Puerto Rico, that beautiful archipelago in the Caribbean, ceded by the Spanish to the Americans in 1898, is engulfed in debt. Living it’s life as a commonwealth of the United States but without voting rights to elect the President of USA, this beautiful island is unable to make basic payments like fuel for its police force. It’s resources are threadbare and it’s citizens are leaving its shores in search a more stable life. On May 2nd, 2016 Puerto Rico defaulted on its $422 million debt payment. The next payment date is July 1st and Governor Alejandro Garcia Padilla is hoping America steps in to help Puerto Rico, else a full blown economic crisis will come into force.

The Congress is mulling over bailing Puerto Rico out of its financial crisis. They want to place an overseeing board that will monitor how the aid is used. Puerto Rico’s leaders feel this is against their autonomy. The Congress however feels that things have long being mismanaged and in this hour of crisis Puerto Rico cannot afford to complain.

A large number of mutual funds and retirees had invested heavily in Puerto Rico’s municipal bonds thanks largely to the fabulous returns promised on them, some as high as 8%. The missed Monday payments were by the Government Development Bank, Puerto Rico’s development wing.

The Genesis:

Puerto Rico had enjoyed tax breaks right after the second world war, the most notable being Section 936 which exempted US companies from paying taxes. This method was implemented to encourage and promote industry in Puerto Rico. Sure enough Puerto Rico and its people thrived. In 1996, the US had a rethink and rolled back the tax breaks. This was the beginning of Puerto Rico’s slide into recession. By 2006 it was well and truly in the throes of one. The island was borrowing heavily to keep itself afloat financially. It borrowed more debt to pay old debt and so on. Companies moved on to other tax havens, making Puerto Rico more vulnerable. This also prompted several Puerto Ricans to move to the mainland. The revenue sources were drying up, and the debt was piling up.

Still, Puerto Rican bonds were exempt from federal, local and state taxes and despite Puerto Rico’s low growth rate, a lot of Americans still chose to park their savings in them. The worsening economic condition of Puerto Rico meant that the payments to be made on them were unlikely to be done.

The debt is owed to American citizens, mutual funds and hedge funds respectively. In the Congress the Democratic party feels that a debt restructuring is in order.The Republican party is against this and wants a deeper approach of addressing the problems at its roots. Unfortunately Puerto Rico may not have that much time. Unlike Detroit it cannot declare bankruptcy. Instead the Governor will have to start sending its citizens out of their jobs. Furthermore how it will impact capital markets is yet to be seen. The major debtors in the crisis are:

Way Out Of Crisis

The Krueger, Teja and Wolfe report written by Anne O.Krueger, Ranjit Teja and Andrew Wolfe (former International Monetary Fund members) have put up a proposal after understanding the financial crisis in Puerto Rico.

In the report they acknowledge that the Puerto Rican government has been working hard to fight economic stagnation due to weak public finances, structural problems and economic shocks. It also faced emigration and reduced market access. Despite the government’s attempts to raise taxes, introduce pension reform and cutting on expenditure they have been accumulating debt. The report notes that Puerto Rico must be given a chance to grow and come out of its debt trap and this can be done by bringing about structural changes and Government intervention. The three key reforms the report suggests are laid out in its executive summary:

Structural reforms:

Restoring growth requires restoring competitiveness. Key here is local and federal action to lower labor costs gradually and encourage employment (minimum wage, labor laws, and welfare reform), and to cut the very high cost of electricity and transportation (Jones Act). Local laws that raise input costs should be liberalized and obstacles to the ease of doing business removed. Public enterprise reform is also crucial.

Fiscal reform and public debt:

Even a major fiscal effort leaves residual financing gaps in coming years, which can be bridged by debt restructuring (a voluntary exchange of existing bonds for new ones with a longer/lower debt service profile).Public enterprises too face financial challenges and are in discussions with their creditors.Despite legal complexities, all discussions with creditors should be coordinated.

Institutional credibility:

The legacy of weak budget execution and opaque data – our fiscal analysis entailed many iterations – must be overcome. Priorities include legislative approval of a multi-year fiscal adjustment plan, legislative  rules on deficits, a fiscal oversight board, and more reliable and timely data.

The US must act quickly and effectively to stop the further ballooning of the economic crisis in Puerto Rico. How quickly, is the question that investors and citizens are asking. One possibility is an IMF bailout. This has not worked so well for Mexico and other developing nations. It also brings to the fore if Puerto Rico must leave the US altogether and strike out on its own. In any event austerity measures and uncertainty looms before Puerto Rico. Latest update: US treasury secretary Jack Lew visited Puerto Rico and emphasized that it was paramount that the House of Representatives come up with a plan to help Puerto Rico come out of its current debt crisis. Talks are underway on the prioritizing of creditors whose bond payments are due.