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18 March 2016 Venezuela Economics ECONOMICS VENEZUELA Assessing default risks and haircut scenarios A new bout of oil price weakness is raising market skepticism on Venezuela’s chances to remain current on debt servicing We think the risks tilt towards a Venezuela default, though the timing is difficult to assess; we update our forecasts Ramiro Blazquez North Andean Senior Economist HSBC Bank Argentina S.A. [email protected] +54 11 4348 2616 A haircut of international liabilities below the average of other default episodes could still lead to a comfortable debt-to-GDP ratio if there is a restructuring, in our view Venezuela’s economic crisis deepened in 2015. Symptoms of hyperinflation dynamics have already kicked in, in our view. The recent downturn in oil prices and the sluggishness expected for a recovery place Venezuela between a rock and a hard place. We believe that a continuation of current policies will eventually lead to a credit event and that there is little the incumbent administration can do to correct this course. The timing of a default is, however, uncertain. This is because there is no reliable information on the quality of the international FX assets Venezuela claims to own. We cannot rule out the possibility that between now and 2H 2017, Venezuela (sovereign and PdVSA) defaults on its scheduled bonded debt payments. On the back of our base case for a hard landing in Venezuela, we update our economic forecasts, and expect an even deeper recession and sharp rises in inflation forecasts. We look in detail at two scenarios for Venezuela: a hyperinflation scenario (which is our base case) and an orderly adjustment scenario (a risk to our base case). In addition, we find that in the event of a restructuring, on the back of its oil wealth, Venezuela could apply a haircut to its international liabilities below other credit event episodes and still reach a comfortable debt-to-GDP ratio. 1. Summary of forecast revisions GDP growth (% y-o-y) CPI, average (%y-o-y) Consolidated government balance (% GDP) Current account balance (USDbn) Current account balance (%GDP) International FX reserves (USDbn) VEF/USD (eop) VEF/USD (avg) Total public debt (%GDP) ____ 2015e ______ _____ 2016f ______ _____ 2017f _____ New Prev. New Prev. New Prev. -5.7 -8.0 -8.3 -4.8 -11.3 1.5 121.7 145.9 826.8 230.6 2,023 81.3 -18.3 -22.3 -21.0 -6.1 -12.8 -4.5 -18.2 -7.0 -16.8 2.6 -1.7 6.0 -24.9 -6.2 -21.2 2.5 -2.7 5.0 16.4 20.1 7.9 14.0 10.5 19.3 206 130 2,000 343 35,000 400 124 79 878 314 23,250 371 157.6 116.6 132.2 131.6 165.1 73.0 Source: HSBC forecasts Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: HSBC Bank Argentina S.A. View HSBC Global Research at: https://www.research.hsbc.com abc ECONOMICS VENEZUELA 18 March 2016 Default risks dominate The timing of a potential credit event is unpredictable Nevertheless, default could be a game changer; we update our forecasts Haircuts could be below 50% of outstanding liabilities in a restructuring and still produce comfortable debt-to-GDP levels Sinking economy, massive depreciation, but baby steps so far President Maduro’s latest measures to address the severe economic imbalances have kicked in too late, in our view. The authorities recently released economic data that had remained unpublished for a full year although fiscal accounts data remain unpublished (the last update took place in 2011). Official figures estimate GDP growth in 2015 at -5.7% with year-end CPI inflation at 181%. Based on official data running up to 3Q 2015, we calculate the current account deficit at an impressive USD18.2bn (c25% of GDP). The activity and inflation results came in as a surprise as both us and other market participants (according to the consensus of the Bloomberg survey) were anticipating that in 2015, real GDP contraction and inflation had respectively been north of 7% and 200%. IMF authorities were quoted by press reports 1 contradicting the official release, by placing 2015 GDP and CPI at -10% and 275% . It is clear that the economic crisis deepened in 2015, even by official standards. Last year was the second year in a row of recession (GDP had declined 3.9% in 2014) while inflation accelerated (from 68.5% by end-2014). On 17 February, President Maduro announced the first gasoline price increase since President Chávez took office in 1998, from VEF0.097 to VEF6.0 per litre, a massive 6,086% hike. Higher revenues stemming from the difference between the old and the new price will be placed in a fund to support social programs, so the measure will do little to bring relief to a rampant 18.2% of GDP fiscal deficit (our new 2015 forecast). Despite this unparalleled price hike, Venezuelan petrol remains the cheapest in the world. Using our estimate of the underlying exchange rate for