Essay ECO802: International Banking and Finance – The Venezuelan Bolivar Black Market – Management Assignment Help

Assignment Task:

SECTION 1 – CALCULATIONS 

1 Cost of Capital 

Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity. 

If Corcovado’s beta is estimated at 1.1, what is cost of equity? (5 marks) and what is its weighted average cost of capital? (5 marks) ( please show your steps of calculation) 

2 Purchase Power Parity 

You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating over the rental of a chateau. The chateau’s owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas season) will be adjusted upwards or downwards for any change in the French cost of living between now and then. You are basing your budgeting on purchasing power parity (PPP). French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The current spot rate is $1.3620/€. What should you budget as the U.S. dollar cost of the one week rental for this Christmas Season one year from now? (10 marks) ( please show your steps of calculation) 

SECTION 2 – SHORT ANSWER 

1 Protectionism 

Please describe following the questions with regard to protectionism: What are the traditional methods for countries to implement protectionism? (5 marks) What are some typical non-tariff barriers to trade? (5 marks) How can MNEs overcome host country protectionism? (10 marks). (Please limit all three answers to 300 words) 

2 Sourcing of capital 

There are potential benefits and risks from raising capital on global markets. Discuss the pros and cons in terms of risk of raising capital on global markets. (Total 10 marks, please limit your answer to 200 words) 

3 Global Remittance 

Please demonstrate your solution to receiving the maximum amount of your home country currency with the initial AUD 20,000 in our global remittance project in this semester. Please organize your descriptions by answering the following questions. What empirical evidence and research you have used to support your solution?(5 marks) What the simulation result you have obtained in the IG virtual trading system. (5 marks) Compared to the research indication with your simulation result, what lessons you learn in this learning by doing practice? (10 marks) (please limit all your three answers to 300 words) 

SECTION 3 – CASE STUDY 

The Venezuelan Bolivar Black Market 

It’s late afternoon on March 10th, 2004, and Santiago opens the window of his office in Caracas, Venezuela. Immediately he is hit with the sounds rising from the plaza—cars honking, protesters banging their pots and pans, street vendors hawking their goods. Since the imposition of a new set of economic policies by President Hugo Chávez in 2002, such sights and sounds had become a fixture of city life in Caracas. Santiago sighed as he yearned for the simplicity of life in the old Caracas. 

Santiago’s once-thriving pharmaceutical distribution business had hit hard times. Since capital controls were implemented in February of 2003, dollars had been hard to come by. He had been forced to pursue various methods—methods that were more expensive and not always legal—to obtain dollars, causing his margins to decrease by 50%. Adding to the strain, the Venezuelan currency, the bolivar (Bs), had been recently devalued (repeatedly). This had instantly squeezed his margins as his costs had risen directly with the exchange rate. He could not find anyone to sell him dollars. His customers needed supplies and they needed them quickly, but how was he going to come up with the $30,000—the hard currency—to pay for his most recent order? 

Political Chaos Hugo Chávez’s tenure as President of Venezuela had been tumultuous at best since his election in 1998. After repeated recalls, resignations, coups, and reappointments, the political turmoil had taken its toll on the Venezuelan economy as a whole, and its currency in particular. The short-lived success of the anti-Chávez coup in 2001, and his nearly immediate return to office, had set the stage for a retrenchment of his isolationist economic and financial policies. 

On January 21st, 2003, the bolivar closed at a record low—Bs1853/$. The next day President Hugo Chávez suspended the sale of dollars for two weeks. Nearly instantaneously, an unofficial or black market for the exchange of Venezuelan bolivars for foreign currencies (primarily U.S. dollars) sprouted. As investors of all kinds sought ways to exit the Venezuelan market, or simply obtain the hard-currency needed to continue to conduct their businesses (as was the case for Santiago), the escalating capital flight caused the black market value of the bolivar to plummet to Bs2500/$ in weeks. As markets collapsed and exchange values fell, the Venezuelan inflation rate soared to more than 30% per year. 

Capital Controls and CADIVI To combat the downward pressures on the bolivar, the Venezuelan government announced on February 5th, 2003, the passage of the 2003 Exchange Regulations Decree. The Decree took the following actions:

1. Set the official exchange rate at Bs1596/$ for purchase (bid) and Bs1600/$ for sale (ask);

2. Established the Comisin de Administracin de Divisas (CADIVI) to control the distribution of foreign exchange; and

3. Implemented strict price controls to stem inflation triggered by the weaker bolivar and the exchange control-induced contraction of imports. CADIVI was both the official means and the cheapest means by which Venezuelan citizens could obtain foreign currency. In order to receive an authorization from CADIVI to obtain dollars, an applicant was required to complete a series of forms. The applicant was then required to prove that they had paid taxes the previous three years, provide proof of business and asset ownership and lease agreements for company property, and document the cur-rent payment of Social Security. 

Unofficially, however, there was an additional unstated requirement for permission to obtain foreign currency: authorizations would be reserved for Chávez supporters. In August 2003 an anti-Chávez petition had gained widespread circulation. One million signatures had been collected. Although the government ruled that the petition was invalid, it had used the list of signatures to create a database of names and social securit numbers that CADIVI utilized to cross-check identities on hard currency requests. President Chávez was quoted as saying “Not one more dollar for the putschits; the bolivars belong to the people.” 

