Antonio Weiss

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Puerto Rico’s Debt Deal Leaves No Room for Error

Desmond Lachman and Brad W. Setser are the co-authors of this Op-Ed column, which was originally published by Bloomberg on October 15, 2019.

Puerto Rico’s Oversight Board has put forward a debt restructuring proposal that, if approved by U.S. District Court Judge Laura Taylor Swain, would allow the commonwealth to emerge from bankruptcy. It promises to make the island’s debt more sustainable and includes necessary protections for pensions and public workers. Yet notwithstanding potential complaints from bondholders, it also leaves no room for error. Neither does it relieve Congress of its responsibility to support the island’s economic recovery.

Prior to the proposed debt restructuring plan, Puerto Rico had around $50 billion of tax-supported debt. That was far more than the island could afford to pay out of a $70 billion economy. Annual debt service was over 28% of Puerto Rico’s revenues, more than five times the average state and three times the average of the 10 most indebted states.

A fundamental objective of the board’s debt reduction plan has been to put the island’s public finances on a sustainable footing and make sure that Puerto Rico isn’t back in bankruptcy 10 years from now.

Thus, its plan to restructure the debt would impose haircuts of 28% to 36% on general obligation and constitutionally guaranteed bonds issued before 2012. Higher haircuts of up to 87% would be imposed on subordinated bonds, and bonds issued after 2011 that are being challenged as unconstitutional because they breached the debt limits set in the island’s constitution when they were issued.  This would cut Puerto Rico’s tax-supported debt in half, from $50 billion to $25 billion, and keep Puerto Rico’s annual debt service at just under $1.5 billion, or roughly 9% of the broadest definition of government revenues.

Front-loading payments on the new bonds to keep the overall debt-service profile flat undoes some of the damage from the steeply escalating payments agreed to as part of the earlier restructuring of the sales-tax-backed bonds. Given the enormous uncertainty around Puerto Rico’s economic trajectory, that flat debt-service profile is essential.

The restructuring plan also includes important agreements on public pensions and workers. Unlike a traditional Chapter 9 bankruptcy, the federal law that facilitated the island’s debt restructuring requires Puerto Rico to provide adequate funding for public pension systems. The public pensions are critical sources of financial security for 25% of the island’s households, underpinning the local economy’s long-term health. As part of the restructuring, pension benefits would be paid before debt service, a pension reserve fund would be established, and benefit reductions would be limited to no more than 8.5% and only for those with monthly retirement benefits greater than $1,200. The agreement with public employees maintains provisions on collective bargaining, restores certain benefits, and provides upfront and potential future bonuses.

That said, the restructuring may not go far enough to reduce the island’s debt burden. After the proposed reductions, Puerto Rico will have per capita debt of more than $7,000, well above the $5,000 per capita debt average level of the five most indebted U.S. states (in descending order, Connecticut, Massachusetts, Hawaii, New Jersey and New York), which all have much higher income levels than does Puerto Rico. Notably, Puerto Rico’s post-restructuring debt would be far higher than the poorest state, Mississippi, which has roughly the same population of Puerto Rico and roughly twice the median income.

There can be little room for complacency on the part of the Puerto Rican and federal governments. Even before Hurricane Maria, there were serious questions about the island’s ability to pull itself out of steady economic decline. Following an initial recovery from the immediate post-Maria contraction, the economy has stalled. Austerity measures will be an ongoing headwind. And that’s to say nothing of the potential for another devastating hurricane – which climate change makes more likely, and which the island’s infrastructure isn’t yet able to withstand. 

There are also significant risks that government revenue will decline from current levels. Corporate tax revenue collected from pharmaceutical companies that have relocated from the mainland cannot be counted on, particularly since the Internal Revenue Service has deemed the so-called Act 154 excise tax no longer creditable against federal corporate income tax. The federal reconstruction support that now buoys Puerto Rico’s economy will also start to dry up after 2023, at which point a new slump is a distinct possibility.

Moreover, Puerto Rico’s shrinking population will limit its capacity to support a heavy debt load – a smaller workforce makes it harder to grow out of debt.

For these reasons, the proposed debt reduction should be seen only as the first step in a broader program still needed to restore Puerto Rico’s economy and public finances – an effort that will entail everything from speedier reconstruction aid to expanded access to federal health-care funding. More politically daunting but no less necessary will be resolving the island’s colonial status.

Yet for now, at least, a successful restructuring should eliminate any worries that federal funds to aid recovery will instead flow to legacy debts. That should make it easier for Congress to do what’s necessary to support Puerto Rico’s 3.2 million inhabitants, helping them to raise their living standards to those of their fellow U.S. citizens in the 50 states.

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