Down for the Count?
by martin guzman
martin guzman, a research associate at Columbia University Business School and professor of economics at the University of Buenos Aires, is a fellow the Center for a New Economy, a nonpartisan think tank in Puerto Rico. A detailed analysis of Puerto Rico’s debt sustainability problem can be found in a paper written by the author with Pablo Gluzmann and Joseph E. Stiglitz.
Published April 27, 2018
Puerto Rico’s failure has been a long time coming. And the creation of a sustainable economy from the wreckage, one capable of brisk growth, won’t be much quicker – or come at all if the short-term thinking that saddled the island with a debt that is simply impossible to repay is allowed to dominate policymaking.
The outlines of Puerto Rico’s predicament are widely known. Last year, it became the largest bankruptcy case in the history of the tax-exempt municipal bond market, which was hardly a surprise since the island never recovered from the Great Recession. By no coincidence, large numbers of Puerto Ricans have been migrating to the U.S mainland. The pace of population decline, which shows no sign of abating, is virtually unprecedented outside countries in the grip of war. Then, of course, a direct hit by Hurricane Maria topped misery with more misery. And emergency assistance was scandalously slow.
Here, I offer a capsule view of what has gone so badly wrong and how massive debt cancellation is a necessary, if not sufficient, condition for stabilizing (and raising) the sinking ship.
The economy of Puerto Rico exists within a unique political framework, whose origins date back to the seizure of the island from Spain in 1898. Puerto Rico is a nonincorporated territory — it is part of the United States but does not belong to it. Local analysts often refer to the island as an Estado Libre y Asociado — that is, neither an estado nor libre nor asociado in any conventional way. As an American territory, Puerto Rico shares U.S. institutions; it operates under U.S. judicial, monetary and tariff systems. But island residents can’t vote in U.S. presidential elections and (in some recompense) don’t pay federal income taxes. Of course, it still takes lots of money to run the place; Puerto Rico operates its own tax system, by no coincidence one that mirrors the U.S. tax code. Another peculiarity, which both serves and debilitates the economy and society: free migration to the mainland provides an escape valve for the unemployed, but also invites a brain drain that undermines productivity and innovation, raises the unit cost of high fixed-cost services like electricity and sucks away tax revenue.
A Success Story, Undone?
While Puerto Ricans gained U.S. citizenship in 1917, the island’s transformation from colony to hybrid “commonwealth” did not come until 1952. What followed was a massive economic and social transformation within a single generation.
“Operation Bootstrap” — the Washington driven initiative that converted an impoverished agricultural economy into a middle-income one with a sizable urban industrial working class — was built on a number of advantages linked to Puerto Rico’s peculiar circumstances. The island’s hybrid political status gave its products unfettered access to mainland markets at a time when foreign competition was far less intense. And while wages were high by Caribbean or Latin American standards, they were significantly lower than on the mainland. That gave Puerto Rico a comparative advantage in the production of labor-intensive goods in an era in which labor costs were a much larger factor in competitiveness. Last but not least, Congress (and Puerto Rico’s own tax code) created incentives for U.S. manufacturers to build factories on the island.
Because Puerto Rico had been excluded from the bankruptcy code, it lacked a legal framework for ensuring an orderly resolution in which creditors and debtors would share the pain.
Puerto Rico’s government complemented the inflow of private capital with large investments in power, transport and water-and-sewer infrastructure, as well as in education and health. Life expectancy at birth rose from 68 in 1960 to 79 today, while the average years of schooling of Puerto Rican workers increased from 2.7 years in 1940 to 11 years in 2000.
But contrary to the dazzling development stories of East Asia, Puerto Rico stopped short of the transition to an advanced knowledge-based economy. And this left it hostage to circumstances beyond its control.
