from Follow the Money and Sovereign and Sub-Sovereign Debt Restructuring

Puerto Rico After Maria: Initial Thoughts on the Fiscal and Economic Implications

September 27, 2017

Carlos Garcia Rawlins/Reuters
Blog Post

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Puerto Rico

Budget, Debt, and Deficits

Hurricane Maria

Disasters

Puerto Rico faced immense challenges even before the devastation from Hurricane Maria. Its economy is 15 percent smaller now than it was ten years ago, and the latest high frequency indicators from the (bankrupt) Government Development Bank indicate the economy was falling by about 2 percent a year going into September. About 10 percent of Puerto Rico’s population has left in the last ten years—and the pace of outmigration has picked up recently, with about 2 percent of the population leaving in recent years. Its pension system had been paying benefits by selling assets, and it basically has no more assets to sell. Its medical system was running off a grant from the Affordable Care Act, and that too is about to run out. Serious fiscal austerity was about to start.

And now Puerto Rico appears on the edge of an acute humanitarian catastrophe. The electrical grid is down, and expected to remain down for some time. Without electricity, many critical services are hard to provide. Providing enough fuel access to run the secondary generators in all of the hospitals is a major challenge. The water utility needs electricity to run its pumps and waste water treatment facilities. Clean water is short in some places. Food too.

And no doubt there are many other acute problems that need to be solved to keep the current humanitarian crisis from becoming a full-on catastrophe.

Puerto Rico's future finances aren't the most pressing problem to address right now. But the discussion about how Maria will impact Puerto Rico’s economy and finances clearly has started, and I wanted to make four initial observations:

  1. There is no way Puerto Rico can pay its debts right now. And thankfully, Puerto Rico already had a framework (as a result of PROMESA) that provides Puerto Rico with protection from creditor litigation while it struggles to recover. Most of the major Puerto Rican public entities were effectively operating under Chapter 9 style bankruptcy protection (title III of PROMESA) before Maria. I would not be surprised if the water authority also seeks protection now. With the approval of the oversight board, Puerto Rico can zero out debt service for the next few years and divert all available cash to cover its critical short-term needs. And over time PROMESA’s court supervised restructuring process should allow Puerto Rico to reduce its legacy debts significantly; the bonds generally thought to have the best legal claim on Puerto Rico now trade at around fifty cents on the dollar.
  2. Puerto Rico’s humanitarian crisis is likely to quickly turn into a budget crisis. Sales tax collections will disappear for several months. Income tax collections will be way down. Tourism over the winter will fall, along with associated revenues. Even with the FEMA waiver of cost-sharing on emergency help, Puerto Rico looks to be facing a budget hole thanks to lost tax revenues. (A super technical point, but the mechanics of the sales tax pledge on the sales tax-backed [COFINA] bonds matter; the oversight board is seeking to adjust the COFINA pledge, which would help).*
  3.  Obviously, there is tremendous uncertainty right now, but I would bet the budget hole is larger than what can be covered by zeroing out projected debt service this year and next in the current fiscal plan (debt service is $400 million this year, $560 million next year, and around $700 million in FY 2020) and drawing on any budget reserve. Cutting the budget further in response to falling revenues would only add to the economic devastation. There should be a mix of emergency federal funds and/or the use of the PROMESA provisions that effectively allow the board to authorize debtor-in-possession (DIP) financing (the board can prioritize payments on new debt) to cover any immediate shortfall in tax revenues. Pulling forward future revenue to cover the current hole though will require further adjustments to the fiscal plan, as it obviously creates a fiscal shortfall later. I suspect the Oversight Board—which already has authorized the Governor to shift a billion dollars across agencies to meet emergency needs—understands this.
  4.  Federal reconstruction funds will help Puerto Rico to rebuild a portion of its public infrastructure. But that alone won’t be enough to assure long-term recovery. Puerto Rico will struggle I suspect to meet the requirement for a local match on new infrastructure investments to build long-term resilience (unless the requirement is waived).** And private businesses also need to decide to rebuild rather than relocate. I worry that the multinational companies that are the mainstay of Puerto Rico's pharmaceutical sector will migrate to other tax-favored jurisdictions: Ireland offers comparable tax advantages these days, and less hurricane risk.*** And I worry that many Puerto Ricans will decide that the time has come to migrate to Florida, to New York, or to a less traditional destination. That will further reduce Puerto Rico’s long-run economic potential.

