The Commonwealth has the Feeling of Decay and Despair

Puerto Rico in Hot Water

Puerto Rico Bond News

This past weekend I returned from a business trip in Puerto Rico. I landed back home in Florida just two days before the court ordered stay on litigation between the Puerto Rico and their many creditors expires. Puerto Rico must now either open themselves up to numerous lawsuits, or seek shelter by entering into Title III under the Promesa Act and begin the process of allowing the courts to modify the $70 billion dollars in debt it owes to bondholders.

It was an interesting time to be on the Island, to witness firsthand the complete state of despair that has befallen Puerto Rico. The images of a tropical paradise publicized by superstar Ricky Martin are no longer an accurate depiction of the island. Driving the streets of the Puerto Rico’s capital city, San Juan, you quickly notice broken traffic lights, crumbling infrastructure and a general malaise among the island’s dwindling population.  This complete lack of hope has lead to daily labor protests, and the threat of a government-wide shut down in early May.

A Growing Number of Issues

The reporting of Puerto Rico’s demise has largely focused on the size of the debt load, effectively reducing the citizens of the island to mere numbers. Much has been said about the enormous debt burden that needs to be restructured, but very little focuses on the abhorrent conditions on the island. While most pundits agree that the debts are unsustainable, Puerto Rico’s problems are structural in nature. The key issues are lack of economic growth, and lack of nongovernmental jobs for Puerto Rican residents.  The lack of opportunity on this beautiful island has led to population outflows that are crippling in the local economy.

More Puerto Ricans on the US Mainland than on the Island Itself

I understand pride for one’s homeland and the desire to remain close to familial bonds. Those ties appear to no longer be strong enough to keep PR residents on the island. Remember, Puerto Rican residents are US citizens. This means that they can easily, and relatively inexpensively purchase a one-way plane ticket to the mainland United States. Many Puerto Ricans have been successful at finding work after a short plane trip to Florida. Puerto Rico has lost almost 10% of its population from the US Census that was taken in 2010 to the measure in 2016. (Source: US Census Bureau) Fiscal austerity and recession may continue to hasten the population outflow, leaving even fewer people on the Island to repay the enormous amount of debt incurred. The young and ambitious dismayed at the local government can and have been buying that plane ticket and setting up shop on the mainland.

Double Whammy over the Last Decade

At the same time folks are leaving, Wall Street bankers and short-sighted local politicians increased the debt burden over 64% in the last decade as the more and more bonds were issued to cover over fiscal deficits.  Puerto Rico creditors and locals find themselves in a precarious position unable to pay what is owed.  As the table below demonstrates Puerto Rico has approximately a 70% Debt-to-GDP ratio far eclipsing all major states and US territories.

Debt-to-GDP Ratio
(Source: The Wall Street Journal)

 

The Brain Drain does not help GDP growth

The Governor, Richard Rossello has proposed slashing budgets over the next several years for the University of Puerto Rico system. The local higher education system has produced four of the island’s ex-governors and currently educates 70,000 students per year at 11 campuses. Puerto Rico’s governor proposed measures to reduce anticipated budget cuts at the University of Puerto Rico to $241 million by fiscal year 2021, from $450 million approved by the struggling U.S. territory’s fiscal oversight board. The mood at the University is palpable, students and faculty have taken to protests to demand that the resources not be cut. It’s hard to build a strong economy when you can’t produce qualified students to enter the workforce of Puerto Rico. It seems pretty obvious if the Commonwealth wants to keep its younger people on the island then forcing those able to attend college in the U.S. is not the answer. Cutting aid to those students that decide to stay within the University system is also not a viable solution to produce young people with the necessary skills to lift the local economy.

