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Brookings panel explores options for financially troubled Puerto Rico
Diplomatic Pouch / July 21, 2016

By Larry Luxner

It’s not a state, but neither is it an independent country — and therein lies the root of Puerto Rico’s enormous fiscal crisis.

A U.S. commonwealth since 1952, the Caribbean island is home to 3.5 million people, half a million less than 10 years ago. Speakers at a July 12 panel at the Brookings Institute warned that more Puerto Ricans will flee to the mainland — principally Florida, New York and Texas — unless the island can lure U.S. and foreign investors back.

“States and municipalities across the U.S. are with some of the same issues Puerto Rico is facing: the need to maintain essential services for their citizens, along with shrinking budgets; the need to fund public pensions, to secure a competitive education for all students, to fight crime and drug trafficking, and to bring security to neighborhoods,” said the island’s governor, Alejandro García Padilla, in his speech at Brookings.

“In facing this issue, states have become individual laboratories,” he said. “We need to learn from each other what works, what does not, and why — about errors and achievements, and how to reduce the former and replicate the latter. We have been forced to try tools that have not been tried before. We have had to knock on doors that ethers might need to approach in the not-too-distant future.”

Panelists agreed that jump-starting economic growth is essential in helping the island climb out of its fiscal hole. On June 30, President Obama signed into law the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) following its passage by both houses of Congress.

Gerald E. Rosen, a former U.S. District Court judge in Michigan and architect of the “grand bargain” that brought Detroit back from the edge of financial ruin, stressed the “need for a robust restructuring under court supervision” — which in Puerto Rico’s case will be done by a financial control board mandated by PROMESA.

“In Detroit, we had an emergency manager,” said Rosen, who is writing a book about those tumultuous times. “Detroit was insolvent. It really wasn’t a city at all. We had to provide a pathway out of bankruptcy so that the city could be a city again.”

Municipal bankruptcy expert James Spiotto, who helped advise Detroit in its Chapter 9 proceedings, said jurisdictions in crisis must not neglect their infrastructure.

“It’s important for municipalities coming into bankruptcy to look at what the city will look like on the other side, and not simply think about restructuring debt,” he said.

Spiotto also said that creditors should work with the commonwealth government to ensure that everyone comes out ahead, even though a haircut may be inevitable.

“The market can’t understand unwillingness to pay. But the market historically has understood an inability to pay,” he explained. “You may be a creditor with all the rights to everything, but if you don’t help the municipality to help itself, you’re not going to get paid.”

Yet Natalie Cohen, head of municipal research at Wells Fargo Securities, said it’s clear that investors are worried — and that some of them have been scorned in the media.

“Not everyone investing in Puerto Rico is a vulture or a hedge fund,” she noted. “The value of that investment or who has made it is becoming more prevalent. Certain investors are being punished. In Chapter 11, that’s not an issue. But the law itself should be indifferent as to where the money came from.”

Cohen dismissed suggestions that the financial oversight board required by PROMESA is an “abuse of democracy,” as some have suggested.

“Anytime there’s an oversight body, there’s an outcry that this is an abuse of democracy. I remember the Rev. Malik Shabazz saying he’d rather burn down the city of Detroit than have the state come in. But some oversight programs are, like in North Carolina, not just a monitoring process but pro-active engagement with local government. And people in North Carolina aren’t crying that democracy is being stepped on.”

In Puerto Rico, though, Cohen conceded, “it’s more intense because the political parties are defined by status. Anyone growing up there is aware of the inferiority of services that come from the federal government. That is part and parcel of their identity — even more so than in Detroit.”

Yet García Padilla said “Puerto Rico’s problems have no parallel,” largely because the island’s manufacturing-driven economy prior to 2006 was based on Section 936 of the Internal Revenue Code. Under 936, U.S. companies that located factories on the island were exempt from paying federal income tax on profits earned by their Puerto Rico subsidiaries.

“Section 936, which incentivized companies to invest in Puerto Rico rather than Ireland or Singapore, was a win-win for both Puerto Rico and the U.S., which kept companies at home. It was Congress’s reaction to the 1970s recession, due to the oil crisis. And it worked. Puerto Rico got out of recession back then,” said the governor.

“But in 1996, Congress repealed 936 with a 10-year phaseout period that ended in 2006. Companies decided to go to Ireland and Singapore, and Puerto Rico lost thousands of industrial jobs,” he said. “Industrial income was substituted by issuing debt.”

In fact, he said, in December 2005 — just one year before the end of the phaseout — Puerto Rico’s debt was $37 billion. Six years later, in December 2012, it had nearly doubled to $70 billion.

Unlike states and municipalities, Puerto Rico is prohibited from declaring Chapter 9 bankruptcy. Because it’s not a state, it also does not have senators or voting representatives in Congress (though it does have a nonvoting resident commissioner in Washington, Pedro J. Pierluisi).

Even so, said the governor, Puerto Rico has slashed annual expenditures from $11.9 billion in 2012 to $9.1 billion today while deferring other obligations and putting off tax reform — resulting in the loss of commercial trade.

On the other hand, Puerto Rico’s debt-to-budget ratio is 36 percent, nearly three times that of Hawaii, which at 13 percent is the most indebted state. The U.S. average is 5 percent, and the world average is 7 percent.

“That’s why I said one year ago that the debt is unsustainable,” the governor told his Brookings audience. “In order to generate a permanent fix to the debt crisis and lacking the mechanism that New York City and Detroit have, we created our own restructuring statute, but federal courts closed that door. We tried negotiating a settlement with the creditors, but to no avail. We were pushed to the edge of the cliff. Puerto Rico’s municipalities and the island itself cannot declare bankruptcy. That’s not a political statement, that’s the law.”

García Padilla called the newly passed PROMESA legislation a “mixed bag,” noting that it offers Puerto Rico the legal tools to complete its debt restructuring and turn the economy around, but that it also creates an oversight board “that unnecessarily undercuts the democratic institutions” of the island’s commonwealth structure.

“PROMESA gave Puerto Rico no true choice, so I needed to choose: misery for my people, or unnecessary intervention from the federal government. When someone points a weapon at you and asks you for your wallet, you might say no,” he said. “But the consequences are worse than those of losing it.”

The governor, who is not running for re-election, added: “Our administration plans to use the tools provided by PROMESA to ensure we adequately fund our pension fund. These steps will protect our most vulnerable citizens and ensure a return to economic sustainability. The challenges are not over, and prosperity won’t return overnight, but we see a bright future. We can choose to take the easy way out, or we can choose to fight. I know we are on the right path.”

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