The economy started to fade in the 1970s, and the trend continued for decades. The reasons for the fade are still subject to debate. But a number of contributing factors are clear. For one thing, the relatively high-wage Puerto Rican economy never reached levels of productivity to make it competitive with rapidly industrializing economies in Asia that increasingly targeted U.S. markets. Meanwhile, tax subsidies designed to lure high-tech firms from the mainland fizzled in the sense that they left little of value for the local economy when they were phased out by Washington.
Even before the hurricane, per capita income (adjusted for purchasing power) was less than one-half that of the mainland. And, more ominous, the gap has grown in the last half-century.
Aggregate economic statistics reflect both a lack of opportunities and a collapsing population. Between the 2007 fiscal year and the 2016 fiscal year, the island’s output in real terms shrank by 14 percent and total employment declined by 17 percent. Meanwhile, the portion of the working-age population that was employed decreased from 41 percent in 2008 (at the onset of the Great Recession) to 36 percent in 2016, by which time the mainland economy was percolating along nicely.
The lack of employment opportunities, a significant decline in birth rates and, of course, Puerto Ricans’ legal right to live and work on the U.S. mainland have led to a significant decrease in the island’s population. Between 2010 and 2016, the population contracted at a rate exceeding 1 percent annually, and the decline approached 2 percent in 2016. (The figure is certain to be even higher for 2017, thanks to the hurricane and the botched relief effort.) Today, more Puerto Ricans live on the U.S. mainland than on the island.
Living On Borrowed Time and Money
Not surprisingly, the growth slowdown (and then reversal) undermined the tax base, and eventually both the central government and many municipalities began to run deficits. Big government-owned utilities with huge fixed costs were also affected deeply by deindustrialization: both the Puerto Rico Electric Power Authority and the Puerto Rico Aqueduct and Sewer Authority lost large high-margin customers with the closings of factories.
By 2005, the central government acknowledged the existence of a structural budget deficit approaching 2 percent of gross national product. (GNP is generally used in Puerto Rico instead of GDP because GDP is distorted by the transfer pricing policies of multinational companies.) Those structural deficits, of course, constitute only part of the red ink since the economy has been running well below capacity for a couple of decades.
The fiscal juggle ended in February 2014. The central government’s bonds and those of several state-owned corporations were demoted to below-investment grade, effectively blocking access to the bond market. With government agencies and state corporations unable to refinance payments falling due, and with tax revenues flat or declining, default was only a matter of time. The time in question was June 2015, when then-Governor Alejandro García-Padilla told The New York Times that the public debt of the territory was “not payable.”
How did the debt get this big before the plug was pulled? It takes two to tango. Puerto Rico’s elected officials were understandably reluctant to acknowledge that the government’s fiscal stance was untenable. But lenders also had incentives to continue lending (at increasing interest rates) as the repayment problems became visible to all who cared to look.
Puerto Rico bonds were an easy sell for decades. Thanks to the island’s quasi-colonial status, the bonds had unique triple-exempt status: no matter where they lived, owners were exempt from all state and local income taxes as well as federal income tax and taxes imposed by Puerto Rico’s government. This increased institutional demand for the bonds because they could fit into single-state municipal bond mutual funds without triggering tax liability anywhere. As important, this unique legal status, along with protections in Puerto Rico’s constitution, (mistakenly) led investors to assume their claims had priority over public employee wages and pensions. Thus, by the time institutional investors woke up, they were in too deep to extract themselves without incurring the wrath of their retail customers.
Feds to the Rescue?
Virtually everyone with a stake in Puerto Rican debt eventually acknowledged the need for some sort of restructuring. But unlike U.S. municipalities (think Detroit), Puerto Rico faced an additional – and crucial – obstacle: it did not have the right to default and seek protection against creditors under Chapter 9 of the U.S. bankruptcy law. Though no one seems to know why, the territory had been excluded from the bankruptcy code in 1984. Thus, Puerto Rico lacked a legal framework for ensuring an orderly resolution in which creditors and debtors would share the pain.
