VENEZUELA'S 2009 ECONOMIC OUTLOOK: GRIM TO DIRE

C O N F I D E N T I A L SECTION 01 OF 04 CARACAS 000087

SIPDIS

HQ SOUTHCOM ALSO FOR POLAD
TREASURY FOR RJARPE
NSC FOR JSHRIER
COMMERCE FOR 4431/MAC/WH/MCAMERON

E.O. 12958: DECL: 01/05/2019
TAGS: ECON EFIN PGOV VE
SUBJECT: VENEZUELA'S 2009 ECONOMIC OUTLOOK: GRIM TO DIRE

Classified By: Economic Counselor Darnall Steuart for reasons 1.4 (b)
and (d).


1. (C) Summary: If oil prices remain at or near current
levels, 2009 will be an extremely difficult year, perhaps
even a crisis year, for the Venezuelan economy. Most
independent analysts expect anemic economic growth or a
slight contraction; inflation at 40 percent or above; a loss
of real purchasing power for almost all Venezuelans;
increased labor unrest and protests; and rolling shortages
resulting from a variety of distortions and other problems.
The Government of the Bolivarian Republic of Venezuela (GBRV)
will have to finance a significant fiscal deficit and manage
a severe external (foreign currency) shock, though it is
likely to defer any visible and unpopular adjustments, such
as increased taxes or a devaluation, until after the
referendum to eliminate presidential term limits that
President Chavez has proposed for early 2009. We believe
many Venezuelans are unprepared for the magnitude of the
economic problems they and their country will face, partly
because the GBRV has to date downplayed the local impact of
the global economic crisis. End summary.

-------------- --------------
2004-2007: Thriving Economy, Unsustainable Model
-------------- --------------


2. (SBU) After suffering a short but painful recession from
2002 to 2003 related to a national strike, Venezuela's
economy rebounded quickly, with real growth of 18, 10, 10,
and 8 percent from 2004 to 2007, respectively. During this
period, rising oil prices allowed the GBRV to spend vast sums
of money. The average price of the Venezuelan oil export
basket rose from USD 33 per barrel to USD 64 from 2004 to
2007 (an increase of 94 percent),and central government
spending rose an astounding 140 percent in nominal terms.
This spending, which included transfers to poor Venezuelans
through social programs known as missions, led to a huge
increase in aggregate demand. At the same time, the private
sector grew increasingly unwilling to make medium or
long-term investments in productive capacity because of
threats to property rights, symbolized by several large-scale
nationalizations and Chavez's proposed constitutional reform
(defeated in a December 2007 referendum). The impressive
economic growth that accompanied the increased demand,
therefore, was concentrated in nontradable sectors and
dependent on continually increasing government spending and
imports.

--------------
2008: The Decline Begins
--------------


3. (SBU) The problems inherent in the GBRV's economic model
became manifest beginning in mid to late 2007. The most
obvious sign of these problems were severe shortages of many
staple goods, which peaked in early 2008. These shortages
were the predictable result of rigid price controls in an
inflationary environment. By relaxing price controls and
subsidizing food imports, the GBRV substantially reduced
these shortages over the course of 2008. Inflation worsened,
however, from 22 percent in 2007 to 31 percent in 2008. If
Venezuela's recent inflation was once primarily a monetary
phenomenon (i.e., resulting from the liquidity increase that
accompanied the GBRV's expansive fiscal policy),it has
converted into a structural problem augmented by
expectations. Local supply is not growing as fast as local
demand, leading to higher prices and greater reliance on
imports.


4. (SBU) Except for the relaxation of some price controls,
economic policies in 2008 only exacerbated underlying
problems. The GBRV further reduced incentives for anything
but short-term private investment by another wave of
announced nationalizations (the major ones still unpaid for),
the decree of 26 laws that diminished property rights and
implemented controversial aspects of the failed
constitutional reform, harassment of private companies by tax
and consumer protection authorities, and other measures such
as the windfall profits tax. Many price controls remain, as
do other distortions such as a fixed and increasingly
overvalued exchange rate, currency controls, and an expensive
gasoline subsidy. Labor regulations, labor unrest,
bureaucracy, corruption, and decaying infrastructure

CARACAS 00000087 002 OF 004


(particularly in electricity and ports) are also
progressively increasing the cost of doing business in
Venezuela. As a result of these factors, real GDP growth
slowed to 5 percent in 2008, again concentrated in
nontradable sectors.

