A HISTORICAL PERSPECTIVE: NOTHING'S CHANGED,

C O N F I D E N T I A L SECTION 01 OF 06 CARACAS 001544

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E.O. 12958: DECL: 08/02/2017
TAGS: ECON EFIN EPET VE
SUBJECT: A HISTORICAL PERSPECTIVE: NOTHING'S CHANGED,
EVERYTHING'S CHANGED

REF: A. CARACAS 568

B. CARACAS 930

C. CARACAS 959

D. CARACAS 994

Classified By: Economic Counselor Andrew N. Bowen for reason 1.4(d).

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SUMMARY
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1. (C) In analyzing Venezuela's history of boom and bust
cycles, a series of patterns emerge that offer predictive
value for the end of the current cycle. Links between oil
prices, government spending, inflation, and devaluation are
clearly evident over the past 35 years as oil booms have led
to huge spending increases exceeding the state's revenues.
These expenditures produced increases in the money supply and
inflation, which along with declining revenues from oil
sales, eventually forced the government to devalue, setting
off a stagflationary spiral. Oil production has steadily
fallen from its 3.8mbd peak in 1970 and production up-ticks
have followed large investments (and similarly down-ticks
have followed cut backs on investment) normally associated
with International Oil Company (IOC) participation in the
sector. Given declining production, decreasing investment
(especially following recent nationalizations),and massive
public spending, it is only a matter of time before
Venezuela's history plays itself out once again with
devaluation and subsequent stagflation possible within the
next two years. END SUMMARY.

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FREE MONEY
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2. (C) Venezuela's GDP growth during the past fifty years has
been closely associated with oil income, especially since the
early 1970s when oil prices shot up. Venezuelan professor
and well-known economist Jose Toro Hardy (PROTECT THROUGHOUT)
describes Venezuela's situation from the 1940s until 1983 as
one marked by "continual good luck." World crises conspired
to drive up oil prices every time the GOV began to endanger
its country's fiscal health by profligate spending. World
War II, the Shah's nationalization and overthrow, the Suez
crisis, the Six Day's War, the Libyan nationalizations, the
Yum Kippur War and oil embargo, and the Iranian Revolution,
ensured that oil prices continued on their upward trend,
keeping the GOV relatively in the black. From the end of
WWII until the oil embargo in 1973, oil prices averaged
around USD 2/barrel. In 1971, prices jumped 23 percent.
They rose another 22 percent in 1972, 46 percent in 1973, and
had grown almost 225 percent by the end of 1974.

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FLAPPER GIRLS AND CHAMPAGNE
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3. (SBU) The major spike in oil prices at the beginning of
the 1970s led to massive expenditures under President Carlos
Andres Perez. Much of Venezuela's infrastructure dates to
the period between 1950 and 1980. Real spending grew by 26
percent annually from 1974 through 1977. Per capita GDP more
than doubled during the era (1970-77). Salary growth and the
fixed Bs. 4.3/dollar exchange rate led to many Venezuelan
shopping trips to the United States, where they coined the
phrase, "ta barato, dame dos," or "so cheap, I'll take me
two." The accompanying economic growth led to labor
shortages and productivity decreases as less-skilled laborers
were employed without sufficient training or education. The
windfall oil revenues were not sufficient, however, and the
government began to take on debt. Public external debt grew
from USD 1.2 billion in 1973 to over USD 11 billion by the
end of 1978 (in 1978 the Venezuelan oil basket was USD
13.77/barrel, or 617 percent above its price at the start of
the decade).


4. (SBU) Venezuela's balance of payments experienced a
similar decline, falling from a global surplus of USD 3.9

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billion in 1974 to a global deficit of USD 5.3 billion in

1978. By the end of 1978, the country's foreign debt
exceeded its international reserves, although reserves had
grown almost 400 percent during this period. Government
expenditures resulted in large liquidity increases, which
pushed inflation from an average of 1.6 percent during the
period between 1960 and 1972 to a high of over 10 percent in
the year 1975.

