SALUDOS, NESTOR G RAMIREZ.
ANALISIS DEL UBS BANK SOBRE CAPACIDAD DE PAGO DE VENEZUELA.
UBS Investment ResearchLatin American Economic FocusHow much longer can Venezuela pay itsbills?.. The train at the end of the tunnelThe combination of ballooning public sector debt stocks and declining oil exportvolumes can only lead to an explosive fiscal cocktail. To quantify, if the publicsector continues to issue US$8 billion dollar debt on a net basis per year at say a9% coupon, the resulting increase in dollar interest cost is equivalent to 20,000barrels of exports per day, or nearly 1% of the total. And if oil export volumescontinue to head south and oil prices remain stable, the dollar interest payment/oilexport volumes ratio would increase at a faster rate over time. This erodesVenezuela’s public sector large net long dollar flow position and therefore theeffectiveness of devaluations as a fiscal adjustment mechanism, the country’srecurrent exit strategy to address imbalances. In the absence of policy adjustmentsor ever higher oil prices, we think Venezuela’s fiscal story ends in an accident... How bad?Today’s fiscal situation isn’t bad at all. Key vulnerability indicators remainreasonably solid, comparing quite favourably against better rated credits, andsignificantly more favourably against those observed during the 1980s, the era ofLatin America’s debt crisis. However, their speed of deterioration is rapid, andeventually they will reach levels where ability to pay becomes a serious concern... How soon?Not soon. Venezuela doesn’t face solvency problems. Public sector external debtobligations amount to less than US$10 billion/year over the next several years. Onthe other hand, oil exports amount to more than US$65 billion, of which aroundhalf go to the Central Government and other off-budget government accounts. Wethink default is not around the corner, not even a few blocks away... OK, but when?When we simulate the Venezuelan economy using trends of the last few years asparameters, we find that key vulnerability indicators begin to turn from green toyellow in about five years, right before a spike in amortizations in 2017. Even then,we think the government would still be able to service the debt but not withoutinstilling socially painful measures... So…?We don’t see any policy breakthroughs that could put the country on a moresustainable path any time soon and therefore can’t be positive on the country’sfuture. There are also plenty of downside risks: new bond supply, unfavourablerulings in international courts or costlier US sanctions. That said, Venezuela’s cashflow and balance sheet position suggest that we are at least a few years awaybefore we really need to start worrying about a default in Venezuela. We also findlittle reason for concern about willingness to pay issues. Markets don’t seem toagree with this view. Default probabilities implicit in CDS spreads discountgrimmer scenarios than we are prepared to entertain. For example, 1yr, 2yr and 3yrPDVSA CDS spreads discount default probability of 14%, 25% and 42% over thecorresponding period, respectively. We think this is excessive.Global Economics ResearchLatin AmericaNew York7 June 2011www.ubs.com/economicsJavier KuleszEconomistjavier.email@example.com+1-203-719 1603Andre CarvalhoEconomistandrefirstname.lastname@example.org+55 11 3513-6522Rafael De La FuenteEconomistrafael.email@example.com+1 203 719 7127Gustavo ArtetaEconomistgustavo.firstname.lastname@example.org+1-203 719 5863This report has been prepared by UBS Securities LLCANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 12.ab.Latin American Economic Focus 7 June 2011UBS 2How much longer can Venezuelapay its bills?The train at the end of the tunnelWith Venezuela’s public sector issuing dollar debt a rapid rate, concerns about a default have beenon the rise. The fact that the economy is not growing and the oil sector shrinks can only exacerbatethese concerns. In this note, we try to estimate how close Venezuela is to a fiscal accident. This is aquestion that has become quite recurrent.Four important comments before we start:1) We are not going to give you the exact date and time of Venezuela’s default (unlike thosepreachers who dare to predict the end of the world on a specific date). The best we can hope for is togive a rough idea about how bad things will get over time if policy is not adjusted and key macroindicators continue to deteriorate at the pace of recent years. This could still provide someparameters about timing that many, especially those carrying CDS or jump-to-default positions tiedto specific dates, can find useful.2) The 'bills' we are referring to in this note’s title exclude