Bolivar Time Bomb To Keep Ticking, Towards 2014 Devaluation

BMI View: The fundamental dynamics at play in Venezuela's exchange rate continue to deteriorate, with rapidly rising inflation and supply of money contributing to record-weakness on the black market. While another devaluation of the currency is warranted, we expect that authorities will try and hold off for as long as possible, likely until after the elections in December, in order to prevent a political backlash.

We believe that the downside risks to the Venezuelan bolívar fixed exchange rate are on the rise, with fundamental dynamics pushing the black market rate to new lows. While the official exchange rate, currently at VEF6.292/US$, will likely have to be significantly adjusted over the medium term to account for growing imbalances and market distortions, we expect authorities to refrain from devaluing through the remainder of the year , in part in order to avoid a political backlash against the ruling party, with local polls scheduled for December 8.

While our previous forecasts call ed for a currency devaluation in 2015, we now believe that this timeline is changing, with an adjustment now more likely to occur in 2014 . The magnitude of the devaluation is nearly impossible to ascertain due to political dimensions of such a decision - bringing the unit to par with the black market exchange rate would require a devaluation of around 700%, which is extremely unlikely - but for now we are pencilling in an adjustment to VEF9.00/US$ in 2014, implying a decline in value of about 43%. We believe that the risks to this forecast are weighted towards a weaker bolívar.

Pressure Building
Venezuela - Official & Black Market Exchange Rates, VEF/US$

BMI View: The fundamental dynamics at play in Venezuela's exchange rate continue to deteriorate, with rapidly rising inflation and supply of money contributing to record-weakness on the black market. While another devaluation of the currency is warranted, we expect that authorities will try and hold off for as long as possible, likely until after the elections in December, in order to prevent a political backlash.

We believe that the downside risks to the Venezuelan bolívar fixed exchange rate are on the rise, with fundamental dynamics pushing the black market rate to new lows. While the official exchange rate, currently at VEF6.292/US$, will likely have to be significantly adjusted over the medium term to account for growing imbalances and market distortions, we expect authorities to refrain from devaluing through the remainder of the year , in part in order to avoid a political backlash against the ruling party, with local polls scheduled for December 8.

While our previous forecasts call ed for a currency devaluation in 2015, we now believe that this timeline is changing, with an adjustment now more likely to occur in 2014 . The magnitude of the devaluation is nearly impossible to ascertain due to political dimensions of such a decision - bringing the unit to par with the black market exchange rate would require a devaluation of around 700%, which is extremely unlikely - but for now we are pencilling in an adjustment to VEF9.00/US$ in 2014, implying a decline in value of about 43%. We believe that the risks to this forecast are weighted towards a weaker bolívar.

The clearest indication regarding the fundamental weakness of the bolívar is the black market exchange rate, which captures the value of the currency among traders who were unable to secure sufficient foreign currency through the highly restrictive official channels. On the black market, the bolívar was trading at a record VEF42.40/US$ on September 30, compared to an official rate of just VEF6. 292/US$.

Pressure Building
Venezuela - Official & Black Market Exchange Rates, VEF/US$

The huge mismatch between the black market and official exchange rates (now at a ratio of about seven to one) is unsustainable over the long term, particularly since the government's war chest to defend the currency's peg to the dollar is also under p ressure. Foreign reserves stood at US$22.95bn in August, providing just 4.8 months of import cover, the lowest amount of import cover seen in decades.

Sinking Ability To Defend Overvalued Bolívar
Venezuela - Stock Of Foreign Reserves, US$bn

Meanwhile, the government's expansionary fiscal policies, vital to maintaining its bedrock populist appeal, have compelled authorities to keep money supply growth elevated. Both narrow money (M1) and broad money (M2) grew by more than 60% year-on-year (y-o-y) in August, the most recent month for which data are available. This is the most rapid pace of money supply growth seen in the economy since the introduction of the bolívar f uerte at the beginning of 2008, and is a driving force behind the rampant inflation which has seen headline price growth reach the highest levels seen since 1997, coming in at 45.4% y-o-y in August.

Fundamentals Point To Further Weakness
Venezuela - Money Supply & Inflation, % chg y-o-y

Official inflation figures would be even higher were it not for government price controls, which ostensibly hold down the costs of key goods, but in reality create enormous inefficiencies and shortages. The government has blamed the US, 'greedy shopkeepers', and the opposition for the ongoing scarcity of toilet paper, cooking oil, food, and machinery parts , but in reality President Nicolás Maduro administration's own policies are largely to blame . At the end of September, the government took over Manufacturas de Papel, a producer of toilet paper, in order to fulfil 'the state ' s obligation to ensure a steady supply of basic goods for the people', according to the government's price control agency. The government announced it would occupy one of the company's factories for 15 days, and the National Guard would 'safeguard' the building. Clearly authorities are resorting to increasingly drastic measures to cope with the market distortions created by anti-market policies, including the currency peg.

Despite the abundant motivations for a currency devaluation, the government's primary concern is likely that of political blowback . As a result, we expect that Maduro's administration will opt to struggle on under the status quo over the coming months, to avoid the political blowback that another devaluation in the same calendar year would create in the lead-up to the December elections. Nevertheless, we believe fundamental pressures will necessitate an adjustment relatively soon thereafter.

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Sector: Country Risk
Geography: Venezuela
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