Should they have gone long?

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Venezuela Has Good Reasons to Avoid Default

Francisco Rodriguez is chief economist and managing director of Torino Capital LLC in New York.
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With Venezuela's economy veering into depression and Venezuelans scrambling to find basic goods, the government's decision to keep servicing the country’s $68bn in  external bonds has been called everything from “crazy” to “a crime against humanity.” Putting bondholders above Venezuelans, these critics argue, is just morally wrong.

But such charged rhetoric is no substitute for a sober analysis of Venezuela's debt predicament. Seen in that light, the wisdom of defaulting is less clear cut. Moreover, focusing the economic policy discussion on whether to pay the country’s external debt creates a dangerous distraction that could derail necessary and urgent reforms.  

If Venezuela's opposition ultimately takes control of the country's executive branch, it will have to define and communicate its stance on the country’s international financial obligations. (Full disclosure: I work for a New York-based investment firm that trades in, among other things, emerging market debt, including Venezuela's.) And that calls for careful consideration of the economic implications of a forcible debt restructuring and the realistic options for covering the country’s external financing needs.

For starters, Venezuela is in more ways than one not a typical debtor.  The government's status as the country’s main exporter -- oil accounts for 95 percent of Venezuela's export earnings -- makes it significantly more vulnerable to potential legal actions by bondholders in international courts.  While oil shipments in and of themselves may not be directly attachable if they are sold prior to leaving the country’s ports, most legal experts would also agree that the receivables associated with these oil sales as well as the assets owned abroad by the state-owned oil company PDVSA are fair game. 

The closest example of the consequences for an oil exporting sovereign of a credit event comes from Ecuador’s 2008 default.  President Rafael Correa defaulted on the country’s sovereign bonds in December 2008. After the decision, the price of the Ecuadorean oil basket collapsed to 59 percent of the price for Brent crude, from 80 percent on the month prior to the default.  Prices only recovered to pre-default levels in June after Ecuador announced that it had repurchased the defaulted bonds. 

This evidence is consistent with the view that entering into an oil delivery contract with an enterprise owned by a government that has defaulted on its debt is a risky business.  Were Venezuela to pay a corresponding cost upon defaulting as did Ecuador, the loss in export revenues would amount to $5.7 billion a year, erasing most if not all of the short-term cash flow gains from defaulting. Indeed, Venezuela's relatively large overseas assets and PDVSA's large share of the debt (53 percent of outstanding bonds) both suggest that the cost could be higher.

But couldn’t Venezuela renegotiate its debts with bondholders, proposing an agreement to provide it near-term relief so it can get its economy back in order?  It certainly wouldn’t be the first country to do so, and in many cases orderly restructurings have allowed countries to regain a foothold and ultimately reshape their relationships with markets.

Unfortunately, restructuring these bonds would be very difficult. When they were issued, their buyers were understandably concerned about the willingness of Hugo Chavez's administration to honor its commitments. They thus demanded covenants that would make it very difficult for PDVSA to default. PDVSA bond covenants lack collective action clauses – a provision that allows a majority of bondholders to make an agreement binding for all holders, thereby impeding a minority from holding out against a restructuring.  They also include a non-standard clause requiring unanimous consent for any change in the bonds that might impair the right of each holder to receive payment or go to court to enforce such payment.

Without an orderly restructuring, PDVSA would be left with the alternative of filing for bankruptcy. While this is certainly feasible in Venezuelan courts, obligations with bondholders must be settled in U.S. courts.  In order to extend this declaration of bankruptcy into the U.S., a company essentially has to establish that it is insolvent and thus cannot simply sell its assets to pay off its liabilities (otherwise it doesn’t need the courts to decide how to divide these assets up amongst its creditors).

Making a credible argument before a U.S. court that PDVSA is insolvent would be a daunting task. After all, PDVSA holds a monopoly over the extraction and commercialization of 300 billion barrels of oil - the world’s largest oil reserves.  If each of these barrels of oil were worth a mere $0.40, they would still be enough to pay off the entire Venezuelan (sovereign and PDVSA) debt stock. 

Venezuela could try to transfer those rights to a new state-owned oil company, therefore stripping PDVSA of its most valuable assets.  But when that new company starts exporting, bondholders will almost certainly go after its revenue flows, arguing that it is nothing more than a thinly veiled attempt by the government to defraud creditors of their rights.

Venezuela has some of the world's most dysfunctional policies, including price controls that force retailers to sell goods at a loss and exchange controls that have made arbitrage the economy's single most profitable activity.  Were Venezuela to default without changing its policies, it wouldn’t put $10 billion of goods on store shelves; it would simply generate $10 billion more of over-invoicing and corruption. 

Venezuelans are certainly going through dire economic times. Yet blaming external debt for the state of Venezuela’s economy is kind of like blaming New Hampshire for Trump’s nomination.

Venezuela is not insolvent.  Venezuela is poorly run. Addressing its economic problems requires a credible macroeconomic stabilization plan, economic reforms to recover the country’s productivity and allow it to take full advantage of its resource endowments, and a restoration of its political institutions. To regain access to international financing, Venezuela needs to change the way it manages its economy.  It does not need to default.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Francisco Rodriguez at frodriguez60@bloomberg.net

To contact the editor responsible for this story:
James Gibney at jgibney5@bloomberg.net