R&R: It Gets Worse


train-wreckSo I already blew one gasket over Reinhart and Rogoff’s Project Syndicate piece, and now the time has come to blow the other. Turns out Francisco Rodríguez over at Bank of America was just as suspicious as I was of their claims, but being a proper economist went back to their database to check.

Turns out that, even leaving aside the claim that Venezuela is in legal default (which it’s not) their statement that domestic default leads to an “almost one” probability of external default isn’t borne out by their data!

Only 71% of countries in legal domestic default (which Venezuela is not) incur external default. And that’s working from R&R’s own database! And of countries in the kinds of “de facto” default (which is what Venezuela is in), just over a third (34%) end up in external default.

This whole thing is quickly acquiring the hallmarks of an academic train-wreck.

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  1. I am interested in the idea of de facto domestic default, or DDD.

    Can it be defined rigourously?

    After all, a wise person recently wrote that it is a near-meaningless idea which could be stretched to include any government failure, even citizenship wait-times.

    Yet now we find, supra, that a precise 34% of countries in de facto domestic default also fail to pay internationally.

    Is DDD anything more than a rhetorical trope?

    • The argument is that legal domestic default is relatively rare, because it’s so easy for governments to just inflate away domestic debts they can’t pay. That way they stay within the letter of the bond contract, while violating its spirit.

      So R&R build an index for DDD that includes things like domestic financial repression (offering interest rates on bonds that are below the rate of inflation, but which you don’t really have good options for because foreign exchange is controlled) and high inflation rates. Venezuela, by that standard, certainly is in DDD. It’s just that the External Default rate for countries in de facto domestic default is just 34%, which as Setty points out is more or less the chance of default implied by the spread on Venezuela bonds already…

  2. Sounds like somebody is *really* interested in convincing investors to continue bankrolling a bankrupt regime.

    So I take it the semantic quibble now is that 0.71 is not really “almost one”?

    • The people raising questions about this article so far are FRod, Quico and me. You’re going to have to work hard to convince the world that we want investors to bankroll Venezuela’s government. Personally, I want accurate assessments from all sides. I am very frustrated when real assessments — like my recent discovery that PDVSA is facing $6 billion more in legal claims than previously announced, or Quico’s research into Fonden — get widely ignored basically because we don’t wear the right ties to the right parties in Cambridge, Washington and Miami, and personally, when my blog does influence coverage or policy, nobody has the humility to give credit. Meanwhile self-promoters with no knowledge of this situation walk in with their “veritas” tie pins and simply make shit up and get written up in Reuters and Bloomberg. How does that help anything?

      As far as F-Rod, his institutional interest is in accurately predicting default. He is not saying there is “little” chance. But his clients don’t benefit from panic, either. And since the market has already priced in something like a 1/3 chance of default on Venezuelan bonds, suddenly the R&R figures are not interesting at all; they are just what people already knew. As for principles, I think you know that people generally don’t mix principles with bond investing.

      What would have been interesting would have been an article saying “watch for domestic bond default, because at that point the chance of a foreign default more than doubles.” But that’s just sort of modest finding slips into the void. Better to make up wild claims, resting on credentials rather than evidence, and sell a few more books. Congratulations R&R!

      • I agree with you that a healthy dose of skepticism is warranted. I don’t however, agree that R&R’s interpretations of the events amounts to a train-wreck – that seems, to me, like grasping at straws.

        I guess we’ll see soon enough who was right about Venezuela defaulting on foreign bondholders, right?

        • But this is so lazy, Juan. It’s as if I said: I have proof that a giant invisible caterpillar pushes the sun up into view every morning. And you said “bullcrap, there’s zero evidence of that.” And I said “well, just wait until tomorrow morning: when the sun comes up we’ll have proof.”

          Venezuela can default fifty times from now until the end of the year, it won’t make R&R’s argument less scandalously sloppy.

          • It’s one thing to say “there are problems with R&R’s argument.” It’s quite another to say that Venezuela’s external default “is an unlikely event,” which is what FRod is saying. FRod is making a prediction that is the complete opposite of what R&R are saying, and he’s not even hedging his bets … which is indredibly bold and risky on his part.

