Venezuela Commercial Banking Report Q3 2007

Over the last 12 months, overheating, manifest in runaway price growth, has been the key economic theme in Venezuela. Now, as inflation data for the first half of the year are made available, the dangers facing economic stability become ever more apparent. According to the Banco Central de Venezuela , prices rose 1.8% m-o-m in June, above a consensus poll estimate of 1.6%. On an annual basis, CPI stood at 19.4% y-o-y, a level around which it has stubbornly remained since April. Once again, revisiting the breakdown of inflation data we examined in March, it is prices of food and beverages (25.7% y-o-y), alcohol and tobacco (27.2%), and healthcare (25.4%) that represent some of the key drivers of runaway inflation, categories which are most likely to affect the poorer segments of society significantly. Perhaps even more worryingly, the increase in prices of goods not subjected to government price controls was 2.0% m-o-m in June, hinting that without direct intervention, headline inflation could be even higher.

With the release of these latest data, it seems little has changed with inflation patterns since the start of the year, despite government promises that CPI would be brought under control, and down to 12%, by the end of 2007. The achievement of this target now looks impossible, in line with our longstanding view that the government's efforts to tackle inflation are largely ineffectual. In March, for example, a cut in the sales tax (from 14% to 11%) and a series of large dollar-denominated bond issuances (to drain domestic liquidity) caused prices to fall on a monthly basis. Yet these measures can only ever have a temporary effect so long as the real source of inflation pressures - excess demand spurred on by profligate government spending and flagging domestic production - remains untreated.

The Commercial Banking Sector The economic boom that has resulted from the rush of oil revenue into the Venezuelan economy has been a cause of extraordinary growth in the commercial banking sector. Asset growth through the year ending December 31 2006 was the highest of the 59 countries surveyed: At 110%, growth in assets was almost double that of the second-ranked country, the Ukraine. Loan and deposit growth rates (67.5% and 78.6% respectively) were also substantially higher than equivalent figures for all of the 59 countries surveyed except the Ukraine. Venezuela's period of rapid growth has led its banking sector to move out of the very bottom bracket in terms of total assets, total loans and total deposits, however, the sector remains small compared to many developed nations.

The key question remains whether Venezuela's commercial banking sector can cope with the historic volatility of the Venezuelan market, especially when the expected economic slowdown, galloping inflation and growing government intervention are taken in account. While improved banking supervision over the last few years has resulted in a sector that is much better capitalised and provisioned than in the past, and the banks have continued to engage in aggressive lending, loans nonetheless account for only 37.3% of total assets which is fairly low by the standards of other countries. Although default rates have been reduced as the economy has continued to grow strongly, loan loss provisions may have lagged behind the rapid loan expansion. Nevertheless, loan losses may put the system under pressure once the slow down sets in. Although this may be mitigated by the fact that Venezuela's commercial banking sector is in large part in the hands of very large foreign banking groups able to provide support in the event of a crisis.

The banking system has continued to act as a facilitator of the state's cash flow; on the one hand receiving funds from state companies and ministries, while on the other purchasing tax-free government debt, with the result that the Venezuelan commercial banking sector continues to enjoy its most profitable ever times. This has eventuated largely by virtue of the fact that the government is the largest single depositor among many banks, which, in conjunction with the profits derived from government debt acquisition, has made the banks very dependant on the government. Drowned in the liquidity shown by the surge in deposits, commercial banks have been very ready to expand their loan portfolio while, in a low interest rate environment, their customers have been prepared to borrow.

Press Reports Recent reports in the international press generally reflect two general issues. First, as discussed throughout this report, the Venezuela economy is booming and as a consequence the banking sector is reporting increased profits. Bank profits stood at VEB950bn (US$441.8mn) during the first quarter, a 38.9% increase from the same three months in 2006, according to a monthly report by Softline Consultores CA, a banking-sector research firm. Also bank lending rates have increased 79.6% during the last 12 months.

However, the second issue covered in reports is that the banking sector remains vulnerable to increased government regulation. Venezuela is now down to 144 out of 161 nations in the 2007 Economic Freedom of the World, one of the most rapid declines ever. In 1995 it was number 75. The government directs financial institutions to provide credit in accordance with its requirements, establishes maximum and minimum levels for lending and deposit interest rates, controls fees and commissions charged by banks, imposes foreign exchange controls and has stripped the central bank of its independence. For example, in recent times the government has forced banks to devote almost one-third of all loans to key activities such as mortgages, agriculture, tourism and small business activity, all at below market interest rates.