Puerto Rico's problems are fundamentally more economic than fiscal. The sheer number and severity of the economic hurdles that the island has had to deal with over the last couple of decades is what has driven the accumulation of debt and the formation of a structurally imbalanced budget. While the fiscal problems may be able to be resolved, failure to address the fundamental economic issues confronting Puerto Rico will return their finances to structural imbalance again in a matter of a few short years.
The Economic Challenges: Historical
The economic challenges confronting the island have been long-standing, well-identified concerns:
1. Significant cost disadvantages arising from over dependence on oil and very high electricity costs relative to the US mainland.
2. Poor incentives for businesses to hire given that the island's minimum wage is set at the US rate despite the fact that the per capita personal income is about half the poorest US state.
3. Poor incentives to seek employment since entitlements are set at a level close to per capita income and tax policy on the island imposes a high marginal tax on wage income above entitlement income.
4. Outdated US-imposed requirements that inflate costs and reduce competitiveness, like the Jones Act, which requires US ships, US flags, and US employees on all ships transporting goods between US ports. As an island, Puerto Rico depends much more on shipping than any US port city, and has been hurt proportionally that much more as a result. Curiously, the US Virgin Islands have been exempted from the Jones Act since 1992.
5. A poor transportation grid on the island with scant presence of railroads, and over-reliance on trucking across a system of poorly maintained roads.
6. Productivity that ranks among the worst in the world, according to the World Bank.
7. A weak banking system with impaired capital and over-reliance on external financing rather than deposit gathering. The weak banking sector limits the availability of financing available to businesses, making the availability and cost of capital for business expansion and entrepreneurial activity problematic.
8. A system of business regulation that makes basic activities like acquiring a business license an excessively long, difficult, and expensive proposition. The US mainland is a model of efficiency by comparison.
In this list of economic ills, Puerto Rico has major disadvantages in the cost of producing goods, the transportation of goods, the incentives to hire workers, and the incentives for people to seek employment. Puerto Rico has a government that is large even by European standards (although a little smaller now), significant poverty, corruption, and underground activities that vastly exceed US proportions. The removal of the last tax incentives for US corporations to operate in Puerto Rico in 2006 was another nail in the economic and fiscal coffin for the island. Finally, Puerto Rico has much less significance to the US as a Caribbean showcase of the power of capitalism to raise living standards now in the post-Soviet world. The solutions to these problems would be difficult under the best of circumstances. The fact that Puerto Rico's unique legal status will require some legislation to go through San Juan while other measures will have to go through Washington adds significantly to the degree of difficulty in securing needed legislative solutions.
The Ongoing Concern Issue
Auditors who provide opinions on both public and private sector entities are governed by the same guidelines with respect to "going concern" determination. While the topic comes up with relative frequency for corporations, it is not very common for governmental issuers of municipal bonds, owing to the historically low rates of default that have been a feature of general government finance for state and local entities.
The Commonwealth of Puerto Rico's Auditor, Deloitte & Touche LLP, did not address the "going concern" issue in their most recent Comprehensive Annual Financial Report. The omission is significant, because Puerto Rico has recorded General Fund operating deficits for 11 consecutive years. While current law does not permit a Chapter 9 bankruptcy, the issue of the Government's ability to continue timely payment on about $87 billion worth of bonded debt and pension liabilities is of great interest to the bond market.
To what extent should investors pay attention to Auditor's opinion in this regard is not clear. The audit standards change in two years, placing the determination upon the entity getting the opinion. The omission of the "going-concern" discussion in this case could be consoling or troubling, depending on your view of Puerto Rico's prospects.
The Economic Challenges: Prospective
Our concerns about Puerto Rico's creditworthiness are primarily based upon the application of a straightforward economic argument. The basic cornerstones of the argument rest on some basic principles:
1. Population growth is an essential ingredient for long-term economic growth.
2. Puerto Rico's low productivity growth is a constraint on growth.
3. The magnitude of the demographic challenges regarding retirement and health costs indicate that the degree of relative stress on long-term fiscal health is greater for Puerto Rico than even the US.
4. Increased tax revenue and/or expenditure cuts on structurally imbalanced budgets impose significant fiscal headwinds to economic growth.
5. Restoration of long-term fiscal stability requires budgets that grow slower than the rate of growth in the economy.
6. Economic development efforts through tax incentives, tax credits, tax abatement, and other techniques increase costs before benefits are ever achieved (if at all).
7. Cuts in pension benefits can provide significant long-run savings that make the difference between solvency and fiscal ruin. The benefit of any actions taken, however, typically require a number of years before savings become significant in any given year's budget.
The Basic Argument
The basic economic dynamics in Puerto Rico are strongly negative. The World Bank forecasts a 40-year decline (starting from 2010) in Puerto Rico's population at a rate of 0.3% per year. Arresting that decline will be extremely difficult given the ease with which Puerto Ricans can legally relocate to the US, and the strong economic incentives to do so for better economic opportunities. This week, the Puerto Rico Planning Council reported that the fertility rate was below that of the US mainland.
