Venezuela and Hyperinflation – How Long Will They Battle?

April 3, 2019
Editor(s): Matthew Trachevski
Writer(s): Laukik Parulkar, Anthony Wong, Preethika Padmanabhan

Imagine the daily life of a Venezuelan, living with an annual inflation rate of 1,000,000%. At that rate, the price of a cup of coffee doubles in a fortnight. This is what the citizens of Venezuela are facing, according to a recent report from the IMF. The story of how the country went from relative stability to aggressive hyperinflation involves more than just economics; it is a tale of corruption, social unrest, self-serving politics, capital controls, price-fixing, and a global commodity bust.

It is hard to believe, but Venezuela’s economy was once the envy of South America. Blessed with the largest oil reserves in the world, the country had a steady stream of USD revenue and immense per-capita wealth. Then, in 1998, Hugo Chavez came into power. The near decade-long rise in oil prices that followed improved government finances and allowed the socialist regime to increase both spending and borrowing. From subsidies for those on low income, to health services, the government’s spending obligations were high. The introduction of a currency peg, installation of import controls and the nationalisation of industries other than oil, are among the factors that sowed the seeds for the future inflation crisis.

Reliance on imported food and consumer goods increased during the oil price boom. Domestic production decreased after years of added regulations (e.g. price controls) and inefficient operations of nationalised businesses. Since oil accounted for 96% of Venezuela’s exports, the economy took a major hit when the price of crude oil collapsed in 2014. According to the IMF, the Venezuelan economy shrank by 30% from 2013 to 2017, with a fall in real GDP of 18% happening in 2018 alone. Government revenue plummeted along with oil prices, and with fewer US dollars to spend on imports, there became a scarcity of many products.

A shrinking economy caused large fiscal deficits. Having exhausted its foreign reserves and with foreign direct investment from the US steadily declining from $600 billion per year in 2011 to below zero today, the only option for the government to raise money was to issue local currency debt. The more money it printed to fund imports, the more its currency depreciated leading to today’s hyperinflationary scenario.

Explaining Hyperinflation

It is very difficult to arrest hyperinflation once it starts. Even though the government raised the minimum wage five times in 2018, the average person cannot afford to live. To prevent paying more tomorrow, people begin hoarding and stockpiling. This creates shortages, which in turn, causes more hoarding, further perpetuating the cycle. It starts with durable goods such as automobiles and washing machines, and if hyperinflation continues, people begin to hoard perishable goods, like bread, milk and other staple foods. Once these daily supplies become scarce, the economy falls apart.

With cash becoming worthless, people lose their life savings. It is for this reason that senior citizens are the most vulnerable to hyperinflation. Banks and other lenders go bankrupt as their loans lose value, and they run out of cash as people stop making deposits. Hyperinflation sends the value of the currency plummeting in foreign exchange markets and the nation’s importers go out of business as the cost of foreign goods skyrockets. Unemployment rises as companies go bankrupt. Subsequently, government tax revenues fall with it having trouble providing even basic services. The government prints more money to pay its debts, further exacerbating hyperinflation.

This is where Venezuela stands today. It has almost run out of foreign reserves, it has lost access to foreign debt markets, it has fallen out of favour with most other governments due to political corruption, its nationalised economy is horribly inefficient, and its people are literally starving in the streets.

Citizens Fight Back

To protect themselves, Venezuelans started to convert their savings into a more stable currency, like the US dollar. This lowered the value of the Bolivar even further. The government responded by issuing currency controls. It set a fixed exchange rate, to stop the official value of the Bolivar dropping against the US dollar, and made it difficult to get permission to exchange Bolivares into US dollars. The idea was to stabilise the currency by effectively shutting down all currency transactions. Yet, US dollars were still available on the black market. As the crisis deepened, more and more Venezuelans looked to switch their Bolivares into US dollars.

By August 2018 the Venezuelan currency was worth so little that it was more prudent to use cash for toilet paper rather than buy toilet paper. President Maduro tried to end the hyperinflation by devaluing the Bolivar by 95%, removing five zeros off the face value of banknotes, and pegging the Bolivar to the Petro, the state-issued, oil-backed “cryptocurrency” that he had created in early 2018. The new currency, Sovereign Bolivar, failed to have any impact. The Petro was widely regarded as a joke currency, due to the country’s dwindling oil production, which meant that it was hardly going to be a credible anchor. Since there weren’t any drastic monetary and fiscal reforms, hyperinflation simply continued from the new base.

