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How Will the End of the Accord with Venezuela Affect the Cuban Economy?


How will the end of the Accord with Venezuela affect the Cuban Economy?

Ernesto Hernández-Catá[1]

August 2016

Since the beginning of this century Cuba has benefited considerably from an arrangement with Venezuela, whereby Cuba receives oil in exchange for the services of doctors and other professionals. The oil supplied by Venezuela satisfies a large share of the demand for energy by Cuban households and enterprises. It also provides crude oil to the Cienfuegos refinery (a Venezuelan-Cuban joint venture), where it is processed and re-exported to the world market.[2]

For some time now, the increasingly severe economic and political difficulties faced by Venezuela have raised questions about the sustainability of the Accord and about the possible effects on the Cuban economy of an elimination (or a substantial reduction) in its trade provisions. This note seeks to quantify those effects under various assumptions concerning the reaction of Cuban policy makers. It concludes that the complete elimination of the agreement would lower Cuba’s real GDP by around 11%.

  1. A simple Keynesian framework

By definition, gross domestic product (Y) is the sum of total expenditure or absorption (E) and net exports of goods and services (X – M) [3]. Expenditure (which includes household and government consumption and domestic investment) has two components: spending on domestically produced goods (D), and spending on imported goods (M). Therefore, GDP is equal to expenditure on domestically produced goods plus exports:

Y  =  E + (X – M)  =  (D + M) + (X – M)  =  D + X

Taking first differences and assuming that changes involve exclusively those variables related to Cuban trade with Venezuela (i.e., ΔD=0), we obtain:

ΔY  =  ΔM + ΔX – ΔM =  ΔX,

Where ΔM and ΔX now refer specifically to changes in Cuban oil imports from Venezuela and to Cuban exports of professional services to that country, respectively. The conclusion is that the contraction of GDP is simply equal to the drop in exports of services. No multiplier effects are assumed, so that this result may be seen as a minimum estimate of the fall in GDP. As for the decline in absorption, it is simply equal to the fall in imports.

ΔE  =  ΔM,

In this section it is assumed that oil imports are exclusively used to satisfy domestic consumption and/or investment and that exports consist only of professional services. (The case of imports of crude oil delivered to the Cienfuegos refinery for re-export is examined in the following section.)

Table 1 illustrates the impact on the Cuban economy of a complete elimination of all commercial transactions with Venezuela under two extreme and admittedly unrealistic assumptions: (a) that Cuba allows domestic spending on oil to fall pari pasu with the decline in oil imports from Venezuela; and (b) that Cuba replaces oil imports from Venezuela by imports from other countries, which implies that it borrows the required amounts from abroad[4]. The table relies on actual data for 2014, with real GDP expressed in billions of 1997 dollars[5].

  1. In the first case, net exports change little, since both oil shipments and services exports disappear. However, absorption is severely affected by the fall in oil supplies and falls by 7% in relation to GDP—a very difficult outcome for Cuban households and enterprises. Real GDP would fall by 8.2%, which would force the government to accept a large increase in open unemployment or, worse, to subsidize employment as it did in the post-Soviet period.

  1. In the second case Cuba is assumed to borrow from abroad to finance oil imports from countries other than Venezuela. The balance on goods and services (and therefore the current account) deteriorates by 8% of GDP, the mirror image of the additional inflow of capital required to finance the oil imports that can no longer be bartered against services exports. Absorption is protected in this scenario (as Venezuelan imports are replaced by imports from other countries). As in scenario (a), GDP falls by 8.2%, reflecting the fall in services exports.

EHC Effects of Venezuela 1
  1. Complicating the model

We now recognize that the change in exports to Venezuela includes not only the change in services exports (Xs), but also the change in exports of goods (Xg), which consist almost exclusively of re-exports of petroleum products processed in the Cienfuegos refinery using crude oil imports from Venezuela.

