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China’s Latest Big-Ticket Purchase: Venezuela’s Presidential Election

Venezuelan President Hugo Chavez has been in power for 14 years. On Sunday he earned the right to remain there for another six (though he’s battling cancer).

Chavez is often characterized as a dictator, but the truth is, Venezuela’s election process has been lauded by international observers. So if not through brute force, how does a president – whose country has the world’s highest rate of inflation (28%) and a soaring crime rate – win re-election?

Answer: He buys it…

You see, Chavez went on a huge spending spree during the run-up to the election, pouring billions of dollars into “social development” programs, including healthcare, education and free housing.

Under Chavez’s direction, Venezuela’s central government spent some $9.3 billion in August, according to the National Treasury. That compares with $8.6 billion in July and $5.2 billion during August 2011.

Yet Venezuela also has some of the highest borrowing costs in the world. Fitch, Standard & Poor’s and Moody’s all grade Venezuela in speculative – or junk bond – territory, limiting the number of funds willing to buy its debt. As result, Venezuelan bonds due in 2027 yield 10.9%, compared to 4.7% for equivalent Colombian paper.

So where’s Chavez getting the money?

Simple: He’s solicited low-cost loans from China by putting his country’s vast oil reserves up as collateral.

According to a recent Bloomberg report, in the past five years, the China Development Bank has lent Venezuela $42.5 billion. And $12 billion of that sum was accrued in the past 15 months, as Chavez ran his hotly contested campaign.

Venezuela pays no more than 6% interest on these loans – half of what it pays to investors for bonds issued in capital markets.

In return for its generosity, China gets a steady supply of crude.

Crude Kickbacks

Venezuela’s Oil Minister, Rafael Ramirez, said last month that of the 640,000 barrels of oil a day his country exported to China, 200,000 went toward servicing the country’s debt to Beijing.

And that’s not all.

In addition to the oil bounty, Chinese companies are given lucrative contracts for state-run construction projects. For instance, a $20 billion loan China granted Venezuela in 2010 stipulated that 75% of the money be invested in “cooperation projects” between the two countries.

That means the money Venezuela borrows from China is being fed right back into Chinese companies.

China’s Citic Construction Engineering Co. is building more than 33,000 homes in Venezuela. And Qingdao Haier Co. has supplied three million appliances – air conditioners, televisions, etc. – to the country’s “My Well-Equipped House” program, which is backed by credit from state banks.

Still, oil remains China’s primary concern.

In fact, Beijing’s oil-for-loans program isn’t unique to Venezuela. Developing countries around the world – particularly in Latin America and Africa – have been eager to exchange their resources for Chinese money. Some of that money goes to infrastructure development and social programs, and the remainder is usually wasted.

The risk, though, is that oil prices will fall. If that happens, it will take a much larger supply of oil to service the debt that’s been accrued. And that’s a serious concern for Venezuela, not just because of the massive size of its loans, but because its production is on the decline.

Digging the Hole Deeper

Oil production is down 22% since Chavez first took office in 1999. There are two reasons for this drop…

The first is that Western oil majors like ExxonMobil (NYSE: XOM) and ConocoPhillips (NYSE: COP) were forced out of Venezuela’s energy sector. They’ve been supplanted by PDVSA, Venezuela’s state-run oil major, and a slew of Chinese companies that don’t have as much talent or technology as their Western counterparts.

The second reason is that PDVSA has increasingly been used as the mechanism through which Chavez funds his massive social programs. And with more and more of the company’s funds lining government coffers, it’s been unable to reinvest in production.

PDVSA has more than tripled its government contributions, which have soared from $16.5 billion in 2004 to $58.6 billion last year.

More than $30 billion of that capital went toward programs, according to the state oil giant. Worse, the money doesn’t go through the official government budget approved by the legislature, so there’s little oversight on how it’s spent. And that opens the door to waste and corruption.

All in all, the oil sector makes up 95% of Venezuela’s total exports and 40% of the government’s budget revenue.

However, even with its weighty contributions, public expenditure now exceeds tax collection and oil revenue by 12%. As a result, the country’s debt amounts to 50% of GDP.

So far, the fact that oil prices are 10-times higher than they were when Chavez came to power has masked many of these problems.

But the clock is ticking.

Morgan Stanley (NYSE: MS) believes Venezuela could default on its debt as early as next year.

Of course, that wouldn’t mean much to China, which – thanks to Chavez – now has a substantial claim to the world’s largest oil reserves.

Cheers,

Jason Simpkins

Jason Simpkins

, Energy Editor

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