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Crisis!

The often overlooked backdrop to Venezuela's political upheaval is an economic disaster.

The often overlooked backdrop to Venezuela's political upheaval is an economic disaster.

By Jake Keaveny
July 2002
Institutional Investor Magazine

Hugo Chávez deserved a fair shake, concluded Luis Blanco. It was the fall of 1998, and Blanco, a respected restorer of musical instruments, had watched his business decline for years, while high unemployment and falling real wages had triggered a crime wave that made him afraid to take his family for an evening stroll in El Paraiso, the middle-class Caracas neighborhood where his shop stands. Presidential candidate Chávez, brash and antiestablishment, promised that he would rid Venezuela of corrupt politicians and rechannel the wealth of the hemisphere's biggest oil exporter back to the people.

Today the 46-year-old Blanco is squarely in the anti-Chávez camp. During the president's three-year tenure, Blanco managed to looked past Chávez's public battles with the business establishment, traditional political parties, labor unions and even the Catholic Church. He initially gave the president the benefit of the doubt when his foreign policy turned against the U.S., Venezuela's longtime ally and trading partner, and embraced China, Cuba and Iraq. What eventually infuriated Blanco, however, were Chávez's long-winded weekly radio speeches in which the president described how his "Bolivarian Revolution" had led to steadily improving living standards.

That certainly wasn't Blanco's experience. Twenty years earlier, when he was a member of the brass section of the Orquesta Filarmónica de Caracas, he had been trained to restore instruments by one of the many foreign musicians hired by the state-sponsored orchestra. For years the Philharmonic contracted with Blanco to do repairs, but the work slowly dwindled, and then came to a halt this January when the orchestra's budget failed to win government approval amid a financial crisis. Orquesta Sinfónica de Venezuela hasn't paid Blanco this year either; nor has the State Foundation for Young Artists; nor the Orquesta Mariscal de Ayacucho. The Honor Guard Martial Band, which plays at the presidential palace, has yet to retrieve a trumpet that was left for repair a couple of months ago.

As a result of this falloff in business, Blanco hasn't been able to pay his shop rent in three months and expects to have to move his tools and workbenches to a spare room in his house. Since Chávez's term began in February 1999, Blanco has let five of his six employees go. His last remaining assistant , a close friend , is about to depart as well. Blanco can't afford to pay him full severance, so he plans to give him several brass instruments instead.

"We've hit the absolute bottom," says Blanco, who recently applied unsuccessfully for a U.S. work visa. "I'm thinking of my children; I'm thinking of my future. There's not much left but to try to leave the country."

While Blanco and the vast majority of Venezuelans battle to hang on economically, an increasingly besieged Chávez struggles to survive politically. In his June 23 radio address, the president said that he might even call a referendum on his presidency, though he didn't give specifics, such as a date. Some of his advisers have urged him to seize the initiative while he can still call elections on his own terms, before he's forced to. But many dismissed the comment as a political ploy.

In any event, in late June Venezuela remained under the threat of civil upheaval. Two and a half months after troops loyal to Chávez swept the president back into power after a short-lived coup on April 11, the country is more divided, and more wretched, than ever. Pro- and anti-Chávez supporters clash in the streets almost daily, middle-class citizens are stocking up on food, gasoline and even shotguns, and the National Guard has placed antiaircraft batteries near the presidential palace.

So now, with his political footing the shakiest yet, the former army colonel is faced with the task of righting the worst economic catastrophe Venezuelans can remember. "What was a crisis of unemployment and recession is now leading into a financial crisis, what I would predict will be a fiscal meltdown," says former Venezuelan Planning minister Ricardo Hausmann, now a professor at Harvard University.

Even if Venezuela enjoyed political unity, the hurdles would be immense. A stunning first-quarter economic contraction of 4.2 percent surprised even pessimists. It occurred, moreover, despite rising prices for Venezuela's dominant product: oil ,the source of 80 percent of export earnings and half of the government's revenues. Investors have gone from anxious to panicky: Capital flight reached $6 billion last year. In April unemployment rose by 3.5 percentage points to 17.5 percent. Half of all Venezuelans now work in the so-called informal sector , receiving no benefits and often earning less than the 190,080 bolivares ($145) monthly minimum wage.

The bolivar has tumbled against the dollar since the government suspended exchange controls in February. That has fueled inflation, which some economists expect will reach 35 percent this year. All of this has further eroded the purchasing power of Chávez's core constituency: the poor. According to a study by Caracas's Andres Bello Catholic University, about 2 million Venezuelans dropped below the poverty line between 1999, when Chávez took power, and 2001; in all, some 18.8 million out of 23.5 million Venezuelans are considered poor.

