Bankruptcy Boricua

April 7, 2014, ISSUE

Bankruptcy Boricua

Carolina, Puerto Rico — While Polar Vortex Part Whatever is tightening its wicked arctic grip on the defenseless bare scrotum of the northeastern United States, things are looking relatively good here at the El San Juan, and the news that some 1,500 flights into JFK have been preemptively canceled is met with something between stoicism and merriment: So we’re all stuck here with the 88-degree poolside weather and the perfect beaches and the $20 snifters of Zacapa XO rum for another day or two. We’ll live.

It isn’t always pretty: There’s the usual tacky casino, although here it is tucked into an off-room behind a set of double doors, like something the suits at Hilton are slightly ashamed of, rather than splat in the middle of the main floor of the hotel, Vegas-style. Instead, the lobby tonight is hosting a dance band as a wedge of oldsters and not-quite-oldsters salsas and merengues the night away, the whole thing having the distinct feel of a cruise ship that never leaves port, with vast and bulbous expanses of semi-exposed gynecomastia not so much deeply tanned as rotisseried, the gentlemen accompanied by desiccated former queens of happy hour, their tiaras abdicated approximately sometime during the Clinton administration, who are still bravely clinging to the clingy cocktail dresses and the brutal tanning regime — prom-queen jerky. An elegantly outfitted wedding party makes its way through the crowd, bridesmaids and groomsmen scanning the bar scene at an establishment christened, with admirable forthrightness, “Meat Market.” The silver-maned septuagenarian king of this particular dance floor has his well-honed act momentarily upstaged by the bad bar mitzvah dancing of a rummed-up young interloper, whom he challenges to a push-up contest. He wins.

And the band played on. It’s not the Ritz, but it’s not five grand a night, either.

This wasn’t the plan. San Juan is a picturesque colonial city, its dramatic ramparts commanding views of the apparently endless Dodger-blue sea. Artists paint at easels in the public squares, and, unlike the case at most tourist destinations, there is not a panhandler to be seen, no obnoxious drunks on the street, nobody sleeping on the sidewalks, the most aggressive form of street life being the capital city’s famous colonial cats, which, like their celebrated cousins in Rome, stalk with haughty impunity through the ruins and outdoor cafés. It’s all terribly comfortable and welcoming, but when Luis Muñoz Marín, the “Architect of the Commonwealth,” contemplated the future of this Caribbean island, he didn’t envision casinos or plantations — he wanted factories. Puerto Rico was supposed to be the gold standard of the Caribbean.

Now, undone by gigantic deficits and rapacious public-sector unions that have looted an otherwise productive economy, it’s the junk-bond king of paradise.

While much of the Caribbean was largely content to peddle rum, sugar, and freshly laundered beach towels, Marín had hoped to build an industrial economy in Puerto Rico, and to some extent he was successful: Manufacturing, particularly that related to pharmaceutical, medical, and electronics companies, accounts for about half of the commonwealth’s industrial output. Major players such as Johnson & Johnson and Abbott have extensive operations in Puerto Rico, and even with the economy in the depths of a long recession and the government teetering on the edge of insolvency, the so-called 936 companies — named for a section of the U.S. tax code that conferred certain advantages on Puerto Rico–based operations — are still robust enough to be paying some $2 billion a year in taxes, or nearly a quarter of the commonwealth’s government revenues. This is remarkable given the fact that Section 936 and the benefits that went with it were repealed by a law signed in 1996 by Bill Clinton. During the ten-year phase-out of Section 936, the pharmaceutical industry did not collapse but instead grew, and by the turn of the century pharma accounted for more than half of Puerto Rico’s manufacturing, 20 percent of its industrial jobs, two-thirds of its exports — and 43 percent of the island’s net income. It hasn’t retreated to any significant degree. Tourism accounts for another 8 percent or so of the economy. Agriculture, by comparison, is a minuscule slice of it.

With a well-educated work force and a beneficial if thoroughly weird relationship with the United States, Puerto Rico was positioned to thrive, and it did, at least relative to most of its Caribbean neighbors. Puerto Rico is poor by mainland standards — its average income is about half that of Mississippi, the poorest of our states — but it is rich by Caribbean standards, with a per capita income that is nearly three and a half times that of the Dominican Republic and 27 times that of the poor country at the other end of Hispaniola. In fact, the only Caribbean jurisdictions that are better off are the tiny banker colony that is the Cayman Islands, Saint Barthélemy, and the British Virgin Islands, where Her Majesty’s subjects enjoy almost exactly the same per capita income as their cousins in the motherland.

