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Special Report

Venezuela: The Value of Opportunistic Adjustment We came back from our investor trip to Venezuela last week with mixed – but on balance positive – feelings about current policy dynamics. The Venezuelan economy is undergoing a sharp economic adjustment – although incomplete, it will allow economic authorities to restore a healthier external balance favoring external (financial) creditors while putting the burden of the adjustment on the domestic sector, where stagflation will be the most likely outcome for 2014. We argue that the adjustment is incomplete because neither the fiscal and monetary policy imbalances nor the lack of confidence from the private and external sector in the economic policy mix will be sufficiently addressed. But this year will allow economic authorities to build buffers ahead of the National Assembly elections in late 2015, when we expect the expansionary domestic policy to return with a resurgence of imports to combat scarcity.

Date 29 April 2014 Armando Armenta Economist (+1) 212 250-0664 [email protected] Hongtao Jiang Strategist (+1) 212 250-2524 [email protected]

On the bright side, some of the instability factors are expected to be partially – albeit slowly – solved in the coming months. First, the trip confirmed our assumption that SICAD II – through which the government implements stealth devaluation with minimum political cost – will likely be a successful policy move. It helps reduce exchange rate distortions, improve fiscal balance, and attract foreign investment (especially benefiting the oil sector), as well as reducing the need for monetization of the fiscal deficit through PDVSA (though it is expected this policy will continue) and allowing the private sector a formal way to access foreign currency, putting a stop to the depreciation of the parallel exchange rate. Second, the pragmatists, led by Vice President of Economic Affairs Ramirez and supported by Central Bank President Merentes, have gained the upper hand to make economic decisions. On the other hand, the pragmatism shown recently was introduced as a necessity not as a change in the fundamental direction of economic policy. These dynamics are likely to continue in the near term, although the risk of the resurgence of more radical policy makers, who insist on the failed policies of increasing the grip of the government in varied economic sectors, is still significant. In addition, even though there is no threat to the continuance of the current regime from the already waning opposition and student movement protests, the deep political polarization will continue. Nevertheless, as we suggested in EM Daily of Monday April 28th, we feel that our post-trip assessment of the fundamentals is somewhat inconsistent with our neutral recommendation on Venezuelan assets. While the risk-reward of a long position has become less attractive after the recent rally, and positioning has likely turned heavy, valuation remains attractive vs. the global high-yield index. With the improved risk sentiment towards EM assets recently, we believe an overweight exposure to the Venezuelan complex would be more appropriate at this juncture. However, the extent of the recent outperformance, uncertainty in further policy directions and increased positioning suggest one should keep the overweight small at the moment and look to increase on weakness. We also expect continued dis-inversion of the curve and hence retain our preference of the 3-5Y sector (especially the PDV 17s and VEN 19s). We expect PDVSA to issue bolivar-dollar bonds (via private placements) again this year in the amount of about USD 3-4bn, mainly for the purpose of settling with suppliers; we also expect PDVSA to conduct debt liability management transactions, which will benefit PDV 15s – 17s. Given the latter we also favor curve steepeners via long 17Ns vs. bonds at the long end of the curve, such as the 35s. See detailed notes inside.

________________________________________________________________________________________________________________ Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.