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JUMPING OUT OF SKYSCRAPERS, HAD THEY BOTHERED TO BUILD ANY
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5. (C) Venezuela was saved from a balance of payments crisis
by the increasing price of oil after the fall of the Shah of
Iran in 1979. Oil prices for Venezuelan crude grew to a new
high of USD 38.21 in 1981 (an 1800 percent increase over a
decade earlier). At the same time, the Venezuelan economy
was showing signs of trouble marked by huge budget and
current account deficits, which Toro Hardy attributed to: a
rigid system of price controls, state subsidies, and massive
importation (all of which will sound familiar to present day
Venezuela watchers). By 1983, public external debt had grown
to over USD 27 billion, more than double the country's USD 12
billion in foreign exchange reserves. On February 18, 1983,
"Black Friday," Venezuela instituted currency controls and
partially devalued the currency from Bs. 4.3/dollar to a dual
rate of Bs. 4.3/dollar for preferential items and Bs.
6/dollar for other items. This was the first significant
devaluation in Venezuela's modern history. Among other
effects according to Toro Hardy, the Differential Exchange
System Office, or RECADI, setup in 1983 "transformed itself
into one of the largest sources of corruption ever known in
the history of Venezuela."


6. (SBU) The 1983 devaluation was followed by others, such
that the bolviar today has fallen to Bs. 2150/dollar at the
official exchange rate, Bs. 4200/dollar as of August 1 at the
parallel exchange rate. In his 2005 article "El Capitalismo
Rentistico," economics professor Asdrubal Baptista charts
productivity and real salaries over a period from 1950 to

2002. Productivity had grown by as much as 70 percent from
1950 to 1978, before steadily falling below 1950 levels by

2002. Real salaries per capita grew over 350 percent by the
end of the 1970s, only to have fallen back to 1950 levels in

2002.


7. (SBU) Venezuela experienced another boom in the late 1980s
under President Jaime Lusinchi, despite relatively low oil
prices and stagnant production. This boom, driven by massive
deficit spending, failed to jump-start the economy. The
government's policy of devaluation (from Bs. 7.5/dollar to
Bs. 39.3/dollar at the end of 1988) made it possible to
increase spending (in bolivar terms) throughout this period,
though rising liquidity (almost doubling between 1985 and
1989) and inflation resulted in an economic crisis in 1989.
Having continually postponed austerity measures under
Lusinchi and then Carlos Andres Perez, when the government of
Carlos Andres Perez eventually did accept IMF policy
prescriptions, the measures were harsh and poorly understood
by the population. The direct result of this crisis was the
"Caracazo," a period of massive civil unrest which resulted
in hundreds (if not thousands) of deaths before the military
restored order.

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FEWER DRILLS, MEANS FEWER HOLES, MEANS LESS OIL
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8. (C) While oil prices have by and large had the most
important effect on the Venezuelan economy during the past
half century, oil revenues are equal to price multiplied by
production. Despite some upticks related to IOC investment
in the 1990s, Venezuelan oil production has trended downward
since 1970, when it peaked at 3.8 million barrels/day (mbd).
Contrary to government claims, most experts estimate
Venezuela's current crude production to be approximately
2.4mbd. Oil production is closely related to investment in
the sector, which for the majority of Venezuela's modern

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history has been provided by international oil companies
(IOCs). In a recent presentation to Econoffs, the investment
firm Sequoian (PROTECT THROUGHOUT) charted oil investment and
production levels over the past 50 years. During "open"
periods, IOCs invested heavily in Venezuela, and investment
preceded increases in production by a couple of years. When
the government clamped down on foreign investment, or
nationalized the sector (as it did in 1976),IOC
participation dropped, as did subsequent production levels.