those that may be issued by judges ininternational courts in compensation for the unpaid nationalization/expropriation of variouscompanies or oil projects. We mention this because, depending on upcoming rulings, we might beleaving out ‘bills’ amounting to tens of billions of dollars.3) We just discuss ability to pay here. If the government wakes up one morning reneging on its debtbecause they find it to be a good reason to retaliate against the US for recently imposed sanctionsagainst PDVSA, or the social situation becomes untenable and there is a need to deflect attentionblaming greedy creditors for the country’s ills, or an international court decides to freeze keyVenezuelan assets, or any other ‘exogenous’ shock of this nature, that will not be incorporated inour analysis.4) This is more of a disclaimer than a comment. The exercise involves the projection of many‘known unknowns’: price of oil, volume of exports, GDP growth, the real exchange rate, size andstructure of the new issues, etc. Needless to say, nobody has the faintest idea where many of thesewill be in a month from now, let alone in a few years. As such, we feel the need to acknowledgethere is a degree of a shooting-in-the-air component in the exercise we are carrying out.How bad?Let’s now talk about how good or bad the starting point of our simulation in 2010 is. In Chart 1, youcan see how external public sector debt levels1 have ballooned over the past five years in dollarterms (rather hard currency). PDVSA explained the bulk of this growth. Sovereign debt levelshaven’t really gone up as much (they are actually lower as a share of GDP). This is part of thereason why a) Venezuela’s official government debt-to-GDP ratios you see in the country’s macrodata is quite low (Chart 2), even by investment grade standards and b) PDVSA’s debt trades withsuch a large discount to the sovereign along the entire dollar curve.1 We take the external public sector debt as the sum of the total outstanding hard currency debt of the government and PDVSA. For simplicity, weignore the external debt of other public sector entities.Latin American Economic Focus 7 June 2011UBS 3Chart 1: Public external debt (US$ billion) Chart 2: Public external debt (% of GDP)10203040506070801997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Gov ernmentGov ernment + PDVSA05101520253035401997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010PDVSAGov ernmentSource: Haver, Sintesis Financiera and UBS Source: Haver, Sintesis Financiera and UBSDollar GDP may be overestimated to the extent that the exchange rate is, in our view, grotesquelyovervalued. This and other factors have resulted in lower debt to GDP ratios than perhaps we shouldbe observing (for more, see ‘How high is Venezuela’s public debt ratio?’ September 8, 2010).2 Toremove the impact of an ‘inflated’ dollar GDP, we compute external public debt ratios as percent oftotal exports. We find they don’t look bad in historical terms, either (Chart 3). We are much closer tothe lows observed right when debt levels started to balloon in 2006 than the highs when oil priceswere hovering at around US$10/bbl more than 10 years ago.Chart 3: Public external debt (% of oil exports) 1/ Chart 4: Public external debt (% of foreign reserves)0501001502002503001997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010PDVSAGov ernment0501001502002503001997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010PDVSAGov ernment1/ Excludes debt of other public companies and China loanSource: Haver, Sintesis Financiera and UBSSource: Haver, Sintesis Financiera and UBSWe find a less rosy picture if we compute external public sector debt relative to foreign reserves. Thisshould not be a surprise for those following Venezuela closely enough. The Central Bank has set anoptimum reserve level (which really doesn’t change much irrespective of whether oil prices are atUS$40/bbl or US$140 bbl) and transfers the excess over this optimum level to government off-budgetaccounts on a regular basis. That explains why foreign reserves in Venezuela have remained stabledespite large current account surplus and strict exchange controls.Things don’t look as bad as one might think when we look at specific fiscal flows in historical terms,either. External interest payments are rising in dollar terms at a rapid pace, but relative to oil exports,believe it or not, remain close to an historic low. A similar argument applies when we compare theseobligations against Central Government revenues (Chart 5). Even relative to its foreign reserves, wehave some ways to go before we approach the highs reached about a decade ago (Chart 6).2 The government carried out a large