Trapped on a sinking island

Like politicians everywhere, Puerto Rico’s legislators never like to be reminded of failure – not least (in their case) the island’s dubious distinction of sliding into recession in 2006 when much of the West was still in the throes of an economic boom.

After eventually becoming a self-governing US territory (a new constitution was approved in 1952), which was a legacy of the US victory in the 1898 Spanish-American War, the island latterly entered an economic cycle punctuated by fiscal mismanagement that hit its nadir in 2006 when yet another budget crisis this time saw the government temporarily shut down, putting 100,000 people out of work.

Puerto Rico by numbers




Unemployment rate (June 2013)


Deficit hoped to be wiped by 2016

The closure came after the legislature and then Governor Anibal Acevedo Vila failed to seal a last-minute deal to address the government’s $740m budget shortfall. Debt meanwhile continued to mount.

While the leader of the Senate offered to implement a 5.9 percent sales tax to help pay off an emergency $532m line of credit the government needed in order to see it through the fiscal year, this was subsequently vetoed by the island’s House of Representatives, which would only go up to 5.5 percent.

Exemption to the rule
Vila, who was later to be charged by US authorities for campaign finance violations, said neither plan was sufficient and that a seven percent tax would be required to pay for an additional $640m loan. The straw that finally broke the camel’s back though was a decision by the US Congress removing an exemption, allowing US companies to avoid paying tax on profits generated by their Puerto Rican manufacturing operations; ostensibly because US legislators concluded their own taxpayers had been systematically bilked.

The island meanwhile found it increasingly difficult to finance – through the use of so-called ‘triple tax-free bonds’ – its accumulating debt, resulting from a decades old industrial policy that had seen heavy investment in education, infrastructure and high-tech manufacture. Hence, when Congress pulled the tax exemption rug from under the economy the fiscal landscape became even more hostile.

Superficially, Puerto Rico may have the appearance of a typical US state, including a governor and bicameral legislature; yet its extensive use of public corporations to deliver public services sets it apart from US states. Directly and indirectly the island manages more than 40 public benefit corporations, leading to charges that such a structure limits both transparency and fiscal accountability in its public sector.

Looming large over the economy is the Government Development Bank (GDB), which acts as the fiscal agent and primary lender to the island’s political subdivisions and public corporations. Hence, growth and financial stability in many respects are a function of a healthy GDB. Complicating the issue further, the island cannot legally file for bankruptcy – a legacy of becoming a US territory – given its constitution states debt payments must be made before anything else is paid for. Unsurprisingly, for decades the island was (and continues to be) sustained by federal subsidies from pensions to food stamps – a reflection of its people being poorer than the American average.

Debt spirals out of control
While debt has been issued to finance the annual budget deficit – now rolling over into its 13th straight year – the island has required market access to meet payroll and other obligations. Between 2001 and 2010, gross public debt soared from 25 percent to 90 percent of GDP. It eased back to 84 percent of GDP in 2012, according to data from Morgan Stanley, while unemployment had slowed to 13.2 percent as recently as June 2013, having peaked at 16.9 percent in May 2010.

A closer examination of the island’s $3trn plus municipal bond market though will readily show that successive government objectives of fixing the island’s finances have subsequently proven hollow – borrowings by the government (and its agencies) more than doubling over the 2004-13 period to $70bn – this at a time when the economy contracted 16 percent.

Indeed, despite unemployment having seemingly peaked, Puerto Rico’s problems are far from over. Against a backdrop of an ageing and shrinking population (of 3.66 million) the island has continued to run annual budget deficits of around 2.5 percent of GDP in recent years and sought to reduce them by levying yet more taxes, raising the retirement age for government employees, and increasing the share of their salaries they contribute to their pensions – the objective being to wipe out a $1.38bn deficit this year by 2016.

Described by some commentators as the ‘Greece of the Caribbean’, the similarities between Puerto Rico and Greece are striking in many ways. Greece was living beyond its means even before it joined the euro with public sector wages, for example, surging 50 percent between 1999 and 2007 – far faster than in most other eurozone countries.

Adding to the problem, public coffers were progressively drained as tax evasion – almost a national sport – lurched further out of control, leading to the budget deficit itself becoming uncontrollable without the implementation of drastic measures.

Not helping matters either was that much of the Greek government’s borrowings had been concealed as successive Greek governments sought to meet the 3 percent of GDP cap on borrowing required of euro members.

When the global financial downturn hit – and Greece’s hidden borrowings came to light – the country was ill prepared to cope. While Greece is now in its sixth year of recession, aggravated by swingeing public spending cuts linked to a €240bn ($320bn) bailout from the euro area and IMF. Puerto Rico’s Government Development Bank, tasked with handling the commonwealth’s capital market transactions, claimed in a recent statement that the island’s capacity to service its public debt was being unfairly compared to Greece. Yet neither economy, linked as they are to the euro and US dollar respectively, have any control over monetary policy – hence neither can devalue their currency to kick-start the economy.

Moreover, neither have a strong productive base, while both economies are economic mirages based on consumption that has been sustained by a monetary illusion. That is, by having access to a stronger currency than their fundamentals warrant, according to Sergio M Marxuach, Policy Director and General Counsel at the Puerto Rico think tank The Center for a New Economy (CNE).