Chávez's response to the country's chronic poverty has been to boost government spending. It rose 11 percent during the first two months of this year alone, according to the Banco Central de Venezuela, even as government revenues fell by 19 percent. The upshot of a persistent pattern of spending increases is that the government faces a gaping budget deficit this year of as much as $9 billion, or 9 percent of Venezuela's $100 billion gross domestic product. The prospective shortfall has driven the country's sky-high borrowing costs even higher , to 40 percent on benchmark one-year government bonds , sparking fears that the administration will have to print money to pay its debts. In turn, this would further fan inflation and eat into the purchasing power of the poor.

The daunting task of bankrolling the budget gap falls to Chávez's recently christened Finance team. Following the April coup and his restoration two days later, the president reshuffled his cabinet to appease detractors and build support in the military. And to assuage the investment community, Chávez eased out Jorge Giordani from the powerful post of Planning minister. A leftist academic who had tutored the young colonel in prison following Chávez's failed coup against president Carlos Andrés Pérez in 1992, the scholarly Giordani felt more comfortable reviewing World Bank infant mortality rates than international bond spreads. He had alarmed the financial community by focusing on land reform and big public works projects rather than on investment and fiscal discipline.

To replace Giordani, Chávez chose Felipe Pérez, a University of Chicago,educated economist, who appreciates markets and speaks the global technocratese that investors feel comfortable with.

"That Chávez is a communist or a socialist is a myth," asserts Pérez, who voted for the president. "He supports the markets but has to face this huge problem we have , poverty."

The Planning minister, who describes Chávez's policies as "trickle up" economics, is best equipped to make a contribution through reforms: improving tax collection, developing tighter budgets, reducing corruption through the use of technology and diversifying the economy away from dependence on oil. He has moved rapidly to build a working relationship with local and foreign businesses , meeting, for instance, with officials of Procter & Gamble Co. and Cargill.

Finance Minister Tobias Nobrega, a former consultant and economics professor at the Universidad Central de Venezuela, finds himself more conspicuously in the hot seat. His precarious position is that of middleman between foreign and domestic creditors and Chávez's spend-happy administration. Six officials have been appointed to the post in three years; the preceding Finance minister, Francisco Uson, an army general and former military budget director, lasted just six weeks.

"It's been the same story with every Finance minister," says Orlando Ochoa, a University of Oxford,educated economist and columnist for Caracas newspaper El Universal. "When you don't have the backing from the rest of the administration, you'll never have the power to impose fiscal discipline."

Nevertheless, the detailed economic package that Perez and Nobrega unveiled on May 30 takes a comparatively tough line on fiscal policy in a clear attempt to boost market confidence. It makes modest cuts in spending, but mainly seeks to narrow the budget deficit by raising taxes: an increase in the value-added tax from 14.5 percent to 15.5 percent; a boost in the bank debit tax from 0.75 percent to 1.0 percent; and new custom duties and taxes on cigarettes, liquor and luxury imports. In addition, the scheme calls for intensified efforts to cut tax evasion. The economic team estimates that the tax measures will raise $950 million annually.

To further narrow the deficit, Caracas would tap into a macroeconomic stabilization fund that it created from a revenue windfall provided by soaring oil prices in 1999 and 2000, draw on loans from multilateral agencies, roll over local debt and borrow heavily on international capital markets.

Economists are skeptical , and investors even more so. The spread on Venezuelan bonds vis-à-vis U.S. Treasuries widened by more than 2 percentage points, to almost 12 percentage points after the proposals came out. For a start, point out the doubters, the proposed spending cuts would be more than offset by May's 20 percent hike in the minimum wage and by other labor commitments. The tax hikes would be largely regressive, hurting the poor the most. And Venezuela's political volatility and underlying economic travails would make borrowing billions abroad so expensive a proposition , even if Caracas could somehow pull it off , that it would be crazy to try it. "Raising money in this environment may not be impossible, but it would be very tough and very expensive," says Carlos Novis Guimaraes, head of Latin American investment banking at Salomon Smith Barney.

J.P. Morgan Chase & Co. economist Luis Oganes suggests an alternative scenario for how the government might go about closing the $9 billion deficit he projects for this year: already proposed tax increases and spending cuts (about $1 billion), the macroeconomic stabilization fund ($2.2 billion), central bank profits ($1 billion), the public sector surplus, chiefly from various state companies ($500 million) and project-linked loans from multilateral agencies ($500 million). And of the remaining $4.8 billion, $3.1 billion will likely come from the government's refinancing its debts with local banks.

