Puerto Rico crisis in America’s back yard
There is never a perfect time to announce you are virtually bankrupt. For Puerto Rico, however, this week was a better moment than most. On Sunday, the island’s government released a long-planned economic report written by Anne Krueger, a former World Bank chief economist, which declared that the territory was in fiscal crisis. As governor Alejandro García Padilla put it, the island’s $72bn debts are now “not payable”.
But instead of sowing widespread fear, debt prices only wobbled. For with Greece in full-blown financial crisis, and the Chinese markets tumbling, Puerto Rico’s revelation seems almost a sideshow. Nevertheless, it would be a mistake to ignore what is happening in Puerto Rico. For Professor Krueger’s report highlights two important points. First, Greece is not the only place grappling with excess debt, poor governance and opaque finances. Second, America, like Europe, badly needs to become more imaginative — and practical — in dealing with excess public sector debt.
For the problem bedevilling Puerto Rico is not simply its $72bn debt pile, but the fact that it lacks any obvious mechanism to restructure it. The island could be in for a choppy time in the municipal debt markets. Other debt-laden entities, such as the state of Illinois, might soon be caught in the storm.
To understand this, look at Puerto Rico’s numbers. A couple of decades ago, this US territory of 3.5m people enjoyed a healthy rate of growth, driven by a large American military presence and tax breaks that attracted mainland businesses. But since then, tax breaks have ended and military budgets have been cut. Output has shrunk by around 10 per cent in real terms since 2005.
Normally, this might cause creditors to panic. But since global markets have been flush with liquidity, and municipal bonds offer tax breaks for American investors, money has instead flooded in. That has enabled the government to maintain a generous welfare state, and a governance culture that is (at best) inefficient and (at worst) rife with cronyism. Meanwhile, the debt-to-output ratio has surged above 100 per cent — or 150 per cent if unfunded liabilities, such as pensions, are included.
This pattern is unsustainable. So Prof Krueger — entirely sensibly — proposes two initiatives: Puerto Rico must implement structural reforms, such as cutting welfare payments and labour costs; but it also needs to restructure the debt to a more sustainable level.
But, as in Greece, it is unclear whether Puerto Rico’s government has the stomach for austerity. Worse still, the island’s debt structure is staggeringly complex, since the bonds have been issued by numerous different entities, with varying types of guarantees. These creditors show no desire to co-ordinate; instead, they are threatening to sue each other and the island. Thus the nightmare scenario that now haunts Puerto Rico is not so much that of Greece but Argentina: years of legal limbo, shut out of the capital markets.
Is there a solution? In theory, as Lawrence Summers, a former Treasury secretary says, one resolution would be for the International Monetary Fund to intervene. But it will not, since Puerto Rico is not a sovereign state. Washington could play an IMF-style role if it chose, since Puerto Rico, as a territory, is part of the federal system. But the Obama administration has made it clear it does not wish to intervene.
That suggests that the least bad remaining option is to find a third party legal referee to oversee an economic plan that forces the creditors into a compromise. America does have one existing model for this: a Chapter 9 framework that offers bankruptcy protection for public entities.
This was used to restructure Detroit’s $18bn debt pile. That worked because it focused on restoring city services, says Kenneth Buckfire, a restructuring expert. Creditor haircuts were the result of this analysis; they were not imposed to support a failed system.
But since Puerto Rico is a territory, not a city, it is not allowed to use Chapter 9 without a change in US law. This seems unlikely to occur soon, since parts of the Republican party fear that letting Puerto Rico use Chapter 9 would prompt other American entities, such as Illinois, to default too.
The result, then, is stalemate. Thankfully, the situation is not (yet) bad enough to spark a full-blown crisis; but piles of “unpayable” debt have a nasty way of sapping confidence and growth. Or to put it another way, the next time that US officials lecture eurozone leaders on their failure to sort out Greece, they should glance at their own backyard first; or better still, take resolute action — say, by reforming that Chapter 9 code.