The model of section 1 must now be modified by redefining net exports (N) and real GDP as follows:

Net exports                                                     ΔN  =  ΔXs +ΔXg –ΔM

GDP                                                                   ΔY  =  ΔXs +ΔXg

Table 2 shows the amounts involved under the revised model.

  1. In scenario (a) the contraction of GDP is larger than in Table 1 (by roughly 3 percentage points) because refined product exports now disappear. The declines in imports and absorption is unchanged.

  1. In scenario (b) the contraction of GDP is larger than in Table 1 (by almost 3 percentage points) because refined product exports now disappear. The declines in imports and absorption are unchanged from Table 1.

  1. In scenario (b) the fall in GDP is also larger than in Table 1, and again there is no effect on absorption since the level of total oil imports is unchanged. However the drop in net exports (and therefore the need for external borrowing) is larger, because of the disappearance of refined product exports.

EHC Effects of Venezuela 2

  1. An intermediate scenario.

The consequences of the first extreme assumption, that Cuba accepts the full impact of the fall in oil imports, would be very hard to accept from a political viewpoint. The second extreme assumption, that Cuba borrows from abroad to finance oil imports from countries other than Venezuela, is not feasible given the country’s current capacity to borrow. To be sure, Cuba’s reputation in world financial markets had improved noticeably in recent years as illustrated by the debt rescheduling agreements with Russia, Mexico, and other countries. However, this improvement may soon be reversed. Venezuela has started to cut oil deliveries to Cuba; Minister Murillo Jorge has recently reported substantial arrears on suppliers’ credits; and the recent re-scheduling arrangements imply that, from now on, Cuba will have to make higher interest payments on the now active debt. Cuba’s credibility in world financial markets may deteriorate even further if the agreement with Venezuela is cancelled or substantially reduced. Everything considered, this would not be a good time for Cuba to obtain large-scale financing from world financial markets. Of course Cuba could try to borrow from “friendly” countries like China or Iran, but there is doubt as to how much could be available from these sources.

An intermediate scenario could assume that Cuba borrows from abroad to replace one half of the decline in oil imports from Venezuela. As a result, absorption would fall by 3 ½ %, and next exports by over 7 ½ %. The resulting current account deficit would be extremely large by historical standards and is unlikely to be sustainable under present circumstances. This may be a good time to think about a unification-cum-devaluation of the peso. The drop in real GDP would still be 11%, since it is determined by the fall in exports and is invariant to the policy regarding oil imports.

*

One final question relates to the effects of the cutback that has already occurred.[6] The Venezuelan authorities announced in July of this year that shipments of oil to Cuba would be reduced by 20%. Based on the estimates presented in this note, this would lower Cuba’s GDP by approximately 1% in the second half of 2016 and by 1 1/2% to 2 % in 2017.

[1] I am grateful t Luis R. Luis and Yusuke Horiguchi for an extensive discussion of the issues involved in this paper.

[2] Even though these exports appear in Cuban official statistics under the heading of “exports to Venezuela”.

[3] As defined here, net exports are equal to the current account of the balance of payments less current transfers abroad plus interest payment on the debt. The former is not relevant to this exercise; the latter is relevant in some scenarios but its effect would be relatively small in the short run and it is ignored in this note.

[4]  Or that it draws down its foreign exchange reserves which, of course, can only provide temporary relief.

[5] Cuban exports of professional services to Venezuela are estimated by subtracting tourist expenditure from total exports of services and multiplying the result by the estimated share of Venezuela in total exports of medical personnel. Other variables are author’s estimates or are taken directly from the 2014 issue of the Anuario Estadístico de Cuba, Oficina Nacional de Estadísticas e Información. It is noteworthy that the estimate of services exports to Venezuela is larger than the recorded level of Cuban oil imports from Venezuela. This could suggest an upward bias in the estimated level of professional services exports, possibly because it may include unpublished non-tourist exports (such as communications services) that should in principle be netted out.

[6] Pavel Vidal Alejando, “El shock venezolano y Cuba: crónica de una crisis anunciada”, Cuba Posible. August 2016.

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