Capital Over People? Puerto Rican Debt Crisis Explained

August 3, 2015August 14, 2015 COHA

By: Chandler Foust, Research Associate at the Council on Hemispheric Affairs

UPDATE (August 4, 2015, 2:28 p.m.): On Monday, August 3, Puerto Rico’s Public Finance Corporation failed to pay the $58 million USD it owed creditors, making only a $628,000 USD payment. In addition, the island owes $5 billion USD over the next twelve months. Monday marked the first day in the island’s history where it failed to make a payment.

The current debt crisis in Puerto Rico not only illustrates a need for a complete restructuring of the island’s economy, but a closer look taken toward its further political union with the United States. In addition, the current crisis shows the flawed way that politicians respond to debt crises, and how the people who end up getting hurt are usually not the ones who started the crisis. Lastly, the current political debate between debtors and creditors, harsh austerity measures, and further concessions to capital has shown that these lessons have yet to sink in for many.

What Happened

On June 28, 2015 Puerto Rican Governor Alejandro García Padilla declared the commonwealth’s massive debt not payable. Likening the island’s economic trajectory to a “death spiral”, Padilla concluded that Puerto Rico’s creditors must take part in the island’s attempt to rid itself of its debt problem. He claimed that without debt restructuring, Puerto Rico’s economy would not grow, and added that lack of growth would, in turn, make it increasingly unlikely that Puerto Rico would be able to pay off its debt in the foreseeable future.[1] In addition to this statement, Governor Padilla passed an executive order that created the Working Group for Economic Recovery, and commissioned a report on the island’s economy by former International Monetary Fund Economist Anne Krueger. The group is tasked with crafting legislation by August 30, which includes a five-year fiscal plan, cuts in government spending, privatization of certain services, and establishing a Fiscal Council to ensure that the proposed changes are implemented in good faith.[2] The group consists of Governor Padilla’s Chief of Staff Victor Suárez, President of the islands’ Government Development Bank (GDB) Melba Acosta, Senate President Eduardo Bhatia, and House President Jaime Porello. The group met for the first time at the GDB, on July 7, to begin forming its recommendations for future economic reforms. Whatever the final recommendations, the legislature is required to approve the plan.[3]

Thus far, Puerto Rico has managed to pay off its debts and avoid default, but with so many deadlines in the near future, it will get no easier from here. Recently, the commonwealth’s Electrical Power Authority (PREPA) staved off default on its $9 billion USD debt with a $415 million USD payment. The GDB paid $300 million USD on July 10, while the Public Finance Corporation was not able to pay the $94 million USD it owed on July 15.[4] By August 1 Puerto Rico will owe another $169.6 million USD to service its sales tax-backed bonds as well.[5] On top of this, the commonwealth is constitutionally bound to pay off its General Obligation Bonds before all other debt, which necessitates Puerto Rico setting aside $93 million USD each month.[6]

To put Governor Padilla’s comments about the impossibility of paying off its debt in perspective, the Puerto Rican government, under Padilla, has implemented massive austerity reforms, yet has little to show for it. In fact, cuts in government spending and increases in taxes have further constricted the Puerto Rican economy, making it increasingly difficult for the island to pay off its outstanding debt: the “death spiral” Governor Padilla has referred to. Just to show how serious Puerto Rico’s economic situation is and how little continued austerity will help, simply look at the government’s response to its performance over the past decade.

Since 2006, the Puerto Rican economy has contracted every year except for one. The unemployment rate of 14 percent is over double that of the United States and 45 percent of the population lives below the federal poverty line.[7] A seven percent drop in population in the last decade accompanies the sheer size of the island’s debt, $73.5 billion USD with $38 billion USD in unfunded pensions and public health care liabilities.[8] Since the United States has made it clear that no bailout will be given, Puerto Rico has fended for itself, which is reflected in this year’s budget. On May 14, the island’s government submitted a budget request for $9.8 billion USD, which entails a $674 million USD cut in spending. The budget proposed raising the sales tax from seven percent to 11 percent and increasing the value-added tax four percent. The budget set aside $1.5 billion USD for debt repayment but also plans to close 95 schools and 20 public agencies. This piles on top of continuous cuts since 2013.[9]

The current trend is unsustainable. For instance, even while cutting spending and raising taxes, Puerto Rico is only expected to bring in $825 million USD in 2015, despite needing $1.2 billion USD to run the government.[10] What Puerto Rico needs isn’t more austerity; it needs structural reforms to put the economy on a sustainable path so it can pay off its debt without irreparably damaging itself in the process. This means Congress giving Puerto Rico the ability to declare Chapter 9 bankruptcy, which will in no way forgive all of Puerto Rico’s debt, but will help some. This means creditors forgiving debt or at least allowing the postponement of debt payment for a period of time until Puerto Rico is in a position to pay. This means guilt falls on both sides of the mainland, the U.S. for propping up a noncompetitive and inefficient economy with tax-breaks for most of its history while incentivizing the continued buying up of unsustainable debt, and Puerto Rico for spending money it simply did not have, even before its economy began to contract. As Governor Padilla said, “sacrifices must be made by all.”

