March 22, 2009

What exactly happened on Saturday?

Quico says: In response to my insta-analysis of last night's economic announcements, a reader who, ahem, actually understands macroeconomics pipes in to say:
I really think you are missing the key point here, I have to say. First of all, we are talking about the budget, so the relevant benchmark for the amount budgeted for 2009 is the amount they had budgeted for 2008 - which was well below the BsF. 197 billion they actually ended up spending.

What makes you think there won't be any "creditos adicionales" and off-the-books spending this time around? What do you think the 12 millarditos taken away from the central bank are for? Or whatever is left over in Fonden, for that matter?

The real issue here is the new borrowing. Remember, the original 2009 budget already implied a deficit worth 2.5% of GDP. So basically what we're looking at is an additional fiscal gap to be filled, this one worth 8% of GDP. The tax increase will contribute 1.5% of GDP at most, the spending cuts are good for maybe 2% of GDP. So we're left with a hole of around 4.5% of GDP, over and above the original budget's deficit forecast, that they say they're going to fill with domestic debt.

Now, remember they had already planned to place 2.5% of GDP worth of domestic debt in the original budget. So, the “adjustment” brings the amount of new domestic borrowing needed this year to 7% of GDP.

That's huge.

How huge? Look at it this way: the total amount the private banks had on hand and available for lending, as of last Friday, was just BsF.2.1 billion. That's not even 10% of the additional BsF. 22 billion Chávez announced the government will borrow this year!

How on earth are they going to pull off this conjuring trick? There are two ways.

The first is to force the banking system to swallow a huge amount of new bonds, which would dramatically increase the financial sector's vulnerability, shattering what remains of the public's confidence in the banking system, as well as implying a significant contraction in credit to the private sector that could severely affect the payments system.

The other is to implicitly force the BCV to lend the money. If the encaje legal is used for that purpose, this will be exactly equivalent to an increase in high-powered money: the monetary base. In that case, we'd be looking at a very, very sharp spike in inflation.

This move, together with the monetization of the international reserves they've already grabbed, would result in a very significant increase in liquidity, precisely at a time when the slow down of the economy and the reduction in confidence are leading to a collapse in the demand for money.

So, people want less bolivares in their portfolio, but they're forced to hold more. As a result they will try to get rid of the excess, and the way they'll get rid of it will be to go to the parallel market and bid for all those dollars PDVSA is placing there. The foreseeable consequence? A sharp depreciation of the bolivar in the parallel market and a very significant spike in prices.

For all of you that are disappointed thinking that yesterday's announcements were dull, brace yourself for the very bumpy road ahead.

This was a hell of an announcement! Or should I say…hellish?