With Puerto Rico missing a payment on a bond overnight "due to
non-appropriation of funds" but denying that this constitutes
anything close to a default, the territory may be about to retake
the limelight as Greece is now "fixed."
As MarketWatch reports,
The missed payment could have serious implications for
holders of Puerto Rico bonds, “as the signal from breaking a
seven-decade streak of bond payments may imply more defaults are
looming,”Daniel Hanson, an analyst at Height Securities,
said in a note.
Not all Puerto Rican bonds are created
equal,being backed by different types of revenues,
such as tax revenues, road tolls, electricity bills etc.
The first thing investors should do is
“find out what revenue backs their bonds and whether their
bonds are insured or not,”said Mary Talbutt, head of fixed
income at Bryn Mawr Trust.
Approximately 30% of muni mutual funds have holdings in Puerto
Rico, more than half of which are insured, according to a Charles
Schwab Investment Management report. As for the revenue that backs
the bonds, most exposure is with the sales-tax backed bonds, known
as COFINA bonds from their Spanish-language acronym, and the
general-obligation bonds, known as G.O. bonds, according to the
report.
In that sense,
investors that hold the PFC bonds are somewhat in a bind
because “the language in PFC bonds makes payment dependent on
appropriations from Puerto Rico’s legislature,”Hanson
said.
This is the main difference between the PFC bonds and the G.O.
bonds. The former require appropriation, while the latter are
backed by the full faith and credit of the territory and their
repayment is guaranteed by the constitution.
“The language... makes [the PFC bonds] a weaker credit relative
to G.O. bonds.
But a default is still a default,”said Andrew
Gadlin, a research analyst at Odeon Capital Group.
This has investors worried about other types of bonds that face
a repayment deadline, most notably those issued by the island’s
Government Development Bank (GDB).
“The market is becoming more skeptical of the payments due
August 1 on GDB debt, though the budget does set aside
funds for paying these obligations,” Gadlin said.
And as Euro Pacific Capital's Peter Schiff
explains,
this is far from over
While Greece is now dominating the debt default stage, the
real tragedy is playing out much closer to home, with the downward
spiral of Puerto Rico.
As in Greece, the Puerto Rican economy has been destroyed
by its participation in an unrealistic monetary system that it does
not control and the failure of domestic politicians to confront
their own insolvency.But the damage done to the Puerto
Rican economy by the United States has been far more debilitating
than whatever damage the European Union has inflicted on Greece.
In fact, the lessons we should be learning in Puerto Rico,
most notably how socialistic labor and tax policies can devastate
an economy, should serve as a wake up call to those advocating
prescribing the same for the mainland.
The U.S. has bombed the territory of Puerto Rico with five
supposedly well-meaning, but economically devastating policies. It
has:
Exempted the Island's government debt from all U.S.
taxes in the Jones-Shaforth Act.
Eliminated U.S. tax breaks for private sector
investment with the expiration of section 936 of the U.S.
Internal Revenue Code.
Required the nation to abide by a restrictive trade
arrangement.
Made the Island subject to the U.S. minimum wage.
Enabled Puerto Rico to offer generous welfare benefits relative
to income.
While passage of such politically popular laws seems benign on
the surface (and have allowed politicians to claim that their
efforts have helped the poorest Puerto Ricans), in reality they
have deepened the poverty of the very people the laws were
supposedly designed to help. The lessons here are so obvious that
only the most ardent supporters of government economic control can
fail to comprehend them.
Tax-Free Debt
By exempting U.S. citizens from taxes on interest paid on
Puerto Rican sovereign debt, Washington sought to help the Puerto
Rican economy by making it easier and cheaper for the Island's
government to borrow from the mainland. As a result, Puerto Rican
government bonds became a staple holding of many U.S. municipal
bond funds. As with Fannie Mae and Freddie Mac bonds a decade ago,
many investors believed that these Puerto Rican bonds had an
implied U.S. government guarantee. This meant that the Puerto Rican
government could borrow for far less than it could have without
such a belief. However, this subsidy did not grow the Puerto Rican
economy, but simply the size of the government, which had the
perverse effect of stifling private sector
growth.
In contrast to the tax-free income earned by Americans who buy
Puerto Rican government bonds, those with the bad sense to lend to
Puerto Rican businesses were taxed on the interest payments that
they received. Businesses could have used the funds for actual
capital investment (that could have increased the Island's
productivity), but instead the money flowed to the Government which
used it to buy votes with generous public sector benefits that did
nothing to grow the Island's economy or put it in a better position
to repay. That problem was left for future taxpayers who no
politician seeking votes in the present cared about.
This dynamic is almost identical to what happened in Greece,
where low borrowing costs, made possible by the strong euro
currency and the implied backstop of the European Central Bank and
the more solvent northern European nations, permitted the Greek
government to borrow at far lower rates than its strained finances
would have otherwise allowed.
Taxing Private Investment
Perversely, as the U.S. government made it easier for the
Puerto Rican government to borrow, it made it harder for the
private sector to do so. In 2006 the government ended a tax break
that exempted corporate profits earned on private sector investment
in Puerto Rico from U.S. taxes. As a result, U.S. businesses that
had been making investments and hiring workers on the Island pulled
up stakes and moved to more tax-friendly jurisdictions. The result
was an erosion of the Island's local tax base, just as more
borrowing (made possible by triple tax-free government debt)
obligated the remaining Puerto Rican taxpayers to greater future
liabilities.