29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

Venezuela: The Value of Opportunistic Adjustment Executive Summary We came back from our investor trip to Venezuela last week with mixed – but on balance positive – feelings about current policy dynamics. The economic and political situation had deteriorated sharply during the last year, even amid stable oil prices, which increased worries that reached a zenith during February on domestic and external imbalances. The deterioration was exemplified by several factors, of which the more important were: a gridlock in economic policy characterized by the lack of an effective exchange rate reform to solve the overvaluation of the currency, which is a reform widely opposed by the radical wing inside the economic policy making team, the low level of transparency in external accounts with dwindling Central Bank foreign exchange reserves, and an increase in political instability epitomized by violent social unrest that seemed to have decreased the government’s margin of maneuver. The Venezuelan economy is undergoing a sharp economic adjustment that, although incomplete, will allow economic authorities to restore a healthier external balance favoring external (financial) creditors while putting the burden of the adjustment on the domestic sector, where stagflation (high inflation with negative growth in economic activity) will be the most likely outcome for 2014. This strategy is exemplified by the rapid increase in inflation, hard currency and goods scarcity; a 20% drop in imports, engineered during 2013 by rationing of dollars to the private sector, was joined by stealth devaluation in 2014 and that should restore confidence in external accounts. We argue that the adjustment is incomplete because neither the fiscal and monetary policy imbalances nor the lack of confidence from the private and external sector in the economic policy mix will be sufficiently addressed. This year will allow economic authorities to build buffers ahead of the National Assembly elections in late 2015, when we expect the expansionary domestic policy to return with a resurgence of imports to combat scarcity. On the bright side, in our opinion, some of the factors of instability are expected to be partially – albeit slowly – solved in the coming months. First, the trip confirmed our assumption that SICAD II – through which the government implements a stealth (and quite significant) devaluation with minimum political cost – will likely be a successful policy move. It helps reduce exchange rate distortions, improve the government’s fiscal balance, attract foreign investment (especially benefiting the oil sector), as well as reducing the need for monetization of the fiscal deficit through PDVSA (though it is expected this policy will continue), and allowing the private sector of a formal way to access foreign currency, putting a stop to the depreciation of the parallel exchange rate. Second, the pragmatists, led by Vice President of Economic Affairs Ramirez and supported by Central Bank President Merentes, have gained an upper hand to make economic decisions. On the other hand, the pragmatism shown recently was introduced as a necessity - not as a change to the fundamental direction of economic policy as well as the absence of electoral contests this year. These dynamics are Page 2

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

likely to continue in the near term, although the risk of the resurgence of more radical policy makers, who insist on the failed policies of increasing the grip of the government in varied economic sectors, is still significant. We do not observe meaningful signs that the government will begin to reign in fiscal and monetary expansion (apart from the effect of the devaluation through SICAD II), as this policy is part of the economic policy mix and is important for political support. Price controls remain in place through the “Law of Fair Prices”, and although some revisions in prices have been announced, the strategy of enforcing caps in prices will continue to be used. Moreover, members of the productive private sectors still find themselves in a very difficult business environment, and consequently the problem of goods scarcity – among many other economic problems – is not being resolved in the near term. The recent pragmatic policy moves have slowed – but not stopped – the deterioration of macro fundamentals. On the political front, even though there is no threat to the continuance of the current regime from the already waning opposition and student movement protests, the deep political polarization will continue as the will to compromise from both the government and the opposition continues to be low. The opposition seems deeply divided over the means to obtain political change but the goal of regaining power will most likely unite them again ahead of next year’s electoral contest. It remains to be seen whether the government can turn the overall situation around and we remain unconvinced that the country is at a definitive turning point in terms of economic policy making, and more importantly, in terms of economic conditions. Nevertheless, as we suggested in EM Daily of Monday April 28th, we feel that our post-trip assessment on the fundamentals is somewhat inconsistent with our current neutral recommendation on Venezuelan assets. While the riskreward of a long position has become less attractive after the recent rally and positioning has likely turned heavy, valuation remains attractive vs. the overall EM index, and especially vs. the global high-yield index (see chart). With the improved risk sentiment towards EM assets recently, we believe an overweight exposure to the Venezuelan complex should be more appropriate at this juncture. However, the extent of the recent outperformance, uncertainty in further policy directions and increased positioning suggest one should keep the overweight small at the moment and look to increase on weakness. We also expect continued dis-inversion of the curve and hence retain our preference of the 3-5Y sector (especially the PDV 17s and VEN 19s). We expect PDVSA to issue bolivar-dollar bonds (via private placements) again this year in the amount of about USD 3-4bn, mainly for the purpose of settling with suppliers; the PDVSA is also likely to conduct debt liability management transactions, which will benefit PDV 15s – 17s. Given the latter, we also favor curve steepeners via long 17Ns vs. bonds at the long end of the curve, such as the 35s.

