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Country Report Puerto Rico

Country Report

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Puerto Rico’s government is on the very verge of a default. Structural problems, economic shocks and weak public finances have yielded a decade of economic stagnation, outmigration, fiscal deficits and an unsustainable public debt.

Author: Dragos Aftoni

Strengths (+) and weaknesses (-)

(+) Integral part of The United States

Given its legal status of U.S. territory, Puerto Rico benefits in terms of currency stability, legal system, property rights, and federal backing of welfare, education, defence, and banking.

(-) High public debt and limited capital market access

Puerto Rico’s public debt of USD 72bn (ca. 100% of GNP) has become unsustainable under the current weak economic conditions. The island’s normal access to capital market has vaporized, while the credit ratings of outstanding public debt have been downgraded deep into junk territory.

(-) Absence of a lender of last resort

As Puerto Rico is not a sovereign country, it is not eligible for IMF intervention. Its fiscal agent, the Government Development Bank for Puerto Rico, does not have access to U.S. Federal Reserve liquidity assistance and is not a member of the Federal Reserve System.

(-) Structural economic and fiscal flaws, undermining growth potential

Short-term economic improvements are unlikely given the inability to devalue the local currency (USD) and the complexity of an extensive package of structural, debt, fiscal and institutional reforms to facilitate an economic turnaround.

Key developments

1. First payment missed, heading for default

On June 30, Puerto Rico’s Governor Padilla publicly acknowledged that the Commonwealth’s debts of USD72bn are not payable. The island averted a last minute payment default on July 1, but still has very low cash balances as the island was not be able to service the Public Finance Corporation’s (PFC) bond payments scheduled for August 1. Unfortunately the country’s growth potential is too limited to grow out of its debt. Despite the island's incorporation in the United States of America, there are some institutional loose ends: as a Commonwealth, the island is unable to file for bankruptcy under Chapter 9 U.S. legislation. This impedes an orderly restructuring process of its public debt and could lead to a shutdown of governmental agencies when liquidity would dry up. The economic consequences of a default are therefore significantly more far-reaching than in case of an ordinary sovereign or (US) municipal default. So far, the US doesn’t look keen to intervene as particularly Republicans are sceptical of providing debt relief to the island. Without an easy way out, Puerto Rico will have to strike a deal with its creditors to prevent a government shutdown. The current negotiations with creditors (primarily U.S. mutual and hedge funds) to obtain debt relief commenced on July 13, but they are expected to be lengthy and complex, as each type of public debt has its own legal status. In the meantime, the Puerto Rican government may default on several bond payments in the face of a cash shortage.

2. Continuous economic contraction precipitates a challenging 'turnaround' plan

The Puerto Rican economy remains in the doldrums as the GDP is projected to contract by 1% in 2015 and a major turnaround in the near future, with a focus on growth as well as fiscal adjustment, remains challenging. Next year growth is projected to be 0%, but could easily dip into the red as a result of austerity measures or due to an increase of emigration from the island. This poor economic performance is not a new phenomenon; Puerto Rico's real economy has almost continually contracted since 2006 (a cumulative real GDP loss of ca. 13%), following the phasing out of U.S. tax breaks for off-shore manufacturing in that year. The dismal economic performance also drives emigration to the US mainland, which further lowers the growth potential, putting the island in a negative spiral. The low growth performance has also led to a shrinking of the tax base, which has resulted in liquidity problems for the government. Without additional austerity measures, the budget deficit is expected to rise further, from USD 3.7bn in 2016 to USD 6.0bn by 2018. Even if Puerto makes substantial progress on implementing structural reforms, this is unlikely to generate sufficient growth to avert a default. A restructuring of the public debt, which is projected to hit 105% of GDP this year, looks necessary. Part of this debt is owned by the Puerto Rican banking sector which has significant exposure on Puerto Rican public debt. A government shutdown or default will affect the banking sector but even when a sovereign default leads to defaults in the banking sector, its effects on the economy will probably be limited. This is because Puerto Rican deposits are guaranteed by the FDIC. Moreover the FDIC’s fast intervention with Doral bank signals the FDIC can restructure banks overnight in case of default. As such, Puerto Rico's economic conditions in the short and medium term will heavily depend on the outcome of the debt restructuring process, along with the effectiveness of additional reforms to stimulate the competitiveness and the economic growth of the island. A general government shutdown is the main downside risk for the Puerto Rican economy.

Figure 1: Rising public debt and deficit
Figure 1: Rising public debt and deficitSource: Government Development Bank for Puerto Rico
Figure 2: Negative economic growth
Figure 2: Negative economic growthSource: Bloomberg

3. Political scope for unpopular reforms is narrow

Regardless of the leeway Puerto Rico is granted by creditors on its debt service, the government will have to implement structural reforms and austerity measures to force an economic turnaround and to ensure sustainability of public finances. The scope for implementing painful measures is limited however; Governor Padilla’s Popular Democratic Party currently holds a thin majority in the Puerto Rican Legislative Assembly, while the party itself is internally divided over the government’s current strategy in the face of gubernatorial elections in 2016. In addition, the opposition is very vocal against (tough) reforms for obvious electoral reasons, and has little incentive to support further austere measures. The lack of political appetite for reform casts a shadow on the island’s economic outlook and the prospect of a deal with creditors.

Factsheet of Puerto Rico
Factsheet of Puerto RicoSource: EIU, CIA World Factbook, World Economic Forum, Transparency International, Reporters Without Borders, World Bank, Government Development Bank for Puerto Rico

Background information

Puerto Rico is an unincorporated U.S. territory located in the Eastern Caribbean with a nominal GNP of about USD 69bn (2014). Given a population of 3.6m, GNP per capita amounted to almost USD 20,000 last year, which, while comparing favourably to local peers, is only equivalent to about 40% of U.S. mainland GNP per capita. Benefitting from federal tax breaks for mainland companies setting up manufacturing operations on the island since the 1950s, Puerto Rico’s economy under-went a major transition from a mainly agriculture- and tourism-based economy to a local industrial hub. Manufacturing, mainly chemical and pharmaceutical production, today accounts for almost half of total GDP. Puerto Rico’s success story ended in 2006, when the above-mentioned federal tax breaks were phased out and the local economy faced rising regional competition from NAFTA member Mexico. Since then, economic output has been on a rather constant downward trend, as Puerto Rico struggles to regain competitiveness. The applicability of U.S. minimum wages in spite of lower productivity and high energy and shipping tariffs put the territory at a competitive disadvantage while the usage of the USD prevents a currency devaluation. Puerto Rico’s economic decline went hand-in-hand with a worrying increase in public indebtedness (to USD 73bn at the end of 2014), which resulted in the island’s debt downgrade to junk territory by all major credit rating agencies in last year. As municipal bond funds can no longer invest into Puerto Rico’s public debt issuances, the territory’s financial market access has deteriorated markedly, sparking recurrent concerns about a sovereign default. As Puerto Rico is neither a U.S. state nor an independent country, external financial assistance is quite uncertain.

Economic indicators of Puerto Rico
Economic indicators of Puerto RicoSource: EIU, Government Development Bank for Puerto Rico
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Author(s)
Jurriaan Kalf
RaboResearch Netherlands Rabobank KEO
+31 (0)30 21 62666
Other authors
Rabobank KEO
+31 30 21 62666

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