Puerto Not-So-Rico

This Friday, the Commonwealth of Puerto Rico had been due to make $2 billion of debt repayments, the first step on the road to tackling the burden of the $70 billion debt load currently encumbering the island territory.

But things have not gone according to plan. As the deadline loomed, an executive order came from the office of Governor Alejandro García Padilla, declaring that repayment would be suspended on almost half the outstanding debt, including $779 million of constitutionally-backed general obligation bonds.

The announcement has not come as a surprise to many. Indeed, political wheels had been turning for several months to avert – or at least mitigate the impact of – Puerto Rico’s debt crisis. Only on Thursday – mere minutes before the order went out in San Juan – President Barack Obama had put pen to paper on the Puerto Rico Oversight, Management, and Economic Stability Act – optimistically-acronymed PROMESA – subjecting the unincorporated territory to the fiscal rigour of a federal oversight board.

The losers in this scenario are, unsurprisingly, unlikely to be the hedge funds and municipal bond funds that make up the majority of Puerto Rico’s creditors. Although individually some have exposure to Puerto Rican debt in excess of $1 billion, it is fully expected that bond insurers will bear the brunt of the default, picking up the short term tab, with the long term financial consequences suffered by ordinary Puerto Ricans.

Governor Padilla has come out fighting, declaring that the default is the consequence of the Commonwealth becoming a “colony of Wall Street”. But to many, this will seem a little too much like “doing a Kirchner” – holding faceless foreign financial organizations solely responsible for a crisis caused by myriad factors, not least domestic economic mismanagement. In reality, blame for Puerto Rico’s unenviable status as the “Greece of the Caribbean” can be apportioned just as much at home as abroad.

Puerto Rico is no stranger to debt defaults. Only last August, the Government Development Bank reneged on $58 million of bond repayments, citing concerns about the Commonwealth’s liquidity. But this latest turn of events is many orders of magnitude greater, reflecting a growing crisis in domestic fiscal administration. Concerns have even been raised that the territory is entering an irrecoverable “death spiral”, as an increasingly large proportion of revenue goes towards debt servicing over economic stimulation.

The latest default forms part of a continuum of indignities suffered by Puerto Rico in recent years. The island has experienced almost consistently negative GDP growth since 2006, culminating in the simultaneous “junking” of the territory’s credit rating by all 3 major ratings agencies in 2014.

The whys and wherefores of this litany of misfortune can be traced back over a decade. In 2006, IRS Code 936 – a tax code giving mainland US companies a federal tax exemption on income earned through subsidiaries based in Puerto Rico – was repealed after a 10-year phase-out. Although a seemingly minor administrative change in the context of wider US tax policy, the local effect was crippling – removing incentives for businesses nationwide to operate on the island, it hit manufacturing particularly hard.

Moreover, this local setback coincided with the global economic crash of 2007-2009, with Puerto Rico acutely affected given its exposure to the USA, the territory’s largest investor, trade partner and source of tourist revenue.

The local economy has struggled to recover from this double whammy, in large part due to an array of structural problems.

Foremost among these is labour force participation rates. Although the formal unemployment rate has now climbed to 11.4%, a 2015 GDB report found that only 40% of the adult population is in or seeking formalized work, with the rest either idle or employed in the informal economy.

The reason for this is twofold. Firstly, the cost of formalized employment is prohibitively high for Puerto Rican employers – particularly in the low-skilled, seasonal tourism industry that provides 7.3% of GDP – a by-product of the federally-mandated minimum wage. On the mainland, this runs at 28% of per capita income but on the island this jumps to 77%. Hiring off-the-books – and beyond the reach of the taxman – makes financial sense for most employers.

Secondly, Puerto Rico runs a generous welfare system; an estimate cited in the report shows that a household of three eligible for food stamps, Aid to Families with Dependent Children, Medicaid and utilities subsidies could receive $1,743 per month – as compared to a minimum wage earner’s take-home earnings of $1,159. Work, formal or informal, does not pay.

And this is to say nothing of the toll that a decade of economic stagnation has imposed on the Commonwealth’s human resource. The population has dropped by an average of 1% per annum, with the principal demographic being people of working age. While the desire to seek fortunes elsewhere is eminently understandable, the loss of the most economically activity in society further undermines efforts to alleviate the slump.

The response of the government in San Juan has been a triumph of hope over reality. The same GDB report draws particular attention to “extremely optimistic revenue projections”, consistently overestimating collections at 15% more than the figure actually received, whilst tax revenues have slid by 3% as a percentage of GNP since 2006.

Against this backdrop, public sector debts have cantered over the horizon, rising to 100% of GNP by the end of 2015. Whilst the government has, over the years, introduced a series of ad hoc measures in an attempt to stave off the looming crisis – a sales tax hike in 2006, public sector staff cuts in 2009 and pension reform in 2013 – but there has been no grand strategy to tackle it once and for all. A short-termist politics has emerged that mandates plugging holes by raiding public pension schemes rather than face the fiscal music.

For the most part, this is down to a lack of proper oversight at local or federal level. Given the situation, it is perhaps ironically appropriate that the Office of Management and Budget, which has been diligently lowering revenue forecasts and assigning lower spending targets for several years, has limited authority to actually manage budgets.

But now that the chickens are home and well-and-truly roosted, signs of change are emerging. In September, the appropriately-named Working Group for the Fiscal and Economic Recovery of Puerto Rico put together a comprehensive plan for growth, putting forward a raft of practical solutions to the principal problems: greater fiscal responsibility, proposed exemptions to the federal minimum wage and plans to make doing business easier.

However, whether these changes are now implemented domestically or imposed by a Washington-based committee under the terms of PROMESA remains to be seen. The deal allows plenty of room for Puerto Rico to restructure its debt, avoid economic implosion and move forward; however this is likely to come at the cost of some drastic public sector belt-tightening.

Moreover, the incursion of Washington into Puerto Rican affairs will, in all probability, bring up another vexed question: that of the island’s relationship with its mainland neighbour.

Since its capture during the Spanish-American War of 1898, Puerto Rico has held the status of “unincorporated territory”, a quasi-statehood that grants unspecified “fundamental rights” without guaranteeing full membership of the union or “constitutional rights” for its citizens, including a vote in presidential elections.

This arrangement has held for 118 years but recent times have seen a change. In a 2012 referendum, 54% of Puerto Ricans voiced their dissatisfaction with the existing political settlement, with 61% favouring full statehood and accession as the USA’s 51st state. By contrast, a modest 5% rowed in the other direction, casting a vote for independence, a position backed by the Puerto Rico Independence Party (PIP). Meanwhile, the generation of puertoriqueño politicians currently in power favours a middle ground; an “Enhanced Commonwealth” featuring voting rights and entitlement to financial support whilst remaining exempt from federal laws, a “rights without responsibilities” position that is never likely to gain traction in Washington.

The problem seems intractable but if anything was going to break the deadlock it is this present crisis. Whether Puerto Rico finds itself drawn inexorably closer to the USA or straining at the leash for a separation, the Commonwealth is in for an arduous political and economic adventure.


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