SICAD II – a dose of pragmatism out of necessity It was a consensus view by members of the government, local observers, and the private sector that SICAD II will be a successful operation. The stealth devaluation was initially an idea proposed by Nelson Merentes when he was VP of Economics last year but was only announced and fully implemented by the government in the last two months given the internal struggle among Deutsche Bank Securities Inc.

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

economic authorities. Some local political observers are of the opinion that the protests that started in February played a role in forcing the government to resort to some pragmatism and adopt such a policy. While SICAD II helps partially satisfy dollar demand (around USD850mm have been sold in SICAD II in the first 20 days of operations while demand has by far exceeded this amount), it will help cut the general government’s fiscal deficit by 7.0 percentage points from 15% to 8% according to Ecoanalitica, a leading local economics consultancy, and it provides a much needed benefit to the oil sector, which will be able to sell resources for capital expenditure at this rate. PDVSA suggests it will sell about USD5bn in SICAD II. Finally, SICAD II will reduce the need for the Central Bank to continue monetizing the government’s deficit through subsidizing PDVSA’s operational cost, which in our opinion is an important cause of the rapid increase in inflation during 2013. In a recent statement, President Maduro suggested that 80% of the government’s dollar supply will be distributed by CENCOEX, 13% by SICAD I, and 7% by SICAD II. However, these clearly are moving targets. It is widely believed that eventually the government will merge the CENCOEX rate (6.3 VEF/USD) to the SICAD I rate (currently around 10 VEF/USD) early next year to achieve further devaluation. The official at the Central Bank we met shares this view, and also thinks the SICAD II system should dominate in the future and even envisions that there will be only one exchange rate eventually, but we believe this is currently his personal view rather than accepted policy directive. He further thinks the devaluation through SICAD II will decrease, not increase, inflation, because it helps to lower the parallel rate, which is the source of pricing for many goods as it increases devaluation expectations and the recovery value of imports. We believe the main impact to inflation will be through the drainage of liquidity from the financial system taking away the pressure on the parallel exchange rate. However, this measure will need to be accompanied by fiscal and monetary tightening to effectively decrease capital flight and depreciation pressures on the SICAD II (and the parallel) exchange rate. As the table below shows, we expect that the effective exchange rate for imports will be close to 16.1 VEF/USD but the one for the private sector will be around 25.1 VEF/USD during 2014, delivering a sharp devaluation. Dollar supply for imports and effective exchange rate

VEB 160,000

Volume (USD bn) 2014F 25.0 13.0 2.5 9.0 3.0

VEB 140,000 VEB 120,000 VEB 100,000 VEB 80,000 VEB 60,000 VEB 40,000 VEB 20,000

4/25/14

3/26/14

2/24/14

1/25/14

12/26/13

11/26/13

9/27/13

10/27/13

8/28/13

7/29/13

6/29/13

5/30/13

4/30/13

3/1/13

3/31/13

VEB 0 1/30/13

52.5 27.5

* Incl ude oi l i mports , ca pi ta l expendi ture (i n fx), a nd res t of publ i c i mports Source: Deutsche Bank estimates and National Sources

Excess reserves in banking system

Millions

Dollar supplies and effective exchange rates Exchante Rate (VEB/USD) Current 2014F Public Imports* 6.3 6.3 CENCOEX 6.3 6.3 SICAD I 11.0 15.0 SICAD II 50.0 45.0 Parallel Market 70.0 55.0 Effective exchange rate Total 17.7 16.1 Private imports 28.0 25.1

Source: Deutsche Bank and Banco Central de Venezuela

In terms of monetary policy, our impression is that a timid contraction is underway as the Central Bank has tightened reserve requirements (to 21.5 since April 1st) and increased open market operations to drain liquidity from the financial system. As the Figure below shows, excess reserves in the Page 4

