Puerto Rico's Debt Crisis (part 1)

Monday 05/02/16

Last night Puerto Rico's governor, Alejandro Garcia Padilla, announced that Puerto Rico will default on $389 million of a $422 million payment due by the Government Development Bank (GDB) today. This will not be Puerto Rico's first default, but it is more significant because the GDB is central to economic development and liquidity on the island. Puerto Rico has accumulated about $71 billion in debt and also has unfunded pension liabilities of about $44 billion. Puerto Rico has struggled with a declining population and weak economic growth, in the next two weeks I will look at some of the reasons for this crisis.

Municipal Bonds

     Interest income from municipal bonds is exempt from federal income taxes. Furthermore, if you buy a bond issued by a state or local government located in the same state where you live you are (usually) exempt from state and local income taxes as well. If you purchase a municipal bond from a state other than your state of residence you will only be exempt from federal income taxes. But if you purchase a bond from Puerto Rico you will be exempt from state and local taxes, just as if you were lending to your home-state.

     This triple exemption has been a double-edged sword for Puerto Rico. Puerto Rico was able to borrow much more easily than many other states because of this exemption. Investors were enticed by Puerto Rican bonds because they generally have a higher yield than local municpal bond funds due to their higher level of risk. Municpal bond funds liked to mix Puerto Rican debt into their funds to help raise the yield without impacting taxation, their customers who invested in these funds probably had no idea that they were investing in Puerto Rico. According to Morningstar, 298 of 565 municipal bond funds contained Puerto Rican bonds in 2015.

     Because of easy access to capital, the Puerto Rican government, instead of balancing their budget, continued to borrow more debt to fund increased government spending. This did not seem to concern investors as long as Puerto Rican debt remained investment grade, even though it was clear to most sophisticated investors that this was unsustainable. In February of 2014, S&P downgraded Puerto Rican debt from BBB- to BB+, which is significant because that is the cutoff between investment-grade and junk. Moody's and Fitch followed with downgrades to junk status shortly after citing liquidity concerns and a lack of economic growth. These downgrades led to acceleration clauses which required that Puerto Rico repay certain debts on a faster schedule than originally anticipated.

Emigration and Economic Growth

     More Puerto Ricans live in the mainland U.S. than in Puerto Rico. In 2014 alone, Puerto Rico lost about 2% of its population. Figure 1 shows Puerto Rico's declining population. This is especially a problem because a large percentage of those Puerto Ricans are highly educated. Many of the best and brightest Puerto Ricans are leaving the country to look for economic opportunities in the United States, but this brain drain only further erodes the economic opportunities in Puerto Rico. It also reduces tax revenue making it even harder for Puerto Rico to meet its debt obligations.

     Puerto Rico lags other Caribbean nations in tourism and this slowdown has increased since the debt crisis. One might think that Puerto Rico would have an advantage in tourism because U.S. citizens do not need a passport to visit, but there are other factors at play. Puerto Rico is required to pay the U.S. minimum wage, but its competitors in the Caribbean are not. This makes it more cost-effective to open tourist destinations in other neighboring countries. Regulations also prohibit split-shifts, which is important in the hospitality industry because workers are often only needed for a few hours at a time. Labor laws also require Christmas bonus pay and numerous labor laws are also cited by hoteliers as reasons why they invested elsewhere.

    Unlike many Caribbean nations, Puerto Rico does not rely on agriculture and tourism. Instead, because of interesting tax incentives, Puerto Rico became an economy based on manufacturing. Next week we will look at how this has shaped the Puerto Rican economy and how it fueled the current crisis.