the economy excluding public debt payments at VEF206 per USD by 4Q 2015 (table 3), gasoline in Venezuela currently costs less than USD0.03 per liter and below USD0.01 if the conversion is made using the parallel market rate at VEF1,000 per USD. The incentives to continue smuggling gasoline out of the country (which creates losses of up to 1.3% of GDP per year, according to former Vice-President Arreaza) remain in place, since in neighboring Colombia, gasoline costs around USD1 per litre. On the FX front, Maduro simplified the official FX system by eliminating the middle leg of the three-tier system. Following the elimination of Sicad (which was trading at VEF13 per dollar), the henceforth two-tier system will be based on a priority rate for essential imports at VEF10 per dollar (up from VEF6.30) and the SIMADI rate that will start floating within bands in some kind of 1 2 “FMI: Inflación de Venezuela en 2016 será de 500%”, El Nacional, 17 January 2016 abc ECONOMICS VENEZUELA 18 March 2016 2. FX rates and convertibility ratios VEF/USD 1000 VEF/USD 250 800 200 600 150 400 100 200 50 0 0 4Q11 4Q12 Parallel (LHS) 4Q13 M0/Res. 4Q14 M1/Res. 4Q15f HSBC Weighted Avg. FX Source: BCV,Dolartoday, HSBC controlled market. So far, the government has not supplied the full details on the mechanics of the new FX scheme, which is leading to speculation by representatives of private sector guilds (notably, the federation of private companies, Fedecámaras) according to some press 2 releases. Looking back at previous FX overhauls under the Maduro administration, these implementation delays are not good news and could suggest internal dissent about floating the currency among some sectors of Chavismo. In addition, how much fiscal improvement this measure will bring is uncertain since it will depend on the amount of petrodollars PdVSA will be allowed to cash in at the weaker rate. Considering that 74% of total imports, on average, in 2015 were conducted at the VEF6.30 per USD rate, and that they henceforth will likely be traded at VEF10 per dollar, the increase in fiscal revenues would be far from significant, even under official estimates of running inflation. Further, the weaker priority rate does little to cut short the profitability margins of smugglers and arbitrageurs, who can get hold of goods priced at the lower leg to later sell domestically or abroad at the full international dollar price, thus making a profit of more than VEF1,000 per dollar (one hundred times the new priority exchange rate). 3. HSBC estimated average FX rates by market Public Private SITME SICAD SICAD II / SIMADI Cencoex / Cadivi Parallel FX Devaluation 2011 Weight (%) 2012 4.3 32% 4.3 5.7 68% 6.9 5.3 18% 5.3 4.3 9.0 5.2 26% 57% 25% 4.3 15.2 5.7 9% Weight (%) 2013 Weight (%) 2014 Weight (%) 48% 6.3 49% 6.3 46% 52% 14.7 51% 65.1 54% 13% 11.0 9% 12.0 5% 50.0 12% 64% 6.3 76% 6.3 40% 23% 57.5 16% 131.6 43% 10.6 37.8 87% 256% 2015f Weight (%) 6.3 57% 469.7 43% 13.5 199.7 6.3 835.0 206.4 446% 3% 8% 35% 54% Source: HSBC We estimate that the dramatic slide in oil prices in late 2015 led to a massive FX depreciation in Venezuela. According to our calculations, the weighted average exchange rate of the economy (excluding public debt payments) jumped 41% q-o-q in 4Q 2015, to VEF206 per dollar, for a total 446% y-o-y depreciation in 2015. Our estimated average FX rate is no longer proxied by the M0-to-international reserves ratio but it is now bounded from above by the higher M1-to-reserves coverage ratio (figure 2), the ultimate dollarization ratio if bank deposits and money held by the public were converted into cash dollars (time deposits are almost nil due to 2 “Fedecámaras también duda de la flotación del dólar”, El Estimulo, 18 February 2016 3 abc ECONOMICS VENEZUELA 18 March 2016 the very negative real interest rates so there is no substantial difference between M1 and M2). To us, this could be suggesting an increase in the velocity of circulation of money (i.e. a lower real money demand) that could be fuelling inflation. In real terms, the VEF weakened 103% y-oy against the USD in 4Q 2015 (see figure 4). There is no ceiling to the black market rate, in our view, due to the lack of nominal anchors in the Venezuelan economy, the fiscal dominance, and interest rates less than one-tenth the level of inflation. In 2015, the black market rate weakened 381%, according to website Dolartoday, well above the most pessimistic CPI estimates (e.g. the IMF’s), but volumes in the parallel market (USD31m per day in 2015, see figure 5) remained under the USD46.7m daily average of 2010-12. Despite the huge depreciation, parallel market dollar supply failed to pick up further because of (1) unanchored expectations on nominal variables (i.e. inflation and the exchange rate) and (2) shrinking USD allocations to the private