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

banking system have decreased, which should alleviate the pressure on the parallel exchange rate. However, at the current SICAD II rate, they still amount to around USD1.6bn which precludes this system from being actually unrestricted in satisfying total demand for dollars. A complete monetary tightening to correct the current imbalance is not likely to be undertaken as the current economic model is based on directed credit and financial repression (negative real interest rates) and the decrease in government expenditure is not expected to be so large as to preclude the continuation of monetary financing from the Central Bank. Based on our impressions from the meeting, the Central Bank seemed to recognize that expansionary monetary policy was partly to blame for the acceleration of inflation but stressed that the strategy would be to stop/accelerate credit growth, not to risk falling into a larger recession. We believe 2014 will be characterized by the “stop” phase, only to be reinstated next year to accelerate ahead of the National Assembly elections. Apart from the effect of the devaluation brought by SICAD II on fiscal accounts, which will decrease the public deficit from 15% to around 7%, and public statements of a tax reform, we did not obtain much information on the details of a fiscal tightening. One important possibility that had been mentioned is the revision of the oil price subsidy, which amounts to around USD9bn a year; we do not believe the subsidy will be discarded in the short term. Even though the government could raise prices, the increase required to have an impact on fiscal accounts would be too large and costly in political terms, especially after the effective devaluation of the currency, the revision on price caps of basic goods, and the subsequent fall in real income.

Replenishing of external accounts Different sources gave us broadly consistent information of available FX resources held by the public sector. Central Bank’s foreign exchange reserves were approximately USD21bn (USD16-17bn of which are gold), and there is cash available in FONDEN and the National Treasury (USD6.5bn), the Chinese Fund and the FGVFLP fund (USD 4.5bn not under government discretion, rest pledged for projects; more details below). In addition, the Central Bank suggested there is an USD1.5bn Republic/PDVSA bond held in Central Bank’s “investment portfolio” 1 and USD3.5bn of such bonds in the public financial sector, which is under government’s control. So in total the available liquid public sector resources, including gold held by the Central Bank 2, is about USD47bn. This represents a significant increase over 2013, mostly because the delay of CADIVI distributions and delay (as well as ineffectiveness) of SICAD I over the last few months of 2013 and first two months of 2014. It is important to note that aside from the increasing external resources, there is significant flexibility in the government’s ability to pay. For 2013, a local consultant estimates the EBITDA of PDVSA to have been around USD 32bn, out of which a majority was directed to social spending, transfers to the government through programs managed directly by PDVSA, and payment of royalties, taxes, and more importantly of a USD10bn special dividend

1 In our meeting, Nelson Merentes, President of the Central Bank, suggested that the total size of the investment portfolio is about USD 12bn; however, how liquid this portfolio is apart from around USD1.5bn Republic/PDVSA bonds was not disclosed. 2 Even though most of the gold is held onshore, the Central Bank argues that it could be moved offshore and liquidated or used in swap transactions to boost liquidity.

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

mandated at end-2013. A re-prioritization of debt payment away from vast social spending could be easily undertaken if the government or the state oil company were to face stricter-than-forecasted financing constraints. External liquidity of the public sector

Details of the two "Chinese Funds" (all in USD bn)

P ublic S ec t or Ha r d Cur r enc y Res our c es (in U S D bn)

Det a ils of t he t wo " Chines e Funds " (a ll num ber s in U S D bn)

Tot a l E nt it y

Ca pit a l Fund/

Liquid & Not es

Repa id*

Dis bur s ed

Undis bur s ed

Am ount

Unc om m it t ed

Cent r a l Ba nk FX Res er ve

21.0

5.0

USD16bn is in gold

FCCV

30.0

19.2

19.6

Fonden, Ba ndes , & Na t iona l Tr ea s ur y

6.5

6.5

Source: Ecoanalitica

FG V LP in U S D

10.0

2.0

8.4

1.6

Chines e Fund (FCCV )