Credits, Credits and Credits-Gimme Tax Credits not more Debt

In 1976 as an attempt to drive business to Puerto Rico and other US Territories, Congress enacted the “Possession Tax Credit, Section 936” popularly referred to as Section 936. This rule was simple, any profits earned by US companies in a territory was exempt from federal income tax. As anticipated many US corporations began to shift profits to Puerto Rico (and other territories) to take advantage of the tax exemption, providing an economic boost to the island. (it is debated how great that boost was, as many corporations used shell companies to shift profits to the island, rather than investing directly on the island)

Fast forward two decades and the reversal of Section 936 begins the economic downturn of Puerto Rico of which they are still trying to fight out of. In 1996, President Clinton signed legislation that phased out section 936 over a ten year period, leaving it to be fully repealed at the beginning of 2006. Without section 936, Puerto Rican subsidiaries of U.S. businesses were subject to the same worldwide corporate income tax as other foreign subsidiary. Since the full repeal of Section 936, the United States has suffered through a once in a generation recession. These two factors have contributed greatly to Puerto Rico’s economy shrinking year over year and their unemployment rate reaching 12% with a labor participation rate of less than 50%.

Economists from the Federal Reserve and the private financial sector have pointed to the repeal of section 936 as a major cause of Puerto Rico’s current recession. Quite possibly, Puerto Rico needs a new tax credit legislation under the US Tax Code, maybe this time around with a provision that actually requires economic investment on the island, to spur economic activity and create a strong corporate base, jobs and income tax revenues.

Puerto Rico's Bond Prices
(Source: abglobal.com)

The United States is partly to blame for Puerto Rico’s debt crisis.

Tourism- Faster Growth Needed

While cruise ship tourism revenues have been a bright spot generally, the  Commonwealth’s tourism revenues have not increased at a fast enough pace over the last decade to lift the island out of its financial morass.

 

Reuters highlighted how other islands have grown at a much greater pace than Puerto Rico as reported in their article entitled: Puerto Rico tourism industry lags rivals, offers little relief from debt crisis

In the 1970s, Puerto Rico had about 9,000 hotel rooms, while Jamaica had about 6,600, and the Dominican Republic 1,600, according to a World Bank report. Today, the Dominican Republic has about 60,000 hotel rooms, and Jamaica has around 20,000, according to tourist board annual statistics, while Puerto Rico has only 15,000. (Source: Reuters)

The government has failed to woo enough large hotel and resort chains losing out to other islands like the Dominican Republic and even Cuba. Hotel operators are battling not only Zika fears but higher construction costs and electricity costs from the Island’s struggling PREPA utility. Electricity rates in Puerto Rico are among the highest in the U.S., putting the island at a disadvantage to other resort locations, where they are much lower. That is largely because the government-controlled Puerto Rico Electric Power Authority is reliant on imported oil.

Labor: An Outstanding Issue

Labor Costs on the island are higher than their caribbean competitors and much of that is attributable to governmental red tape. Rules on the island, portrayed as benefits to employees, add significantly to the labor expense of a hotel or restaurant. For instance Puerto Rican companies are obligated to pay workers a Christmas bonus (Yes, described as a Christmas bonus, so much for separation of church and state) of 3% of their earned wage. As of March 2017 Puerto Rico has made some adjustments to their rules in an attempt to level the playing field, but they still have not gone far enough, and it will be tough to make up for the decades of inefficiency.

I saw it firsthand that the Casino at the iconic El San Juan Hotel is now closed. I really used to like that place!

Dean Myerow
Dean Myerow is a municipal bond market asset manager and along with partner, Sean Vesey the team structures institutional and high net worth investor portfolios at Las Olas Wealth Management of NatAlliance Securities LLC.

For 20 years Dean Myerow has been a professional in the field of municipal bonds. He has earned degrees from the University of Massachusetts School of Business and the University of Miami School of Law.

Check the background of this investment professional on FINRA’s BrokerCheck.


Author: Dean Myerow
<a>Dean Myerow</a> is a municipal bond market asset manager and along with partner, Sean Vesey the team structures institutional and high net worth investor portfolios at <a href="http://lasolaswealth.com">Las Olas Wealth Management of NatAlliance Securities LLC</a>. For 20 years Dean Myerow has been a professional in the field of municipal bonds. He has earned degrees from the University of Massachusetts School of Business and the University of Miami School of Law. Check the background of this investment professional on <a href="https://brokercheck.finra.org/">FINRA’s BrokerCheck</a>.

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