Puerto Rico

By Rob Garver
June 29, 2015

As creditors in Europe look with trepidation at the increasing probability that Greece will default on its debts, investors in the United States are watching a similar situation play out in Puerto Rico, where decades of borrowing and a stagnating economy have, according to the commonwealth’s governor, made default on general obligation bonds all but inevitable.

In an alarming report that leaked over the weekend, a team of economists headed by Anne O. Krueger, former chief economist for the World Bank and more recently first deputy managing director of the International Monetary Fund, issued dire warnings.

“Puerto Rico faces hard times,” the authors found. “Structural problems, economic shocks and weak public finances have yielded a decade of stagnation, outmigration and debt. Financial markets once looked past these realities but have since cut off the commonwealth from normal market access. A crisis looms.”

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Any move to restructure the commonwealth’s obligation will likely meet stiff resistance from the bond markets. Puerto Rico’s debt is widely held by U.S. hedge funds, mutual funds and other investment vehicles. It has been particularly popular because a special provision of U.S. law for years made it exempt from federal, state and local taxes.

Related: ‘Grexit’ Chances Increase with Greek Referendum

That allowed Puerto Rico to fund large amounts of deficit spending for well over a decade, resulting in a debt load that has placed an enormous fiscal burden on an economy that has begun shrinking. As recently as 2013, Puerto Rico’s Government Development Bank could borrow at between 5 and 6 percent interest. Today, that rate has rocketed to more than 15 percent, essentially shutting the island out of the bond markets.

The combination has left Puerto Rico unable to pay its debts, Gov. Alejandro Garcia Padilla admitted in an interview with The New York Times. “The debt is not payable,” he said. “There is no other option. I would love to have an easier option. This is not politics, this is math.”

The Krueger report notes that Puerto Rico’s close association with the United States is both a benefit and a curse when it comes to the island’s economy.

For example, employers are subject to federal minimum wage laws, despite the fact that the federal minimum of $7.50 per hour is much higher relative to per capita income on the island than it is on the mainland. A mainland U.S. worker earning the minimum wage is making about 28 percent of per capita income in the country as a whole. A worker earning the same in Puerto Rico earns 77 percent of the island’s per capita income. This means that even entry-level workers are much more expensive to hire in Puerto Rico.

Additionally, the report found, social safety net benefits are, given the cost of living on the island and the relative earnings of minimum wage, more generous than on the mainland.

“Workers are disinclined to take up jobs because the welfare system provides generous benefits that often exceed what minimum wage employment yields; one estimate shows that a household of three eligible for food stamps, AFDC [Aid to Families with Dependent Children], Medicaid and utilities subsidies could receive $1,743 per month — as compared with a minimum wage earner’s take-home earnings of $1,159.”

One result is that only 40 percent of the adult population is gainfully employed, versus more than 60 percent in the mainland.

The report paints a picture of an island trapped in a vicious cycle. Poor economic growth, the result of past fiscal mismanagement, has led to an increasing need for deficit spending, which further depresses growth, perpetuating what Garcia Padilla has called a “death spiral.”

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http://www.vox.com/2015/7/1/8872553/puerto-rico-crisis

The Puerto Rico crisis, explained
Updated by Matthew Yglesias on July 1, 2015

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2) What is the "death spiral" Padilla is warning about?

The bad news is that Puerto Rico is really facing two separate death spirals.

One is the basic death spiral of self-fulfilling default risk. The more money you owe, the more likely it is that you won't be able to pay back all the money that you owe. That means that when your debts come due and you need new loans to pay off the old ones, investors start demanding that you compensate them for their risks in the form of higher interest rates. Those higher interests rates increase the financial burden on your country, and that in turn makes default more likely.

But the death spiral Padilla was referring to is a second one.

People generally don't like paying taxes but do enjoy receiving high quality government services. Consequently, a given territory's ability to turn tax revenue into useful services is an important driver of whether people will want to live and do business there. To the extent that your tax revenue is going to pay off old debts, it is not going to provide current services. Thus the more of your budget that you dedicate to debt repayment, the worse the value proposition that you are delivering to your territory's residents and businesses.

The harder Puerto Rico squeezes, in other words, the more its economy suffers. But the more the Puerto Rican economy suffers, the harder it is for Puerto Rico to pay back its debts. In other words: death spiral.
[As in Greece.]

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4) Who lent Puerto Rico all this money? What were they thinking?

A large share of the money was initially lent by people not so different from you or me — middle class Americans, especially those living in higher tax states. As for what they were thinking, they probably weren't thinking much of anything in particular.

They were just putting money away for retirement in municipal bond funds to diversify their portfolios.
[As financial "experts" tell them they should do.]

Those funds, in turn, were invested in a diverse array of US public sector bonds. Since Puerto Rican bonds feature some unusual tax advantages, there was an unusually robust level of demand for Puerto Rican debt. Successful Puerto Rican governments responded to demand for their debt in the economically rational way — they borrowed an unusually large amount of money.

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7) What went wrong for Puerto Rico?

Starting in 2006, the island has been hit by a series of negative shocks that have undermined its economy and its creditworthiness.

That was the year that Puerto Rico lost its longstanding federal tax advantages as a location for US companies to do business in. From 1986 to 1996, these took the form of special tax credits that were rationalized as a way to help Puerto Rico be competitive with developing countries as a manufacturing location, given that Puerto Rico-based firms need to comply with basic US labor rights and safety standards. But starting in 1996 these advantages were placed on a 10-year phaseout schedule and despite the hopes of Puerto Rican politicians (and tax break hungry business) they were never extended or replaced. That began an exodus of businesses from the island from which it has never really recovered.

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A related ongoing development is that in response to Puerto Rico's economic woes, Puerto Rican people have increasingly chosen to leave the island.

For any given individual, migrating to the mainland makes a lot of sense given the economic conditions on the island. But each person who departs leaves the people who remain with a higher share of old debts to repay. That makes the economic situation even worse and the debt even harder to pay.

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