sector in the official markets (figure 6) that collapsed 58.1% relative to 2014. Public external purchases experienced a milder setback, with a 15.7% contraction, we calculate. Following the release of detailed balance of payment statistics running up to 3Q 2015, we believe that total imports contracted c22.3% in 2015 mostly on the back of the relative resilience of public imports. This took the current account deficit to USD18.2bn, a daunting 24.9% in terms of GDP if we use HSBC’s weighted average FX to convert nominal GDP into dollars. We highlight that if priority rate imports (public purchases to a large extent) were to adjust further, that might curb the profits of the rent-seeking sectors that are benefitting from the exchange rate differential. From the point of view of optimal policy making, to us it is clear that eliminating distortions would enhance the levels of welfare of the population and/or improve external accounts. Politics could constrain economic developments The opposition coalition MUD, currently controlling the National Assembly with more than two-thirds of total seats, has said publicly that it would start considering legal options to unseat Maduro. The menu of options would include calling for a recall referendum for an early end of the presidential term, shortening the mandate through a constitutional reform, and impeachment. For the Maduro administration, a meaningful fiscal and FX adjustment could entail political costs too high to bear since it would inflict more pain on its support base (i.e. lower income segments) while it could also be opposed by the rent-seeking sectors that have gained influence following the death of former President Chávez on 5 March 2013. Thus, the executive branch is between a rock and a hard place, in our view. No matter which policy Maduro applies (adjusting or upholding the status quo) the political situation going forward looks highly volatile, which is not supportive for the economy. Two scenarios Below, we examine two scenarios for the Venezuelan economy. Based on the previous arguments, our base case scenario is for a hard landing. Under these dynamics, Venezuela, at best, maintains the current very gradualist approach to reforms that do little to bridge the imbalances. This could lead to a credit event either this year or the next, and also to hyperinflation. The timing is unclear given the uncertainty on the market value of the country’s FX savings. 4 abc ECONOMICS VENEZUELA 18 March 2016 Alternatively, the country could implement severe adjustments from 2Q 2016, which we believe would lead to a strong recession this year but would open the door to a market-friendly restructuring, the support of multilateral creditors, and the convergence of inflation dynamics with fiscal dominance easing due to policy design. Several conditions would need to be met for the soft landing scenario to materialize. At the time of this writing, we think that these conditions (possibly including a national unity government and strong commitment to fiscal moderation) are not present, and, therefore, we do not believe this scenario is likely. Based on the factors discussed above, in our view, it cannot be ruled out that Venezuela exhausts its resources and stops servicing its debt at some point between now and 2H 2017, when debt servicing peaks in the short term. We believe that the government is aware of the hefty costs of a default given the size of Venezuela’s attachable overseas assets (e.g. Citgo, PdVSA’s refineries abroad, and even oil shipments) and its strong dependence on imports. The question, in our view, is whether the Chavista authorities will be able to avert a default in case the external FX assets owned by the public sector are of very low quality. We discuss this below. 4. Bilateral real exchange rate with the US 2009=100 500 450 400 350 300 250 200 150 100 50 0 4Q09 4Q10 4Q11 4Q12 4Q13 4Q14 4Q15f Bilateral RER w/USA (avg.2009=100) Source: HSBC 5. Black market volumes and FX USDmn. 120 6. USD traded in official markets VEF/USD 1,000 USD bn. 15 10 80 500 5 40 0 0 2008 2009 2010 2011 2012 2013 2014 2015 Est. daily traded vols. in parallel mkt. Parallel FX rate e-o-p Source: Dolartoday, HSBC 0 4Q11 4Q12 Cencoex Sicad II 4Q13 Sitme Simadi 4Q14 4Q15f Sicad I Total Source: Ecoanalítica, HSBC 5 abc ECONOMICS VENEZUELA 18 March 2016 7. Uses and sources of FX, 2015(e) and 2016(f) 2015 USDbn 2016 _______________________ 2016 _______________________ No ____________________ Break-even _____________________ adjustment 0% M cut 10% M cut 20% M cut 30% M cut 40% M cut FX demand (1) Imports Interest Bonds + loans China Principal Bonds + loans China Other o/w: Services o/w: Current transfers 67.7 36.9 5.8 4.9 0.9 12.2 5.7 6.5 12.8 12.6 0.2 61.6 36.9 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 61.6 36.9 