Venezuela’s Economic Machine, or what life’s like on the scary road to hell.
Today I am going to head down to South America, and more specifically, Venezuela, which has been a wild economic environment as of late. There are serious domestic economic issues in Venezuela, including rampant inflation, and a lack of basic goods like toilet paper and diapers. This is very worrisome, and could easily cause citizens to turn violent if it continues for too long.
But lets start as we always do, by looking at the Economy through “transaction-based” approach, which means at the bottom of everything, an economy is just someone selling something and someone buying something. That is it.
As in all posts, I will look at 3 main factors to determine how the Economic Machine is working:
(1) Productivity Growth
(2) The Long Term Debt Cycle
(3) The Short Term Debt Cycle.
Let’s get started!
Venezuela is the 5th largest economy in Latin America, with the largest proven reserves of oil in the world. Oil accounts for 96% of exports and 12% of GDP. The country needs to pivot away from oil and improve infrastructure, poverty and inequality if it is to compete on a global scale.
To begin our analysis we first look at Venezuela current Annual GDP Growth Rate, which expanded at 6.80% in the 4th quarter of 2013 (most recent data).
For the past 20 years Venezuela has seen an average GDP growth rate of around 0.83%, with an all time high of only 22.0% or so, and an all time low of around -15% or so. Outside the falloff in GDP growth around 2003 and subsequent large growth, the trend line seems to be around 2–3% or so, and I would look for GDP growth to get back in line with those numbers.
One of my key views is that movements in GDP growth are typically due to expansions or contractions in credit. So, to really understand where productivity is going you have to examine the debt cycles.
Recessions/depressions don’t occur because a drop in Productivity, as many economists think. They occur because a drop in demand, and that is largely due to a drop in credit creation.
Additionally, the most important thing to keep in mind is that debt can’t grow forever, because eventually people can no longer afford to service the debt. The debt-service payments grow faster than incomes, and you have defaults. That is how we get cycles.
Lets look at the Long Term Debt cycle to clear up the picture a bit.
2. The Long Term Debt Cycle
Long Term debt cycles typically occur over a period of 50–75 years, and are a result of debts rising faster incomes, until you get to a point where people/countries can no longer afford to service their debts, usually because interest rates are low and can’t go any lower.
We look at the Long Term Debt Cycle because the availability of credit(debt) expands spending beyond income levels. And one person’s spending is another person’s income. So, an increase in credit, increases spending, which increases income levels, which increases spending, which increases demand, which increases production, and as production increases so should income levels.
The above events are what cause the long term debt cycle.
This cycle churns and churns, and the bubble inflates and inflates, and everyone is happy. But this cannot go on forever. Eventually debts grow faster than incomes, and debt service payments become too high and people/countries can’t afford to service that debt. That is when the entire thing comes crashing down, and everything works in reverse.
Knowing where a country is in this process, and where it is likely headed, will give you insights as to how certain assets will perform.
To begin, the below chart shows the Government Debt to GDP in Venezuela at 49.8% of GDP, which is low, but for Venezuela we seem to be nearing a top in Government Debt at these levels, and that is worrisome to me. This suggests that the government may pull back on debt levels, reduce spending and that is not a great sign for future economic growth prospects.
Now, the above chart details debt relative to GDP, but it is more precise to look at the debt service payments, and not high debt levels, because it is the service of the debt that we should concern ourselves with. As long as countries/companies/people can afford to service their debt, the party can continue. The party ends when the debt service payments grow to more than we can borrow.
I would like to examine data on Debt Service Payment levels as a % of income, but I could not find any reliable data for Venezuela on that.
One could consider Interest Rates in Venezuela, which are currently at 19.27%, and has been trending around these levels for the last 5 years or so.
With rates at this level, central bankers have plenty of room to lower rates to increase growth in credit, which ultimately spurs growth in the overall economy. But central banks have recently raise rates to curb inflation, which is out of control and we will look at below. Taking the long term view I think we might be at a low in interest rates, which is hard for me to say. How is 19% a bottom? But for Venezuela it just might be.
Lets switch to Money Supply (M0) in Venezuela, which has ballooned in recent years, and steadily rising for the last 10 years.
With an increase in the money supply you will typically see an increase in purchases, increased incomes, increased demand, and fast economic growth. The only worry of this increase in spending and demand is of course inflation.
