The Brady Bond swap made simple

An intense debate has been unleashed about the government’s recently executed bond swap operation. As far as the financial implications of this swap are concerned, we note that many renown financial analysts are producing studies thereof, some showing positive results while others are negative. There is great confusion all around.

A few weeks ago, before the storm, I expressed certain reserves about the operation. Above all that results of the swap definitely were not as positive as those the authorities were promoting to validate the deal. I will try to present a simple analysis which I hope will shed light on the operation and allow readers to come to their own qualified conclusions.

In order to limit the analysis to strictly financial matters, it is necessary to clarify and to eliminate the noise created by some initial aspects that may cloud the issues. The first refers to the question of legality of the operation and the second to whether corruption was present.

As far as the legal issue is concerned, I should, not being a lawyer, refrain from taking positions. However, since one of the key inputs to a legal study would be whether or not the country has taken on new debt, I find it difficult to understand how Venezuela all of a sudden ends up with an additional US$ 1.317 billion in its kitty without net indebtedness. The only possible alternatives are either that the Nation has won a gigantic Lotto or, God forbid, has been involved in some type of misappropriation in the international markets. Anyhow, it is apparent that it is frequently more important to comply with one’s duty formally than realistically. In this sense, the bond swap could be totally “legal”.

With respect to the issue of corruption, only solid police investigation could reach a serious conclusion. Obviously, any such investigation should take into consideration not only the swap itself, but also any operation that took place prior to its execution and through which people in the know could have taken undue advantage. Since I am neither an investigator nor a policeman, it is impossible to issue a factual opinion. It is also irrelevant, since corruption may be present both in excellent financial operations as well as in the bad ones.

Having eliminated the aspects of legality and corruption we can proceed to the financial issues. This analysis is, in truth, extremely simple. By the way, in our analysis we have avoided all discussion as to whether the effects of the swap should be measured from the perspective of the Ministry of Finance or that of the Central Bank. For the common citizen, both form part of the same Venezuela.

Before the swap operation, Venezuela had an obligation on paper of US$ 4.441 billion. Interest incurred annually up to the year 2020 was to have been in the order of US$ 300 million. The debt was guaranteed by collateral that produced its own return which in turn, by the year 2020, should have been sufficient to amortize the principal of the debt.

After the swap operation, which in essence canceled the beforementioned debt, the collateral originally held was returned to Venezuela. This collateral, in the form of Zero Cupon US Treasury Bonds with a current value of approximately US$ 1.371 billion, has already or will obviously be sold in the open markets. In turn, Venezuela issued new debt instruments for US$ 4 billion maturing in the year 2027 and which create annual interest payments of US$ 370 million.

As a result then, the real difference between the “before” and “after”, and therefore the only valid basis for financial analysis, is the fact that Venezuela received US$ 1.317 billion in fresh funds. The cost of these funds will be US$ 70 million in additional interest (the difference between annual interest of US$ 300 million on the original debt and US$ 370 million on the new debt) that must be paid during 23 years until the year 2020, US$ 370 million in total interest to be paid during the seven years between the years 2021 and 2027, and finally, the capital of US$ 4 billion maturing in the year 2027. If all of this were rolled into a calculation as if the fresh funds were a new loan, the equivalent interest rate would be 8.8%.

In order to reach a final conclusion as to the validity of the swap, we must analyze whether the fresh funds are to be used to produce sufficient returns and/or social benefits over the 30 year period to merit the service of additional debt at 8.8% interest or if, on the contrary, and as has been tradition, the new debt simply adds to the country’s troubles.

Obviously, all this requires personal appreciation. In its analysis, the Government has used the basic premise that its management of the funds will produce a return of 10% per annum. The result, therefore, is positive. For those who believe that the government does not have a plan of action that will guarantee sufficient returns, the result is negative. Financial analysis shows that both could be right. It all depends which lens you look at it through, or in financial jargon, which discount rate is being used.

Legalizing preferential treatment

Article 13 of the Privatization Law contemplates preferential treatment for certain parties participating in the privatization processes. Among these is the clause that allows workers of privatized entities to acquire up to 20% of the shares, which should be considered normal from all points of view. The Law also establishes the possibility of awarding certain preference to “Entities domiciled in the Federal Entity in which the asset or activity to be privatized is located..”. This does not seem to make sense.

The idea that any entity, by the sole virtue of being domiciled in any given State, should be entitled to preferential treatment is not understandable. On top of being unconstitutional as far as it is discriminatory and violates economic freedom, it could seriously and adversely affect the Nation’s income from privatizations.

