Puerto Rico didn't fall into its current state of difficulties overnight, and it surely won't extricate itself very quickly either. In fact, as we know from too many examples of crisis management that it's very hard to avoid stumbling blocks on the road to stability. While Puerto Rican policymakers are moving forcefully ahead to stabilize government finances and addressing the key structural weaknesses in the economy, the headwinds may end up being too strong an impediment. It can't be ruled out that Washington DC will be obliged to take on leadership of the situation, well beyond sending a task force to the island.
Will Puerto Rico's Dire Economic Situation Correct Itself?
Time will tell but the challenges are formidable. On the positive side, fiscal policy developments are encouraging. According to official publications, the deficit (excluding amortizations) is planned to shrink to 1.2% of GNP this FY from 3.4% of GNP just two years ago. Should the government stay on schedule, it will also post a small primary surplus this year, implying that it is at the cusp of turning around its adverse debt dynamics. The government launched an ambitious pension reform and took steps to improve the performance of struggling SOEs. Debt service appears manageable at $1.2-$1.3 billion per year for the General Fund. Total debt service hovers around just $3.5 billion a year on the $70 billion of debt of this $70 billion economy.
And Puerto Rico has engines for growth. The tourism sector is poised to expand thanks to the concerted effort being launched to tap this island economy's largely unexploited comparative advantage in fun and sun. Puerto Rico possesses a very high skilled work force that's been trained by MNCs, particularly in the pharmaceutical sector. They just need jobs to occupy.
The problem is this $70 billion economy is shrinking. GDP has been negative since 2006 and the decline is accelerating; indeed, the Economic Activity Indicator has declined by over 5% for each of the past four months, and it poised to deteriorate further, threatening negative nominal GNP growth. Skilled Puerto Ricans are emigrating in droves, with unfettered access to the US continent thanks to the free movement of labor. The population is on a steady decline.
As I mentioned in my recent Seeking Alpha contribution, Puerto Rico's fundamental competitiveness constraints are not under its control to a great extent. The Commonwealth has the same minimum wage rate as the US despite the gaps in skills and income levels. And, as Puerto Rico uses the USD as its currency, there is no scope for using the famed devaluation tool to boost competitiveness.
A rating agency downgrades to junk status seems on the near horizon, and this could trigger a technical selloff in the markets. Any bad news will rock the markets and confidence, and make it all the more difficult to follow the slow and steady path towards achieving stability in public finances.
Some creative thinking from the US may be called for to assist this beleaguered island economy.
What form could this leadership take?
Altering Chapter 9?
One unpalatable option might be altering Chapter 9 to allow Puerto Rico a procedure within which it can restructure its debt. Puerto Rico could be viewed as hovering in grey territory in US bankruptcy law. Municipalities are eligible to file for Chapter 9, but US States are not. Puerto Rico is neither a municipality nor a State - it is a commonwealth. At present, Puerto Rico cannot file for bankruptcy like Detroit has, but if the option left on the table is a nasty default, perhaps an amendment to Chapter 9 would be contemplated.
Another solution might be government receivership, whereby the government takes over economic and financial management of the distressed concern. Sergio Marxuach of the Center for the New Economy wrote about the precedence for this in a paper that he authored back in 1996, exceptionally clairvoyant about the train wreck approaching Puerto Rico. In two of the past examples he discussed in his paper, New York City in the 1970s and Philadelphia in the 1990s, state governments intervened to manage the crisis. In the case of Washington, DC in the 1990s, Congress intervened and set up the infrastructure to supervise and manage the crisis situation. In all three cases, emergency liquidity facilities were set up to "allow the cities to function while fiscal sanity was restored."
This type of intervention doesn't appear likely for Puerto Rico. For one, as noted, Puerto Rican policymakers have moved aggressively and convincingly on the fiscal situation and don't appear to require the outside technical assistance. In addition, with Puerto Rico's problems being more economic than fiscal, the solution isn't to be found in better cash flow management. Moreover, the precedent set by Detroit's default suggests a more laissez-faire approach to Puerto Rico is the most likely course of action to be followed.
Fed Muni Bond Intervention?
Should financial market pressures not abate, another possible option could be Fed intervention in the muni market, and specifically, buying up distressed Puerto Rican paper. This course of action would only be intended to "buy time" for Puerto Rico for it to make the necessary structural adjustments that would allow it to manage its over-indebtedness. Fed intervention is a very low-probability event, and is an option that would only be contemplated if severe systemic risk to the markets would develop. Given the push to start Fed tapering, and the arguments against the Fed's program of QE, it is highly unlikely that the Fed would embark on a new form of intervention.
The most likely creative solution, if indeed one is needed, would be an amendment to Chapter 9 to facilitate a debt restructuring by Puerto Rico. None of the other solutions identified get at the heart of the problem, namely, that Puerto Rico's debt is too large and it's economy too feeble, to manage.
The precedent established by Detroit's debt restructuring suggests that the government will not intervene to avoid a default. Moreover, sounder fiscal management does not appear to be what is required in order to stabilize Puerto Rico. With regards to Fed intervention, quantitative easing has overstayed its welcome. In any case it would not solve the fundamental economic problems of the Island and the reasons for market distress.