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January 23, 2014 7:06 pm
On the cusp of the Caribbean, rising from the Bay of San Juan atop high castle walls, stands La Fortaleza, Puerto Rico’s gleaming white and blue fortress. It was built 500 years ago by Spanish colonists to protect residents from pirates and invaders.
Today the building is home to Alejandro Garcia Padilla, the governor, who is overseeing austerity measures that are squeezing the living conditions of the local population in order to assuage investor fears from beyond its shores.
Four decades after US tax concessions helped swell corporate investment, Puerto Rico’s bonds are at risk of being downgraded to junk status. But Mr Garcia Padilla argues that his belt-tightening policies will restore fiscal stability. “No one believed that we could do that, but we did it,” he says.
Puerto Rico’s modern growth began in the mid-1970s. As the island struggled with soaring oil prices and high unemployment, the US Congress decided to throw its territory a lifeline. It granted a special status that allowed American companies to expand their manufacturing operations on the island without being taxed on the profits earned there.
The plan worked: manufacturers flocked to Puerto Rico. By the 1980s it had become a hub for pharmaceutical companies, including Schering-Plough, Abbott Laboratories, Eli Lilly, Merck, Pfizer, and Johnson & Johnson. Thousands of jobs were created.
But by 2006 the incentives were phased out. Some companies scaled back. And while many multinationals have stayed, the end of the tax breaks made Puerto Rico less competitive – a situation not helped by rising costs such as water and electricity. The financial crisis in the US only added more pressure, sending the territory into recession as unemployment climbed and debt ballooned.
Facing a shortage of funds, the island could rely on another favourable aspect of the US tax system: US municipal bonds. A unique status granted to Puerto Rico, an unincorporated territory of the US, meant that its “munis” were exempted from federal, state and local taxes. This “triple tax-free” advantage was popular with US investors, who were undaunted by Puerto Rico’s history of fiscal trouble. In fact, it was part of their appeal, as the added risk meant they carried even higher yields compared with other local government debt in the US. Thanks in part to munis, Puerto Rico was able to paper over years of economic malaise.
Instead of borrowing to finance investment, Puerto Rico was borrowing to fund its own deficit
“As the economy started to decline, we borrowed more,” says Antonio Sosa, a managing director at financial advisory firm REOF Capital in San Juan. “And soon, instead of borrowing to finance productive capital expenditures and investment, Puerto Rico was borrowing to fund mainly its own deficit.”
The small island of 3.7m people borrowed at levels rivalling large US states such as California and New York. It accumulated $70bn in debt – roughly equal to 80 per cent of its gross domestic product. But the $4tn muni market turned less friendly in 2013. All bonds were sold off when the Federal Reserve signalled it would begin tapering asset purchases. In the muni market, the Fed news was followed by Detroit’s $18bn bankruptcy, leading to concerns about other troubled issuers. Yields on some Puerto Rico bonds rose to record highs and the three big credit rating agencies cut the territory’s status to one notch above junk, warning of the potential for further downgrades.
This interactive guide shows the global recession has had markedly different impacts on different countries in the Caribbean
Puerto Rico’s mounting problems have led some to label it America’s Greece for its potential to send shockwaves far beyond its shores. The tax breaks on its debt mean that its bonds are widely held in the US.
Should the situation in Puerto Rico deteriorate further – or, worse still, ultimately lead to a restructuring – it could rattle the entire municipal bond market, long seen as among the safest of investments. For Puerto Rico and other heavily indebted US cities and states, such disruptions could send their borrowing costs even higher.
“Sooner or later the question for investors becomes simple: are you being properly compensated for the risk of holding such bonds? In the case of Puerto Rico, the answer for us was and still is no,” says Jason Brady, a portfolio manager at Thornburg Investment Management in New Mexico.
The man charged with repairing Puerto Rico’s finances is Mr Garcia Padilla, who inherited six years of recession and a 14 per cent unemployment rate when he took office last year. He is proclaiming short-term success and predicting a long-term course for prosperity.
Mr Garcia Padilla, a Democrat who narrowly unseated the Republican incumbent Luis Fortuno, has challenged party orthodoxy by increasing the retirement age and requiring a heftier pension fund contribution from public sector workers. That, combined with other belt tightening, is meant to slice the country’s deficit to $820m in the current fiscal year that began on July 1, from $1.3bn last year and $2.4bn in fiscal 2012.
But Puerto Rico’s long-term plan to create economic growth has yet to take shape fully.
Mr Garcia Padilla is promising a transformation unseen on the island since the late 1940s, when “Operation Bootstrap”, implemented jointly by the US and Puerto Rico governments, helped convert the economy from agriculture to industry. The governor’s vision includes attracting investment from biotech companies, natural gas developers and the tourism industry to help generate 90,000 new jobs by 2016.
. . .
Some of Mr Garcia Padilla’s cost-cutting measures are similar to efforts in US cities with debt problems and soaring pension obligations, including Chicago and Detroit. But his administration is quick to point out important distinctions. Unlike Detroit, Puerto Rico does not have the option to declare bankruptcy. There are also impediments to default. Puerto Rico’s constitution prevents it, so investors can take some comfort in the territory’s political resolve to pay its debts.
“We couldn’t default even if we wanted,” Mr Garcia Padilla says. “Our constitution is clear and it says we must honour our debts first.”
The question is whether they can afford to keep borrowing. Average yields on Puerto Rican debt nearly doubled in 2013 to 9 per cent – exceedingly high for a large municipal bond issuer. The S&P Municipal Bond Puerto Rico Index dropped more than 20 per cent last year.
