Venezuela Parallel Exchange Rate Update

Here we go with the latest in this semi-regular series.

First the main chart, that of the VEF/USD parallel (permuta) exchange rate...

...and as things stand, you need VEF6.49 to buy a dollar on the streets of Caracas today. The recent news has been that Chávez&Co is now studying a new multibanded exchange rate system to take pressure off the official 2.15-to-1 fixed rate. Or put into simple English, as this blog predicted Venezuela is in the process of a currency devaluation. We also predicted that the deval wouldn't happen in the first half of the year, but run the risk of getting Argentines shouting "¿Che, no tenés abuela?"* if we start preening too much.

Anyway, back to the subject in hand. The driving force of the weakness in the VEF (as we've explained many a time) isn't inflation. The cause of inflation is the problem, and that's a monetary thing known as M2, which measures the amount of currency in circulation inside the country. Here's how M2 stands right now..

..with the VEF equivalent of U$101.79Bn sloshing round inside Venezuela. This amount of money is up from under U$90Bn (equivalent) at the beginning of April and explains why Venezuela's inflation rate stays stubbornly in the high 20s to 30% range. Put in the most basic terms, if you add 30% more money to a country there are 30% more pieces of folding paper trying to buy the same amount of goods, which means you'll find you're using 30% more of those folding pieces of paper to buy that thing you want to buy. Just good ol' fashioned supply and demand stuff, ask Adam Smith.

However, the Central Bank keeps a store of wealth that backs up the money in circulation. Called International Currency Reserves, it provides backbone to the fiat system. So if we look at the amount of reserves in Venezuela right now....


....we see they've tucked away U$31.45Bn. This means (and the calculation is pretty straightforward), for every single dollar the Central Bank keeps in reserve, there are 6.96VEF circulating in the country. This gives us our theoretical equilibrium point for the VEF/USD exchange rate.

So right now the rate is lower than the theoretical rate by about half a Bolivar Fuerte. This indicates that the financial brains out there in Venezuela expect good things from the government and its plans to tame the permuta. What IKN can say right now is that if the Vz gov't does devalue (or stealth devalue by adding different exchange bands...it's the same thing, really) the parallel rate will drop further as people see arbitrage value in buying dollars at a lower price and selling them higher. However if the Vz Econ team make a SNAFU of plans and the new devaluation system brings no extra flexibility to the exchange rate, the VEF parallel rate will certainly float back up to 7:1 and probably go higher still.

DYODD.

*"Hey, don't you have a grandmother?", an expression that says " grandmothers kiss you and love you, but it seems like you have to love yourself, so presumably you don't have a grandmother to do all that for you"

Mo' Venezuela currency

Here's a bit of extra to add to the previous post.

I've just been mailed and asked

"What do reserves have to do with the parallel rate? Why does the amount of money in circulation affect the parallel rate?".

Well we've been through this one before as well, but let's do it quickly. What follows is a real world explanation of something economists think is important, thus they normally dress it up in weird jargon and terminology that makes something pretty logical into something inaccessible (by the way, that's one of the reasons I like Krugman's blog; he's never afraid to put things into layman's terms and demystify his field).

In a country with a non-reserve currency (aka soft currency), the money circulating needs some sort of back-up. This is usually done by collecting a whole heap of dollars (or perhaps Euros, or perhaps gold) as reserves.

Imagine this: Say that one day the whole population of a country decides that it doesn't trust its currency any longer and decides to give them back to the people that made them, i.e. the Central Bank. So they form a long queue at the CenBank and the bank people swap the local currency for the reserves they have. In the case of Venezuela, the Central Bank is currently in the position to give out one dollar for every 6.82 Bolivares Fuertes (VEF) that are handed in. So, according to the equation VEF-vs-Dollar that the Central Bank operates inside Venezuela, U$1 should equal VEF6.82.

So after a while, the people waaay back in the queue get to hear that the bank is giving anyone a buck for each 6.82 VEF they hand in. So rather than wait a long long time for the five million or so people in front of them to get served, they start exchanging amongst themselves. And..errr...that's what happens in every exchange house and bank all over the world; people just cut out the hassle of turning up at the central bank and do the exchange thing between themselves.

