5 Reasons Puerto Rico Is in Debt Trouble
Allianz Global Investors
By Kristina Hooper
July 20, 2015
Trouble in Greece seems to be stabilizing, at least for now, but there’s another debt crisis brewing closer to home—in Puerto Rico.
Up until 2006, Puerto Rico experienced solid economic growth. However, the economy has contracted in each of the last nine years. There are a number of reasons for this deterioration:
- The 1996 repeal of an important tax break for manufacturers that brought many pharmaceutical companies to the island in the 1970s.
- The housing crisis in Puerto Rico, which began before the US housing crisis and was more severe.
- The Great Recession in the US also hurt Puerto Rico, which relies heavily on US spending.
- Banks in Puerto Rico have come under pressure, forcing them to reduce their balance sheets, which led to a 30% drop in commercial bank assets since 2005.
- The substantial increase in oil prices from 2005-2012 had an adverse effect because Puerto Rico relies almost entirely on imported oil for its energy.
Compounding those developments are the serious headwinds Puerto Rico has faced for years, such as weak labor-force participation. Only 40% of the adult population is employed or seeking employment, as compared to 63% of the US population. Federal minimum wage is significantly higher than market wages in Puerto Rico. And there are stricter regulations for employers too. That makes it undesirable to hire additional workers. Further, US government benefits are generous compared to local wages, providing an incentive for people to stay home.
Another major obstacle for Puerto Rico is its large government bureaucracy. Among the 905,000 jobs in Puerto Rico, 230,600 of them were government jobs—the largest source of jobs on the island. This compares with 21.8 million government employees in the entire US, which is approximately 8.4% of all employees.
Plus, since Puerto Rico isn’t part of the US mainland, it is subject to the Jones Act (also known as the Merchant Marine Act of 1920). The law requires that ships from other countries only stop at one port in the US, at which point the cargo can be broken up and sent to other US ports by a US ship. This requirement has added significant costs to doing business in and living in Puerto Rico. Despite vigorous lobbying efforts to waive this criteria, there has been little progress.
Another headwind has been an aging and shrinking population. Since Puerto Ricans have US citizenship, younger job seekers can go to the mainland, while pensioners and entitlement recipients are likely to remain on the island. Meanwhile, the normalization of US relations with Cuba threatens to take away a chunk of Puerto Rico’s tourism dollars.
Given all of these challenges, it’s no surprise that its labor market is struggling. According to the Bureau of Labor Statistics, the December 2014 unemployment rate was 13.7%. It fell to 11.7% by March of 2015 but increased to 12.2% in May of 2015. As it tries to get spending under control, the government is cutting jobs, which is making matters worse.
Why have investors continued to buy Puerto Rico’s debt? Investors were enticed by the “triple taxation” benefits it offered—it’s free from federal, state and local taxes for US citizens. However, starting in 2013, risk premiums began rising on general obligation bonds and public enterprise debt, as investors began taking note of the growing debt burden. In early 2014, when ratings agencies began downgrading Puerto Rico’s municipal debt to below investment grade, we saw a narrowing of the traditional base of municipal bond investors. New investors demanded higher risk premia, shorter maturities and greater seniority.
Is Puerto Rico Like Greece?
Puerto Rico is estimated to have a 100% debt-to-gross national product ratio, which is not terrible compared to some developed countries. However, Puerto Rico’s economic stagnation and the potential for the situation to worsen is alarming. Some observers have even likened it to Greece’s debt crisis:
- Neither Greece nor Puerto Rico has its own currency or central bank.
- Both countries are seen as victims of poor policies. Greece has been forced into an austerity that has only worsened its economy, making it more difficult to pay taxes. In Puerto Rico, the Jones Act has made the cost of living substantially higher while its lack of status as an actual US state prohibits it from filing for bankruptcy.
- Both countries have had difficulty collecting taxes. Greece’s tax-collecting woes are legendary. And estimates reveal that Puerto Rico has failed to collect $900 million, or 44%, of the Puerto Rico Sales and Use Tax.
- Both countries have said they can’t continue to pay existing debt and need a restructuring. However, they face an uphill battle in actually being able to restructure on terms that will be palatable to their respective populaces. Given Puerto Rico’s status as a territory and not a state, its citizens don’t have the same rights and responsibilities as other US citizens. This is an important distinction given its current fiscal issues. Like states, Puerto Rico can issue debt. But it can’t file for bankruptcy. In both cases, structural and fiscal reforms are needed.
Puerto Rico’s default pales in comparison to other global issues. Its total debt is just $72 billion, although it’s estimated that unfunded pension and health-care liabilities put total debt in the neighborhood of $100 billion. Unlike Greece, Puerto Rico’s debt crisis will certainly not lead to the breakup of the US.
However, given its status as a significant issuer of municipal debt—Puerto Rico represents nearly 2% of the overall US municipal debt market—it could lead to contagion among US municipal debt, some of which (most notably Illinois) is showing vulnerability. We will continue to follow this situation closely.
Kristina Hooper is the US investment strategist and head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree in labor economics from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
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