Puerto Rico's Deteriorating Fiscal Situation

Background

Puerto Rico now has approximately $72 billion in debt outstanding; $15,637 on a per capita basis. This is more than ten times higher than the average per capita debt of the fifty states (Puerto Rico has the same amount of debt as New York state, but the population of Connecticut). The economy has been shrinking and in recession since 2006.  It has an unemployment rate above 12%, more than twice that of the mainland. The island continues to experience substantial population emigration.

In 2014, the Puerto Rican government passed a law seeking to give itself the equivalent of Chapter 9 bankruptcy protection. Federal courts at both the district and appeals level struck down the law.  The U.S. Supreme Court is expected to hear the case in March.

The island’s government faces significant debt payment deadlines early in 2016.  A major default is likely (Puerto Rico already failed to make a 2015 interest payment on a bond that is neither high in the capital structure nor widely held). On January 1, nearly $1 billion in interest payments come due, including on General Obligation (GO) bonds guaranteed by the island’s constitution. Subsequently, on May 1, 2016, approximately $422 million is due to holders of bonds issued by the Government Development Bank (GDB). In the words of Puerto Rican Governor Alejandro Garcia Padilla, his government is "very, very unlikely" to avoid a default.

Puerto Rico, a U.S. territory, is not subject to U.S. bankruptcy laws like the fifty states, leaving Congress with the Article IV constitutional power “to dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States.”  The task of determining the proper resolution of a large Puerto Rico default is complicated by the massive amount of debt its government and several related entities have issued.  For example, holders of constitutionally protected GO bonds are likely to have materially different treatment versus holders of unprotected debt issued by the Puerto Rico Electric Power Authority (PREPA).  Further complicating the matter is that some bonds are backed by dedicated tax revenues (COFINA) that may give those holders the right to dispute or reclaim payments to holders of other parts of Puerto Rico’s capital structure. Resolving these issues in an orderly process will be daunting.

The Bigger Picture

Debt crises and defaults, whether in the public or private sector, are usually symptoms of larger dysfunction.  Default is merely the proximate trigger to a long succession of poor decisions and lack of forethought. Rarely does simply refinancing produce a sustainable plan without correcting the deficiencies that caused the problem.

Puerto Rico, like Greece, is a perfect example of the “Blue State model”—favoring unions, public sector employment, and government-induced investment—gone horribly wrong. Its economic failure and the resulting debt crisis are products of years of bad public policy. 

The U.S. government has played a meaningful role in undermining the island’s economy

Minimum Wage:  Starting in 1974, Congress set Puerto Rico on the path of matching the mandated U.S. minimum wage by 1983.  The result: by 1992, the U.S. level of minimum wage dominated the island’s earnings distribution, which, according to the National Bureau of Economic Research, reduced total employment in the commonwealth by 8-10%.  The costs were felt most strongly in the low-wage industries, driving an earlier wave of migration of the unskilled labor force to the mainland. Today, Puerto Rico’s local income and productivity are significantly below Mississippi (the poorest state), with the minimum wage equal to 77% of per capita income.

Jones Act:  As an island, Puerto Rico relies extensively on shipping trade.  The Jones Act artificially raises Puerto Rico’s economic costs, making its economy less efficient.  While a myriad of special interests in the United States insist on the value and necessity of the Jones Act, the fact is the U.S. does not apply the Jones Act to the nearby U.S. Virgin Islands.   

Federal Reserve Interest Policy:  Investors’ search for higher yielding tax-exempt bonds in the near-zero interest environment after the global financial crisis enabled Puerto Rico to finance its operating budget shortfalls with cheap debt.  Since 2008, Puerto Rico’s government has managed to double its debt levels without investing in its future, producing nearly zero GDP growth and a debt level that exceeds 100% of its GDP. 

Obama’s Cuba Policy Hurts Puerto Rico:  The effort to open diplomatic ties and expand economic relations with the oppressive, communist Castro regime will likely further constrict Puerto Rican tourism, undermining 7% of Puerto Rico’s GDP.  Every opened flight to Cuba will likely reduce on the margin the number of U.S. tourists traveling to Puerto Rico.   Those tourists will pay Castro at the expense of Puerto Ricans.