            Faced with this, it’s prefectly reasonable to wait and see how the facts play out. One of the two will be proven right in the end.

          • The question is really whether Venezuela bonds are appropriately priced. With the monster spreads they pay over U.S. long bonds, it’s just a given that Venezuela bonds are relatively risky. Nobody buying a financial instrument that gets 14% yields is expecting a smooth ride. If you have a heart condition you invest in US treasuries and learn to live with your 1% yields.

            The real issue is whether the underlying risk of Venezuela defaulting is high *at*the*current*level*of*yield.* The question is whether Venezuela is more likely to default than Ukraine, which is at war with a nuclear-armed superpower run by a hyper-aggressive power-mad lunatic, yet whose bonds have lower spread than ours. The question is whether Venezuela is more likely to default than Argentina, which *is* in default. The question is whether Venezuela is more likely to default than Cameroon, or Ghana, or Kenya, or any of a number of extremely impoverished LDCs with weak governments whose bonds still yield half what our bonds yield.

            The argument is about the relative chance of default in the context of given bond prices. The question is whether an investor chasing a high yield bond would be well advised to sell off their Venezuela bonds and accept somewhat yields from Ukraine, or Kenya, in return for extra security. Is that *really* advice that makes sense? That’s what’s at stake here…

          • The market would appear to be pricing in the possible coming explosion when the Venezuelan population finally says enough and hits the street and tosses out these bums. Most people I talk to in North America and Europe are dumbfounded at the ability of the Venezuelans to accept a continuing and continuing deterioration of their living standards and assume that the explosion must be very near. If bond traders know any Venezuelans personally they will be well or very well off Venezuelans who are fed up with the government and have voted with their feet to leave and would support any pushct to overthrow the idiots in charge.

            I would suspect that this is the case with most players in the bond market and hence the yields on the Venezuelan bonds reflect this belief that an explosion amongst el pueblo is very near at hand. I still maintain from my experiences living in current Venezuela that no explosion will occur until there is widespread hunger amongst the hard core supporters in the barrios and that this is still maybe more then a year or two distant. My feeble 2 cents worth!

          • the reason we haven’t defaulted is because the market is behaving in a stupid/greedy manner, and investors keep rolling out the principal. The question is not whether or not Venezuela will default, the questions is, when.

          • Juan, I’m a card-carrying economic historian, paid-up member of the mafia. By that standard, you gotta admit that it is incredibly sloppy to conflate legal default and financial repression. After that, they compound the error by calling 71% “nearly all,” but it’s the first error what’s the problem.

            There is a reason to think that high inflation and financial repression make it easier to pay the external debt — simply put, they make it way easier for the government to get its hands on the needed dollars.

          • I’m not sure that I’d call it a riposte. He’s arguing that the scale of financial repression in Venezuela is immense … and who would argue with that? But he’s not arguing that such financial repression makes an external default more likely.

            Prof. Rogoff implicitly thinks that the scale of Venezuelan financial repression is such that his own general finding does not apply. Fine enough. But that’s not what he said!

          • Meanwhile .. what is the significance of a ‘default’? This itself needs to be soberly analyzed.

            While it is of course an important event were it to occur, the constant preoccupation over ‘will Venez. default?” and “What oil price will cause default” (for years now) is clearly accompanied by the notion that somehow the political/social/cultural rule of chavismo would ipso facto fall along with the external finances of the Bolivarian state.

            But, the reality is that the state will not be transformed until the people decide to transform it.

            A country where the people have (some willingly, some unwillingly) put up with such economic and civil deprivations as have the Venezuelan people in recent years — from all classes — is not a country that is apt, in my view, to suddenly become unstable just because there is an external default. It would be a mere ‘factor’ . albeit a significant one.

            But, it would not in the slightest compensate for the persistent organizational and ideological amateurishness of the opposition — an opposition that has repeatedly failed to politically capitalize on the economic and social incapacities and blunders of the PSUV government.

            If this is accurate, then what needs to be done to capitalize on a default?