But this still leaves $1.6 billion to fund, and Oganes warns that Caracas could try to cover the shortfall by letting the bolivar slide further and then paying local debts with devalued bolivares it buys with U.S. dollars earned from foreign oil sales.

Such a patchwork solution might allow the country to muddle through this year, other economists say, but could have grave repercussions when Caracas tries to finance its 2003 budget. Domestic banks, which currently have about 25 percent of their portfolios in government bonds on average, are reluctant to buy more. Only $82 million of government bonds were sold in the first four months of this year, compared with $1.5 billion in the same period last year, despite interest rates that have doubled. Banks might accept a debt swap, says Oganes, but if not, the government may have to forcibly roll over its debt.

The devaluation of the bolivar against the dollar, meanwhile, reduces Caracas's short-term borrowing needs, so it's not surprising that the new economic team has allowed the currency to drop. Economists estimate that it could easily fall to 1,400 bolivares to the dollar by year-end , from 800 in mid-February when exchange controls were lifted. Of course, a devaluation of this magnitude fans inflation , especially for critical imported food , and fuels growing discontent.

Chávez, however, may have politics rather than economics uppermost in his mind. The possibility of another coup attempt cannot be discounted. The opposition is using every tool available , corruption charges, popular referendums, constitutional amendments and even threats of violence , to try to oust the president.

The president himself has used referendum after referendum to rewrite the constitution and disassemble and refashion congress and the Supreme Court. He has also called new elections at every level to amass power. But as popular discontent began to simmer, Chávez suffered his first major defeat: Last September his candidate lost a vote to control the Confederación de Trabajadores de Venezuela, the country's umbrella labor union.

Three months later the business community reacted to a series of new laws , including a land reform measure that threatened large landholders and the doubling of royalties and taxes on oil projects , with a nationwide strike. Opposition forces mounted a series of street protests. A highly politicized six-week struggle to stop Chávez from placing allies atop state-owned oil giant Petróleos de Venezuela, or PDVSA, led to his temporary ouster.

Now, mounting tensions between anti-Chávez factions in the armed forces and fiercely pro-Chávez civilian militias , so-called Bolivarian Circles , are a time bomb. Ever since returning to power, Chávez has tried to purge the military of disloyal officers. In one broad swath, he relieved 117 of the armed forces' 260 generals and admirals of their commands, according to Austin, Texas,based intelligence company Strategic Forecasting. A further 700 officers are believed to be under investigation to determine their political loyalties.

The purge has inflamed military infighting. On June 4 a group of purportedly low- and middle-ranking officers in black hoods and National Guard uniforms released a videotape in which they threatened to kill Bolivarian Circle members and violently force a change of regime if Chávez didn't reform the military and the government. Three days later El Universal published an anti-Chávez manifesto from another clandestine group that described itself as consisting of active military officers and civilians from Caracas and nearby industrial states. It complained that the military was being weakened even as the government diverted millions of dollars to organize Bolivarian Circle members, who are likened either to community service groups or to Benito Mussolini's Black Shirts, depending on whether you talk to supporters or critics. The government has said there are 1.5 million Bolivarian Circle members; others put the number at closer to 15,000, only a handful armed. Still, even a small civilian militia could cause panic if it engaged in pitched battles with the military in the streets of Caracas.

In late June the government's talks with the political opposition broke down. "The major opposition parties have refused to accept their role in [causing the current crisis], and that's contributed to the failure to find compromise," says Teodoro Petkoff, a leftist and former minister of Planning who as editor of Caracas's popular afternoon newspaper Tal Cual is one of the president's most influential critics. On the advice of Cuban President Fidel Castro, Chávez has invited former U.S. president Jimmy Carter to Venezuela to mediate.

Opponents, though, have their own agenda. A half dozen opposition parties , led by Acción Democrática and Comité de Organización Política Electoral Independiente, or Copei, which dominated the political landscape until Chávez quashed their power base in 1999 , have banded together to press such measures as a so-called revoking referendum to boot out the president. The sticking point is that the referendum can't be called until halfway through his term, and because of various election technicalities, this means that it can't be held until January 2004 , unless Chávez follows through with his hint to conduct his own referendum sooner.

His opponents grow more impatient by the day. Opposition parties are gathering voters' signatures to hold a referendum to shorten the presidential term from six years to four, so that the revoking referendum can be called early next year. Chávez's opponents are also collecting signatures to pass a constitutional amendment to mandate a new election.

