Business Monday

How Puerto Rico got into its current financial mess

A man drinks a beer in a local bar as he watches Puerto Rico’s governor Alejandro Garcia Padilla on television delivering an address on the state of the island’s finances, in San Juan, Puerto Rico, in June.
A man drinks a beer in a local bar as he watches Puerto Rico’s governor Alejandro Garcia Padilla on television delivering an address on the state of the island’s finances, in San Juan, Puerto Rico, in June. AP

Among the many who have been hit by Puerto Rico’s 11-year economic recession are the island’s school teachers.

With the closure of more than 200 schools, cuts to benefits and a freeze on salaries, many teachers are among the tens of thousands of professionals who have left the island for better jobs on the mainland as the government struggles with about $70 billion in public debt.

Teachers have not seen a raise in the base salary of $1,750 a month since 2008, according to Aida Diaz, president of the Puerto Rican Teachers Association, the island’s largest teachers union.

“A teacher can’t aspire to getting married, much less starting a household,” she said.

Across the U.S. territory, conditions are grim. Nearly half of the island’s 3.5 million people now live below the poverty line, and more than 50 percent of all children live in families that receive some sort of public assistance. The unemployment figure stands at about 12.2 percent, according to the U.S. Bureau of Labor Statistics. That’s a drop from 16 percent in recent years, but it would be much higher if the island weren’t undergoing an extraordinary bout of depopulation: One out of 13 people left the island between 2010 and 2015.

Even Santurce, once one of San Juan’s most upscale neighborhoods, filled with shops and cultural venues and once home to a solid middle class, is now pockmarked by shuttered buildings covered in graffiti. The island’s economic stagnation has defied all efforts to redevelop this once-tony district.

“People have tried to start businesses in some of these buildings, but they have had to close down,” said Samuel Medina, 30, the owner of Libros AC bookstore on Santurce’s main avenue.

The islanders’ misery is poised to become worse, a top U.S. Treasury Department aide has warned.

Antonio Weiss, counselor to U.S. Secretary of the Treasury Jacob “Jack” Lew, told the U.S. House panel looking into the island’s fiscal crisis that Puerto Rico’s debt should be restructured immediately.

“Puerto Rico is already in distress. What started as a recession has turned into a fiscal and a liquidity crisis that shows signs of becoming a humanitarian one as well,” Weiss testified in Washington on Feb. 25.

SEEDS OF CRISIS

Puerto Ricans can date the start of the current economic slide to 2006. That’s when the 10-year phaseout of the federal tax code provision — commonly known as Section 936 — exempting income earned by U.S.-based companies in Puerto Rico was complete.

Since going into effect in 1976, the tax breaks had attracted numerous manufacturing companies, especially pharmaceutical firms and medical equipment makers. The companies provided thousands of well-paying jobs, underpinning a large middle class.

The double whammy of the end of that favorable tax provision and the onset of the Great Recession pushed Puerto Ricans, including tens of thousands of professionals, to move to the U.S. mainland, further eroding the tax base in a vicious downward cycle local leaders characterize as “a death spiral.”

“The phaseout of the tax benefits to corporations was accompanied by a spike in unemployment, which was tempered by the exodus of Puerto Ricans from the island,” said Vicente Feliciano, a San Juan-based economist.

“When the chips are down, Puerto Ricans don’t have to pay the debt. They can buy a one-way ticket to Florida,” Feliciano said. “People leave the island and reduce the capacity [of the government] to pay.”

As tax revenues dried up, successive governments began borrowing heavily — into the teeth of the recession — to pay their debts, racking up tabs well into the billions. Some of the bigger creditors are Franklin and Oppenheimer funds.

But despite the island’s mounting debt, investment portfolio managers continued to gobble up Puerto Rico’s government bonds thanks to another favorable provision exempting bondholders from paying tax on dividends. The bonds sold well to both institutional and mom-and-pop investors.

According to the Government Development Bank, Gov. Anibal Acevedo, who governed between 2008 and 2012, added $15 billion to the government debt, while his successor, Luis Fortuño added $15.6 billion

In addition to borrowing heavily, then-governor Fortuño instituted austerity measures that included cutting 30,000 public-sector jobs and closing 200 public schools during his four-year term.

Some island leaders also blame U.S. policies that, they contend, treat the territory less generously than states.

“Consider that, historically, Puerto Rico has received $300 million in annual Medicaid funding, while similar-sized Oregon receives $5 billion,” said Pedro Pierluisi, Puerto Rico’s resident commissioner. He is the island’s sole member of the U.S. House of Representatives but has no vote. “I challenge any state to run a decent Medicaid program with that insulting sum without overborrowing in the capital markets.”

The unpopular measures cost Fortuño the governor’s office. In 2012, he was defeated at the polls and replaced by current Gov. Alejandro García Padilla.

García Padilla began his term with defiant words for the bond-rating agencies that have downgraded Puerto Rico’s bonds to junk status. But as the situation worsened, he instituted an 11.5 percent value-added tax on business-to-business transactions and juggled government pension fund money to make debt payments.

By the middle of 2015, García Padilla acknowledged that the crisis was so severe that the government would not be able to pay its debts.

“This is not politics,” said García Padilla. “It’s mathematics.”

The unpopular economic policies have led García Padilla to announce he will step down after his first term ends next year.

