Colombia and Venezuela: Brotherly Tantrums

The trade connection

Bilateral tensions between Colombia and Venezuela have recently resurfaced, with Venezuela announcing that it has put relations with Colombia “in the freezer” and is “reviewing” the relationship. So far, it is not clear what is meant by this.

Understandably, there are concerns in the market that Venezuela might somehow shut off exports from Colombia. The consequences for Colombia could be severe. After all, exports to Venezuela have risen by 77% during the first eight months of the year, and Venezuelan demand has contributed to roughly half of the 15% growth in total Colombian exports year to date.

Of course, Colombia is vulnerable to a drop in exports to Venezuela. Exports to Venezuela have grown sharply.

It is easy to conclude that Colombia has more to lose out of a disruption to bilateral trade. In terms of magnitude, Colombian exports to Venezuela are four times that of Venezuelan exports to Colombia, both measured on a FOB basis (US$4.8 billion versus US$1.2 billion). Also, whereas Venezuela makes up for 15% of Colombian exports (2.8% of GDP), Colombia barely buys 1% of Venezuelan exports.

Ultimately, trade flows respond to macroeconomic and microeconomic forces. On the macroeconomic front, exports to a particular country depend on that country’s growth (income effect) and on the bilateral real exchange rate (price effect).

Clearly, the explosive growth in Colombian exports to Venezuela has a great deal to do with the rebound and subsequent boom in Venezuela’s economic activity after the crippling 2002-03 crisis. In addition, contrary to our expectations, the bilateral real exchange rate (RER) between Colombia and Venezuela has not been a major driver of export flows.

This behavior coincides with international evidence, which shows that the income effect is more relevant than the price effect when estimating export-demand functions.

More importantly, there are microeconomic reasons why Colombian exports to Venezuela are booming: The Venezuelan economy is riddled with distortions, arising from exchange and price controls and a challenging business environment, compounded by negative real interest rates, which subsidize consumption and exacerbate import growth. In such an environment, the supply response is very limited, and the production of non-oil tradables is suffering (‘Dutch Disease’-cum-cheap dollar). A clear signal of this phenomenon is that while growth in the main trading partners is healthy, non-oil exports have been falling since mid-2005.

Can Venezuela squeeze out Colombian exports?

We suspect that Venezuela could try to deny or delay Cadivi dollars, hike import tariffs, or outright ban certain Colombian exports, but these policies would not be without costs. Let’s examine several possible consequences:

· In the case of agricultural products, which comprise almost 15% of Colombian exports, this would only worsen food shortages in Venezuela, which public opinion is increasingly blaming on the government and not on private speculators;

· Vehicles and auto parts were already under the Venezuelan authorities’ eye, well before the most recent crisis exploded. In particular, Venezuela is setting up a licensing mechanism for automobile imports, and eventually can source cars and auto parts in other South American markets (e.g., Brazil and Argentina);

· The remaining Colombian exports can be sourced elsewhere, but probably at higher prices, stoking inflation in Venezuela, at a particular sensitive time (during the introduction of the bolivar fuerte); and

· If the authorities decide not to pass onto consumers the higher cost of (alternative) imports, they would end up footing the bill, with the associated fiscal cost.

Particularly worrisome would be the impact on food inflation (24%Y), as it is already running above headline inflation (17.2%). This is why we suspect that it is highly unlikely that Venezuela tries to curtail agricultural exports originating in Colombia.

How Venezuela proceeds depends on how narrow political considerations prevail over economic rationality. Again, squeezing out Colombian exports is likely to have deleterious effects on food availability, inflation and fiscal accounts.

Bottom line

Our initial argument right after the current crisis in bilateral relations broke out was that we are still at the early stages of the ballgame. In the end, Venezuela cannot afford to shut off Colombian exports completely. The Venezuelan authorities are likely to tread carefully in terms of curtailing exports from Colombia, as efforts in punishing their neighbor are likely to backfire in terms of worsening food shortages, rising inflation or higher fiscal costs.

By Boris Segura New York
Morgan Stanley
December 4, 2007