The experiences of sovereign-nation defaults suggest how problematic this legal fog can be. Sovereign debtors do not have access to anything remotely close to a bankruptcy framework. As a result, their debt restructurings are often delayed by standoffs with creditors. And, when these impasses are resolved, restructuring rarely provides enough relief to restore the economic viability of the distressed debtors – thereby slowing economic recovery and exacerbating social suffering.
One reason that default in a deficient legal framework is so costly is that it is fertile ground for “vulture funds” – hedge funds that buy debt on the cheap in circumstances of high distress and then typically resist collective settlement efforts by creditors in hopes of carving out special deals for themselves. Vulture funds kept Argentina hostage for more than a decade after the country’s massive economic crisis of 2001 and ended up making a killing at the expense of Argentina’s citizens. One of the funds that did so well in Argentina, it should be noted, is apparently trying for a repeat performance in Puerto Rico’s default proceedings.
Puerto Rico’s lawyers attempted to sidestep this threat of legal extortion by advising the commonwealth to pass its own bankruptcy law. But institutional bondholders fought back and succeeded in having the federal courts declare that law unconstitutional.
Finally, in June 2016 the U.S. Congress passed the Promesa statute, which translates as “promise” from the Spanish, but is just an acronym for the Puerto Rico Oversight, Management and Economic Stability Act. The statute, supported by a bipartisan majority, provides a legal framework for managing debt default that is similar to bankruptcy law.
But Promesa is more than just a tool for forcing creditors and debtors to share losses; the act also created a financial oversight and management board to make budget decisions for the island. Thus, to a considerable extent, Puerto Rico’s future is now in the hands of a group of nonelected technocrats who are not accountable to Puerto Ricans.
The first signs of what the board was planning were worrisome to those of us who understand that it would be self-defeating to impose draconian austerity in the midst of a deep recession. In January 2017, in an exchange of letters with Puerto Rico’s governor, the board demanded large cuts to both pensions and to education and health spending that probably would have sent the alreadyreeling economy into a near-fatal cycle of depression and depopulation.
But in March 2017, the board approved a more moderate 10-year fiscal plan. Moderate, however, is a relative term: it still projected negative economic growth over the decade. And even that projection seems overly optimistic since it was based on a number of questionable assumptions that led to an underestimate of the budget measures’ impact on economic activity. Two months later, the board acknowledged that the island’s debt could not be paid in full, finally filing a petition for the restructuring of Puerto Rico’s debts in federal court under Promesa. Nearly all of Puerto Rico’s indebted entities, including the electric power authority, have followed suit.
Murphy’s Law, Puerto Rican Edition
What happened next is no secret. Weather catastrophe, in the form of Hurricane Maria, followed close on the heels of budget catastrophe, leaving much of the island without electricity or potable water for months. But Maria did offer one small compensation: it put a human face on Puerto Rico’s suffering, making it more obvious and perhaps more acceptable to all stakeholders that the fiscal plan had to be revised.
In January, the government countered with a blueprint that reduced the planning horizon from 10 to 5 years — a sensible move considering that uncertainty about Puerto Rico’s prospects makes rigid commitments for long periods unrealistic. It also proposed to suspend all debt service for the next five years. And for good reason: any attempt to drain funds from the government’s already bare-bones operating budget would be counterproductive since it would render the economy even more dysfunctional and less likely to attract private capital or retain skilled labor.
One of the vulture funds that did so well in Argentina, it should be noted, is apparently trying for a repeat performance in Puerto Rico’s default proceedings.
The board rejected the plan in February, asking for clarifications and demanding new measures — including more structural reforms, the creation of an emergency reserve fund of $650 million over the next five years (at a time when Puerto Rico has no savings capacity) and a reduction of government workers’ fringe benefits. Details of the debt restructuring proposal are absent as this is being written.
