The public sector of Puerto Rico is in deep trouble. A number of public corporations are insolvent. Some are on the verge of bankruptcy. Restructuring may mean substantial haircuts to bond holders and rate increases to public utility consumers. Public employees and teacher’s pension funds are rapidly approaching insolvency. Governor Alejandro Garcia Padilla’s fiscal team has tackled a number of politically costly revenue enhancement, i.e., tax measures. Revenue wise, however, these measures have proved lacking. Now, tax reform is the buzzword in fashion.
The economy of Puerto Rico has been stagnant for nearly a decade. In fact, for eight years the economy has continued to contract. Labor force participation has sunk. Increasing public expenditures have masked the seriousness of the situation. As public and private investment declined, productive capacity has deteriorated. For decades, aggregate demand has been overstimulated through government deficit spending. Financing deficit spending has reached its limits.
Unfunded liabilities of government pension systems were only partially met by legislative action. Not even recently legislated contributions to the public employees retirement system have been disbursed. In fact, these funds were stopped through an executive order. Several sections of the teacher’s pension system were found unconstitutional. No legislative remedy has been filed yet.
Net migration is reducing resident population. Family financial and real assets have suffered substantially in market value. As a result, the middle class is suffering. Social mobility is now a one-way street going south.
Economic development has stopped and is going in reverse gear. The shrinking real economy is reflected in the government’s fiscal and financial conditions. The fiscal response has been limited mainly on increasing taxes and user fees. The structural nature of imbalances and political realities have made expenditures extremely difficult to control. If at all, they have increased.
Currently the municipal tax-exempt bond market is closed to the Commonwealth of Puerto Rico. Commonwealth debt has been classified at junk levels. Credit quality is about credibility. Credibility is about confidence. Puerto Rico´s credibility is today at stake. In fact, I cannot honestly recall any other time when Puerto Rico’s credibility was at such lows. At the root of this calamity we find politics. Populism has finally taken its toll. Politicians find fertile ground when crisis conditions prevail. Let me provide an example of the way politicians contribute to make matters even more difficult. Political discourse and government decisions are contributing to make matters worse. For instance, legislators pop up to call for a default on debt service as a remedy to fiscal difficulties. A local statute is legislated in record time to enable certain Puerto Rico’s public corporations to file for bankruptcy in local courts. Several unfortunate pronouncements made by the Governor have strengthened the perception that debt servicing is now at a lower priority level, compared to providing services and adjusting rates.
This may get worse as more and more investors begin to learn that the Governor is calling it “immoral” to pay legal obligations. The policy now appears to be that it is more important to pay for social welfare programs than to abide by contracts. All this, in reaction to a court judgment. This will – and I am sure that it has – send shivers through Wall Street, raising questions as to whether Puerto Rico is still a safe place to invest and to do business with. Even as Puerto Rico is trying to attract wealthy investor residents with succulent tax incentives, chauvinistic and populist vocabulary will only bring Argentina to mind.
More sophisticated discourse has been emanating from the so-called sovereign wing of the governing party. The ex governor, Anibal Acevedo Vila has recently published a book in which he formulates what he refers to as an economic proposal to the US federal government. The ex governor’s proposal is portrayed as a first step that would eventually lead to the resolution of the status dilemma. In a nut shell the proposal calls for the US federal government to buy the Commonwealth’s outstanding debt at current market prices. In return, Puerto Rico would forgo annual adjustment to certain federal transfer payments. Excluded from this waiver would be those transfer payments that emanate from social security, veterans pensions, and other programs for which individuals were subject to periodic wage bill retentions.
Foregoing a thorough analysis of the ex governor’s proposal, the fact is that it centers on what is nothing more than a bailout of the Commonwealth by the federal government. Publication of Acevedo Vilas’ book and the centrality of the proposed bailout skim, reinforces the perception that there is a growing political faction within the governing party that contemplates default as a practical solution. Something that would have been unthinkable just a year ago.
Complacency may lead some to believe that the Commonwealth can raise endless amounts of money at 7.75% interest. However, even at that steep price, Wall Street will not continue to feed the beast forever. Notice that in the most recent bond offering there are substantial new requirements. For instance, conflict resolution will take place under New York law. The Commonwealth must extend guarantees for future Government Development Bank (GDG) and GDB related offerings.
Puerto Rico needs to confront reality. The answer lies on the supply side, not on the demand side. Production, not consumption, is the key. The current logic of government spending, together with limited access to the bond market, makes it unlikely that the Commonwealth will be able to honor debt service requirements and pension liabilities in the coming years. Confronting this reality is not synonymous with default as an option. No doubt, hard work and sacrifice will be required. Only economic opportunity and a decent standard of living will stop migration. Population loses will place a heavier burden of debt service on the resident population. Eventually, social upheaval will reign loose.
The systemic implications for the bond market of a Commonwealth default on its $73.4 billion debt must be addressed before it happens. Ignoring the crisis will only assure that it will gain systemic proportions. The solution to the debt problem must come from a combination of expenditure reductions and a sustained rate of private-public investment. A smaller government sector, together with the expansion of productive capacity, are the key. No doubt this will require a new tax structure. Current tax policy is biased against income earners, saving, and investment. The opposite is needed. However, in the short term, that will not be enough. To assure putting in place an expansion of productive capacity, the federal government must be willing to help. Otherwise, populism and demagoguery will inexorably drive the Commonwealth to oblivion.