Venezuela Parallel Exchange Rate Update

I've done a lot of mining posts in the last two days and they're getting boring. So here's the long overdue update on a chunk of macroeconomic commentary that's probably just as boring for all but about eight of you. However I know those eight or so like this subject, so off we go.

First, let's start with the Venezuelan Bolivar Fuerte (VEF) parallel headline rate. As carnaval is in full swing in Caracas there's been no trading this week so far, so the most recent price for the VEF against the dollar is 5.75. We can see from the chart that since the pre-Christmas hike it's stayed on or around that level.

If we look at the next two charts it seems that the above current level is about right, at least for the time being. This one shows the Venezuelan international currency reserves and please make note that this chart (for its own weird reasons) reads from right to left.

The main thing to note is the big recent drop (on the left) back down to the U$30Bn level. That was the withdrawal made by....well, made by Chávez really....to fund social programs going forward. Currency reserves are not a big problem here and the current $30Bn level is more than enough for a country of Venezuela's size and macro wealth.

We've recently had a whole bunch of blog-based Venezuelan 'experts' doing mutual handwringing sessions over that supposedly polemic withdrawal of reserves. These people seem to miss entirely the real point while preaching to their own little choirs. Venezuela's reserves are in good shape, but the next chart shows the problem.

This is the amount of money and quasi-money in circulation (if you like, imagine all the cash bills and all the virtual money stored on digitial and electronic systems in banks...that gives you the broadstroke idea). This money is called M2 by jargon lovers. Here we see that M2 has been increasing very rapidly over the last couple of years. This is a problem, because the money in circulation (in a soft currency country* such as Venezuela, at least) is, in theory at least, backed up by the reserves in the Central Bank. So if we start with every VEF backed up by a dollar but then suddenly double the amount of VEF in circulation and don't add any more reserves, it means that for every dollar there are two VEF and therefore the VEF loses purchasing power. In short, it causes inflation (e.g. you need more bits of paper to buy something worth one US dollar).

That's just a chunkette of very basic monetary theory for you, but the bottom line is; the more VEFs in circulation, the weaker the currency is. And right now if we do the necessary calculation, one US dollar in the Central Bank is covering 6.25 VEF. This explains (to a theoretical extent, at least) why the current parallel rate of VEF5.75 is so much higher than the official VEF2.15/USD1 rate the government does its business at via its CADIVI body.

There are other factors, of course. These things are never as cut and dried as economists would have you believe. Just as one example, with dollar inflation currently dropping worldwide we can expect less inflationary pressure in Venezuela as well. This means that the VEF currency is likely to hold up a bit better than 6.25 and kind of explains the gap between the current sub 6 numbers and the theoretical 6.25 number.

The question going forward for Venezuela is how to stop that money supply from growing even further and weakening its nominal value, because that's the cause of future inflation we're looking at right there (far worse than anything the USA might be about to experience). There are several answers; one is to "take money out of circulation". This can be done by emitting government bonds in foreign currency (presumably dollars) and exchanging those VEF on the street for nice pieces of paper that say the government owes you greenbacks. Fine in theory, but right now with oil so low it's difficult to see where the government can get its hands on enough dollars without tapping reserves. Another way of taking money off the streets is hiking banks' reserve requirement, a fancy way of saying to a bank "you dudes have to keep at least 10%/20%/30% of the VEFs you say you have on your books in your safes and don't let 'em out...or else you're in trouble".

Another possible is, of course, the devaluation that many are expecting. I also expect Venezuela to devalue this year, maybe moving the official rate to 2.9 or even perhaps 3.0 to the dollar. However I don't expect it just now and I've pencilled in the second half of the year if, and only if, oil stays below $65/bbl or so.

We shall see what happens.


*think of it as a currency that people don't like to save in