Big Trouble in Paradise: Puerto Rico Faces $87B Collapse

Tuesday, 08 Oct 2013 07:09 PM

By David A. Patten and Matthew Lysiak

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Image: Big Trouble in Paradise: Puerto Rico Faces $87B Collapse
(Landov)
Puerto Rico’s island paradise may be teetering on the precipice of a financial collapse that would make Detroit’s implosion look modest by comparison, economists and analysts warn.

Detroit, a city of about 700,000, went bankrupt after piling up $18 billion in debt. Puerto Rico, by contrast, has 3.7 million residents -- and faces a whopping $87 billion in debt and unfunded pension liabilities.

“The Puerto Rican economy is near collapse,” prominent Puerto Rican economist Gustavo Vélez tells Newsmax. “The government is running out of money and there is no end in sight.”

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Puerto Rico Senate President Eduardo Bhatia told bond analysts in New York on Monday that the Obama administration is “wondering how they can help Puerto Rico send a very strong signal of stability right now.”

He added that island officials are expecting “an announcement” soon from administration officials. But that appears to be at odds with a Bloomberg report that a U.S. Treasury Department spokeswoman said no plan is afoot to bail out the island’s economy.

In September, UBS AG and other U.S. brokerage firms warned some 40,000 U.S. investors and brokers to stay away from the bonds that Puerto Rico uses to finance its deficit. Not long afterwards, the island’s bond yield – the amount it has to offer to lure investors – rose to 9.29 percent, surpassing even that of Greece. Predictably, Internet headlines began referring to the beautiful tourist haven in the Caribbean as “America’s Greece.”

Puerto Rico, however, probably still has some time to work out its finances. Unlike Greece, very little of its debt is short term. But the New York Times reports Puerto Rico Gov. Alejandro Garcia Padilla and other officials are engaging in intense shuttle diplomacy between New York, Washington, and the Caribbean. Their objective: To convince bankers, credit analysts, and political leaders that the island is on a path toward restoring financial stability.

Since assuming office in January, Gov. Padilla has taken several austerity measures. State employees’ contributions to their pension plans were increased from 8.275 to 10 percent.
The retirement age was increased. Utility rates were hiked sharply to bring in more revenue, and new taxes have been imposed as well. So far, financial markets appear almost indifferent to the tough belt-tightening measures, leaving island officials frustrated.

Unlike Detroit, a declaration of bankruptcy for Puerto Rico may not be an option due to its status as a territory, rather than a state. The Times reports the Northern Mariana Islands tried to seek bankruptcy protection in 2012, but that effort was rejected by the courts. The way out of the legal limbo for Puerto Rico would be a financial plan of support enacted by the U.S. Congress. But that would assume Congress is better equipped to deal with Puerto Rico’s budget impasse than it has been dealing with its own.

The Times reports that the President’s Task Force on Puerto Rico has been discussing whether the U.S. Constitution gives Congress the power to impose special fiscal controls. One idea would be for Congress to designate a financial control board led by an official with the power to overrule its local, politically elected leaders. But the legality of such a move has reportedly not yet been established.

Puerto Rico leaders, meanwhile, object to the aspersions cast upon their ability to plug their fiscal liabilities, and insist the island is not on the verge of bankruptcy.

Alan Schankel, a managing director for the Janney Montgomery Scott investment firm, tells Newsmax that Puerto Rico will probably avoid a default in the near term. But, he adds, “this outcome isn’t assured.”

“The one assurance we make, is that volatility is likely to continue in the near term — and perhaps beyond,” he says.

Puerto Rico’s unemployment rate hit 13.2 percent in September. A fourth of the island’s residents receive entitlements such as food stamps or income assistance. Tax revenues, meanwhile, have steadily dwindled.

So how did Puerto Rico lose its status as one of the richest spots in the Caribbean? Economists cite the decline of its once-powerful manufacturing sector.

Fifty years ago, Puerto Rico relied primarily on exports of coffee, sugar cane, and rum. The tourist industry, of course, brought in revenue as well.