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 57.9 33.2 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 54.2 29.5 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 50.5 25.8 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 46.8 22.1 6.5 5.6 0.9 11.8 5.0 6.8 6.4 6.2 0.2 Cash exports (2) Headline oil exports Volumes (m bpd) Oil price (USD per barrel, VENZ basket) Non-oil exports Non-cash exports 35.8 35.1 2.1 23.8 21.8 1.9 46.7 44.7 1.9 43.0 41.0 1.9 39.3 37.3 1.9 35.6 33.6 1.9 32.0 29.9 1.9 45.1 2.2 1.6 32.1 3.2 1.2 66.0 3.2 1.2 60.5 3.2 1.2 55.1 3.2 1.2 49.6 3.2 1.2 44.2 3.2 1.2 Expected financing (3) Off-budget funds Savings from debt buybacks China Gold reserve Others o/w: Discounted receivable accounts o/w: SDRs funding o/w: CITGO dividends o/w: Gold swap o/w: Arrears with suppliers 27.6 0.7 0.0 10.0 0.0 16.9 3.7 1.3 2.5 1.5 7.9 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 14.9 2.0 0.6 5.0 2.0 5.3 1.0 0.8 1.0 2.5 0.0 4.4 22.9 0.0 0.0 0.0 0.0 0.0 13.5 61.9 0.0 10.0 20.0 30.0 40.0 FX gap after expected financing (4 = 1 - 2 - 3) Memo: Int’l reserves (10 March, USDbn) %age cut in imports for break-even Source: HSBC, BCV, Globalsource Hard times ahead Most oil forecasters (figure 9) do not see the oil price bouncing back fast enough to spare Venezuela from a sharp adjustment (either orderly or disorderly) and an erosion of its hard currency savings. 6 abc ECONOMICS VENEZUELA 18 March 2016 8. Upcoming sovereign and PdVSA debt maturities USDbn 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1Q16 2Q16 Principal 3Q16 4Q16 Interest 1Q17 2Q17 3Q17 Buybacks savings 4Q17 Source: Finance Ministry, PdVSA, HSBC Venezuela faces a demanding debt servicing schedule in the coming months (figure 8), with payments spiking in 4Q 2016 (USD4.3bn for the sovereign and PdVSA combined excluding liability management and rollover from bonds held in PdVSA’s pension fund) and in 2Q 2017 (USD7.3bn). In addition, Venezuela is paying off its debt with China with oil shipments at a pace of USD1.8bn per quarter. As shown in table 7, if the price for the Venezuelan mix were to average USD32 per dollar (USD36.6 per barrel in terms of Brent crude) in 2016, in the absence of any adjustment on FX demand, Venezuela would face an FX gap of USD22.9bn even after tapping expected funding sources amounting to USD14.9bn. This financing would include USD5.0bn from China (we do not expect the Asian country to increase its exposure to Venezuela as the promised increase in oil shipments has so far failed to materialize), the recent agreement with Gold Reserve Co that could supply USD2.0bn, and others (equivalent to scraping the bottom of the barrel), amounting to USD5.3bn. The flipside to examining the FX gap is to find the break-even oil price, which we have estimated at USD66 per dollar in the absence of any further import cuts. However, this oil price level would likely only be achieved several years from now, according to an average of oil price forecasts from different sources (see figure 9). On 29 February 2016, central bank 3 governor Nelson Merentes said that imports would be cut by 40% . Still, to bridge the gap, Venezuela would need an oil price that is almost USD12 higher than our current assumption (table 7) or, alternatively, additional funding sources. Under our USD32per barrel average oil price assumption for 2016, Venezuela would have to cut imports by c62% to bridge the external shortfall. In any case, the magnitude of the required adjustment is such that it is highly unlikely that it could be implemented without major social costs. 3 “Merentes ratificó que el BCV emitirá billetes de 500 y 1.000 bolívares”, El Nacional, 29 February 2016 7 abc ECONOMICS VENEZUELA 18 March 2016 9. Oil price forecasts Oil futures Venezuela basket equivalent (USD/bbl) 140 US EIA OPEC IMF WB Average 120 100 80 60 40 20 '15 '16 '17 '18 '19 '20 '21 '22 '23 '24 '25 '26 '27 '28 '29 '30 '31 '32 '33 '34 '35 '36 '37 '38 '39 '40 Source: HSBC, US EIA, OPEC, IMF, World Bank, Bloomberg On the other hand, if Venezuela had foreign currency savings on top of its meager international reserves stock below USD14bn (4.5 months of imports), then it might be able to muddle through in the short run. Central bank statistics place the amount of hard currency securities – stocks, bonds, loans – and unidentified hard currency savings, at USD69.1bn at 3Q 2015 (figure 10). However, authorities have been reluctant to supply more details as to the composition and liquidity of these savings. We believe that by providing evidence on the quality of these holdings, Venezuela might have helped to lower risk premiums and could have issued debt at reasonable rates so as to smooth out the transition. However, communication remains poor on this front, which has not helped to alleviate the general view among market participants that such savings could be highly illiquid, with very low actual market value. 