The road ahead We explore two scenarios. In the first one, oil prices remain low, as do import levels, and financing needs rise to $25.4bn. In a second one, oil recovers and the government allows imports to rise, so that financing needs drop only to $20.3bn. Table 1 lays out potential financing strategies under both scenarios. Our basic takeaway is that authorities have at their disposal the means to avoid a default even at current oil prices. We expect $5bn of these needs to be covered through the automatic renewal of the Chinese agreement. We also expect the country to run down around $2bn of its existing unspent balances from past China loans. We estimate $2bn from mining concessions – an amount that appears guaranteed by the Gold Reserve deal - as well as $3-$5bn from new loans backed by assets such as CITGO, other refineries or stakes in oil JVs. We see the country packaging $1-$2bn of its remaining Petrocaribe trade credits, selling some of its current stock of bond holdings in the secondary market and swapping out of the 2016 and 2017 maturities. A voluntary swap is feasible without causing a significant increase in debt burden given the high level of inversion of the sovereign and PDVSA curves. International reserves would drop by $3-$5bn and end the year at $11-$13bn

 

BoAML LatAm in Focus Francisco Rodríguez + 1 646 855 5910 Venezuela: the case against default Last Friday, Venezuela paid the amortization on its 2016 sovereign bond for $1.5bn. While the news was well received by investors, the market is still pricing in a very large probability of default - 61% by year-end and 97% within the next five years. We hold a different view. While we recognize that Venezuela is under considerable financial stress given the decline of oil prices and limited liquid foreign currency reserves, we believe that authorities see default as bringing greater costs than benefits and are willing to make politically costly choices to avoid it. In our view, the market has underestimated the country’s capacity to reduce imports as well as its willingness to use its stock of external and internal assets to avoid defaulting. In fact, in January of last year, markets were assigning a 68% probability to default within a year. The issue of capacity A common line of reasoning starts out from quantifying the country’s financing needs given expected import, export and debt service projections. However, any complete assessment of a country’s payment capacity must consider not only the country’s hard currency revenue flow but also the stock of assets it can tap. We estimate that as of the start of this year, the country had $52.0bn in external assets susceptible of sale or securitization, allowing it to continue to cover a sizable financing gap even under the extreme assumption that new financing is not viable (see The Red Book: 4Q15 Edition). Our estimate does not include internal assets such as the 298bn of oil reserves, 7 thousand tons of gold deposits, nor the numerous privatizable state-owned firms. The announcement of an agreement with mining company Gold Reserve from which Venezuela stands to obtain $2bn in financing, was a salutary reminder of the country’s capacity to leverage its internal assets, as well as a demonstration of authorities’ ability to put aside past nationalistic stances when facing an acute financing constraint. The imports question The capacity to service a country’s debt depends not only on its availability of hard currency. It also depends on the ability of authorities to reduce the use of hard currency for other ends. Over the past years, the government has shown a willingness to prioritize debt payments over alternative uses of foreign exchange. The key relevant question for bondholders is whether this prioritization will continue in 2016. Are recurrent shortages an indication that import restriction is reaching its limits? Not necessarily. Shortages are as much an expression of binding price controls as they are of limited availability of dollars. Even Venezuela’s acute medicines shortages seem to be more than anything a result of the country’s dysfunctional price system, given that pharmaceutical sales continue to be well above the regional average (see Life and debt). Whether Venezuela has enough dollars to function adequately is hard to know given the country’s lack of a functioning price system. Shortages do not show that hard currency is unavailable – they simply show that it is poorly allocated. The country’s large reliance on exchange and price controls has evidently generated sizable efficiency and welfare losses. It does not follow from this that the country will ultimately be forced to default. What follows is that the country will ultimately be forced to restore some basic functionality to its mechanisms of resource allocation. The issue of willingness We believe that authorities’ willingness to comply with their external debt obligations reflects an awareness of the large economic and welfare costs that would result from defaulting on them. The fact that the sovereign is also the nation’s largest exporter makes Venezuela atypical. Since oil-related assets and revenue flows would run the risk of attachment upon default, the potential short-term cash flow gains to the country from a default are limited and may not even be positive. PDVSA (and some sovereign) bonds lack collective action clauses, making an orderly restructuring very difficult to implement and thus raising the costs of a default. Consider the example of Ecuador. The discount of Ecuadorian crude to Brent oil rose by 20 percentage points – from 11 to 31% - when the country defaulted in 2008, reflecting the perceived risk of attachment of receivables. Ecuadorian crude prices remained at depressed levels until a debt buyback was announced in 2009. The buyback was facilitated by the lack of external attachable assets and the fact that the defaulted debt was sovereign and not of the state-owned oil company. Were Venezuelan oil prices to experience a similar drop today, the country would forgo $5.4bn in export revenue a year. In other words, it is not clear that Venezuela’s cash-flow problem is made any easier by defaulting. A matter of timing We estimate that Venezuelan imports in 4Q15 fell 58% below their levels three years ago. If this decline is sustained through 2016, imports of goods and services would fall 31% to $35.3bn this year. These levels would be consistent with a public sector current account in balance – i.e., external debt not increasing – with Venezuelan oil at $43. Whether Venezuela’s external accounts are sustainable depends on where one thinks oil prices are headed in the medium and long term. Futures markets are pricing in a return of WTI to $49 by 2022 – a level that would correspond to Venezuelan oil at $42. We are more optimistic and see WTI at $59 by next year (Venezuelan oil at $55). In either of those cases, current import levels would be consistent with long-run sustainability. The road ahead We explore two scenarios. In the first one, oil prices remain low, as do import levels, and financing needs rise to $25.4bn. In a second one, oil recovers and the government allows imports to rise, so that financing needs drop only to $20.3bn. Table 1 lays out potential financing strategies under both scenarios. Our basic takeaway is that authorities have at their disposal the means to avoid a default even at current oil prices. We expect $5bn of these needs to be covered through the automatic renewal of the Chinese agreement. We also expect the country to run down around $2bn of its existing unspent balances from past China loans. We estimate $2bn from mining concessions – an amount that appears guaranteed by the Gold Reserve deal - as well as $3-$5bn from new loans backed by assets such as CITGO, other refineries or stakes in oil JVs. We see the country packaging $1-$2bn of its remaining Petrocaribe trade credits, selling some of its current stock of bond holdings in the secondary market and swapping out of the 2016 and 2017 maturities. A voluntary swap is feasible without causing a significant increase in debt burden given the high level of inversion of the sovereign and PDVSA curves. International reserves would drop by $3-$5bn and end the year at $11-$13bn