devaluation that took effect in early 2011. This will result in a discrete jump in debt to GDP ratios of around 5ppts that we incorporate in our simulation.Latin American Economic Focus 7 June 2011UBS 4Chart 5: Public sector external interest payments Chart 6: Public sector external interest payment (% ofreserves)0.02.04.06.08.010.012.014.016.018.01997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010% of Central Gov t rev enues % of oil ex ports0246810121416181997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Haver, Sintesis Financiera and UBS Source: Haver, Sintesis Financiera and UBSThe debt amortization profile for both the government and PDVSA is as light as it can be for the next5 years. We are looking at less than US$5 billion of debt amortization, spiking in 2017 as a result of alarge PDVSA bond that comes due (Chart 7). As for foreign debt payments, obligations amount to lessthan US$4 billion. Put both combined and Venezuela’s external debt obligations amount to less thanUS$10 billion per year against much higher Central Government oil revenues (in 2010, they amountedto nearly US$21 billion and more if you add revenues flowing into off-budget government accounts).Chart 7: Foreign debt amortization profile (US$ mill) Chart 8: Foreign debt interest payment (US$ million)0.05,000.010,000.015,000.020,000.025,000.030,000.02011 2012 2013 2014 2015 2016 2017 2018 2019 >2019PDVSAGovernment01,0002,0003,0004,0005,0006,0007,0008,0009,0002011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 >2022PDVSAGov ernmentSource: Haver, Reuters, Sintesis Financiera and UBS Source: Haver, Reuters, Sintesis Financiera and UBSThis quick overview shows that though the increase in public sector dollar debt has beenphenomenal, when we measure the level and the cost to service against dollar receivables and assets,it is not as bad as it was not long ago. If you want to see how many of these ratios stuck up duringthe Latin American debt crisis of the 1980s, we put together in the Appendix a set of charts with keyindicators from the World Bank Debt Tables going as far back as 1980. These numbers show thatthere is a long way to go for Venezuela to approach the levels in the 1980s. Looking at those charts,it does suggest that Venezuela’s solvency indicators might be closer to Norway’s than Greece’s. Inany event, all the evidence is pretty conclusive that default is not around the corner, not even a fewblocks away.How cheap?We’ll diverge a bit here. It just occurred to ask ourselves how Venezuela traded 10-15 years agoduring those low oil price days, and all key macro metrics look a lot worse than they do today. Wethought you might be interested in the answer. It’s in Chart 9, which shows that Venezuela trades alot wider today against the market.Latin American Economic Focus 7 June 2011UBS 5Chart 9: Venezuela EMBI+ spread – EMBI+ spread Chart 10: Public sector external debt and interest /barrel of oil exports per year-400-20002004006008001000120014001/11/19991/11/20001/11/20011/11/20021/11/20031/11/20041/11/20051/11/20061/11/20071/11/20081/11/20091/11/20101/11/2011203040506070801997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20101.01.52.02.53.03.54.04.5Public sector ex ternal debt / barrels ex ported (LHS)Public sector ex ternal interest payment / barrels ex ported (RHS)Source: Datastream Source: Haver, Sintesis Financiera and UBSSo far, creditworthiness doesn’t look awfully bad, while spreads look awfully wide. It sounds likeVenezuela is way too cheap. Maybe so, but let’s not forget that a lot of things are not reflected inmacro metrics, from potential large liabilities in the event of unfavourable rulings in internationalcourts to an accumulation of policy inconsistencies, especially as far as the FX regime is concerned,which threaten to dig the country deeper into a hole.Moreover, it’s the macro trends more than the macro snapshot that we are all most worried about. Thecombination of ballooning debt stocks and declining oil barrels available for exports at a pretty steeprate (either because production keeps going down, domestic consumption rises or new barrel of oilsare committed to pay loans) leads to an explosive fiscal cocktail. To quantify, if the public sectorcontinues to issue US$8 billion debt on a net basis at a say 9% coupon, the interest bill increases byUS$720 million per year. This is equivalent to 20,000 barrels of exports per day, or nearly 1% of thetotal. And with oil export volumes heading south and oil prices stable, the number of barrels needed toservice the interest bill would increases at a faster rate over time. If we just look at oil fiscal revenues,the number of barrels that would have to