To almost no one’s surprise, Puerto Rico lack a US$422 million debt payment earlier this month, raising fears among investors that more defaults are on the way and increasing pressure on Congress to act.
the warnings for this to happen could hardly have been stronger. The main rating agencies cut long ago Puerto Rico’s $72 billion debt at some of the lowest levels. Its bonds have been trading at significant discounts to face value for several years. And in December, the Governor of Puerto Rico Alejandro García Padilla told the US Senate that his government was “out of money” and would have to restructure its debt or face “disastrous” consequences.
And this week, Treasury Secretary Jack Lew visited the island with a similar message, urging lawmakers to act and highlighting the human toll of the crisis.
The warnings so far, however, have fallen on deaf ears, leading to this month’s inevitable default. The only question is – as it has been for a long time – how to resolve the crisis before it spirals out of control.
What’s at stake are years of falling incomes and house prices, chronic unemployment and lost economic opportunity – typical results of unresolved debt crises, such as Greek citizens can certify.
No easy way out
Debt crises are usually contentious and take a long time to resolve.
I’ve been researching financial crises for 25 years, and several unique features promise to make Puerto Rico particularly messy. These include years of economic decline, no appearances in US bankruptcy courts, and hedge funds determined to raise as much as possible in a lawsuit.
At this point, resolving the crisis without action from Washington is hard to imagine.
How did Puerto Rico get here? And what options are left to avoid disaster?
For decades, Puerto Rico, a largely self-governing U.S. territory, had a vibrant economy. Real per capita income more than doubled between 1975 and 2006, growing at an annual rate of 4.2%, much faster than in the United States or Latin America over the same period.
But the Commonwealth suffered a severe economic shock in 2006, when Congress allowed tax breaks to encourage businesses to locate on the island to expire. Result: factories closed and job cuts followed.
Then came the financial crisis and recession of 2008-09, which hit Puerto Rico particularly hard. Its economy has contracted every year but one since, resulting in the loss of more than a third manufacturing jobs and drive unemployment up to 17% in 2010. Economic output is expected to decrease at least through fiscal year 2017.
As US citizens, Puerto Ricans can move to the mainland in search of employment, and the island’s population has shrunk as thousands have done so, leaving the Commonwealth with a tax base weaker.
These shocks, coupled with chronic fiscal deficits, put Puerto Rico on an “unsustainable path of financing shortfalls” with no end in sight.
Skyrocketing debt levels
But how did Puerto Rico’s economic crisis turn into a debt crisis?
Puerto Rico bonds benefit from what is called a triple tax exemption. This means that the interest investors earn on the bonds is exempt from federal, state and local taxes, giving them higher after-tax returns than debt of the same rating.
Normally, the triple tax exemption is only available to those who live in the state or city that issued the bonds. But buyers of Puerto Rico bonds get the exemption regardless of where they live, which has made them popular with tax-exempt mutual funds, hedge funds and high net worth individual investors.
That meant there was still plenty of demand for debt, even as Puerto Rico’s budget deficits grew and its economy contracted — problems that required ever more borrowing to pay the bills. Consequently, his debt burden jumped to 89% of personal income, about nine times that of the most indebted US state by this measure (Hawaii).
How to get out of this mess?
The first step in resolving any debt crisis is to recognize that a loss has occurred and that, without policy change or outside intervention, it is likely to get worse. In the case of Puerto Rico, this is no longer in question.
The only real question now is how the loss should be divided among Puerto Rico’s creditors, its residents, and the taxpayers of the continental United States. Here, the Puerto Rican government’s options are limited.
Its access to the bond market has been cut off, so borrowing more is out of the question. With another $2 billion in debt payments due in July, the the government says that paying creditors would require cutting essential public services.
Moreover, bankruptcy is currently not an option because neither Puerto Rico nor its municipalities are eligible for protection under Chapter 9.
So what options are left to deal with the crisis, at least in the short term? Here are some of the main ones under consideration:
Provide a bailout. A federal bailout could be designed to cover losses on Puerto Rico’s bonds, but it’s highly unlikely because neither the White House nor Congress wants it. The concern is, in part, that it would set a precedent for states in financial difficulty. The federal government has not directly assisted a state since it assumed its independence-related debts in 1790. Barring an outright bailout, Congress could alter some federal programs for the island, what the The Obama administration seems interested doing. Under current rules, Puerto Rico receives less Medicaid than the states and no Supplemental Security Income.
Change the law to allow bankruptcy. Congress could amend Chapter 9 to allow Puerto Rico and its cities to declare bankruptcy. Treasury Secretary Lew voiced his support for this approach. Legislation has been introduced to do just that, but has faced opposition from some hedge funds and other investors. In December, an effort to bring one of the bills to a failed vote.
Establish an oversight board. Almost everyone involved in the Puerto Rico crisis agrees on the need for fiscal and economic reforms, but not necessarily on how to implement them. The government of Puerto Rico has already cut the public pension system, raised taxes and laid off government employees, but the red ink of the budget keep flowing. Recently, House Republicans negotiated with the White House over legislation calling for a federal board of control to oversee Puerto Rico’s finances. Corn some Democrats oppose it such advice, arguing that it would undermine the sovereignty of the island.
Restructure debt. Resolving a debt crisis often involves convincing investors to accept a loss on their holdings. The Latin American debt crisis of the 1980s, for example, did not end until Brady plan provided reduce the amount owed by countries by an average of 30%. Prospects for a debt deal are uncertain, however, as hedge funds bought Puerto Rico’s debt with the apparent aim of using US courts to force a favorable settlement – as happened recently on Argentina’s default in 2002.
Long-term challenges and way forward
Solving the debt crisis, however, is only a first step towards solving Puerto Rico’s problems. It must also find a path to sustainable economic growth, which inevitably means becoming more competitive.
A group of former economists from the International Monetary Fund published a report last summer in which they argued that Puerto Rico needed to change labor market practices to reduce the costs of doing business, such as temporarily exempting businesses from the federal minimum wage and relaxing rules governing overtime, vacation and layoffs. They also advocated cutting federal social benefits, noting that these benefits can deter working for low-wage workers.
A longer-term strategy would be to build on the island’s strengths, such as its well-educated workforce. Nearly 49% of Puerto Rico’s population is college educated, making it one of the best educated work forces in the world. Another advantage is a credible legal system (especially compared to its Latin American neighbors).
These strengths suggest that Puerto Rico could grow by increasing support for high-value industries like finance, management and software rather than competing to attract low-wage producers. Singapore and South Korea are two examples of countries that have successfully followed a development strategy aimed at moving up the value-added ladder.
But following such a strategy requires a more favorable business climate. According to the World Bank, Puerto Rico ranks 47th out of 188 countries in terms of ease of doing business (the United States is 7th), and is particularly low in terms of ease of paying taxes, registering property and obtaining building permits.
the Jones Law, meanwhile, hurts business by requiring goods shipped between US ports to be carried on US ships. An exemption from the law would help Puerto Rico grow as a regional hub.
Although there seems to be a consensus that reforms like these are necessary, they will take time to implement and bear fruit. And before we can tackle Puerto Rico’s long-term problems, we must first find a way to solve its debt crisis.
Time is not on our side: Latin America’s debt crisis took a decade to resolve, and Europe is still grappling with aspects of its debt crisis six years later . Hope Puerto Rico doesn’t take so long.