While there are some examples of some western governments who successfully stemmed population loss, the population growth generally resumed at very low rates. Japan and Germany are two examples of nations with vastly greater wealth and economic maneuverability who have suffered as a result of aging population and declining population growth. In Puerto Rico, wealth is very low and population is falling. The expected decline of population and the likelihood that trend productivity will be well below that of the US suggest a trend economic growth rate of less than 1% (-0.3% population growth + 1.2% productivity growth), compared to about 2.3% for the US.
Even a generous evaluation of the current structural imbalance of the budget of about $1 billion suggests that balancing the budget with expenditure cuts of that magnitude would produce a fiscal headwind of about 1.6% ($1 billion divided by Puerto Rico's Gross National Product of $61 billion) if effected over a one-year period. Thus, fiscal balance requires a significant one-time hit to the economy before a return to weak trend growth about 1%. It should be noted that currently, Puerto Rico's economy is in recession.
The expectation that trend growth will be marginal at best severely limits the options available to the government. It is easier to successfully navigate a fiscal contraction to restore budgetary balance if growth is robust. Puerto Rico will not have the best tool available to heavily indebted entities: the ability to grow their way out of the problem by leaning on the ability of the economy to outrun the rate of growth in debt. Even if growth were likely to be sufficient to provide this possible benefit, there is no guaranty of its success.
Demographics impose a heavier burden on Puerto Rico than on the US. Puerto Rico has a cohort of 65+ year olds that is 2% larger relative to the same cohort in the US. The citizens of Puerto Rico also enjoy greater longevity than US citizens. Thus, the fiscal stress from managing retirement and healthcare costs is significantly worse than in the US on a relative basis.
Management has done a good job of reducing pension costs, confronting market concerns with greater transparency, deferrals of some planned debt issuances scheduled for the remainder of 2013, and crafting new bond structures that expand flexibility in raising capital. Our expectation is that management will continue to make progress. Unfortunately, fiscal pressures are building at a much more rapid pace than the government's ability to address the significant long-term economic and demographic challenges.
Below is a partial list of scenarios that we have identified for the long term. No doubt there are many more scenarios. We start from a vantage point of assuming the continuation of the current adverse trends and ask what avenues might be available to management to resolve the dilemma. This should not be interpreted as a prediction of default, or a view that economic decline and/or default are inevitable. The basic premise we start with is:
"The economic and demographic trends are sufficiently adverse over the long run that it is not obvious to us what steps could be taken by the Commonwealth in the short run to offset them, while successfully arriving at fiscal stability that can be maintained in the long run."
Here are our most likely scenarios for Puerto Rico issuers (using the GOs as the relevant base):
The Deus ex Machina Solution
The federal government comes to the rescue with direct financing, loan guaranties, or cash infusions. An idea that we have not seen discussed is the reimplementation of Section 936, which we know to work, and which would spread the cost to the federal government over a long time horizon. While we think that renewal of Section 936 has significant merit, it is a very low probability solution.
This scenario is unlikely because there is no good political argument for bailing out Puerto Rico, but not Detroit. The related theory that perhaps the federal government would bail out both is equally unlikely due to the enormous sums required, the precedents that neither political party wants to establish, and the current contentiousness in Washington, which would cause an Administration from either party to rule out a bailout to avoid the political drubbing the other party would provide.
The Management Miracle
In this scenario, the government of Puerto Rico continues to whittle away at expenses, finds sources of additional revenue, boosts tax collections, and skillfully manages its way to stability. While the current leadership of the government does appear to have significant market savvy -- beyond the average state government -- and are making effective, timely responses to market related events, our long-run outlook suggests that the problems facing Puerto Rico are beyond the capacity of any management to solve, regardless of how capable.
Nations with vastly greater wealth and financial flexibility, such as Germany, Japan, the US have struggled to manage similarly severe demographic changes that threaten their fiscal stability. The steps that could be taken to reduce and reverse population decline are unclear. Tax incentives may provide some help, but there is generally a short-term cost and some years before results start to appear, if at all. The ease with which Puerto Ricans can legally locate to the US, and the vastly greater opportunities, almost guaranty that younger, more educated people will continue to leave for greater opportunity in the US.
What steps could management take to reduce budget deficits of $1 billion without increasing poverty and promoting increased migration? The structural imbalance of $1 billion requires a one-time hit to GNP of about 1.6%, which would significantly deepen the current recession. With fiscal policy on the island contracting, multiplier effects could augment the economic decline and boost social costs.
Long-term Decline with Uncertain Prospects
It is very difficult to construct a positive scenario for the island that offsets the certainty of the negative population and demographic effects. Can the island increase its share of tourism in the Caribbean? Is there a bank haven opportunity as in the Grand Cayman Islands? Can rum production be increased? The economic steps required to reverse the economic plight of the island take time and investment dollars. Can Puerto Rico hang on during this fiscal crisis to see positive results even if they are able to find the government resources to promote economic development?
Management's Best Strategy
Despite the dire prospects for Puerto Rico, no situation is a fait accompli. The island could benefit from political instability in other Caribbean nations that could boost tourism or increase migration from other countries to Puerto Rico. Puerto Rico's location could become more valuable to the US from a change in the geographical location of threats from terrorism or drug trafficking, which might boost federal employment on the island. Fortuitous events cannot be assumed, though.