          • Well, but I think the calculus here is that Venezuela is exceptionally poorly placed to withstand external default, because the domestic productive sector has been so decimated that it wouldn’t really be possible to substitute imports with domestic production in the short or even the medium term. A hard stop in international credit would just mean the cargo ships stop turning up at Puerto Cabello, and the factories that used to produce the things that those ships bring in have been moth-balled for years. Bad as scarcity has gotten, the sense is that it could get dramatically worse in very short order, and it’s hard to imagine how you keep political order then.

          • Quico: I have been reading up on defaults and what I have found so far is that the picture that you give of the consequences of default runs counter to history. Predictions about the effects of defaults are always dire, but they don’t materialize. As an example, when Argentina defaulted the prediction was its GDP would be cut by 8% the first year, it turned out to be half. Trade was not affected, as was predicted. I don’t know if there are papers that prove your point, but all I have read suggests that trade continues (and even improves) read, for example, this paper below . I am thinking about writing a post on that, but have to read up more.


          • That seems like a good line of research. I bet it won’t be easy to find good comparison cases, though: how many energy mono-exporters with no industrial base and total dependence on imported consumption goods have really defaulted? (I have no idea – probably R&R’s database is a good place to look!)

            My sense: to import anything (legally) you’re gonna need a letter of credit. No foreign counterpart is going to give you a letter of credit if you’re in default. Y entonces?

      • Hey! I give you credit, buddy, and I go to parties in Cambridge all the frickin’ time. Or at least I did until September. So don’t cry to me about the Veritas tie pins, amigo.

        Seriously. Good work. Let’s write a book.

      • Hey, waitasecond! I give you credit all the time, and I go to those Cambridge parties. Or at least I did until September. You do great work, we should write a book.

        Seriously, we should write a book.

        • If I came off as bitter and ungrateful, that’s because I am. But not at you. I think you know that you are a bit of a weirdo in the Stutts University set. Thanks for all the props, seriously.

    • Qué bolas! 0.71 NO ES “casi uno”. Esta gente es muy poco seria, coño. Lo que si es serio es lo que hace el pana FRod, que entra a las bovedas del BCV y saca una cuenta a vuelo e’ pajaro de cuantos lingotes quedan. Esa si es una evidencia solida! Dato duro, pues.

    • “semantic quibble now is that 0.71 is not really “almost one””

      Is this a serious statement? “Semantic quibble”? 0.71 is closer to half, than one.

      This column, like the book they cite, was full of sloppy errors (including saying oil production has halved) and looseness with numbers. Leaving aside those problems, it didn’t add anything to the discussion.

      Why do these two bother with this issue at all if they are going to put out such a poor and easily picked apart product? Were they obligated to provide a column, or just plugging their book?

  3. The rate at which the price of a barrel of oil is currently plummeting threatens to render this, otherwise interesting, discussion almost entirely moot.

  4. One thing I don’t understand: is FRod accusing R&R of falsifying their own data? Is Quico doing so? Or is this something that is open to interpretation?

  5. I sympathize immensely with Quico and Setty’s penchant for “Just the facts, Ma’am.” That is, put aside the hype and look at the facts. THEN, from the real facts, make your analysis. (I also sympathize with Setty’s tempered rant against the ‘credentialed’ types who often only make quick, pop jabs, with little addition of data or real analysis, and move on.)

    Well, here’s my 5 cents: The R&R article says that “Oil production has more than halved since 1997, in no small part because the state-owned oil company has repeatedly defaulted on suppliers and joint-venture partners.”

    Here are the actual facts of the matter: 1997 3.5 mbd and 2013 2.5 mbd – which is the latest year avail from the EIA. This is not ‘more than halved.’.

    Also, Marc, I’d be a bit careful in interpreting the fact PDVSA is importing Algerian crude The opposition trope about the ‘disaster’ of rojo-rojito PDVSA “importing” Algerian crude ignores that old-PDVSA also mixed light, imported crude with extra-heavy oil (or so I am told by Venez. contacts working with PDVSA in CCS), but they did it in Dutch territory just offshore Venezuela.