10.4

2.9

As of Dec 2013

FG V LP in RMB

10.0

4.0

7.2

2.8

Chines e Fund (FG V LP )

1.6

1.6

As of Dec 2013

Tot a l

50.0

25.2

35.2

7.3

Rep/P DV bonds in Cent r a l Ba nk

1.5

1.5

Estimates

All numbers are as of December 2013

Rep/P DV bonds in P ublic Ba nks

3.5

3.5

Estimates

P DV S A

2.4

2.4

Source: Ecoanalitica

46.9

23.4

Tot a l

Source: Deutsche Bank and National Sources

Cr edit Line

Com m it t ed

Ava ila ble

7.5

2.9

* Repayment via oil shipments FCCV - China-Venzuela Joint Financing Fund FGVLP - Large Volume and Long-term Financing Fund (consists of a USD and a RMB 10y credit line)

Source: Deutsche Bank and National Sources

Non-financial debt selective renegotiation The travails of members of the private sector (both domestic and external) to recover arrears are well known. There is a substantial amount of public sector non-financial debt that the Venezuelan government and PDVSA will need to repay or settle. According to Ecoanalitica estimates at end-2013, these amounted to USD 56bn; among these are various kinds of CADIVI arrears (about USD 17 bn), dollars owed to oil sector suppliers and joint ventures (about USD 14bn), and compensation in dispute out of the expropriations (USD 15bn – but the eventual settlement amount will likely be smaller). Many believe there is virtually no chance the arrears will be settled at the official rates. It will likely be a mixture of SICAD I and SICAD II rates (more of the latter), depending on sectors. PDVSA, in particular, suggested it would settle all its arrears this year (via multiple strategies, including continuing to use bolivar-dollar bond issuance), a claim that appears to be overly ambitious to us, but it nonetheless suggests that the hard currency part of the arrears will likely be settled at unfavorable exchange rates to the counterparties. In fact, in recent statements President Maduro has announced that the government is working with the private sector in disbursements agreements that will use the SICAD rate (around 10 VEF/USD) for arrears that had been approved at the 4.3 or 6.3 rate, and more importantly, that only around 30% of demand would be satisfied. According to local consultants, however, these arrangements will vary in the rate, as well as the percentage of arrears recognized, depending on the power of negotiation and importance of the sector. Members of the real productive sector stressed how external credit lines were near exhaustion and delays in the disbursement of these resources were harming the productive capacity of the different sectors of the economy due to the lack of inputs of production, including basic food staples and health related products.

Investors’ relations and debt management strategy Consistent with the strategy to finance the fiscal account in the local market in recent years, the Finance Ministry indicated that the Republic currently has no Page 6

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

plan to issue global bonds this year, despite the government’s preparation of a NY/London road show. They suggest that the road show is to reestablish the contact with the international market that has been shut down for many years. This should be interpreted as a good signal given that the opacity in the government’s accounts and statistics has been an extra source of concern from external creditors. However, when asked about the possibility to reinstate a full relationship with the IMF (that would include an Article IV consultation), The Central Bank suggested economic authorities did not deem it necessary under the current circumstances. The last time the Republic issued dollar bonds was in 2011, when it sold the bonds due in 2026 and 2031 as bolivar-dollar placements. It has not issued bonds directly to the international market since 2008. While we cannot rule out that the Republic does come to the market with a direct dollar bond sale this year if the valuations become more favorable, thus providing lower financing cost than the current yields that average 12%, financing in the local market is much cheaper for the government given the abundant bolivar liquidity and high inflation. Debt repayment schedules for the Republic and PDVSA (next 10 years) PDVSA Interest VENZ Interest PDVSA Principal VENZ Principal

Repayments (USD bn) 10 9 8 7 6 5 4 3 2 1 0 2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

