In a move to meet the promise of delivering Puerto Rico's first structurally balanced budget in a generation, the Alejandro García Padilla administration submitted a package to the Legislature this week that includes 40 measures that essentially restructure 25 government agencies. It also promises to be the most contentious budget debate in decades, say some observers, because the measures contain $1.357 billion in cuts, which if passed will have far-reaching consequences for some of the government workers hired under professional services, who will see their contracts terminated. The cuts in contracts are a sacrifice that the government is pushing across the board at all public corporations to guarantee self-sufficiency in the public sector without resorting to debt to square the bottom line.
To be certain, there are many questions that remain to be answered. Analysts at the credit-rating agencies on Wall Street are still concerned about pending revisions to the teacher-pension reform, which was overturned by the Puerto Rico Supreme Court last month. The reform was intended to address the issue of a severely underfunded pension system and would have helped the teachers' pension plan to self-correct by 2025. Another concern looming large on the horizon is that these austerity measures are taking place in an economy that is hemorrhaging net jobs.
During a wide-ranging interview with CARIBBEAN BUSINESS, Office of Management & Budget (OMB) Executive Director Carlos Rivas explained that the government must cautiously approach austerity, looking at a balanced bottom line as the foundation for sustainable economic growth.
"Clearly, the government is a big part of the economy in Puerto Rico. Perhaps more than it should be and there is no denying that," Rivas told CARIBBEAN BUSINESS during the editorial board meeting held days ago. "So, what the government does has an impact on the economy. The right way to look at this is in the longer term and ask ourselves what is the impact of having a fiscally unsustainable government and what that implies in terms of financing costs and the amount of money that the debt service takes out of the economy to pay those creditors."
Rivas' remarks are consistent with the García Padilla administration's assertion that a reduction in current government expenditure is a measure that will help to ease a drop in gross domestic product (GDP) in the short term and lead to economic development in the long term by boosting labor participation and private investment.
FOUR GUIDING PRINCIPLES
Rivas said the budget was the result of a long analytical process that took into account four "design principles."
"The first and most important is to take the opportunity to make government better, and not just do what you are doing with less money, but also do it better," Rivas said, adding that the idea was to make government "more effective, more agile."
That principle is behind the reorganization of 25 government agencies and the closing of 100 underutilized schools, the OMB executive director said.
The second design principle is that Puerto Rico has one government, despite the division of powers between the three branches of government and the autonomy of public corporations. "Fiscally, the government is interdependent, so we have to structure the finances of the government in a way that everyone is rowing in the same direction, and everyone is pulling together and working together," Rivas said. "In this budget, we have all branches of government—the legislative, the judicial, autonomous entities such as the Comptroller's Office and the State Elections Commission, with budget adjustments proportional to the change in the size of the budget.
"Generally, the concept of fiscal interdependence in the government is essential if we are going to pull out of this hole," he added.
Rivas said this philosophy will allow for public corporations that are "very solvent" to pick up expenses for activities traditionally covered by the general fund that are related to their missions. One example, he cited, is the ability of the Puerto Rico Tourism Co. to pay for incentives for the cruiseship industry.
A third guiding principle is to maximize and respect the human capital in the government as an asset, and not lay off or furlough employees, he said.
The last guiding principle is that of austerity and fiscal responsibility. "We have an 8% decrease in terms of headcount over the past year. We have a dramatic decrease in terms of professional-service purchases," Rivas said.
If the 40 measures of this budget package become law, the García Padilla administration is hopeful that Puerto Rico will see structural balance for the next three years, 2% GDP growth by 2018 and yields in the bond market that will come down to 4.8% by 2016.
Those projections, however, are based on job numbers that don't fully reflect the reality of a Puerto Rico market that is losing net jobs at an alarming rate. The budget report titled Agenda Para la Recuperación Económica points out that the Jobs Now Act, a stimulus measure to promote job creation, had helped generate 44,704 new jobs during the past 15 months.