How U.S. and Puerto Rican Policy Has Contributed to the Debt Crisis

Placing all the blame on U.S. policy would be disingenuous at best, but concentrating all ire on the Puerto Rican government is irresponsible. Throughout Puerto Rico’s history as a US possession, and eventual Commonwealth, its economic fortunes have not only been tied to a strong U.S. economy, but have been propped up by tax breaks and bond exemptions. These tax breaks go all the way back to 1921 when Congress passed the Revenue Act. Later on in 1948, when Puerto Rico changed its tax policy through the Industrial Incentives Act, U.S. subsidiaries became tax exempt from both Puerto Rican taxes and from the U.S. Income Tax.[11] Section 936, which has generated substantial publicity in explanations of the island’s current debt crisis, only began in 1976. Section 936 fully exempted profits and passive investments made by U.S. subsidiaries in Puerto Rico from federal corporate income taxes. By 1993, around $3.9 billion USD in tax revenue had been forgone due to the tax credit.[12]

On top of the huge benefits US companies received from the Section 936 tax credit, Puerto Rican tax law allowed a subsidiary that was at least 80 percent foreign owned to deduct 100 percent of dividends paid to the parent company.[13] This means that US subsidiaries in Puerto Rico could pay all their revenue to parent companies in dividends and pay no taxes whatsoever on their profits. Even with the high input costs of doing business on the island, these tax breaks made Puerto Rico an attractive place for investment and business by US companies. At least as long as the tax breaks were left intact. In 1996, President Clinton passed legislation that began a ten-year phase-out of the Section 936 tax credit, which ended in the same year that the Puerto Rican economy began to contract in 2006.[14] By phasing out the Section 936 tax credit, US subsidiaries were forced to pay the same corporate tax rate as all other foreign companies, which added to the high input costs of doing business on the island, contributed to the whittling away of the island’s manufacturing base, and many companies leaving the island.

In addition, the U.S. government effectively subsidizes Puerto Rico’s debt through its legal treatment of the purchase of the island’s bonds. Ever since 1917, the US government has exempted the purchase of Puerto Rican bonds from local, state or federal taxes.[15] They are referred to as “triple-exempt” bonds and have remained popular even as the island’s debt climbed up to 100 percent of GNP in 2014. The amount of debt held by US mutual funds, hedge funds, and individuals has led to major investor concern over the thought of Puerto Rico restructuring its debt. Currently, $11.3 billion USD of the island’s debt is held by mutual funds, $15 billion USD is held by hedge funds, while largely Puerto Ricans and “mainland Americans” hold the rest of the debt.[16] This cycle ended, in June 2014, when Puerto Rico’s bonds were demoted to junk status by various rating agencies. High yield bond funds, in turn, began buying up more of the Puerto Rican debt, due to the lower quality but higher possibility of return given high interest rates. Many of the largest holders, run by Oppenheimer Funds and Franklin Templeton Investments, have made it clear that they will seek litigation if Puerto Rico does not pay.[17]

Kreuger Report

The pure amount of debt, the number of Puerto Rican debt holders who are gearing up for litigation, and the lack of money brought in from austerity measures illustrates the need for structural reform of the Island’s economy, as well as Congress allowing Puerto Rico to declare Chapter 9 bankruptcy. Anne Krueger, a former economist at the International Monetary Fund, stated in her report commissioned by Governor Padilla that the debt cannot be paid if the economy doesn’t grow. She then states that the economy will not grow if structural reform is not implemented and if questions about the future of the heavy debt burden are left unanswered. In the report, Krueger documents many reasons for how Puerto Rico got to this perilous situation.

