22 September 2010
Emerging Markets Strategy | Latin America
Alert | Venezuela
The conflict of credit analysis
„ On reviewing the investment strategy ahead of the
congressional elections, our view is that investors
should opportunistically buy on the prospects of a
relief rally with current sovereign debt prices trading
at cheap levels.
„ We adopt an opportunistic short-term trading
strategy for Venezuelan sovereign debt. For the
strong technical position, on the consolidation
of an external risk rally, we assume some
laggard catch up gains for the highest yielding
credit on the relief of an uneventful election and
the digestion of imminent supply.
„ We are forced to trade Venezuelan credit risk for its
high contribution to indexed returns, though remain
cognizant of our medium-term strategy of a
“structural offer” to “sell into strength” for a credit
that seems on track towards a deeper
economic/political crisis.
„ The congressional election results are a test to the
dominance of the Chavez Administration with the
opposition polling at around 50% support at the
national level and will likely take around 30% of the
congressional seats. There is a high margin of error
for the difficulty of measuring the representation at
the congressional level, however the low popularity
of Chavez suggests that the risk is for higher
support for the opposition.
„ The recent relative underperformance of Venezuela
credit risk should reverse if 1.) elections occur
without major incident, 2.) planned $3bn in PdVSA
issuance comes sooner rather than later and, more
importantly, 3.) the external risk appetite remains
resilient with investors unable to forfeit the high
Siobhan Morden
Head of Latin America Strategy
+1 203 897 7944
siobhan.morden@rbs.com
www.rbsm.com/strategy
Bloomberg: RBSR<GO>
carry returns while Venezuela remains an obvious
outlier.
„ The favourable technicals amidst resilient
external risk appetite is critical since we
assume that President Chavez will become
more pragmatic to assert more political control
without deviating from the current
macroeconomic policy mix and the imminent
supply slowly digested but still an overhang
postponed until next year.
„ On the break above key resistance levels on the
SPX with support from a more pro-active Fed, this
could jump start gains on the lower credit quality
laggards.
„ On prospects of resilient external risk we expect the
5Y Venezuela/Argentina CDS spread premium to
decline closer to 250bp from current levels of 525bp
based on current levels on SPX (1,000bp on
Venezuela 5Y CDS) with stop/loss of 660bp. It is
worth mentioning that Venezuela is trading at
historic worst levels to Argentina with a lot of bad
news already discounted in current prices.
„ When we regress 5Y CDS against Brazil 5Y CDS
and log WTI with a dummy variable on the PdVSA
and sovereign supply for past 12 months then
Venezuela 5Y CDS should be closer to 1,000bp.
„ This should also coincide with recent highs on
benchmark USD’2038 of around 59 from current
prices of 53.for 3-MO potential total returns of
12.9%. (The low cash price and liquid benchmark
bonds remain our preference on the curve).
The Royal Bank of Scotland
Venezuela | conflict of credit
analysis – technical strength
The technical position remains quite strong in terms of
Venezuela representing a dominant market
capitalization within the benchmark EM indices and
the highest yielding sovereign credit against
widespread compressed yields. If external risk
remains stable then investors are eventually forced to
reduce their underweight exposures and
opportunistically trade their exposure so as not to
forfeit the high carry returns (Venezuela contributes
around 0.77% to the 5.7% EMBIG YTM as of end
August). Venezuela has been absent from the latest
risk rally with the 5Y CDS spread widening out to
worst levels versus Argentina, interrupting the high
correlation to external risk trends.
Venezuela | relative underperformance
-100 1250
0 may deliver a surprise, however the previous
1200
100
200 1150
300
400 1100
500
1050
600
700 1000
4-May 8-Jun 13-Jul 17-Aug 21-Sep
SPX VEN-ARG 5Y CDS
Source: RBS
We would attribute this relative underperformance to
both the event risks of the upcoming elections and the
threat of imminent supply. This relative
underperformance should subside if 1.) elections
occur without major incident, 2.) planned $3bn in
PdVSA issuance comes sooner rather than later and,
more importantly, 3.) the external risk appetite
remains resilient with investors unable to forfeit the
high carry returns while Venezuela remains an
obvious outlier.
On the break above key resistance levels on the SPX
with support from a more pro-active Fed, this could
jump start gains on the lower credit quality laggards.
On prospects of a short-term rally we would expect
the 5Y Venezuela/Argentina CDS spread premium to
decline closer to 250bp from current levels of 525bp
based on current levels on SPX (1,000bp on
Venezuela 5Y CDS). This should also coincide with
recent highs on benchmark USD’2038 of around 59
from current prices of 53.for 3-MO potential total
returns of 12.9%. When we regress 5Y CDS against
Brazil 5Y CDS and log WTI with a dummy variable on
the PdVSA and sovereign supply then Venezuela 5Y
CDS should be closer to 1,000bp.
The favourable technicals amidst resilient external
risk appetite is critical since we assume that
President Chavez will become more pragmatic to
Emerging Markets Strategy | Latin America | 22 September 2010
assert more political control without deviating
from the current macroeconomic policy mix and
the supply overhang only postponed until next
year.
