New Devalued Currency: Solution or Same Old Problem?

Saturday July 4, 2009

In January 2008, Venezuela did something very big and very bold and that was to launch its new currency, boldly named the Bolivar.  It is also called, optimistically perhaps, the ‘strong’ bolivar, to separate it from the previous bolivar, which is now known as the old bolivar.

So if the old currency was the bolivar and the new currency is the bolivar, then how can the new bolivar be a new currency?  Isn’t it just the old currency with a little bit of a tweak to it?

Well, the answer to this is an ambiguous Yes and No, in the sense that it is still using the same name, but the bolivar has had quite a dramatic make over and now looks completely different and more to the point, is worth something completely different! 

Old Bolivar Problems

The old bolivar had been in use in Venezuela since the 19th Century, having replaced a very unsuccessful currency named the venezolano.  The bolivar was pegged to the dollar as part of its exchange rate and was on the gold standard, and then it came off it, and continued its link to the US dollar.

All was well until the 1970’s and then inflation didn’t just strike, but it took hold of the Venezuelan economy.  As a result the country struggled to keep hold of inflation and stop it from taking hold of the economy, but will only limited success.  It simply became more and more of a problem and nothing seemed to ease it.  Whatever the government did: it just kept on rising.

Eventually by 2007, the government realised that it had to do something to try and stop the bolivar becoming even more worthless.  Indeed, around this time it took 2150 bolivare to buy just  $ 1 US, so the situation was untenable.

Inflation at this point actually stood at 20%, which was a nightmare not just for business, but really for everyone and prices just seemed to be escalating on a daily basis.  The situation was also looking very shaky for the government, who were concerned that unless they could curb inflation, people would soon be unable to afford necessities.  Once that happens, political instability can gradually creep in, so there is good reason to ensure that if your inflation rates hit 20%, you take action: drastic action.

The government decided that it would launch the new bolivar, the bolivar fuerte, at a rate of 1 new bolivar to 1,000 old ones, effectively wiping three digits off the value of the bolivar.

The new currency was therefore only worth one thousandth of the previous currency, which is actually quite a dramatic change.

People had been gradually acclimatised to the change, by all shops and service providers having to advertise their prices in both new and old bolivar rates, for three months, prior to the switch over. 

The soaring inflation rate in Venezuela is interesting and potentially quite serious.  When you consider that it is the 5th biggest oil exporter in the world and that it is one of the major suppliers of crude oil, particularly to the US, this country should not be teetering on the brink of economic collapse, but rather should be stable and almost quite comfortably off. 

It is also in the interests of the world, including the US, to see economic stability in this area.  Oil is a very precious and some believe finite resource and as such we need to ensure that it can be exported easily to all parts of the world needing it.  A country that has gone into economic meltdown will struggle to achieve this.

Yet to some extent, Venezuela has been the master of its own destiny.  Because it had oil, it simply relied on oil for its income.  This meant that it did not properly develop the rest of its economy and so has no proper economic infrastructure; apart from oil.  Yet the price of oil fluctuates so much at times, that this is not a stable basis for the economy.  As a result, inflation set in.

Launch of New Currency

The new currency was launched in a blaze of publicity.  This was going to symbolise a new start for Venezuela, everything would now be different.  Inflation would be stopped and there would be increased confidence in the economy and basically all the problems of the old bolivar would effectively be wiped out.

A bold advertising campaign accompanied the bolivar.  This had a very positive and up beat message, which told people that there was to be a new and strong bolivar, which would lead to a strong economy and therefore a strong country.

The thinking behind the introduction of the new currency was that it would make life easier for people on a day to day basis,  Instead of having to carry around large amounts of cash, say 50,000 bolivar, just to get some groceries from the store, they could now just carry 5.  So this would be more straightforward.  Also it was thought that the new bolivar could stem the rise of prices, thereby helping to control inflation.  The new bolivar is only issued up to the 100 bolivar level, whereas previously it was issued in 1,000’s.

The final aim for the new, strong bolivar was to get it on a par with other countries throughout South America.  They also issue their notes in denominations of up to 100 rather than 1,000 so this parity, the government hoped, would make the bolivar less volatile.

Has the new currency worked?

The optimism that accompanied the new currency does seem to have been misplaced.  The situation does not seem to have been remedied and in the first 6 months of the new currency, inflation rates have not significantly declined.  Some statistics issued by the government for the first four months of 2008, show that inflation may actually be at around 25% by the end of 2008.  This would potentially be higher than 2007.

The government had set a target of 11%, that is to say that they aimed to get inflation down to 11%, but after April 2008 it became clear that this was simply not achievable.  So the government decided, in true bullish style, that it would abandon the target and instead not set one.  At least that way there are no accusations if the target isn’t met!

But for the people of Venezuela, there will be challenges ahead until the situation is resolved and this will not happen overnight.  One interesting aspect in human terms is the effect of a devaluation on the people. Usually devaluation is talked about in terms of economics or the effects that this will have on the currency, on how the currency can be used and even the political system.

However, money is more than just dollar bills and coins.  It is something that is very much part of the national psyche and people have a kind of fondness for their national currency.  In the UK every time they want to make changes to the coins, there is uproar and people get really annoyed about it.  And look how fondly the penny is viewed by many (but by no means all) people in America.

