Cablegate: "Tan Barato, Dame Dos" (so Cheap, Give Me Two):

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UNCLAS SECTION 01 OF 06 CARACAS 002244

SIPDIS

SIPDIS

NSC FOR DTOMLINSON

E.O. 12958: N/A
TAGS: ECON VE
SUBJECT: "TAN BARATO, DAME DOS" (SO CHEAP, GIVE ME TWO):
CONSPICUOUS CONSUMPTION UNDERMINES VENEZUELA'S FUTURE
ECONOMIC WELLBEING

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accordingly.

1. (U) SUMMARY: Record high petroleum prices have handed
Venezuela strong economic growth and a sharp increase in
national income. BRV fiscal and economic policies are
incentivizing Venezuelans to direct this newfound wealth
toward credit-financed consumption, in general, and
consumption of imports, in particular, rather than toward
saving and investment. In the near term the steady flow of
petrodollars will moderate the negative effects of these
distortions in Venezuela's economy. But failure to invest in
and diversify Venezuela's non-oil-export and import-competing
sectors will leave the country overly reliant on its oil
sector for income, with painful consequences for ordinary
Venezuelans. END SUMMARY.

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VENEZUELAN CONSUMPTION, SAVING, INVESTMENT, AND IMPORTS
--------------------------------------------- ----------

2. (U) Venezuela's economy is growing briskly. With
petroleum prices at record levels and the Venezuelan oil
basket currently selling at USD 64.83, Venezuela's real GDP
grew 10 percent year-on-year through the first quarter of
2006. (NOTE: Broadly speaking, the BRV and the Venezuelan
private sector can either consume or save the income derived
from this growth in output. In macroeconomic terms,
consumption, by either the public or the private sector, is
current expenditure on goods and services. Saving is simply
income not consumed. Saving is in turn intermediated through
the banking and financial sectors -- which transform savers'
cash into loans and other credit for borrowers -- and thus
becomes the domestic source of funding for investment.
Investment is public- or private-sector expenditure intended
to enhance future economic output, e.g., on infrastructure,
plant and equipment, or inventories. In short, the more of
its income a country consumes, the less it saves and invests.
END NOTE.)

3. (U) According to a recent analysis by MetroEconomica, a
leading Venezuelan macroeconomic consulting firm, comparing
the twelve months ending March 2006 with the twelve months
ending March 2005, in constant 1997 prices (i.e., adjusted
for inflation), overall Venezuelan consumption grew by 17.4
percent. Perhaps more important, much of this consumption is
of foreign goods: imports to Venezuela increased by 22.6
percent in real terms, while exports increased by 4.4 percent
over the same period. In 2005 roughly 25 percent of
Venezuelan imports were consumer goods, 47 percent were
intermediate goods, and the remainder capital goods for
investment. About 30 percent of Venezuelan imports came from
the United States.

4. (U) Comparing the twelve months through March 2006 with
the preceding twelve, Venezuelan overall investment grew by a
mere 0.5 percent. MetroEconomica reports that recent changes
to the Venezuelan Central Bank's methodology for compiling
the national accounts make it difficult to distinguish
public-sector from private-sector investment in constant
prices. But with overall investment growth of only 0.5
percent -- despite greatly increased BRV spending on roads,
metro systems, hydroelectricity projects, and buildings and
infrastructure for its social programs -- the consulting firm
concludes that private-sector investment is at best constant,
and perhaps falling.

5. (U) Longer term measures of these variables indicate that
the recent figures in fact reflect trends under Chavez's
watch. Overall consumption as a percent of GDP has increased
from approximately 67 percent in 1999 to 78 percent in 2006.

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Overall investment as a percent of GDP plummeted from roughly
34 percent in 2001 to 12 percent in 2003 (due to acute
political uncertainty at the time), bounced back to 30
percent in the first quarter of 2005, but then fell again to
roughly 25 percent in the first quarter of 2006. Moreover,
the ratio of Venezuelan exports to imports AT CONSTANT 1997
PRICES has been falling (from 140 percent in 2003 to 80
percent in 2005) as the country's oil production, which
accounts for roughly 80 percent of its exports, has stagnated
while the volume of goods and services it imports has grown
markedly.

