In a two-year long saga, the U.S. territory of Puerto Rico has made many attempts to reduce its debt burden and save its economy. On March 22, 2017, the Governor Ricardo Rossello proposed a new deal to restructure debt of the premier utility company, Puerto Rico Electric Power Authority (PREPA), which constitutes $9 billion or nearly 13% of Puerto Rico's over $70 billion in bond debt outstanding. While Rosello's plan has been backed by the federal oversight board, appointed last year to navigate Puerto Rico out of this debt trap, it is being opposed by creditors.
"It affects the broader restructuring negotiations that Puerto Rico intends to conduct. So we are very concerned about what’s happening in Prepa. We’re very concerned about the possibility of that deal falling apart,” Houlihan Lokey's Steven Spencer, an adviser to creditors Franklin Advisers Inc. and Oppenheimer Funds Inc. said according to Bloomberg.
Under the new plan, Puerto Rico is to service $800 million per year versus the $1.2 billion a year over 10 years, according to a Reuters report. That would alter the earlier terms of 15% concession by creditors on the principal and reduce their recovery rate to almost 30 cents a dollar.
The island territory has until May 1 to negotiate a deal with its creditors, at which point a stay granted by courts would expire and allow creditors to sue. That could put even more pressure on Puerto Rico, which is already struggling with the harsh decision of repaying creditors versus cutting essential services for the island's 3.2 million people.
The money Puerto Rico owes represents nearly 70% of the territory's gross domestic product (GDP). For comparison, the average debt-to-GDP ratio for states in the United States is 17%. Even worse, Puerto Rico's prospects for paying its debt according to agreed terms are slim and getting slimmer. The territory's escalating debt combined with its weakening economy caused three major credit rating agencies in 2014 to downgrade Puerto Rico's debt to non-investment grade, also known as junk status. This downgrade triggered acceleration clauses with many of the territory's creditors; when this happens, principal and interest payments on debt come due much sooner. Unfortunately for Puerto Rico, its revenues are insufficient to pay its debt according to the original schedule, much less an accelerated schedule.
Last year, Lin-Manuel Miranda, the mind behind Tony and Pulitzer Prize-winning play Hamilton, made an appearance on Last Week Tonight With John Oliver to draw attention to the Puerto Rican financial crisis. He rapped, "Hoping to God John Oliver's comical dissertation resonates with the Congress that got us in this situation, along with suicidal tax incentive declarations.." The artist even joked that he would be willing to perform at Paul Ryan's house for the sake of his parent's native land.
The Puerto Rican debt crisis has many origins. Most notably, investors in Puerto Rican municipal bonds have received favorable tax treatment for years. Bond investors from all 50 states have taken advantage of this benefit by purchasing Puerto Rican bonds. When a government issues bonds, it is effectively lending money, with interest, to bondholders. Prompted in large part by this tax advantage, Puerto Rico issued too much bond debt and began relying on borrowed funds from bond issuance to balance its budget.
Economic decline in Puerto Rico has led to widening budget deficits over the years. The tiny island is ill-equipped for manufacturing and production of goods. Its economy was sustained for decades by the presence of technology and service-oriented companies that located to the island due to its favorable tax treatment. Many of Puerto Rico's tax advantages, however, were ephemeral. The U.S. tax code called for these advantages to expire over time. When that began to happen, companies fled the island, eviscerating its economy.
Compared to other states and territories, spending on social programs is disproportionately high in Puerto Rico. The majority of the island's residents receive Medicare or Medicaid. A high poverty rate in Puerto Rico invariably means a lot of its inhabitants seek welfare and other government benefits. Confounding the issue further is the fact Puerto Rico receives far fewer federal dollars to assist with social spending than states with comparable populations.
Puerto Rico has been shedding residents since 2005. The island's population is also aging. These combined factors have reduced its tax base substantially; not only has the territory taken on increasing debt in the 21st century, but it has less revenue coming in to pay that debt.
The Puerto Rican Bond Boom
The Jones-Shafroth Act of 1917 granted U.S. citizenship to residents in Puerto Rico. It also spelled out a number of stipulations defining the territory's relationship with the U.S. mainland. One of these stipulations involved Puerto Rican municipal bonds and the ways in which they would be treated differently than bonds issued by states.
Interest income on most municipal bonds is subject to taxes by various levels of government, including federal, state and local. The primary exception is when an investor purchases a bond issued by his state of residence, as in a Floridian buying a Florida municipal bond. Jones-Shafroth exempted Puerto Rican municipal bonds from all three levels of taxation; as a result, residents of all 50 states and other U.S. territories could invest in Puerto Rican bonds without paying interest on the income.
Unsurprisingly, investment dollars began flooding into Puerto Rican government bonds. This failed to cause major problems for many decades. During the 1970s, however, the territory's government started using bond investment money to balance its budget, despite it being borrowed funds and not actual revenue. This practice resulted in rapid accumulation of debt, the interest payments on which Puerto Rico covered by issuing even more debt. The resulting debt snowball comprises a large part of the territory's current crisis.
Puerto Rico's Disappearing Tax Advantages
Unlike most states in the U.S., Puerto Rico has never in its history sustained a strong economy on the back of manufacturing or producing goods. The territory's remote island location, tiny land area and lack of natural resources precluded it from ever developing a strong manufacturing base. For a while, Puerto Rico had something else to drive its economy. The federal government created an incentive for companies to locate there by establishing corporate tax exemptions. This was especially attractive to technology and service-oriented companies, for which Puerto Rico's remote location and dearth of resources posed few challenges.
These tax advantages, however, were not permanent. As they expired over time, many companies elected to discontinue their Puerto Rican presence. The economic decline that resulted was tantamount to what Detroit experienced during the darkest days of the Big Three auto slump. Reduced corporate presence led to GDP declines, worsening the island's debt-to-GDP ratio and hastening its credit downgrade.
Oppressive Social Spending
More than 60% of Puerto Ricans receive Medicare or Medicaid. However, compared to other states with high percentages of poor residents, such as Mississippi, Puerto Rico receives a tiny fraction of federal funds to assist with social spending. As a result, the territory must heavily earmark its own budget to provide money for these programs, along with welfare and other safety net initiatives to help the needy. Over the past few decades, declining tax revenues and mounting debt in other areas have forced Puerto Rico to borrow money to keep its Medicaid program solvent.
Another serious problem stems from Puerto Rico's underfunded social safety net. Because so many of the territory's residents receive government assistance to pay for health care, providers struggle perpetually, and their workers are underpaid compared to their peers on the mainland. As a result, many of Puerto Rico's most skilled health care workers have jumped ship in favor of more lucrative jobs in other parts of the U.S.
Puerto Rico's population peaked in 2005 at 3.91 million. A 2012 U.S. Census estimate reports that during the intervening seven years, the island lost over 150,000 residents. A 2015 Pew Research Study estimated that between 2011 and 2013, Puerto Rico’s net population decreased by 50,000 people annually. Puerto Ricans are relocating to the mainland in droves due to better economic opportunities and low airfare and moving costs.
Moreover, the population that Puerto Rico has managed to retain is aging rapidly. An aging population means less tax revenue and greater expenditures. When a Puerto Rican resident ages out of the workforce, the government not only loses out on tax revenue from his income, but, due to high levels of poverty among the elderly, it often must spend money on this resident in the form of social welfare.
The Bottom Line
Last year, the U.S. Congress passed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) and President Obama nominated 7 members to a federal oversight council. But Puerto Rico's only hope is to negotiate a deal that does not set harsh repayment terms its population can ill-afford and one that is acceptable to its creditors.