How Puerto Rico Can Avoid a Descent Into Third-World Economy

Puerto Rico will need help from Washington to maintain future market access and avoid a descent into a "third-world" economic conditions, municipal bond fund managers said.

Puerto Rico's fiscal forecast grew cloudier with a $422 million default on Government Development Bank debt on May 2, municipal analysts said this week, as they waited for action from Congress.

Proposed legislation, which has been stalled since the House Natural Resources Committee cancelled an April 14 vote because of a lack of support, seeks to balance competing interests by creating an oversight board that can both get Puerto Rico's fiscal house in order and start a debt restructuring process.

The default on GDB debt worsened the island's already-bleak status as a municipal issuer, making the situation all the more urgent, fund managers said.

"If there is a major default, the federal government will have no choice but to guarantee P.R.'s bonds going forward if the [territory] ever expects to issue sizable debt on the open market," said David Tawil, president of Maglan Capital.

Tawil was among municipal experts asked to assess Puerto Rico's prospects of recovery and forecast the commonwealth's fiscal status five years from now. Some forecasts were dire, while others assumed government intervention would ameliorate problems. Most put the island's future ability to tap the bond market as a prime concern.

Tawil currently has no exposure to Puerto Rico debt and had been avoiding ownership for two and a half years. But he said that a series of factors, including the outcomes of Congressional bills, Supreme Court rulings, and the Presidential election, may convince him to re-establish ownership.

"A default on [General Obligation] debt would make such access near impossible as well as impede any stabilization to the recovery process," said Jeffrey Lipton, managing director, head of municipal research and strategy at Oppenheimer & Co.

Lipton, who declined to comment on his holdings, said the commonwealth must preserve its "issuance portal" at all costs.

"The GDB, which has historically acted as the Commonwealth's fiscal agent, has already been operating under a state of emergency with withdrawals limited to fund health care, public safety and education expenses so as to preserve extremely thin liquidity," Lipton said.

Following the latest default, Lipton said market attention has now shifted to July 1, when about $2 billion in debt service comes due. "There is growing concern over the status of the $805 million that is owed by the Central Government on GO debt," Lipton said. "The eventual fate of the GO debt service may also be influenced by the content of the Congressional legislation that we hope will find its way to the President's desk soon."

The climate and favorable geography of the island the commonwealth will always be a draw for tourism, but that won't be enough to turn around the economy, Tawil said.

"Unless there is a major stimulus from the U.S. federal government, in one form or another, the island will be a beautiful third-world country, with the majority of residents living in poverty and rife with crime," Tawil said. In the absence of federal stimulus, the local economy will lack the fiscal and economic strength to retain and attract talent, "and only those with no other option will remain."

Lipton predicted that remedial legislation would be the starting point for debt restructuring and potentially lead to a recovery.

"The debt solution should not take on a 'one size fits all approach' given the various structures, liens and revenue sources," Lipton said. "It must also provide the economic tools to reverse the course of outmigration and provide the necessary incentives to attract and retain a corporate presence that chooses to do business on island. There needs to be a more aggressive effort to flush out the underground economy and capture a meaningful percentage of this lost revenue."

In addition, Lipton said Congress should be moving more expeditiously to provide relief. "At the heart of the legislation will be the creation of a Federal Control Board," he explained. "This has been a key impediment to getting the legislation through as the Republicans want a much more powerful control board while the Democrats argue to preserve control within the hands of the Puerto Rico government."

Mark Tenenhaus, director of municipal research at RSW Investments, said the firm hasn't purchased any Puerto Rico debt since its inception in 2005. He said the island needs better tax collection policies and progress on pension funding to help re-establish the confidence needed for future debt acceptance and economic growth.

"While no bailout will be forthcoming from the federal government, some sort of bankruptcy-like scenario will ultimately be forthcoming – that is step 1," Tenenhaus said.

That, he said, could lead to an "orderly" transition to a new debt structure, though market access at reasonable levels is still in the distant future.

"It will also do nothing to set a framework for a fundamental change in the economy or fiscal affairs of the commonwealth," Tenenhaus said. "Resolving the pension issues are paramount and a source of potential ongoing discourse between bondholders and the commonwealth."

Tenenhaus said he doesn't see any near term solutions that would "halt the exodus of productive citizens to the mainland looking for better opportunities.

"Hopefully in five years," he added, "the beginning of economic recovery and structural general fund fiscal operations will be in evidence."

By Christine Albano

How Puerto Rico Can Avoid a Descent Into Third-World Economy