6. (U) What do these figures mean in practical terms? Using
both cash and credit the BRV and ordinary Venezuelans are
purchasing increasing amounts of imported consumer goods.
Automobiles and cellular phones are two leading examples.
The Venezuelan Automotive Chamber reported that vehicle sales
increased nearly 70 percent in 2005, compared to 2004, and a
report by Venezuelan financial research firm Softline
Consultores found that car loans increased by 229 percent
over the same period. LG Electronics, a leading cellular
phone and consumer electronics firm, recently reported that
its Venezuelan sales have increased 700 percent since 2001.
The Softline report further found that credit card purchases
increased 73 percent in 2005. According to Venezuelan
Central Bank data, overall bank credit for consumption has
increased 360 percent from December 2003 to May 2006. Simply
stated, Venezuelans are going shopping and incurring
increasing amounts consumer debt.

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IT'S YOUR POLICIES, STUPID
--------------------------

7. (U) Venezuelans' penchant for consuming instead of saving
cannot simply be ascribed to cultural proclivities. BRV
economic policies are fueling this consumer behavior, both
directly and indirectly. Among the direct incentives are
subsidies and price controls for goods of the basic food
basket, health care services, and countless other consumer
items. Such measures facilitate consumption not only of the
subsidized/price-controlled goods and services themselves,
but, by freeing up additional income, also of automobiles,
personal electronics, and the like. In addition,
Chavez-decreed increases to the minimum wage over the past
two years have far outpaced the rate of inflation, increasing
the real purchasing power of low-income earners.

8. (U) In addition to these direct measures, there are at
least three important policies indirectly driving consumer
behavior: robust government spending, banking regulation, and
the fixed foreign exchange rate regime. With the public
coffers as well as its off-budget financial vehicles (e.g.,
the National Development Fund or "FONDEN") full of
petrodollars, the BRV has increased public spending
substantially: from the equivalent of USD 26 billion in 2003
to an estimated USD 42 billion for 2006. Moreover, these
figures do not include BRV spending through its off-budget
accounts, which analysts estimate could total another USD
10-15 billion this year. According to the Central Bank, M2
-- a monetary aggregate that includes currency in
circulation, as well as demand, saving, and time deposits --
increased 57.5 percent, 50.4 percent, and 52.7 percent in
2003, 2004, and 2005, respectively. Despite the Central
Bank's ongoing efforts to soak up excess liquidity (it sold
roughly USD 1.6 billion in CDs to the banking sector from
January to May of this year), M2 has increased more than 16
percent to date in 2006.

9. (U) This increased liquidity in turn has two primary
effects. First, more money circulating in the economy

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pursuing a slower growing quantity of available goods and
services pushes up consumer prices, leading to inflation of
27.1 percent, 19.2 percent, and 14.4 percent in 2003, 2004,
and 2005. While the BRV's stated aim is to reduce annual
inflation to below 10 percent, most analysts forecast that it
will hover around 12 percent for 2006. Second, as happens
with any good, the greater supply of money in the economy
lowers its price, here the "price" being the interest rates
banks charge borrowers when they take out loans. Market
interest rates have fallen steadily since 2003, squeezing
banks' profitability. In response banks have increased their
fees for various services, lowered their own borrowing costs
-- that is, the interest they pay out to clients on savings
accounts and time deposits -- and aggressively marketed
higher risk credit to consumers, such as personal consumption
loans and credit cards.

10. (U) Banks find their search for profitability hampered,
however, by BRV-inspired regulation of the banking sector.
Ostensibly, the Central Bank independently establishes
interest rate regulations for banks, but few question the
influence over the Bank's decision-making of Jorge Giordani,
BRV Minister of Planning and Development, who sits on the
board. Under Central Bank regulations issued in 2005, banks
must pay out at least 6.5 percent on savings accounts and 10
percent on time deposits (e.g., CDs), and they may charge no
more than 28 percent interest on loans and credits to
borrowers. In addition, banks must allocate 31.5 percent of
their loan portfolios among various classes of borrowers --
home buyers, farmers, small business owners, and the tourism
industry -- all at preferential rates. Thus while banks'
revenues and profits have been growing in absolute terms as
they manage more market liquidity, their net financial margin
per average asset, which measures profitability, has been
narrowing: it shrank from 5.89 percent in December 2004 to
3.66 percent in December 2005.