be committed is even higher. The story can’t end happilyunless policy is changed radically or oil prices go ever higher.This brings us to the truly scary chart. In Chart 10, we show the ratio of public sector external debtand interest / barrel of oil exports per year. They are at the highest levels ever, with a particularly steepincrease over the past four years. This makes the obvious point of how vulnerable the Venezuelanstory is becoming to oil prices. Ever higher (permanent) dollar liabilities are being financed with asource of revenue that is inherently volatile but, in the steady state, heads south given the continueddecline in oil volume exports (see Chart 13).The second nontrivial issue is that as the government continues to issue dollar debt, the real exchangerate loses power as an adjustment mechanism. Given large dollar revenues, the government isstructurally long, way long, dollars and therefore, a devaluation does wonders to the fiscal accounts.This, by the way, has been Venezuela’s traditional way to adjust fiscally. But there is a high enoughlevel of dollar debt (and/or low oil output) in which a devaluation impacts the fiscal negatively. Thegood news is that we are far from that point, but the bad news is that we are approaching it at a rapidclip.Venezuela’s reasonably strong but deteriorating macro indicators are nicely captured by the EM riskindices that UBS EM Chief Economist Jonathan Anderson computes for this universe of countriesevery year. His index includes a set of broad economic indicators that reaches beyond the fiscal, but itcan still provide a good representation of what we are discussing here. In Chart 11, you can seeVenezuela standing in the ranking slightly better than the median. This is not bad, especially if wecompare it against a ranking with the same countries showing their bonds or CDS spreads or theircorresponding credit ratings. But it is pretty bad once we bring Venezuela’s absolute and relativeLatin American Economic Focus 7 June 2011UBS 6position in the 2008 rankings. Indeed, Venezuela was one of the countries with the largestdeterioration between these two years.Chart 11: EM total risk score (2010) Chart 12: EM total risk score (2008)3.3012345678910ChinaTaiwanSingaporeIndonesiaThailandPhilippinesPeruHong KongEgyptMexicoRussiaSaudiArgentinaNigeriaChileMalaysiaIsraelKuwaitColombiaVenezuelaIndiaS AfricaPakistanOmanTanzaniaBrazilMoroccoSri LankaKazakhstanKoreaTurkeyQatarCzechCroatiaUAESerbiaSlovakPolandRomaniaBulgariaUkraineSloveniaEstoniaVietnamHungaryLithuaniaLatviaTotal risk score, 2010Low risk High risk2.8012345678910ChinaHong KongSingaporeTaiwanMalaysiaNigeriaMexicoEgyptOmanVenezuelaThailandKuwaitPhilippinesPeruArgentinaIndonesiaRussiaSaudiQatarTanzaniaColombiaIndiaBrazilChileMoroccoIsraelTurkeyCzechS AfricaPakistanSerbiaKoreaPolandSlovakCroatiaUAEKazakhstanSri LankaRomaniaVietnamUkraineSloveniaBulgariaHungaryLithuaniaEstoniaLatviaTotal risk score, 2008Low risk High riskSource UBS Source: UBSSumming up so far. Despite nasty headlines and wide spreads, the macro snapshot doesn’t look bad atall. Venezuela has no solvency issue we really need to worry about at the moment, but given currenttrends we will have to start worrying at some point in the future.How soon?OK, default is not around the corner, but if not now, then when? This question brings us to thesimulation exercise. The intention is to assess at which point the deterioration starts to reach levelswhere ability to pay becomes a more serious concern. We will do so by projecting key vulnerabilityindicators. The exercise could be particularly complex given the many variables involved. We willsimplify it by making assumptions (sorry, we are economists), letting the last few years dictate thefuture for us.We will also use the premise that if the financial shoe begins to hurt, it won’t be because of inability torollover large amortization but because the growing dollar interest bill will take up a high enoughshare of government revenues. As shown earlier, the debt amortization profile is quite light (again,excluding potentially large contingent liabilities) and it’ll take a lot of short dated issuance beforerollover becomes a serious threat (and judging by recent issuance and debt swap, we suspect thegovernment is not inclined to pile up near-term amortization). On the other hand, dollar interestpayments are at more than US$3 billion per year and rising quickly, representing more than theupcoming foreign debt amortizations for the next few years. These interest payments are permanentspending that can’t be inflated away via a devaluation, as it is done with the VEF-denominated debt.You may have noticed already we give