The provision of emergency help to Puerto Rico should not be controversial (even if the disaster relief fund has funds left over from Harvey and Irma, there will need to be another appropriation soon).

There also needs to be a discussion of how the federal government’s current fiscal bargain with Puerto Rico needs to change. Right now low income Puerto Ricans with children are effectively disadvantaged by the tax system if they work in Puerto Rico rather than in Florida (or any of the 50 states), as Puerto Rican workers do not qualify for the earned income tax credit (EITC). And right now the Medicaid funding formula provides Puerto Rico with less support than it would get if it were a state, though care should be taken to assure that new Medicaid funds go to improving access to healthcare in Puerto Rico—not to bondholders.**** Addressing such discrepancies seems like low-hanging fruit and the budget cost is actually very modest (nothing at all compared to the cost of many tax changes now under discussion).

Remember that Puerto Ricans can already access these federal funds if they migrate off island, but then their work won’t support the reconstruction of Puerto Rico.

No doubt there are other ideas too—ideas that would go beyond providing low income Puerto Ricans equal access to federal funding and that would move toward providing special incentives to encourage investment and industry.*****

But there should be no doubt that Puerto Rico needs help. Today. And over the next 10 years.

* Sales tax funds traditionally have flowed into the COFINA trust fund before going into the budget—so sales tax funds only arrive in the budget after all the funds needed to make bond payments for the full year are set aside. That traditionally creates a hole in the budget from July to December. But, well, if sales tax receipts fall sharply, almost all of this year’s collections could go to the COFINA trust fund, with very little flowing into the budget until late in the year, if at all. (And to make this more complicated, the incremental sales tax revenue from the 2015 sales tax hike flows directly to the budget, this is only true for a portion of the sales tax proceeds—welcome to the wonderful world of securitization of general government revenues).

** The bond holders of the power company are offering to provide DIP financing to help PREPA meet the federal match, but only if some of their old bonds are also given priority. The second part may be a stumbling block; from afar, I would guess there might be less expensive ways to get DIP financing. 

*** For corporate income tax purposes Puerto Rico is outside the United States, so the pharmaceutical industry can defer U.S. income tax on the “foreign” profit they earn on their Puerto Rican operations (which can be structured as controlled foreign corporations).

**** Money is fungible, and there is an argument that the existing confirmed budget already covers essential medical care, so any new federal funds would be available for bond holders. I am no lawyer, but I would think creative legal drafting could limit the risk that new federal funds would be used for purposes other than raising access to medical care relative to the baseline in the current approved budget. 

***** Bloomberg, the Wall Street Journal oped page, Dan Drezner, Vox, and others are all arguing for exempting Puerto Rico from the Jones Act—a completely reasonable proposal. But in my view the long-term impact of a Jones Act waiver would likely be fairly modest. The Jones Act unquestionably raises the cost of shipping goods from the U.S. to Puerto Rico, but it doesn't seem to raise the cost of shipping back to the U.S. (the ships have a lot of excess space on the return journey, as they sail back roughly 20 percent full: see this GAO report, page 17. The GAO report also offers a ton of institutional detail, including maps showing shipping routes to Puerto Rico). While permanently lifting the Jones Act would clearly provide a one-off increase to real income in Puerto Rico by lowering the cost of goods "imported" from the U.S., in my view, it isn't likely to be sufficient to overcome the disadvantages of geography or fundamentally change Puerto Rico’s economic trajectory.

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