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Vulnerabilities of Borrowers and Lenders: The Case of Venezuela

Vulnerabilities of Borrowers and Lenders: The Case of Venezuela

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FINANCIAL CYCLES



high cost of borrowing. As of August 2014 there has been a year-on-year

interest rate of more than 20 percent in Venezuelan sovereign bonds, on

average. As far as junk is concerned, this has been among the “best performing” emerging market “assets” in 2014.

Other characteristics of the country’s socialist regime were price and

capital controls, expropriation, and a weak protection of property rights

as well as inefficiencies and corruption, all of which led to numerous

shortages and kept inflation persistently above 50 percent. Again, in a

way similar to the case of Argentina, Italy, and other mismanaged countries, radical reforms tapping into international bond markets or additional bilateral loans can at best delay but will not stop the country from

running out of liquid assets in the next year or two.

The irony is that Venezuela is a country rich in minerals. By some

accounts it has some of the world’s largest proved oil reserves. An estimated 300 billion barrels account for nearly 18 percent of the global oil

reserves and are obviously worth a lot. But at the same time, Venezuela’s

net oil production—that is, total production minus domestic consumption—continues to decline.

On the contrary costs continue to mount. According to several opinions, the dramatic effect of Venezuela’s debt service ratios came from the

decline in the rates of return perceived on Venezuela’s net assets. When a

country pays a high rate for its liabilities but receives a low return on its

assets, its overall return on assets turns negative. This Central American

case has been another paradox of the current financial cycle.

The government of Venezuela says that the country is a net creditor,

but many economists believe that official statistics overestimate the extent

to which it is a net creditor to the rest of the world. It is a net creditor of

sorts in that it faces a rate of return on assets lower than its growth rate,

because it lends ever-increasing sums to other countries by way of special

financial deals.

Venezuela’s public finances certainly look tight. Despite $21 billion of

reserves, less than $3 billion of these are liquid. The difference between

defaulting by Argentina and that by Venezuela is that Argentina had

nothing to lose while Venezuela has substantial foreign assets under risk.

A Venezuelan default would be widely felt, as:

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The country accounts for 7 percent of emerging market benchmarks, and

Its default could force redemptions of other investments by passive

index-tracking funds.



Holding a positive net international asset position is a demanding standard, and few nation-states satisfy it. When an economy is a net debtor,



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the sustainable current account can be negative but the external primary

balance must be positive so that the country is able to set aside resources

to service its liabilities with the rest of the world.

A key question to ask in this connection is what would be the country’s sustainability. Specifically what would be the maximum ratio of net

foreign liabilities to GDP that Venezuela could sustain, given its current

primary external surpluses. Given the adverse market conditions faced

by Caracas and the low return on its assets, it would be difficult for it to

sustain more than a moderate debtor position with its current relatively

small and uncertain primary external surpluses.

The situation is indeed complex because the Venezuelan public sector’s

only major source of receivables is the oil industry. Since 2008, there has

been a growing divergence between the outstanding receivables and those

captured in the net international investment position. To a large measure,

this discrepancy arises from the export of a barrel of oil in exchange for a

receivable such as an in-kind payment.

The irony with Venezuela is that it displays an overall negative income

balance despite being a net creditor to other countries, according to official

statistics. This is opposite to the case of the US external accounts, which

show a positive income balance despite the country being a net debtor.

The explanation economists give is that Venezuela faces substantially

higher interest rates on its liabilities than on its assets. Concerns about a

potential default arise from the country’s weak fiscal accounts that ensure

it pays a high risk premium on its liabilities.10

Whether we talk of Argentina, Venezuela, Italy, France, or any other

socialist-run country, the established system of popular perks known as

“welfare” cannot seriously be reformed when there are a large numbers

of losers. Because of this, politicians are hyping the issue, and they avoid

deciding on the details of a turnaround. Even the objectives of restructuring in countries that venture into the repositioning of welfare, remain

uncertain.

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Is the basic idea to reduce total public spending?

If so, are the savings to be used to improve the budgetary balance or

to cut taxes?



Or, is the idea to reduce social security spending in order to spend

more on health and education? Or, are governments choosing to leave

spending unchanged, but shift it from better-off to worst-off recipients?

A valid answer has to be clear and well documented. It must also account

for the fact that meaningful change must involve large sums of money

that will come mainly from taxing the middle classes—rather than the

often-heralded “taxing the rich.”