less relevance to bolivar-denominated debt. In our opinion, itdoesn’t constitute a source of major risk at the moment, as it can always be paid by printing bolivares.There are really no major institutional constraints on the way of monetary financing of the debt. TheVenezuelan Central Bank has become a government entity and monetary decisions are subordinated tothe meet the needs of the executive. In some ways, it is already happening from the moment foreignreserves are being transferred to the government’s account in discretionary ways (money is fungible,as they say). We will still incorporate them in the simulation charts but for illustration purposes only.By focusing primarily on dollar flows and dollar interest payments based on recent trends, we greatlyreduce the scope of the simulation and the discretion we would need to apply setting up ourassumption. Now, for example, we are not required to decide arbitrarily maturities of new issues or aspecific fiscal performance (which is already implicit in the size of the debt issues). The real exchangerate still plays an important but a more limited role in that it doesn’t alter the ratio of dollar receivablesdue to oil revenues vs dollar payables determined due to debt obligations. But a devaluation, of course,Latin American Economic Focus 7 June 2011UBS 7is still important because it improves the fiscal accounts and reduces the need to issue new dollar debt.In our exercise, we assume constant real exchange rates at current levels.Having said all this, let’s list our key assumptions:.. US$8 billion debt of net issuance between the government and PDVSA (we’ll treat them as onlyone issuer) per year. This is the average of the last 4 years. Given how 2011 is evolving, this maybe a reasonable, if not a conservative estimate.3 We assume a constant 9% coupon rate for all theseissues... Oil exports decline at 3.5% in volume terms. This is the average for the last five years (Chart 13).This implicitly assumes that the Orinoco oil projects don’t get off the ground (actually, off thebasin). We derive oil export volumes from balance of payment data and assume that all oil exportsare cash transactions at market prices (even those carried out with friendly nations at below marketlevels)... The average oil price for the Venezuelan mix stays constant at current levels (US$100/bbl), whichis roughly what future markets are currently discounting... We tied oil Central Government revenues at 41.4% of exports, about the average of the last fouryears.4 For non-oil Central Government projections, we tied them to an assumed GDP of 17.4%,also the average for the last four years (Chart 14)... Real GDP grows at 2% annually. The real exchange rate remains constant at current levels... Foreign reserves remain constant at US$27 billion, with the Central Bank transferring any excessto government off-budget accounts... We ignore public sector liquid assets believed to be in various accounts and liabilities not showingin official debt statistics, including the large Chinese loans.Chart 13: Barrels of oil exports (mbpd) Chart 14: Government oil revenues (% of total exports)and non-oil Central Government revenues (% of GDP)184.108.40.206.220.127.116.11.81997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010PDVSA strike0.010.020.030.040.050.060.070.01997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Oil CG rev enues (% total oil ex ports)Non-oil cg rev enues (% of GDP)Source: BCV and UBS Source: Haver and UBSLet’s now present simulation of key vulnerability indicators. There is no specific threshold level atwhich indicator x or y will tell us a government is in trouble. But there are ranges we can still use torepresent warning signs that things could get ugly. We will present a series of charts for a number of3 Recently, President Chavez requested the National Assembly government debt for this year for US$10.5 billion to help pay an ambitious housingprogram. Questions linger as to how much this will be raised in the international markets.4 With the revision in the windfall tax, this ratio should decrease at high oil prices as more money is transferred from PDVSA to Fonden bypassingthe Central Government.Latin American Economic Focus 7 June 2011UBS 8them, with historical references for countries that experienced default or near default situations. Wewill let each of these charts do the explaining for us.Chart 15: Foreign public sector interest payment(% of Central Government revenues)Chart 16: Total public sector interest payment (% ofgovernment revenues0.02.04.06.08.010.012.014.016.01997199920012003200520072009201120132015201720192021Actual external interestSimulated (external