Warmongering in LatAm darkens prospects

The Colombian and Venezuelan media reactions to the killing of rebel group FARC leader Raúl Reyes and at least 20 other rebels in Ecuador are instructive in their gaping differences. Many Colombians cheered as they watched media reports. In Venezuela, meanwhile, President Hugo Chavez went on national television to decry the Colombian action and order 10 battalions of troops to the border, threatening to bomb his neighbour if it went after FARC in Venezuela, where the group is thought to have key hide outs. The immediate row may now have been defused by a hastily assembled conference in Santo Domingo, but peace is fragile.

The deterioration in the situation threatens to derail investor confidence in the region and has hit Colombia’s currency, bond and share markets, although not as badly as many expected. If prolonged, the tense situation will deter foreign direct investment, which has tripled in Colombia in the last three years. Key Colombian companies have been hurt and are increasingly questioning just how far they can be involved in Venezuela.

The move also directly threatens fast-growing trade between Colombia and Venezuela. That had been building thanks to Venezuela’s urgent need to import an increasingly wide range of basics and now totals about $6 billion annually. That dependence means Venezuelans would be hard hit by a trade disruption.

Tension Builds
The stand-off between Colombia and neighbours Ecuador and Venezuela over the former’s incursion into Ecuadorean territory to kill members of FARC (Revolutionary Armed Forces of Colombia) neatly illustrates the deep political fissures in Latin America. The inflamed row highlights the ideological split between a pro-United States Colombia under Álvaro Úribe and Peru under Alan García pitted against a left-wing grouping of states led by Venezuela that includes Nicaragua under Daniel Ortega, Cuba under the new leader Raúl Castro and Ecuador under Rafael Correa as well as Bolivia’s Evo Morales and to an extent Argentina’s Cristina Kirchner. Chile and Brazil stand apart.

Chavez has proven successful in grouping these like-minded countries round him. Part of his power comes from his ability to distribute directly and indirectly oil revenues to his close allies. And more direct political influence can be seen particularly in the emerging scandal surrounding a private jet that landed in Buenos Aires with $800,000 in cash, money that was purportedly destined to the campaign to elect Kirchner. For Chavez, Colombia and Peru are impediments to what would otherwise be a solid grouping in Latin America and threaten his ability to build purely Latin institutions to run the region’s affairs.

To add fuel to the fire, Chavez had been enjoying his role as a negotiator with FARC and had met with some success in clinching the release of a small number of the 700-odd hostages. This moment in the international limelight has probably been cut short by the Colombian assassination of Reyes, which brings an end to negotiations with FARC. Even so, Chavez almost immediately called a meeting with the family of Franco-Colombian hostage Ingrid Betancourt, a totem in the west in part because of her dual nationality.

Finally, recent Colombian allegations that both Venezuela and Ecuador have been funding FARC – in Venezuela’s case to the tune of $300 million -- means further damage to relations between the three is likely.

Colombian economy
What’s so disappointing about the current spat is that it could hurt prospects at a delicate moment for what has been a renascent Colombian economy. After a period of strong growth, the economy had already started to suffer thanks to the worsening situation in the US. Colombian GDP growth came in at 6.6% last year, but is expected to drop to 4.8% this year. That weakness is coming in large part thanks to its continued dependence on the US and would clearly be even worse if relations with Venezuela deteriorate.

The close relationship with the US means that a free trade agreement has come tantalizingly close. President George Bush agreed a deal in February and has been pushing Congress to approve the agreement, but the legislation has been pending ever since.

If the free trade agreement deal is signed, it would give a long-term shot in the arm to Colombia, although what appears to be a looming recession in the US will limit its short-term impact. The more likely scenario is that the agreement will fail to make it. That’s particularly the case because prospects will be dimmed by the run-up to the US Presidential elections and the deal will almost certainly be scotched if the Democrats emerge triumphant. Both Hillary Clinton and Barack Obama have been falling over themselves to vilify international trade and have played up the perceived disadvantages of the North America Free Trade Agreement as a vote-winner.

The US remains Colombia’s dominant trade partner by a long chalk and buys about 40% of its exports. Ironically, Venezuela has become a far more significant trading partner for Colombia in recent years and now accounts for some 20% of exports. For some, that is likely to dampen down the bellicose stance of Chavez. Trade links between Colombia and Venezuela are strong and that should help mitigate the risk of military action, according to a report put out by Shelly Shetty, a sovereign ratings director at Fitch Ratings. Heightened tensions between Colombia, Venezuela, and Ecuador are unlikely to put downward pressure on Colombia's sovereign ratings, at least for now, she adds.

That may be so but given all the uncertainties and the negative headlines, Colombia’s financial markets have see-sawed and proven highly vulnerable to news flow. They have been caught between the pessimism of a worsening relationship with Venezuela, including the possibility of further temporary border closures, a skirmish or even and war and the optimism generated by the possible deal with the US together with the weakening of the FARC.