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Tinkering will disappoint everyone. Tackling the problem aggressively

will alienate many voters. Therefore politicians push the subject to their

successors who are doing likewise. There is also an organization of lenders established in the 1950s known as the Paris Club. Sixty-five years ago,

creditor governments got together to decide whether or not to reduce

debtor governments’ debt, and by how much. Over time, the Paris Club

has developed into an international outfit dealing with global sovereign

debt largely consisting of a combustible mixture of:

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Raw politics, and

Financial engineering wizards.



Like African countries, Latin American sovereigns have plenty to do

with the Paris Club itself and the wider debt forgiving policies. In July

2014 Russia wrote off 90 percent of Cuba’s $35 billion Soviet debt. More

debt was created by the export of Russian nuclear technology to Argentina

and arms to Brazil (which is interested in a $1 billion antiaircraft missile

system). China has given Venezuela some $50 billion, in loans, mainly

backed by oil.11

Deals outside the Paris Club are not uncommon, as over time it became

a sort of appendix to Western governments. A reform enacted in June

2003 in the course of a Paris Club meeting in Evian, France, established

a politically motivated quantitative approach based on how much relief

the debtor country needed in order to grow on a sustainable basis without generating another debt problem. Known as debt sustainability, it was

based on the notion that if a country was granted debt relief on Evian

terms, it would have to make a serious commitment that it would not

return to the Paris Club for debt relief.

Theoretically, the aim of debt-sustainability models is to assist in

determining whether a country’s debt is too high relative to its ability of

making interest and principal payments on the debt. A country’s GDP

and its ongoing debt obligations are considered to be a good measure of its

capability of paying. Hence an often-used criterion is the ratio of the debt

to GDP, which has been used in this book. But the background reason for

the aforementioned Paris Club policy change was political, and the first

beneficiary was Iraq in the wake of the George W. Bush Jr. sweep.



5. Private Debt Is Another Nightmare

In contrast to public debt, total private debt is the sum of household and

company debt. Private persons, households, and companies that have



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assumed too many debts in relation to their income, are eventually obliged

to trim their spending and rebuild their balance sheets. This is necessary,

but it has a negative impact on business activity and employment. When

households retrench their buying on credit, firms reduce or avoid investing outright. They also concentrate on shrinking their balance sheets.

As Hans-Werner Sinn, president of the Wirtschafts Forschungsinstitut

at the University of Munich (IFO), has pointed out: Within the euro system households and companies are overindebted, banks are overindebted,

states are overindebted, and national central banks are overindebted. It’s

not nice for the creditor to recognize that he would not get his money

back, but the sooner he faces the truth, the better.

One sees this economically damaged landscape by lifting the curtain

of the present financial cycle. Let’s face it. Our society is overexposed to

negative development and the likelihood of such a risk is itself rising. In

an article Raghuram Rajan published in the Financial Times on August 7,

2014, he states: “The world is at risk of another financial crash following a

steep rise in asset prices.” This plus overindebtedness of the private sector

is the worst enemy of:

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Investments, and

Therefore, of employment.



It needs no explaining that when private investment is being delayed or

cancelled the economy suffers. As business confidence wanes, companies

complain about political uncertainty: How can they plan for the longer

to medium term when the economy does not move and the government

cannot provide a stable direction? In a stop-go economy investments are

curtailed or they altogether disappear.

For their part, government departments are waiting to discover what

their budgets will be. Their immediate reaction is that of saving money

by skimming on maintenance, firing contractors, delaying payments,

or leaving for later on what they planned to do. This scaling back hurts

the economy twice: Projects are not moving forward, while costs mount.

Delays have a nasty habit of bringing higher expenses sometime down

the line.

As for the financial industry, bad debts erode the banks’ capital, making them reluctant to lend. All these examples add to the lender’s and to

the borrower’s vulnerability. The negatives reinforce each other, increasing the overall drag on economic growth. They also document the reason

why economists look at a consumer-led recovery as the best step in an

orderly rebalancing from debt-induced stagnation to growth. But growth

remains elusive.



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The options are limited even if rebuilding may take different forms.

For instance, from too much dependence on services to reinvigorating

manufacturing, or switching focus from consumption to investment and

exports. Other things being equal, debt affordability improves when gross

domestic product is promoted by the strength of industrial sectors; and it

is penalized when construction and production, including manufacturing, remain below their potential.