Walking through San Juan, even the rough parts, it is clear that this is a very different sort of city from Santo Domingo, in a very different sort of country. And outside of the capital, in Coama and Ponce and Mayagüez and on the roads connecting them, there is little sign of abject poverty or economic catastrophe. Even La Perla, allegedly one of the most dangerous places in the Caribbean, seems pretty decent as slums go. Said to be a way station for itinerant narco-traffickers from points south, it is, perversely, right on the waterfront, the sort of place that ought to be home to a $20 million mansion. It had been a slaughterhouse — appropriate enough given the neighborhood’s reputation for violence — and 19th-century laws required that freed slaves and non-white servants, along with others regarded as social undesirables, make their homes outside of the city walls, thus the billion-dollar view from a ramshackle slum. But La Perla is pretty squared away. I do wonder about the billboards advertising “Gasolina — Party in a Pouch!” Turns out that’s a prepackaged cocktail that comes in a Hawaiian Punch–style juice box with a straw attached and seems to be the Sunday-morning breakfast of choice in La Perla. A very thoughtful gentleman offers me one.

It’s not in your face, but the economic catastrophe is here, and it is measured by three numbers: The first is 15.2 percent, which is the unemployment rate; the second, arguably worse number is 30 percent, which is the share of puertorriqueños employed by government; the third is 51 percent, which is the share of residents on welfare. In this case, 15 + 30 + 51 = $70 billion, the amount of outstanding government debt suffocating the economy, $3.5 billion of which has just been refinanced at credit-card rates, Puerto Rican bonds having been downgraded to junk status some time ago. Far from being scared off by that junk rating, the bond market ate up the latest offering from this distressed island — where else are you going to get a yield of almost 9 percent on a tax-free bond? Barclays, Morgan Stanley, and RBC Capital, which handled the bond offering, got $16 billion in orders for the $3.5 billion they had for sale, so even at junk rates, Puerto Rico ought to be able to continue to roll over its debt for a while. (And, given that the banks made $28 million on the deal, Puerto Rico will not want for financial services.) But that’s just issuing new debt to pay off old debt. And though the point is a matter of some contention, Puerto Rico is either near, at, or beyond its constitutional limit on general-obligation debt. The ongoing problem is the island’s deficits, chump change in absolute terms for mainland types in the Age of Obama grown horrifyingly blasé about throwing around the word “trillion” when it comes to deficits, but an ongoing $1.5 billion shortfall is serious fiscally existential business when you have a population of only 3.6 million — and that declining rapidly, with the most skilled and educated in the vanguard of the exodus. With its enormous, unionized public sector and swollen welfare rolls, Puerto Rico consumes $10 billion worth of government annually with only $8.5 billion to pay for it. One of those things is going to have to change — or all those bondholders are going to be ruing the day they took that call from Barclays as their 9 percent returns vanish in default.

The unemployment rate understates the severity of the problem: Just as there are more people of Irish origin living in the United States than in Ireland, most Puerto Ricans do not live in Puerto Rico but in the continental United States, and the ones most likely to move to the mainland are those who are in possession of good employment prospects. Because Puerto Ricans are U.S. citizens, the pattern of immigration is radically different here than it is in the rest of the Caribbean. “We have a saying: ‘All economic problems are solved with JetBlue,’” says Marcos Rodriguez-Ema, a lawyer and banker who served as president of the Government Development Bank for Puerto Rico and later as chief of staff to the reformist governor Luis Fortuño of the New Progressive party. “Those who leave are those who are bilingual and have degrees — and they take their families with them. When they leave Puerto Rico, the grandparents come. It’s not like the Dominican Republic, where you leave and you send money back.” He notes that his own children reside on the mainland.

Governor Fortuño’s tale is a cautionary one, the moral of which is this: Get yourself in enough financial trouble and doing the right thing — even all the right things — is not going to be enough. Governor Fortuño was elected in 2008 and came to office with a crumbling economy and a $3.3 billion deficit, with the government unsure it would even be able to make its payroll. Despite the name of his New Progressive party, Fortuño is a conservative’s conservative (he even hosted the editors of National Review at the governor’s mansion in 2011 during one of our seagoing excursions), and his economic agenda consisted of doing the sorts of things that Washington Republicans dream about doing but never get done: He waged a two-front war, cutting the top corporate tax rate from 39 percent to 30 percent (partially offsetting those cuts with some higher taxes on multinationals) and halving income taxes to encourage growth and investment, and then cutting thousands of government jobs and lopping nearly 20 percent off of government spending. The deficit was reduced from 44 percent of revenues to 7 percent. He met with the bond-rating agencies and promised further reforms. His efforts were rewarded in 2012, when Puerto Rico saw its first measurable economic growth in seven years.

