Boots and hearts and the demand for money

BCV ReservesOne way to make Omar Lugo’s dismissal matter is to really stop to understand the front-page spread that got him canned. The story that the regime found so objectionable is that the Central Bank’s international reserves are falling at unprecedented pace. They’re half what they were at the start of 2009 and have been falling at a staggering billion dollars per month recently.

Remarkably, the liquid portion of reserves is pretty much gone, leaving the government with the humiliating prospect of having to cash out the gold reserves that Hugo Chávez brought into the country to such fanfare two years ago.

But how can that be? So far, the Maduro administration has been just one big paquetazo, as measure after painful measure is taken to stanch the flow of hard currency. We already had a 32% nominal devaluation, CADIVI’s increasingly a black hole that no dollar escapes from and SITME/SICAD has been shut down for much of the year.

After all we’ve been through, after all the bare shelfs and the shoving matches for perniles and the scary inflation spike this year and the harsh cuts on public spending, you’d think we’d at least come out the other end having stabilized our Central Bank reserves, wouldn’t you? That’s what Bank of America’s FRod seems to think: that Maduro’s paquete has brought Venezuela’s foreign accounts to some sort of rough balance.

And yet, despite all the pain, BCV still finds itself with reserves a third lower than they were at the start of the year, and falling faster all the time. How can that be?

Over on Distortioland, Omar Z. starts to sketch out an answer. It gets pretty technical pretty fast, but the nub of it is that external balance isn’t just about the external accounts: a domestic monetary imbalance can drive a fast drawdown in BCV’s foreign reserves, even in the middle of an external adjustment.

To grasp why, you have to think like a macroeconomist – an exercise most of us muggles find tantamount to cruel and unusual punishment, to be sure, but one that will become increasingly unavoidable in the months and years to come, so best get used to it.

Let’s give it a go:

Last week, as we looked at the pictures of long lines outside Daka, most of us saw people trying to get something: a nice new TV, say, or an Air Conditioner. But macroeconomists saw something else. They saw people desperate to get rid of something, namely: the fast-depreciating bolivars in their pockets.

It wasn’t just a case of mindless consumerism, of mere rapiña. People were making a rational decision to trade something whose value they’re sure will fall – bolivars – for something whose value seems more likely to hold steady – appliances.

The length of those lines is a testament to the increasingly widespread belief that tomorrow’s bolivar is going to be worth a lot less than today’s. If that’s what you believe, your best bet is clear: spend your bolivars as soon as you get them. After all, you’re better off holding almost anything bolivars can buy rather than holding those fast self-destructing bolivars themselves.

When that way of thinking starts to spreads, the economy shifts onto a highly perilous new path.

The operative bit of jargon here is the “demand for money” – people’s willingness to hold bolivars rather than the things bolivars can buy, whether that’s a plasma screen TV, a pair of fake boobs or a DPN bond. 

Omar Z. argues that, for most of last few years, the demand for bolivars has been propped up by the control raj: price controls, capital controls and, especially, exchange controls have conspired to pen in demand for bolivars by cutting people off from many of the alternatives to holding them (chief among those alternatives: the US dollar).

That’s one of those things that works for a while, and then stops working. As the government covers more and more of its deficit through BCV’s printing press, as inflation rises and the expectation starts to take hold that it will keep on rising indefinitely, and as confidence that the BCV has some idea what it’s doing evaporates, the control raj finds it increasingly difficult to sustain the demand for real bolivar balances.

But what does any of that have to do with those fast falling BCV reserves? That’s where Omar Z’s post proves so valuable. It brings much needed clarity to the question of why, when the supply of money (a.k.a., liquidity) is rising at the same time as the demand for money is falling, that will turn up in the national accounts in the form of depleting Central Bank reserves.

If you’re mathematically minded you absolutely should go to his blog and see for yourself why that must be so. But you don’t have to get into the equations to grasp that if people are increasingly eager to trade their money for real assets, and a big portion of those real assets are imports paid for in dollars, BCV reserves will come under pressure (since, ultimately, BCV reserves is where the dollars that pay for the imports must come from.)

There’s no easy way out of this mess. In principle, BCV could take even harsher measures to stop the net outflow of reserve assets, or even stop them altogetherbut that would defeat the purpose, shifting the burden of adjustment onto even harsher shortages and even faster inflation, as more and more bolivars chase a fewer and fewer imported goods. Insisting on one-in-one-out conditions for reserve dollars would simply recreate today, when there are still $21 billion in the till, the conditions that would prevail if reserves ran out altogether. And that would be a good way of triggering the hyperinflationary spiral they’re supposed to be trying to prevent.

So BCV reserves are going to continue to fall. Because liquidity keeps expanding and, in Omar Z’s view, leading indicators suggest that the demand for real money balances is already starting to falter.

Now, if you’re at all sensitive to economic history, talk of faltering demand for real money balances amid rising liquidity will be setting off all kinds of alarm bells in your head: that way hyperinflation lies.

To be sure, we’re not there yet: a hyperinflationary freakout would probably come after reserves run out altogether, and even though they’re depleting way too fast, $21 billion is still a good chunk of change. (And, lest we forget, even after that’s all gone, there’s an unknown extra cushion in the off-budget funds such as Fonden.) So, to be clear, an apocalyptic crash doesn’t appear to be imminent.

The direction of travel is clear, though. Worse: there’s no sign that the people in charge have even begun to grasp the need for a change of course. If you’re accelerating towards an abyss in a car with no brakes and a driver hell-bent on ploughing straight ahead, it’s not much comfort to be told “relax, we’re not in any imminent danger: that abyss is miles away.”

What’s more, in this context, “imminent” is a slippery term. Because, as Omar Z. explains in a passage that manages to be chilling even through a thick haze of jargon:

Entre otros factores, sabemos que la demanda de dinero también depende de las expectativas de inflación, que a su vez puede ser una función de factores como la velocidad de expansión monetaria y la credibilidad del BC (¡!). Es decir, la solución de esta simple ecuación pudiera ser recursiva y bajo ciertas condiciones ser dinámicamente inestable.

In other words, the fact that it’s taken 11 months for BCV reserves to fall from $30 bn to $21 bn in no way guarantees that it will take another 11 months to shave off the next 9 billion dollars.

The demand for money could turn out to be like boots and hearts: when it starts to fall apart, it really falls apart.