Source: Deutsche Bank

We expect PDVSA to issue bolivar-dollar bonds (via private placements) again this year in the amount of about USD3-4bn, mainly for the purpose of settling with suppliers, and also for supplying dollars to the exchange market – in a similar fashion as the issuance of the 26s last October. In addition, PDVSA indicated that it has in its plan to conduct debt liability management transactions, which will include PDV 15s – 17s, likely via combination of rerepurchase and debt swap (for a longer duration bonds), with financing provided through a loan from China. However, we note that such refinancing strategy has been discussed for a long time during the past year and so far it has not materialized. We believe this was due to the policy paralysis observed over the course of the past couple of years with multiple elections and internal uncertainty within Chavismo ranks. We believe the chances that such a strategy will be implemented this year have increased. If it materializes, it will obviously benefit the local law 15s and 16s, and the global 17s and 17Ns (the latter begin to amortize already in 2015 and will be repaid in three equal installments).

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

Scarcity, price control, labor law and the private sector Scarcity (dollars and goods), price controls, and a rigid labor law are among the top obstacles that the private sector mentions as the more important obstacles. Systemic destruction of the private sector and mismanagement of the oil revenues over the past years reached a more unstable situation in 2014, but with the exception of the partial exchange rate liberalization, we have not seen any signs that the government is planning to tackle these structural problems. We did not receive any indication during our meetings that the government has a plan to abandon the “Law of Fair Prices” that limits profits, sets price caps for a variety of products, and mandates criminal prosecution for those that infringe it. The government has indeed told select private sector companies that they could raise prices on certain goods but without putting it in the official gazette. However, the private sector companies we talked to indicated they would not hike prices without an explicit and official approval from the government, fearing attributions and being used as a scapegoat for the inflation and scarcity problems. After our trip, the government made announcements of price cap increases in some items. However, we believe gradualism is the best case scenario in terms of price adjustment. Scarcity remains a big problem. While the official estimate on the scarcity level is 30%, private estimates point to numbers close to 60% for some basic food basket items. The government has suppressed imports, and in addition, according to estimates by local consultants, as much as 40% of imported goods – which are bought with dollars obtained at the official exchange rate – are being transferred to Colombia to be sold at market prices. Companies in the private sector, even the ones that are entitled to obtain dollars through CENCOEX at the official exchange rate, continue to suffer from dollar shortages. CADIVI/CENCOEX is running increasing delays, compromising the credit lines of the companies with their suppliers. Overall, members of the private sector still find themselves in a very difficult business environment. Besides the price control and difficulty in getting dollars, the rigid labor law has helped lower productivity tremendously in recent years as it encourages absenteeism in the labor sector, adding significant inefficiency. With the exception of the oil sector, which is made up of net exporters and can participate in SICAD II, the private sector remains in limbo. There have been continuing dialogues between the private sector and the government, but in most cases they have resulted in frustrations. In addition, the tax reform being suggested by the government will add to the worries of the private sector due to likely tax increases.

PDVSA and the oil sector While there is no doubt that the oil sector, which had already benefited from the reform to the oil windfall tax last year 3 , is a big beneficiary of SICAD II, it will take time to overcome inefficiencies and see the results of the ongoing foreign investments in the sector. Consequently, oil production will be at best

3 The Tax Law for Extraordinary and Exorbitant prices was amended in 2013 and increased the price of oil to which PDVSA is required to transfer resources to FONDEN, effectively easing the pressure on PDVSA’s finances.