And his efforts were punished later in 2012, when Puerto Rico’s public-sector unions — with a critical assist from their mainland allies — sent him packing.

The public-sector unions were bound to be displeased with his economic program, which amounted to a swift kick in the bank account for the bureaucratic class, but Governor Fortuño’s reforms were, while admirable, not an unalloyed success. The credit-rating agencies backed off a bit, with Moody’s giving Puerto Rico its highest rating in 35 years. But the markets were not entirely convinced, and bond yields eventually crossed the 10 percent mark. An audit of Puerto Rico’s 2012 finances revealed that the general-fund deficit climbed by a quarter in 2012 to $1.3 billion. And the island’s comprehensive deficit — which includes not only the commonwealth government’s fiscal deficit but also those of public corporations and entities such as the University of Puerto Rico and the Government Development Bank — hit a record $39 billion. Governor Fortuño’s administration imposed real ledger restraint on the official budget, but there is always more to the fiscal picture than that, and in this case there was much more. Puerto Rico’s public agencies were in such a shambles that the fact did not even come to light until four months after the regularly scheduled audit was supposed to have been completed. The Fortuño administration nudged Puerto Rico into growth territory, but it was not enough — not economically, and certainly not politically.

Fortuño’s successor, Alejandro García Padilla of the center-left Popular Democratic party, thanked his union allies profusely when he was sworn in and promised an end to public-sector layoffs — and then began twisting their arms, reducing some bloated pensions and benefits programs. Taxes leapt up, with the corporate tax returning to 39 percent, its legal limit, and taxes overall increased by 1.1 percent of GDP, a substantial number. The new governor hopes to get the deficit back down below the $1 billion mark, but the signs are not good. Unemployment does not look to be budging and growth remains elusive. He may very well end up adopting most of the Fortuño program whether he wants to or not — Puerto Rico is running out of options.

Juan Carlos Batlle, a Santander veteran who also served in the Fortuño government, is cautiously optimistic that all parties — government, unions, and electorate — will be boxed into doing the right thing. “Based on what we know today from what has been communicated by the current administration about presenting a balanced budget for next year, one of two things has to happen: increase revenue or cut expenses,” he says. “We’ve already had our share of increased taxes, so I don’t see much space to increase revenue. That means you’re left with the expense side. You’re going to have to take out $1.5 billion in government spending — out of education, out of the University of Puerto Rico, out of collective-bargaining agreements — and it’s all politically difficult.” But, he says, the unions’ political position has been weakened by illuminating media reports on the fat compensation and generous benefits of their members, which stand in politically queasy contrast to the situation of typical Puerto Ricans. “There will be opposition from unions,” he says, “but they will not have as much clout.”

Governor Fortuño himself declines to discuss the specific policies of the current administration as a political courtesy to his successor, but he does see some lessons for other governments in Puerto Rico’s predicament. “Puerto Rico, the federal government, and every jurisdiction in the world should follow the same rules that a traditional family or business owner follows: not to spend more than you take in, allow people to do what they do best, and not try to impose government on their ingenuity and their will. They’ll succeed. Do the opposite and you’re not only imposing on their freedom, but you’re imposing a set of values not shared by the majority of people.”

The island’s very friendly tax environment for investors has attracted some activity — hedge-fund gazillionaire John Paulson has taken a stake in a few resort properties and plans to put $1 billion into Puerto Rican investments in coming years — but the Switzerland-in-the-Caribbean strategy is of limited potential. Billionaires can send their money to live in the Cayman Islands; that doesn’t mean they have to live there themselves. Puerto Rico had hoped to entice a small gang of super-rich U.S. tax refugees into bringing their residences and their economic activity to the island — which is, after all, only a short flight from New York City and Washington — but it has had more luck in attracting tourists, from the older Florida types to the superlatively well-heeled ones unloading their Louis Vuitton luggage at the recently opened Ritz-Carlton Reserve at Dorado Beach, which is doing brisk business in its $5,000-a-night suites.