Another negative regarding debt affordability is when households are

saving more than they were but the growth of credit is far below previous

levels. This may be absolutely necessary for individuals and families in

order to rebuild their balance sheets after an orgy of borrowing but, as

already stated, it has a negative aftermath on the recovery of GDP.

The dynamics of household debt is instrumental in shaping political

and socioeconomic decisions. Monitoring the ratio of public debt to GDP

is not the only measure of vulnerability. For reasons explained in the preceding paragraphs, tracking the ratio of private debt to GDP is also quite

important.

Companies with high debt to equity ratios are particularly stressed.

Therefore it is unwise to consider them as investment vehicles. The

European Commission, which monitors emerging macroeconomic imbalances, right or wrong, uses a figure of 160 percent of GDP for the sum

of private debt (households and nonfinancial companies, including in the

latter both loans and corporate bonds). Private debt ratios that are high

compared to the EU’s target value are seen as a source of worries.

Financial analysts are also concerned because they know by experience that banks are not forthcoming in recognizing and writing down

their nonperforming loans. According to a rising number of expert opinions, there is an urgent need for an honest assessment of financial institutions’ balance sheets, followed by management’s willingness to sell or

restructure corporate loans and mortgages. But the stress tests done by

the European Banking Authority (EBA) in 2012 were such a carnival that

very little came out by way of enlightenment (chapter 8).

While the share of frail companies is so much higher in Portugal,

Spain, and Italy, it is always wise to watch out for the unguarded moment

when something big might happen in an unexpected place—including

one that seemed to be financially healthy—and escape control. This is

particularly important as one of the so-far unanswered questions is how

the European banks capital and liquidity holes will be filled. The pros say

that private equity markets would shoulder some of the burden, but this

is not at all true of badly busted banks.

Will they bail-in their bondholders under stringent new rules agreed

upon by the EU? Will they avoid taxpayers being called in as a last resort?



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The ECB would prefer to use the European Stability Mechanism (ESM)

as a backstop. But this runs contrary to the principle that governments

should be responsible for their own banks and that they may turn to the

ESM only if their finances risk being insufficient.

While a good deal of attention is being paid to the way household debt

unfolds, the banking industry is far from having recovered its financial

strength. The policy of heavy penalties by overindebted nation-states

(chapter 7) makes a bad situation even worse. From January 1 to August

1, 2014, European subordinated debt rose 185 percent to $76.8 billion,

compared with the same period in 2013 (the highest amount since 2008).

Banks in peripheral Euroland countries increased their subordinated

issuance 276 percent year on year.12

Investor confidence has declined. Since June 2014, and the onset of

worries surrounding Banco Espirito Santo (chapter 9), subordinated debt

funding costs have risen 20 percent. Still there is a curious level of complacency about the risks in debt instruments. Exposures being assumed in

household debt have not been priced in the interest rate curve.



6. A Lesson Learned from the Fall of Feudalism

The unavoidable result of kicking the can down the street has been the

lengthening of the list of subjects to be addressed by policymakers. To a

large measure, these are subjects that influence, and are influenced by,

the voting public’s broader reaction. As chapter 3 already brought to the

reader’s attention, the price that has to be paid so far by Western economies is deleveraging. In a similar way, in medieval times the keyword was

security and the price was feudalism.

As far as their history is concerned, including their rise and decline,

capitalism and feudalism have many things in common, even if the life

of the former has been less than 200 years13 while that of the latter lasted

a long time. Precisely because of their similarities, the disappearance of

feudalism can be taken as a proxy of capitalism’s life cycle. Ignorance of

history is one of the most fundamental reasons of faulty judgment.

Feudalism started in Western Europe with the rather sudden disappearance of the Roman Empire and, in parallel to this, the invasion of

large masses whose culture and behavior was new to European life. That

meant a sudden increase in dangers, and history teaches that when confronted with a greater danger people are not averse to giving up several of

their prerogatives for something else to which they attach a higher price.

Feudalism did not come out of the blue sky. Its way of dealing has

been a regrouping into smaller communities made necessary to provide



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protection, since the almighty Rome was in a shambles. Neither was

feudalism monolithic. Roughly halfway in its course its original model

started showing signs of obsolescence and it underwent restructuring,

even if in the Middle Ages developments went on very slowly.