The Jobs Now Act statistic refers only to new hires and makes no reference to the most recent employment numbers from the Puerto Rico Department of Labor, which show that the island is down 46,000 net jobs. "We are reconfiguring a labor force focused on the private sector and that is a good thing. And we have had this conversation with the [credit] rating agencies," Rivas said. "If you look at the number of public sector jobs through diminished government, it might change those net numbers or at least force us to see it in a different light. It isn't the same to have an employee retire, although it is one fewer job, but that person then has a pension and a livelihood and they keep paying their mortgage. They keep making a living and participating in economic activity. It is different to have a layoff in the public sector, which has a ripple effect on consumer expenditure."
He admitted it would have been easier to furlough some of the employees to obtain savings. "It would have been easy to do that, but it goes against the governor's value set," Rivas said. "The governor has made very clear that we must appreciate the public employee as an asset to Puerto Rico. That is one element and to the extent that we are affecting economic benefits, we aren't affecting core wages, hours and compensation such as the Christmas bonus. We view the Christmas bonus as part of the core compensation."
In the private sector, companies that are showing a loss for the year can apply for a waiver freeing them of the obligation to pay the Christmas bonus. The same rule won't apply to public corporations. "The Christmas bonus is actually granted by law as part of base compensation. If the government has a commitment to the employee's wage package and benefits, which includes the Christmas bonus, we will meet the labor commitments as they stand at this point in time," the OMB director said.
Failing to fully apply the same rule for the public and private sector is one example of challenges that remain in having the government behave as a truly self-sufficient business.
WALL STREET REACTS POSITIVELY, BUT CONCERNS REMAIN
Wall Street investors and analysts hailed Gov. García Padilla's budget proposal, but remained concerned by the stagnant local economy and the government's ability to handle its $73 billion debt load.
"The 2015 budget proposal appears to be a positive development for the commonwealth, based on its effort to move toward structural balance, its call for spending restraint and the avoidance of new deficit financings," Moody's Investors Service said.
"While the budget may constitute a significant, positive step if enacted, this financial plan still leaves the commonwealth with many economic and financial challenges," Moody's concluded.
Moody's reaction was echoed by a number of analysts. "Significant fiscal and economic challenges remain, but it is important to emphasize the immense progress made in the past 18 months," Janney Capital Markets Managing Director Alan Schankel wrote in a report following the budget's release.
The vote of confidence was also evident in a rally in the prices of Puerto Rico government bonds following the announcement, with bond value jumping by as much as 3% the next day.
"Anytime you get closer to having a balanced budget, it's a positive for the bonds and the long-term financial health of the island," Joseph Rosenblum, director of municipal credit research at AllianceBernstein, told the Wall Street Journal. "What's also important is the significant attention to economic development and public corporations."
For Robert Donahue, managing director at Municipal Market Advisers, the filing of legislation declaring the fiscal emergency shows the governor is serious about the island's fiscal challenges. By not discussing restructuring of debt, the governor's most important message is that Puerto Rico won't engage in a "pre-emptive restructuring," Donahue said.
While the administration has been adamant that it isn't considering restructuring its outstanding debt, it has hired some of the top restructuring experts in the U.S., including Millco Advisors LP, a Washington, D.C.-based affiliate of Millstein & Co.; Cleary Gottlieb Steen & Hamilton LLP; Proskauer Rose LLP; and FTI Consulting Inc.
Also, the government warned investors in last month's bond deal that it "may be unable to honor its obligation to pay the principal and interest on the bonds in full, or in a timely manner," and that it could "seek relief under existing law, or under laws enacted in the future, regarding restructuring, moratorium and similar laws affecting creditors' rights."
So the focus on making public corporations self-sufficient and paying back the debt in the budget helped quell growing concerns that Puerto Rico was planning on restructuring debt.
"Restructuring remains a very possible and, many would argue, probable outcome, but the governor is doing all that he can to avoid it," Donahue said."They might have restructuring plans on the shelf ready to go if the cash-fl ow crisis endangers public safety and welfare. The governor made clear he isn't going to do a pre-emptive restructuring. He will need a catalyst," he added.
