The switch back to controls: 1994-

In 1994 a new government assumed office, inheriting an economy characterised by recession with accelerating inflation and capital flight. This situation was further aggravated by a bank crisis that arose that year and then systematically spread to the

The privatised enterprises were C A NT V (telephones), V IA SA (Airline), A ST IN A V E (Navigation), "Central Azucarero del Tocuyo"(Sugar), and the banks "Italo Vénézolane" and "Republica".

rest of the financial system^^. Inflationary pressures worsened as financial assistance given to those banks that were experiencing problems led to an expansion in money supply. After several unsuccessful attempts to recapitalise the banks, they were nationalised. The bank crisis had a negative effect on foreign-exchange markets and the "crawling peg" policy, which had been implemented at the end of 1993, was replaced with a floating exchange rate system and a substantial decline in the exchange rate. As capital flight and inflation accelerated, the government decided to introduce exchange controls and switch back to a fixed exchange rate. Price controls on basic goods and services were also re-introduced^^

The new administration tackled the fiscal deficit by reducing its spending and introducing a number of revenue generating measures, including; (i) replacing VAT with a general tax on luxury items at the wholesale level, (ii) the creation of a temporary 0.75 percent tax on bank deposits and (iii) increasing the maximum income tax rate from 30 to 34 percent in order to increase tax revenue from sources other than oil. The government also applied a set of stabilisation measures which included quadrupling the domestic gasoline price to help the fiscal deficit reduction and issuing medium - and long - term bonds indexed to the dollar in order to absorb excess liquidity.

The creation of a temporary tax on bank deposits and the increase in the income tax rate, allied to the significant increase in the domestic gasoline price, might have had an immediate greater impact on the economic position of middle classes in comparison with other groups of the population. The lowest income groups are less likely to hold a bank account and do not pay income taxes, while the increase in the domestic gasoline price affects, with some lag, the public transport price (due to political pressures) as some low-wage workers are benefiting from transport subsidies. On the other side, the highest-income groups are more likely to be better endowed with income assets which allow them to protect their income from inflation.

The crisis started in January 1994 with the bankruptcy o f the second largest bank in the country in terms o f deposits (Banco Latino). Follow ing the closing o f Banco Latino other banks began to be affected by withdrawal o f deposits (lA D B , 1995).

^ These goods include, apart from those o f “m assive consumption” m entioned earlier, vegetables, sardine, and m edicines. A lso, the prices o f services such as telephone, gas, water, electricity, and transport were regulated.

or even to take advantage of the situation. The middle-income groups widely use their own automobile for transportation, as being less endowed with income assets than the highest-income groups.

Although the intention was to continue the privatisation policy, the worsening economic outlook saw the shelving of most plans - although some progress occurred in opening up the petroleum sector.

On the social side, the government reformed the country’s labour legislation, the nominal minimum wage was increased in urban areas by 66.7 percent and in rural areas by 78. 6 percent and food and transport subsidies equivalent to 2 percent of the minimum wage were introduced for all workers with a wage equal to -or less than- three times the minimum wage. Salary increases for administrative and technician workers in the public sector was also approved. However, it is worth pointing out that only workers in the formal sector can benefit from these measures and that their effectiveness in counteracting the adverse impact of the economic situation on the lowest-income groups would be called into question if the informal sector is found both relevant in total employment and over-represented at the lower end of the distribution.

While GDP declined in 1994, output growth recovered in 1995 thanks to the expansion of the petroleum sector, prompted by favourable conditions in the world market^^. The higher inflation in 1994 (70.8 percent), notwithstanding price controls, could be attributed to a combination of the expectation of a high fiscal deficit, a declining exchange rate, and an excess of liquidity resulting from the financial assistance provided to the banks. This excess liquidity helped push nominal interest rates down which, in an inflationary context, led to negative real rates of interest. Eventually, as price controls began to take effect, inflation declined to 56.6 percent in 1995. A decline in imports in 1994, due to the reduced economic activity and the imposition of exchange control, led to a surplus in the current account balance.

The fall in GDP in 1994 cam e mainly from the construction and manufacturing sector (Table 5 A. 1.4).

However, unemployment rose in both 1994 and 1995, while real wages deteriorated even further (Table 5A. 1.3). This increase in unemployment might have had a regressive impact on income distribution, since there was a significant reduction in construction and manufacturing activities during this period, and it was argued earlier that these two sectors have a relevant contribution to manual worker employment, with these type of workers being over-represented at the lower end of the distribution.