Currently, the inflation rate in Venezuela is at a whopping 63.42%, which is a astronomical and crippling to an economy. Looking at the below chart we can see cycles in inflation, and that we are at a high at these levels, which could be good. I would keep on eye on this, obviously, and look for a turn downward in the next couple of quarters.
As well, one can look at the Sovereign Bond yields to get an expectation of inflation in a market. The 10Y remained unchanged at 14.95% in January, but has seen wild swings in the last decade, with a peak of near 1200%. That’s right, 1200%!!!!!
The yield on government debt indicates expectations on inflation and debt repayment. Inflation is typically seen as the primary killer of bond portfolios, as higher inflation typically drives interest rates up, and bond prices down.
Many are predicting that Venezuela is likely headed for a default on its debt. With the lack of basic goods on grocery store shelves like milk and diapers, I think there are serious problems here.
Keep in mind the drop in oil prices, and Venezuela is a net oil exporter, and apparently needs oil at $100 a barrel to balance its external accounts, so with oil nearing $40 the pain looks likely to continue.
However, debt problems typically occur because financial assets are bought at high prices with credit. Let’s look at Venezuela Stock market to get a general picture of where financial assets are currently.
As you can clearly see, Venezuela Stock Market has ballooned in the last few years, and is at a high in the short term cycle, so I would look for the reversal at these levels in stocks. The crash is coming to this stock market!
Another key indicator is how much the Government is spending, as the Government is one of the most important aspects of the economy. If the government is increasing its spending, that will increase demand, increased demand leads to increased incomes, which leads to more spending, and eventually an increase in prices.
As seen above, Government spending in Venezuela has been highly cyclical, and seems to be on an upward trend, and doesn’t show any signs of stopping in 2015. But the spending won’t be enough to save this economy.
Now, the top of the long term debt cycle occurs when 1) debt service payments are high and/or 2) monetary policy doesn’t spur credit growth.
With Debt to GDP high, interest rates high, and inflation out of control, I think we could be somewhere near the long term debt cycle high. But to be honest, I’m just not sure. The main problem here is in the short term cycle I think.
Let’s look at the Short Term Debt Cycle to better understand this economy, as I was able to find more relevant data there.
3. The Short Term Debt Cycle
Short term debt cycles occur when you have 1) spending growing faster than 2) the capacity to produce, which then leads to 3) increases in prices (inflation), and that continues until 4) spending is slowed by tightening monetary policy, and that is when a recession happens.
Recessions typically arise from a contraction in private sector debt growth, which is typically the results of central banks tightening (increasing rates) to stave off inflation. If we work that backwards we see that increasing inflation will drive central banks to tighten, which will slow private sector debt growth and bring about a recession.
So, to begin, we want to examine the growth rate in Consumer Spending (money and credit) and Government spending, and see if total spending is growing faster than the growth rate of the capacity to produce.
Below is a chart showing Consumer Spending, which increased in the 3rd Quarter of 2014 in Venezuela. And over the last 10–15 years we have seen a ballooning here, and I think this is going to head downward over the next few years. Watch for this number to fall off a cliff!
Now, as spending falls that will pull down incomes, decrease demand and the economy slows.
Wage growth in Venezuela has seen steady growth over the last decade or so, which is good for economic growth because as wages increase, so will spending, and one person’s spending is another person’s income, so you see more spending, and more income growth, which pushes economic growth even higher.
Still, this wage growth doesn’t matter, if there are no products to buy at the store.
As well, when discussing the short term debt cycle, we have to examine whether total spending is growing faster than the growth rate of the capacity to produce, because that leads to inflation, until spending is curtailed by tighten monetary policy, which brings about a recession.
To examine production capacity we look at Industrial Production, which increase 0.81% in September of 2013 (the most recent data available).
But as you can see Production typically rebounds to a trendline of around 2–3%, so I would expect this number to improve in 2015, and when it does it has some room to grow, which should push economic growth higher, but not drastically.
To get back to our Short Term Debt Cycle analysis, if spending is growing faster than production we will see price increases, or inflation, which is the killer of economic prosperity. Well, we already have ridiculous inflation, so I think the economic growth prospects are bleak in Venezuela.
Lets pull it all together.
The really worrisome facts for me is the lack of basic goods in store, and the deep depression the country has been in for the last year. Venezuela is headed for a default, and if that happens watch out. Tread lightly here, as there is definitely places to put your money. But there could military coups, wide-spread violence, and a total breakdown of the society in Venezuela if it defaults.
Things are about to get very scary in Venezuela.