10. Non-reserve FX assets USDbn. 90 80 70 60 50 40 30 20 10 0 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 Stocks Debt instruments Commercial credit Loans Money and deposits Others Source: BCV Hyperinflation dynamics and debt default We present two different scenarios through 2H 2017: one, our base case scenario, featuring a hard landing; the other an orderly adjustment. We have argued previously that a hard landing is our base case since we do not believe that current or future political conditions will be conducive to an orderly (and painful) adjustment of the economy. In a hard landing (our base base), the government would be unable to rein in fiscal dominance, so that eventually, hyperinflation dynamics would kick in. According to data provided by economists Reinhart and Savastano (2003), the trajectory of Venezuela’s 8 abc ECONOMICS VENEZUELA 18 March 2016 CPI, fiscal deficit, and black market rate premium in recent years is consistent with the run-up of recent hyperinflation episodes (see tables 11, 12, and 13); therefore, we think it is reasonable to expect a similar outcome if the economy deteriorates further. We estimate that GDP will contract 8.3% and 11.3%, respectively, in 2016 and 2017, with average inflation accelerating from c827% to c2,023%. We classify this as a hyperinflation episode following 4 economist Philip Cagan’s classic definition that was published in 1956 , with monthly inflation exceeding 50% by late 2016. In addition, the ensuing sharp real depreciation, combined with the economic depression we would expect, would drive the dollar GDP to cUSD62bn, down 80% from 2012 levels, reaching one of the lowest historical marks (see table 11). In real terms, the economy would shrink an accumulated 19% by end-2017 relative to 2015. Ironically, a hard landing could entail an even sharper adjustment compared to the alternative of a front-loaded attack on imbalances, despite the acute pain that might immediately follow. 11. Average annual inflation rates (%) in recent hyperinflation events Argentina (1989-90) Bolivia (1984-85) Brazil (1989-90) Peru (1990) Ukraine (1991-94) Average Venezuela (2017) (Default scenario) t-3 90.1 32.1 147.1 86.3 n.a. 88.9 62.2 t-2 131.3 123.5 228.3 667.3 2.1 230.5 121.7 t-1 343.0 275.6 629.1 3,398.5 4.2 930.1 826.8 t (hyper) 2,697.0 6,515.5 2,189.2 7,485.8 1,613.7 4100.2 2,022.6 t+1 171.7 276.3 477.4 409.5 376.4 342.3 t+2 24.9 14.6 1022.5 73.5 80.2 243.1 t+3 10.6 16.0 1927.4 48.6 15.9 403.7 t+1 1.7 2.5 27.2 1.4 8.7 8.3 t+2 -0.4 7.4 44.2 2.6 4.9 11.7 t+3 0.2 5.7 58.1 2.7 3.2 14.0 Source: Reinhart and Savastano (2003), HSBC 12. Fiscal deficit (% of GDP) in recent hyperinflation events Argentina (1989-90) Bolivia (1984-85) Brazil (1989-90) Peru (1990) Ukraine (1991-94) Average Venezuela (2017) (default scenario) t-3 4.2 7.8 11.3 9.0 n.a 8.1 21.2 t-2 6.7 14.7 32.3 6.4 n.a 15.0 18.3 t-1 8.6 19.1 53.0 7.2 n.a 22.0 21.0 t (hyper) 4.9 16.7 56.3 7.4 14.1 19.9 12.8 Source: Reinhart and Savastano (2003), HSBC 13. Average parallel market premium (%) in recent hyperinflation events Argentina (1989-90) Bolivia (1984-85) Brazil (1989-90) Peru (1990) Ukraine (1991-94) Average Venezuela (2017) (default scenario) t-3 66.7 54 111.5 278.8 n.a. 127.8 1,339.9 t (hyper) 67.7 119.1 102.3 32.7 n.a. 80.5 t+3 10.9 7.3 18.1 6.4 11.1 10.8 Source: Reinhart and Savastano (2003), HSBC 4 Following Cagan, a hyperinflation episode would begin in the month when the rise in prices exceeds 50% and would end the month before the monthly rise in prices drops below that rate and stays below it for at least a year. For more on this, please see Cagan, Philip, 1956, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money, ed. by Milton Friedman (Chicago: University of Chicago Press), pgs 25–117. 9 abc ECONOMICS VENEZUELA 18 March 2016 14. Hard and soft landing scenarios for 2016 and 2017 2009 2010 2011 2012 2013 2014 2015f 2016 no default 2016 default 2017 no default 2017 default Real GDP Nom GDP % y-o-y USDbn -3.2 195.3 -1.5 256.0 4.2 271.7 5.6 316.8 1.3 247.3 -3.9 185.1 -5.7 72.8 -11.6 70.3 -8.3 79.5 0.5 85.5 -11.3 62.3 Fiscal def % of GDP -8.7 -10.4 -11.6 -17.5 -16.9 -21.2 -18.3 -8.0 -21.0 -4.3 -12.8 ___ Inflation _____ _____FX rate _____ Avg. eop Avg. eop 25% 27% 3.8 3.6 27% 28% 4.1 4.0 28% 26% 5.2 5.0 20% 21% 5.7 5.2 56% 41% 10.6 10.2 69% 62% 37.8 22.0 181% 122% 206.4 124.2 259% 341% 600 460.0 1,785% 827% 2,000 877.5 49% 66% 580 632.5 930% 2,023% 35,000 23,250 Curr acct deficit _ USDbn % of GDP 0.4 0.2 5.6 2.2 16.3 6.0 2.6 0.8 4.6 1.9 3.6 1.9 -18.2 -24.9 -10.3 -14.6 -16.8 -21.2 -5.2 -6.1 -1.7 -2.7 Reserves Total pub debt USDbn % of GDP 35.8 38.8 30.3 36.7 29.9 48.1 29.9 49.0 21.5 59.5 22.1 70.8 16.4 157.6 13.2 148.6 7.9 132.2 17.1 71.4 10.5 165.1 