In his State of the Commonwealth speech last month, he laid the blame on both of the island’s major political parties — the Popular Democratic Party, which supports the continuation of commonwealth status, and to which he belongs, and the New Progressive Party, which favors U.S. statehood and to which Fortuño belonged. “Governors from both parties have come before you balancing their budgets with loans,” he said.

REMEDIES UNCERTAIN

Various policies meant to reinforce the economy have failed.

An income tax-break program devised by Fortuño that aimed to entice wealthy mainlanders to move to the island has failed to produce ancillary investments the government had hoped for. Overall, the austerity measures have had the effect of driving Puerto Ricans to the mainland.

In the U.S. Congress, committees are now considering whether to give the island the right to Chapter 9 bankruptcy protection, now prohibited. Chapter 9 is available exclusively to municipalities to assist them in the restructuring of debts; Detroit, for example, filed under Chapter 9. The plan, favored by the governemnt of Puerto Rico, would create a “strong independent federal oversight” restructuring authority to take charge of island finances.

Because Puerto Rico is not an independent country, it cannot turn to international lending agencies such as the World Bank or the International Monetary Fund. Because it is not a state, it cannot seek Chapter 9 bankruptcy protection without authorization by Congress.

That authorization may be slow to come.

At a Congressional hearing in early February, creditors argued that the bureaucracy-heavy government should be reformed before debt is restructured. House Republicans oppose restructuring the Caribbean island’s debt, suggesting instead that the Puerto Rican government adopt “pro-growth” policies.

Some, like Puerto Rican-born Rep. Nydia Velázquez, D-New York, have suggested restoring tax breaks for companies doing business in Puerto Rico.

House Speaker Paul Ryan has promised Puerto Rico that Congress will take up the territory’s economic predicament before the end of this month.

During a trip to Puerto Rico in January, U.S. Treasury Secretary Lew repeated his call for congressional action. He told government officials that the House bill should be “comprehensive” — that is, cover the entirety of the island’s liabilities. That would cover more than Chapter 9, which is more limited in its coverage.

“A legislation is urgent to promote the sustainability of the island through tools of comprehensive restructuring, federal monitoring and economic growth measures,” said García Padilla in a statement after the meeting in San Juan with Rob Bishop, R-Utah and House Natural Resources Committee chairman, on March 4. “Congress owes the 3.5 million American citizens who live in Puerto Rico an opportunity to struggle for their future.”

Time is growing short. The government has already defaulted on $232 million in debt and has no money to pay $400 million due May 1 or a subsequent $700 million payment due on July 1. Some creditors have already filed suit in San Juan federal court.

All this is happening as the debt crisis slides toward a humanitarian crisis, said Eric LeCompte, the executive director of Jubilee U.S.A., which represents island churches.

The most vulnerable populations have been disproportionately affected by budget cuts, LeCompte said. One example: special education students whose teachers’ salaries have been slashed.

“Puerto Rico can’t cut its way out this crisis. It can’t tax its way out of this crisis,” he said. “There is no path to economic growth in Puerto Rico that does not start with debt restructuring.”

Meanwhile, Puerto Rican public agencies desperate for money have declared war on theft and cheating that went unpunished in the past.

The island’s water utility has prevailed on the Justice Department to file criminal charges against people who have not paid their bills or have stolen service, a step only taken in drastic cases in the past. And a government agency that issues permits recently trumpeted the fact that it imposed a $34,000 fine against a company operating an electronic billboard without its permission.

Many impoverished Puerto Ricans say the crackdown is making life even more miserable for them. “It’s not right that they are targeting Puerto Rico’s working class,” Wilma Rivera, a 46-year-old mother of three, said as she watched power company workers inspect her meter for evidence of tampering. “We’re the ones paying for everyone else’s mess.”

But for all the bad economic news, Medina, the Santurce bookstore owner, is sanguine. He said his shop, which features a restaurant space next to the book stacks, is doing well. “It’s because we offer something different: a space where people can come, meet and relax,” he said.

This report was supplemented by material from the Associated Press.

Timeline of crisis

1996

▪ In negotiations over the minimum wage, President Bill Clinton and House Speaker Newt Gingrich agree to phase out tax incentives for U.S. companies that move to Puerto Rico.

2006

▪ Tax-code phase-out takes full effect.

▪ Puerto Rico experiences the first in 10 straight years of negative economic growth.

▪ Tens of thousands of residents begin move to the states.

2008

▪ Luis Fortuño elected governor, lays off 30,000 public workers and closes 200 schools.

2015

▪ August: Puerto Rico makes first default on public debt; Gov. Alejandro García Padilla pronounces government public debt of more than $70 billion “unpayable.”

▪ December: House Speaker Paul Ryan promises full House will take up Puerto Rico debt issue by the end of March 2016.

2016

▪ March: Government Development Bank proclaims bankruptcy would only cover fraction of the debt

▪ April: 11.5 percent Value Added Tax slated to go into effect

▪ May: $400 million due on Government Development Bank debt

Snapshot of Puerto Rico: 2005 vs. 2014

Year

Gross Domestic

Fixed Investment

(in millions)*

Construction

investment

(in millions)**

Annual personal

income, total

(in millions)

Tourism

(no. of visitors)

Gross Domestic

Product

(in millions)

2005

111,901.5

6,513.6

30,676.9

5,072,800

3,821

2014

8,943.7

3,534.4

29,777.0

4,555,200

3,548

*The total investment for sectors such as construction, manufacturing, etc.

**The total investment for construction projects

Source: Government Development Bank of Puerto Rico

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