from Follow the Money

Puerto Rico Needs Tools to Help It Carry Out A Necessary Restructuring

June 27, 2016

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

Full disclosure: I worked on Puerto Rico while at the U.S. Treasury in 2015. All views here are my own.

The Hill has published my column on PROMESA (the bill that sets out a framework for fiscal oversight and territorial debt restructuring that passed the House earlier this month and that the Senate is taking up this week). I support the bill.

Puerto Rico cannot continue to rely on fiscal gymnastics to delay an inevitable default, and needs to start building its budgets around credible estimates of revenues. The game of passing budgets that balance thanks only to overestimating revenue—and then finding ever-more-creative ways to cover the cash flow gaps that inevitably arise—needs to end. Puerto Rico desperately needs legal tools to organize its incredibly complex debt stock into a vote, and ultimately reach agreement with its creditors, the oversight board, and the court on a new payment structure.

A few additional points:

Puerto Rico’s nominal GDP growth over the past years has averaged about 1 percent. The nominal interest rate on Puerto Rico’s tax supported debt is about 5 percent. The basic debt dynamics are bad.

Contractual debt service on the tax-revenue supported debt is about 5 percent of Puerto Rico’s GNP (counting amortization payments, which tend to be modest). There is no way Puerto Rico can, nor should, run a primary surplus sufficient to cover all these payments. The new oversight board isn’t just needed to increase the credibility of Puerto Rico’s budgeting. It also should use its powers over the restructuring process to help guide the needed adjustment of Puerto Rico’s debts so Puerto Rico can avoid Greek-style austerity.

Puerto Rico is not like a typical sovereign. And not just because it has a strange legal position as a territory, and not just because traditionally it has issued in the municipal bond market.

Most sovereign governments fund themselves by issuing unsecured bonds, which broadly speaking have the same legal rank (and yes, I am aware of the complexities here, and recognize that domestic-law domestic currency debt does differ in important ways from foreign-law foreign currency debt, even if both are typically unsecured).

Sovereign debt typically isn’t fragmented across different issuers that all ultimately draw on the same pool of revenue. Rather, a typical sovereign’s debt gains value because it is a highly fungible and thus extremely liquid asset. U.S. Treasuries are all full faith and credit. None are backed by a specific revenue pledge.

That is not Puerto Rico. Puerto Rico has some constitutional debt that has priority over other spending (and other, nonconstitutional debt) in its constitution. It also has set up a ton of funding corporations that have raised money by issuing debt backed by pledges of specific tax revenue. And to add to the complexity, the security pledges on some but not all bonds can be clawed back to help make payments on the constitutional debt. Different groups of creditors can easily come up with arguments for why they can be paid even if others cannot be paid. While the market has developed some sense of the likely recovery on different sets of credits, there is a big gap between different prices in secondary market trading and an actual restructuring agreement that crystallizes new contractual payment terms.

And, of interest to those versed in past debates on sovereign debt restructuring, creditors were the ones who pushed hard for the legislation to include “collective action clauses” to facilitate voting. The collective action clauses, of course, are not really contractual clauses (one of the problems Puerto Rico faces is that its bond contracts rarely allow any voting). They are set out in the proposed statute. But they also were included because creditors wanted them, because there are real problems of coordination among creditors, and, no doubt, because creditors wanted it to be a bit easier to reach an enforceable agreement without going through a full court-supervised process.

As a result, the legislation that passed the House effectively and is now before the Senate sets out two distinct legal paths to restructuring. One based on using clauses to vote on new terms, the other based on a special court supervised restructuring process available only to territories. Broadly speaking, the clauses-based process (Title VI) is the only one available for the next several months. And if the clauses based process fails to produce an agreement within the requisite time frame—and any agreement has to be reviewed by the oversight board to make sure it fits into an overall fiscal framework that provides for a return to sustainability—then the oversight board can vote to put Puerto Rico in the court-supervised process (Title III).**

A standard sovereign restructuring this is not.

* The ballpark math. Roughly $50 billion of Puerto Rico’s $70 billion in public sector debt is supported by the commonwealth’s tax revenues. Most of the remainder was issued by the power and water utilities. Puerto Rico’s GNP, a better measure of payment capacity than GDP in Puerto Rico’s case, is around $70 billion. Average debt service on the tax-supported debt over the next five years is about $3.5 billion. Contracted interest payments are around $2.4 billion a year, and full payment on the sales tax-backed bonds and the constitutional bonds (counting bonds with constitutional guarantee that are paid out of budget resources) would take a bit over $2 billion. Underlying tax revenues—counting all the pledges that are outside the budget—are a bit higher than the $9 billion or so in the budget. A number of a bit over $11 billion (excluding federal transfers) is about right. That includes $1 billion from the recent sales tax hike; Puerto Rico already has done a meaningful fiscal adjustment. My revenue estimates reflect an assumption that the fall in non-sales tax collections will prove to be a bit higher than the estimates embedded in Puerto Rico’s January estimate, and thus the net gains from the new revenue measures will be a bit less than the January fiscal and economic growth plan forecast for consolidated revenues. Latest data on "on budget" tax collections are here. All the underlying data I used can be found here. Consolidated budget that maps to the concept of "tax supported" debt is on pp. 29-30.

** Stephen Lubben has more on the legal mechanics.