Santiago’s Alternatives Santiago had little luck obtaining dollars via CADIVI to pay for his imports. Because he had signed the petition calling for President Chávez’s removal, he had been listed in the CADIVI database as anti-Chávez, and now could not obtain permission to exchange bolivar for dollars. The transaction in question was an invoice for $30,000 in pharmaceutical products from his U.S.-based supplier. Santiago intended to resell these products to a large Venezuelan customer who would distribute the products. This transaction was not the first time that Santiago had been forced to search out alternative sources for meeting his U.S. dollar-obligations. Since the imposition of capital controls, his search for dollars had become a weekly activity for Santiago. In addition to the official process—through CADIVI—he could also obtain dollars through the gray or black markets. 

The Gray Market: CANTV Shares In May 2003, three months following the implementation of the exchange controls, a window of opportunity had opened up for Venezuelans—an opportunity that allowed investors in the Caracas stock exchange to avoid the tight foreign exchange curbs. This loophole circumvented the government-imposed restrictions by allowing investors to purchase local shares of the leading telecommunications company CANTV on the Caracas’ bourse, and to then convert those shares into dollar-denominated American Depositary Receipts (ADRs) traded on the NYSE. The sponsor for CANTV ADRs on the NYSE was the Bank of New York, the leader in ADR sponsorship and management in the U.S. The Bank of New York had suspended trading in CANTV ADRs in February after the passage of the Decree, wishing to determine the legality of trading under the new Venezuelan currency controls. On May 26th, after concluding that trading was indeed legal under the Decree, trading resumed in CANTV shares. CANTV’s share price and trading volume both soared in the following week The share price of CANTV quickly became the primary method of calculating the implicit gray market exchange rate. For example, CANTV shares closed at Bs7945/share on the Caracas bourse on February 6, 2004. That same day, CANTV ADRs closed in New York at $18.84/ADR. Each New York ADR was equal to seven shares of CANTV in Caracas. The implied gray market exchange rate was then calculated as follows: (Implicit Gray)/(Market Rate)=(7×Bs7945/Share)/($18.84/ADR)=Bs2952/$ 

The official exchange rate on that same day was Bs1598/$. This meant that the gray market rate was quoting the bolivar about 46% weaker against the dollar than what the Venezuelan government officially declared its currency to be worth. Exhibit A illustrates both the official exchange rate and the gray market rate (calculated using CANTV shares) for the January 2002 to March 2004 period. The divergence between the official and gray market rates beginning in February 2003 coincided with the imposition of capital controls. 

The Black Market A third method of obtaining hard currency by Venezuelans was through the rapidly expanding black market. The black market was, as is the case with black markets all over the world, essentially unseen and illegal. It was, however, quite sophisticated, using the services of a stockbroker or banker in Venezuela who simultaneously held U.S. dollar accounts offshore. The choice of a black market broker was a critical one; in the event of a failure to complete the transaction properly there was no legal recourse. 

If Santiago wished to purchase dollars on the black market, he would deposit bolivars in his broker’s account in Venezuela. The agreed upon black market exchange rate was determined on the day of the deposit, and usually was within a 20% band of the gray market rate derived from the CANTV share price. Santiago would then be given access to a dollar-denominated bank account outside of Venezuela in the agreed amount. The transaction took, on average, two business days to settle. The unofficial black market rate was Bs3300/$. 

In early 2004 President Chávez had asked Venezuela’s Central Bank to give him “a little billion”—millardito—of its $21 billion in foreign exchange reserves. Chávez argued that the money was actually the people’s, and he wished to invest some of it in the agricultural sector. The Central Bank refused. Not to be thwarted in its search for funds, the Chávez government announced on February 9, 2004, another devaluation. The bolivar was devalued 17%, falling in official value from Bs1600/$ to Bs1920/$ . 

With all Venezuelan exports of oil being purchased in U.S. dollars, the devaluation of the bolivar meant that the country’s proceeds from oil exports grew by the same 17% as the devaluation itself. 

The Chávez government argued that the devaluation was necessary because the bolivar was “a variable that cannot be kept frozen, because it prejudices exports and pressures the balance of payments” according to Finance Minister Tobias Nobriega. Analysts, however, pointed out that Venezuelan government actually had significant control over its balance of payments: oil was the primary export, the government maintained control over the official access to hard currency necessary for imports, and the Central Bank’s foreign exchange reserves were now over $21 billion. 

Time Was Running Out Santiago received confirmation from CADIVI on the after-noon of March 10th that his latest application for dollars was approved and that he would receive $10,000 at the official exchange rate of Bs1920/$. Santiago attributed his good fortune to the fact that he paid a CADIVI insider an extra 500 bolivars per dollar to expedite his request. Santiago noted with a smile that “the Chávistas need to make money too.” 

The noise from the street seemed to be dying with the sun. It was time for Santiago to make some decisions. None of the alternatives were bonita, but if he was to preserve his business, bolivars—at some price—had to be obtained.

Questions

1. Why does a country like Venezuela impose capital controls? 

2. In the case of Venezuela, what is the difference between the gray market and the black market? 

3. Create a financial analysis of Santiago’s choices. (5 marks) Use it to recommend a solution to his problem.