9. (SBU) Rig counts serve as a proxy for measuring the
country's ability to maintain and increase production. The
number of working rigs in Venezuela rose from 30 in 1990 to a
high of 120 at the end of 1997 (during the "apertura
petrolera," or oil opening that the GOV instituted in the
1990s to attract foreign investment during a period of oil
prices below USD 20/barrel). In 1997 oil production also
peaked at 3.5mbd. The campaign and election of Chavez in
1998 scared off investment, and rig counts fell to 58 at the
beginning of 1999, when Chavez took office. As of June 2007,
Baker Hughes estimates that there are 82 working rigs in the
country, well below the number needed to achieve the BRV's
claimed production of 3.1mbd.


10. (SBU) The Central Bank calculates the oil sector as a
percentage of GDP at constant 1997 prices, reflecting mostly
changes in production and investment, rather than changes in
the price of oil. The price of the Venezuelan oil basket has
grown from USD 10.60/barrel in 1998 to USD 67.72/barrel as of
the week ending July 13 (a 539 percent increase). Yet,
according to the Central Bank, the oil sector as a percentage
of GDP has essentially not changed since 1997 (remaining
below 10 percent),demonstrating a lack of investment or
production increases, even during recent years of
historically high oil prices.

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MONEY SUPPLYING THE EXCHANGE RATE
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11. (SBU) Since the Bs. 4.3/dollar exchange rate was broken
in 1983, Venezuela's currency has steadily devalued to Bs.
2150/dollar where it is set officially today. The
implementation of exchange controls in February 2003 made
managing the exchange rate more important as the Finance
Ministry tried to balance the government's needs for spending
with foreign exchange reserves and inflation expectations.
During the 2003-2005 period under Finance Minister Nobrega,
Venezuela steadily devalued every year, always devaluing the
currency such that the new rate was higher than the implicit
rate obtained by dividing the money supply (M2) by foreign
exchange reserves. By keeping the official rate above the
implicit rate, the BRV reduced capital flight and protected
its reserves.


12. (SBU) Venezuela last devalued its currency in March 2005.
Since then, the money supply has grown by 141.8 percent and
accumulated official inflation has been 39.5 percent. FX
reserves covered 140 percent of monetary liquidity in 2004
and only 46 percent as of the end of July 2007. This has
changed the implicit value of the currency from Bs.
1895/dollar in March 2005 to Bs. 4676/dollar as of the end of
July 2007. If one includes outstanding certificates of
deposit (CDs) issued by the Central Bank (BCV) to banks to
reduce monetary liquidity, the implicit rate grows to Bs.
6644/dollar. As of August 1 the unregulated parallel market
rate was Bs. 4400/dollar.

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RUNNING OUT OF STEAM?
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13. (SBU) At the same time that oil prices have remained
relatively high but with production falling, the government
is implementing new policies that will affect its bottom
line. On July 1, Venezuela reduced the Value Added Tax (IVA)
rate to 9 percent, down from 14 percent at the beginning of
the year and exonerated a number of agricultural and food
items from the tax. The economic newsletter Analisis

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Venezuela estimates that the reduction will cost the
government as much as USD 6 billion (at the official Bs.
2150/dollar exchange rate) over the course of the year. This
amount represents over 45 percent of the IVA take estimated
in the 2007 budget. The reduction in tax revenues places
additional burden on oil exports to fund the Venezuelan state
as in 2006 income from IVA represented almost 47 percent of
total (non-oil) tax revenues. Government revenues are
divided almost evenly between non-oil and oil income.


14. (SBU) Recent nationalizations have placed additional
burdens on the state. In taking over the heavy oil strategic
associations, PDVSA has effectively increased its required
capital contributions to the new joint ventures. National
telecom provider CANTV recently announced that it would need
a USD 150 million subsidy from the state in 2007. In 2006,
CANTV paid out USD 340 million in dividends to its private
shareholders.


