BRV MOVES TO CONTROL PARALLEL RATE

C O N F I D E N T I A L CARACAS 000376 SIPDIS SIPDIS HQ SOUTHCOM ALSO FOR POLAD TREASURY FOR MMALLOY NSC FOR JSHRIER COMMERCE FOR 4431/MAC/WH/MCAMERON E.O. 12958: DECL: 03/17/2018 TAGS: ECON EFIN VE SUBJECT: BRV MOVES TO CONTROL PARALLEL RATE REF: A. CARACAS 313 ¶B. CARACAS 190 ¶C. 2007 CARACAS 2362 ¶D. 2007 CARACAS 2186 ¶E. 2007 CARACAS 2084 ¶F. 2007 CARACAS 1292 Classified By: Acting Economic Counselor Shawn Flatt for reasons 1.4 (b ) and (d). ¶1. (SBU) Summary: The parallel exchange rate has fallen almost 40 percent since its November 2007 high. The BRV has played a major role in bringing the rate down by selling dollar-denominated debt instruments for bolivars, thus effectively supplying dollars to the parallel market. Given the market's relatively small size, the BRV has the capacity to be the market maker, at least in the short term. The BRV's principal objective in bringing down the parallel rate appears to be reducing inflation. While supplying dollars to the parallel market undoubtedly will absorb liquidity, it is does not address the root causes of inflation, which include high fiscal spending and stagnant productive capacity. Furthermore, the instruments the BRV is using to target the parallel rate introduce their own set of distortions. End summary. -------------- -------------- Selling Debt Instruments to Target the Parallel Rate -------------- -------------- ¶2. (SBU) Thanks in part to a concerted BRV effort, the parallel exchange rate has tumbled almost 40 percent in the last four and a half months, from a high of 6.8 bolivars (Bs) to the dollar on November 1, 2007, to about 4.1 Bs/USD on March 13. Measures the BRV has taken to bring down the parallel rate include local sales in bolivars of dollar-denominated "structured notes" (ref B) and sovereign debt (ref D),as well as steps to reduce liquidity growth (and thus the supply of bolivars with which to buy dollars on the parallel rate; ref A). (Note: Structured notes in this context are products that combine sovereign debt of several Latin American countries acquired by the BRV's National Development Fund (Fonden) in 2005-2006 (ref F). End note.) While these measures have clearly played a major role in bringing down the rate, the BRV cannot take full credit. Other factors have also contributed, such as the defeat of Chavez' proposed constitutional reforms in the December 2 referendum, seasonality (e.g. the need for Bs to pay income tax by March 31),and the continued slide of the dollar. ¶3. (SBU) The resources the BRV has devoted to bringing down the parallel rate are considerable. In November and December the government sold USD 1.6 billion worth of dollar-denominated sovereign debt in bolivars at an implicit exchange rate of roughly 5 Bs/USD. While no official announcement has been made, one press report suggested that the BRV will issue another USD 1.7 billion of dollar-denominated sovereign debt in April (presumably payable in Bs),with further emissions throughout the year. (Note: The same report suggested that the BRV goal was to drive the parallel rate to between 3 and 3.5 Bs/USD. End note.) In recent weeks, the BRV has also reportedly sold at least USD 350 million worth of "structured notes" in bolivars at implicit exchange rates below 4 Bs/USD. Both these sales and the debt issuances alleviate pressure on the parallel rate by supplying dollars to the parallel market. -------------- Comment -------------- ¶4. (SBU) Given its giant oil windfall and the relatively small size of the parallel market, the BRV certainly has the capability to be the market maker by supplying dollars, at least in the short term. (Note: In the late fall of 2007, contacts estimated that the parallel market was roughly USD 30 million per day. End note.) Aside from the obvious irony that the BRV is the major player in a market in which it has decreed any mention of price illegal (ref C),it is unclear that intervening in the parallel market will help the BRV achieve what appears to be its major objective, namely reducing inflation. The BRV apparently reasons that targeting the parallel rate will help control inflation, partly by taking away one reason for merchants to mark up prices (some merchants reportedly use the parallel rate as a "reference price") and partly by absorbing excess liquidity (although the extent to which liquidity will tighten depends on what the BRV and Fonden do with the bolivars they receive). This reasoning has some validity: tightening liquidity should have some impact on inflation. Given entrenched inflationary expectations, an array of microeconomic distortions, stagnant local productive capacity, and pressure for increased fiscal spending in an expected election year, however, few analysts expect 2008 inflation (as measured by the Caracas IPC) to be less than the 2007 figure of 22.5 percent. ¶5. (C) The BRV's efforts to reduce the parallel rate fit into a common pattern: rather than addressing the root causes of an economic problem (in this case, inflation),the BRV often takes steps that simply add additional distortions. The sale of the structured notes provides a perfect example. Fonden acquired the structured notes in part by using dollars transferred from Central Bank reserves. Given that the Central Bank expanded the monetary base when it acquired the reserves (by exchanging them for bolivars),it is another irony that the BRV would then sell the structured notes in an effort to reduce inflationary pressures. Furthermore, the BRV has sold the notes in a completely opaque way that benefits selected banks and intermediaries rather than maximizes return on a public asset. The overall signal to the financial sector is that being the BRV's friend is as profitable as being efficient. We will comment further on the BRV's use of sovereign debt issuances to reduce the parallel rate septel. End comment. DUDDY