Venezuela’s economic nightmare takes an ugly turn

Amid violent protests, product shortages, and crushing inflation, the Venezuelan government is looking to increase the supply of U.S. dollars. But the effort is unlikely to stem the tide.

By Cyrus Sanati

Anti-government protest in Caracas, Venezuela

FORTUNE — The protests in Venezuela are starting to get nasty. The death toll is now at 28 and rising as people take to the streets in opposition to the government’s mishandling of the economy.

In response, the Venezuelan government this week announced a new “third” exchange rate mechanism (SICAD II) to increase the supply of U.S. dollars to private businesses and individuals. The government hopes this new scheme will help alleviate the crushing inflation and goods shortages at the heart of the month-long protests.

But while SICAD II might make things easier for small businesses in the short term, it is hard to see how further manipulation of Venezuela’s worthless currency will do anything to stem the tide of mass protests. Under President Nicolas Maduro, successor to Hugo Chavez, Venezuela has continued to flounder in a cesspool of self-induced crime brought on by economic stagnation. If the middle class and students leading the protests are able to draw enough support from the poorer classes to join their struggle, Maduro won’t stand a chance.

The recent month-long protest in Venezuela is the strongest civil-disobedience movement the country has seen since 2003, when then-President Hugo Chavez was almost ousted from power in a military-led coup. In the years that have followed, Venezuela’s standard of living has fallen dramatically as the government took to manipulating the nation’s currency as a way to maintain popular support from the poorer classes. By using the state-controlled energy company, PDVSA, as a piggy bank, the Venezuelan government has subsidized a dubious state-regulated exchange rate to keep the price of food stuffs and medicine cheap.

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The system never worked well, but it has really fallen apart in the last two years. The market distortions have created major economic disincentives for investment and production inside the country. This has made Venezuela almost entirely dependent on imports for pretty much everything from electronics to food. As a result, inflation has skyrocketed (56% last year) as the central bank printed more and more bolivars, Venezuela’s currency, to sustain the exchange rate.

Today, the government’s official exchange rate remains locked at 6.3 bolivars to the dollar, but on the black market the rate is at 80 to 90 bolivars to the dollar, around 14 times the official rate. Such disparity means that foreign goods are now incredibly expensive, leading to shortages. It’s become so bad that people are only allowed to go to the supermarket once a week, and when they get there, they find little on the shelves.

Last year, in a bid to stem the shortages, the government implemented a new foreign exchange system known as SICAD, which allowed state-owned enterprises to “bid” for dollars in state-run auctions. SICAD gave these key businesses access to scarce dollars so they could pay their foreign suppliers at a rate that was higher than the official rate but below the black market rate.

This is understandably very confusing. It is easier to think of SICAD as just another unsustainable state subsidy. It does nothing to foster investment or growth; it just continues the same old, broken economic policy that has turned Venezuela into a textbook example of how not to run an economy.

So where are all these U.S. dollars coming from? Venezuela can’t print them so they have to earn it somehow. With 95% of Venezuela’s dollars coming from oil sales, this means that it is pretty much all coming from PDVSA. Therefore, the state-owned enterprises received dollars from PDVSA, and PDVSA received a bunch of devalued currency in return. That’s bad news for the oil company, which has seen production fall off a cliff in recent years due to a lack of capital.

The economic collapse has had many consequences, most notably, a huge increase in violent crime. People are fighting over scraps, and the police are checked out. The black market for goods and dollars has the country looking like a dystopian hell, with crime bosses and private armies looting and murdering to control finite resources. Roves of highway bandits ambush vehicles they think could be carrying dollars. In one such attack last December, robbers shot and killed popular soap-opera actress and former Miss Venezuela Monica Spear and her husband in a violent carjacking near Puerto Cabello, the country’s main port. The incident inflamed the media and brought the dollar-fueled crime spree home for many Venezuelans.

Popular anger boiled over last month when the attempted rape of a student sparked mass anti-government protests at universities across the eastern part of the country. The harsh police response to the student-led protests spawned even larger protests across the country, including in Caracas, Venezuela’s capital. The students have since been joined by the disillusioned middle class, who have seen their savings and wages obliterated by inflation.

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In a desperate attempt to alleviate the economic calamity and reduce the dollar crime wave, the government this week announced it was extending the SICAD program to individuals and private businesses. The hope is that with greater access to dollars, store shelves will be full again and that crime would then fall.

But the new program, known as SICAD II, just creates another shifty exchange rate. PDVSA doesn’t have enough dollars to fulfill the needs of all the businesses in Venezuela, let alone those of individuals. This means the government would need to issue dollar-denominated debt to fulfill that demand. Considering Venezuela’s junk credit rating, which was recently cut by SP in December to B- with a negative outlook, it won’t be easy.

The details of the auction haven’t been released, but it is doubtful that SICAD II will cure Venezuela’s economic woes or have any meaningful impact on the protests or the crime rate. With so many people competing for such a limited supply of dollars, the SICAD II exchange rate will probably just end up mirroring the black market. There are simply too many desperate people looking to get rid of their worthless bolivars.

At the same time, today’s protests risk fizzling out without broad-based support from the lower classes. So far, Venezuela’s poor have stayed neutral in the conflict. The government has painted the protesters as a bunch of treasonous “spoiled brats” out to destroy Venezuela. That narrative worked well for Chavez, but as crime spreads and food becomes increasingly scarce, even for the lower classes, it is unlikely to work forever.

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