VENEZUELA has dominated emerging market news for the past nine months. According to Bloomberg data, US dollar- denominated Venezuelan bonds lost an average of 31 per cent in 2014. This melodrama was prompted by a widely publicised report from two Harvard economists that predicted an almost inevitable sovereign default. Prices of bonds issued by the sovereign and the State oil producer Petroleos de Venezuela (PDVSA) fell sharply as a result. The economists’ report cited a shortage of foreign exchange (as a result of decade-long currency controls) and poor economic growth as the primary factors eroding the Government’s ability to repay its debt.

The significant decline in oil prices further compounded the negative market sentiment. Oil accounts for more than 95 per cent of Venezuela’s exports; and the price of Venezuelan oil fell by more than 50 per cent in 2014. In early September 2014 Standard and Poor’s (S&P) downgraded Venezuela’s credit rating from B- to CCC+. Their analysis cited a deteriorating economy and rampant inflation. In fact, it is projected that the Venezuelan economy will contract three per cent in 2014 and by 1.5 per cent in 2015.

Consumer prices rose 63 per cent in the 12 months through August 2014 and the minimum wage has been increased three times since the start of the year. Rising social unrest has also created unease among investors. The revenue generated from oil and tax income is quickly falling short of the massive current account and fiscal deficits that the Government is accumulating.

Despite that, there are factors that are encouraging buyers to take advantage of what some deem to be an exaggerated market reaction. Venezuela maintains the largest natural crude oil resources in the world, for example. They have also demonstrated a willingness to honour their debt. On October 8th 2014, the country paid US$1.56 billion of Government bonds that matured and the State oil company Petroleos de Venezuela redeemed US$3 billion of debt that matured on October 28th, 2014.

This temporarily provided a modicum of comfort to investors. Some speculators took the opportunity to purchase shorter dated debt at the steeply discounted prices on offer. But this fleeting sense of security was short-lived.

Despite a series of public pronouncements on economic reform, President Maduro has not implemented any new policies or changes. In late 2014, he announced his intention to devalue the currency and increase the crude oil and petroleum products tax domestically; significant steps that would help to reduce the country’s deficit. However, no action has been forthcoming. This week, Maduro announced that he has secured a loan of US$20 billion from China.

Some analysts have published research reports supporting overweight positions in PDVSA, particularly at the shorter end of the curve and at price levels below potential recovery values. These analysts highlight the relative ease with which Venezuela could significantly improve its fiscal position. For example, reducing the size of oil and gas subsidies, devaluing the currency, reducing imports, and foregoing current expenditure on infrastructure projects and social spending.

They also cite Venezuela’s US$22.5 billion in foreign reserves. It is estimated that this is sufficient to cover about two years of overseas debt payments for the Government and PDVSA. However, some analysts feel that the political consequences of pursuing the necessary economic reform are too severe and that Maduro is unlikely to “take the bitter medicine”.

Investors seeking to profit from the discounted prices would be well advised to stay short and be prepared for further price declines given the uncertainty around the direction of oil prices and Venezuela’s political regime. On the other side of the trade, selling amidst market upheaval is usually ill advised, particularly if the potential recovery value in a default may be above the current market price.

Any Venezuela trade is a gamble, and investors should be prepared to withstand a potential loss or count each blessing as it may or may not occur.

Marian Ross is Assistant Vice President business development at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor.

Visit our website at www.sterling.com.jm.

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