Venezuela’s financial woes are evident in the numbers. The country’s bond yields are among the highest in the world, its benchmark 2027 Eurobond yielding more than 25%. The local currency has plummeted nearly 60% on the black market in the last year.

On the streets, thousands line up outside the country’s supermarkets for basics such as bread, milk and detergent. When they get in, they’re met by poorly stocked shelves and prices around two-thirds higher than a year ago.

According to official figures, Venezuela’s economy shrank 2.8% last year. In January, IMF director for the Western Hemisphere Alejandro Werner said he expects its economy to contract 7% in 2015.

Given such drama, speculation over a potential default on Venezuelan debt was rising even before oil prices started to collapse in October. At stake is the future of the national oil company, PDVSA, as well as the political stability and economic strength of the country.

Harvard University economist and former Venezuelan planning minister Ricardo Hausmann sparked a selloff of Venezuelan debt in September by suggesting he found “no moral grounds” for the government to repay its bonds. He argued that the government had already shirked its population by failing to pay hard currency arrears to importers that were cutting off supplies of food and other basics.

A default would be large, but with precedent in the region. Research from Bank of America-Merrill Lynch indicates the size of a default by PDVSA and the sovereign would be around $70 billion, still less than Argentina’s default in 2001.

But whether the country will miss international bond payments is anybody’s guess at this point. Certainly Venezuela is not bankrupt, according to Efraín Velázquez, president of the National Economic Council, a Caracas-based think-tank. After all, the country still has the world’s largest proven oil reserves, more even than Saudi Arabia. “Venezuela doesn’t have a major financial problem — it has a liquidity problem,” says Velázquez.

Because Venezuela imports most of its food, the government seems likely to go a long way to avoid a default. Further, foreign creditors could seize assets valued much higher than those held by Argentina before its default. PDVSA still owns the US oil refining and distribution company Citgo, for example.

“There’s an acute understanding [in Venezuela] of the consequences of the failure to pay,” says Daniel Freifeld, co-founder of Washington DC-based Callaway Capital Management.

Recognition of that, in addition to factors such as its relatively low debt-to-GDP ratio and its large size — Venezuela is still one of the region’s biggest economies — means some are willing to take the risks of investing in the country’s bonds, given how cheap they have become. “We’re bullish about the 2015 obligations. We think they will be repaid at maturity,” says Freifeld.

But other distressed investors are staying away from Venezuelan credits, partly because of uncertain recovery rates amid a volatile political situation.

Baby steps

President Nicolás Maduro blames Venezuela’s problems on an “economic war” waged against his government by political opponents and foreign agents.

“Maduro’s big message was, ‘We’re aware and we acknowledge that we need to take severe measures,’” says Diego Moya-Ocampos, senior political risk analyst at IHS Global Insight, a London-based consultancy. But critics say the government’s steps have been too little, too late.

Henkel García, director of Econométrica, a Caracas-based consultancy, blames the food shortages primarily on a complex and highly wasteful system of currency controls that former president Hugo Chávez enacted more than a decade ago. These have been modified over time, allowing for three fixed exchange rates, the strongest of which puts the bolívar at 6.3 to the dollar. But on the black market, the dollar sells for over 200 bolívares.

“To maintain the 6.3 bolívares per dollar rate is madness,” says García, who maintains the exchange rate “just allows for corruption, over-invoicing, and illegal exchange. The only way to fix the economy is to get rid of the currency controls.”

In January, the government tinkered, again, with the currency system. The two stronger foreign exchange mechanisms, which offered dollars at around 12 and 50 bolívares each, were merged at the rate of 12 bolívares. A third, slightly more market-orientated channel, was added. It allows small amounts of foreign exchange to be traded through brokers at roughly 170 bolívares per dollar — still far shy of the black market rate.

However, the government said it was retaining the strongest exchange rate for medicine and essential foods, guaranteeing about 70% of the country’s economy at the 6.3 bolívares per dollar level. Moreover, doubts about the new market mechanism remained. “They will find a way not to make it completely open, and that’s where the inefficiencies start,” says one broker dealer in late January.

