The Bolivarian Republic of Venezuela is going through a chaotic phase with a slowdown in economic growth, annual inflation heading beyond 60 percent, and a shortage of essential goods in stores. Venezuela has been mired with economic issues for some time now, but the fragility of its economy became evident when foreign exchange earnings from the country’s oil exports began to evaporate as oil prices plummeted by half in a span of few months. The problems in Venezuela can be largely blamed on its mismanaged economy, populist policies, dysfunctional exchange rate system, and the dollar crunch stemming out of it.

Exchange Rate System

The Venezuelan bolivar (VEF), the official currency of Venezuela, has been under a controlled system for over 12 years. Although it has undergone periodic devaluations, it is still overvalued at the “official” exchange rate. However, its value is approximately 30 times lower on the black market. Venezuela has a complex multi-layered exchange rate system that offers different exchange rates. The first exchange rate offered is the official exchange rate, intended for importing food and medicine at the rate 6.3 VEF per USD. This rate is reserved for only a few circumstances and is highly overrated. The second exchange rate for priority sectors is supposedly auction-based, but is fairly fixed, currently at around 12 VEF per USD, it is called the Ancillary Foreign Currency Administration System I or SICAD I. There is another rate, SICAD II, which was introduced in March 2014 and is slightly more realistic at around 52 VEF per USD. The government controls these three rates. Outside the government setting, however, exists the bitter reality—the black market, where the exchange rate is at almost 190 VEF per USD, according to DolarToday.com.

In February 2015, the government in Venezuela announced a new exchange rate system in an attempt to de-control the currency. The new mechanism does not end the tier system, but allows for legal buying and selling of bolivars wherein the price of the currency will be set by the forces of supply and demand, i.e., the market rate.

Per the new system, the first-tier, which sells dollars at 6.3 VEF per USD, continues as it is. However, SICAD I and II will be merged and will be used for certain sectors and imports at the government regulated rate of 12 VEF per USD. This will be the second-tier. The new mechanism, SIMADI or the Marginal Currency System, will be the third-tier. Under SIMADI, the purchase and sale of foreign currency by businesses and individuals will be allowed at the price set by market forces. For the time being, according to the Venezuelan President Nicolás Maduro, the new system will account for only three to five percent of the dollar dealings, as the system will under “test trial” initially.

The SIMADI system on its first day of trading was at 170.1 VEF per USD, a de facto devaluation of around 2698 percent over the unrealistic official exchange rate of 6.3 VEF per USD. Though it was still stronger than the black market rate of about 178 VEF per USD on the same day.

Dollar Crunch

Although Venezuela is a major crude oil exporter, it is dependent on imports for almost everything else. Thus, dollars earned on oil exports are precious, as they are used to pay the import bill. The government has been issuing its petrodollars at artificially maintained subsidized rates, and this “subsidy” on dollars has given rise to economic and social problems, as it is not reaching the common man but is manipulated by the affluent.

The Venezuelan exchange rate system offers different rates to different people, depending on the purpose. While it might be passable to give a preferred rate for essential imports, the problems start when the preferred rates are accessible to only the influential. This, along with a system that supports arbitrage of the currency because of the different rates for dollars within the country, has been destroying the balance. Say, for example, an influential businessman puts in a request to the government for $100,000 to import pain relief spray. He needs to pay 100,000 X 6.3 = 630,000 VEF to get the dollars. The businessman can use these dollars to his advantage, he can import relief sprays worth just $10,000 dollars and sell the rest of dollars in the thriving black market, to get 90,000 X 180 (assumed) = 16,200,000 VEF. So, the businessman has earned a lot more than he initially invested—but in the process, he created a “shortage” of pain relief sprays, which will now be sold at even higher rates than what they cost, feeding inflation.

The Venezuelan government sold around $11.4 billion of USD in 2014 and intends to sell $8 billion of USD in 2015 at the official rate of 6.3 VEF per USD, according to Barclay’s. 70 percent and 25 percent of the country’s imports are paid in dollars exchanged at 6.5 VEF (official) and 12 VEF (SICAD I now SICAD). This explains the huge shortage of essentials and soaring prices. The graph below shows the official and non-official exchange rates in the country. The difference between the two rates has been widening over time.

 

The overvaluation of the domestic currency is hurting in another way. In situations where the official exchange rate is fixed and devaluation is not uncommon, people tend to hold dollars instead of their own currency and sell those dollars when the currency undergoes devaluation (or they sell dollars in the parallel market to get more of the domestic currency). As more people start making easy money this way, they start demanding dollars, and, in cases where it is scarce, the black market price goes up. This further pushes up inflation and higher inflation again pushes the price of the dollar. Thus in a way, inflation and the dollar rate start feeding each other. (Related reading, see: The Importance Of Inflation And GDP)

The Bottom Line

The Venezuelan government’s introduction of SIMADI is the first step towards a market-based exchange rate system. But it accounts for just five percent of the dollar exchanges, which is not sufficient enough to solve issues like dollar crunch. On the positive side, this may induce people to opt for the government-backed legal exchange rate system rather than the black market, as the difference between these two is not substantial. The Maduro government fears political loss if it devaluates the official exchange rate to ease inflation in the country, as prices of goods will go up. But the gap between “artificiality and reality” has to be gradually filled for the economic health of the country in the long-term, as this will curb currency arbitrage and black-marketing of currency and goods.

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