Source: Business Insider, Nov 2018

Halting hyperinflation requires radical monetary reform, accompanied by equally radical economic reforms, to restore business and consumer confidence. As part of the monetary reform, popular economists suggested to either replace the Bolivar with a hard currency such as the U.S. dollar, or to introduce a currency board. In a strict currency board, the currency is pegged to a hard currency and backed 100% or more by reserves denominated in that hard currency. Back in 2009, the Zimbabwe economy was saved from hyperinflation by adopting the U.S. Dollar as its currency. Unfortunately, neither dollarisation nor a currency board are remotely acceptable to Maduro’s socialist government for various vested reasons.

Another workaround for Venezuelans in this dire situation, has been to resort to Bitcoins. Bitcoin trading has exploded in recent months: in early December 2018, Venezuelans traded nearly 1300 BTC in a single week; that is worth US$ 5.1 million. Speculation, fraud, and greed in the cryptocurrency and blockchain industry have overshadowed the real, liberating potential of Satoshi Nakamoto’s invention. However, for people living under authoritarian governments, Bitcoin can be a valuable financial tool as a censorship-resistant medium of exchange through which money is moved in and out of Venezuela, evading both government controls and the high fees imposed by conventional banks. Government censorship is not possible, as bitcoin is not routed through a bank or a third party, but instead arrives into your phone wallet in a peer-to-peer way which helps to preserve the citizens’ savings from devaluation.

It is exciting to think that cryptocurrency could empower the citizens of a failed state, isn’t it? But given President Maduro’s growing authoritarianism, there is consensus that this will not end well. It is simply not credible that he would just stand by and allow Bitcoin to replace the elaborate currency structure that he has created. Although Bitcoin itself is censorship-resistant, access to it is not. It is likely that Maduro would, if necessary, resort to violence and repression to prevent widespread adoption of Bitcoin. Also, adopting Bitcoin as Venezuela’s new currency, or pegging Bolivar to it, is a distant dream. The fact that Maduro created a “cryptocurrency” fully controlled by his government means that this is a non-starter. And for these reasons, although Bitcoin could solve Venezuela’s hyperinflation problem, it most likely won’t.

That, however, does not mean the Venezuelans can’t take matters into their own hands. They don’t need a cryptocurrency, they need a revolution. Venezuela needs a government that can restore stability through economic reforms and commitments to reduce the money supply. The government needs to implement austerity measures and privatisation of state-run companies to reduce its budget deficit and bring back investor confidence. The government must also diversify the economy away from oil, boost economic growth and consequently reduce unemployment and poverty in the country. After Germany in the 1920s and Zimbabwe in the 2000s, the world is curiously watching how long Venezuela will fight the hyperinflation battle and how it will emerge out of it.

References

  1. Amadeo, K. (2019). Hyperinflation, Its Causes and Effects with Examples. Retrieved from https://www.thebalance.com/what-is-hyperinflation-definition-causes-and-examples-3306097
  2. Friesen, G. (2018). The Path To Hyperinflation: What Happened to Venezuela? Retrieved from https://www.forbes.com/sites/garthfriesen/2018/08/07/the-path-to-hyperinflation-what-happened-to-venezuela/#1023fec915e4
  3. Coppola, F. (2018). Why Venezuela’s Hyperinflation Problem Is So Difficult To Solve. Retrieved from https://www.forbes.com/sites/francescoppola/2018/12/31/why-venezuelas-hyperinflation-problem-is-so-difficult-to-solve/#232a986d373c
  4. Carmody, M. (2019). What caused hyperinflation in Venezuela: a rare blend of public ineptitude and private enterprise. Retrieved from https://theconversation.com/what-caused-hyperinflation-in-venezuela-a-rare-blend-of-public-ineptitude-and-private-enterprise-102483
  5. Partington, R. (2018). 14m bolivars for a chicken: Venezuela hyperinflation explained. Retrieved from https://www.theguardian.com/world/2018/aug/20/venezuela-bolivars-hyperinflation-banknotes
  6. O’Brien, M. (2016). Venezuela’s currency is dying. Retrieved from https://www.washingtonpost.com/news/wonk/wp/2016/11/04/venezuelas-currency-isdying/?noredirect=on&utm_term=.a7be7cce253c
  7. Martin, W. (2018). Venezuela’s inflation rate just hit 830,000% – and is likely to keep rising. Retrieved fromhttps://www.businessinsider.com.au/venezuela-inflation-rate-hyperinflation-2018-11?r=US&IR=T

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, its Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Matthew Trachevski
Editor
Laukik Parulkar
Writer

Laukik is a Master of Finance student and a CFA Level 3 candidate. An interest in global economic developments, technological advancements and investment strategies has driven him to pursue a career in asset management. When his head isn’t hidden behind a laptop, he is in the gym doing burpees and mountain climbers!

Anthony Wong
Writer
Preethika Padmanabhan
Writer