Wall Street isn't necessarily buying the claims of a "balanced budget," but seems pleased with the progress made. One big reason is that the government won't pay interest and principal payments for the next few years on the $3.5 billion general-obligation bond deal that took place in March and is keeping the Puerto Rico government afloat financially. Those payments would have added up to $270 million this year.
Puerto Rico's serious commitment to paying off its debt is evident in the budget's numbers. Overall, around $906 million will go to pay off bond debt and $305 million will go toward paying Government Development Bank (GDB) loans to entities.
Additionally, the central government is putting up nearly $600 million in extra payments to shore up the retirement systems for public employees. This figure is slated to increase by at least $50 million a year during the next several years.
Debt service currently accounts for 12.56% of the general-fund budget, when loans to the GDB are included, and this will go up when the government starts paying for its $3.5 billion bond issue and other bills come due.
"Puerto Rico will be facing a larger ball of maturities in the future. The debt service levels will continue to grow," Donahue said.The overriding concern on Wall Street, as in San Juan, is the stagnant local economy, and government officials and analysts acknowledge that the spending controls will be a drag on the budget.
Noting that the new budget comes with nearly $1.4 billion in fiscal drag, and new tax enforcement measures that could hamper growth, Daniel Hansen, of Height Securities, said the budget will "undoubtedly have a deleterious effect on growth in the coming year… Puerto Rico will remain in mild recession through fiscal 2015."
Hansen, however, found positive news in a number of economic development proposals unveiled by the governor, citing the special tax incentives for young entrepreneurs and professionals, plans to cut electricity costs, and pledges to bolster the tourism sector.
"This year's budget appears to be a credible path toward growth and fiscal responsibility that may succeed in placating investor and politician fears about the viability of the commonwealth over the medium term," he said.
IT'S THE ECONOMY…
Rivas is well aware that the budget's fiscal austerity will have an impact on the economy. "We are clearly rowing against the current and the current is economic development," he said, noting that only through an improved economy can Puerto Rico's fiscal problems be finally resolved.
That is why economic development is the main focus of Gov. García Padilla and his cabinet.
"The fiscal part of it takes up a lot of bandwidth in terms of public discussion, but the priority of this administration is economic development. That's the focus, that's what everyone spends their time on," Rivas said. "Maybe 20% of the time is spent on the fiscal part. The rest is economic development."
The governor dedicated much of his address to recent promising events on the economic development front. These include the investors' summit last month in which John Paulson, one of the biggest names in world finance, championed Puerto Rico as the "Singapore of the Caribbean" and a land of opportunity,predicting a swift return to better days. Also last month,Honeywell Aerospace announced plans to establish a new $30 million laboratory in Puerto Rico that will create 310 new jobs. And Lufthansa Technik announced it would launch a new aviation maintenance, repair and overhaul facility in Aguadilla, a project that is also expected to create hundreds of jobs.
The budget address was not only about austerity either; there were also a number of initiatives aimed at boosting economic development.
García Padilla reiterated his support to promote bioscience, aerospace and high-tech manufacturing. The spending plan also aims to make educational improvements, from preschool to university level, which should help better meet the needs of a modern economy. He pledged to increase resources to the Science & Technology Trust, bolster tourism promotion and increase funding for small businesses.
García Padilla said his government would continue to work to increase agricultural production on the island after decades of decline. He pointed to recent projects to grow rice and sugar on the island as advances.
The governor also proposed zero income tax for recent college graduates ages 27 and younger who stay on the island, and a zero corporate tax rate for companies that hire a large percentage of workers between the ages of 22 to 27.
The governor also announced several infrastructure initiatives, including a $257 million project to build a natural-gas terminal in Guayama, the commuter train to Caguas, and improvements at local ports and regional airports.
THE TRUTH ABOUT THE UPCOMING BUDGET
The fiscal year 2015 budget proposed last week by Gov. García Padilla basically holds overall spending to current year levels, but officials said they will have to make "cuts and other adjustments" of nearly $1.4 billion to halt the growth of government and pay for all its expenses during the year with recurrent revenue.
