From Financial Repression to External Distress: The Case of Venezuela

Abstract

Recent work suggests a connection between domestic debt and external default. We examine potential linkages for Venezuela, where the evidence reveals a nexus among domestic debt, financial repression, and external vulnerability. The financial repression tax (as a share of GDP) is similar to OECD economies, in spite of higher debt ratios in the latter. The financial repression “tax rate” is higher in years of exchange controls and legislated interest rate ceilings. We document a link between domestic disequilibrium and a weakening of the net foreign asset position via private capital flight. We suggest these findings are not unique to Venezuela.

KEY WORDS:

• capital flight
• capital and exchange controls
• default
• domestic debt
• external debt
• financial repression
• inflation
• interest rates

Acknowledgments

The authors would like to thank Dany Bahar, Sebastian Bustos, Ricardo Hausmann, and Vincent Reinhart for useful comments and suggestions. We are also grateful to the Executive Committee of the Business Association of Latin American Studies (BALAS) for presenting this article with the Sion Raveed Award during their Annual Conference held in San Juan, Puerto Rico, on March 2015.

Notes

1. See Reinhart, Rogoff, and Savastano (2003) for a discussion of the concept of debt intolerance and an application to a broad array of emerging markets and Bannister and Barrot (2011) for further applications.

2. Besides the presence of “hidden” domestic liabilities, there are other explanations for the debt intolerance phenomenon. Reinhart, Rogoff, and Savastano (2003) emphasize the role of reputation and a history of serial default (countries with a recurring history of adverse credit events cannot digest even what are widely considered as moderate levels of external debt). Catão and Kapur (2006) highlight the role played by macroeconomic volatility in explaining debt intolerance. While volatility increases the need for international borrowing to help smooth domestic consumption, the ability to borrow is constrained by the higher default risk that volatility engenders. Kraay and Nehru (2006) emphasize the role of institutions while Mendoza and Oviedo (2006) argue that the volatility of revenues makes continuous debt servicing more challenging.

3. Reinhart and Rogoff (2009) provided long dated time series on domestic and external public debt; Abbas et al. (2010) and Barrot (2015) have recently expanded this line of research. Also, recent theoretical work has begun to focus on the nexus between domestic debt, sovereign default and, in some instances, inflation (see for instance, Aguiar et al. 2013; D’Erasmo and Mendoza 2013; and Hur, Kondo, and Perri 2013).

4. Reinhart and Belen Sbrancia (2015) arrive at a similar conclusion for inflation-prone Argentina but not for India or South Africa, the other two developing countries in their predominantly advanced-economy sample.

5. Other measures of the financial repression tax have been suggested by Easterly (1989) and Easterly and Schmidt Hebbel, (1994); see also background material to Reinhart and Belen Sbrancia (2015) for a discussion of this literature.

6. The latter escapes the scrutiny of the National Assembly, is shielded from any formal mechanism of accountability, and not included in the official external debt statistics, as reported by the World Bank.

7. VEF refers to the new currency unit introduced by the Venezuelan Central Bank on January 1, 2008 (bolivar fuerte or strong bolivar), equivalent to 1,000 bolivares.

8. See chronology in Appendix I.

9. Cline (1989, 1995) provides a comprehensive analysis of these events.

10. Reinhart and Rogoff (2004) examine this issue for 153 countries over 1946–98 for which they have monthly parallel exchange market data. They conclude the parallel rate is a better predictor of future inflation but also note in the background material that based on their estimates of the over-invoicing of imports and under-invoicing of exports there is considerable cross-country variation.

11. Usually refers to the fact that the interest rate ceilings that usually accompany financial repression need not a priori be binding.

12. See Cruces and Trebesch (2013).

13. Apart from a trivial amount of Carter bonds in the 1970s, the U.S. debt is domestic, whether it is held by residents or nonresidents.

14. Note that this is the consolidated budget constraint for the government, which is obtained by combining the budget constraints of the fiscal and monetary authorities. This budget constraint makes explicit the link between monetary and fiscal policy.

15. It may be also the case that in periods of financial repression the government may have a higher potential to “surprise” via unexpected inflation. This owes to the fact that prices do not fully adjust to supply and demand forces, but rather (at least partially) follow controlled “official price lists” that are adjusted sporadically.

16. Reinhart and Sbrancia (2010, 2015) calculated the effective interest rate as a weighted average based on the actual year-by-year composition of the debt.

17. We have also estimated expected inflation using an ARIMA model for the period 1957–2013. We have reported the “naïve” random walk forecast because a) the Venezuelan economy has gone through large structural changes over these fifty-six years, and therefore parameter instability might be a relevant source of bias, and b) results do not vary significantly, except for the inflation surprise component (Appendix II replicates Table II using ARIMA forecasts).

18. In terms of real ex-post interest rates, these ratios imply a real rate very close to zero during the financial liberalization spells and a real rate average of –8.6 percent during the financial repression eras.

19. It must be remembered that risk characteristics aside, within such a small, illiquid market, these bonds do not support a “liquidity premium” that would make them viable instruments to hold even at anticipated negative real interest rates.

20. Reinhart and Belen Sbrancia (2015).

21. Bloomberg (2014).

22. Effective weighted average yield on national public debt bonds traded in the Caracas Stock Exchange; from January 1999, weighted average yield on national public debt.

23. In the case of Venezuela, government-controlled oil exports dominate. As such, this limits the scope for understating exports.

24. We estimate the quotient to perform this test to correct for the fact that larger economies would register larger absolute errors than smaller ones.

25. We have used the second revision of the Standard International Trade Code statistics (SITC-R2), available up to 2011 at the moment of this writing.

26. As a percentage of GDP at official rate (2.6 percent vs. 1.8 percent), at parallel exchange rate (4.3 percent vs. 1.8 percent), constant 2011 dollars (4,564 vs. 2,050), as a percentage of exports (9.4 percent vs. 7.1 percent), and percentage of imports (15.5 percent vs. 10.7 percent).

27. The cumulative calculation would be much higher. Thus, the magnitude of the haircut on domestic debt is on par with some of the highest calculated during episodes of external debt restructuring, as shown in Cruces and Trebesch (2013).

28. Reinhart, Rogoff, and Savastano (2003) show that more than half of the post-1970 defaults on external debt occurred at debt-to-GDP levels that would have satisfied the Maastricht criteria of 60 percent (for public debt).

29. Reinhart and Rogoff (2009, 2011) present evidence that in several emerging markets (Venezuela was not among these) domestic debt played a bigger role prior to the widespread rise in inflation during the 1970s.