The preferential treatment referred to is described according to Article 14 of the Law as the “possibility of equaling the offer presented by the winning bidder in the privatization process”. In the case of the workers, this means that they must pay the same price as that tabled by the final investors.

In the case of the parties domiciled in the same Federal Entity as is the privatized asset and that are interested in acquiring 100% of the latter the story differs. The “preferential treatment” means that they can quietly fan themselves while watching the process from the sidelines, and if the price is right take control of the privatized asset at the expense of non-domiciled parties, without paying one Bolívar more and without the expense of going through a formal round of bidding. This does not seem rational or fair if you consider that this merely reduces the number of bidders who formally go through the usually tough bid preparation process (which normally tends to maximize the results of the bid) and that only non-domiciled interested parties must do so.

To maximize the results of a bid process, it is important to have the maximum number of bidders come to the table and that all of them have been sufficiently motivated. Only interested and motivated parties would agree to run the inherent risk that their bid could possibly be on the high side and result in a bad deal.

It is not easy to interest and motivate participation in a card game with marked cards. Unfortunately this can easily happen when preferential treatment is awarded the “local boys” to the detriment of foreign investors or Venezuelan investors from other States. On top of this, think of the negative effect on the credibility of the process should this “preferential treatment” be used by “foreign” entities to perpetrate fraud by establishing suitable “local” fronts.

The “preferential treatment” is not obligatory. The Law states that “Preferential rights may be awarded..”. The mere possibility of preferential treatment, however, should be a source of preoccupation and difficulty for, say, the Venezuelan Investment Fund. It would not be surprising if the Directors of the Fund are continually faced with the conflict created by their desire to comply with their duties of maximizing income generated by privatization on one hand (i.e. safeguarding national patrimony), and the continuous vociferation of local groups (whether bona-fide or Trojan), all vying for supposed preferential rights, on the other.

A formal legal complaint has been recently introduced in the corresponding courts by Drs. Fredrik Kurowski and Santiago Cabrera on behalf of a firm interested in the privatization of Fesilven. (Dr. Fredrik Kurowski is the brother of the undersigned and so more that simple coincidence must be acknowledged).

This legal process requests that, in the specific case of the privatization of Fesilven, no “preferential treatment” as discussed above be awarded by the Venezuelan Investment Fund. Obviously, this firm considers that only the clear definition of this situation prior to the actual bid date will allow them to be sufficiently motivated in order to proceed with the expensive due diligence and analysis required.

It would make sense to believe that other interested investors must harbor the same concerns, whether they are domiciled on another continent or simply on the other side of the Orinoco River.

Hopefully this legal process, initiated by an entity that is evidently demonstrating its confidence in the country’s development through its will to invest in the latter, produces rapid results. They would only be for the good of foreign and national investors, the managers of the privatization process, the Directors of the Venezuelan Investment Fund and, last but not least, of the country as a whole.

Pequiven, Sidor – double standard?

During the last few weeks, we have been informed about the national petrochemical industry’s (Pequiven) ambitious ten-year investment plan which calls for outlays of US$ 8.3 billion.

Investments for the first three years are estimated to be US$ 1.53 billion. During this same period, Pequiven’s cash flow is projected to be US$ 680 million. The question that immediately arises is how to fund the resulting deficit during the years 1998, 1999 and 2000 which comes to US$ 850 million. To begin with, a bridge loan is to be negotiated with its head office, PDVSA. In addition, the idea is to exonerate Pequiven from the debt limits imposed on it by the Organic Law of Public Credit.

The press notes that accompany the news describe the debate relative to whether this investment plan should be implemented with the participation of the private sector (evidently without giving up government control) or if, on the contrary, the Nation should reserve for itself the totality of the shares in Pequiven and fund this growth with debt and State funds.

This debate is depressing. It is a clear indication that we have made few inroads into the identification of a horizon for the future of our country. I’ll explain what I mean.

Why is it that while the country is trying with great difficulty to come to terms with the privatization process, for example Sidor, in other corners of the official bureaucracy, someone is brazenly developing investment plans for a whopping US$ 8.3 billion?

In the meantime, where is the Nation’s financial management? Pequiven’s projects admittedly will yield returns of between 9% and 12% in dollar terms. This seems like a meager result for project risk, specially when compared with the returns in excess of 9% being offered by the Republic to the 30-year bond holders, presumably without risk.

A few weeks ago, the press published what seemed to be a scolding by a government official, stating that since the flow of funds received from the National Government has stopped, “FIV’s teat has dried out”. This has made it impossible for the FIV to continue subsidizing the power sector in order to accelerate privatization of the latter, which simply “requires a sufficiently attractive tariff structure” (i.e., an expensive one).