    In addition, I have talked to N. American refinery experts who tell me they prefer this mix to the synthetic ‘up graded’ oil, as it has a broader distribution of hydrocarbon chain lengths, facilitating production of a wider range of products. Interesting point of view. It is a complex question

    • Oh, some sanity. Thx

      Quibble, quibble:

      In addition, I have talked to N. American refinery experts who tell me they prefer this mix to the synthetic ‘up graded’ oil, as it has a broader distribution of hydrocarbon chain lengths, facilitating production of a wider range of products.

      Err, yes and no, sort of but not really.

      Indeed, upgraded syncrudes bring some issues to North American refiners. The market is strongly biased towards gasoline and syncrudes have a high content of distillates (jet fuel and diesel range). As most North American refineries are equipped with FCC units as their primary cracker, the refinery has to run part of the distillates through the FCC if the the crude menu is too rich in distillates for the local market.

      It’s not a very good fit. Distillates make for a pretty expensive FCC feedstock. They also tend to be too light, too rich in hydrogen, typically 14%wt hydrogen and more, when most FCC units prefer to run feeds in the vicinity of 13%wt hydrogen content. At high ratios of distillates in the feed, the operation of the FCC becomes difficult, with no enough coke make in the riser to sustain the reaction and, overall, an excessively tight heat balance.

      But the real reason is much simpler. In refining, there is one simple truth :

      He who cracks the black gunk white makes the big bucks.

      The margins are on the cracking side of the business, running the FCC, hydrocrackers and delayed cokers. This is where a refinery makes its money. The rest of the business, turning already in-range naphtha and distillate into finished products, gasoline, Jet-A, diesel, is a necessary activity but it’s fairly miserable in terms of margins. So well-equipped refiners prefer to buy crudes as raw and discounted as possible to capture the cracking margins for themselves rather than have upgraders turn the crude into a nearly finished product upstream of the refining, leaving the refiners with only the boring, ultra-low margin business of finishing and distributing the products.

      • Aye, aye! That is exactly right.

        On the subject of R&R’s sloppy article, the main issue which concerns Bondholders overseas, is simply, will Vene keep on paying its foreign debt- even if it’s to the detriment of everyone else domestically? The answer is probably yes at this point. Everything else is academic mental masturbation. As Quico pointed out in a comment to a previous post on the same subject, there are more things at stake than purely a quick look at a (debatably reliant) database.

        Recent articles in the press have already pointed to the fact that PDVSA is looking at different operational terms to increase production with the help of oil service companies and oil majors, contradicting many of the things they may be publically saying. The proof is in the pudding, as they say, but still, unless oil remains at or below $80/bbl for over 6 months, it seems they will still be able to pony up for at least the next payments due. If nothing has changed in terms of production or an increase in prices at this same time next year, then default may be a more probable outcome, maybe…

        In the meantime, investors will continue to clip the coupons. Don’t forget that the bonds are yielding a rich +15% and the prices we see now we haven’t seen in over 5 years. A good trade for speculative capital.

      • This is very helpful, Fifi. Thanks.

        So, to summarize: it seems that: “yes”, indeed, N. Am. refiners would prefer the diluted crude over upgraded ‘syncrude’; but only because by upgrading the crude PDVSA would have already captured most of the possible refining value (i.e., “He who cracks the black gunk white makes the big bucks”).

        So, this puts a bit of a different spin on PDVSA assertions that foregoing the upgraders for the now, and instead diluting any new ‘early production’, will not make Faja extra-heavy any less attractive to US refiners. It’s true .. but it also means PDVSA gives up a good chunk of the possible refinery value added.

        (Though, I wonder what a detailed cost-benefit comparison would show? Upgraders are so expensive and there is some question as to how differentiated the ex-heavy product is from place to place.)

    • The first time import of foreign oil is not really the issue , its what it says about the economic impact of a radical change overtaking the make up of Venezuelan exports , Production of conventional crudes is dropping and must be replaced with production of extra heavy crude oil in ever larger volumes. The economic impact of this change is bound to be averse because EHCO must be either upgraded or blended with lighter crudes and refined diluents in order to be saleable so that if the upgraders cannot be built in time ( because of financial and timing considerations ) and local production of light crudes and refined diluents are insufficient requiring the latter to be imported at high prices from far off places, the net revenue Venezuela is likely to obtain from the selling of such blended EHCO is bound to be lower than that obtained when most exports were made up of lighter crudes or from the blending of EHCO with locally produced light crudes or refined diluents. The cost and complicated logistics of buying blending material abroad and the storing and blending it with local EHCO are going to affect the economies of Venezuelas oil exports in ways that may probe significant . If exports revenues fall because of the above thats not going help the regime pay its coming debt service , rather the opposite. how much attention is FRod paying to the above ?? If on top of the above you add the effect of lowering market prices , the impact is bound to be quite substantial .

