In a provocative article published last week by Project Syndicate (Should Venezuela Default?), Venezuelan economists Ricardo Hausmann and Miguel Angel Santos make an interesting argument. They contend that Venezuela cannot meet all of its foreign currency obligations and is already defaulting on some of them. If authorities adopted a set of common-sense policies, they argue, these would include defaulting on the country’s foreign debt and making bondholders bear part of the burden of adjustment.
Default is the economic equivalent of major invasive surgery: an aggressive intervention with high risks and side effects which is only justified when it is indispensable for restoring an economy to health. Default makes sense only when a country is insolvent.
If an economy’s assets and revenue flow do not allow it to continue to pay its debts, you can make a good case that it should not pay some of its creditors at the expense of others.
The problem is that it is very hard to make the case that Venezuela is insolvent. In research carried out at Bank of America, we have estimated the value of the Venezuelan public sector’s net external liabilities after marking down illiquid assets such as Petrocaribe receivables. We conclude that the public sector’s net debtor position – the result of subtracting its external assets from its external liabilities – is no larger than 3.5 per cent of GDP. We also find no evidence that these liabilities are increasing over time nor that the government’s external assets are decreasing, other than as a result of the effect that the decline in international gold prices had on the central bank’s reserves.
Our difference with Hausmann and Santos comes from the fact that they do not build their argument up from an evaluation of the country’s solvency position. Instead, they infer that solvency position from the state’s inability to satisfy the population’s demand for imported goods. If the government has defaulted on its obligation to provide medicines to Venezuelans, they argue, it should also – if only for the sake of moral balance – default on bondholders.
The shortcoming in their argument comes from the idea that the phenomenon of scarcity has anything to do with solvency. The fact that people cannot buy all the dollars or imported goods they want at the current price tells us nothing about how many dollars the government has. It simply tells us that the government is selling these dollars at an artificially low price.
Imagine for a moment that a central bank – any central bank – decided to put up a sign on its front door that said “we sell $10 bills for $1”. Word gets around of the central bank’s Great Dollar Giveaway and throngs of people start massing at its doors. As officials struggle to satisfy people’s demand for dollars, they explore solutions. Maybe they should sell some of those gas stations they bought several years ago. Maybe they should put fingerprint machines at the bank’s entrance to control access. Maybe they should default on the country’s foreign debt.
None of these solutions make sense, because the problem is not a lack of dollars. It is that the government is giving dollars away. No matter how many dollars you provide the central bank with, it won’t be able to keep up with demand. The only way to solve this problem is to change the price of $10 bills… to $10.
But what about all of those people who have spent days and nights at the door of the central bank? Isn’t the government defaulting on them by not selling them the dollars it led them to believe they had a right to?
Judged by that standard, every politician who has ever broken a promise has defaulted. Modern societies recognize that holding elected officials to such a standard would bring public administration to a standstill. That is why we hold our policymakers accountable to the law and the contracts that they explicitly subscribe. On the issue of arrears, Venezuelan law and jurisprudence is extremely clear: the government has an obligation to provide access to foreign exchange to those to which it committed to do so, but can do it at the exchange rate that is valid at the moment at which the foreign exchange is disbursed. In other words, the state has an obligation to sell dollars to those to whom it has promised to, but it has no obligation to give those dollars away.
Venezuela does not need to default. It needs to start charging a realistic price for foreign exchange. It also needs to do the same thing for the other goods and services – such as gasoline and electricity – that it sells for near-zero prices. If Venezuela charged a reasonable price for its foreign exchange, it would cut its budget deficit (which reached 17.2 per cent of GDP last year) by 10 points of GDP; doing away with the gasoline subsidy would reduce it by another 7 points. Defaulting, in contrast, would free up resources for at most 1.5 points of GDP.
But wouldn’t these adjustments be costly for Venezuelans, leading to price increases and declines in living standards? No. Sure, Venezuelans will pay more for imports and gasoline. But they will no longer have a large chunk of their wealth confiscated every year through inflation. Right now, the Great Dollar Giveaway is being paid for by the majority of Venezuelans through a vicious tax on their holdings of local currency. Setting relative prices right would correct that.
This, in a nutshell, is the essence of the problem in a country that has carried out an external adjustment but failed to adjust internal relative prices. As a whole, the economy is not overconsuming. It is simply using a very inefficient and distortive tax called inflation to transfer wealth from some groups of the population to others. If we want to look for a moral contradiction in the government’s economic strategy, it is not in its preference for bondholders over Venezuelans. It is in its inexplicable decision to continue to tax the working and middle classes through inflation while giving away cheap dollars to importers and rent-seekers.
Francisco Rodriguez is chief Andean economist at Bank of America Merrill Lynch. This post is published by permission. Copyright © 2014 Merrill Lynch, Pierce, Fenner & Smith Incorporated.