Going back to the cash flow for the next three years of US$ 680 million that Pequiven maintains it will generate, the following questions arise: Who establishes the country’s investment priorities? Can the management of a State-owned company allocate the firm’s entire cash flow into eternity to perpetuate its growth? Is it possible that Pequiven’s investment plan, with its dubious returns, is more important that, for example, insuring power supply at reasonable cost for the Island of Margarita, or even more imperative, ensuring that the country’s youth receive decent physical and spiritual nourishment?

In spite of the multiple accolades awarded Venezuela by the International Monetary Fund (which frequently and justifiably are not understood the common citizen), there are rumors circulating that the IMF is slightly preoccupied with the disorganization in entities responsible for the management of the country’s economy, Cordiplan among them. In view of the apparent institutional vacuum in which Pequiven’s investment plan is being hatched, it is important that we join the IMF in its preoccupation.

And while we are at it, we should strive to avoid the tragic results which normally result when a public (or private) entity is allowed to fall back on bridge loans, “while the situation is being defined”. Unfortunately, we are much too inclined to allow transitory patches to quietly convert into permanent fixtures.

Hopefully, we will not have to ask the Central Government (as we have done so many times before) to assume an immense amount of Pequiven debt a few years down the line in order to facilitate its privatization. Hopefully, Pequiven’s investment plan will contribute heavily and positively to the country’s future development and well being, and that these uncomfortable feelings will be proven to be unjustified.

Energy in Venezuela

The local press has recently published articles referring to the presentation by the National Executive to the National Energy Commission of a document which will lay out the plans to finally eliminate Venezuela’s rentist mentality. This means, basically, that increases in tariffs and prices of fuel are around the corner.

It seems clear that this document, in addition to establishing the bases for justifying new sources of income for the central government, will once again promote the thesis that the principal rentists of Venezuelan society are the common citizens, not its politicians and governors.

The identity card debacle is still fresh in our minds. This is a classic example of parasitic behavior. The Government was ready to dish out a macro-investment of US$ 500 million to solve the problems with our national identification system rather than putting just a little bit of effort into developing realistic and sane administration of the latter.

One of the main arguments used in the aforementioned document has to do with efficient use of our natural resources. The gist of the matter is that we are basically to forego the comparative advantages given us by nature in the form of abundant oil, gas and hydroelectric energy. Faced with high utility bills, companies and citizens alike must learn how to optimize and make more efficient use of these resources. The prime example of inefficient use of energy the authors of the document could come up with is that the Venezuelan aluminum and steel industry uses three time the amount of energy used in Japan.

This logic does not necessarily make sense, since Venezuela has abundant energy resources while Japan does not. The mix of production inputs such as capital, raw material and labor are usually established according to the conditions in each country. Surely most people would much rather see our comparative advantages be biased in favor of cheap energy rather than on cheap wages. It seems we don’t see eye to eye with the current or previous Governments on this.

On top of this both the aluminum and the steel industry have been managed by the State. Could it not be possible that this supposed inefficiency in the use of energy resources be related more than anything else to poor government administration?

The final blow was the publication in the press (on the same day the news of the document broke) of the invitation to prequalify for the privatization process of the power generation system of the State of Nueva Esparta. The basic terms of the invitation clearly stipulates that 100% of the shares will be sold to the highest bidder, on a strictly cash basis and without financing by the Venezuelan State.

This undoubtedly means that the power generation system will be allocated to the candidate who guarantees maximum income for the Central Government (which basically means charging higher rates to insure a return) rather than to the bidder that offers the Margariteño the best service and the lowest tariffs. Again, as far as I can see, this is just another example of the parasitic fiscal planning that has cost Venezuela immense amounts of financial resources and time. Why should Margarita pay tariffs that are higher than the in the rest of the country and might even be higher that what Venezuela will charge Brazil and Colombia for our exports of electricity? This makes no sense either.

For example, the implications of drastic increases in electricity rates for the hotel industry are horrible. A hotel needs a supply of abundant and continuous energy and there are preciously few ways to increase efficiency unless there is an unlimited amount of capital available which, for example, would allow for the importation of efficient but costly airconditioners. Today, faced with depressed room rates due to a flood of state owned supply and the lack of steady transportation due to Viasa’s exit, Margarita’s tourism industry simply does not have these resources.

Finally, as a sweetener, the Government most generously promises to limit its fiscal appetite to levels established by export values. This implies that it is it’s intention to at least not take undue advantage of the monopolistic conditions that tend to skew prices. We will live, eternally gratified with the hope that our average Venezolano will not one day pay more for each kilowatt of power than the average citizen in Tokyo.