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A Puerto Rican default: Its effect on the municipal bond market

Part 2
A Puerto Rican default: Its effect on the municipal bond market (Part 2 of 9)

How did Puerto Rico become the fiscal wreck it is today?

For more than a decade now, Puerto Rico has been using tax incentives to draw corporations to do business in the territory.Puerto Rico has been using tax incentives to draw corporations to do business in the territory. The island, having the ability to offer such tax breaks, was in large part, restructuring its economy around them. The tax laws being abundantly generous, fueled the spread of textile and pharmaceutical factories. There was a time when 16 of the 20 top-selling drugs in the U.S. were made on the island.

Puerto Rico Economic IndicatorsEnlarge Graph

The Puerto Rican economy had been powered by the U.S. firms that set up factories for years. This allowed them to tap a large, relatively low-cost labor market and to book profits under the favorable tax laws, while keeping cash-intensive research and development operations with themselves in the U.S. Some of the multinationals with significant assets in Puerto Rico are Johnson & Johnson (JNJ), Abbott (ABT), and Medtronic (MDT). These companies were able to reduce their tax rate by 1.5% through their presence in Puerto Rico.

Many exchange-traded funds (or ETFs) have emerged in the U.S. to take advantage of the tax-free nature of bonds issued by Puerto Rico and other such municipalities. The iShares National AMT-Free Muni Bond ETF (MUB), the State Street SPDR Barclays Short Term Municipal Bond ETF (SHM), and the Invesco PowerShares VRDO Tax Free Weekly Portfolio ETF (PVI), are a few examples.

All was well until 2006, when the U.S. Treasury phased out tax breaks for the parent companies of Puerto Rico-based U.S. manufacturers. The tax credit provided American firms operating in Puerto Rico with tax-free income. When the incentives were completely phased out in 2006, many U.S. companies left, taking their jobs with them.

Meanwhile, little was done to revamp the island’s economic framework, deficits climbed and pensions accumulated, leading to an explosion of borrowing. In 2006, the government shut down for two weeks, as it lacked cash to meet the expenses. Subsequently, in 2008, the situation worsened with a marked slowdown in the world economy, and the island fell into recession.

Over the past decade, Puerto Rico has accumulated $70 billion in public debt, which is close to 70% of its gross domestic product (or GDP). The economy is also distressed with unfunded pension obligations to the tune of $36 billion. This is 235% of its tax revenues.

The economy is inflicted with a high unemployment rate of 15.4%. The island also has the lowest labor participation rate—a meager 63%, with only 41.3% of working age people in jobs. Puerto Rico continues to lose population, notably the younger, well-educated people who don’t see much future there. With the exodus of professionals and middle-class Puerto Ricans moving to Florida and Texas in search of better jobs, there seems little hope and much effort needed for the employment situation in the territory.

The inefficient transmission and distribution of electricity coupled with a 67% dependence on petroleum for its generation (which is a very high-cost resource), contributes to the rising cost of living. The island is also experiencing an increase in pervasive crime. For an economy which seeks to earn a major part of its revenue from tourism, increasing crime rate is like a nightmare.

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