--------------
2009: Oil Price Shock Adds Injury to Insult
--------------


5. (SBU) For an economy that was already faltering during
summer 2008 with oil prices at record highs, the recent
plunge in prices, if it holds, will be devastating. The
Venezuelan basket has dropped from a monthly average high of
USD 129 in July 2008 to USD 32 in December, a decline of 75
percent. Assuming an average price of USD 38 in 2009,
PDVSA's former chief economist estimates PDVSA gross cash
revenue would decline to USD 23 billion in 2009, as compared
to USD 57 billion in 2008 (post estimate). If it occurs,
this decline will deal a critical blow to the Venezuelan
economy in three ways. PDVSA will have much less money
available for investment, social spending, and transfers to
Fonden, the GBRV's national development fund. GBRV revenue,
more than half of which comes from taxes and royalties from
oil activity, will be significantly lower. Finally, the
country's trade surplus will be sharply reduced or - more
likely - turn into a deficit, leaving fewer dollars for
imports and transfers abroad.

--------------
When Will the Money Run Out?
--------------


6. (SBU) Given the likely precipitous decline in PDVSA
revenue, the question of "when the money will run out" has
become a favorite local theme. This question really has two
components. First, the GBRV is expected to run a substantial
primary fiscal deficit of between 4 and 7 percent, according
to analysts' estimates. The second component relates to the
GBRV's external (foreign currency) position, which at
year-end 2008 consisted of USD 43 billion in the BCV's
international reserves and perhaps an additional USD 15 to 20
billion in several quasifiscal funds. (Note: Reserves rose
from USD 38 billion to USD 43 billion in the last two days of
2008, apparently due to large sales of dollars to the BCV by
PDVSA and Fonden, one of the quasifiscal funds. End note.)
Asking when the money will run out is somewhat misleading,
however, as the GBRV can use a variety of policy tools to
reduce or finance its deficit and to prevent the BCV's
reserves from drying up. A more realistic question is what
tools the GBRV can use to stay afloat, and at what political
and economic cost.

--------------
GBRV Policy Options: Pick Your Poison
--------------


7. (SBU) Venezuela's external position cannot be sustained
through 2009 under current patterns. BCV reserves are
largely determined by three components: a regular inflow as
PDVSA sells the BCV some of the dollars it earns; a regular
outflow as the BCV sells dollars for imports and other
purposes authorized by CADIVI, the GBRV's foreign currency
board; and periodic transfers of "excess reserves" from the
BCV to Fonden. In 2008, PDVSA turned over roughly 65 percent
of its export earnings to the BCV (per one analyst's
calculation),and the BCV liquidated about USD 45 billion of
authorized foreign currency requests. Were these patterns to
continue, BCV reserves would be gone by early to mid 2010.
Faced with this reality, the GBRV has no choice but to reduce
CADIVI authorizations (indeed, it already is); it may also
increase the percentage of PDVSA revenue sold to the BCV
and/or draw down quasifiscal funds to import priority items.


8. (SBU) The GBRV has a variety of options to cover the
fiscal deficit. Most analysts expect the GBRV to increase
taxes (specifically by raising the value-added tax rate and
implementing a tax on bank debits); slow down central
government spending on long-term investment and transfers to
state and local governments; issue bolivar-denominated debt
(forcing local banks to buy it, if necessary); draw down
existing bank deposits and quasifiscal funds; and reduce
PDVSA investment spending at home and in Petrocaribe
countries. The government is less likely to devalue the

CARACAS 00000087 003 OF 004


bolivar or sharply reduce social spending. Almost no one
believes the GBRV will cut subsidies to Cuba, raise domestic
gasoline prices, or be able to access international financial
markets (except perhaps for specific PDVSA projects).


9. (C) Each of these options has a political and/or economic
cost. Reducing CADIVI authorizations will have a direct
inflationary impact and probably lead to shortages, as
imports will be reduced or moved to the parallel rate.
Increasing taxes will increase inflation and reduce economic
growth, and issuing local debt and reducing investment
spending and transfers will also have a contractionary
effect. Drawing down existing GBRV bank deposits will cause
liquidity and solvency problems at a number of smaller and
medium-sized banks. As President Chavez weighs his options,
he will likely prioritize short-term political goals above
all else, per his custom. For this reason, no one expects
the GBRV to implement visible and unpopular measures such as
raising taxes or particularly a devaluation before the
proposed referendum. In contrast, there is some evidence the
GBRV is already drawing down its deposits in the financial
sector (with the predicted effects) and investment spending
and transfers to state and local governments are slowing down.