11. (U) The net effect of the increased liquidity, inflation,
falling interest rates, and banking regulations is that
ordinary Venezuelans have far greater incentive to consume
than to save and their banks have tremendous incentives to
help them do so. Saving makes little financial sense for
ordinary Venezuelans: with 14 percent inflation outpacing the
7 percent interest paid on savings accounts, would be savers
face a real interest rate of approximately negative 7
percent. Time deposits look little better, offering a real
interest rate of around negative 4 percent, and banks anyway
disfavor them because paying their regulation-mandated higher
interest rates further squeezes profit margins.

12. (U) On the other hand, with interest rates on all forms
of credit capped at 28 percent, ordinary Venezuelans face a
maximum real interest rate on consumer and credit card debt
of roughly 14 percent, favorable even by U.S. standards.
Banks, moreover -- with approximately 46 percent of their
asset portfolios in BRV bonds and Central Bank CDs paying
them just over 10 percent, and another 31.5 percent of their
assets in mandated lending at preferential rates -- have been
aggressively and creatively marketing the remainder of their
portfolios to higher-risk, higher-interest consumer credits.
Beyond stepped up advertising, Venezuelan banks have been
creating and promoting a wide array of consumer credit
products: prizes for using credit cards; personal credit
lines giving customers three times their monthly salaries and
thirty-six months of financing for consumer purchases; and
specialized personal credit lines for purchases of travel,
cars, electrical appliances, furniture, televisions, video
and sound equipment, computers, and cellular phones.

13. (U) BRV economic policy not only directly and indirectly
encourages ordinary Venezuelans to consume instead of save,

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it also encourages them to consume imports instead of local
products. Here, the most culpable policy prescription is the
fixed exchange rate. The BRV enacted exchange rate and
currency controls in February 2003 to staunch widespread
capital flight then taking place due to sharp political
uncertainty. Since then it has kept the official exchange
rate fixed, devaluing it periodically until it reached its
current level of 2,150 Bolivars per USD (Bs/USD) in the first
quarter of 2005. With the parallel market rate hovering
around 2650 Bs/USD, most analysts estimate the Venezuelan
currency to be overvalued by approximately 24 percent.

14. (SBU) Though the justification of severe capital flight
perhaps no longer pertains, the BRV has maintained the fixed
exchange rate policy, among other reasons, to help anchor
inflation: by keeping the exchange rate fixed, the government
artificially depresses the local prices of imported consumer,
intermediate, and capital goods (tradables, in economic
jargon). By way of example, if the government permitted the
Bolivar to depreciate to its parallel market rate of
approximately 2,650 Bs/USD, a USD 100 imported cellular phone
now costing Bs 215,000 would instead cost Bs 265,000. Most
analysts have been anticipating a devaluation of the Bolivar
in 2007 after the December elections, but Rodrigo Cabeza,
Chavista President of the National Assembly's Finance
Committee, told EconCouns that the BRV would not devalue the
currency next year (we shall see).

15. (U) Unless or until the BRV devalues the Bolivar, Chavez
will be able to reap political gain for "keeping inflation in
check," and ordinary Venezuelans will enjoy access to cheaper
imports, incentivizing their consumption thereof. There are,
however, important medium- and long-term negative
consequences associated with the overvalued currency: it
undermines the competitiveness of both Venezuela's non-oil
export sector and its domestic, import-competing businesses.
(NOTE: Because petroleum is sold on international markets in
USD, the overvalued Bolivar does not affect oil exports. END
NOTE.)

16. (U) Consider the following simplified example. Under the
fixed exchange rate of 2,150 Bs/USD, a Venezuelan-produced
manufactured good costing Bs 21,500,000 to make could be
profitably sold overseas (eliminating transport costs,
duties, etc., for present purposes) for any price over USD
10,000. If the Bolivar were depreciated to 2,650 Bs/USD, on
the other hand, any would be buyer with US dollars could
obtain the same item instead for only USD 8,113.21. The
overvalued Bolivar thus makes Venezuela's non-oil exports
more expensive and less competitive. The flip side of this
coin is that a Venezuelan consumer with 21,500,000 overvalued
Bolivars can reach for a foreign-manufactured good (and the
quality and cache associated with it) worth USD 10,000,
instead of settling for a locally produced competitor. With
the same 21,500,000 Bolivars depreciated to their parallel
market value of 2,650 Bs/USD, the same Venezuelan would only
be able to purchase foreign goods worth USD 8,113.21, making
locally produced options more attractive.