The first and most important factor is what Krueger calls the creditors’ “Crisis of Confidence.”[18] Basically, Puerto Rico’s debt burden is due to the eleven consecutive years of economic contraction and mounting public debt, which fed each other. As stated in the previous section, due to the “triple-exempt” status of Puerto Rican bonds, investors continued to buy up debt even as it mounted to over 100 percent of Puerto Rico’s GDP in Fiscal year 2014.[19] While the continued purchase of bonds temporarily kept Puerto Rico afloat, when risk premiums started to rise on Puerto Rico’s bonds, with their eventual decline to junk status, the situation couldn’t be sustained. Due to the much lower ratings and growing fear of the debt’s sustainability, investors “demanded higher risk premiums, shorter maturities, and greater securities.”[20] The decline in ratings exposed the island’s precarious fiscal position and effectively cut it off from continuing on its current trend.

With the economy set to shrink another percentage point in 2015, structural reform must be made if creditors want to get their money back.[21] On the supply side, Krueger suggests that labor, energy, and transportation be reformed. For instance, in Puerto Rico only 40 percent of the population is either employed or looking for work, compared to 63 percent in the U.S. One major contributor to this is the high labor costs and generous social benefits on the island. The minimum wage is 77 percent of the average per capita income, compared to 28 percent on the mainland.[22] On the benefits side, those receiving unemployment benefits generally make more than those earning the minimum wage. For example, a family of 3 that receives food stamps, AFDC, Medicaid, and utility subsidies makes $1,743 USD a month, while a minimum wage earner makes $1,159 USD.[23] These generous benefits incentivize many not to search for work, while the relatively high minimum wage encourages employers not to hire more workers, which helps to explain the massive migration out of Puerto Rico. In addition to the high costs of energy on the island, coupled with the Jones Act, which doubles the costs of imports by forcing all shipments to the island to be made by US crews and vessels, Puerto Rico is not in a position to grow.[24]

Lastly, Krueger states that a complete restructuring of Puerto Rico’s fiscal regime is necessary to prevent this dire fiscal situation from occurring again. The Puerto Rican government has been running deficits since 2000, six years before the economy began to contract. The main drivers of this debt are the public sector agencies such as PRASA, PREPA, and HTA. From 2004 to 2014, the expected revenue was $1.5 billion USD above the amount collected.[25] While debt was increasing, tax revenue was shrinking, from 15 percent of GNP to 12 percent during this time period.[26] In addition to the growing debt burden, the true amount of debt is much larger than expected because Puerto Rico’s General Fund does not properly account for its expenditures. Krueger asserts that the General Fund does not include the deficits run by 150 government agencies, including the GDB, which paid creditors $300 million USD on July 10. In her own calculation, which includes the “full public sector,” Krueger estimates that from 2013 to 2014 the public sector ran a deficit that was five percent of GNP.[27]

Political Union, Bankruptcy, and Bye to Austerity

The question of Puerto Rico’s political status and the Commonwealth’s ability to declare Chapter 9 bankruptcy are connected and must be resolved to help ensure that this debt crisis is ended and never occurs again. For instance, Puerto Rico is home to 3.5 million American citizens but is not represented by a voting member in Congress. This political deficit undeniably leaves the island at a disadvantage when it comes to U.S. policy. This disadvantage is shown in Puerto Rico not being able to declare Chapter 9 bankruptcy, unlike the other 50 states.

Until 1984 Puerto Rican municipalities and public corporations were able to declare bankruptcy, but in that year Congress changed the law and excluded Puerto Rico.[28] This exclusion is critical, because its public corporations and municipalities hold around a third of Puerto Rico’s debt. Recently, Democrats Richard Blumenthal and Chuck Shumer introduced a bill in the Senate that would rectify this. Puerto Rico’s non-voting representative, Pedro Pierlussi, introduced a similar bill in the house back in February, but as it stands nothing has been done.[29] In fact, the bills have gained little traction and can be expected to remain there; in the meantime Puerto Rico’s economic future hangs in the balance.

The lack of political will further highlights Puerto Rico’s current second-class status. The only answer to a lack of political will and political space to end the mounting debt crisis is further representation. The only way to achieve this is statehood. In 2012, Puerto Rico held a referendum on their political status, and 54 percent voted “no” on retaining their current status. In addition, 61 percent voted “yes” in becoming the 51^st state.[30] Becoming a state would grant Puerto Rico access to an additional $20 billion USD in funds, and ensure that the US federal tax code applies to Puerto Rico.[31] The additional federal funds are sorely needed, but, more importantly, applying the US federal tax code would help the Puerto Rican government to raise revenue and better combat tax avoidance.

