Joseph Mariathasan: Venezuela – is the risk priced in?
The economist and entrepreneur Jerome Booth always says the distinction between emerging markets and developed is that in emerging markets the risks are fully priced in, while in developed markets they remain hidden.
Political risk is clearly a case in point. It is political risk above all that characterises emerging markets and is the greatest challenge for potential investors. Argentina was one of the 15 richest countries in the world on a per capita basis for the first half of the 20th century. But a century of political instability with rule by populist politicians and military juntas eroded its relative wealth and its position to the extent that it was even downgraded to frontier market status by MSCI in 2009.
Today, the Latin American tragedy that the world focuses on is Venezuela.
Again, it is a rich country brought low by political mismanagement. Its oil reserves are comparable to – and larger than – those of Saudi Arabia. Its economy, like that of Saudi Arabia, is dominated by oil and Venezuela relies on imports for a major proportion of its industrial, construction, and household items.
The late Hugo Chavez, elected President in 1998, undertook a radical nationalisation program and set up programmes to expand access to healthcare, food, housing, and education. That resulted in shifting masses out of poverty, but it relied on record-high oil prices and a quintupling of its external debt position between 2004 and 2013.
The post-Chavez government, still referred to as Chavista, has proved to be a disaster in its economic mismanagement and in its attacks on the institutions that underpin democracy. Economic output has fallen by roughly 25% since 2013 and inflation in 2016 is estimated to have been around 400%. Society has become more violent, not only through protests and harsh reactions by the government but through criminality and an escalating murder rate.
Oil production, critical for generating foreign exchange required for the imports that sustain its population, has fallen to 2m barrels a day due to lack of capital investment caused by the mismanagement of the state oil company, PDVSA. The depressed production, lower oil prices, and the proportion of the output that has been pledged to China have reduced the capability of the country to generate foreign exchange.
As a result, the population is suffering from shortages of key essential goods including medicines. Venezuela suffered a 35%-40% contraction of its imports within the last couple of years, a situation that is unprecedented in the world. Venezuela is rapidly heading towards becoming a failed state.
Venezuela’s total external debt is estimated at between $120bn and $160bn (€107bn-€142bn), of which $64.4bn is in US dollar-denominated international bonds. Around half of bonds are issued by the sovereign and half by PDVSA. The credit default swap markets are discounting a 95% or so probability of default within the next five years, and the 2038 sovereign bond trades around 45 cents to the dollar at the time of writing.
Single most attractive opportunity?
Venezuela is clearly a risky investment. For investors though, what matters is whether risk is priced in.
Mohammed Hanif, CIO of Insparo Asset Management, argues that it is.
Perhaps what is most surprising has been Venezuela’s almost perverse willingness to continue to pay its debt obligations. This is reflected in the price of its 2017 and 2018 bonds trading at over 75 cents to the dollar. If default is inevitable, that does not necessarily mean investors would lose out though. Insparo considers that the prices of sovereign and PDVSA bonds are already approaching expected recovery rates of 55%-65%.
Aramco, the state-owned oil company in Saudi Arabia, is worth around $3trn. Valuations of PDVSA, Venezuela’s equivalent, should be comparable in magnitude, and any valuation of oil assets would suggest that there is significant asset coverage for the bonds.
Whatever happens on the political front, with elections due in October 2018 and several thousand people engaging in daily and often violent demonstrations in Caracas, it is clear that the debt needs restructuring. There needs to be a credible government before a meaningful recovery can be made but the abundance of assets suggests that a strong recovery is possible.
Hanif believes that, even after a default, investors should be able to receive sufficient assets to make Venezuela the single most attractive opportunity for the dedicated emerging market debt investor.
Venezuela may be a mess, but the risks are clear and the issue is whether, and by how much, they have been discounted in asset prices. The same cannot be said for developed markets.