17. (U) As a result of these incentives created by the
overvalued fixed exchange rate, Venezuela's export-import
ratio has been falling in real terms and its domestic
private-sector manufacturers have suffered. The drop in the
number of industrial firms doing business in Venezuela since
Chavez came to power highlights these effects: CONINDUSTRIA,
the Venezuelan industrial chamber, reports that roughly
11,000 manufacturers were open for business in 1999, while
only 6,700 were operating in 2004.

18. (U) The phenomenon described above is known in economics
literature as "Dutch Disease". Dutch Disease entails an

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income boom to a single-commodity export economy appreciating
its local currency, undermining the competitiveness of its
export and import-competing sectors, reinforcing the
economy's reliance on its primary export (here, oil) for
foreign exchange, and leaving the country overexposed to a
downturn in world prices for its export. (NOTE: The moniker
comes from the travails of the Netherlands' manufacturing
sector after natural gas deposits were discovered there in
the 1960s. END NOTE.) Venezuela's oil endowment, elevated
crude prices, the BRV economic policies detailed above and
its general fostering of an uncertain business environment
have generated symptoms of Dutch Disease in Venezuela.
Facing a difficult and unpredictable climate, the private
sector in general and small and medium businesses in
particular are not investing in new production capacity.
MetroEconomica, the macroeconomic consulting firm, estimates
that investment would need to increase by 10 percent of GDP
for Venezuela to maintain healthy economic growth: a
development little likely given the current policy landscape.

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WHAT HAPPENS WHEN THE MUSIC STOPS?
----------------------------------

19. (SBU) COMMENT: Economic analysts are not as yet sounding
alarms that Venezuela's economy faces grave short-term
difficulties. Elevated petroleum prices foreseen for at
least the next two to two and a half years will continue to
cover a multitude of sins, enabling the BRV to reap
short-term political gains by spending extravagantly,
maintaining an overvalued Bolivar, and allowing -- indeed,
encouraging -- ordinary Venezuelans to consume as if they
were wealthier than they truly are.

20. (SBU) But history teaches that profligate government
spending on large-scale infrastructure projects and populist
subsidies and wage increases are politically difficult to
restrain or cut back. Budgetary rigidities could thus
overwhelm the Venezuelan oil sector's capacity to generate
revenue, even in a climate of sustained high crude prices.
During the price booms of the 1970s and early 1980s,
Venezuela accumulated unmanageable levels of both domestic
and foreign debt and experienced balance of payment
difficulties even before oil prices began to fall. The
eventual decline in oil prices made a difficult situation
critical. It is thus possible, and even likely, that
continuing on its current path Venezuela will experience
macroeconomic and fiscal difficulties that render it unable
to sustain the policies and public spending currently driving
the consumption boom, even under a scenario of elevated oil
prices in the near and medium term.

21. (SBU) History also teaches, however, that those same high
prices will bring new petroleum production online and
encourage conservation, increasing supply and moderating
demand. When (not if, but when) crude prices fall, or if the
oil sector is unable to maintain current levels of
production, Venezuela will find itself, as it did in the
1980s, with an anemic non-oil export sector, starved of
adequate investment, and little able to earn the hard
currency the country will need to maintain public spending
and repay its hard-currency-denominated debts. As the flush
of excess liquidity diminishes, market interest rates rise,
and the BRV can no longer afford to defend the Bolivar's
artificial strength, overly indebted Venezuelans will find
themselves unable to afford their loan and credit card
payments. Moreover, the imports they have been enjoying at
bargain prices will no longer be as affordable, and the local
economy will not have the productive capacity installed to
meet domestic demand or create jobs. The ramifications for
ordinary Venezuelans will be painful.

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22. (SBU) Precisely how these events will unfold cannot be
known for sure, but Venezuela's current course is not
sustainable. One thing, however, is certain: if President
Chavez is still in power when the music stops, the hardships
then suffered by the Venezuelan people will no doubt,
according to him, be the exclusive fault of the "The Empire".
END COMMENT.
BROWNFIELD

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