January 20, 2009

Six of one, half a dozen of the other

Quico says: Yesterday's post was one I'd been meaning to get off my chest for a long time. It felt good to put it out there. Still, there's no pleasing some people, so I wasn't surprised that Greg Wilpert, of Venezuelanalysis fame, wrote in to tut-tut my Magnum Postus.

In particular, he had a bone to pick with this slide, telling me he'd checked with sources in the Finance Ministry and found out it's all wrong, invalidating my whole argument:

Greg knows for sure that the government's plans are not to re-convert Fonden's dollars back into bolivars. Their intention, instead, is to spend them abroad, as dollars, (for instance, using them to pay for imported food or for all those backlogged nationalizations).

Greg may well be right about this. I don't doubt he is, actually. What he hasn't grasped, though, is that even if he is right, that does precisely nothing to invalidate my argument.

To understand why, take a bolivar bill out of your pocket and look at it closely. Notice how it says your bolivars are "Pagaderos al portador en las oficinas del Banco" ("payable to the bearer at the bank's offices")? Ever wonder what that actually means?

It's a funny thing. Turns out that, while the bolivars in your pocket are an asset to you, they're a liability from the point of view of the Central Bank. That may be an unfamiliar thought, but hell, it says so right there on the bill!

In an accounting sense,
Bolivars are a promise of payment, something the BCV owes you. Notionally, at least, you're supposed to be able to take your bolivars back to the Central Bank and trade them for something else of worth - gold, say, or its current day equivalent: dollars.

We're not be used to thinking of it in this way, but it's a fact, and it has consequences. It means that, like any corporation, the Central Bank of Venezuela has assets and liabilities. Activos y pasivos. Stuff it owns and stuff it owes. In other words, it has a balance sheet.
And in that balance sheet, the bolivars in your pocket show up as its biggest liability, while the dollars BCV holds in international reserves make up the bulk of the assets.

With that in mind, lets get back to Greg's objection.

Yesterday, I wrote that The Great "Excess Reserves" Swindle works by increasing the Central Bank's liabilities (the number of bolivars in circulation) without any corresponding increase in its assets (dollars in reserves).

Greg's devastating retort was that, quite to the contrary, the government's plan is to decrease the Central Bank's assets (its reserve dollars), without any corresponding reduction in its liabilities
(the number of bolivars in circulation).

As you can see, that's totally different...


What Greg fails to see is that, either way, the government is out to get something for nothing. A free lunch.

Think about it: if a mere mortal like you or me wants to get his hands on some Reserve Dollars, BCV isn't just going to give them away to us. We have to pay for them. Specifically, we have to fork over some
hard-earned bolivars in exchange for those dollars. Why does Central Bank insist that we pay for our dollars? In order to preserve its balance sheet. When you buy dollars, the bank's reserve assets fall, so it needs its bolivar liabilities to fall proportionately if it's to preserve its value. So we hand over our bolivars, get our dollars, and the bank is worth neither more nor less at the end of the process than it was at the beginning.

A different set of rules applies when it's the government looking for dollars. In effect, Chávez contrived to give himself the power to get BCV to cough up dollars in return for nothing at all. All he has to do is intone the magic words "excess reserves", as though they were some kind of santería spell with the power to make central bankers take leave of their senses!

I mean, if Greg is right, what we're looking at isn't even a swindle; it's more like outright bank robbery. Cuz, hell, if I waltz in to the BCV's offices mumbling something about "excess reserves" and demanding they give me a huge number of dollars, my best case scenario involves a
straitjacket...but El Rodeo is probably the more likely outcome.

The crux of the Swindle is that BCV's takes a massive hit on its balance sheet. Because if there's one thing you'll never be able to get away from it's the simple accounting identity:

Whether the hit comes in the form of BCV owning fewer dollars or owing more bolivars is neither here nor there.

Which brings us to another of those "conventional absurdities" you hear around town all the time. People will say "hey, BCV has $40 billion in reserves, that's a really solid level!" as though such a thing had any meaning whatsoever. "Solid" in relation to what?!

From the point of view of the Central Bank', what's important is neither how many dollars it has in reserves, nor how many bolivars are out circulating through the economy. What's important is the ratio between the two.

That's one of those deceptively simple-seeming principles you may be tempted to skim over. Don't. Grasp this point and you'll already understand more about Venezuelan macroeconomics than Greg Wilpert, Alí Rodríguez and Mark Weisbrot put together!

Because, o
nce you see it, you'll understand why the effect on inflation is exactly the same whether Fonden takes its dollars on a shopping spree to Miami or whether it trades them in for thin-air bolivars at home.

In the end, there ain't no such thing as a free lunch. Somebody always pays. And in this case, that somebody is you, me and anyone else who happens to be holding bolivars. Because as BCV's balance sheet deteriorates, the value of its debt falls...the twist being that BCV is a funny old creature whose debt happens to take the shape of banknotes residing in the pocketbook of "el portador" - a.k.a. you! - and that, when the value of its debt falls, we conventionally call that "inflation."

Understanding that the debate would go this way, Miguel had the foresight to send me a spreadsheet showing that all-important ratio between bolivars in circulation and reserve dollars over the last few years. This is a key indicator of the Central Bank's financial health, the figure that synthesizes this whole assets-to-liabilities relationship we've been talking about all through this post. And the picture that emerges is not pretty:
Click to enlarge

In effect, up until 2006 BCV had more than $1 worth of reserves to cover every Bs.F circulating out in the Venezuelan economy. After the 12 millarditos get handed over, the bank will have one dollar in reserves for every Bs.F 2.89 circulating. Optimal indeed!

"OK," you say, "but I still don't see it...how can I be sure that that really has an impact on inflation?" To answer that question, I overlaid Miguel's Bs.F-per-reserve-$ data onto the monthly inflation numbers for the last three years.

Now, there are definitely some lags in the data. Big spikes in inflation seem to come several months after the ratio of Bolivars-to-reserve-dollars jumps to a higher level. These processes take some time to work themselves out.

Still, even in this form, you can certainly see the pattern:
The thing is, monthly inflation data is "noisy". It's cyclical and seasonal and sprinkled with outliers.

To bring out the underlying trend, I thought I'd try a couple of things: first, for any given week, I calculated the average monthly rate of inflation for the preceding 16 weeks. That ought to smooth out the outliers. Then, to adjust for the lags that retrospective averaging generates - as well as for the underlying lag between cause-and-effect - I shifted the entire inflation series back by 28 weeks.

My jaw pretty much hit the floor when I saw how close the resulting fit is...
That chart, right there, really ought to put the question to rest.

Make no mistake about it. All this tomfoolery with the reserves is going to cost us. Maybe not this month, maybe not next month, but before the year is out, we're all going to pay for this.