-------------- --------------
Slowing Growth, Rising Inflation, Shortages, Unrest
-------------- --------------


10. (SBU) Most economists were predicting slower growth and
higher inflation for 2009 even when oil prices were
relatively high. The policies the GBRV will be forced to
adopt given low oil prices simply compound these trends.
Assuming an average price of USD 52 per barrel for the
Venezuelan basket, Sintesis Financiera, a respected local
consulting firm, estimates real GDP growth at two percent and
inflation of 40 percent or higher. Others are less sanguine:
ODH, another consulting firm, estimates a contraction of two
percent and inflation between 45 and 50 percent at USD 50 per
barrel. Both firms offer alternate scenarios: the lower the
average oil price, the worse the growth and inflation
outlook. The more imports are restricted at the official
rate, the more likely additional shortages of non-priority
items become, as local manufacturers have trouble getting
needed inputs. All of these factors - slower growth, higher
inflation, and potential shortages - will increase pressure
on the private sector, which has already struggled to contain
labor unrest spurred in part by Chavista unions seeking state
takeover.

-------------- --------------
After the Party Ended: Impact on the Average Venezuelan
-------------- --------------


11. (SBU) 2008 was the year the party ended for most
Venezuelans. Datos, a market research firm, estimates the
real purchasing power of poor Venezuelan families in the "E"
socioeconomic class grew a stunning 181 percent from 2003 to
2007, thanks to government transfers and overall economic
growth. (Note: Sociologists divide Venezuela's population
into five classes; E is the poorest and largest class,
accounting for almost 60 percent of the population. End
note.) In the 12 months ending September 2008, it grew only
five percent. During these 12 months, according to Datos,
the real purchasing power of families in the D and C classes,
which make up almost 40 percent of the population, fell by
approximately 12 percent. For 2009 it is almost a given
that, for the first time in six years, the vast majority of
Venezuelans will find themselves worse off at year end,
possibly significantly worse off.

--------------
Paying the Piper
--------------


12. (SBU) If oil prices stay low into 2010, Venezuela's
economy will almost certainly be in a recession, and
inflation will surge even higher. But it would be wrong to
blame Venezuela's economic woes on low oil prices, just as it
would be wrong to expect higher oil prices would lead to a
meaningful recovery. Rising oil prices from 2003 through the
summer of 2008 allowed the GBRV to mask an array of problems
of increasing gravity, including, as noted above, decaying
infrastructure, a bloated and inefficient bureaucracy
(including at PDVSA),corruption, massive distortions from

CARACAS 00000087 004 OF 004


price and currency controls, and ever-diminishing incentives
to productive private investment. While they have grown
worse, these problems are not unique to Chavez's tenure;
indeed, they have contributed in varying degrees to
Venezuela's economic stagnation since the 1970s. Putting
Venezuela on a long-term path to prosperity will require
addressing these problems and progressively reducing
Venezuela's dependence on oil.

--------------
Comment: Are Venezuelans Prepared?
--------------


13. (C) We believe the majority of Venezuelans are not
prepared for economic problems of the magnitude they are
likely to face in 2009 and 2010. Although opposition media
has featured numerous articles and programs about the
country's economic vulnerability, the GBRV has to date
downplayed the potential impacts of the global economic
crisis on Venezuela. During his annual "state of the nation"
speech on January 13, Chavez boasted Venezuela would not be
affected by the crisis. Despite this bluster, Chavez and his
ministers have hinted at problems. For example, Chavez
stated on another occasion Venezuela would be affected
marginally, but he promised social spending would not be cut
and asserted the government has ample reserves to see it
through the crisis. Even if Chavez and his ministers
understand the gravity of Venezuela's economic situation,
they will not acknowledge it until after the referendum to
eliminate presidential term limits (indeed, the poor economic
outlook is the primary reason Chavez wants the referendum
held as early as possible). As a result, many Venezuelans,
and especially those inclined to support Chavez, do not
anticipate the coming economic problems. According to Datos,
58 percent of people in class E (the socioeconomic class most
supportive of Chavez) think the country is in good shape, in
contrast to only 26 and 18 percent in classes D and C,
respectively. We will discuss the political implications of
Venezuela's likely economic unraveling septel. End comment.

--------------
Background Cables
--------------


14. (SBU) For more background on topics mentioned above,
please see the following cables: nationalizations - 2007
CARACAS 59, 2007 CARACAS 411; 2008 CARACAS 1690;
constitutional reform - 2007 CARACAS 2013; shortages - 2007
CARACAS 2381, 2008 CARACAS 1152; the 26 laws - 2008 CARACAS
1127; increased harassment by SENIAT - 2008 CARACAS 1463; the
windfall profit tax - 2008 CARACAS 559; decaying
infrastructure - 2008 CARACAS 1228 (electricity),2008
CARACAS 1607 (ports); PDVSA finances - 2008 CARACAS 276;
quasifiscal funds - 2008 CARACAS 1554; transfers to state and
local governments - 2008 CARACAS 1453; banks - 2008 CARACAS
556, CARACAS 4; CADIVI - 2008 CARACAS 647, CARACAS 3; term
limits referendum - 2008 CARACAS 1739, CARACAS 80.
CAULFIELD