Bilateral RER Avg % chg 100.0 13.6 86.9 -13.1 89.8 3.3 77.8 -13.4 111.4 43.1 146.1 31.2 364.2 149.3 321.7 -11.7 294.7 -19.1 277.2 -13.8 352.3 19.5 Source: HSBC An orderly adjustment (soft landing) would command an unprecedented fiscal adjustment since we consider this would be a necessary condition for Venezuela to implement a marketfriendly restructuring and start normalizing its economy. The manoeuvring room for Venezuela to implement shock policies would be very low right now, due to the extraordinary magnitude of its imbalances and the lack of collaboration between the different branches of government. Even if the concerns on the liquidity of FX savings are overstated, credibility would only come after the country has given proof of its commitment towards healthier policies. Hence, we estimate that in this scenario, real GDP would fall 11.6% in 2016. The fiscal deficit would decline by 10ppt of GDP to 8%, similar to the current account deficit, which we estimate would sink to 14.6% from 24.9% of GDP in 2015. This being said, we estimate that by 2H 2017, activity could improve and that the negative statistical carryover from 2016 could be overcome, as the economy regains access to external funding and Venezuelans repatriate some of the overseas savings, which the central bank estimated at USD160.2bn at 3Q 2015. Thus, we would expect GDP to interrupt its freefall and post positive growth of 0.5% in 2017. It is worth mentioning that notwithstanding a deeper contraction in 2016, the orderly adjustment would lead to a shallower activity cost compared to the hard landing case, according to our calculations. Also, Venezuela would be able to maintain a higher current account deficit, although the flipside to this would be much more severe fiscal discipline (see a comparison of both scenarios in table 14). By end-2017, we would expect dollar GDP to also be significantly higher in a soft landing. Noteworthy are the differences in the behavior of the inflation and real exchange rates in both scenarios. We factor in hyperinflation dynamics only in the case of a hard landing: year-on-year inflation would peak at almost 3,600% by mid-2017, we estimate. We believe that conditions for a regime change could emerge after an outbreak of hyperinflation and that by end2017, annual inflation could decline to below the 1,000% threshold. Despite this, we acknowledge there are material upside risks to this inflation projection, depending on how fast money demand can recover. Conversely, in an orderly adjustment scenario, we believe that once expectations become anchored and fiscal dominance is reined in, inflation could drop below 50% by end-2017, although the speed of disinflation could ultimately depend on the type of stabilization plan put into place (see Venezuela Economics – Growing strains: a gloomier macro outlook with default more likely in 2016, 2 June 2015). Importantly, hyperinflation (according to Cagan’s definition) would not kick in, in this orderly adjustment scenario, assuming of course that market participants find policies credible enough. 10 abc ECONOMICS VENEZUELA 18 March 2016 Regarding the real bilateral exchange rate with the US, after peaking in 4Q 2015, in a default trajectory, it is likely that the government attempts to anchor the nominal exchange rate to control inflation in the short term. In this scenario, capital controls remain in place, as well as the segmentation of the official FX markets and the existence of a subsidized exchange rate. Importantly, we are not modeling the exchange rate framework as there are multiple shapes that this could take. In this regard, we have to consider that as table 3 shows, in the last few years, the average level of the currency has weakened by diverting more dollar demand to the parallel market, instead of allowing for a more expensive dollar in the official markets. Eventually, we believe that the attempt to anchor the FX rate would be followed by a new and abrupt real devaluation triggered by a credit event and the exhaustion of dollar savings. An orderly adjustment could feature a RER appreciation once the government ends the restructuring efforts and uncertainty on debt servicing eases (figure 16). We think that for the orderly adjustment to take place, capital controls would have to be eventually removed and that it would also be necessary to eliminate the multiple exchange rates that foster distortions and arbitrage opportunities. 