Still, at the roots of feudalism’s course toward its decline was the

fact that the old feudal principles had lost contact with the realities of

European societies—something similar to what is happening today with

socialism. To survive, in the second half of its existence the feudalistic

regime had to adapt, and over time the mutations produced by this adaptation became significant as:

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The reasons that gave rise to feudalism were forgotten, and

The abuses of the feudalist society steadily increased.



Not only did the feudal society no longer respond to its original security objectives, but also, little by little, the social costs became unbearable and in some cases intolerable. The goal of security was the remit

of the chevaliers. Slowly, however, the sense of this original mission disappeared, and the sought-after function of security transformed itself

into one of privilege with the chevaliers becoming the aristocracy.

This has not been feudalism’s only transformation. Privileged positions became hereditary, and as the number of those in power multiplied

vast privileges were established from within. The result was that those

outside the clan were not welcomed as members.14 As the number of

outsiders increased, forming a mass society of sorts, another important

transformation saw the light:

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Feudal rights lost their character of social service, and

The links provided by fidelity significantly weakened.



All this took centuries, and the changes to which reference has been

made did not spread automatically all over medieval Europe. Still changes

were promoted by several factors, one of them being the Crusades, which

accelerated and amplified local developments and enlarged the horizon of

European society with new ideas coming from the East.

Slowly but surely, the result was profound economic and social transformations, followed by wars and intense economic crises. Instability and

uncertainty lasted for centuries. The intensity of wars first increased then

subsided, making place for financial innovation and capitalist ideas. Some

economies prospered and ways and means had to be found to take advantage of the advances in technology—starting with manufacturing, railroads,



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and internal combustion engines whose more general application required

lots of capital.

The answer was provided by the invention of capitalist rules for industry and business, whose initial excesses, as well as accomplishments, have

been questioned since the end of the nineteenth century. Like feudalism, capitalism was a necessity; and also like feudalism it did evolve over

time—till it became a victim of its own success.

Like feudalism, capitalism has been obliged to reform itself in order to

survive. An example is the abolition of child labor that capitalism inherited from the feudalistic regime. Other improvements, too, like publicly

sponsored primary cycle education, have been significant. Such reforms

altered society’s behavior for the better as long as their promoters did not

press to sustain the unsustainable, haphazard, and improvised way of

doing things that in the late twentieth and early twenty-first centuries led

straight to trouble.

The early adaptations of capitalism were rather gradual. Instituted after

World War I, the eight-hour working day was an important restructuring.

Even more crucial was the social insurance for pensions that preceded itinstituted in late nineteenth century in Prussia by Otto von Bismarck. In the

1930s came public healthcare and paid vacations (Roosevelt’s and Blum’s

initiatives). But then started the epoch of excesses. After World War II:

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Entitlements flourished, many of them unsustainable, and

Successive Western generations were born in prosperity espousing

featherbedding.



This also meant that over more than six decades successive generations

in Western nations were brought up in an easy life, while memories of

hard days experienced in the past faded. With weakening remembrance,

excesses accumulated without a thought about their consequences and,

like feudalism, the capitalist system started to crack.

Much of this has been capitalism’s own (wrong)doing. Aside from

unaffordable public services financed through debt, there was too much

gaming of the system till the pillars on which it rested started collapsing.

The merger of capitalism and socialism adopted by Western societies is

just not working as the utopians had thought it would. In its wake:

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The sense of performance and of deliverables that promoted the

industrialization of Western society has taken a leave, and

The system of public administration has been corrupted, rotten to

its core, by rapidly multiplying special interests.



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To fill the vacuum created by this turn to absurdity, Islamic theology

was given a free hand. But to sustain itself in public conscience, theology

(like every ideology) needs big, sweeping ideas detached from their consequences which are usually in collision with reality. Unable to directly

confront self-appointed imams, Western politicians often found themselves in a cul de sac. Also on economic issues the politicians of both capitalism and socialism lied to the public, not just once but as a policy.

Knowledgeable people in Western capitals believe that the minimization of the effect of a huge public debt and of private debt, let alone the

perception of fake surpluses, is corrosive to the maintenance of spending discipline. Banks, too, have got the message that as long as the taxpayer foots the bill it is free for all. Like feudalism in its time, capitalism

has wounded itself deeply with extravagant policies and acts all over the

Western world.