Blood From a Stone
The reform Puerto Rico most urgently needs is a debt restructuring that restores the sustainability of the island’s public finances. Before Maria, my co-authors and I estimated that the debt reduction needed to fulfill this goal would be as large as 90 percent of the $72.2 billion of public debt. Post-Maria, that percentage is surely larger.
One other point here; whatever is paid should be linked to the future performance of Puerto Rico’s economy — possibly by indexing debt payments to GNP. This approach would align the incentives of the debtor and the bondholders, as the latter would receive more as Puerto Rico recovered. It would also reduce the chance that a second restructuring would be needed down the road; an underperforming economy would translate into lower debt payments, thus stabilizing the debt burden in relation to ability to pay.
Puerto Rico simply can’t pay its debts. The real question for public policy is whether the economy can be put on a track that restores hope for raising living standards.
Implementing a proposal that virtually wiped out the value of the debt would not be easy. For starters, some bondholders can be expected to oppose a settlement that Puerto Rico could live with in hope of carving out a better deal on the side. Beyond asserting the sanctity of contractual obligations (forget that the high yields reflected a high probability of default), they rely on a pair of arguments. First, Puerto Rico should pay more because a less favorable outcome for bondholders would prevent the island from borrowing in the future. Second, the effects of writing off the debt would be disastrous for the economy because part of it is held by Puerto Ricans of moderate means. Neither bears close examination.
Future access to credit will mostly depend on the market’s perceptions of Puerto Rico’s capacity for future debt repayment. The reputation argument is moot; no one is likely to lend money to Puerto Rico on an arm’slength basis again if the current unpayable debt is virtually wiped off the books. And while it is true that debt restructuring would be less expansionary than might otherwise be expected because a fraction of the debt is in the hands of residents of Puerto Rico, the net effect of debt write-off would still be expansionary. The logic is simple: a debt discharge is a transfer from the creditors, who on balance would spend a modest small fraction of the cash in Puerto Rico, to the debtors, who would invest or spend most of it locally.
There is yet another factor muddying the waters: Puerto Ricans remain deeply divided on the issue of the island’s future political status. Some are committed to statehood. And it would be a shame if influential Puerto Ricans did not push hard enough on debt issues because they feared that standing up to the creditors would sour their prospects of persuading Congress to grant statehood.
The timing of the restructuring will also matter. Speed is of the essence. The current uncertainty about the island’s future debt burden is bound to depress long-term private investment since investors must worry about the tax burden they will face. More subtly, uncertainty about debt settlement creates uncertainty about who will benefit from federal recovery assistance. Absent a liberal debt restructuring, federal aid that goes into the government budget could well end up in bondholders’ pockets.
It’s always tempting to cast the struggle over Puerto Rican debt as a test of the sanctity of contracts in the financial markets. But parsing fault in a bankruptcy in which all sides seemed oblivious to the consequences of creating a mountain of debt is not easy. And in this case, it is also unnecessary: Puerto Rico simply can’t pay its debts. The real question for public policy is whether the economy can be put on a track that restores hope for raising living standards.
The Long and Winding Road
Digging Puerto Rico out of its jam will require much more than imposing a plan that cuts the debt down to size and provides sufficient aid to rebuild infrastructure and to make life tolerable for all residents in the period of transition. While the damage of unsustainable debt, compounded by the destructive might of a 100-year hurricane, was the proximate cause of the crisis, it took decades of dysfunction to fritter away the island’s capacity to pay its bills.
Once the dust has settled, the decisive question for Puerto Rico is how to break out of the vicious cycle of stagnation and depopulation. Though you wouldn’t know it from a cursory scan of the news these days, Puerto Rico still has a lot going for it: talented professionals, remarkable physical beauty, vibrant culture, unique access to the U.S. economy. Step 1 to recovery, helping Puerto Rico to rise from the wreckage left by financial mismanagement and catastrophic weather, will be tough. Step 2, the creation and implementation of a vision for development that unites Puerto Ricans, will be a lot tougher. But it is possible.