Could Puerto Rico default?

Could Puerto Rico default?

Puerto Rico is about to follow in the footsteps of Detroit, with few options left but declaring bankruptcy. With U.S. retirement funds relying on Puerto Rican bonds in portfolios, the problem is likely to spread to the mainland.

Echoing a previous post on Detroit’s chapter 9 bankruptcy, another U.S. local government has its public debts ballooning making default an imminent threat. Puerto Rico has battled the headwinds of recession over the past eight years. At the moment, Puerto Rico’s public debt stands at $70 billion, it is liable for $37 billion in unfunded pension obligations and the unemployment rate is 15 percent.* As a reference point, Detroit’s debt was $18 billion when the old motor city pulled the bankruptcy trigger.

The economic woes of the U.S. territory have caused a major exodus of people moving to the mainland, in the hopes of finding better fundamentals elsewhere. Not since the 1950s, when 500,000 people left Puerto Rico to seek employment in the States, has an equivalent mass fled the island. Just in the span of 2010 to 2012, 57,000 residents – 1.5 percent of the population – chose to leave their homes behind, and try their luck elsewhere in the U.S. Since the recession struck in 2006, almost 140,000 people have left.

Puerto Ricans do not abandon their former homes for no reason. Crime is a major issue. With a homicide rate six times higher than that of the U.S. on average, most other places are safer than Puerto Rico. What used to be an industrial hub primarily comprised of pharmaceutical industry, textiles, petrochemicals and electronics now sees companies and jobs disappearing due to higher corporate taxes and the eight-year recession.

Trying to stave off the crippling debt burden and keep the budget afloat, Puerto Rican governor Alejandro García Padilla has increased taxes, introduced a broadened sales tax and a gross receipts levy. Seeing as the economy was already vulnerable, the timing of these tax hikes could hardly have been worse. “To say that Puerto Rico’s tax increase for 2014 was monumental is an understatement,” according to Richard Larkin, senior vice president of investment firm H. J. Sims.

Since 1996, the number of factory jobs in Puerto Rico has plummeted from 160,000 to 75,000, a quarter of the work force are currently public employees (versus 16 percent for the U.S. in general), a third rely on food stamps, and Puerto Ricans are twice as likely as mainlanders to receive Social Security disability benefits. In brief, just as Detroit, Puerto Rico shows how bad things may turn if you combine lavish pension schemes with a disappearing industry base.

The risk of default in Puerto Rico is not isolated, and it will have a knock-on effect on other parts of the U.S. as well. Several U.S. retirement funds rely on Puerto Rico bonds in their portfolios, despite the fact that these currently carry a rating of just above junk. As explained in an article in the Guardian:

“A taxpayer bailout would be expensive and a default would be far more disruptive than Detroit’s record bankruptcy filing. A federal bailout is not on the table, but the situation is being monitored by the White House, which recently named an advisory team to help Puerto Rican officials navigate the crisis.”

The problem, which keeps cropping up when U.S. municipal bankruptcy is on the table, is the lack of a constitutional provision for municipalities like Detroit and Puerto Rico to declare bankruptcy. That means that the only option available, if Puerto Rico has no way to pay its bills, pensions and public workers, is defaulting on its obligations. Furthermore, its constitution secures that bondholders get paid before pensioners and public workers if the government goes broke. “I can assure you that Puerto Rico will not default,” Padilla boldly stated. “Puerto Rico will pay our debts. It is a constitutional obligation. But for me it is also a moral obligation.”

In the end, he may not have the luxury of valid guarantees. Fitch warned in November that it considered downgrading Puerto Rican general obligation bonds to junk. If that happens, borrowing will be prohibitively expensive for Puerto Rico and effectively cut it off from the market, possibly forcing federal action in relation to its debt pile-up.

* This is the official, registered unemployment rate. Due to criteria for being unemployed such as being actively seeking a job, this number is often offensively small in comparison to actual unemployment. Only roughly 41 percent of working-age Puerto Ricans actually have a job or are looking for one.

Categories: Finance, North America

About Author

Mikala Sorenson

Mikala Sorensen is an Economist with regional expertise in Europe. She holds a first class honours degree in Philosophy, Politics and Economics from the University of York and a Masters in Economics from the University of Copenhagen. Having interned at the Danish OECD-delegation in Paris and currently working at the Danish Ministry of Finance, she specialises in politics and macroeconomics. Analysis for GRI is an expression of her own views.