15. Inflation scenarios % y-o-y 3500 3000 2500 2000 1500 1000 500 0 4Q11 2Q12 4Q12 2Q13 4Q13 2Q14 Inflation EOP (% y-o-y) 4Q14 2Q15f 4Q15f 2Q16f Default Scenario 4Q16f 2Q17f 4Q17f No Default Scenario Source: BCV, HSBC 16. Bilateral RER with US in both scenarios 450 400 350 300 250 200 150 100 50 4Q11 2Q12 4Q12 2Q13 4Q13 Bilateral RER w/USA (avg.2009=100) 2Q14 4Q14 2Q15f 4Q15f Default Scenario 2Q16f 4Q16f 2Q17f 4Q17f No Default Scenario Source: HSBC 11 abc ECONOMICS VENEZUELA 18 March 2016 Haircut scenarios To set out these different scenarios, we rely on a simple concept often used to evaluate “haircuts” by financial market participants, namely, to compare the market value of the new debt and cash received to the sum of the outstanding face value of the old debt and past due interest. We note that economists Sturzenegger and Zettelmeyer (2005) also discuss an alternative definition, but we prefer to stick with their traditional one. Sturzenegger and Zettelmeyer provide hard evidence on local and international debt restructurings and ensuing haircuts in recent times. Under the traditional definition above, the average haircut for external debt restructurings has been 48.3% of outstanding face value, with a median of 51% (see table 17). The case of Uruguay (2003) stands out as a possible outlier due to its very low haircut compared to other renegotiation experiences. 17. Historical evidence of haircuts in sovereign debt (%, traditional definition) Haircut Russia (1999-2000) GKO/OFZ non-residents MinFin3 PRINs/IANs Average Ukraine (1998-2000) OVDPs non-residents Chase loan ING loan International bonds Average Pakistan (1999) Eurobonds Ecuador (2000) International bonds Argentina (2005) 2005 international Uruguay (2003) External Average Median Std deviation Minimum Maximum 61.5 61.0 69.2 63.9 59.2 30.7 38.0 40.1 42 30.4 60.0 67.0 26.2 48.3 51.0 17.8 26.2 67.0 Source: Sturzenegger and Zettelmeyer (2005), HSBC In table 18, we present different haircut scenarios and how these would impact the debt-to-GDP ratio of Venezuela, a standard metric in terms of assessing the burden of a country’s liabilities relative to its income (although not of its wealth). During financial distress episodes, the real exchange rate typically overshoots, which could lead to an artificially low dollar GDP compared to the country’s underlying potential dollar output. Hence, we acknowledge this by depicting the different values that debt to GDP could assume with different dollar income levels: (1) our 2017 nominal dollar GDP forecast, (2) 2017 GDP using the level of the real exchange rate in 2009 when the Venezuelan basket averaged USD56 per barrel and there was a much lower perception of political risk, and (3) the level of 2004 dollar GDP (when the oil price stood at USD33.9 per barrel) in terms of 2017 dollars. Applying a 67% haircut on Venezuelan debt à la Argentina would produce a debt-to-GDP ratio of 74.6%. While this is a high level, it is necessary to take into account that an undervalued currency would be producing an artificially low dollar GDP. In the case of the updated 2004 nominal GDP level, the debt-to-GDP ratio would be only 31.1% with an Argentina-type restructuring. Instead, a 48.3% haircut, in line with the average of past experiences, would yield a 100.4% debt-to-GDP ratio under our 2017 forecast and a very manageable 41.4% under the 2004 12 abc ECONOMICS VENEZUELA 18 March 2016 nominal USD GDP. Therefore, judging by table 18 and figure 19, we conclude that a haircut of outstanding external liabilities of the sovereign and PdVSA combined that would be consistent with a debt-to-GDP ratio in the vicinity of 50% once the exchange rate reaches a fair value, could be below 50%. If the real exchange rate were to converge to 2009 levels (a nominal USD GDP equivalent to USD237bn in 2017 dollars), then a haircut similar to the Uruguayan episode would lead to a debt burden of only 36% of GDP. 18. Haircut scenarios Min H (Uruguay) 26.2 130.8 36.1 53.6 2017 nominal USD GDP (f) 2017 GDP (using 2009 RER) 2004 GDP (2017 dollars) Avg H 48.3 100.4 28.1 41.4 Max H (Argentina) 67.0 74.6 21.4 31.1 Source: Sturzenegger and Zettelmeyer (2005), HSBC 19. Debt-to-GDP ratio in different haircut scenarios % of GDP 200 175 150 125 100 75 50 25 0 0 10 20 30 2017 GDP (forecast) 40 50 % of Haircut 60 2017 GDP (using 2009 RER) 70 80 90 100 2004 GDP (2017 dollars) Source: HSBC 20. Old vs new estimates Previous VEF/USD average VEF/USD end-year Nominal GDP (USDbn) Current account balance (% GDP) Total public debt (%GDP) Int’l FX reserves (USDbn) Current VEF/USD average VEF/USD end-year Nominal GDP (USDbn) Current account bal (% GDP) Total public debt (%GDP) Int’l FX reserves (USDbn) 2012 5.2 5.8 316.4 3.5 49.0 29.9 2012 5.2 5.7 316.8 0.8 49.0 29.9 2013 10.3 11.1 244.9 2.2 61.5 21.5 2013 10.2 10.6 247.3 1.9 59.5 21.5 2014 23.1 40.0 178.4 2.9 83.0 22.1 2014 22.0 37.8 185.1 1.9 70.8 22.1 2015f 79.5 130.5 113.8 -6.2 116.6 20.1 2015f 124.2 206.4 72.8 -24.9 157.6 16.4 2016f 314.4 342.5 103.4 2.5 131.6 14.0 2016f 878 2,000 79.5 -21.2 132.2 7.9 2017f 371.3 400.0 120.0 5.0 73.0 19.3 2017f 23,250 35,000 62.3 -2.7 165.1 10.5 Source: HSBC, BCV, Finance Ministry 13 abc ECONOMICS VENEZUELA 18 