With borrowing in the muni market prohibitively expensive, Puerto Rico suspended its bond issuance programme for most of 2013. Near-term maturities are covered, the territory says. Puerto Rico has $786m in general obligation debt maturing before the end of the fiscal year in June 2014, according to government data as of late last year. To meet payments, it can tap funds from the government development bank. The GDB has about $2.3bn available in its investment portfolio and it could access up to $2.8bn in government deposits held in commercial banks, government officials say.
“Certainly we need to access capital markets to get long-term funding,” says David Chafey, chairman of GDB, “but we are fine through to the end of this fiscal year in June, which means that we could operate for another eight months or so with internal funds and with liquidity from the GDB.”
But Puerto Rico is considering a return to capital markets in the coming weeks, a signal to investors and rating agencies that it still has market access. The prospect of a bond offering has cheered some investors, sending bond yields lower, but the stakes for any sale are high. A large deal, of at least $1bn, could help ease concern about near-term liquidity and buy time for the government to focus on long-term economic policies. Ultimately it is an economic recovery that will avert a restructuring.
The governor’s tight fiscal policies will have the negative effect of shrinking Puerto Rico’s economy in the short run. While revenue collections are running above budget so far this fiscal year, GDP may decline by 0.8 per cent by the end of June, according to government projections.
In addition to rating agencies and investors, the governor also has to answer to his citizens: he is inflicting pain without a guarantee the economy will take off by 2016 when he will be up for re-election.
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Outside the gates of La Fortaleza, in San Juan’s upscale Condado district, the gyrations of the US muni bond market and the fate of the governor are far from Tito Diaz’s mind.
The 58-year-old former electrical engineer had spent most of the day trying to restore electricity to a local shop on Loiza Street, a busy thoroughfare. His electrical knowledge came in handy when he retired after 30 years. His pension is $400 a month and he earns another $800-$1,000 making repairs. “I wouldn’t be able to survive on just my pension,” he says.
It is an example of how Puerto Rico’s structural dysfunction drives the underground economy, presenting another obstacle to long-term growth potential.
The island’s underground economy is estimated to be worth about $17bn, or 25 per cent of gross national product. It includes unreported income generated by the self-employed and remittances from Puerto Ricans living off the island.
Many have seen their savings dwindle as house prices fell in the aftermath of the US financial crisis, and more recently with a collapse in bond prices.
For people such as Mr Diaz, the strain of higher taxes and lack of employment opportunities is dire. It is also driving young people to emigrate. The island’s population shrank about 2 per cent between 2000 and 2010, and two of Mr Diaz’s three children have left for the US seeking work.
If Puerto Rico succeeds in creating the 90,000 jobs by 2016 outlined in Mr Garcia Padilla’s plan, it would add as much as $7bn to the economy. For some this is an ambitious project. “It will be tough to see a complete turnround in this economy based solely on government initiatives,” says Juan Lara, a professor of economics at Universidad de Puerto Rico.
He argues many local businesses have been strangled by tightening lending conditions from local banks. “If banks start to lend again at attractive rates and finance smaller enterprises and house construction, for example, the multiplier effect would be big.”
Some are still positive about Puerto Rico. John Paulson, the hedge fund billionaire, bought an 80 per cent ownership interest in The St Regis Bahia Beach Resort, a $500m community resort. And Lilly Pharmaceuticals announced a $200m expansion of its operations in the island.
Back in Loiza Street, Mr Diaz managed to fix the faulty wiring at the store and, as he rushed to his next job, he summed up Puerto Rico’s travails.
“There’s a chance the people in La Fortaleza will do the things they say they are going to do, and maybe things will get better,” he says. “But I can’t count on it. I need as many repair jobs as I can get.”
Municipal bonds: Scrutiny after a tough year
Municipal bond investors last year endured their worst performance since 1994. Interest rates were largely to blame. The Federal Reserve began to discuss plans to taper its asset purchases, which have held interest rates low, before unveiling them in December. Credit risk also played a role. Detroit’s bankruptcy last summer, the largest by a US city, raised risk aversion in the market.
Puerto Rico’s mounting problems only added to the sell-off. The market ended the year with a loss of 2.6 per cent, according to the Barclays Municipal Bond Index. Lipper, the fund tracker, calculates muni bond mutual funds had 33 consecutive weeks of outflows as investors withdrew nearly $70bn, or 12 per cent of assets.
Last week, however, flows turned positive – a sign that the market was stabilising after last year’s wreckage and creating hope among investors for a better 2014. The big driver of performance this year will again be interest rates. Munis, like other bonds, fall as rates rise. But in an environment of rising rates, munis tend to outperform US Treasury bonds. The extent to which they can do that and potentially eke out some gains this year will depend on how dramatically rates rise and whether fears of credit risk again surface. “The one big question mark is Puerto Rico and what will the impact be if the worst-case scenario occurs,” says Peter Hayes, head of the municipal bond group at BlackRock.
While Puerto Rico may seem an isolated case, it has broad implications for investors. Most US muni debt is exempt from federal tax but it can be shielded from state and local taxes, too. New Yorkers buying bonds issued by New York, for example, can get breaks on state and local taxes. Puerto Rico’s bonds are triple tax-free, regardless of the state in which the bondholder lives. That means they are held throughout the US, largely by wealthy individuals who benefit from such tax breaks.
According to Morningstar, the fund analyst, Puerto Rico’s bonds have found their way into about 70 per cent of all muni funds.
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