Political supporters hailed the governor for presenting a balanced budget for the first time in two decades, while keeping his pledge not to fire public employees. Political opponents, meanwhile, argued that the cuts didn't go deep enough, while union groups expressed concerns over proposals to cut back public employee benefits, such as sick days, Christmas bonuses and holidays.
"The practice of spending more than we have is over," García Padilla said in announcing the spending plan. "We are going to make clear to the world that this island pays what it owes.
"We are beginning to pay for today's expenses with today's earnings. This balanced budget complies with my commitment to prepare a budget without deficit financing or refinancing of debt," the governor added. "We have accomplished this without firing anyone, respecting the daily bread of public workers." The governor proposed a $9.64 billion general fund fiscal year 2015 budget that consists of $8.865 billion to run the government and $906 million to pay for debt service, ending a years-long practice of putting off these annual payments by refinancing existing debt.
The administration proposes balancing the general-fund budget, which consists of commonwealth government funds, by making cuts and other adjustments of more than $1.357 billion, which consists of actual spending cuts and eliminating planned funding increases set to take effect with the July 1 start of fiscal 2015.
The proposed consolidated budget, which includes federal funds, is $28.13 billion for fiscal 2015, a 3% decrease from $29 billion this year. The 2015 budget proposal represents a $130 million cut from the current year general-fund budget of $9.77 billion, a 2.2% reduction, Rivas said.
25 AGENCIES TO BE 'INTEGRATED' WITH OTHERS
The Economic Development & Commerce Department will absorb four entities: the Labor Development Administration, Film Commission, Youth Affairs Office and Solid Waste Management Authority. The Energy Affairs Administration will be eliminated and fused into a new regulatory board overseeing the energy market contemplated by several bills.
The budget also envisions eliminating a number of advocate offices, as well as the National Parks Co., which will be integrated into the Sports & Recreation Department, and the Inspector General's Office, which will be integrated into the OMB.
The Maritime Transportation Authority and Metropolitan Bus Authority will be fused into a new Integrated Transit Authority that will be spun off from the Highways & Transportation Authority.
Enacting the budget will require 40 pieces of legislation, but the most important measure declares a fiscal emergency, enabling the government to undertake a number of necessary moves needed to strike budget balance.
The government needs the law to pass to be able to reduce the number of trust employees, suspend labor benefits and funding formulas for other branches of governments, modify service contracts, and increase safeguards against agency overspending.
The governor has framed his budget as part of a four-year economic recovery plan as the government grapples with $73 billion in debt, junk-rated general-obligation bonds and an ongoing economic recession dating back to 2006.
If everything goes according to plan, Rivas explained, the principles of government self-sufficiency would institutionalize fiscal stability. The García Padilla administration is hopeful that will lead to 2% growth in GDP by 2016.
100 public schools to be closed by August
As part of the government's cost-saving measures, about 100 public schools are scheduled for closure by August because they have very few students and/or are in poor condition.
Office of Management & Budget Executive Director Carlos Rivas said the savings estimated is $300,000 to $350,000 a year for each school, primarily comprising savings in operational costs, such as water and electricity, maintenance, and payroll.
Students and most teaching staff at schools on the list for closure will be integrated into nearby schools that are in better condition and offer better services. Other staff, whether teaching or nonteaching, will be reassigned to other schools or Education Department offices.
Reconfiguring the "teacher portfolio" of the Education Department is essential to improving services, Rivas said. "If you have a school that has a health teacher and another that has a fine-arts teacher, but the school with the health teacher has a better fiscal plant and maybe a preschool and an afterschool program, you can move students and teachers to this school. Now you can have a school that has all these services."
As part of this effort, Education has been working with the Boston Consulting Group (BCG) to identify the schools that will be closed.
"This is being looked at, not just from a budget point of view, but also from an efficiency point of view and offering better services," Rivas explained. "We have been working on this for months. It's a very analytical process. At one point, in the 1980s, Education had 740,000 students; right now, the number is 430,000. The BCG study is projecting that student enrollment will go down to 320,000 students in five years."
