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Puerto Rico needs debt transparency

Puerto Rico needs debt transparency
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Before going on a two-week recess, the House Committee on Natural Resources published a discussion draft of a new proposal to deal with Puerto Rico’s debt crisis, known as the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). The draft is now subject to a bit of scrutiny before further debate. Hopefully, House leadership will maintain this transparent approach to Puerto Rico legislation. It would be a shame to see the process end with an all-too-typical batch of last-minute changes to the draft, followed by a sudden vote on the floor.

From a content perspective, the draft bill combines two essential ingredients: restructuring authority and federal oversight. Until recently, we heard calls for debt relief from Democrats and oversight from Republicans — but Puerto Rico’s situation requires both.

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According to its published financial statements, the Commonwealth of Puerto Rico has run multibillion-dollar deficits, government-wide, in every fiscal year since 2009. And, as we discuss in a new Mercatus Center working paper, Puerto Rico’s government has been borrowing excessively for decades, with economists warning of impending trouble as early as 1982.

Puerto Rico’s last available financial statement covers the fiscal year that ended on June 30, 2014, but that document is an unaudited draft. Twenty-one months later, it has been unable to produce audited financials — a stark contrast to U.S. states, which generally release them within nine months.

Given the Commonwealth’s persistent inability to match revenues to expenditures and produce timely financial audits, it’s reasonable for the federal government, which provides one-third of the territory’s revenue, and for bond investors to demand strong, external oversight. Our study references an unpublished study produced by Puerto Rico Senate staff that identified numerous cases of wasteful spending and opportunities for cost savings. Actually achieving these savings may require the intervention of third parties whose judgment is not clouded by local political considerations.

Even with spending cuts, it is difficult to see how Puerto Rico’s declining economy can generate sufficient tax receipts to service $70 billion in debt, much of it carrying high interest rates. These high coupon rates, ranging up to 8 percent tax-free, were very attractive to municipal bond investors who snapped up the island’s debt despite its relatively low bond ratings. They knew — or should have known — that default was a possibility irrespective of the fact that Chapter 9 of the federal bankruptcy code doesn’t apply to Puerto Rico.

Consequently, it’s reasonable to implement a legal framework to facilitate restructuring of Puerto Rico public-sector debts. The alternative — a disorderly default — could trigger years of costly litigation and heighten uncertainty in the municipal bond market, raising financing costs for state and local governments across the U.S. mainland.

A strong external oversight board is admittedly undemocratic and will certainly draw opposition, but the current situation demands technocratic attention free of political pressures. As we discuss in our study, this technique was effective in resolving Newfoundland’s fiscal crisis in the 1930s. Others have commented on the success of oversight boards in addressing problems in New York City and Washington, D.C.

This board should not operate indefinitely, but Puerto Rico’s governmental structures must be reformed to prevent a future crisis. The English version of Puerto Rico’s 1952 constitution required a balanced budget, but, as David Martin writes, the Spanish translation allowed government officials to misconstrue revenues to include proceeds from borrowing — essentially rendering the balanced-budget requirement inoperative. Puerto Rico’s constitution should be updated to include the best fiscal provisions found in U.S. state constitutions.

Any reform that lacks Chapter 9 in Puerto Rico will inevitably be criticized by hard-liners who misinterpret it as carte blanche for bondholders. But we must not effectively subordinate the rights of taxpayers to bondholders. Puerto Rico has already imposed significant tax increases, but, given freedom of movement between Puerto Rico and the 50 states, it is unclear whether more taxation on the island can substantially increase revenues.

On the other hand, the current draft imposes a stay on bondholder litigation against Puerto Rico for many months before the oversight board is empowered. This could allow the current government to fritter away money currently earmarked for debt service on politically motivated priorities, free of restrictions from either the courts or federally appointed overseers. This language could be clarified to avoid both an unfair outcome for Puerto Rico bondholders and a dangerous precedent that could be applied to fiscally distressed U.S. states.

In a legislative environment characterized by gridlock and punctuated by insufficiently debated continuing resolutions, it is encouraging to see the beginnings of a transparent process that incorporates both Democratic and Republican concerns. If the trend continues, we may see real results; if not, Puerto Rico faces a train wreck that will be bad for both bondholders and residents. 

Joffe is the principal consultant at Public Sector Credit Solutions and a former senior director at Moody’s Analytics. Martinez conducts research for the Mercatus Center at George Mason University. Both are authors of a new Mercatus Center study, “Origins of the Puerto Rico Fiscal Crisis.”