3 myths Puerto Rico should ignore about its debt crisis
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To further their narrow financial interests, Puerto Rico’s mainland creditors appear to be peddling three myths related to how the island should address its debt problems. Yet, these myths would seem to have little basis in reality. In the interest of its local population, the Puerto Rican government would do well to ignore these myths and to continue with the orderly bankruptcy procedure to restructure its debt that is already underway under the PROMESA Act.

The first myth being bandied about is that the island has the ability to fully service its debt mountain without the need for any debt relief. It is maintained that if only the island had the willingness to do so, it could make deep public spending cuts and raise taxes. By so doing, it could generate a sufficiently large budget surplus, excluding interest payments, which would allow it to fully meet its debt service obligations.

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The fundamental weakness with this myth is that it overlooks the fact that the Puerto Rican economy is already in a deep economic slump that has caused its output to decline by 10 percent over the past decade. More important yet, it ignores the fact that, like Greece before it, the island is stuck in a monetary union and does not have a currency of its own. As such, it cannot lower interest rates or depreciate its currency to promote exports as a means to offset the contractionary effect of budget tightening.

 

If, at its creditors’ behest, Puerto Rico were to take budget-tightening measures over the next few years beyond the 6 percent of GDP that its Oversight Board has already demanded of it, the island’s economic slump would only deepen. It would do so in much the same way as the Greek economy collapsed with similar policies during the European sovereign debt crisis. A further slump in the island’s economy would seriously erode its tax base, which would hardly be conducive to improving its ability to meet its debt service obligations.

The second myth being advanced is that the island can restructure its debt on a voluntary basis without recourse to formal bankruptcy procedures. A basic flaw with this myth is that it overlooks the fact that the island has as many as 18 different bond classes that are backed by different guarantees or that have separate legal claims on different revenue streams. As such, the interests of different creditors do not coincide with one another. Rather, they collide.

In a situation where Puerto Rico cannot fully meet the claims of all of its creditors, the favorable treatment of one class of creditors would necessarily come at the expense of disadvantaging the remaining classes of creditors. In such circumstances, an orderly bankruptcy procedure is necessarily required to establish the relative seniority of the different claims as well as to reconcile these claims with the capacity of the island to repay.

Absent a bankruptcy procedure, there would be a legal free-for-all by its creditors that would seriously damage the island’s economy and hence its ability to repay.

The last of the myths being propounded is that, should the island default on its debts, it will be indefinitely barred from future international capital market access. This myth flies in the face of the experience of many countries that have re-accessed the international capital market after having defaulted on many occasions.

If it was true that economies that defaulted were permanently barred from future capital market access, how is it that a country like Greece, which has defaulted as many as eight times over the past 200 years, repeatedly regains access to the international capital market?

Or, how is it that a country like Argentina, which as recently as 2001 repaid most creditors only 30 cents on the dollar in what was then the world’s largest sovereign debt default, can today place a $2.75 billion 100-year bond in the international capital market on relatively favorable terms?

The truth of the matter is that following a debt restructuring, an economy appears to new creditors as a better risk than it was before, since it is no longer weighed down by excessive debt claims. As long as its old creditors no longer have legal claims that they can pursue in the courts and that can help them thwart that economy’s market access, the economy can now tap the international capital market on better terms than it could before the debt restructuring.

Hopefully, the Puerto Rican government will see the self-interest of its creditors in promoting those debt myths and it will chose not to be swayed by them. By so doing, it will be in a better position to serve the interests of the island’s population.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.  


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