Puerto Rico’s Slide
Puerto Rico has the population of Oklahoma and an economy smaller than Kansas. It also has more debt — $70 billion — than any U.S. state government except California and New York. This fact and the reasons behind it help explain why the territory has tumbled over a fiscal cliff, and why the resulting dismay extends to investors far beyond the Caribbean island. It’s a tale of financial mismanagement, Wall Street complicity and good intentions gone awry.
On June 29, the U.S. Congress passed final legislation that created a financial control board to manage the restructuring of Puerto Rico’s debt, oversee its finances and enforce balanced budgets. President Barack Obama signed the bill — the largest federal intervention ever into the U.S. municipal bond market — on June 30. On July 1, when $2 billion in principal and interest was due, Governor Alejandro Garcia Padilla announced Puerto Rico would skip $911 million of these bond payments. Washington took action after Puerto Rico stated in 2015 that it was unable to pay its borrowings and the defaults began to pile up. The island’s plight 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 about half of open-end muni funds. 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 same combination that brought New York City to the brink of bankruptcy in the 1970s.
Wall Street smoothed the island’s path to fiscal debacle, reaping more than $900 million in fees to manage Puerto Rico’s $126.6 billion of bond sales since 2000. 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 proceeds. These helped the government, which employs more than a quarter of the workforce, put off cuts. Puerto Rico, ceded to the U.S. in 1898 after a war with Spain, has a special tax status that dates to 1917 and the passage by the U.S. Congress of the Jones-Shafroth Act. It has relied on tax breaks to drive economic development, attracting 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, the island’s economy has contracted every year except one and its poverty rate is double that of Mississippi, the poorest state. The population, now about 3.5 million, is shrinking and forecast to reach a 100-year low by 2050.
The financial control board, made up of four Republicans and three Democrats chosen by Obama from a list provided by congressional leaders, is aimed to help Puerto Rico make the politically unpalatable decisions needed to repair its public finances. The island-wide government pays for schools and education — items normally handled by local communities in the states — and agencies that provide water and electricity are intertwined with the territory’s funding. Puerto Rico has already closed scores of schools and proposed tightening an inefficient tax collection system, though critics say it hasn’t done enough. The Obama administration and Garcia Padilla had called for federal oversight paired with a plan to give the island access to an orderly bankruptcy process that would help cut its liabilities and avoid protracted litigation. Bond investors and insurers had opposed this because it could force them to take losses; the conservative Heritage Foundation characterized it as a bailout. While the Congressional bill doesn’t provide any additional funding, it will allow Puerto Rico to turn to federal court to cut its obligations and put creditor lawsuits on hold.
The Reference Shelf
- Text of the 2016 Congressional bill: Puerto Rico Oversight, Management, and Economic Stability Act or ‘‘Promesa.’’
- 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.
- 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.
- Bloomberg View contributor Stephen Mihm traces the history of how Congress decided to strip Puerto Rico’s recourse to municipal bankruptcy law.
First published Feb. 11, 2014
To contact the editor responsible for this QuickTake:
Anne Cronin at email@example.com