The Puerto Rican government has never adjusted to its changing reality

The island’s government has contributed substantially to its economic malaise and fiscal disorder.  It has long promoted European-style vacation and labor laws.  Utilities are government-controlled, possibly corrupt, and operate both inefficiently and expensively, passing through bloated operating costs to the island’s economy.  A complex bureaucracy makes it difficult and costly to start and operate businesses. A 50% increase in the sales tax in 2015 to fund the government mostly helped the government incur more debt.  The island’s government never adapted to the end of forty years of tax incentives the U.S. Congress provided Puerto Rico in the 1950 to diversify its sources of economic activity.

To the contrary, the government allowed public sector unions to secure extremely generous benefits, financed by cheap debt rather than economic growth. The result,  a government bureaucracy composed of nearly 25% of the island’s workforce that supports high welfare benefits and reduces the propensity to work (a whopping 40% of the island’s personal income comes from government transfer payments).

Finally, the Puerto Rican government has failed to issue audited financial statements since 2013, making it difficult to determine the full scope of the island’s current fiscal condition.

The Federal Government's Response to Date

The Obama administration has requested congressional assistance for Puerto Rico, arguing that the island is facing a humanitarian crisis. On October 21, the eve prior to a Senate Energy and Natural Resources Committee hearing on the topic, the administration released a legislative proposal that included four central elements: bankruptcy protections for restructuring of both municipal debts and the debts of the entire territory (so-called “Super Chapter 9”); a quasi-independent federal fiscal control board to oversee the implementation of the recovery plan; increased funding to the commonwealth’s Medicaid program; and access to the Earned Income Tax Credit and Child Tax Credit.

Democratic members in both the House and Senate have offered legislation to extend Chapter 9 bankruptcy protection to the island's municipalities and parastatals.  No Republicans have co-sponsored any of these bills. Only Rep. Sean Duffy (R-WI) has introduced a bill, the Puerto Rico Financial Stability and Debt Restructuring Act of 2015, that provides the same extension of Chapter 9 authority as earlier Democratic-sponsored bills. Rep. Duffy’s bill, however, is contingent on the Puerto Rican Legislative Assembly and governor cooperating to pass a law accepting a five-member independent financial stability council to oversee the island's financial planning and annual budgets.  Puerto Rico's sole non-voting member of the U.S. Congress, Pedro Pierluisi, has publicly expressed his significant concerns about this bill, undermining the only Republican openly supporting a potential Chapter 9 provision.

On December 9, Republican Senate committee chairs Orrin Hatch (R-UT), Lisa Murkowski (R-AK), and Chuck Grassley (R-IA) introduced the Puerto Rico Assistance Act of 2015. This bill is divided into six separate sections that cover: a payroll tax cut for workers on the island; reforms to both Puerto Rico and mainland state and local government pension plans; the establishment of a control board called the Puerto Rico Financial Responsibility and Management Assistance Authority; three studies and reports on the healthcare situation on the island; $3 billion in transition assistance to stave off default in January, which is taken from the Prevention and Public Health Fund created by Obamacare; and authorization for the Federal Reserve Bank of New York and other federal agencies to offer technical assistance.  The most important aspect of the bill is what it does not include, authorization for any bankruptcy protection for Puerto Rico or its parastatals. Moreover, it explicitly states, on pages 38 and 149 of the bill, that existing bonds must be repaid to creditors.

As part of the recent FY16 omnibus spending negotiations, Democratic lawmakers pushed hard to include assistance for Puerto Rico in the legislative package, particularly the extension of Chapter 9 bankruptcy protection. The final bill did include some financial assistance to the island through modified Medicare payment rates.  Although helpful in humanitarian terms, those Medicare changes are certainly not enough to materially address the commonwealth's looming defaults.  At least in part to assist House Minority Leader Nancy Pelosi's (D-CA) efforts to whip support for the omnibus spending bill among her members, House Speaker Paul Ryan (R-WI) released a statement saying, "While we could not agree to including precedent-setting changes to bankruptcy law in this omnibus spending bill, I understand that many members on both sides of the aisle remain committed to addressing the challenges facing the territory. That's why I am instructing our House committees of jurisdiction to work with the Puerto Rican government to come up with a responsible solution by the end of the first quarter of next year."

