Although most people in Europe are watching the Greek vs EU game of debt negotiations, a similar game is being played across the Atlantic in the form of Puerto Rico v USA. Unlike Greece, US territory Puerto Rico paid all of its $1.9 billion to its creditors due on 1st of July. With the payments, the island, for the moment, has avoided sinking further into financial crisis. Puerto Rico Governor, Alejandro Garcia Padilla, recently called its $73 billion debt "not payable”, fueling concerns among investors and bond insurers.

Is Puerto Rico to the USA, the same as Greece to the EU? Let’s start with a few figures. According to Forbes in 2014, of all the US munibond funds, a staggering 75% of them are lending money to Puerto Rico, leaving millions of US investors, and a large portion of US brokerage accounts, exposed to this island. Puerto Rico’s public debt of $73 billion is nearly $18,000 per person, but when the under-funded pension and healthcare obligations are added in, the noose approaches $160 billion. That’s $46,000 per person – less than Greek figure of around $52,000 per person, but still “not payable”.

How did Puerto Rico get itself into this mess? Well, the story is not that dissimilar to Greece’s. Puerto Rico is poorer than the poorest state of the United States; however, when compared to Latin America, Puerto Rico has the highest GDP per capita in the region. It had been one of the great post-war economic development success stories, turning itself from a poor, largely rural society into a manufacturing powerhouse with a thriving middle class. But by the late 1990’s the economy had slowed, and then in the mid-2000’s it had emergency stopped. Puerto Rico has been in and out of recession since 2006. Its unemployment rate is around fourteen per cent; forty-five per cent of the population lives below the federal poverty line; and there’s a fiscal crisis—a scramble to restructure debts of seventy-three billion dollars.

Puerto Rico 2 (PD)

Puerto Rico’s difficulties are rooted, in part, in its earlier success. Its path to industrialisation was paved with corporate tax breaks. The most important one was Section 936 of the U.S. tax code. This came into effect in 1976, and exempted the profits earned by American companies from federal taxes. Between 1970 and 1980, manufacturing’s share of the G.N.P. nearly doubled, as firms, especially pharmaceutical companies, opened plants across the island.

Puerto Rico’s problem was that the growth depended on the external factor – that crucial tax break. Greece’s success also depended on external factor – EU membership and related financial transfers. Both countries also benefited from stability resulting from their membership – EU for Greece and USA for Puerto Rico (US legal system, US dollar is a local currency and so on).

However, in 1996 Congress began phasing out the tax break. It expired completely a decade later, and, as the subsidies disappeared, so did many factories, relocating to places where labour was cheaper and regulation lighter. Between 1996 and 2014, the number of manufacturing jobs on the island fell by almost half.

Alongside this decline in manufacturing, similar to Greece, the Puerto Rican government has made things worse by regularly spending more than it gets in tax revenues.

For 15 years, the government has consistently made unrealistic assumptions about how much it will collect in taxes, given the weak economy. In the middle of each year, government agencies are ordered to make do with less, but they rarely comply. Instead, they carry on with business as usual, and the government is forced to borrow more. And borrowing is relatively simple as Puerto Rico utilises the American wholesale market and benefits from its status as a US dollar country. Lack of official jobs has led to a large emigration to the US and development of a significant shadow economy.

In a situation strikingly similar to Greece, Puerto Rico has an extensive public sector – enough said that in the last decade the number of students in secondary education shrank by 40%, while the number of teachers increased by 10%. Government workers in Puerto Rico are also paid, on average, about twice the national average salary.

True, Puerto Rican problems originate also from the fact that it is an island and many products must be shipped. Due to peculiar US regulations, only US-registered cargo ships can sail to and from the island, which increases the delivery costs significantly. But the reality and lesson from both Greek and Puerto Rican cases are similar. GDP growth is important, but even more important is its source. To achieve a sustainable growth, the country must build a diversified economy, use external support/resources as a supplement to its own and never create a situation in which the country will become completely dependent on one engine growth.

Lastly, and perhaps of most importance, the public sector must be reined in, as Alexis de Tocqueville wrote in 1835: A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.

By Dr Piotr Konwicki
Senior Lecturer, Finance
University of Bedfordshire, Business School

Dr Piotr KonwickiDr Piotr Konwicki has over 20 years of experience in both teaching and practicing finance. Piotr holds a Ph.D. from Gdansk University, Poland and an MBA from the London Business School.

In his professional career Piotr worked with the following companies:
Lazard et Cie (Country Manager, Poland)
Deutsche Bank (Director, Country Head, Poland and Central European Execution Head)
Intercontinental Hotels (Development/M&A Director)
Metsa Tissue Oyj, Helsinki (Senior Board Advisor)

Piotr was the Project Leader advising Polish Government on the sale of the tobacco industry (the largest sectoral privatization in Central Europe), advised the Lithuanian Government on construction of energy transmission lines, led the purchase of Agip Hotels by InterContinental Hotels and helped create and implement European acquisition strategy for Metsa Tissue.

Piotr is also a visiting Professor of Finance at HULT International Business School in Boston and has published several papers in various professional journals.

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