In Spanish, Puerto Rico translates into “rich port.” The meaning of the name took an ironic turn last week when the U.S. territory requested that it enter a new form of bankruptcy protection, burdened by $123 billion in debt and unfunded pension commitments. Puerto Rico’s hopes for redemption lie in a 10-year fiscal plan drafted by a federal oversight board that aims for broad-based structural and economic reforms.
The cornerstone of the plan is debt restructuring and spending cuts, which is key to restoring Wall Street’s confidence in the commonwealth and protecting its future borrowing power in the capital markets, according to David Skeel, professor of corporate law at the University of Pennsylvania Law School, who was one of seven people on the Financial Oversight and Management Board for Puerto Rico that gave the commonwealth the green light to enter the debt restructuring process.
Skeel says many factors led to Puerto Rico’s current economic distress, including the phasing out of a big tax benefit the territory was receiving in 2006. “Rather than ratcheting back on what it was spending, it increasingly financed its operations with debt, which is always a problem,” he said. “You put that together with a number of factors and you end up with $123 billion of debt, if you include unfunded pensions.” Moreover, the $6.4 billion block grant that Puerto Rico received from Obamacare is rapidly running out, Skeel says. Currently, he adds, Congress has set aside $295 million for Puerto Rico this fiscal year.
Skeel says the board saw no option except bankruptcy. “We negotiated as long as we could without filing,” he says on the Knowledge at Wharton show, which airs on SiriusXM channel 111. “The big trigger in a sense was the standstill [against creditors] that was in place. The automatic stay expired the end of [May 1]. … Lots of lawsuits were filed right away after the stay expired. At that point, it became clear we needed to invoke Title III.” Title III of the newly created Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) mimics the Chapter 9 municipal bankruptcy code and Chapter 11 corporate bankruptcy process. It was created because states, including Puerto Rico, cannot file for bankruptcy. Title III is meant to plug the gap.
Puerto Rico’s fiscal plan includes spending cuts across the board and setting up of a debt repayment plan to creditors, Skeel says. “One way to frame how we thought about the fiscal plan is we asked how much can we cut without pushing Puerto Rico over the edge? It’s a real tightrope we have to walk,” he says. “Every dollar that you cut, it’s a dollar that somebody doesn’t have in their pocket, which hurts them and ultimately hurts the economy. … The hope is that once the cuts are implemented and the budgets are back in alignment, Puerto Rico will start to grow again.” In the meantime, the “trajectory is difficult right now. Hopefully several years down the road, we’ll start to see growth.”
“Rather than ratcheting back on what it was spending, it increasingly financed its operations with debt, which is always a problem.”–David Skeel
The Problem in Puerto Rico
The developments cast harsh light on deeper and longer-term problems Puerto Rico must resolve in order to manage its debt obligations and restore economic growth, according to academic experts. Among them are the absence of a credible economic plan; government spending far in excess of revenue; chronic unemployment; inefficiencies in spending on health care and needless subsidies; the flight of young Puerto Ricans into other parts of the U.S., and governance by U.S.-dictated economic policies that the territory cannot afford, such as high minimum wages. (Notably, Puerto Rico does not pay federal income taxes.)
Rosario Rivera-Negron, economics professor at the University of Puerto Rico at Cayey, traced the territory’s problems to the “collapse” of its economic model since 1974 and the underwhelming economic growth that followed in subsequent decades. “Eventually that was going to blow up in our faces, and that is what happened,” she said. She recalled issuing that warning two years ago. Puerto Rico needs “new institutions, new structures, new laws and new incentives,” she told Knowledge at Wharton in 2015.
“Many years ago, we should have realized that different economic conditions call for different policies,” said Orlando J. Sotomayor, economics professor at University of Puerto Rico, Mayaguez. “We should have been allowed to have a lower minimum wage, and allowed to redesign public programs in a way that they don’t discourage too much work.” Added Rivera-Negron: “We should have redesigned our economic model, our institutional agreements, the tax system and how we create the incentives to make people work and go to the labor force.”
“We don’t have an economic plan and the political class hasn’t produced anything similar to an economic plan.”–Rosario Rivera-Negron
Tracing the Decline
“Rich-country policies are imposed on developing country settings without any regard to the consequences,” Rivera-Negron said of how Puerto Rico was hurt by U.S. policies. In 1938, the U.S. extended its minimum wage requirements to Puerto Rico but lowered it in later decades when the territory found it too expensive, but ratcheted that back up to U.S. levels in 1974, along with tax breaks for businesses soon thereafter. Those minimum-wage requirements boosted earnings for workers but generated high levels of unemployment as companies laid off people, prompting government subsidy programs. Then tax breaks were withdrawn in 2006, triggering a long recession. Skeel points out that the territory’s unemployment rate exceeds 12% and 46% of its people are under the federal poverty level.
Few people in the political class know how to successfully fix Puerto Rico’s problems, and those who do hold themselves back because they have to take politically unpopular measures, said Sotomayor. “They have refused time and again to address the problems [such as] balancing the budget and, implementing economic reforms, even when the retirement systems are about to go bankrupt,” he said. “We are passive and have become accustomed to have others solve our problems,” he added, referring to policies drafted in Washington.
Debate over Status
One of the mostly hotly debated political issues in Puerto Rico is its status as a U.S. territory. The island has no political powers but retains control over fiscal policy and some industrial policy, Rivera-Negron noted. The two main political parties, including the party that holds the governorship, are in favor of statehood, while the previous government backed a commonwealth status and an enhanced relationship with the U.S., says Skeel. A smaller political group favors independence. A referendum on the issue that was originally scheduled for June 11 may now be postponed.
However, issues related to economic growth outweigh that of the status of the territory, according to Rivera-Negron. She lamented that those issues don’t get sufficient attention from the political parties. “We don’t have an economic plan and the political class hasn’t produced anything similar to an economic plan,” she said.
“If you push an island too far in terms of paying back creditors you risk pretty much killing the goose.”–Orlando Sotomayor
Along with its debt overhang, Puerto Rico has been embattled in recent years with other problems such as hurricanes and storms, and now, the threat of the Zika virus with warm-weather summer days around the corner. All that has affected Puerto Rico’s tourism industry, said Rivera-Negron. The response to Zika, in particular, has exposed how the physical and social infrastructure of the territory is in dire straits, she added.
Hope in a New Plan
The 10-year fiscal plan crafted by the oversight board aims to boost revenues with tax reforms, increase tax compliance and increase fees and taxes; tighten government spending with a wage freeze until 2020 and cut subsidies and operational expenditures; extract economies in health care spending and pension plans; and introduce structural reforms to increase labor participation, invest in infrastructure projects along with support from public-private partnerships.
Skeel hopes that the reforms planned for Puerto Rico will arrest the flight of young people to the U.S. and encourage others who have already left to return. “There has been a drain on the population,” he said, nothing that the territory’s population has shrunk from 3.6 million a few years ago to under 3.4 million now.
According to Sotomayor, the plan that will now be hammered out with creditors has to be the right medicine and the right dose, or else it could become counterproductive. “If you push an island too far in terms of paying back creditors you risk pretty much killing the goose,” he said. “It is not laying golden eggs but you have to be careful how much to allocate to creditors.”