Puerto Rico: Prudent Policies Won't Solve Competitiveness Deficit

Includes: EEML, FLN, GML, ILF, LBJ
by: Joan Feldbaum-Vidra

Puerto Rican policymakers have taken the bull by the horns in an impressive way. Indeed, they have sliced the swollen fiscal deficit, addressed the cancerous pension system, and stabilized finances in bleeding SOEs. Unfortunately, this won't be sufficient to salvage the government's financial situation over the long run.

Puerto Rico's structural lack of competitiveness and the looming federal tax reform conspire to be formidable obstacles. They provide disincentives to investment in the beleaguered Commonwealth, feeding negatively into its fiscal picture and debt repayments capacity. Unless Puerto Rico's competitiveness deficit problem is solved - indeed, if it can be solved over the medium term-the Island remains vulnerable. Investors should be prepared for prices on investments in the Commonwealth to move farther south.

Puerto Rico's eroding competitiveness may prove insurmountable. In many ways, Puerto Rico cannot exert control over its dire situation. The Commonwealth is powerless to the whims of US commercial and economic policy. For years, it benefited handsomely from Section 936 of US tax law, which waived taxes on income for manufacturing firms operating in the Commonwealth. Pharmaceutical companies, especially, took advantage of the favorable tax treatment under 936, also enjoying the highly skilled, lower cost, and bilingual workforce, as well as strict US surveillance for safety and quality control. But this law was phased out in 2006. Unfortunately, all that lingers from Section 936 is the adverse side effect of the Dutch disease it created. Since the law's repeal in 2006, Puerto Rico has registered virtually consistent negative GNP growth and a cumulative GNP contraction of 15% over the period, according to official statistics.

According to the Commonwealth Report of October 18, 2013 [1]

"Puerto Rico's economy is closely linked to the US economy; around 71% of exports go to the United States and 40% of imports come from the United States. In recent fiscal years, however, the performance of Puerto Rico's economy has not been consistent with the performance of the US economy."

Even when the US grew in recent years, Puerto Rico did not. Simply put, Puerto Rico has not adjusted to its new globalization challenges.

While drug and pharmaceutical companies still have a tax advantage if they don't repatriate profits to the US, their incentives to continue investing are increasingly under threat. This points to another area where Puerto Rico's maneuverability to boost its competitiveness is circumscribed. Thanks to the government's precarious financial situation, with an outsized level of debt to GNP of 100%, the government has had to resort to tax hikes in order to reduce its borrowing needs. In 2010, Law 154 was passed, hiking excise taxes to 4%. The contribution to government finance is huge, expected to bring in tax receipts equivalent to over 20% for the current fiscal year [1].

Another tax hike will be necessary if revenues disappoint, although for the first few months of the year they are overperforming [2]. With the Economic Activity Index tanking over 5% in the first two months of the current fiscal year, it seems the -0.8% contraction expected by the Planning Board is way off. The dismal growth outlook and the government's tentative financial situation create added elements of uncertainty over the profitability of investing and operating in Puerto Rico.

Federal tax reform, expected by the end of the decade, is Puerto Rico's gravest threat. The current discussion in DC involves a reduction of corporate income taxes in tandem with newly instituted taxes on American corporate income generated from subsidiaries domiciled abroad [3]. How Puerto Rico will be treated is up to speculation, but if tax exemptions are indeed eliminated, expect many of these firms to vote with their feet. With no formal representation in US Congress, Puerto Rico doesn't have a loud voice on this critical and potentially devastating issue.

Puerto Rico's adherence to the federal minimum wage law creates an additional structural competitiveness problem, and yet another one which it itself cannot address. Puerto Rico adopted the federal minimum wage many years ago in an effort to converge with the United States. At that time, the economic situation was benign, and Puerto Ricans enjoyed a boost to incomes from their suddenly higher wages. However, as time passed it has become clearer that the costs of a high minimum wage outstrip the benefits. While higher value added (i.e. pharma) segment of the Commonwealth's labor force is considered cheap compared to mainland USA, the rest of Puerto Rico's labor force is very expensive when considering skills. The result is high, sticky unemployment of over 14% at present.

Puerto Rico's daunting competitiveness pressures, and their role in painting a dark economic future have translated into a very meaningful outflow of Puerto Ricans to the USA. The population has shrunk by about 6% since 2000 [1]. Emigrants include the more highly skilled and professional class, and this is causing a structural brain drain. The exodus has been accelerating as economic conditions worsen on the Island.

And once again, Puerto Rico has little ability to stem the outflow. Free movement of labor with the USA means Puerto Ricans can emigrate easily. And other than reducing unemployment, there are no obvious positive side effects for the economy; Puerto Ricans don't send huge amounts of money back home. All that the outflow accomplishes is weak demand and downward pressure on economic output, to the detriment of government revenues and fiscal strength.

While Puerto Rico lacks many tools to fix its competitiveness deficit, there are areas that it can address. Reducing energy costs is one key area under the control of the Commonwealth. Energy prices are 3x the level of the US as a whole thanks to overreliance on oil. Utility company PREPA must move boldly and courageously on the plan - in place--toward conversion to natural gas to make investment more profitable. In addition, policymakers must create incentives to investors to diversify away from the pharmaceutical sector and MNCs and toward domestic investment in the event the federal income tax reform is signed into law. Moreover, the Tourism Board 's overtime work will pay off handsomely; the Island has untapped tourism potential and a lot of low-hanging fruit to be picked which can allow the sector to grow to 8% of GNP quite quickly, from 6% at present [1], compared to the average global ratio of 9%. In addition, labor market and entitlement reform is key towards incentivizing work over leisure, and boosting the abysmally low labor force participation rate of below 40%. Crime needs to be addressed and education reform at the lower level are other key areas to boost productivity.

Creating meaningful and lucrative jobs is the only way to thwart the brain drain and mass emigration underway. Given the formidable obstacles ahead, and the structural barriers to competitiveness, Puerto Rico must overperform on the areas under its control. Indeed, US policy may also have to bend on its stance towards Puerto Rico - whether on the minimum wage or tax environment --given the gravity of the challenges and the systemic risks posed. The large amount and concentration of Puerto Rican "muni" bonds held by US investors who have enjoyed their triple tax exempt status until the recent sell-off may necessitate some creative thinking in DC.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.