While it remains unlikely that Puerto Rico will be admitted as a state in the near future, its current debt crisis must be put into perspective. Paul Krugman writes that as a territory in the US Federalist System Puerto Rico benefits from receiving increased amounts of federal social benefits even as its payments to the federal government decline, which helps to cushion the blows. While mentioning that he is in no way minimizing the human suffering on the Island, he then shows that the unemployment rate has only risen four percent and that consumption per capita has actually risen.[32] On top of this, even though the Puerto Rican economy has steadily contracted since 2006, its “drop per working age adult is less,” because of the 7 percent decline in population in the last decade.[33] In other words, Puerto Rico is a region that has lost its comparative advantage, for a variety of reasons, which means “large scale-emigration” of its working age population and receiving an increasing amount of federal funds is expected.[34] Since states such as West Virginia that lose comparative advantage in producing goods are not expected to reduce minimum wage levels in order to compete, Puerto Rico should not be expected to either.[35]

This leads to a larger point. Puerto Rico, when viewed in this context, must be put back on a track towards growth. Further attempts by creditors to squeeze more payments out of the Island will only make the situation worse, and further hazard the lives of millions of American citizens. A recent report commissioned by “38 investment managers” that hold 5.2 billion of the island’s debt shows this implication.[36] The report states that Puerto Rico can pay back its massive debt by further increasing taxes, selling off some of the $4 billion USD in government real estate, and cutting government spending.[37] One major area the report focuses on is education, saying “education expenditures increased 39 percent or $1.4 billion USD in the past decade while total school enrollment declined 25 percent.”[38] This ignores, as the Guardian noted, that 56 percent of Puerto Rican children live in poverty, and the spending per pupil is $8,400 USD compared to $10,667 USD on the mainland.[39] The island’s debt crisis is only a surface level problem; the Puerto Rican people need investment. Continued austerity will only exacerbate the crisis and lead to further economic contraction, not only harming the lives of millions of American citizens, but also destroying the US budget. Not only does it not make sense for the Puerto Rican people, it does not make sense for the US budget.

Conclusion

With its massive debt and the failure of austerity measures to stop the increasing debt load, Puerto Rico needs help. Help, not in the sense of completely forgiving the debt, but help to implement structural reforms so that this situation can be prevented in the future and so that the economy can grow. Without growth it seems increasingly unlikely that the debt will be paid. Currently, a bill is in both houses of Congress that would give Puerto Rico the same right as states to declare Chapter 9 bankruptcy. While it remains unlikely that anything will be passed soon, Hillary Clinton and Jeb Bush, both front-runners for their party’s presidential nominations, have come out in favor of allowing Puerto Rico to declare Chapter 9 bankruptcy.[40] Lastly, Puerto Rico’s economic problems, and the limits it faces in fixing them are directly tied to its lack of political representation. Any structural reforms must be accompanied by soul-searching and further deliberation on its future political status.

By: Chandler Foust, Research Associate at the Council on Hemispheric Affairs

Please accept this article as a free contribution from COHA, but if re-posting, please afford authorial and institutional attribution. Exclusive rights can be negotiated. For additional news and analysis on Latin America, please go to: LatinNews.com and Rights Action.

Featured Photo: Aeriel view of Old San Juan. From: U.S. National Park Service.

[1] http://www.nytimes.com/2015/06/29/business/dealbook/puerto-ricos-governor-says-islands-debts-are-not-payable.html?_r=1

[2] http://www.nbcnews.com/news/latino/puerto-rico-governor-we-cant-let-our-debt-bring-us-n384121

[3] http://www.reuters.com/article/2015/07/06/us-usa-puertorico-debt-idUSKCN0PG2FO20150706

[4] http://www.ft.com/intl/cms/s/0/1f965f50-20f2-11e5-aa5a-398b2169cf79.html

[5] http://www.reuters.com/article/2015/07/27/usa-puertorico-debt-idUSL1N1071JG20150727

[6] http://www.nytimes.com/2015/06/29/business/dealbook/puerto-ricos-governor-says-islands-debts-are-not-payable.html?_r=1

[7] http://www.newyorker.com/magazine/2015/04/06/the-puerto-rican-problem

[8] http://www.huffingtonpost.com/news/puerto-rico-economy/

[9] http://www.bloomberg.com/news/articles/2015-05-17/debt-choked-puerto-rico-at-fiscal-brink-as-bond-buyers-pull-back

[10] http://recend.apextech.netdna-cdn.com/docs/editor/Informe%20Krueger.pdf

[11] http://www.gao.gov/assets/220/218131.pdf