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Puerto Rico debt crisis sends shockwaves around the world

17/05/2017

​Ian Lavis, on behalf of Praxity​

The fallout of Puerto Rico’s lurch towards bankruptcy while facing debts of $74 billion is set to be felt far beyond the island’s 3.4 million inhabitants.

Investors worldwide will be watching events with bated breath as a complex process begins to restructure the island’s debt after its government initiated an insolvency process earlier this month.

Accountants, financial institutions and governments of debt-ridden countries with low credit rating around the globe will be closely watching developments in what could be a landmark case in the management of debt relief, and a potential disaster for creditors.

The process that Puerto Rico began on 3 May is a form of bankruptcy tailored for governments. A federal oversight board which supervises the financial affairs on the island filed in US courts for what is essentially bankruptcy relief to protect against its enormous debt burden and bondholder lawsuits. It would be the largest such insolvency in US history and goes way beyond the $18 billion bankruptcy filed by Detroit in 2013.

What makes the Puerto Rican situation so extraordinary is not just the scale of the debt, which amounts to 70% of its GDP and includes $49 billion in pension obligations, but the fact that nobody knows what’s going to happen.

Commenting in The Guardian on 5 May, Eric LeCompte, executive director of Jubilee USA, an NGO that focuses on debt relief, said the bankruptcy process was the first of its kind to deal with public debt, adding: “It’s unique in that it may set a precedent for how sovereign debt can be negotiated in the world.” 

LeCompte believes the restructuring process could become an example of how best to manage debt relief, “promoting transparency and enforcing audits so we have a better understanding of what happened in Puerto Rico and how we got into this mess”.

Creditors are less impressed. The investors apparently bought bonds in the belief that Puerto Rico, like US states, would not be allowed to fail and the debt would be protected. However, many of the agencies that issued government debt on the island missed payments, putting them in default. Voluntary negotiated settlements have proved difficult due to the complexity of the bond arrangements, with multiple agencies and different securities and collateral. Now creditors are fighting over who gets what and it’s not clear whether their demands will be in any way met.

So how did things get so bad in the US territory?  

According to the New York Times, the filing cites that Puerto Rico is “unable to provide its citizens effective services” because of its huge debt. The problems are reported in mainstream media as representing a culmination of years of economic stagnation and bad policy, a crumbling infrastructure, poor public services, combined with the departure of multinational firms and a significant ‘brain drain’ to the US mainland which has left 45 per cent of Puerto Ricans living below the poverty line.

Many politicians and historians attribute the crisis to changes to the tax code in 1996, when incentives for doing business on the island were slowly phased out, according to Eric Platt writing in the Financial Times. Economic growth slowed and financial regulators were forced to seize several banks. The government continued to borrow to fund operations, running large budget deficits.

Since Puerto Rico is not a US state, it does not have access to typical bankruptcy protections. Instead, an oversight board was empowered under legislation known as the Puerto Rico Oversight, Management and Economic Stability Act, or PROMESA, to submit a plan to a court with the power to impose a settlement. Puerto Rico must prove that it attempted good faith negotiations with its creditors before the board can sign off what is known as a Title lll filing.

While the debt-cutting legal process could provide much-needed hope and improved services for Puerto Ricans, it could result in severe losses for creditors and may take years to sort out.

It also raises questions over future investment in cash-strapped cities, states, territories and countries. Investors are likely to become more reluctant to loan money to governments if this form of bankruptcy becomes a precedent.

Watch this space!

What does the Puerto Rican situation mean for the USA and the rest of the world? 

Could it really be a landmark case or is it a one-off? 

Find out what Praxity participant firms think in our exclusive article coming soon.

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