15. (C) According to IESA Professor Gustavo Garcia (PROTECT
THROUGHOUT),the first quarter 2007 balance of payments data
released by the BCV paints a troubling picture (reftel C).
The 48 percent decline in the current account from Q1 2006 is
due to decreased oil revenue and increased import
consumption, which imply that Venezuela could begin running a
current account deficit in the near future. Such a deficit,
in Garcia's estimation, would necessitate a devaluation once
foreign exchange needs exceed foreign exchange income as was
the case in 1983. Given the continuing rise in imports (up
47 percent in Q1 2007 as compared to Q1 2006),stagnating or
falling income from oil sales, and a current account inflated
by calculations based on PDVSA's fictitious production
numbers, this deficit could occur sooner rather than later,
in Garcia's estimation by the second half of 2007 or early

2008.


16. (C) At the same time, record-high government spending
continues. When off-budget spending by FONDEN, PDVSA, and
other state-owned enterprises is estimated, public sector
spending now approaches 40 percent of GDP. This level
spending is clearly unsustainable, and the BRV and PDVSA have
been taking on debt to cover current expenditures (reftel B).
According to banking sector contacts, PDVSA drew down its
USD 1 billion revolving credit facility arranged by BNP
Paribas in January in a week, and its USD 3.5 billion loan
from JBIC in less than two weeks. While the BRV has
maintained spending levels for the first half of 2007 at end
of 2006 levels (rather than increasing them 20 percent year
on year, as has been the average increase during the past
eight years),increasing inefficiency and corruption are
taking their toll on spending efficacy. Moreover, Chavez
will surely prime the fiscal pump later this year as he
unveils constitutional reforms and other fundamental changes
to the Venezuelan state.

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DEVALUE THIS
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17. (SBU) Both Chavez and Minister of Finance Cabezas have
repeatedly denied plans to devalue the bolivar. Despite
their persistent denials, most analysts expect a devaluation
in 2008 or early 2009 as the BRV needs more bolivars to fund
spending and pressures on foreign exchange reserves force its
hand. For some, the easiest method to devalue is via the
monetary conversion planned for January 1, 2008 (reftel A).
The BRV insists that there will be no change in valuation,
only in denomination (removing three zeroes, so that a new
"bolivar fuerte" is valued at BsF. 2.15/dollar). Should the
BRV not take advantage of the conversion to devalue, it will
nonetheless have to do so at some point due to increasing
costs, decreasing revenues, and decreasing foreign exchange
reserves caused by a negative balance of payments.


18. (SBU) A devaluation would hit the Venezuelan economy hard
as Venezuela's reliance on trade (exporting oil and importing
goods) has effectively resulted in a dollarized economy.
Inflation would shoot up as producers and retailers adjust
their prices based on the new exchange rate, and individual

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Venezuelans see their savings eroding. The hollowed out
domestic industrial base would mean that local producers
could not increase supply to make up for the decrease in
imports as Venezuelans' purchasing power abroad diminishes.
Oil exports today represent around 90 percent of Venezuela's
foreign exchange earnings, up from 70 percent in 1998.


19. (SBU) The monetary conversion law makes it illegal to
round up or raise prices as part of the monetary conversion.
A packaged devaluation with price freezes could make it very
difficult for businesses to stay open, pushing most commerce
into the black market. Some local analysts suspect that the
BRV may institute economy-wide price controls in advance of
the October 1 requirement to express prices in both "old" and
"new" bolivars, as after that date an illegal price increase
would be too obvious. Given the general expectation of a
future price freeze, most businessmen polled by econoff plan
to raise prices in advance of the October deadline, resulting
in large price spikes in August and September, just as
Venezuelans come back from vacation and go back to work and
school.


