When something is cheaper in one market and simultaneously more expensive in another market, someone will try to profit from the price difference by buying the product in the market with the lower price and selling it in the market with the higher price. This profit opportunity is called arbitrage, which is usually discussed in the context of financial assets. In a well functioning financial system, arbitrage opportunities are rare, though not impossible. Even when such an opportunity arises, the prices will usually come back into balance in a matter of seconds as traders rush to exploit the arbitrage opportunity. Buying and selling financial assets entail transaction costs. Thus arbitrage may not pay if the price differences are small. In some unusual cases, arbitrage is the result of government policies and can be hugely profitable. In the previous post, we talk about the rampant food arbitrage in Venezuela. In this post, we discuss the arbitrage in foreign currency in Venezuela.
The arbitrage on currency (specifically US dollars) stems from the fact that there are multiple exchange rates for dollars in Venezuela. The official exchange rate is kept at 6.3 bolivars per US dollar, which is an attractive exchange rate. Everybody wants to buy US dollars at this rate, from people who plan to study abroad to businesses that import goods priced in US dollars to ordinary citizens who want to save in US dollars. But the amount of US dollars the Venezuelan government allotted at the official exchange rate is not enough to satisfy the demands. People have no choice but to get US dollars at the black market rates, which could be 60 bolivars to the US dollar (sometimes as high as 90 or 100 bolivars). So the prices of US dollars on the black market exchange could be 10 times more expensive than in the official channel.
The arbitrage opportunity is clear. You pay 6.3 bolivars for $1 according to the official exchange rate. Then sell the $1 in the black market for, say, 60 bolivars. What an investment – starting with an initial investment of 6.3 bolivars and it almost immediately ballooning to 60 bolivars! Of course, this is assuming that you can buy US dollars at the official rate.
One way to get cheap US dollars at the official rate is to possess a valid airline ticket. Any Venezuelan with a valid airline ticket can buy $3000 per year at the official exchange rate. Once the trip is over, the traveller can then sell the unused US dollars at the black market rate. This clearly presents a windfall (at least a way to make the purchasing power of bolivars goes much further) for Venezuelans who can afford to take advantage of the arbitrage opportunity. As a result, there has been a run on airline tickets for quite a long time now.
Wait, the gift from the Venezuelan government keeps on giving. By what is known as credit card scratching, travelers can make even more money. Once Venezuelans are in another country, say Ecuador or Peru, they can get $3000 on their Visa or Mastercard at the official exchange rate of 6.3 bolivars per US dollar (thus costing only 18900 bolivars). Back in Venezuela, they can sell the $3000 for 10 times the amount in bolivars. The huge disparity between the official exchange rate and black market exchange had been causing a frenzy in air travel. Everybody who has the means to do so has been trying to game the system.
This is an arbitrage on the US currency via the pretense of buying airline tickets, an illustration of the absurd conditions in the Venezuelan economy. One immediate hardship resulting from the currency (and airline ticket) arbitrage is that people with legitimate reasons for traveling abroad are having a hard time finding tickets, e.g., students who plan to study abroad and people who want to visit relatives overseas.
In a free-market financial system, the practice of arbitrage is a way to make the financial market more efficient and more well functioning. For example, any mispricing of financial assets will be eliminated by traders taking advantage of the arbitrage opportunity. For a currency that is freely exchanged in the foreign currency market (a floating rate regime), any discrepancy in exchange rates between two markets (if large enough) will also be eliminated once it is discovered by currency arbitrageurs. The arbitrage in the Venezuelan bolivar only make the mispricing and its associated problems worse.
The exchange rate regime for the Venezuelan bolivar is of course not floating (it is a fixed rate regime). But the fixed rate regime is not necessarily the problem with the Venezuelan bolivar. In 2003, the Venezuelan government tried to stem capital flight by imposing stringent exchange controls, effectively creating a two-tier currency system. The well-connected can make a fortune by doing arbitrage. The ordinary Venezuelan citizens and businesses that cannot buy dollars at the heavily subsidized official rate will have to turn to a flourishing black market, where the price of dollars is 10 times of the official rate, making life difficult for the businesses and shoppers alike.
About 70% of the products consumed by Venezuelans are imported. Importers that cannot obtain dollars at the attractive official exchange rate have no choice but to get the needed US dollars at the black market rates, which are 10 times more expensive. As a result, the imported goods are 10 times more expensive (even if the merchants are simply selling the products at cost only). Consumers are understandably outraged. The government’s response is to label the merchants price gougers and order price cuts (sometimes as much as 50%). Such actions contributed to worsening shortages of essential goods. No businesses can consistently sell their goods at substantial losses. Thus businesses go bankrupt or simply decide to not open for business. The end result of such price controls on the part of the government is that essential goods are even harder to find as before, thus worsening the shortage of foods and other essential goods.
The scarcities of basic goods stem from the government’s refusal to adopt sensible exchange rate policies. Some commentators suggest that Venezuela’s economic problems – shortage of basic goods, high inflation, and the collapse of the currency just to name a few – stem from the collapse of oil prices in the last few months in 2014. That is only a part explanation. The oil prices were still high (in the $100 plus range) earlier in the year and in the last several years. The shortage of basic goods in Venezuela was widespread during the years with high oil prices too. The collapse of the oil prices certainly do not help. The collapse of the bolivar is perhaps the most striking indication of the economic mismanagement on the part of the Venezuelan government.
The following pieces of reporting are additional fascinating and interesting reads, more indications of the serious economic troubles in Venezuela.
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Counting pennies in Venezuela
Short on dollars Venezuela tries to halt black market trading
Venezuelas black market rate for US dollars just jumped by almost 40%
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Financial Economics 