On Monday, Puerto Rico is expected to skip payment on $389 million in debt owed by the island's Government Development Bank to bondholders. Gov. Garcia Padilla of Puerto Rico has been warning for over a year that this government will be unable to fully pay what it owes, and has asked Congress to provide for a structured path to bankruptcy. He didn't get it, largely due to opposition from congressional Republicans, so he is now being forced to resort to unilateral repudiation of debt.
"Faced with the inability to meet the demands of our creditors and the needs of our people, I had to make a choice," he said "I decided that essential services for the 3.5 million American citizens in Puerto Rico came first."
The Obama administration and many members of Congress had been pushing to create a bankruptcy process for Puerto Rico that would allow bondholders to recoup some of what they are owed while allowing the island's government to continue functioning. Since Congress has, so far, not acted we are now on the precipice of a much more uncertain and chaotic situation in which Puerto Rico will attempt to selectively cancel debts and bondholders will seek to use the federal courts to block the Puerto Rican government from operating until it pays up.
1) What is happening with Puerto Rico?
Puerto Rico is an island in the Caribbean Sea that is also a largely self-governing territory of the United States.
For years, a quirk of US law created a tax subsidy for Puerto Rican debt that encouraged middle class Americans to binge on loaning money to Puerto Rico without really realizing that's what they were doing. The Puerto Rican government took advantage of this situation by borrowing a lot of money, but didn't manage to spend the money that they borrowed to accomplish much that was useful in the long term.
Then starting in 2006, Puerto Rico was hit with a series of economic misfortunes. At that point, Puerto Rico's strong ties to the United States became a liability because Puerto Rico could not adjust to bad economic times with currency depreciation, but Puerto Rican people could adjust to bad times by moving to the mainland United States.
That has left Puerto Rico in a 10-year downward spiral of tax hikes, spending cuts, emigration, and higher interest rates. About a year ago, Padilla announced that Puerto Rico is in a "death spiral" that he needs to halt, and he began saying that bondholders will not be fully paid. He asked for the creation of a legal bankruptcy process but warned that even absent one the money would not all be paid.
2) What is the "death spiral"?
The bad news is that Puerto Rico is really facing two separate death spirals.
One is the basic death spiral of self-fulfilling default risk. The more money you owe, the more likely it is that you won't be able to pay back all the money that you owe. That means that when your debts come due and you need new loans to pay off the old ones, investors start demanding that you compensate them for their risks in the form of higher interest rates. Those higher interests rates increase the financial burden on your country, and that in turn makes default more likely.
But the death spiral Garcia was referring to is a second one.
People generally don't like paying taxes but do enjoy receiving high quality government services. Consequently, a given territory's ability to turn tax revenue into useful services is an important driver of whether people will want to live and do business there. To the extent that your tax revenue is going to pay off old debts, it is not going to provide current services. Thus the more of your budget that you dedicate to debt repayment, the worse the value proposition that you are delivering to your territory's residents and businesses.
The harder Puerto Rico squeezes, in other words, the more its economy suffers. But the more the Puerto Rican economy suffers, the harder it is for Puerto Rico to pay back its debts. In other words: death spiral.
3) How much debt are we talking about?
Puerto Rico's total debt outstanding is $72 billion, which is small relative to the overall United States economy but big pretty much any other way you slice it.
Two US states have more debt than that — California and New York — but Puerto Rico is much smaller, with approximately the population of San Diego County. New York and California are also richer than the average US state whereas Puerto Rico is poorer. Almost all US states have growing populations, but Puerto Rico's is shrinking. In October of 2013, the Economist reported that "in America’s 50 states the average ratio of state debt to personal income is 3.4%" whereas the ratings agency Moody's says the comparable figure for Puerto Rico is 89 percent.
Hawaii, the most indebted US state by this measure, has a 10 percent ratio.
In other words, Puerto Rico's debts really are way out of line with what any state is financing, and there's no real precedent for paying down debts of this magnitude. There's no real precedent for refusing to pay them either, but default is by no means a crazy option.
4) Who lent Puerto Rico all this money? What were they thinking?
A large share of the money was initially lent by people not so different from you or me — middle class Americans, especially those living in higher tax states. As for what they were thinking, they probably weren't thinking much of anything in particular.
They were just putting money away for retirement in municipal bond funds to diversify their portfolios.
Those funds, in turn, were invested in a diverse array of US public sector bonds. Since Puerto Rican bonds feature some unusual tax advantages, there was an unusually robust level of demand for Puerto Rican debt. Successive Puerto Rican governments responded to demand for their debt in the economically rational way — they borrowed an unusually large amount of money. But none of this lending was driven by particular scrutiny of the details of Puerto Rico's economic situation, and when Puerto Rico's economic fortunes began to change about 10 years ago the dynamics became untenable.
The flip side of this mindless lending is that Puerto Rico failed to take real advantage of the financial windfall it provided. In theory, loads of cheap debt could have been used to finance incredibly useful public works projects and other social services that laid the foundations for enduring prosperity. But it didn't happen. Instead, Puerto Rico seems to have mostly taken advantage of the opportunity to run a somewhat more generous welfare state than the island could really afford over the long term. Thus when the easy money went away, the country was left with a huge pile of debts rather than a huge pile of enduringly useful infrastructure.
5) Is there a number from a classic musical comedy that sums this all up?
Not exactly, though "America" from the 1957 musical West Side Story does deal with many of the relevant issues — debt, Puerto Rico's relative impoverishment vis-a-vis the United States, the possibility of mass emigration, and the island's oft-misunderstood political relationship with the mainland United States. The recent Glee version tones down the minstrelry relative to the original:
But problematic though it may be, Rita Moreno's classic 1961 film performance is still worth your time and provides clearer context. A crucial eight-bar musical phrase from the song is replicated in Metallica's "Don't Tread on Me," if heavy metal is more your thing.