The main question is how will
Chavez react?
These congressional elections are significant on the
prospects of a shift of the balance of power with
President Chavez dipping to his lowest approval
ratings and the first opportunity for the opposition to
garner congressional representation since their
boycott of the 2005 elections. There is broad-based
consistency amongst the pollsters that the opposition
should garner around 50% of the national vote and
around 30% representation of congressional seats.
There is a high undecided vote of around 37% that
tendency of the undecided tended to align with the
general voting tendencies. In fact the lower overall
popularity of President Chavez himself at 45% versus
50% voting tendency on the back of the economic
distress suggests the risks favour a better than
expected showing for the opposition. This may prove
a pyrrhic victory.
Whether or not President Chavez accepts these
results and whether there is a more pragmatic
economic policy shift to address his recent
decline in popularity are the more important
takeaways than the actual results.
Venezuela | How do you rate the work of
President Chavez for the well-being of country?
100%
80%
60%
40%
20% threshhold
0%
Feb-99 Apr-01 Jun-03 Aug-05 Oct-07 Dec-09
Approval (very good/good/fair to good)
Source: RBS, Datanalisis
Political pragmatism
Unfortunately, there are no signals to suggest a
passive acceptance or a more conciliatory approach
from the Chavez Administration. The fact that
President Chavez altered the electoral rules to allow
for an over-representation of those districts with
Chavez supporters (hence the wide difference
2
The Royal Bank of Scotland
between the national votes and the much lower
expectations of representation of the opposition in
congressional seats), suggests a pragmatic approach
for a further concentration of power. There is already
pending legislation that might be forced through
during the interim period, before the new congress
takes office next year, called the “Communal Power
Law” that weakens the legislative branch and disables
the recently empowered opposition. This becomes
more of a risk if Chavez loses the 2/3 majority in
congress. There is even the prospect of a more
severe option whereby President Chavez convokes a
national referendum to call for early presidential
elections, capitalizing on the still wide margin between
his support at 45% against the closest opposition rival
at Governor Henrique Capriles at 10% (or the
spontaneous Datanalisis poll on voting tendencies
across all viable candidates that has Chavez at 23%
versus Capriles at 6.5%).
If there is no abrupt shift in economic policy
mismanagement, then the trend will likely continue for
further erosion in President Chavez’s support heading
into the 2012 presidential elections. It is also worth
mentioning that support is approaching critical levels
towards the recent lows of 31% in 2002. This more
radical approach of a constitutional assembly would
only likely occur if the opposition gains a much
stronger showing closer to 50% representation of
congress. Although a forceful backlash from
Chavez is unlikely, more radical actions should
not come as a surprise from investors with
already a lot of skepticism priced into the bonds.
Venezuela | What do you consider is the main
problem facing the country at this time?
0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
Personal insecurity/increase in delinquency
Unemployment
High cost of living/less income/inflation
Scarcity of goods
Corruption
Economic crisis
Electricity shortages
Sep-10 Aug-10 Jun-10
Source: RBS, Datanalisis
Reactive economics – at best
There have been some signs of flexibility on the
economic front with an attempt to re-open the borders
with Colombia and the signals of fiscal conservatism,
which is unusual considering the weak popularity and
approaching elections. There has been only 7.5%y/y
increase in fiscal spending through 1H 2010,
translating into an 18.1% decline in real terms. There
could be a slowdown in the private sector
interventionism, however the recent policy actions do
not suggest a more pragmatic approach to economic
Emerging Markets Strategy | Latin America | 22 September 2010
policy management. Any steps to correct the
policy imbalances would incur a short term
political cost and more importantly run contrary to
the ideology of the Chavez Administration with
still internal conflict amongst the cabinet between
the ideologues and the pragmatics. There is even
the risk that a stronger than expected Chavez victory
would encourage a more ideological bias in macro
policy management.
Venezuela | 5Y CDS spread regressed against
Brazil 5Y CDS, log WTI and dummy for supply
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
Sep-09 Nov-09 Jan-10 Apr-10 Jun-10 Sep-10
ACTUAL FITTED
Source: RBS
This suggests more of the same in terms of new
issuance pressures and real economy pressures that
would only elicit at best a reactive policy response
once these pressures become more acute. Even on
the divided cabinet we assume that policymakers
slowly adjust under duress so as not to completely
undermine their political survival.
The market remains most sensitive on the timing of
new supply to fund the Sitme market as opposed to
any rationale approach for FX flexibility. The local
press continues to reference upcoming PdVSA
issuance that was recently announced by President
Chavez ($3bn) that will fund the Sitme market. If we
assume average daily turnover for a maximum of
USD50mn/day then this suggests that the new
issuance would easily provide sufficient USD through
the end of the year. It is clear that the strategy for
serial issuance is only postponed until next year and
will remain a constant overhang until when/if Cadivi
supplies more USD or allows for more FX flexibility.
3
The Royal Bank of Scotland

Emerging Markets Strategy | Latin America | 22 September 2010

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