The peso, which had been one of the strongest performing currencies in the continent, has been wobbly. Before the incursion, it was trading at 1,908 to the dollar and has gyrated since, closing at 1,937 on March 10. It fell 1.7% on the announcement that Chavez was sending troops to the border.

The Colombian debt markets have also been schizophrenic. Still, it is hard to know how much stems from the friction with Venezuela and Ecuador and how much is attributable to the rise of inflation, an Achilles’ heel of the economy. Many analysts are betting that the central bank will need to raise rates. Consumer prices rose 1.51% in February from the previous month, driving annual inflation to 6.35%, well above the 3.5-4.5% target. The central bank has already raised its key lending rate 25 basis points point to 9.75% in February.

The stock markets have not been immune either. The IGBC index was trading at 9,341 just before the incursion and traded down to 8,541 before recovering some lost ground. In the wake of the invasion, Chavez threatened to nationalize the Venezuelan operations of Colombian companies, substantiating a fear that many already had.

A number of large companies would be hurt. Probably the most at risk is the giant Grupo Nacional de Chocolates. The firm has a large presence in Venezuela where it is an important producer of foods. Other Colombian firms that saw share prices pressured during the stand-off thanks to investments in Venezuela include Cementos Argos and Compania Colombiana de Inversiones, an investment holding company. At the very least, these companies will continue to defer investment.

Venezuela
Venezuela and Ecuador garnered more regional support than Colombia, which was widely criticized for its illegal incursion into Ecuadorean territory including by more moderate Latin voices such as Brazil. And yet while Chavez won the immediate victory, his hard-line position, including sending troops to and closing the border, stoked more fear of Venezuela than Colombia. Chavez’s sudden decision to back down and pardon Colombia underlines his unpredictability.

And in reality Venezuela has a lot more to lose from a cessation of trade with Colombia than the other way round. Colombia is responsible for 10.2% of Venezuela’s imports, making it the second largest exporter after the United States. And most of Colombia’s exports are not high tech but cover day-to-day necessities such as food stuffs including everything from chicken and eggs to milk and flour. Even a short-lived disruption would likely prove extremely unpopular in Venezuela which has been suffering runs on daily necessities.

Meanwhile, the Venezuelan economy is doing the splits. Headline figures continue to show the most robust growth in Latin America. GDP grew over 10% in both 2005 and 2006 although it is expected to have slowed down last year to just over 8% with a further slide to 6% next year.

That, however, masks increasing structural weaknesses and the division between a booming petroleum sector and moribund industrial and agricultural economy. Inflation has been increasing rapidly. Annualised inflation was 15.3% last September and had run up to 22.5% by December. In March, it was running at 25.4%. The government has been freeing prices to try to battle hoarding and the fast-growing black market while at the same time limiting the interest rates banks charge retail customers. Credit-led consumerism has thus been booming, leading to a rapid spike in inflation. That forced the central bank to raise its discount rate rises to 32.5% from 28.5%. With the freeing of prices and continued inflationary pressures thanks to monetary growth, Lehman Brothers is predicting that consumer prices will rise between 30-40% this year. That compares to the government’s target of 11%.

This would seem the ideal condition for a currency meltdown but Venezuela's new ‘strong bolivar’, launched at the beginning of the year (with three zeroes removed from the old currency) has been trading up against the dollar. Indeed the currency was up by some 43% in early March from lows in August.

That currency strength is thanks to other government distortions. Flush with dollars from oil sales in international markets, the Finance Ministry has been selling dollar-denominated bonds to local banks through direct sales. They have been pushed through to clients who are hungry for the (relative) stability of US dollars and can pay for a dollar income stream in bolivars. That has been shrinking the gap between the formal and informal markets. The government has announced that it plans to sell up to $7.6 billion in bonds this year, although not all will be denominated in dollars. Despite this huge fix, many economists still expect the bolivar to weaken later in the year.

Despite the clear dangers surrounding the Venezuelan economy and the drop in production in almost all sectors, the price of oil continues to underpin and sustain the country. Indeed, it has allowed government spending to more than triple in the past five years. Trading at $105 per barrel, Venezuela is extremely well positioned to weather even the most adverse internal conditions.

PDVSA, which has become ever more central to the working of the government for funding, is doing just fine. Still, a lack of transparency in accounts and government plans for the firm, a dearth of investment and Exxon Mobil’s recent success in freezing $12 billion of PDVSA assets is making accessing financing unnecessarily expensive.

The real tragedy of the Venezuela-Colombia row is the renewed emphasis that it puts on risk in the region. Both countries will suffer. For the nationalized economy of Venezuela, the effect may not be so great, but Colombia will find itself set back. And there will be after-shocks throughout the region if the situation is allowed to deteriorate.

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