Another fine debt crisis

By D.R.

IN 2013 Alejandro García Padilla, the governor of Puerto Rico, did his best to tell the territory's jittery creditors what they wanted to hear. He called servicing the American-controlled Caribbean island’s $72 billion debt load a “moral obligation”. He reassured holders of its general-obligation (GO) bonds that the government could not default on them even if it wanted to, because the commonwealth’s constitution gave those securities priority over all other payments. He highlighted the swingeing package of tax increases, spending cuts and pension reform that he was implementing, and said that he would do whatever it took to honour the island's debts.

But after more than two years of stonewalling, Puerto Rico’s governor could keep up appearances no longer. “The public debt…is unpayable,” he admitted in an address on June 29th. He announced he would seek to restructure the territory’s liabilities. “It is time for lenders to join the table of sacrifices.”

Of course, in most of the world, Mr García Padilla’s solemn about-face did not make the day’s biggest debt-crisis headline. Greece, whose fiscal predicament is often cited as a cautionary tale for Puerto Rico, overshadowed it by shuttering its banks and stockmarket as its standoff with European lenders came to a head. But the spectre of a chaotic Greek exit from the euro—if voters reject their country's creditors' latest set of demands in a referendum due to be held on July 5th—gave credence to Mr García Padilla’s stern warning about what would happen if Puerto Rico’s bondholders refuse his demand for a multi-year moratorium on interest payments. “The alternative,” he said, “would be a unilateral and unplanned non-payment of obligations.”

The parallels between Greece’s full-blown debt crisis and Puerto Rico’s burgeoning one are striking. Both sit at the southern, sunny edge of a large currency union, are bereft of natural resources, and developed thanks to generous monetary and fiscal transfers from richer regions. Both borrowed profligately to fund over-generous public payrolls at artificially cheap interest rates—in Greece’s case because lenders assumed that the EU would back the debt; in Puerto Rico’s because its interest payments are tax-exempt for mainland American investors. Both economies lost competitiveness because of high production costs, an overvalued currency and inflexible labour markets. And both have responded to surging bond yields and a loss of market access with grinding austerity programmes, which have stabilised their nominal debts only at the cost of severe recessions.

Now that Mr García Padilla has abandoned the island’s claim to fiscal invulnerability, there is near-universal consensus that debt relief of some kind is needed. Citing an independent report by Anne Krueger, a former official at the World Bank and the International Monetary Fund, the governor argued that Puerto Rico is trapped in a “vicious cycle of contraction, emigration, austerity and taxes”—probably a fair description of the economy, which has been shrinking since 2006. But finding a legal mechanism to trim the island’s mounting liabilities will not be easy. Because it is not an independent country, Puerto Rico cannot simply repudiate its debts and devalue its currency (like Greece, in theory, could). But since it is not an American state either, its government-owned companies and agencies do not fall under the municipal-bond section of the federal bankruptcy code, nor do they qualify for the benefits therein. Puerto Rico tried to escape this catch-22 last year by passing a law to establish broader bankruptcy procedures. However, it was struck down in the courts, and an appeal is still pending.

Puerto Rico’s lenders—principally big mutual funds like OppenheimerFunds and Franklin Templeton Investments—are free to negotiate terms individually. But since the island’s debt lacks “collective-action clauses”, which could impose the terms of a deal struck by a super-majority on all bondholders, the government cannot force recalcitrant investors to accept a loss. Any creditor who does not receive full and timely payment could file a lawsuit to obtain it, and place competing claims on the state-owned enterprises’ remaining assets. Particularly aggressive bondholders might even be able to stop their conciliatory counterparts from receiving a cent until they are paid in full: last year, a group of hedge funds holding defaulted Argentine bonds persuaded American courts to block payments on Argentina’s performing debt. With such strong incentives for investors to balk, Mr García Padilla’s hope for a “transparent and consensual” restructuring looks dim.

Resolving this impasse will probably require federal action. Congress could appoint a committee to administer the territory’s finances, as it did for the city of Washington from 1995-2001. It could also admit Puerto Rican state-owned enterprises into a bankruptcy court; or it could bail out the island directly. Or Barack Obama could offer Mr García Padilla a sort of lifeline, by making permanent an interim tax ruling that grants a dollar-for-dollar federal credit to firms whose subsidiaries pay excise levies in Puerto Rico. Many of the structural reforms that will be needed to jump-start economic growth require action by the American government anyway, such as exempting Puerto Rico from the federal minimum wage and from a law that bans shipments by foreign-flagged vessels. Unfortunately, while Mr García Padilla says he will no longer “kick the can down the road”, the federal government has not shown the same sense of urgency regarding its wayward Caribbean outpost.