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stable over the next three years, despite PDVSA’s claim that recent foreign investments and setup of joint ventures will increase production by around USD 300k bpd in the next four years. Venezuela currently produces about 2.84 mbpd according to private sector estimates, in comparison with the official estimate of over 3.0 mbpd, mainly because the official estimate began to include production of natural gas liquids (NGL) in 2012. According to PDVSA, over the past year the company has entered financing or joint venture agreements with CNPC (about USD 4.0bn), Chevron (USD 2bn), Gazprom (USD 1.0bn), Repsol (USD 1.2bn) and others, and is engaged in over 70 projects in both the traditional and the Orinoco areas. PDVSA plans to transfer about USD40bn to the Central Bank at the official exchange rate, and sell USD3bn in SICAD I and USD5bn at SICAD II rates. Despite all the investments, operational efficiency has been very low. Recently, many joint venture partners have changed their strategies and gained operational control of the projects. Even with that, overall oil production will unlikely ramp up in the near term given multi-year underinvestment that has caused decline of production in the traditional areas. Venezuela is currently exporting around 2.4-2.5 mbpd of crude oil. This includes the shipment of about 500kbpd to China (300k for loan repayment and 200k for other transactions) via the Malacca strait and Singapore, and the 130kbpd in the PetroCaribe program (half for cash at market prices, the other via subsidized financing). While the government has thought about cutting back on the PetroCaribe subsidy, local consultants mentioned that politically this “investment” has garnered substantial returns as the Maduro government has found support from neighboring countries on international diplomatic stages such as the OAS, UNASUR, and the CELAC. Also, PDVSA has certainly contemplated selling its offshore refinery CITGO, as in the end it has turned into a loss-making business. However, to disinvest in this subsidiary is not a priority at the moment thanks in part to the depressed prices of refinery companies worldwide. There have been concerns over the energy strategy change in the US and how it will potentially impact oil prices and the amount of imports from Venezuela. Oil exports to the US from the rest of the world declined by around 1.9 mbpd over the past year, showing the increase in energy independence. While this is definitely a concern over the long, short and even medium term, this will unlikely significantly impact Venezuela’s oil revenue. PDVSA suggested that the US refineries in the Gulf Coast area will continue to rely on heavy crude imports from Venezuela due to the need to mix light crudes and heavy crudes, while the oil consultants point out that Canadian heavy crude – potentially transported through the Keystone pipeline and possibly becoming the main competitor to Venezuelan heavy crudes – are still years away from materializing given both political and economic hurdles. To help mitigate the long-term impact of the US energy strategy, Venezuela has been diversifying its exports to the rest of the world, especially to China and India, in recent years.

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

Political reform out of necessity, not general change of direction The political stir caused by the violent protests from the student movement and the opposition requesting an immediate regime change have waned recently. Although these protests could continue, we do not expect the degree of confrontation experienced during mid-February to be relived in the short term as the government has used violent repression as a means to counteract the protests. In our opinion, the opposition is clearly divided in the means to exert a regime change but would almost surely reunite ahead of next year’s elections. The moderate sector expected popular support for the government to be impacted by the social and economic deterioration and were thinking about capitalizing on it next year in the parliamentary elections. On the contrary, the protests have enabled President Maduro to consolidate his power within Chavismo, and lean towards pragmatist economic policy makers to instill some necessary, practical measures to alleviate certain problems. Some political consultants believe that the government would not have done SICAD II (which was initially proposed by Nelson Merentes when he was VP of Economic Affairs last year but was set aside until earlier this year) if not for the protests. This has enabled Chavismo to buy more time. However, the radical section of the opposition somewhat deteriorated the Maduro government’s exterior image after the violent protests. Diplomatic pressure from allies of the regime caused the first approach to negotiation with the opposition in more than a decade. With respect to support of the President from within the regime, contrary to certain belief, the President of the National Assembly, Diosdado Cabello, is as of now more likely a political partner than rival to Maduro. Overall, the current government has given a larger role to the military than the government under President Chavez, who – with his authority within Chavismo and charisma with the population – did not need to engage the military as deeply as the current government. Fundamentally, there is no change to the radical path the government is pursuing. The pragmatic reform on the oil sector and exchange rate fronts were done out of necessity, not as definitive changes on ideology or political considerations. The government is expected to continue to suppress the private sector and to rely on fiscal and monetary expansion to nurture popular support and manage to stay in power. Given this, we believe there will be continued policy uncertainty despite the recent pragmatic measures.

