Puerto Rico’s Slide
Puerto Rico has the population of Connecticut and an economy smaller than Nebraska’s. It also has more debt — $70 billion — than any U.S. state government except California, New York and Massachusetts. 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.
The federal oversight board that the U.S. Congress created in June 2016 to manage Puerto Rico’s finances has filed a bankruptcy-like case to slash the island’s debt. This would be the biggest restructuring ever by a U.S. state or local government. It followed Puerto Rico’s failure to craft a restructuring deal with its creditors by May 1, when a temporary reprieve against litigation ended; suits were filed the next day. In March, the board approved Puerto Rico Governor Ricardo Rossello’s proposal to deal with the debt crisis, though it would cover less than a quarter of the debt payments due, even if the governor’s plans to cut the size of government and increase revenues collections comes to pass. In April, Congress approved a stopgap budget bill that will provide $295 million in Medicaid payments to keep the health-care system running. The oversight board was the result of the largest federal intervention ever in the U.S. municipal bond market. 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 President Barack Obama from a list provided by congressional leaders, was supposed to help Puerto Rico make the politically unpalatable decisions needed to repair its public finances. The Congressional bill creating the board also allowed Puerto Rico to turn to federal court to cut its obligations in a bankruptcy-like proceeding, known as Title III. The restructuring will have to balance the government’s obligations to bondholders against those to public workers and retirees. It will also have to make hard decisions about services that touch all residents. 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 idea of additional service cuts isn’t popular: May Day protesters in San Juan, the capital, directed their anger at the governor: “Ricky is selling the island!”
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’s blog, Liberty Street Economics, has explored issues like household debt and which workers were leaving the island in search of opportunity.
- The Center for a New Economy, a San Juan think tank, collects ideas for economic reforms.
- National Public Finance Guarantee Corp., a bond insurer, reported on risk factors affecting Puerto Rico.
- Bloomberg View contributor Stephen Mihm traced the history of how Congress decided to strip Puerto Rico’s recourse to municipal bankruptcy law.
- A Bloomberg news profile of Governor Ricardo Rossello.
Martin Z. Braun and Tatiana Darie contributed to earlier versions of this article.
First published Feb. 11, 2014
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