Back to Venezuela, and this 6.82/1 rate held by the moneymasters (i.e. the CenBank, the people who collect dollars and issue VEF to the country) is currently accurately reflected in the actual permuta (parallel) rate. Normally it will fluctuate higher or lower than the theoretical line. This can be for various reasons, as there are other factors that weigh upon a currency exchange rate such as expectations of events to come, political (in)stability, macroeconomic forecasts of key industries (in the case of Venezuela, that means oil) etc etc. However in the long run the relationship of M2-Currency reserves is never that far out.

Venezuela parallel rate update

About time we checked out the progress of the parallel rate. Here's the main chart....

..showing the recent action, April 2009 to date. And what we see is another case of "not much happening". This morning the ask is at VEF6.82 for a dollar, by the way (much to the chagrin of dumbass doom prophets). But as is our wont, let's check out a couple of the main underlying fundamentals that explain why the permuta VEF is where it is. First the evolution of international currency reserves in Venezuela...

...and please note that this chart (for my own screwy XLS reasons) reads right to left. So right now Venezuela has U$30.69Bn tucked away in its reserves pouch. That's a tidy enough sum. However, the good news about reserves is outweighed by the bad news in the next chart:

As a quick reminder (we've done this one before) "M2" refers to the money in circulation in the country, both in the form of physical bills/coins and the money kept in the banking system (your savings amount desposit total, for example). In other words, M2 is basically "how much money there is in the country".

So in the above chart, we see that M2 has risen from the VEF equivalent of U$88Bn in April to VEF eq U$97Bn in July. People, that's a LOT. This means there's 10% more currency floating round Venezuela than there was just three months ago. M2 growth is acelerating since the last time we looked at it, from around 30% per annum to around 43%. This means that Venezuela will come under further inflationary pressure, sad to say.

But back to the parallel rate for a moment: Right now the rate stands at 6.82/1 and this is backed up by monetary theory. If we divide M2 by reserves and then multiply it by the official exchgne rate to get the VEF equivalent, the answer 6.82 pops, out, which is right on the button at the moment. However as the trend is for M2 to grow faster than reserves, the chances are that the parallel rate with continue higher and break 7 in the months to come.

Venezuelan money supply may be signalling accelerated inflation

This one is slightly wonkier than usual because I'm missing out some theory explanations behind the facts offered (feel free to ask questions if something isn't so clear). However it's hardly Krugman-like and I'm not even worthy to polish the dude's boots, so there's the context.

Here's a chart of Venezuela's M2 money supply (the calculation that measures the amount of national currency in circulation) as registered over the past 12 months.


The move from around the 70 billion Bolivares Fuertes (VEF) level to the present VEF89.07Bn means that M2 has moved up by around than 30% in a year...that's a big jump in any currency (that doesn't have Mugabe ruling its destiny). It also comes as no surprise to econ-wonks to note the way the 30% in M2 growth neatly matches the 30% or so annual inflation rate Venezuela is currently running (making percentage-point assumptions in either direction, so no corrective mails necessary, thanks in advance).

But the thing that's caught my eye is the final uptick move on the right-hand side of that chart. In the week ended Feb 27th, M2 moved up 1.68% (from U$87.6Bn to U$89.07Bn); not only is that a large move in just one week, but it's also atypical for the 'normal pattern' (if such a thing exists) for Venezuela. Over the last three years, M2 has held steady in Venezuela for roughly the first six months of the year, only accelerating when other methods of mopping up excess liquidity have been used up, chief among those being dollar bond emissions (check this Feb '09 post for further details). However, chances are that this year there will be no new dollar bonds coming from the Venezuelan government , mainly due to the lower oil price and ensuing lower revenues at PdVSA.

It remains to be seen whether the weekly uptick at end February is repeated throughout March, but it's certainly one to watch. I for one would definitely not like to see M2 breach the U$90Bn level in the next couple of weeks. Add the fact that last week the Venezuelan government dropped its base interest rate from 13% to 11% and more upwards pressure on money supply is likely. The bottom line is that if the pattern is confirmed and M2 keeps rising quickly at this relatively early time of year, inflation in Venezuela is likely to accelerate even while world prices are dropping. That's not good, people. Not good at all.

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