under system’s predecessor, and that the relative price distortions from the multiple exchange rates will therefore persist," the analysts wrote.

Although the authorities sought to curb these distortions with the implied devaluation of the third exchange rate, ongoing shortages of basic necessities underpin the authorities’ decision to maintain a heavy allocation of dollar sales at the strongest rate. Most of Venezuela’s consumer goods, including food and medicine, are sold at below-market prices because they are imported with foreign currency bought at the CENCOEX rate. The large gap between the different exchange rates creates incentives for smuggling and diverts resources from their intended use. It also makes it more challenging for the authorities to stem the outflow of hard currency.

The implied devaluation, continued smuggling of subsidized goods out of the country, and persistent shortages will exacerbate inflationary pressures. Moreover, despite the loss of oil revenue, we do not expect the government to restrain expenditures given that legislative elections are upcoming. The restricted public sector’s fiscal deficit in 2015 will therefore deteriorate beyond that of 2014, which we estimate was approximately 15% of GDP. Continued monetization of a large portion of the public sector deficit will contribute to much higher inflation as central bank financing replaces part of the lost oil income. As such, we are adjusting our inflation forecast to 105% from 58.2% for 2015, following the 68.5% increase in 2014.

The adjustment to the exchange rate and lower availability of foreign exchange from decreased oil earnings will also curb import demand, hurting economic activity. Although increased fiscal spending related to the elections will partly offset this dynamic, the economy is likely to contract beyond our initial forecast of 1.5% in 2015. We believe that the contraction is more likely to be in line with that of 2014, and now expect output to narrow by 4% this year. As with most macroeconomic forecasts for Venezuela, our estimate is subject to a high degree of uncertainty due to substantial lags in data and its limited availability.

Despite the stronger contraction and the implied devaluation, the country’s external finances are unlikely to adjust significantly and a large external funding gap is likely to persist. The authorities’ willingness to service debt remains strong, as evidenced by recent asset sales and other financing operations.4 However, a prolonged period of subdued oil prices will intensify the sovereign’s asset depletion in its effort to avoid a credit event, particularly in the fourth quarter of 2015 when over $3.4 billion PDVSA debt comes due (see Exhibits 3 and 4). In the absence of a strong recovery in oil prices, the probability of default will remain elevated through 2016.

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