Increasingly, though, the court system is surfacing as a weapon. The opposition persuaded the Supreme Court to allow citizens to petition it to strip the president of immunity from trial, opening the door to a grand jury investigation into 14 corruption complaints against Chávez and his administration made by opposition parties. The highest profile: a claim of financial malfeasance. The Nation Election Council, which oversees the electoral process, is investigating whether Chávez's Movimiento V República party failed to report $1.5 million in campaign contributions from Spanish bank Banco Bilbao Vizcaya Argentaria in 1998 and 1999. BBVA owns Banco Provincial, one of Venezuela's largest banks. Opponents are also pressing for a criminal investigation into charges that $2 billion in oil revenues was diverted from the economic stabilization fund; the Chávez administration says it used the money for legitimate government expenditures.

"This is a president that spent $70 billion in oil money, and there's nothing to show for it," says Henry Ramos Allup, the president of the Acción Democrática. "No, there are no compromises, he must go." Chávez maintains that his political enemies are concocting scandals to try to drive him from office.

A new election wouldn't guarantee the president's defeat. To many Venezuelans, business leader Pedro Carmona's brief interim government following Chávez's removal harkened back to the old discredited power structure. Carmona tried to dissolve the National Assembly and Supreme Court. Noticeably absent from his cabinet were dark-skinned delegates, evoking the racial inequality that prompted many to vote for Chávez.

The president actually emerged from the coup attempt with broader support, reports polling firm Alfredo Keller y Asociados. Pro-Chávez Venezuelans increased from 33 percent to 40 percent, while those opposed to Chávez declined from 49 percent to 40 percent. Keller predicts that if the president were to call a new election that required a simple plurality to win, he would be victorious but that he would lose if he were forced into a runoff. Skeptics, however, contend that the tide has turned against Chávez since the firm did its poll, just after his return to power.

But the fact remains that the opposition lacks a credible challenger to Chávez. In a recent tally by pollster Consultores 21, 40 percent of the respondents chose "unidentified" when asked who the opposition candidate should be. Lagging well behind "unidentified" were 31-year-old congressman Julio Borges (16 percent); Enrique Mendoza, governor of the state of Miranda (also 16 percent); businessman Henrique Salas Romer (7 percent); and Caracas Mayor Alfredo Peña (4 percent).

Newspaper editor Petkoff, who has traveled the full political spectrum, from communist guerrilla in the 1960s to congressman to presidential candidate to Planning minister under Chávez's predecessor, Rafael Caldera, says that people on both sides are finally coming to understand that Chávez didn't create the country's social divisions, he simply brought them to the forefront. Petkoff suggests that a growing minority of Venezuelans are now eager for a political compromise for the sake of the imploding economy.

This, of course, would suit foreign direct investors, but they aren't depending on it. Companies that have long histories in the country are putting new projects on hold but are otherwise maintaining the status quo. "You learn to be prepared for political instability; it dates way back into the country's history," says Michael Tangney, president of Colgate-Palmolive Co.'s Latin American operations.

Crucially for Venezuela, international oil companies remain interested in new investment, despite the government's doubling of royalties and taxes on new projects and the stipulation that PDVSA be given a controlling interest in all new ventures. "If a profit can be made, we'll be interested," says a Royal Dutch/Shell Group executive.

Chávez's supporters like to point out that Venezuela's economic model is in fact surprisingly orthodox. Wall Street applauded Caracas's lifting of exchange controls this year, and the government's estimates of oil revenues have traditionally been conservative. As a result, the Chávez administration has been able to put more than $5 billion into its economic stabilization fund, which previous administrations only talked about doing. Last year legislation to liberalize Venezuela's telecommunications and electricity sectors drew billions of dollars in commitments from the likes of BellSouth Corp. and AES Corp.

Moreover, with more than $10 billion in international reserves and a much lower debt-to-GDP ratio than those of its Andean neighbors, Venezuela should have a higher credit rating than the B2 assigned to it by Moody's Investors Service, Chávez's economic team believes. Why, they ask, is Venezuela rated lower than neighboring Colombia, caught up in civil war?

Chávez's critics counter that he has nothing to show for the biggest windfall of oil revenues in decades. The return to OPEC-backed oil quotas and protectionist policies on foreign investments in Venezuela's oil industry is shortsighted, they charge, costing thousands of jobs. Chávez's administration has fallen into the same dreary cycle as past Venezuelan governments , overspending and maintaining an artificially strong currency in boom times, only to devalue and return to spiraling devaluation, inflation and deficits when oil prices fall.

As of November 85 percent of Venezuelans thought their country was still one of the wealthiest in the world, according to a survey by Keller. Yet just to return to the per-capita income levels of 1980, business columnist Ochoa calculates, the economy would have to grow 6 percent annually for ten straight years. And that would require annual private investment equal to 25 percent of GDP. Last year it amounted to less than 1 percent. This year isn't likely to see an increase.