The Jones Act
The Jones Act, a 1920 law designed to protect the U.S.
merchant marine from foreign competition, has had a devastating
effect on Puerto Rico, and should be used as a cautionary tale to
illustrate the dangers of trade barriers. Under the terms of this
horrible law, foreign-flagged ships are prevented from carrying
cargo between two U.S. ports. According to the law, Puerto Rico
counts as a U.S. port. So a container ship bringing goods from
China to the U.S. mainland is prevented from stopping in Puerto
Rico on the way. Instead, the cargo must be dropped off at a
mainland port, then reloaded onto an expensive U.S.-flagged ship,
and transported back to Puerto Rico. As a result, shipping costs to
and from Puerto Rico are the highest in the Caribbean. This reduces
trade between Puerto Rico and the rest of the world. Since a large
percentage of the finished goods used by Puerto Ricans are
imported, the result is much higher consumer prices and fewer
private sector jobs. Even though median incomes in Puerto Rico are
just over half that of the poorest U.S. state, thanks to the
Jones Act, the cost of living is actually higher than the average
state.
The Federal Minimum Wage
In 1938 the Fair Labor Standards Act subjected Puerto Rico to
a federal minimum wage, but it was not until 1983 that a 1974 act,
which required that the Island match the mainland's minimum wage,
was fully phased in. The current Federal minimum wage of $7.25 per
hour is 77% of Puerto Rico's current median wage of $9.42. In
contrast, the Federal minimum is only 43% of the U.S. median wage
of almost $17 per hour (Bureau of Labor Statistics (BLS), May
2014). The U.S. minimum wage would have to be more than $13 per
hour to match that Puerto Rico proportion. The disparity is greater
when comparing minimum wage income to per capita income.
The imposition of an insupportably high minimum wage has meant
that entry level jobs simply don't exist in Puerto Rico.
Unemployment is over 12% (BLS), and the labor force participation
rate is about 43% (as opposed to 63% on the mainland) (The
World Bank). A "success" by the Obama administration in raising the
Federal minimum to $10 per hour would mean that the minimum wage in
Puerto Rico would be higher than the current medium wage.
Such a move would result in layoffs on the Island and another step
down into the economic pit. I predict that it could bring on a
crisis similar to the one created in the last decade in American
Samoa when that Island’s economy was
devastated
by an unsustainable increase in the minimum wage.
It will be interesting to see if our progressive politicians
will have enough forethought and mercy to exempt Puerto Rico from
minimum wage increases. But to do so would force them to
acknowledge the destructive nature of the law, an admission that
they would take great pains to avoid.
Welfare
In 2013 median income in Puerto Rico was just over half
that of the poorest state in the union (Mississippi) but
welfare benefits are very similar. This means that the incentive to
forgo public assistance in favor of a job is greatly reduced in
Puerto Rico, as a larger percentage of those on public assistance
would do better financially by turning down a low paying job.
Because of these perverse incentives not to work, fewer than half
of working age males are employed and 45% of the Island's
population lived below the federal poverty line (U.S. Census
Bureau, American Community Survey Briefs issued Sep.
2014). According to a 2012 report by the New York Federal
Reserve Bank, 40% of Island income consists of transfer
payments, and 35% of the Island's residents receive food stamps
(Fox News Latino, 3/11/14).
In other words, Puerto Rico's problems are strikingly
similar to those of Greece. Its government spends chronically more
than it raises in taxes, its economy is trapped in a regulatory
morass, and its economic destiny is largely in the hands of
others.
* * *
As The FT notes,
Puerto Rico’s economy and population have been shrinking
for almost a decade, and debts have ballooned to about 100 per cent
of its gross national product as the government took advantage of
the tax exemption enjoyed by US municipal debt.
The Puerto Rico Electric Power Authority is already
restructuring $9bn of bonds and loans.
By September 1 Puerto Rico is expected to deliver a plan for
turning round its finances.
Officials have called for patience from creditors about how
its various bondholders will be treated.
Patience... indeed.
* * *
The solutions to Puerto Rico's problems are simple, but,
Peter Schiff warns, politically toxic for mainland politicians to
acknowledge.
Puerto Rico must be allowed to declare bankruptcy, the Federal
incentive for the Puerto Rican government to borrow money must be
eliminated, Puerto Rico must be exempted from both the Jones Act
and the Federal Minimum wage, and Federal welfare requirements must
be reduced. Puerto Rico already has the huge advantages of being
exempt from both the Federal Income Tax and Obamacare,
so with a fresh start, free from oppressive debt and
federal regulations, capitalism could quickly restore the
prosperity socialism destroyed.
With the current incentives provided by Acts 20 and 22 (which
basically exempt Puerto Rico-sourced income for new arrivals from
local as well as federal income tax - see my report on
America's Tax Free Zone) and with some
additional local free market labor reforms, in a generation it's
possible that Puerto Ricans could enjoy higher per capita incomes
than citizens of any U.S. state.
If Washington really wanted to accelerate the process, it
should exempt mainland residents from all income taxes, including
the AMT, on Puerto Rico-sourced investment income, including
dividends, capital gains, and interest related to capital
investment.
