America’s own Greece- Puerto Rico

While much attention has been focused on the Greek drama, out-of-control debt is rearing its ugly head closer to home. The small island of Puerto Rico is in a bad way; the lyrics may be different but the melody is the same.

The governor of Puerto Rico dropped the bombshell last month that there is no way the island can pay its $72 billion in public debt. He pledged to begin developing a debt restructuring plan.

Since the financial meltdown of 2008, debt is like a canker spreading across the globe. The Greek analogy may be overused, but in one respect it is relevant. Greece and Puerto Rico are among many governments with too much debt and not enough economic growth to generate the tax revenues needed to cover it.

Short of a federal bailout, the island will be unable to repay its debt between now and the Second Coming. To paraphrase Margaret Thatcher: “Puerto Rico has run out of other people’s money”.

Puerto Rico is by far the most indebted American territory or state, owing $20,400 per capita. Since 2005, the island’s economy has shrunk by about 10 percent. Its unemployment rate is above 12 percent; more than double the national average. Since government benefits are more lucrative than a minimum wage job, just 40 percent of the adult population is working or looking for work. The U.S. labor participation rate is 63 percent.

Moreover, high labor costs have proven onerous for many businesses. Generous overtime provisions, excessive paid vacation benefits and job security regulations that are more costly than on the mainland all magnify employment costs and kill the demand for labor. The island’s population has also declined from 3.8 to 3.5 million since 2005 as Puerto Ricans leave for Florida and other parts of the U.S.

Until 2006, Puerto Rico’s economy was kept afloat by tax incentives for American pharmaceutical, textile, electronic and other firms that manufactured there. When the tax breaks disappeared in 2006, it contributed to the loss of 80,000 jobs. Puerto Rico’s economy has been in free fall ever since. The weak economy drives the middle class to the U.S., the shrinking population results in a smaller tax base and the beat goes on.

Puerto Rico’s bonds, unlike those of states or municipalities, are exempt from federal, state, or municipal taxes everywhere in the United States. Thanks to this competitive advantage, they were quite attractive to bond funds and investors in the highest tax brackets. More than 180 municipal bond funds have at least 5 percent of their portfolios in Puerto Rican bonds. Many hedge funds and distressed debt buyers stepped in to buy Puerto Rico’s bonds at deep discounts as the island’s economy worsened and its credit rating dropped below investment grade in early 2014.

Unlike municipalities, states and Puerto Rico are barred from seeking bankruptcy protection. The Governor has appealed to Washington to change the law so the island can seek bankruptcy protection, buy time to restructure debts and get its fiscal house in order.

Chapter 9 of the bankruptcy code allows a company or municipality to get new financing from markets while continuing to function as debts are restructured or written down. The importance of orderly debt restructuring was in evidence during the recent bankruptcy process that helped Detroit to restructure its $18 billion in debt.

Without allowing Puerto Rico access to the partial remedy of bankruptcy, the island has no chance of pulling out of its death spiral. Like Greece, Puerto Rico is stuck in a vicious cycle and badly needs structural reforms to set the economy on a sustainable path. The challenge is to grow the economy while at the same time fixing its public finances.

There is one lesson to be learned from Greece: Expect Puerto Rico’s fiscal crisis to get worse if debt restructuring and the implementation of reforms to make the island economically competitive are delayed.

Originally Published: August 1, 2015

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