Resolving Venezuela's Debt Default to Take Years


Friday, February 08, 2018 09:12 AM /Fitch Ratings / Image Credit: vox


Venezuela's ongoing political and diplomatic crisis raises the risks of increased near-term economic pain as well as the potential for greater domestic political division, according to Fitch Ratings. Wide-scale protests and the recognition by numerous countries of a parallel administration led by Juan Guaido could mark a significant shift in the country's political dynamics, which had hitherto been characterized by a divided opposition and a solid hold on power by Nicolas Maduro. However, given the scope of the economic challenges and the large sovereign default, any political transition would take time to deliver on debt restructuring and materially improving the economic situation. 

In the short term, new U.S. sanctions imposed on state-owned oil company PDVSA will deepen the country's economic crisis. Oil production will likely fall further and more quickly affecting economic output, exports and government revenues. The domestic disruption caused by protests and political uncertainty will further deepen the severe economic distortions that have been building for years and accentuate the humanitarian crisis. 

External and internal political pressures on the Maduro administration are growing significantly. Most Latin American and European countries, the U.S., Canada and Australia have recognized Juan Guaido as interim president. A number of other countries have declared neutrality on the issue of the legitimate Venezuelan government, while China, Russia, Turkey and several others continue to recognize Maduro as president. 

The military's position will be key to the country's political future and there is the potential for a protracted stalemate and deepening of positions. 

If Maduro is able to retain power, the prospects of reforms to stabilize the economy and end hyperinflation are likely to be diminished, at least in the near term. As noted, U.S. sanctions will have an immediate impact on the oil sector, likely leading to further falls in oil production that will be difficult to reverse. Venezuela currently exports approximately 500,000 barrels a day to the U.S. These oil exports provide critical cash flow to PDVSA and the government. Over time, these exports can be diverted to other destinations, but this would entail a significant discount and higher costs for the company, squeezing margins. Furthermore, sanctions essentially preclude a debt restructuring by prohibiting U.S. entities to participate in new debt issuance by PDVSA or the government. 

Even in the case of a political transition, a debt restructuring is likely to be a lengthy process. A political transition will be complex and likely culminate in elections. Furthermore, humanitarian concerns would be the immediate focus. Over the longer term, economic and political institutions would need to be rebuilt. The nature of numerous classes of creditors including sovereign and PDVSA bondholders, bilateral lenders (especially China and Russia), multilaterals and private creditors will prove to be additional obstacles for a successful debt restructuring. A few legal cases are already under way in U.S. courts. 

Guaido's economic plan includes seeking financial aid from multilateral organizations, bilateral loans, restructuring Venezuela's debt and bringing private investment back into the country's oil sector. He has also called for eliminating currency controls and privatizing state assets. 

Economic stabilization will be crucial after years of deterioration. Hyperinflation, multiple currencies, severe loss of productive capacity, including in the key oil sector, has led to a dramatic contraction in GDP. An additional challenge will be that engagement between the IMF and Venezuelan government has been practically non-existent for years (the last IMF Article IV Consultation was performed in 2004). The IMF has censured Venezuela for not providing adequate economic data (with no GDP, balance of payments or inflation statistics since year-end 2015). A stabilization program in association with the IMF could take months to put together and enact, even assuming a clean transfer of power. 

For the oil sector and industry in general, sustained and significant investment will be needed to stabilize and increase production. PDVSA would need to be restructured from the ground up and incentives put in place for private investment. Institutional capacity, rule of law and political stability will be key after years of weakening government institutions. For many investors, these political factors would need to be in place before pledging large-scale investments. 

Should a successful political transition combined with economic stabilization reforms be implemented, Venezuela would have significant potential. The country has the largest proven oil reserves in the world, which could attract significant foreign direct investment. Furthermore, years of capital outflows suggest that large amounts of private Venezuelan assets abroad could return under the right conditions, helping boost investment and pave the way for sustained economic growth.

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