On the international front, irrational, costly, and ineffectual foreign

interventions by the US in Iraq, NATO in Afghanistan, the French and

the British in Libya, have ended in unmitigated disasters. Yet they are the

favorable game in Western capitals. Barack Obama continued the Bush Jr.

policy of interventions abroad while important issues are left unattended

at home. For instance, the US workforce lacks appropriate skills for the

twenty-first century and this hinders the expansion of the American

manufacturing base.

A report by Bank of America Merrill Lynch puts it in these terms:

“Roughly 95 percent of net job loss during the recession was in middleskilled occupations. Since the recession, job growth has been clustered in

high-skilled fields inaccessible to workers without advanced degrees or in

lower-paying industries. The US now has larger patches of affluence and

poverty, while the middle-class is shrinking.”15



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What Is Special about Banks?



1. A Snapshot of the Banking Industry

After a period of seven years spent in an economic and financial crisis,

bank regulators look forward to a stronger industry by way of improved

capital positions, a reduction in risk-weighted assets (RWA, chapter 9),

and a rebuilding of the banks’ balance sheets primarily through retained

earnings promoted by a recovery in bank profitability.

The principle underpinning this policy is correct. Its downside is that

to rebuild their balance sheets banks have switched from a policy of easy

loans to a very conservative stand. This is starving many companies, particularly small and medium enterprises (SMEs), of funds. Banks answer

that the restructuring of loans policy is part of shifting attitudes toward

risk. Critics say that the switch has a significant impact on economic

growth.

Moreover, critics add that by shifting its emphasis from loans to trading, the banking industry is abandoning its duty as an intermediary. And

while it made progress in healing its wounds, the banking industry’s

progress has not been uniform. Since the 2007–2008 crisis, the “assets”

on which credit institutions count include many damaged goods, while

toxic waste remains a major source of vulnerability.

Credit institutions that have failed to adjust to the postcrisis financial

environment, and rebuild their balance sheets, also face lingering weaknesses from direct exposure to overindebted borrowers. Not the least is

the challenges they confront from overindebted sovereigns and the pressure the latter exercise on them to buy their bonds that are not necessarily

creditworthy.

It therefore comes as no surprise that postcrisis the credit ratings of

many banks have deteriorated, leading central bankers and supervisory

authorities to enforce loss recognition and demanding that the banks’



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actual status becomes more transparent. Stress tests (chapter 8) are the

currently preferred method. The question mark relating to these tests has

been that, rather than applying conditions of stress, they have used mild

criteria, which is misleading.

As a result, while banks and bankers may be passing the tests, conditions remain fragile when assessed in the longer run of a financial cycle.

Up to a point this has been reflected in credit rating cuts. When in June

2012 Moody’s downgraded 15 of the world’s biggest banks, many financial institutions and investors focused on the wider impact a rating drop

would have on the derivatives swaps agreements to be found at the heart

of a growing number of structured finance deals.

At the origin of the market’s worries is the role banks play as counterparties in interest rate and currency swaps put in place to hedge against

risk in structured finance deals like asset-backed securities (ABSs), covered bonds, residential mortgage-backed securities (RMBSs), and collateralized loan obligations (CLOs). Embedded in these concerns is the fact

that the downgrading of a bank:

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Can lead to a swath of downgrades of structured financial deals,

and

May, potentially, force up the cost of funding for banks.



For their part, credit institutions are complaining that central banks

constantly change the capital rules, to the point where capital adequacy

has become a race with no finish line. Regulators also redefine what qualifies as assets. One of the changes with deep market effects is when they

assigned a “riskless” label to government securities. Sovereigns have got

into the habit of financing their huge debt by selling the securities to the

banks, even to those which are not keen to allocate big chunks of capital

to the sovereign (chapter 9).

In late 2011, three years after the global severe banking crisis, a capital

review by the European Banking Authority (EBA) included 71 major EU

banks and tested all their direct government bond holdings for potential losses. According to prevailing accounting rules, positions held as

“available-for-sale” and those within the “held-to-maturity” and “loans

and receivables” portfolio:

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Were not marked at market values, and

Neither had they been tested in previous EBA banking stress tests.



EBA decided that all banks should establish an exceptional (though

temporary) capital buffer to achieve a minimum core Tier 1 ratio of



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