What Washington Risks by Stalling on Puerto Rico

With Congress zeroing in on a salve for Puerto Rico’s debt crisis, Europe’s experience with Greece offers a telling example of the pitfalls to avoid.

An International Monetary Fund report from late last year flagged Europe’s missteps bluntly. “Debt restructuring, when it came, was often too little, too late,” it said.

Greece’s crisis erupted in 2010, but officials didn’t approve a restructuring of the nation’s huge debt load for two years. By then, creditors were forced to take larger haircuts that were still insufficient, the report said.

The lesson for Washington on Puerto Rico seems straightforward: Avoiding strong medicine now—in the form of restructuring the island’s $70 billion in debt, held mostly by investors in the U.S. and Puerto Rico—raises the odds of a federal bailout of the island later.

The Treasury Department has proposed pairing a fiscal oversight authority to audit the island’s finances with a debt-restructuring mechanism, akin to a court-supervised bankruptcy, that kicks in if voluntary negotiations fail.

House Republicans are preparing to unveil a legislative draft with such a framework this week, setting off a scramble by lawyers and lobbyists before Congress returns from recess in mid-April for potential votes.

The main problem is simple. Puerto Rico’s economy has been contracting since 2006. Job opportunities are sparse and dwindling, businesses are leaving, and home prices are plummeting.

Puerto Rico residents, who are American citizens, are responding with their feet by moving to the mainland. The population has been shrinking since 2005, but declines accelerated over the past five years. Prime-age workers are the ones leaving. Around 1 in 5 residents are now over the age of 60, a higher share than any U.S. state. The population of children under age 5 is down 37% since 2000.

“If you wait, the crisis will become considerably worse. More people will leave,” said Simon Johnson, former chief economist at the IMF, at a hearing with lawmakers last month. “The tax base will further disintegrate, and the creditors will get even less.”

To balance budgets over the past decade, the island borrowed heavily. In July 2014, debt service accounted for 27% of government revenues, more than double the highest share of any U.S. state, according to Moody’s Investors Service.

ENLARGE

Revenues are up this year thanks only to a sales-tax increase. The island’s pensions also have an additional $43 billion in unfunded liabilities and are projected to exhaust reserves in two years.

Underinvestment in infrastructure has deterred potential private investment. “Brownouts, water rationing, crime—these are not things that make you want to open up a business,” said Tracy Gordon, an economist at the Urban-Brookings Tax Policy Center.

While there are legitimate concerns that the island’s public sector is bloated, “it’s a dangerous game to some degree to experiment with austerity when your population is declining as fast as theirs is,” said Sean McCarthy, head of municipal credit research at Pacific Investment Management Co. To have the room to put in place a real economic growth plan, “they need relief from debt.”

Puerto Rico has already defaulted on some small debts. Officials have warned of much bigger ones on more than $2 billion in payments due in May and July. The territory isn’t allowed to restructure municipal debts in bankruptcy court because it isn’t a state. Courts struck down a local law that would create a similar avenue last year. The U.S. Supreme Court heard arguments in the appeal last week and should rule by June.

Making matters more complicated, the island has a series of debt issues with competing security pledges, devised over the years to skirt debt-sustainability standards. This has made some creditors more willing to take their chances in court. Others have suggested the island is embellishing its fiscal travails.

The upshot is that some creditors have been reluctant to offer concessions in voluntary restructuring talks. They are also lobbying heavily on Capitol Hill to weaken restructuring legislation, which some have characterized as a bailout even though restructuring puts no taxpayer dollars at risk.

Analysts at asset-management firms Pimco, AllianceBernstein and Nuveen Investments have in recent weeks pushed back against arguments that restructuring legislation for Puerto Rico would introduce new risks in the broader $3.7 trillion municipal-bond market. Without an orderly restructuring framework, the alternative would be a series of defaults and lawsuits. “A long and costly ordeal for all parties involved,” said Mr. McCarthy.

Former Treasury Secretary Larry Summers has called Puerto Rico a test of whether financial interests control Washington.

For policy makers, the choice isn’t necessarily between restructuring the debt or simply imposing tougher oversight. It is between tackling the crisis now or facing calls for more expensive help later in the form of federal transfer payments or loans, says Aníbal Acevedo Vilá, who was Puerto Rico’s governor from 2005 to 2009. Some bondholder advocates and local political leaders, for example, are invoking the 2009 bailouts of Detroit auto makers in calling for the Treasury Department to refinance or guarantee debts.

This is a nonstarter in Washington for now because it could put taxpayers on the hook for a Puerto Rican borrowing binge facilitated by Wall Street.

But the water crisis in Flint, Mich., serves as a timely example of how economic decline can spawn public emergencies that compel more costly responses.

It doesn’t take much imagination to summon parallels for Puerto Rico. The Centers for Disease Control and Prevention warned last month that 20% of the island’s population could contract the mosquito-borne Zika virus in an outbreak this summer. Separately, the island’s power company temporarily cut off electricity to a hospital with $4 million in unpaid bills earlier this month.

The big question is how the island’s economy will stanch migration to the mainland and return to growth, a task made all the more challenging as creditors brawl over who should bear the costs of poor investments.

Decisive action now to halt debt crisis could save much costlier remedies later

By Nick Timiraos

What Washington Risks by Stalling on Puerto Rico