Buy with one hand, not both Overall, as we suggested in EM Daily of Monday April 28th, we feel that our assessment of the fundamentals upon returning from the trip was somewhat inconsistent with our existing neutral recommendation on Venezuelan assets. While the risk-reward of a long position has clearly become less attractive after the recent rally and positioning has likely gotten heavy, valuation remains attractive vs. the overall EM index (still almost 700bp above the overall EM index, see first chart below), and especially vs. the global high-yield index (at +600bp, in comparison with past 5Y average of 500bp; see second chart below). With the improved risk sentiment towards EM asset recently, we believe an overweight exposure to the Venezuelan complex should be more Page 10

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

appropriate at this juncture. However, the extent of recent outperformance, uncertainty in further policy directions and increased positioning suggest one should keep the overweight small at the moment and look to increase on weakness. Venezuelan bonds have outperformed the overall EM

Venezuela bonds are at +600bp wider than the global HY

sovereign benchmark, but remains at +700 wider

index (past 5Y average is +500bp).

Relative spread, EMSI-Venezuela vs. EMSI, bp

Relative spread, EMSI-Venezuela vs. iBoxx Global HY, bp

1200

1200

1000

1000 800

800

600 600

400

400

200

200 Apr-09

Apr-10

Apr-11

0 Apr-09

Apr-13

Apr-12

Source: Deutsche Bank

Apr-10

Apr-11

Apr-12

Apr-13

Source: Deutsche Bank

Position for continued dis-inversion, especially on PDVSA We would continue to hold long PDV 14s (to maturity), which we believe PDVSA will pay in full in dollars. We see no justification for PDVSA to consider bolivarizing this bond from the perspective of its re-financing ability – it is simply not necessary and it would compromise its debt re-financing and investment strategy if that occurred. Our view was in a way enhanced through our conversations with PDVSA’s financial executives during the trip. We expect continued dis-inversion of the curves and hence retain our preference of the 3-5Y sector. On the Sovereign curve, our previously favored 18s have outperformed; we would now extend to the 19s, which we expect to follow the recent path of rolling down the curve of the 18s and to outperform in spread terms. Venezuela and PDVSA curves remain inverted – PDV

We expect PDV 17Ns to eventually trade through PDV

17Ns and VEN 19s offer the best valuation

35s Par Equivalent Spread Difference(bps)

Par-equivalent Spread 1250

700

P'17N

1200 1150

P'15

500

P'16 P'21

400

1100

P'26 V'19

1050 V'16

1000

V'18 (7%)

950

P'22

300

V'22

V'20

P'35 V'24V'26 V'31 V'23

900

V'25 P'27 V'28

3 4 Par-eq spread duration

Source: Deutsche Bank

Deutsche Bank Securities Inc.

5

100 0

850 2

200

-100

V'27 P'37

1

PDVSA 17Ns - PDVSA 35s

600 P'17

6

-200 Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Source: Deutsche Bank

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

On PDVSA, expected issuance of bolivar-dollar bonds (likely at the long end of the curve) will likely not have a material impact on the performance of the bonds in the near term as the new bonds will only gradually be sold to international markets (just like the 26s). Meanwhile, the potential liability management transactions by PDVSA discussed above will benefit the PDV 15s through 17s, especially the 17Ns, which begin amortizing in 2015 with three equal repayments. We therefore favor the 17Ns, which also offer the widest par-equivalent spreads, and also recommend par-equivalent spread dv01neutral curve steepeners of 17Ns vs. 35s (entry: 175bp; target: 50bp; stop: 275bp).

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Deutsche Bank Securities Inc.

29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr

Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Armando Armenta/Hongtao Jiang

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29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

Regulatory Disclosures 1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

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Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a Page 14

Deutsche Bank Securities Inc.

29 April 2014 Special Report: Venezuela: The Value of Opportunistic Adjustment

loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

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Page 15

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