But the island’s biggest boost arguably came in 1976, when Congress effectively exempted Puerto Rico-based companies from paying federal income taxes. The goal was to boost the territory’s economy, and it worked. The tax breaks, coupled with the island’s proximity to the United States, made it a prime destination for multinationals.

Companies lured by low taxes, gentle tropic breezes, and reliably sunny weather made Puerto Rico a mecca of manufacturing. But the boom would be short-lived.

In the 1990s, critics attacked the tax breaks as too expensive. After an intense lobbying battle in 1996, Congress repealed the tax abatement, which was phased out over a decade.

As those tax breaks disappeared, much of Puerto Rico’s tax base disappeared with it. But Puerto Rico’s entitlements and liabilities, which rapidly expanded during the boom years, remained unchanged.

“The effect was immediate and crushing,” says Vélez. “Our economic model was developed around these tax breaks, and after they were allowed to lapse, investment just stopped, and that model just disappeared.”

As a result, hundreds of thousands of Puerto Ricans lost their jobs. About 100,000 Americans of Puerto Rican origin have relocated to the mainland in search of better opportunities, according to Vélez.

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That Puerto Rico, whose name ironically translates to “rich port,” has avoided calamity as long as it has may be thanks to its attractiveness to investors. As a territory, Puerto Rico can offer bonds that pay tax-exempt interest across the country. It offers special legal protections to investors and a high rate of return. Investors gobbled up Puerto Rico’s bonds – to the tune of some $70 billion. But after markets were spooked by the signal earlier this summer from the Federal Reserve that it would not continue to prop up the bond markets interminably, Puerto Rico effectively found itself unable to sell its debt for less than outrageous prices.

Today, its credit is hovering at just one notch above junk-bond status, with the Wall Street agencies putting it on a negative watch for more possible downgrades. Considering the austerity steps the island has already taken, Puerto Rico officials are more than a little frustrated with the credit-rating analysts on Wall Street.

“I disagree with them and believe they are treating Puerto Rico unjustly,” Gov. Padilla said earlier this week.

If the credit-worthiness of the Commonwealth’s debt is downgraded yet again, it could trigger another run on its solvency. The New York Times reports that Puerto Rico has engaged in financial deals known as interest-rate swaps. These contracts force it to come up with additional cash as collateral, should its credit fall to junk-bond status. That could push the island’s balance sheet closer to the brink.

Padilla has tried to reassure investors that he can put the island back on an even financial keel, and the island’s 2014 budget includes over $1 billion in expected new taxes.

Puerto Rico's Government Development Bank has stated: “We are confident that no major debt issuer will default on its debt.”

But skeptics aren’t so sure. The latest report to the federal officials who keep a watchful eye on the municipal securities market revealed that the commonwealth ran a $39 billion deficit in 2012. That was a $5.4 billion increase over 2011.

And if higher taxes create too big a drag on the Puerto Rican economy, the deficit could get even worse.

“The problem isn’t that taxes aren’t high enough,” says Vélez. “The problem is that the government has done nothing about spending, and there is no strategy that grows the economy and expands the tax base.”

Until that happens, Vélez warns, “the people of Puerto Rico are going to continue to struggle.”

Perhaps the biggest question stemming from Puerto Rico’s financial crisis is how it will affect the island’s ongoing bid to become the 51st state in the union.

Statehood is a near perennial question in Puerto Rico. In a nonbinding referendum conducted last year, 54 percent of Puerto Rican voters said they favored changing Puerto Rico’s current status as a commonwealth. But Puerto Rico Gov. Alejandro Garcia Padilla says that vote was invalid because the referendum referred to Puerto Rico’s “present form of territorial status” rather than describing it as a “commonwealth.”

There have been four plebiscites on statehood since 1967, and there may soon be another. President Obama has requested $2.5 million to pay for a new statehood referendum.
But given Puerto Rico’s deep financial turmoil, its leaders are busy just trying to avert insolvency.

“Right now we are aren’t even thinking about statehood,” leading Puerto Rican economist Gustavo Vélez tells Newsmax. “Right now the government is just trying to meet payroll.”



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