THE PRICE OF GROWTH

Venezuela’s government continues to struggle to bring down inflation, which has been stoked by government spending and a liquidity-driven consumption boom. The monthly inflation rate dipped notably in July, but year-on-year inflation remains very high. We expect price pressures to resurge again, and annual inflation to remain in the double digits into the medium term.

Runaway economic growth, averaging 12% per year over the past three years, has unleashed one of the highest inflation rates among the world’s large and medium-sized economies. July inflation came in at 0.5%, a reduction from 1.8% in June. This brought year-on-year inflation to 17.2%, from 19.4% a month earlier. However, this decrease is likely to be a one-off improvement, the direct result of a cut in the value-added tax in early July, to 9% from 11%. An earlier three-percentage-point VAT reduction in March actually generated a decline (-0.7%) in the consumer price index. By comparison, the July result does not look so impressive.

In isolation, the impact of the second VAT cut will not be lasting, and underlying inflationary pressures will quickly resurface. Indeed, while such VAT cuts may temporarily reduce prices, they also act to raise aggregate demand, boosting inflationary pressures once again.
Meek monetary measures

The Central Bank also made an effort in July to curb domestic liquidity by raising the minimum savings rate to 8% from 6.5% and by imposing stricter reserve requirements on banks. However, the hike in the savings rate, which remains negative in inflation-adjusted terms, will not even be enough to compensate savers for real losses stemming from the increase in the rate of inflation in the first half of the year. A sharp increase in lending rates would be more effective in containing the expansion of credit, but this is not likely to be contemplated under the existing policy framework.

In the absence of a major fiscal adjustment, price pressures will continue to build. The prices of many regulated goods have become misaligned and will have to be raised at some stage. Further, there is a lack of sufficient capacity in a variety of sectors as a result of inadequate investment, and this has been only partially offset by an increase in imports. Hence, there have been goods shortages and supply bottlenecks, and some producers and retailers have been selling regulated products above the official prices.
Bolívar droops

A spiralling black-market exchange-rate premium is another source of inflationary pressures, and will further spur speculation about a devaluation of the official exchange rate. The bolívar depreciated to its lowest level since March in unregulated trading in late July, when it hit Bs4,375:US$1 (the fixed official rate is Bs2,150:US$1). We foresee that the government will adjust the official rate by 20% in early 2008, to Bs2,700:US$1. High oil prices may tempt the government to delay this (to contain inflation), but this would keep the black-market premium at over 100% and raise the risk of a larger adjustment further down the line.

Even under our assumption that the authorities maintain the exchange-rate peg in 2007, inflation will remain at double-digit levels, and will likely reach around 20% by year’s end. (This is well above the government’s optimistic projection of 14%.) To reverse this trend, there would have to be a greater-than-projected withdrawal of excess liquidity. On the basis of our forecast of a devaluation in early 2008, we expect price pressures to build further rather than ebb. Only when domestic demand growth begins to slow substantially—beginning in 2008—will inflation begin to gradually decline as well.

For the moment, we expect strong economic expansion to continue. Venezuela posted a GDP growth rate of 10.3% in 2006, and the rate this year will be notably lower at around 5.9%. This is still a very robust pace of activity, however, and will do little to help trim inflation from its current levels.