Stranded at Sea: Puerto Rico’s Debt Crisis

As Puerto Rico barrels toward a default on $70 billion in public debt, investors and politicians are concerned about how to save the U.S. territory. Historical prescriptions to avoid a default are not feasible within the current law. The inevitability of default in Puerto Rico renders the timing of the default instrumental in determining the island’s economic future.

By Zachary Toal
Contributor
December 16, 2013

Puerto Rico is the latest quandary in a growing queue of Caribbean debt issues. In an effort to manage the current debt crisis, the U.S. government recently announced it would be sending a task force to advise Puerto Rico on how to efficiently use its federal funds. The U.S. territory’s decade-long crisis is a mirror image of Detroit’s debt problems, exacerbated by shrinking tax revenue and overwhelming debt. Puerto Rico and Detroit, as well as many heavily-indebted, poor countries in the Caribbean, are in dire need of debt restructuring and structural reforms. But while Detroit’s bankruptcy filing and the Caribbean’s access to the International Monetary Fund may be their saving grace, life support appears to be out of reach for Puerto Rico. How and when Puerto Rico approaches a default on its $70 billion in public debt will influence its long term sustainability.

The current debt crisis in Puerto Rico is a result of heavy borrowing over the last ten years to finance a budget deficit borne from a lingering recession. In 2006, a federal tax break for U.S. corporations with operations in Puerto Rico expired and was not renewed by Congress. Businesses, particularly pharmaceutical and manufacturing firms, fled the island in response. Puerto Rico’s economy has since contracted by nearly 16 percent and its budget deficit stands at over 2.2 billion dollars . As the territory issued more debt to cover its deficit, its ability to pay interest on the new bonds came into question. Despite this heightened risk, investors in the United States continued to purchase the bonds because the interest payments on those bonds are exempt from federal, state, and local taxes. This tax exemption offered higher returns for U.S. pension fund managers, who then filled their low-risk municipal bond funds with high-risk Puerto Rican debt. Today, three out of every four municipal bond funds hold Puerto Rican debt. The retirement income of many U.S. workers, who invested a portion of their paychecks in these trusted pension funds, is exposed to a significant amount of risk.

Puerto Rico’s response to its rising budget deficit and debt levels has been similar to that of Greece during its debt crisis. The territory cut government spending and raised taxes on its residents. However, the response has only served to further cripple the territory’s economy. With an unemployment rate higher than any U.S. state, Puerto Rico has seen its residents leaving the island in search of opportunities in the comparatively better job markets on the mainland. This shrinking tax base, along with high unemployment in a population known for its welfare benefits, directly competes with Governor Alejandro Padilla’s monumental tax increases and with his adjustments to government employment. Even if Governor Garcia Padilla is able to eliminate the budget deficit – a lofty task – analysts expect that interest payments on Puerto Rico’s outstanding debt will consume at least twenty percent of its budget, leaving little for spending on economic growth. The island’s foremost concern should therefore be eliminating the shadow of debt hanging over its diminished economy.

Puerto Rico’s options for addressing its interest burden, despite many historical models available, are not as straightforward as refinancing its debt. One well-known method of refinancing debt is to file for bankruptcy like Detroit. Incidentally, U.S. laws prevent its states from going bankrupt. Because the U.S. Constitution declares its territories and states as identical under the pertinent laws, Puerto Rico may not explore legal policies to refinance its debt. A second historical model common in heavily indebted poor countries in Africa and the Caribbean is to request temporary loan assistance from the International Monetary Fund in order to compensate bondholders in the short term for reduced interest rates in the future. U.S. laws, in conjunction with theInternational Monetary Fund’s mandate to serve only its member nations, exclude Puerto Rico from approaching international institutions for debt relief assistance. Alternatively, bondholders could agree to a voluntary cut on interest payments to avoid a default, but this is unlikely due to the large number of creditors demanding to be repaid. The island’s remaining option is to request some form of federal bailout from the U.S. government. However, this would be widely unpopular and expensive for U.S. taxpayers, who are already concerned for their national government’s budgetary situation. At the end of the road, though it may be painful, choosing to default on $70 billion in debt may be the only outcome left for Puerto Rico.

Greece proved in the Eurozone’s recession that defaulting as early as possible saved the region from a much more systemic crisis. Puerto Rico must follow suit. The island’s creditors – and, ultimately, U.S. taxpayers – will be protected. Puerto Rico’s constitution and Governor Garcia Padilla all but guarantee that the government will compensate bondholders in the event of default. And while Puerto Rican pensioners and government employees will undoubtedly suffer losses in the short term, the island’s economy is already more dependent than all 50 U.S. states on government employment and benefits. The government will be forced to implement unpopular structural reforms and develop organic, domestic sources of economic growth, rather than borrowing to cover up fiscal shortcomings.

Access to capital is essential for the island’s small and under-developed economy, but it can also be toxic. If Puerto Rico maintains its current path and attempts to circumnavigate a default, it may end up stranded and cut off from capital markets in the near future. Although unfortunate, an immediate short term adjustment is essential to reverse Puerto Rico’s injurious course.

Zachary Toal is a M.A. candidate at the Elliott School of International Affairs in the International Affairs program, concentrating on global finance and economic policy. He previously earned his B.A. in international security and European studies at the University of North Carolina in Chapel Hill.

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