Well, imagine then, that you are suddenly told that your currency is worth nothing.  It is effectively wiped out.  Not to be used any more, suitable only for use as scrap paper.  That’s has to have some kind of effect on people and it must make them view their nation and their collective worth, just that little bit differently.

Some economists believe the effect that devaluation has on the people, means that it should only be used as a last resort, since it will make them lose confidence and if the people lose confidence then who will stimulate the economy? 

The economy can only be truly stimulated if people are willing to take risks, to put their money and enterprise into new challenges and businesses.  Yet when there is a devaluation and people feel dejected and down they are less likely to wish to speculate.  They need a bit of hope and confidence to do that.

There may also be a feeling that they should wait to see what happens.  If devaluation is seen to be working, then they may throw themselves into new projects with renewed vigor.  So there is a definite tendency to sit back and see how things shape up.

And yet, in the case of Venezuela this was the last thing it needed.  One of the major problems it faced in 2007 was the problem of a proper economic infrastructure, which would act as the foundation for the economy.  What should have happened, immediately after the launch of the new currency, was a period of frenzied economic activity, thereby starting to build the infrastructure to take Venezuela through this difficult time.  That does not appear to have happened and as a result, the people are now paying the price and they may do so for some time to come. 

Was devaluation the right move?

If Venezuela has not solved its economic crisis by devaluing, then was she right to have done it, or did the government just make a bad call?

Well there is no hard and fast answer to that.  Sometimes devaluing a currency works and sometimes it doesn’t.  The logical approach is to view it from the angle that if it were a definite certifiable success every time, then it would be used on quite a regular basis.  In fact some regimes could simply let inflation go up a lot, devalue and then start all over again, so there are always risks associated with devaluing any currency.

In theory at least the devaluing of the currency in Venezuela could have worked well.  First of all it was going to make the oil it exports much cheaper, thereby stimulating the economy.

It should also have made imported goods much more expensive, thereby making it more likely that people would buy goods produced in the country. 

Next, it should have made other international trade, particularly with other South American countries, much more on a par and as a result, have stimulated the economy.

Yet the result is that at least for the first year after the devaluation, it has not been a success, which is quite worrying, because the first year is actually the critical year and will have a significant impact in terms of long term success.  Indeed it could be argued that there should be deep concern that the first 6 months have been so poor, because the economy may now never recover.

Whilst it is still too early to assert that it has definitely failed, the reasons for the devaluation failure are actually very complex.

One very important issue is that sadly, Venezuela is not alone in suffering at the hands of inflation.  Inflation is rife throughout South America, leading to a great deal of economic uncertainty.  It is for this reason that although Venezuela has devalued, other countries would not be able to import goods from her, apart from oil, because they simply cannot afford it.  This is particularly true of her neighbours.

Can devaluation ever work?

There have been instances where devaluation has been successful.  Brazil,  a relatively close neighbor to Venezuela, devalued in 1999 and since this time it has attained slow but steady growth and is certainly better placed than many of its neighbors to face the economic crises that most of the developed world face today.  However, there is one vital component attached to the Brazilian devaluation that is missing from the Venezuelan model and that is namely, a structured plan to go along with the devaluation.

Venezuela has been particularly reticent about saying how it will implement economic activities to accompany the devaluation.  This means that the devaluation is almost seen to be operating alone and without anything to back it up.  Brazil, on the other hand, had a reasonably strong planning policy, which guided and shaped the economy up to and after the devaluation. 

Thus it would have made sense for the Venezuelan government to have implemented the same kind of plan and to set deadlines, targets that could act as an anchor and reign inflation back in. 

For whatever reason, it does not appear to have done this.  Yet this could be a big error of judgement, since a firm plan and a clear message of what the government was going to do and what it thought that it could achieve, would have undoubtedly stimulated confidence.  That confidence would have been in the government, in the economy and in the new currency.

So devaluation can work, but many economists and financiers feel that it can only work if it is part of a package.  If it has nothing to fall back on, then it becomes less potent and ultimately can achieve very little.

Is the future bright?

Alas, the future does not really look bright for the bold new Bolivar, indeed it looks decidedly shaky and overall, the devaluation seems to have achieved little in its first 6 months.

Whether that situation will change dramatically over the next few years is to a large extent on how the government reacts.  It has tried devaluation, but that does not seem to have worked.  It now has a choice, either it can continue to simply state that it will work, or it can acknowledge publicly that the devaluation needs some other financial plan if it is going to be successful.

This plan should be at least a 5 year plan, so that people can have a clear idea of where the economy and indeed the government is headed.

This would ensure that at least some confidence is instilled back into the economy and that the new currency is seen in a more positive light, with people actually believing that it will make a difference and that things are going to get better.

But on past behavior, it seems unlikely that the government will actually adopt this kind of firm and resolute planning.  Instead, it seems set to carry on hoping that the devaluation will be a success and keeping very secret about what it plans to do if inflation does really hit 25% as it may well do by the end of 2008.

However, they may well have a detailed plan to carry the economy through the next 5 or 10 years, but until they make this very public, the people simply don’t know if this is the case.

This situation is not a good one for the people of Venezuela to be in, but given some of the world issues relating to oil and this country is the 15th biggest oil producer in the world, we should all be praying that the brave new Bolivar does work, even if its success is not overnight.  So perhaps the rest of the world should just cross its fingers…and keep hoping.