The Venezuelan banking system is on the eve of a major crisis. As always, there have been subtle indications of this looming calamity, but few have identified or spoken out about them. Even though the Venezuelan authorities did not anticipate similar crises in 1983 and 1994, veteran banker Oscar Garcia Mendoza predicted them and is again calling attention to impending devaluation. Mendoza comments on the possible effects of the already announced devaluation of the Bolívar and on the excessive liquidity of the Venezuelan financial system.
The Threat of Excessive Liquidity by Oscar Garcia Mendoza
For most of the Castro-Chavismo period, excessive public spending and tight exchange control produced high liquidity in the Venezuelan monetary markets. But, liquidity only creates an illusion of prosperity and control. It is actually a sign of corruption and most often leads to market failure.
When governments overspend and money circulates in excess, it creates the opportunity for citizens and businesses to get cash. Having immediate cash provides access to goods and services. With higher demand, assets go up in price; such is the law of “Supply and Demand.” The overspending creates massive inflation and resulting liquidity shortages. As the price of goods increases, governments institute better interest rates to encourage continued buying power. If they go one step further and raise the legal reserve, then the banks retain purchasing power without paying off debts. The result is further liquidity, inflation, and major market shortages.
Lending money under these conditions is dangerous, but banks are basically forced to do it. When there is a lot of money in circulation, it inevitably ends up deposited in banks. The banks are intermediaries; they receive money from depositors and lend that money to borrowers at a profit. But when liquidity is great the interest rates for both assets and liabilies tends to fall. Banks have so much money in their accounts, they have no choice but to lend more money out.
Right now, the financial system’s liquidity is at an all-time high and it is facing difficult and overwhelming challenges. How will the Bank continue to fund the operation? How can it lend money to solvent debtors? Answering these questions is difficult and frustrating. The government, which produced the increased demand for currency in the first place, knows that this is not sustainable. It then takes advantage of its increased buying power and uses it to achieve its goals at the expense of consumers. The government creates targeted or compulsory credits by imposing, under penalty of enormous and disproportionate fines, requirements that banks invest significant percentages of depositors' money in sectors that do not meet the criteria to ensure that depositors are guaranteed.
The Bank also takes advantage of the liquidity by issuing bonds and treasury bills without provision of payment, just to continue increasing current spending. This perpetuates the illusion of wellbeing that keeps them in power. The BCV prints money without the bank determining whether it can truly back the currency.
This combination is explosive. Banks appear solvent even though there is an enormous amount of liquidity. If a debtor cannot pay Bank X, he can go to Bank Y, which will lend him money even though it knows the debt is bad because its feels pressure to lend. If the government does not have a way to cover these bonds and letters, it simply issues more and then banks will buy them. This vicious cycle cannot go on forever and it ends in a devastating market crash.
There have been times when circumstances were right for sensible people to come together to determine that this perpetual inflation was dangerous and had to stop. The universally accepted solution is to reduce liquidity and make a series of coherent adjustments. Interest increases, public spending diminishes, and legal reserve requirements are all necessary to affect change. Any of these measures, or a combination of them, has a triggering effect on banking.
But reducing liquidity creates difficulties as well. It can halt the economy and hits the poorest people hardest. With higher interest rates, many borrowers cannot pay their debts and incur late penalties and compounded interest. Treasury Bills cease to be attractive and it may be difficult to pay them back. In addition, most of a bank’s deposits come from people awaiting the availability of foreign exchange transfers, meaning that money is not expected to stay in the country.
Banks are not good at dealing with long periods of illiquidity. The last time the financial system faced this situation was in the early millennium, after the arrest, when banks had to ask the government to impose exchange controls.
The question now is, how will the bank face this new period of illiquidity?
Editor's Note:
This article is published in El Universal Digital Journal
on June 25 and July 17. It is herewith reproduced with permission.
The Threat of Excessive Liquidity by Oscar Garcia Mendoza
For most of the Castro-Chavismo period, excessive public spending and tight exchange control produced high liquidity in the Venezuelan monetary markets. But, liquidity only creates an illusion of prosperity and control. It is actually a sign of corruption and most often leads to market failure.
When governments overspend and money circulates in excess, it creates the opportunity for citizens and businesses to get cash. Having immediate cash provides access to goods and services. With higher demand, assets go up in price; such is the law of “Supply and Demand.” The overspending creates massive inflation and resulting liquidity shortages. As the price of goods increases, governments institute better interest rates to encourage continued buying power. If they go one step further and raise the legal reserve, then the banks retain purchasing power without paying off debts. The result is further liquidity, inflation, and major market shortages.
Lending money under these conditions is dangerous, but banks are basically forced to do it. When there is a lot of money in circulation, it inevitably ends up deposited in banks. The banks are intermediaries; they receive money from depositors and lend that money to borrowers at a profit. But when liquidity is great the interest rates for both assets and liabilies tends to fall. Banks have so much money in their accounts, they have no choice but to lend more money out.
Right now, the financial system’s liquidity is at an all-time high and it is facing difficult and overwhelming challenges. How will the Bank continue to fund the operation? How can it lend money to solvent debtors? Answering these questions is difficult and frustrating. The government, which produced the increased demand for currency in the first place, knows that this is not sustainable. It then takes advantage of its increased buying power and uses it to achieve its goals at the expense of consumers. The government creates targeted or compulsory credits by imposing, under penalty of enormous and disproportionate fines, requirements that banks invest significant percentages of depositors' money in sectors that do not meet the criteria to ensure that depositors are guaranteed.
The Bank also takes advantage of the liquidity by issuing bonds and treasury bills without provision of payment, just to continue increasing current spending. This perpetuates the illusion of wellbeing that keeps them in power. The BCV prints money without the bank determining whether it can truly back the currency.
This combination is explosive. Banks appear solvent even though there is an enormous amount of liquidity. If a debtor cannot pay Bank X, he can go to Bank Y, which will lend him money even though it knows the debt is bad because its feels pressure to lend. If the government does not have a way to cover these bonds and letters, it simply issues more and then banks will buy them. This vicious cycle cannot go on forever and it ends in a devastating market crash.
There have been times when circumstances were right for sensible people to come together to determine that this perpetual inflation was dangerous and had to stop. The universally accepted solution is to reduce liquidity and make a series of coherent adjustments. Interest increases, public spending diminishes, and legal reserve requirements are all necessary to affect change. Any of these measures, or a combination of them, has a triggering effect on banking.
But reducing liquidity creates difficulties as well. It can halt the economy and hits the poorest people hardest. With higher interest rates, many borrowers cannot pay their debts and incur late penalties and compounded interest. Treasury Bills cease to be attractive and it may be difficult to pay them back. In addition, most of a bank’s deposits come from people awaiting the availability of foreign exchange transfers, meaning that money is not expected to stay in the country.
Banks are not good at dealing with long periods of illiquidity. The last time the financial system faced this situation was in the early millennium, after the arrest, when banks had to ask the government to impose exchange controls.
The question now is, how will the bank face this new period of illiquidity?
Editor's Note:
This article is published in El Universal Digital Journal
on June 25 and July 17. It is herewith reproduced with permission.