Back in May, our co-head of Emerging Markets Debt, Rob Drijkoningen, wrote a guest column for CIO Weekly Perspectives. He emphasised the positive momentum in emerging market fundamentals and the reforms being pursued in Brazil, Argentina, India, Indonesia and Mexico. But topping the list of risks he identified was Venezuela, which was rapidly running out of money to pay its debts.
Right on cue for the 20th anniversary of the Asia crises, and the 35th anniversary of Mexican default that set off the Latin America crisis, Venezuela has hit the headlines. Will we be writing about this in 20 years’ time, reflecting on the events that set off another summer crisis in the emerging world?
Echoes of the 1980s
There are distinct echoes of the 1980s crisis in Venezuela. Back then, rising oil prices forced commodity importers to borrow to meet their costs, while encouraging exporters to leverage their good fortune for development, in the belief that expensive oil was forever. When oil prices collapsed, the resultant debt levels became unsustainable.
Venezuela has relied on high oil prices to sustain ruinous populist economic policies that have pushed up its debt while doing little to benefit its citizens or its productivity. GDP is contracting by 10 per cent a year and the populace suffers under triple-digit inflation and shortages of food and medicine. The regime of President Nicolás Maduro seeks to consolidate its power as antigovernment protests sweep the country, leaving scores of casualties.
The government has done everything it can, including eating deep into its dwindling foreign-exchange reserves, forcing a collapse of imports, and resorting to off-balance sheet deals to raise cash by pledging future oil production and related assets on the cheap — all in a desperate scramble for hard currency to meet its debt obligations. But its determination to cling to power is not only exponentially worsening the conditions for recovery under a new regime, it is also threatening a vicious circle. Foreign condemnation includes talk of US sanctions that would include a ban on oil imports, while civil strife threatens to disrupt exports — either of which would deal a huge blow to the country’s ability to meet the rest of its debt payments in 2017.
Markets are already pricing for default
The market in Venezuelan debt appears to have concluded that default is all but inevitable. Bonds trade at 35-45 cents on the dollar, with prices dipping further around rumours of US sanctions. Price volatility is now associated less with the probability of default than with estimates of the timing of a bankruptcy, subsequent recovery values, and the political circumstances surrounding all of this.
The real question for most investors concerns the potential knock-on effects.
This crisis has unfolded all too predictably. Because default will not be a shock, contagion will likely remain contained. An impact in energy markets is to be expected given that Venezuela is such an important oil exporter. Oil prices have been firmer of late, but other factors have played a role here: pledges of production cuts by Saudi Arabia and falling US stockpiles. Moreover, this move in oil prices has not translated into a commensurate move in energy stocks and bonds, suggesting that the market sees this as a short-term spike rather than anything more sustained.
Venezuela represents 1.7 per cent of the JP Morgan EMBI GD Index at present. Given the substantial investment in passive index strategies, it is important to remember that a default would not trigger automatic exclusion from the index as long as other index inclusion criteria are met.
Tragic, unnecessary — but not representative
Nonetheless, emerging market assets’ long winning streak since early 2016 confirms that broader sentiment is positive. Importantly, that is rooted in recovering fundamentals: better growth rates around the world, a progressive and pro-growth mix of policies in most countries, benign inflation, reasonable levels of government debt, more solid current-account dynamics. Venezuela’s circumstances do not change those wider facts on the ground.
This is perhaps the most important message for investors out of the current crisis. Venezuela looks like a Latin American country from the 1980s, when big economies such as Brazil and Mexico could collapse, spreading contagion through the weak banking systems of an over-indebted, inflation-plagued emerging world. But it is both small and a throwback. Most other emerging markets look very, very different today.
What is happening in Venezuela is tragic and unnecessary. But at the same time, it reminds us just how much progress the emerging economies have achieved over the past 35 years.
The writer is Chief Investment Officer and Global Head of Fixed Income at Neuberger Berman.