Venezuela: Is Akerlof Wrong?

Venezuela is in the midst of a consumption boom, with a corresponding sharp rise in imports. High oil prices, which are transmitted to the economy via greater government expenditure, are stoking demand pressures. Exchange controls trap the enormous growth in domestic liquidity; in turn, the banking system recycles this excess liquidity in the system into ‘easy’ credit.

Domestic credit has been growing at explosive rates in Venezuela. Total credit in real terms has grown at a compound annual rate of 108% during 2004-07; consumer credit has grown at a rate of 132%, and credit to finance car purchases at 186%. Car loans now make up 44% of total consumer credit, up from 19% in December 2003.

Interest rate and exchange controls, plus directed lending by the central bank, are additional factors behind this explosion of car credit. Exchange controls allow the monetary authorities to keep negative real interest rates without the fear of a balance of payments crisis. This discourages savings and promotes consumption, further fueling the ongoing consumption boom. Interest rate caps and directed lending encourage banks to focus their lending where they can charge the highest nominal interest rate, such as the purchase of vehicles, thereby boosting their bottom line. The Venezuelan banking system has been one of the most profitable sectors during the current boom.

The Venezuelan car market defies economic rules

In his seminal paper, Nobel-Prize winning economist George Akerlof employed the market for used cars as an example of the problem caused by quality uncertainty. One conclusion from his analysis was that, given information asymmetries, once you drive a car off the lot, its price immediately goes down.

However, in Venezuela, the opposite holds – once you take a new car out of the dealership, its price goes up. For example, a used 2007 Ford Explorer XLT commands a 28% premium over a brand new one; in the case of a second-hand 2007 Ford Explorer Eddie Bauer Edition, that figure is 23%. Is Akerlof wrong? We don’t think so. There are long waiting lists to get a new car in Venezuela; in the case of a popular model, they can stretch up to a year. So, consumers are willing to pay a premium in order to avoid delay. This is clearly a case of excess demand for cars in Venezuela, which is explained by a series of distortions that engulf the Venezuelan economy. Our concern is that these distortions may take a more meaningful toll on the Venezuelan economy in the medium term, although in the short term it will dance to the tune of oil prices.

The car market is red hot in Venezuela. Car sales rose to 500,000 units at the end of last year, up from 230,000 units in 2005. You can certainly appreciate this growth in the vehicle fleet in the middle of heavy traffic in Caracas.

Increasingly, imports have been filling this demand, and more export units are being diverted to the local market. However, this is close to ‘as good as it gets’ for the car dealership community: The government is now licensing imports in order to protect the local industry, and has also set a total limit of 500,000 units to be sold in the domestic market for 2008, the same number as last year.

Venezuelais the world’s leader in subsidizing gasoline at the pump. As a result, if you own a car in Venezuela, you don’t feel the pinch at the pump. This undoubtedly fuels demand for cars, but also promotes an inefficient use of energy. Our equity research colleagues from the Energy team have prepared an interesting chart that compares gasoline costs on a global basis.

A cheap dollar subsidizes your car purchase. The (real) bolivar has been on a tear since the last nominal devaluation in March 2005, appreciating by 66%. However, not all of this move can be construed as mere overvaluation; oil prices have risen steadily throughout the same period.

In a typical ‘Dutch Disease’ fashion, the strong real bolivar is hindering tradables production and promoting their consumption; in fact, it is subsidizing imports and also widening the non-oil current account. Venezuelans have access to cheap dollars at the official exchange rate to buy imported cars, which are displacing local production.

Purchase of a car as a store of value and not as a consumption decision. Another reason for the pent-up demand for cars is that they are increasingly being perceived as a store of value in an economy where there are few investment alternatives available for a large section of the population. This observation takes added significance given the large gap between the official and the permuta exchange rates. If there are expectations for currency devaluation, a somewhat liquid asset such as a car could become a decent store of value, particularly when the much weaker permuta exchange rate is viewed as a replacement value. Cars are cheap if you can sell dollars in the permuta market; the problem is that in Venezuela the main supplier of dollars is the government itself, via Pdvsa.

But no crisis is imminent. As we have been arguing for a while, Venezuela does have the ability and willingness to pay its debt, based on current high oil prices and a healthy stock of liquid assets. But its policy framework is far from ideal, as it creates a challenging business environment and myriad distortions in the economy, such as those discussed above for the car market. However, although we suspect that the economy will follow a slow process of deterioration, with increasing macroeconomic imbalances, we do not expect a crisis in Venezuela over 2008-09, unless there is a material and sustained drop in oil prices.

By Boris Segura New York
Morgan Stanley
January 16, 2008