  6. So, who’s buying Venezuela’s foreign-currency denominated bonds?–F-Rod’s clients (maybe)–OK, maybe, with imminent Regime change (probably not imminent). With Venezuelan crude at $80/bbl., this is not a good bet.

    • The problem for the regime is not selling newly issued debt to the market (terms are so horrid you have to be an idiot to try that) , its convincing the old creditors to accept to pospone the collection of their money by accepting as replacement debt payable at a later date . To do that they have to persuade them that doing so does not place them in a very high risk zone .

  7. Who says Venezuela is not in default for failure to pay airlines and everybody else will ADDs? Where do you get the idea that ADDs are not binding? These are contractual obligations of the government that are clearly being breached. You do not have to ask 100 Wall St lawyers. BTW I myself have been admitted to the NY and DC Bars, and worked at Wall St for a while. Well, to be precise One Broadway and 825 3rd Ave, close enough

    • Yay! A lawyer!

      OK, seriously explain this to me. An Autorización de Adquisición de Divisas seems like it’s an administrative document, an authorization, given unilaterally by the state to a dollar buyer. How can that be considered a contract? I seriously don’t get that: a contract at a minimum needs two signatures, it needs to bind two sides to certain obligations. How can an authorization that one side bestows on the other have the force of contract?

      • A mutually-binding contract requires both signatures because it obligates both parties to deliver something to the other.

        A check, promissory note, or IOU is a unilateral promise by one party to pay money to the other. It is binding when signed by only the payer, yes?

        I know nothing of the language of these ADD documents, but they only bind the Venezuelan authorities, so only they have to sign them.

      • Well, lets see.
        1. The government makes it illegal, even a crime, to buy or sell foreign currency to anybody other than the central bank.
        2. In order to buy foreign currency from the central bank, you have to meet certain conditions (the Cadivi process).
        3. After you have met all the conditions imposed on you, the government may or may not agree that you are eligible to receive dollars. They will even tell you that dollars will be made available to you within a certain number of days (the ADD). Here is when you have a contract, after your offer (Cadivi application) is accepted (ADD).
        4. Based on what the government has promised, you may decide to act (e.g. bring you import, sell your products at controlled prices, not close your business).
        5. The government however doesn’t make good on its promise, leaving you with losses and monopoly money.
        Could you argue that the government´s non-compliance has caused you damages? No question. Should the government be held to a different standard of conduct than ordinary citizens? No, they are held to a higher standard of conduct, assuming the rule of law exists, that is. Could you take the government to court to claim damages? Not in Maduro´s Venezuela, and no ICSID either, sorry.

  8. Just a thought…

    I believe that the government can carry on servicing its debt anywhere from 18-36 months, although its really murky trying to pick at all the variables involved and the government’s ridiculous opacity. There are still a number of means to exhaust before they really hit that wall. However, to continue floating given their relative economic intransigence, they’ll have to keep screwing over their citizenry.

    The question is, which comes first: the fall of the current government, or default. While one doesn’t necessarily preclude the other, should it happen, what guarantee is there the government will continue to pay its bonds, assuming it can given the possible outcomes, depending on whomever happens to assume the reins?

  9. I guess this is one of the first times I agree with Mr. Toro’s view. It is hard to find another example of a country with similar dynamics.

    A key thing that the R&R article fails to address, as well as other people here, is the understanding that Venezuela owns the oil and the export proceeds. On the other hand, a county like Argentina, for example, as well as any other non-oil owning country, has to produce a local currency fiscal surplus to buy the balance of trade surplus if there is one. As governments produce local currency deficits, they can only buy the BOT surplus printing money which is inflationary. On the contrary, Venezuela’s problem is deciding how to allocate the money and how to spend resources.


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