March 2016 Conclusion Despite the hefty costs associated with a credit event, and given that the government would have internalized these, a default in the near term cannot be ruled out because of: (1) uncertainty on the market value of FX holdings, (2) unpredictable political events in a highly polarized society, with the opposition seeking to unseat the incumbent president, (3) the government’s inability to implement an aggressive reform agenda, which might dry up FX savings, even if fears about these savings’ true market value have been overstated. Venezuela will have to choose between the lesser of two evils: (1) a painful and socially costly adjustment, or (2) to maintain current policies, which we believe will eventually lead to a collapse. Given the country’s vast oil wealth (owning the largest proven recoverable oil reservoirs in the world), Venezuela might be able to withstand a lower-than-average haircut of its liabilities compared to previous international episodes. The immense oil resources of Venezuela support our view that dollar GDP could undershoot under distress conditions, but once expectations improve, a significant rebound could be expected, thus enhancing the country’s debt servicing ability. 21. Main economic forecasts for Venezuela GDP growth (% y-o-y) CPI (% y-o-y) Current account balance (% GDP) Consol gov’t balance (% GDP) Int’l FX reserves (USDbn) VEF/USD end-year 2008 5.3 31.9 11.5 -3.5 43.1 2.7 2009 -3.2 25.1 0.2 -8.7 35.8 3.8 2010 -1.5 27.2 2.2 -10.4 30.3 4.1 2011 4.2 27.6 6.0 -11.6 29.9 5.2 2012 5.6 20.1 0.8 -17.5 29.9 5.7 2013 1.3 56.2 1.9 -16.9 21.5 10.6 2014 -3.9 68.5 1.9 -21.2 22.1 37.8 2015f -5.7 180.9 -24.9 -18.3 16.4 206.4 2016f -8.3 1784.9 -21.2 -21.0 7.9 2000.0 2017f -11.3 929.7 -2.7 -12.8 10.5 35000.0 Source: HSBC, BCV, INE On the other hand, the destruction of physical and human capital over the past few years will be a formidable challenge for authorities going forward, particularly if oil prices surprise to the upside, and the real exchange rate once again becomes undervalued. Venezuela’s oil bonanza critically damaged non-oil industries to the point that non-oil exports sunk to an all-time low, while enhancing the country’s dependence on imported manufactures and foodstuffs. Paradoxically, oil has been, at the same time, Venezuela’s closet friend and enemy. References Calvo, Guillermo A., Alejandro Izquierdo and Ernesto Talvi, Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises, NBER Working Paper No12101 Fischer, Stanley, Ratna Sahay and Carlos A. Vegh, 2002. “Modern Hyper and high inflations” Journal of Economic Literature, volume 40 (September), pgs837-880 Sturzenegger, Federico, and Jeromin Zettelmeyer, 2005. “Haircuts: Estimating investors’ losses in sovereign debt restructurings 1998-2005,” IMF Working Papers n5/137 Reinhart, Carmen and Savastano, Miguel, 2003 “The realities of modern hyperinflation”, Finance and Development, June 2003, pgs20-23 Sargent, Thomas J., 1982, “The end of four big inflations” in Inflation: Causes and consequences, ed by Robert E. Hall (Chicago: University of Chicago Press), pgs41-97 14 ECONOMICS VENEZUELA 18 March 2016 abc Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Ramiro Blazquez Important Disclosures This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. 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MICA (P) 073/06/2015 and MICA (P) 021/01/2016 [503353] 16 abc Americas Research Team Americas Research Management Global Equity Strategy Head of Research, Americas Ben Laidler Global Equity Sector Head Ben Laidler Yevgeniy Shelkovskiy 1 212 525 3460 Research Marketing, Americas Shora Haydari Guillermo Berger 1 212 525 3335 1 212 525 7653 Global Management Global Head of Research David May 852 2996 6573 Patrick Boucher 1 212 525 7632 Economics Janet Henry 44 20 7991 6711 Fixed Income Steven Major 44 20 7991 5980 1 212 525 3460 1 212 525 3035 Botir Sharipov, CFA (Precious Metals) Leonardo Shinohara Osmar Camilo LatAm Equity Strategy Oil & Gas, Petrochemicals LatAm Luiz F Carvalho Filipe M Gouveia Ivan Enriquez Andre C Carvalho Equity Product Management Metals & Mining 55 11 3371 8190 Brazil Andre C Carvalho Marina F Valle 55 11 3371 8190 55 11 3371 8191 Mexico Jaime Aguilera 52 55 5721 2379 Southern Cone & Andean Francisco J Schumacher, CFA 1 212 525 4430 Kevin R Gonzalez 1 212 525 4394 1 212 525 5150 55 11 8747 5433 55 11 3847 9502 55 11 3371 8178 55 11 3847 5451 52 55 5721 2397 Pulp & Paper Jonathan Brandt, CFA Botir Sharipov, CFA 1 212 525 4499 1 212 525 5150 Real Estate Jonathan Brandt, CFA Ivan Enriquez Fred Mendes, CFA Victor Tapia 1 212 525 4499 52 55 5721 2397 55 11 3847 5436 55 11 3847 5317 Currency Strategy David Bloom 44 20 7991 5969 Emerging Markets Multi Asset Strategy Murat Ulgen Bertrand J. 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