Puerto Rico’s Debt Crisis
Puerto Rico’s Debt Crisis

With one debt crisis averted in Washington, another one is still brewing on the horizon in Puerto Rico. The consequences of a default would have a wide-spread impact beyond the island as Puerto Rico’s bonds are a major part of U.S. municipal bond market. Because of their rating, tax-free status and high profit margins, 77 percent of municipal bond funds in the U.S. are invested in Puerto Rican bonds (Kaske, 2013).

The Puerto Rican government denies that it is near bankruptcy (which it is not formally allowed to declare) or that it needs a U.S. bailout. Many analysts wonder how it will pay back its $70 billion in public debt, with its 13.9 percent unemployment rate (Puerto Rico denies bankruptcy and takeover rumors, 2013).  The current government has made tremendous progress since taking power in January 2013, but the structural challenges that are at the root of the crisis are still festering and are likely to do so in the near term.

This news analysis will examine the structural problems underlying Puerto Rico’s debt crisis and explore options for moving forward.

Why does Puerto Rico have a debt crisis?

Puerto Rico has been in a recession since 2006 (Caruso-Cabrera, 2013). The debt crisis is not new and has been building for years as the government covered its budget deficits with bond sales. In 2008, the governor cut 38,000 government jobs, reduced income tax by half, and cut the corporate tax rate. These efforts led to modest growth by 2012; however, since one-third of the country is employed by the government, those who lost their jobs were not pleased with these reforms and voted in a new governor in 2012 (Puerto Rico’s Debt Trap, 2013).

In an in-depth analysis on the stock investing site, Seeking Alpha, Chris Mier (2013) outlines why he thinks Puerto Rico’s problem are economic rather than fiscal. Historical challenges include over-dependence on oil and high electricity costs compared to the U.S., which serve as a disincentive for foreign direct investment (FDI).

FDI (and local business growth) is further hampered by minimum wages set at the U.S. rate, and the requirements to use U.S. ships, flags, and employees on all ships transporting goods between U.S. ports. Poor workers are dis-incentivized to seek employment due to high entitlement spending and high tax rates on wages above entitlement income. Other structural challenges include a poor transportation grid, weak banking system (that relies too much on external financing rather than deposits), and extensive business regulations.

Puerto Rico also faces demographic challenges including low birth rates and high numbers of seniors. Because Puerto Ricans can easily relocate to the U.S., the demographic challenges are compounded by migration trends that further weaken the labor markets and prospects for growth. These demographic challenges are long-term drivers of debt and will need to be addressed to growth the economy.

What can Puerto Rico do to avoid a default?

A U.S. federal of bailout is highly unlikely given the current political situation in Washington. Puerto Rico has already taken a number of steps to avoid a default and calm investors and handle the short-term debt drivers. These steps include cutting the budget deficit by $2.4 billion dollars and reforming the public pension system, by increasing the retirement age and increasing worker’s retirement contributions (Kaske, 2013). The government also increased the borrowing capacity of Puerto Rico’s main debt issuer, the Sales Tax Financing Authority (Puerto Rico denies bankruptcy and takeover rumors, 2013).

Puerto Rico’s Government Development Bank plans to cut remaining bond sales for 2013 by $500 million to $1.2 billion (Puerto Rico Denies Bankruptcy and Takeover Rumors, 2013). The government plans to introduce legislation to overhaul the teacher’s pensions system, which is running out of funds.  In addition, Puerto Rico plans to cut its budget deficit in half by 2015 to reach $820 million (Puerto Rico denies bankruptcy and takeover rumors, 2013).  Deficit funding will also not be used to balance the 2015 budget (Kaske, 2013). These actions will reduce the future amount the government owes in interest payments to bond-owners, allowing the country to focus on repayment of existing bonds, and make current bonds more valuable.

The actions taken by Puerto Rico have a good chance of stemming the immediate debt challenges, but do not address many of the long-term drivers of debt. The commonwealth needs attract FDI by reducing energy and labor costs, as well as encourage more people to work by reducing the tax rates on income over entitlement spending. Even more long-term, Puerto Rico needs to reduce the cost of living and make the island more attractive to its most educated workers, many of whom leave for better employment possibilities in the U.S (Mier, 2013).

Conclusion

While Puerto Rico’s debt challenges are not unique, its commonwealth status and proximity to the U.S. make overcoming these challenges more difficult. Its per capita income is less than any U.S. state, yet it does not have the flexibility to address labor and other economic policies that could make it more competitive in the global marketplace. Given the tax-free status of its municipal bonds, Puerto Rico’s debt has grown tremendously as the cost of borrowing money was quite low. While bankruptcy is not an option for the island, investors everywhere will need to work with Puerto Rico to reduce the debt and give it latitude to let the recent reforms improve the economic climate.

Works Cited

Caruso-Cabrera, M. (2013, October 15).  Puerto Rican government seeks to calm investors about debt. CNBC. Retrieved from http://www.cnbc.com/id/101113739

Kaske, M. (2013,October 16). Puerto Rico may skirt new debt sales to avoid high costs. Bloomberg. Retrieved from: http://www.bloomberg.com/news/2013-10-15/puerto-rico-may-avoid-accessing-debt-markets-after-yields-soar.html

Mier, Chris. (2013, October 16). Puerto Rico: severe economic trends cloud fiscal solution. Retrieved from: http://seekingalpha.com/article/1748882-puerto-rico-severe-economic-trends-cloud-fiscal-solution?source=google_news

Puerto Rico’s debt trap (2013, October 8). The Wall Street Journal. Retrieved from: http://online.wsj.com/news/articles/SB10001424052702303918804579109412927349576

Puerto Rico denies bankruptcy and takeover rumors (2013, October 16). Fox News. Retrieved from:  http://latino.foxnews.com/latino/news/2013/10/16/puerto-rico-denies-bankruptcy-and-takeover-rumors/

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