Puerto Rico has reached a very dark hour. All of the major rating agencies now assign speculative grade ratings to the Commonwealth General Obligation bonds, in spite of concerted action by the authorities to gain control over their train wreck of a financial situation. Puerto Rico will have to pay up dearly for the coming debt issue, thanks, in part, to restrictions that traditional tax-exempt oriented funds have from buying junk paper, dampening its once bread-and-butter source of demand. New, non-traditional investors in Puerto Rico - namely, hedge funds - aren't necessarily attracted to the triple tax exempt benefits of the securities, and will demand high returns for holding the risk. These more technical market issues, on top of the Commonwealth's fundamental macro credit challenges - a large debt of 70% of GDP, a shrinking population, high unemployment, a steeply shrinking economy, and credit rating downgrades to junk -- are reflected in the massive risk repricing of Puerto Rico.
While bold government policy initiatives should help close the fiscal gap (indeed, Puerto Rico isn't far away from a primary surplus, a feature that normally points to the onset of improved debt sustainability), in Puerto Rico's case there are too many offsetting factors. In addition to the ones mentioned above, the ongoing exodus of pharmaceutical firms and related contraction of the manufacturing sector are is a major impediment to improved fiscal dynamics. Rising crime and unemployment may prove formidable political obstacles to sustaining this fiscal position too.
Pro-growth policies are essential for Puerto Rico's successful adjustment - and this necessitates the availability of investment-related financing to boost infrastructure and development spending in order to generate employment, output, and demand. Unfortunately, the debt accumulated by the Commonwealth to date - amassed to 70% of GDP -- was largely money misspent, and the fruits of this indebtedness are at best elusive.
In a prior contribution to Seeking Alpha, I referenced the need for creative thinking to manage this crisis without recourse to an outright nasty default. Puerto Rico's proactive fiscal policy efforts to contain the mess resulting from many years of profligacy and irresponsibility are not in themselves sufficient. Growth and employment creation, if only to stymie the massive emigration of Puerto Ricans to the US continent, is vital.
Some analysts have argued that a reinstatement of something similar to Law 936 is necessary to stop the hemorrhaging of multinational pharmaceutical investment in the Island. This preferential tax status, phased out in 2006, was actually a mixed blessing for Puerto Rico, breeding acute Dutch Disease in the economy. In any event, there is no appetite in Washington, DC for preferential tax legislation for Puerto Rico. Indeed, if anything, US legislators want to level the playing field as suggested by the tone of the ongoing federal tax reform debate.
By creative solutions, Puerto Rico needs something similar to an IMF program that provides a backstop of conditional cash in exchange for an aggressive set of restructuring and reform measures. The availability of such support and surveillance could boost investor confidence in the economic promise of Puerto Rico, to the extent the policy thrust is both credible and growth-producing over the longer-term. Puerto Rico is itself not a member of the IMF, so the recommendation would be an arrangement devised according to similar principles as an IMF funding program. Like IMF funding, the emergency loan could have "preferred creditor" status so that US taxpayers are not likely to be on the hook. Admittedly, this proposal opens up more questions than provide answers.
Such a proposal is unlikely to be adopted. Bureaucrats and legislators in Washington, DC insist that aid won't be forthcoming to Puerto Rico. Indeed, given the precedent of Detroit and the general tone of the current discussion on Puerto Rico, investors should be forewarned that financial assistance - even the type suggested above - is hypothetical.
It should be noted that Washington, DC is no stranger to providing financial assistance when it deems it to be in our nation's own self interest. Just take a look at the US Loan Guarantee program. Indeed, as recently October 2012 the US extended its $9 billion loan guarantee program to Israel, allowing undrawn portions to be tapped until 2016. Washington also extended loan guarantees to Turkey, Jordan and Egypt after the Gulf War. One needs to ask, wouldn't it be reasonable for Puerto Rico to receive some extra help? After all, US policies - the Jones Act, the federal minimum wage, and the legislation and subsequent repeal of 936 bear some responsibility to Puerto Rico's current mess, right? Or does DC think that the triple tax exempt status of Puerto Rican debt is sufficient assistance even in the current market environment?