Profligate Puerto Rico on the Brink

Wall Street Journal

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As Puerto Rico struggles under the weight of more than $70 billion in debt, it has become popular to draw parallels with Greece. But the comparison isn’t apt: For one thing, Greek leaders’ profligacy is tempered by their need to answer to the European Union.

Puerto Rico, on the other hand, is for the most part left to chart its own course, and the crisis in the Caribbean is so severe because its leaders have been so much less serious.

“The debt is not payable,” Alejandro García Padilla, the governor of the unincorporated American commonwealth, told the New York Times a few days ago. “There is no other option. I would love to have an easier option. This is not politics, this is math.”

If only that were true. Gov. Padilla has stuck to a pledge not to lay off government workers, though more than two-thirds of the territory’s budget is payroll. The proposed budget—supposed to be approved Tuesday—for the fiscal year beginning July 1 contains no plans for head-count reductions. That budget still does not have enough votes to pass, despite the reality that the territory’s leaders could run out of cash by mid-July.

Puerto Rico’s debt crisis is the result of years of government mismanagement. Dozens of agencies and publicly owned corporations have run deficits year after year, making up the difference by borrowing from bond markets.

Since Puerto Rico’s bonds are not subject to taxation at the state, local or federal level, portfolio managers have scooped them up to bolster returns, often without a lot of disclosure to clients regarding what, exactly, is going into their retirement accounts. As the fiscal crisis has grown more severe, retirees have begun to realize that their supposedly vanilla municipal funds might contain serious risks.

The prospect that Puerto Rico might not repay its debts has sparked debate in Congress over a bill, H.R. 870, that would allow some of the commonwealth’s subsidiaries, like its electric and water utility companies, to file for bankruptcy. Investors feel cheated by the prospect that the territory, which issued its debt under a legal framework that excluded it from default, might walk away from its obligations.

Underlying the proposed legislation—and the governor’s comments—is the assumption that Puerto Rico would repay less than the face value of its bonds. Under the bankruptcy code, however, the territory first would have to prove that its eligible subsidiaries are insolvent. That means demonstrating a structural inability to pay, not simply an unwillingness to implement necessary reforms.

The lack of seriousness in Puerto Rican budgeting seems to suggest that the territory would not meet a legal test for insolvency. Overspending in Puerto Rico is a bipartisan phenomenon through at least five administrations—four Democrats and one Republican, former Gov. Luis Fortuño. In the past four years, when the fiscal crisis has been most severe, four successively larger budgets have been enacted. The budget proposed for the coming year is $235 million larger than last year’s and $713 million, or 8%, higher than four years ago. Austerity this is not.

Median household income in Puerto Rico hovers around $20,000, according to the U.S. Census Bureau, but government workers fare much better. Public agencies pay salaries on average more than twice that amount, a 2014 report from Banco Popular shows. Salaries in the central government in San Juan are more than 90% higher than in the private sector. Even across comparable skill sets, the wage disparity persists.

The administration seems to believe higher taxes are the answer. An increase in the island’s sales tax passed last month, to 11.5% from 7%, is projected to raise more than $1 billion in a year. This is the fifth tax increase since 2013, intended cumulatively to generate more than $4 billion. In reality, they have raised less than $1.5 billion in new money as more Puerto Ricans move their economic activity underground, businesses cut outlays, and the exodus to the U.S. continues.

In Greece, more than 150,000 government workers have been laid off amid a recession that has seen output decline by more than 25% and total employment drop by 17% since 2006. In Detroit, cuts to pensions, sales of public assets, and a reform of governance structures preceded negotiations with creditors over debt repayment. In both cases, government reform helped make the official sector more efficient.

In Puerto Rico, the decline in the real economy has been less than 8% over the past decade, and while total employment has declined 16%, the population has declined more than 10%, leaving the unemployment rate only slightly higher than it was in 2006. Yet the commonwealth continues to spend more on growth-inhibiting programs—regulations, fees and taxes—rather than on pro-growth stimulus initiatives like agency mergers, investment in business infrastructure and public-private partnerships.

The continued inability to tame spending highlights Puerto Rico’s deficit of governance that has prolonged its recession and driven its debt to crisis levels. Regardless of whether Puerto Rico can file for bankruptcy, any American judge is going to demand that the territory engage in a program of fiscal consolidation that includes reducing payroll and eliminating superfluous expenses. Until such a program is adopted, expect the crisis to swell.

Mr. Hanson is an analyst at Height Securities in Washington, D.C., which advises clients with financial interests in Puerto Rico.

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