Juan Carlos Dao, President of Bancaribe, one of the country’s biggest banks, estimates that this year’s average exchange rate will be around 25 bolívares per dollar, an implicit devaluation of 32% from the average rate of around 17 to the dollar last year.

Another central plank of retained Chavista policy is price controls, which have removed profit incentives for importers.

Venezuela also loses billions of dollars a year on retail gas prices, which are among the lowest in the world. In his State of the Nation speech, Maduro admitted gas subsidies create “distortions”. Rather than announce an immediate price hike, he simply called for a national debate on the matter.

Political inertia

By January, Maduro’s approval ratings were down to 22%, according to local polling firm Datanálisis. The president’s lack of popularity makes it even tougher for him to launch policy changes, such as cutting back on a bloated public wage bill, especially before legislative elections towards the end of this year.

“Maduro lost 30 percentage points [in his approval rating] in one year and the trend is negative,” says Luis Vicente León, Datanálisis’ president. “Taking rational decisions will get him into more trouble — and [not acting] will be even worse.”

Jonathan Lemco, sovereign risk analyst at US investment manager Vanguard, says Venezuela could gain external financial support, eventually even from the IMF. But first the president will have to do some hard bargaining within the various fiefdoms in his government. “The competing interests in the cabinet have come to the fore under Maduro,” he says. “There needs to be a sense of common purpose.”

A change in government looks likely, says Graham Stock, head of emerging market sovereign research at BlueBay Asset Management in London. Yet trying to predict what kind of policies Maduro’s replacement might follow is difficult. A new administration could come from the ruling party rather than a more market-friendly opposition. “There could just be an attempt to blame things on Maduro,” says Stock.

In the event of a default, recovery rates could be quite high under a more market-friendly government. But a default under a Chavista government would more likely be accompanied by a populist backlash against international creditors. At that point, says Stock, recovery rates could be next to nothing.

It is that risk which is putting off distressed investors such as New York-based Maglan Capital. David Tawil, Maglan’s president, says that negotiating with a defaulted sovereign is always trickier than negotiating with a defaulted company, whose executive pay structure is more likely to be aligned with investor interests. “Elected officials are working on an entirely different set of interests, and even more so in an undemocratic or socialist regime,” he says.

Coming due

One short-term solution is to get cash by any means and Maduro has been working hard to do that. In January he visited China and the Gulf in search of financial aid, although neither trip brought any clear or immediate results.

In late January, PDVSA managed to raise $1.9 billion when the Dominican Republic paid back debt, although that came at a 48% discount to face value.

Maduro also said in his State of the Nation speech that the government would allow its partners in the oil sector to increase their stakes in joint ventures. Such a move could raise further funds even if, not surprisingly, the word privatization was avoided.

However, the lack of a longer-term plan on how Venezuela will manage its economy makes finding new funds hard, whether bilateral, multilateral, or private-sector. “How can anybody lend you money if you don’t present what your strategy is going to be?” asks Velázquez.

It seems that many within the government — at the central bank, PDVSA, and other ministries — are well aware of Venezuela’s problems and how to solve them. But when action is needed, major hurdles arise. “There is a very good understanding of the technical issues that the country needs but the political agenda is stifling most of the decisions,” says Dao. “According to this political model, it’s really difficult to do what the rational mind would suggest. It’s like putting your right shoe on your left foot.”

Political divisions may pose further barriers to resolving the country’s liquidity problems. For example, one banker asks what would stop the government from mandating investment banks to quietly buy back debt while Venezuelan Eurobonds are trading at around 30 cents on the dollar.

A relatively small amount of capital (say, $2 billion) could retire a huge pile of bonds, which could have a big impact on Venezuela’s ability to raise new funds. One obstacle to taking such a decisive step, says the banker, could be that too many officials close to the president want him to fail, so they can step up him to replace him. LF

Additional reporting by Dominic O’Neill