Ineffectively treading water
Certainly the portents for Alejandro García Padilla weren’t looking good when he assumed office as Governor of Puerto Rico back in January 2013. Unemployment stood at 14.6 percent – more than any US state – and murders were at an all-time high as the drugs trade continued to plague the island.

In addition, the economy was being weighed down by debt of $70bn worth of bonds outstanding and a budget deficit of $2.2bn (later to be revised down), leading to rating agencies downgrading the island’s bonds to near-junk status. Total income tax collections meanwhile fell for a fifth straight year and were $4.4bn in fiscal 2013, (FY 2012: $4.54bn; FY 2011: $5.19bn).

Nearly all other categories of income taxes also declined, but for a $92m year-on-year rise in those collected from non-residents. Excise tax collections on cigarettes and motor vehicles also showed increases in the last fiscal year. The current fiscal 2014 budget covering the 12 months that began July 1 relies on a projected $1.38bn from tax increases.

However, the island’s Treasury Department said an initial fiscal 2013 general fund deficit projected at $965m by an earlier administration now looked to total $247m, suggesting that economic forecasting isn’t necessarily one of the government’s strengths. The island’s general fund covers education and other essential spending. Treasury Secretary Melba Acosta-Febo added in a statement that her department had just added 65 auditors to reduce tax evasion on the island.

The blame game is always subject to rigorous political debate, and if economic mismanagement is at the top of the list no such list would be complete without the inclusion of Wall Street. As it borrows frequently to fund operations, Puerto Rico must retain market access to avoid a bond default.

In October 2013 the nation suffered the ignominy of seeing 10 year debt yields climb to 7.94 percent (13 percent on a taxable basis) – exceeding that of an economically incompetent post-Chavez Venezuela, which was witnessing 12.6 percent on similar maturity US dollar debt.

If much of the froth in the Puerto Rican munibonds market was down to their attractiveness to US investors from a tax standpoint, events have subsequently shown how quickly fund managers can head for the exit. Interest on Puerto Rican bonds is exempt from state and local taxes in the US for most investors. Coupled with attractive yields, due to credit ratings just above ‘junk’ status, they’ve proven popular. So much so that 77 percent of US based muni-bond mutual funds reportedly hold Puerto Rican debt.

Reactionary-based business
Chasing yield can become self defeating after a while, especially when markets temporarily head south as they did last May when US Federal Reserve Chairman, Ben Bernanke spooked investors by flagging up the possibility of reducing monetary stimulus to the US economy.

Investors have reacted to selloffs in the interim by pulling tens of billions of dollars out of US muni-bond funds, forcing those funds loaded with Puerto Rican paper to offload some of those holdings. Prices fall, further investor redemptions ensue, more bonds are sold off and the vicious circle continues.

Puerto Rico’s current budget expects to raise more than $2.5bn in revenue though new taxes and other levies

Also in October ratings agency Moody’s downgraded $6.8bn of Puerto Rico sales tax revenue bonds to A2 from Aa3. While the bonds still maintain a high investment grade, it noted the island’s continued weak economy (a 5.4 percent contraction over the year to August 2013) and an even weaker underlying credit rating, given general obligation bonds are rated just one notch above junk.

The downgrade also reflected the agency’s view that the sales tax bonds are more tightly linked to the sovereign’s underlying credit rating than the previous six-notch gap had suggested. The agency affirmed Puerto Rico’s general obligation bonds at Baa3 and $9.2bn in subordinate sales tax bonds at A3.

The outlook for both ratings was revised to negative from stable, however, because of the negative outlook of the commonwealth’s general obligation bonds, trading at the time at some 70 cents on the dollar and yielding 8.8 percent.

Puerto Rico’s current budget expects to raise more than $2.5bn in revenue though new taxes and other levies. Or, to put it another way, an estimated 25 percent of the general fund budget. Yet, despite such optimism, which also includes a five-year economic plan designed to create 130,000 jobs by 2018, the markets are saying otherwise – the S&P Municipal Bond Puerto Rico index showing a 17.8 percent decline, year-on-year, as of early November.

US investment research group Morningstar estimated in September that Puerto Rico can only cover 11.2 percent of its public pension costs – even less than that of the notoriously underfunded Illinois retirement system. It added that Puerto Rico’s liability now equates to $8,900 per person, and this as three of the island’s public pension plans are projected to deplete their respective assets over the coming years.

The pensions time bomb, prompting an overhaul earlier this year to bring down the island’s $37.3bn of unfunded pension liabilities, in part explains why the economy has tipped back into recession.

Meanwhile, $35bn of pension debt is likely to remain on the books for years. Any further ratings downgrades will mean higher government borrowing costs. Then the big question is what can the government do once it runs out of funds to cover pensions, social welfare funds and debt servicing.

As a federal territory it remains unclear how Puerto Rico can be ‘restructured’ should the doomsday scenario of default come to pass, for example. As it is not a municipality it doesn’t have the option of reorganising its debt via a US style bankruptcy. While the US Congress would likely get involved, it remains open to question from a legal standpoint, as to how they would.

In the meantime, markets stand ready to further punish Puerto Rico if its economic situation fails to improve soon. That will only exacerbate the market-dependent island’s already serious economic problems. Time is running out.

Puerto Rico in pictures


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