20. (C) Section contacts almost universally agree that the
BRV will have to devalue within the next 6-18 months, though
there tends to be two schools of thought as to the amount by
which they will devalue. Some expect a 10-20 percent
devaluation as has been the case in recent years, whereas
others argue only a massive devaluation (by as much as 100
percent) would be sufficient to bring the economic indicators
back into alignment. A devaluation to 4.3 BsF./ dollar tied
up in the monetary conversion would have the historical
significance of returning the nominal exchange rate to the
rate seen during Venezuela's glory days of the 1970s. Of
course, in reality it would represent a 1000 percent fall in
the bolivar's value vis a vis the dollar during the past
three decades and kick off an inflationary wave.

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I GET KNOCKED DOWN, BUT I GET UP AGAIN
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21. (C) Toro Hardy is quick to point out that while the
causes of the next economic crisis may be similar to previous
crises, the government's ability to manage a crisis is very
questionable. In a recent issue of Veneconomy, its editor
Robert Bottome notes that, as opposed to 1989, today the
private sector is effectively hollowed out and lacks the
capacity to survive a downturn, let alone ramp up production
to meet domestic need as imports become prohibitively
expensive after devaluation. In addition, it seems unlikely
that Chavez would be willing to take "orthodox" steps to
re-balance the economy in a crisis. In 1989, the IMF bailed
out Venezuela and the government imposed a series of
structural adjustments--the bogeymen of many of Chavez'
attacks. Institutions such as the Central Bank, Fogade (the
Venezuelan FDIC),and Sudeban (the banking regulator) are no
longer autonomous (the BCV may lose its dejure autonomy
during constitutional reforms currently planned) and Econ
contacts have become increasingly skeptical of the capacity
of these entities to deal with a crisis in a calm or
competent manner.

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COMMENT
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22. (C) Devaluation has become unfortunately common in
Venezuela's recent history, however it would nonetheless be a
bitter pill for Venezuelans to swallow. Coupled with
retrograde policies such as a general price freeze, a
devaluation could severely disrupt the distribution/supply
chain, already strained by rolling shortages (reftel D).
Conventional wisdom dictates that inflation and devaluation
hurt the poor the most, though the pervasiveness of both in
Venezuelan history make it hard to judge how Chavez' (mostly
poor) supporters would react. As recently as 1996 inflation
exceeded 100 percent. It is likely that he would lay the
blame on someone else, and could use such an opportunity to
take over productive sectors accused of raising prices or

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hoarding goods that would be sold at a loss, further
destroying the country's productive capacity.


23. (C) Since 1957, the Venezuelan economy has grown on
average at 0.4 percent per year. This dismal picture is in
part a result of the series of oil-fueled booms and busts
that have tended to leave Venezuelans worse off than when
they started. During that time period, the population grew
from 6.6 million to 27 million today. At the same time,
historically Venezuela has been able to increase oil
production when prices fell (often cheating on its OPEC
quota). This ability does not exist today. The foolishness
of the 1970s and 80s, including growing expenditures faster
than revenues, taking on additional debt, increasing state
economic intervention, and under-investment in all economic
sectors took its toll for two decades. The disillusionment
of many Venezuelans with the "punto fijo" system (which
refers to the political system between the end of
dictatorship and Chavez' rise to power, governed by a
supposed 1958 agreement between Venezuela's political parties
to share power) stems from their memories of the 1970s and
disappointment of all that followed (around 75 percent of
Venezuela's population was born after 1970).


24. (C) The virtual unanimity among economists that Venezuela
will eventually have to devalue combined with the variety of
opinions as to when this will occur illustrate the amount of
maneuvering room still available to Chavez. A devaluation
will hurt most Venezuelans by decreasing the value of their
savings and increasing the costs of goods and services, and
it will be very unpopular and lead to rapid inflation.
Whether devaluation is the result or cause of an economic
correction depends on other factors, including the price of
oil, the balance of payments, foreign exchange reserves, and
how long the government postpones the decision to devalue.
At some point, as has been the case during much of
Venezuela's recent history, it will be unavoidable. END
COMMENT.

FRENCH