The commonwealth has run out of wealth. Will Washington save it?
PUERTO RICO’S creditors have plenty to complain about, but they can’t claim they weren’t warned. Last June Alejandro García Padilla, the governor of America’s Caribbean outpost, announced that its $72 billion public debt was “unpayable”, and that a “unilateral and unplanned non-payment of obligations” loomed. Half a year later, he has fulfilled that threat: on January 4th the government missed a $36m coupon on paper issued by its Infrastructure Financing Authority. “There were those who said I was bluffing,” he says. “I told the truth. To avoid a new default, [bondholders] have to sit down and negotiate.”
Unlike fiscal crises elsewhere, the decision did not set off pot-banging protests or queues at cashpoints. On the contrary, the governor was all smiles the next day as he welcomed children into La Fortaleza, his colonial-era palace in the capital of San Juan, for the eve of Three Kings’ Day, which Puerto Ricans (boricuas, as they call themselves) celebrate as much as Christmas. Plaza las Américas, the city’s mega-shopping mall, was packed as parents finished shopping for gifts to put under their children’s beds overnight, and waiting times at popular restaurants were over an hour. The contrast between the island’s dire public finances and its holiday spending binge was surreal, and impossible to sustain.
Only in a territory as unconventionally governed as Puerto Rico could this through-the-looking-glass economy persist. America conquered the island from Spain in 1898 and granted its residents citizenship in 1917, just in time to draft 20,000 of them for the first world war. In 1952 the island became a self-governing “commonwealth”, subject to American law but excluded from federal income taxes and from voting representation in Washington.
Federal investment and tax breaks helped Puerto Rico develop from a sugar-based economy to a pharmaceutical-manufacturing hub. But once producers like Ireland and Singapore began to compete and the tax preferences expired, the island did not develop a new comparative advantage. As part of the United States, Puerto Rico could not devalue its currency, and the national minimum wage inflated its labour costs. But being American offered benefits as well. Residents could move to the States to find work, and were eligible for federal welfare payments if they stayed. Meanwhile, the government could issue tax-exempt municipal bonds, prized by mainland investors.
As a result, the economy slowly hollowed out. The population has fallen from 3.9m to 3.5m during the past decade, with young workers accounting for much of the exodus. Those who stayed tended either to depend on the state—as students, public employees, pensioners or recipients of federal largesse—or to fall into the sprawling underground economy and bustling drug trade. Candidates from across the political spectrum have won office by keeping the gravy train running: more than a third of Puerto Rican schoolchildren are classified as having special needs, inflating the teacher-to-pupil ratio, and the island’s health plan for the poor would be the envy of any American state. A paltry 40% of working-age boricuas are in the labour force, and just 57% of personal income in Puerto Rico comes from formal private jobs, compared with 76% for the 50 states, according to José Villamil, an economist. Investment has collapsed, from 27% of GNP in 2001 to 13% today. Yet retail sales have held steady since 2008. The only way to maintain consumption was via massive borrowing: during the past 15 years, the government’s nominal debt load has tripled.
This system worked as long as mainland investors retained their appetite for Puerto Rico’s high-yielding bonds. But after Detroit went bust in 2013, municipal creditors fled to safety and the commonwealth lost market access. That forced Mr García Padilla to cut spending and raise taxes. The island’s only children’s hospital, whose budget has been cut by 14% in the past two years, lacks CT and MRI machines. Overall spending has dropped by 6.2% since 2013, while tax increases have raised revenues by 8%. This has exacerbated the island’s decade-long recession. The government’s audited 2014 financial statements are long overdue, but according to Mr Villamil GNP shrank 0.9% that year and a further 1.7% in 2015. The sharpest decline is forecast for 2017.
“The numbers don’t add up in Puerto Rico’s books,” Mr García Padilla says. Only by reducing and delaying the government’s liabilities, he argues, can the island resume growth and generate enough tax revenue to maximise repayment to creditors. However, the commonwealth’s awkward status within the United States has stymied his efforts.
If Puerto Rico were either an independent country or the 51st state, it could abrogate its central-government debt, because states cannot be sued in federal court. As an “unincorporated territory”, it may not enjoy this privilege. Similarly, in 1984 Congress excluded Puerto Rico from Chapter 9 of the federal bankruptcy code, which covers “instrumentalities” of states such as local governments and state-owned enterprises. In 2014 the territory passed its own version of Chapter 9, but it was struck down in federal court (though the Supreme Court is to hear its appeal). Mr García Padilla is desperate for Congress to change this. But the hedge and mutual funds that hold large swathes of its debt oppose the idea vigorously, and so far the legislature has failed to act. “The bottom line is our political status,” says Juan Torruella, a Puerto Rican federal judge who voted to reject the territory’s home-grown bankruptcy law. “Any way you put it, Puerto Rico is a colony. What happens in Puerto Rico is decided in Washington.”
Unless and until the law changes, the government will keep juggling liabilities to stave off default. After 17 months of talks, the Puerto Rican power company recently struck a deal with its creditors. But with 18 different issuers and the treasury running dry, such an agreement will be hard to replicate at scale. To conserve cash, Mr García Padilla is taking his sweet time to pay tax refunds and public contractors. Guillermo Martínez of GM Group, which provides security guards, says $4.5m of his firm’s bills to the commonwealth are over 90 days past due. Just like its bondholders, the government has these suppliers over a barrel. “If we stop providing services, will they pay me, or the people who will replace me?”, he asks. “Puerto Rico has been good to us. We have to help the government—until we can’t afford it any more.”
After exhausting such gambits, Puerto Rico is now resorting to payment prioritisation. In August it failed to pay a legally unenforceable “moral obligation” bond. And last month it “clawed back” rum taxes originally destined to pay infrastructure bonds in order to make good on its constitutionally guaranteed “general-obligation” bonds. That left the lower-ranked securities to default. Mr García Padilla says that if he must pick between servicing debt and paying police, nurses or teachers, he will choose the latter, which would set off a constitutional crisis. Without a reprieve from the federal government, a cascade of lawsuits appears inevitable.
Fortunately, a solution could be forthcoming. The Treasury Department has proposed a mechanism that would allow a restructuring of the constitutionally guaranteed debt. Paul Ryan, the Republican Speaker of the House, has promised a “responsible solution” by March. What would be life-changing sums of money for the commonwealth are rounding errors in the federal budget. Rescuing Puerto Rico might prove a relatively cheap way to curry favour with Latino voters in this year’s congressional and presidential elections. And the Supreme Court may yet rule that state-owned companies can enter Chapter 9. Three Kings’ Day may have already passed. But Mr García Padilla has reason to hope that the camels will soon bring a belated gift.