interest)Simulated (total interest)0510152025303540Argentina(2001)Uruguay(2002)Greece(2010)Brazil(2001)DominicanR. (2003)Ecuador(1999)Mex ico1994Russia(1998)Source: Haver, BCV, UBS Source: IMF, Haver, Global Source and DomRep Central BankChart 17: Public sector interest payment (% ofreserves)Chart 18: Total interest payment (% of reserves)0.05.010.015.020.025.030.035.040.045.050.01997199920012003200520072009201120132015201720192021Actual external interestSimulated (external interest)Simulated (total interest)020406080100120140160Argentina(2001)Uruguay(2002)Brazil(2001)DominicanR. (2003)Ecuador(1999)Mex ico1994Russia(1998)Source: Haver, BCV, UBS Source: IMF, Haver, Global Source and DomRep Central BankChart 19: Public sector interest payment (% ofGDP)Chart 20: Total public sector interest payment (% ofGDP)0.000.501.001.502.002.503.003.504.001997199920012003200520072009201120132015201720192021Actual external interestSimulated (external interest)Simulated (total interest)012345678Argentina(2001)Uruguay(2002)Greece(2010)Brazil(2001)DominicanR. (2003)Ecuador(1999)Mex ico1994Russia(1998)Source: Haver, BCV, UBS Source: IMF, Haver, Global Source and DomRep Central BankLatin American Economic Focus 7 June 2011UBS 9Chart 21: Public debt (% of GDP) Chart 22: Total public debt (% of GDP)0.0010.0020.0030.0040.0050.0060.001997199920012003200520072009201120132015201720192021Actual ex ternal debtSimulated (ex ternal debt)Simulated (total debt)020406080100120140160Argentina(2001)Uruguay(2002)Greece(2010)Brazil(2001)DominicanR. (2003)Ecuador(1999)Mex ico1994Russia(1998)Source: Haver, BCV, UBS Source: IMF, Haver, Global Source and DomRep Central BankChart 23: External public debt (% of exports) Chart 24: External public debt (% of exports)0.050.0100.0150.0200.0250.0300.0350.01997199920012003200520072009201120132015201720192021Actual ex ternal debtSimulated (ex ternal debt)Simulated (total debt)050100150200250300350400450500Argentina(2001)Uruguay(2002)Greece(2010)Brazil(2001)DominicanR. (2003)Ecuador(1999)Mex ico1994Russia(1998)1332Source: Haver, BCV, UBS Source: IMF, Haver, Global Source and DomRep Central BankAssuming status quo, key ratios start moving into a more dangerous zone in five years.5 This would beright before the amortization spike in 2017. And as more time goes by, we also start to encounterexisting amortization and the new amortization humps coming from the new issues we are notincorporating in the exercise. Needless to say, this five year horizon is susceptible to assumptions. Ifwe have materially different oil prices, real exchange rate weakens, oil export volumes, then we wouldbe looking at different horizons.Don’t take this to mean that we are calling for a default in 2016. Even then, we think Venezuela canmuddle through financially but not without introducing more politically costly tightening measures.It’s here where we are faced with another key assumption: what’s the willingness (and/) or ability ofthe executive to instil pain to society? Logic suggests that populist administrations such as Chavez’swould have limited appetite to impose tightening measures to generate savings to pay foreigninvestors, especially considering that Venezuelans have already been suffering from pretty severestagflation problems with shortages of key goods and services (and dollars). Going to the IMF to seekfinancial help is also a non-starter. But so far, Chavez hasn’t knocked on investors’ door either, evenunder the worse conditions we reflected in the charts above. We suspect that when push comes toshove, he will subordinate policy to meeting debt payments as he did in the past. But we admit, wecan’t really say this with a high degree of conviction.5 For our simulations, we incorporate the VEF-denominated government debt and interest bill to be able to compare with the experiences of othercountries that face default or near default events. We keep the former and the latter constant throughout our forecast horizon at 8.5% and 0.8% ofGDP, respectively. They are both roughly the average of the last 4 years.Latin American Economic Focus 7 June 2011UBS 10ConclusionsInvestors have always scratched their heads trying to figure out Venezuela. Reconciling highvaluations with strong ability to pay has been, for as long as we can remember, the center ofdiscussion around this credit.However, something distinctively different has been taking place in recent years: the public sector hasstarted to issue dollar debt as if there is no tomorrow. Much of this rapid growth owes to balance ofpayment rather than fiscal issues. Authorities have tried to sustain an unsustainable FX regime, even atthe expense of severely undermining the country’s creditworthiness