The best strategy currently available to management is to buy time, grow the base of bond buyers, find new financing structures to ensure continued access to capital and seek to limit the growth of total net bonded debt and pension debt to the rate of growth in the economy or lower. If the island can tread water for a number of years, changes in the political environment in Washington may bring the opportunity for some measure of federal support. Maybe some variant of Section 936 could come back. The lack of federal assistance cannot be any worse than it is at present, so time would likely bring improvement in the US-Puerto Rico relationship.
Puerto Rico, however, needs a strategy that provides immediate impact. Some alternatives include a subminimum wage to boost incentives for businesses to hire, immediate waiver from the Jones Act to restore competitiveness in shipping with Kingston, Jamaica and other competitors, and a reduction in energy costs through tax incentives, credits and more rapid movement to natural gas as a substitute for the island's current dependence on oil. Addressing the high marginal tax rates that apply to income earned in excess of entitlement income would encourage more individuals to seek employment.
The best long-term solution may be the same one necessary to resuscitate Detroit: to shrink the cost of living and working in Puerto Rico in order to create compelling reasons for people to want to stay on or move to the island. This is the economic version of devaluing the currency. In Detroit, consolidating tracks of mostly abandoned residential areas, clearing them, and making the parcels available for development at very low cost (to give companies free land in exchange for unabated property tax payments, for example) could be the basis for reversing that city's long-term decline. Can the government of Puerto Rico take actions like those contemplated in Detroit? Ultimately, economies stabilize when prices adjust enough to motivate more people to live and work in the affected area. Lowering labor costs in Puerto Rico, finding ways to reduce costs that are imposed upon the island by the US, and attracting investment through innovative strategies are what are needed. In the meantime will there be enough cash to service $87 billion in overall debt?
It is very difficult to do a cash flow analysis to estimate when the Commonwealth might be most vulnerable to a debt payment problem. The information that the Commonwealth is required to provide is dated, as is typical of the municipal market. The island's system of government finance is a Byzantine labyrinth of agencies, debt issuers, and governmental entities with active movement of financial resources between them. The magnitude of the debt servicing issue is of immediate concern. The government explicitly recognized the need for maintenance of sufficient sources of cash to meet debt service requirements during their recent investors' conference call on October 15th. The scale of the structural budget imbalance is equally daunting. With skillful creation of bond structures that have coverage sufficient to produce investment grade ratings, the island may be able to continue to finance its structural imbalance. Asset sales and leasebacks can provide short-term cash infusions, but with diminishing productivity. The crown jewel -- the airport -- has already been privatized.
What if Puerto Rico "Breaks Bad"?
If things go badly, the collateral damage could be extensive. The rating agencies have maintained investment grade ratings for a long period of time while economic and fiscal conditions unambiguously deteriorated. This allowed the island to accumulate $70 billion in outstanding bonded debt. Did the rating agencies maintain these investment grade ratings far too long in the face of clear trends that would normally indicate a below investment grade rating? Were the ratings "political" in some sense? The regulatory scrutiny of the rating agencies can only be inflamed by a major Puerto Rico problem.
Mutual fund companies, broker-dealers, UITs, and other retail-oriented investment providers will face hard questions if they are found to be leaning too far over their skis in Puerto Rico paper in order to boost yields on single state funds because of the triple exemption. Justifying a reasonable exposure will not be a problem. Pity the mutual fund that is caught with 25% exposure to Puerto Rican issuers in a single state fund. The Attorney General of the Commonwealth of Massachusetts is already making inquiries along these lines.
The worst-case scenario could be developments that would encourage Congress and the Treasury Department to call into question (again) the value of tax exemption. A major blow-up, no matter when or how it occurs, could provide more fuel to the fire and reverse the progress made by lobbying groups in favor of maintenance of tax exemption.
The Future: From Ashes to Ashes
While we hope that solutions are found that keep all Puerto Rico issuers in good credit standing for the long run, the possibility that a dark future awaits gives us a sense of irony about Puerto Rico. Section 936 and other tax breaks and inducements made the island an effective tool of US State Department policy, helping to demonstrate that capitalism offered more promise to other Caribbean nations than Cuba's communist vision. Unfortunately, with virtually all the incentives gone since 2006, we may be seeing the gradual return of Puerto Rico to its former state of nature before US tax policy boosted its prospects.
Additional disclosure: Loop Capital Markets LLC, an investment bank, prepared this document for informational purposes only. Loop Capital Markets LLC does not provide research services, therefore this product is not a research report and it should not be construed as such. Loop Capital has or may have provided investment banking services to issuers referenced in this document. All materials are indicative and for discussion purposes only. Opinions expressed are our present opinions only and are subject to change without further notice. Opinions expressed herein are current opinions only as of the date indicated. Any historical price(s) or value(s) are also only as of the date indicated and as applicable from any source that may be noted. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. Loop Capital Markets LLC shall have no liability, contingent or otherwise, to the user or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the data or formulae provided herein or for any other aspect of the performance of the materials. Loop Capital Markets LLC is a Delaware limited liability company.