This statement very well could foreshadow the introduction of legislation in the House early this year similar to that already introduced by Senators Hatch, Murkowski, and Grassley. Following Ryan's statement, Senate Minority Leader Harry Reid (D-NV) gave a speech on the Senate floor in which he said, "Senate Democrats are ready to work across the aisle towards a real solution for Puerto Rico with the understanding that any viable plan will include a federal process that allows Puerto Rico to adjust its debt."  Thus, the Chapter 9 issue remains a key sticking point in the development of any bipartisan legislation.

On the final day of last year’s session, Minority Leader Pelosi took to the House floor and asked for unanimous consent to consider the Puerto Rico Emergency Financial Stability Act, which would create a short-term stay on creditor litigation until Congress could return to consider Puerto Rico-specific legislation as promised by Speaker Ryan. Senate allies, including Minority Leader Harry Reid and Senators Chuck Schumer (D-NY) and Elizabeth Warren (D-MA) followed suit, but only after the Senate had recessed.

Recommendations for Congress

We strongly believe that any congressional action that addresses Puerto Rico's deteriorating fiscal situation should take into account the following:

Financial transparency.  The omnibus spending legislation did provide for further technical assistance from the Treasury Department and Federal Reserve Bank of New York.  But first, it is necessary to understand and publicly disclose the full scope of the problem to devise any effective solution. Congress should direct Puerto Rico to prepare updated audited financial statements by a date certain. If the auditors working on the island continue to be unable to render a decision due to island-based governmental obstruction, Congress should use its subpoena powers to compel delivery of all necessary financial documentation to the auditors as soon as possible—the people of Puerto Rico, U.S. taxpayers and creditors deserve to know the true extent of the problem.

Enforcement mechanisms for budget management and revenue collection. Whether or not a full control board or a modified version is implemented, there needs to be some effective means to ensure that the government of Puerto Rico is forced to make the difficult budgetary choices it faces and that its fiscal profligacy will not be repeated in the future. These enforcement mechanisms would also include a prohibition on no-bid contracts, regular audits of the island's agencies and departments, and a cessation of hiring any new public servants or contractors.  The contracting situation is rife with corruption as evidenced by the recent uptick in FBI arrests and investigations, and amazingly the government continues to expand its payroll and contracting despite public statements of a lack of available funds to meet existing debt obligations.

Financial assistance through pro-growth policies. Any financial assistance provided by the federal government to Puerto Rico should not be in the form of a bailout, but rather should promote policies that facilitate long-term economic growth. An example of such a policy is the payroll tax cut included in the legislation sponsored by Senators Hatch, Murkowski, and Grassley.  Other policies could include reforms to the labor market to encourage increased labor force participation and uncoupling Puerto Rico from the national minimum wage.  Extending the federal Earned Income Tax Credit should not be considered because Puerto Ricans do not pay federal income taxes, though a private sector work-rewarding credit for domestic taxes paid should be considered.

A stay in considering Chapter 9 bankruptcy protection. Although Democrats in Congress argue that extending Chapter 9 bankruptcy protection is integral and even paramount to resolving the Puerto Rican debt crisis, it is impossible to identify a meaningful and comprehensive solution without first obtaining a full accounting of the scope of the island’s financial problems.  Only once the true extent of the commonwealth’s structural budget problems are clear and a congressionally approved mechanism is in place to ensure policy corrections are implemented to prevent Puerto Rico’s government from resuming its profligacy does it make sense for Congress to apply Chapter 9-style bankruptcy protection to permit an orderly resolution to Puerto Rico’s debt obligations.

A moratorium on further liberalization of economic ties with the Castro regime. Of particular concern are any policies that facilitate increased tourism travel to Cuba until the economic condition of Puerto Rico is stabilized and its debt obligations are met.