Puerto Rico at a Crossroads

Puerto Rico

Concern about the balance sheets of American cities and states has started to recede as the economy improves, but the U.S. territory of Puerto Rico is facing a crisis thanks to a stagnant economy, high unemployment, yawning budget deficit and underfunded pensions.


Two of the three major ratings agencies have downgraded the commonwealth’s widely held debt in the past few months citing public sector pensions with lower funding levels than any U.S. state and a budget gap that Moody’s Investors Service, which downgraded Puerto Rico’s debt in December, recently said had doubled to $2.2 billion.


“We believe the shortfalls against (the) budget in fiscal 2013 will make it difficult for the commonwealth to achieve structural balance in the next two years,” Standard & Poor’s credit analyst David Hitchcock said in a statement earlier this month, when the agency lowered the island’s credit rating to just above junk status.


A below-investment-grade rating would put the U.S. commonwealth at risk of losing access to bond markets, lower the value of its bonds and affect the liquidity of financial institutions and insurance companies, according to Sergio Marxuach, of the island’s Center for a New Economy, an independent think tank based in San Juan.


“It would be a whole different ball game for Puerto Rico,” Marxuach told The Financialist. “You’re talking about losing access to the U.S. capital markets. There’s always someone willing to lend to you at 17 to 18 percent … but we really cannot afford those rates anyway.”


“That means that the government really would have to start cutting expenses and laying off workers, which would have a detrimental effect on the economy.”


Investors would also feel the burn. Nearly 80 percent of the 570 municipal bond funds tracked by Morningstar are exposed to Puerto Rico debt, the Wall Street Journal reported recently.


“I think the rating agencies realize that Puerto Rico is an important player in the bond markets, and if Puerto Rico were to be downgraded below investment grade, that would trigger a sell-off and really cause a problem in the markets,” Carlos Colón De Armas, a finance professor at the University of Puerto Rico, told The Financialist. “I think they have to be commended for that kind of patience, but I think Puerto Rico has to get its house in order.”


The added pressure could hardly come at a worse time. The island faces a $745 million debt payment this year, which officials had hoped to refinance, according to Moody’s. But that might prove difficult with the debt rating in question. In addition, the sequester has cut federal funding to the island.


Puerto Rico is also wrestling with tough economic and demographic challenges. The commonwealth has been in recession since 2006, and the population is declining as islanders seek better prospects elsewhere. Unemployment reached 14.4 percent in December.


“Some economic indicators, such as retail, auto and cement sales … have stabilized or are now trending up for the first time since 2006,” Moody’s wrote in its downgrade note in December. “But they are improving off a very low base and reflect what is still essentially a weak economy that is not likely to be able to absorb much additional stress.”


Democratic Governor Alejandro Garcia Padilla has proposed pension reforms that would cut the commonwealth’s $33 billion unfunded public pension liability – four times the size of the annual budget, Moody’s says – by increasing employee contributions and raising the retirement age.


But the legislature has yet to pass the reforms and also must address the current year’s budget gap.


“All the members of Governor Garcia Padilla’s fiscal team are aware of the gravity and urgency of the moment,” Government Development Bank for Puerto Rico President Javier Ferrer said in a statement after the S&P downgrade. “We have been working very hard to increase collections, stabilize the finances, restore the credit and revamp economic development for the island.”


Puerto Rico has already made significant cuts, and the current fiscal year’s budget is 11 percent lower than the one in 2010, according to Moody’s. Marxuach said the government has talked about one-time measures to raise revenues this year, but that would leave the commonwealth with another budget challenge next year.


Ultimately, the island’s recovery relies on restoring growth.


Marxuach said Puerto Rico’s advantage over neighboring countries in providing access to U.S. markets faded after the passage of several free trade agreements, including one with Mexico. Better use of public-private partnerships, he said, could be a way to spur further foreign direct investment.


Colón de Armas, the University of Puerto Rico professor, said he believed the commonwealth’s economic problems stemmed from relying too heavily on offering tax incentives to entice big businesses.


“By putting all the emphasis on outside capital, we have burdened local firms with high tax rates and regulatory processes, and therefore we do not have the environment that needs to be created for local businesses to grow and really participate in global markets,“ he said.


That, he said, is not something fiscal tightening can fix.


“I think what you are looking at is an economy that really needs a major overhaul,” Colón de Armas said.


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