Puerto Rico has the population of Oklahoma and a gross domestic product smaller than Kansas’. It also has more debt, $72 billion, than any U.S. state government except California and New York. This fact and the reasons behind it help explain why the island has tumbled over a fiscal cliff. And why the resulting dismay extends to investors far beyond the island’s borders. It’s a tale of financial mismanagement, Wall Street complicity and good intentions gone awry.
Like a consumer using one credit card to pay off another, Puerto Rico had been borrowing to pay its debts as they came due. In June, Governor Alejandro Garcia Padilla said the jig was up: The island commonwealth’s debt can’t be paid. Padilla said the island would develop a debt-restructuring plan to delay payments by “a number of years” by Aug. 30. Market reaction was swift — prices on Puerto Rico’s newest general obligation bonds sank to record lows. As Puerto Rico’s credit ratings have eroded, it has turned to hedge funds, distressed-debt firms and corporate high-yield funds to lend it money. Puerto Rico’s plight also affects most people with a mutual fund invested in the municipal bond market. Unlike the bonds of most states and municipalities, Puerto Rico’s are exempt from local, state and federal taxes everywhere in the U.S. As a result, they are held by 52 percent of open-end muni funds, according to Morningstar Inc. The competitive advantage made it easy for Puerto Rico to double its debt in 10 years by selling bonds to plug annual budget deficits and pay for operating expenses — the combination that brought New York City to the brink of bankruptcy in the 1970s.
Wall Street smoothed Puerto Rico’s path to fiscal debacle. After the U.S. territory adopted a sales tax in 2006, investment banks worked with officials in San Juan to create new bonds backed by a portion of the tax. Banks including UBS, Citigroup and Goldman Sachs reaped more than $900 million in fees to manage Puerto Rico’s $126.6 billion of bond sales since 2000. These helped the government, which employs more than a quarter of the workforce, put off cuts. The island’s bond rating had fallen below investment grade in March 2014 as it issued $3.5 billion of general obligation bonds. The idea was to balance the budget, refinance debt and buy time to revive a shrinking economy. But it paid dearly, as these junk-rated bonds had an 8.7 percent interest rate. Like U.S. states, it can’t file for bankruptcy. Puerto Rico’s special tax status dates to 1917 and the passage by the U.S. Congress of the Jones-Shafroth Act. Puerto Rico, ceded to the U.S. in 1898 after a war with Spain, has relied for 50 years on this and other tax breaks to drive its economic development. The incentives attracted pharmaceutical, textile and electronics companies. The U.S. phased out the incentives from the mid-1990s to 2006, contributing to the loss of 80,000 jobs. Since 2006, Puerto Rico’s economy has contracted every year except one and its poverty rate is now almost double that of Mississippi, the poorest state. As jobs disappear, more Puerto Ricans are leaving. Population is heading toward a 100-year low by 2050.
Puerto Rico faces the difficult prospect of boosting its economy while fixing its public finances. Since taking office in 2013, Garcia Padilla has moved to raise excise taxes and expand the sales tax base, and to restructure public pensions and reduce the deficit. At the same time, the Puerto Rican government created tax breaks to entice non-residents to move to the island and invest. New residents are exempt from Puerto Rican taxes on interest, dividends and capital gains. Businesses that move and provide services for clients outside of Puerto Rico pay a 4 percent tax rate. Sergio Marxuach, policy director at the Center for a New Economy, a think tank in San Juan, says the government needs to cut spending on services, reduce business tax credits and increase investment in education, infrastructure and technology.
The Reference Shelf
- The Federal Reserve Bank of New York made recommendations for improving Puerto Rico’s competitiveness in 2014.
- Puerto Rico put forward its economic development and budget plans in presentations aimed at potential bond investors from 2006 to 2013.
- The Center for a New Economy, a San Juan think tank, collects ideas for economic reforms.
- National Public Finance Guarantee Corp., a bond insurer, reports on risk factors and trends affecting Puerto Rico.