and dislocating the governmentand PDVSA’s dollar curves. In the end, dollar bonds are issued to finance capital flight ofVenezuelans who, given VEF’s appreciated rate(s), only feel compelled to buy dollars, creating a onewayflow in their domestic FX market. The great irony is that this problem can be fixed overnight,literally, by letting the exchange rate flow. This is unlikely to happen.We really don’t see any policy breakthroughs that could put the country on a more sustainable pathany time soon. News in the months to come is unlikely to get any better. It may actually get worseconsidering a number of looming developments: more bond supply, expensing rulings in internationalcourts, escalation of US sanctions against PDVSA or the government, more nationalizations, etc.All this said, we think it’s a mistake for investors to throw in the towel on Venezuela, as many mightalready have done. Given current conditions, the country’s default risks are rather low, and thereforeequally low are the risks that spreads will spiral out of control, in our view. The government is likelyto find enough buyers for new issues in the primary markets for an extended period of time and, evenif it didn’t, it should have sufficiently large space to muddle through financially for quite a while. Wethink the market is already pricing in quite negative scenarios for Venezuela. For example, 1yr, 2yrand 3yr PDVSA CDS spreads discount default probability of 14%, 25% and 42% over thecorresponding period, respectively. Considering the country’s still solid cash flow and balance sheetposition, we think this is excessive.Javier KuleszStamfordLatin American Economic Focus 7 June 2011UBS 11Appendix: Long-Term ChartsChart 25: External Debt/Exports of Goods, Servicesand Income (%)Chart 26: External Debt Stocks/Gross NationalIncome (%)0501001502002503003501980198219841986198819901992199419961998200020022004200620080102030405060708090198019821984198619881990199219941996199820002002200420062008Source: World Bank Debt Tables Source: World Bank Debt TablesChart 27: Debt Service/Exports of Goods & Services(%)Chart 28: Interest Payments in ExternalDebt/Exports of Goods, Svcs, Income (%)05101520253035404550198019821984198619881990199219941996199820002002200420062008051015202530198019821984198619881990199219941996199820002002200420062008Source: World Bank Debt Tables Source: World Bank Debt TablesChart 29: Interest Payments on External Debt/GrossNational Income (%)Chart 30: Reserves/Total Debt (%)01234567891980198219841986198819901992199419961998200020022004200620080102030405060708090100198019821984198619881990199219941996199820002002200420062008Source: World Bank Debt Tables Source: World Bank Debt TablesChart 31: Reserves/Imports of Goods and Services(months)Chart 32: Short-Term Debt/External Debt (%)02468101214161980198219841986198819901992199419961998200020022004200620080102030405060198019821984198619881990199219941996199820002002200420062008Source: World Bank Debt Tables Source: World Bank Debt TablesLatin American Economic Focus 7 June 2011UBS 12.. Analyst CertificationEach research analyst primarily responsible for the content of this researchreport, in whole or in part, certifies that with respect to each security or issuerthat the analyst covered in this report: (1) all of the views expressed accuratelyreflect his or her personal views about those securities or issuers and wereprepared in an independent manner, including with respect to UBS, and (2) nopart of his or her compensation was, is, or will be, directly or indirectly, relatedto the specific recommendations or views expressed by that research analyst inthe research report.Latin American Economic Focus 7 June 2011UBS 13Required DisclosuresThis report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches andaffiliates are referred to herein as UBS.For information on the ways in which UBS manages conflicts and maintains independence of its research product;historical performance information; and certain additional disclosures concerning UBS research recommendations,please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance isnot a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co.Limited is licensed to conduct securities investment consultancy businesses by the China Securities RegulatoryCommission.UBS Global Credit Strategy and Research: Recommendation DefinitionsUBS employs a recommendation scheme designed to rank potential investment opportunities within non-government fixedincome markets and sectors.TimeHorizonUBSTerminology Expectation DefinitionSector recommendations 3 months OVERWEIGHT outperformMARKET WEIGHT perform in lineUNDERWEIGHT underperformSector is anticipated to