As this downward trend continues, there are obvious consequences in terms of budget and infrastructure issues, he noted. "It's urgent that the government act now, with foresight, when looking at this scenario. Education is also facing declining federal funds and a large infrastructure, so we are turning what could be a problem into an opportunity to have more resources and better services for students."
Rivas outlined the general criteria when selecting the schools for closure: state of the facilities; enrollment numbers; additional services offered, such as preschool and afterschool programs; academic performance; and location within three to four miles of another school. He explained that academic performance is based on the results of the yearly Puerto Rico Achievement Test in Spanish, math and English. However, he was quick to point out that schools weren't being punished for academic failure. "We aren't closing schools because they are failing. We are integrating them with schools that have better infrastructure, services and academics."
Rivas also agreed that Education would likely have to close more schools as demographics continue to change and there are fewer children in Puerto Rico. "It is critical that this is done right so that people see results: Academic achievement improves and parents see their children are in a better school, with better services."
Education Secretary Rafael Román Meléndez is already meeting with mayors about the school closures. Rivas said some mayors have expressed an interest in turning the closed schools into elderly- care centers, community centers or residential properties. If a school is funded by the Public Buildings Authority, by law it cannot be used for commercial reasons, he noted. "We aren't really looking at using schools for commercial purposes, except perhaps in the San Juan metropolitan area," the OMB executive director said.
The official announcement of the schools that will be closed should be made shortly.
The budget by the numbers
The $1.357 billion in cuts and other adjustments that will be made to bring budget balance includes: $542 million in actual budget cuts; $364 million from eliminating planned funding and salary increases; a $184 million savings from efficiencies created from a lower spending base; and $267 million in savings by using funds outside the general fund for expenditures that the central government currently pays for.
THE $1.357 BILLION IN SAVINGS MEASURES INCLUDE THE FOLLOWING:
- $296 million from reorganizing public-school teacher staffing, including an expected one-time increase in the number of retirees, shutting 100 schools and reducing school transportation costs by 40%, among other measures in the public school system.
- $116 million through an "across the board spending cut" in government agencies supported by the general fund.
- $132 million through freezing automatic funding increases due to the University of Puerto Rico, the judiciary and the municipalities.
- $60 million from changes to the Municipal Debt and the Municipal Improvements funds.
- $120 million from suspending increases in benefits and canceling extraordinary compensation.
- $75 million in Christmas-bonus changes for central government, public corporation and municipal workers.
- $92 million from modifying the uniform additional retirement contribution.
- $58 million in redirecting special state funds for the payment of lawsuits.
- $54 million in redirecting public corporation spending to recurrent expenses.
- $19 million through eliminating the practice of paying cash to employees for unused sick days.
- $10 million from cutting the amount of trust positions by 10%.
- $2 million through the fusion of about 25 government entities (annual savings to be $10 million once fully implemented).
THE $579 MILLION INCREASE IN TAX REVENUE INCLUDES:
- $170 million through the commencement of the collection of the sales & use tax (IVU by its Spanish acronym) on items shipped into local ports.
- $124 million by eliminating the earned income credit.
- $100 million from cutting back on the senior citizen's bonus.
- $10 million by limiting the IVU exemption on nonprepared food.
- $15 million through a 5% tax on remittances.
- $5 million from the potential legalization of marijuana for medical purposes.
- $10 million by freezing the Green Energy Fund to its current $20 million annual funding level.
- $10 million in increased regulation of illegal slot machines.
- $30 million by reducing exemptions on certificates of deposit on income from $4,000 a year to $2,000.
- $30 million in changes to the corporate gains tax.
- $32 million from reducing the basic alternative tax to individuals who earn $300,000 or more, versus the current level of $500,000.
- $30 million from applying the Law 154 tax on dividends.
- $13 million from the Power Ball implementation.
The government also plans to close 100 schools this summer.
The commonwealth won't cut government jobs, nor reduce public employees' work hours or base salaries. Employees who work at agencies slated for shutdown will be absorbed by related government entities.
Office of Management & Budget
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