6) What's this business about Puerto Rican bonds and taxes?
All municipal bonds are exempt from federal income taxes. In addition, if you buy municipal bonds issued by the place where you live, those bonds are exempt from state and local income taxes as well. Such bonds are known as triple tax exempt, and they're a big deal for municipal finance and high tax places like New York and California.
But Puerto Rico's bonds are triple tax exempt regardless of where you live.
This is not a huge deal for most Americans, but for a high-income person living in a high-tax state it can be a very big deal. And it helped fuel a lot of lending to Puerto Rico that wasn't necessarily thought through in a very serious way.
7) What went wrong for Puerto Rico?
Starting in 2006, the island has been hit by a series of negative shocks that have undermined its economy and its creditworthiness.
That was the year that Puerto Rico lost its longstanding federal tax advantages as a location for US companies to do business in. From 1986 to 1996, these took the form of special tax credits (pre-1986 the tax advantage worked differently but had a similar impact) that were rationalized as a way to help Puerto Rico be competitive with developing countries as a manufacturing location, given that Puerto Rico-based firms need to comply with basic US labor rights and safety standards. But starting in 1996 these advantages were placed on a 10-year phase-out schedule and, despite the hopes of Puerto Rican politicians (and tax break hungry business), they were never extended or replaced. That prompted an exodus of businesses from the island from which it has never really recovered.
- The 2007 financial crisis made investors suddenly more suspicious of just about everything, including potentially risky Puerto Rican debt.
- The steep recession in 2009 and the slow recovery from the recession hurt Puerto Rico's tourism industry.
- The Tea Party surge in 2010 clarified that a federal bailout of Puerto Rico was politically untenable, and that the risk of default was very real.
- Detroit's 2013 bankruptcy went through without causing disastrous shockwaves for the rest of the country, further bolstering the conclusion that Puerto Rico should be left to its own devices.
A related ongoing development is that in response to Puerto Rico's economic woes, Puerto Rican people have increasingly chosen to leave the island.
For any given individual, migrating to the mainland makes a lot of sense given the economic conditions on the island. But each person who departs leaves the people who remain with a higher share of old debts to repay. That makes the economic situation even worse and the debt even harder to pay.
8) So is Puerto Rico going bankrupt like Detroit did?
No. People throw the word bankrupt around a lot, but it actually has a specific technical meaning laid out in the US Bankruptcy Code and other laws. There are a lot of different kinds of bankruptcy, and they all lay out one way or another for a person or organization that cannot pay back its debts to restructure its payments and move forward. The key is that bankruptcy is an organized, rule-governed process designed to bring some clarity to the situation and ideally to resolve it sooner rather than later.
But US bankruptcy law makes no provision for Puerto Rico (or a US state) to declare bankruptcy. Indeed, what's really special about Puerto Rico is that Puerto Rico's municipalities and municipal corporations — unlike towns, utilities, and school districts in the US mainland — can't declare bankruptcy either.
Puerto Rico's supporters in the White House, in Congress, and the Treasury Department have been trying to create a bankruptcy process for Puerto Rico, but bondholder organizations have characterized this as a "bailout" and blocked action in Congress. So now we get a situation that is going to be a lot more chaotic and generate a lot more revenue for lawyers.
First, the Puerto Rican government will try to unilaterally decide which bond payments it needs to skip in order to keep the lights running. Then there will be lawsuits — lots of lawsuits — in which various creditors try to force Puerto Rico to pay them ahead of paying Puerto Rico's civil servants, pensioners, social assistance recipients, and other creditors.
It is relatively unlikely that a federal court based in New York will actually try to dispatch cops to Puerto Rico to physically haul money off. But it's easy to imagine a scenario in which banks based in the mainland are told it's illegal to participate in processing payments of salaries for Puerto Rico's police officers because Puerto Rico's bondholders have not yet been paid.
9) Why doesn't Puerto Rico become its own country?
Puerto Rico should be an independent country.— Noah Smith (@Noahpinion) June 30, 2015
To many residents of the mainland United States, separation between the USA and Puerto Rico seems like a natural solution to the island's financial woes as well as the most logical resolution of an anomalous constitutional situation. After all, the empire-building and thirst for military bases that led the United States to take Puerto Rico away from Spain in 1898 are long since obsolete, and Puerto Rico is linguistically, culturally, and economically distinct from the United States.
What's more, sovereignty could help Puerto Rico in a number of ways. For starters, an independent Puerto Rico would have its own currency and could set monetary policy that is appropriate to Puerto Rican conditions.
Right now the Federal Reserve does things with little regard for their impact on Puerto Rico, and the value of Puerto Rico's currency (the US dollar) is driven by factors that have nothing to do with Puerto Rico's situation. An independent Puerto Rico could also establish a tax and regulatory framework that is suitable to its status as a middle-income country, rather than subjecting businesses to policies designed for the much richer United States.
The big problem with this idea is that Puerto Ricans don't want to be independent. In a 2012 referendum, a large minority of the population said Puerto Rico should continue with the status quo. Among the 54 percent who desired change in Puerto Rico's constitutional status, 60 percent said Puerto Rico should seek to become a US state. Only 5.5 percent of the 54 percent favored independence.
There are some practical reasons for this, but the main reason is that Puerto Ricans have been Americans for a long time and just like other Americans feel a strong connection to their country. Most Puerto Ricans have friends and family members living on the US mainland, and many people go back and forth. Consequently, the idea of independence is just a total non-starter. Statehood has more appeal to Puerto Ricans, but would not address any of the factors leading to Puerto Rico's debt problems, and securing a reputation for the island as a deadbeat is unlikely to inspire the mainland United States to become excited about statehood.