Greece is a perfect example to gauge what can happen in Puerto Rico. In April 2010, Greece was downgraded to junk bond status which rattled the financial markets worldwide. Bond yields rose dramatically creating uncertainty among private capital markets that were reluctant to provide funding to keep the Greek government operating.
Subsequently, the European Union (or EU) and the International Monetary Fund (or IMF) bailed out Greece with €110 billion in May 2010, which resulted in austerity measures such as the privatization of government assets and structural reforms, causing large demonstrations all across the nation. It eventually led to another bailout of €130 billion so that the European Union, the European Central Bank (or ECB), and the IMF can assist in the funding of Greece’s finances until 2014. The second bailout was for the purpose of regaining the trust of private capital markets to refinance its debts and further assist the Greek government with additional funding for its daily operations.
The Greek recovery can be gauged by the chart above which shows the price performance of the Global X FTSE Greece 20 ETF (GREK), which has its major holdings in Hellenic Telecommunication Organization SA (HTO), and Coca-Cola HBC AG which is the world’s second-largest Coca-Cola (KO) anchor bottler. For the whole of Europe, one could also look at the Vanguard FTSE Europe ETF (VGK), which has the likes of Nestle (NSRGF) and HSBC Holdings PLC in its portfolio.
On February 4, 2014, S&P downgraded Puerto Rico’s general-obligation bonds to junk levels.
With this, it has become very difficult for the fiscally distressed island to borrow money and dig out from its severe fiscal problems. Moreover, the territory has already tapped out on all its funding resources. With increase in taxes (especially corporate tax) raising concerns regarding U.S. multinationals moving their manufacturing operations away from Puerto Rico, the only recourse for it seems to be a forbearance agreement forced on the bondholders, quite similar to Greece. This means, with the approval of the authorities, Puerto Rico may have to lower the coupon on its debt load to, say 3%, and extend maturities out to 2030 through 2050. Although this could cause the price of the bonds to plummet (as reflected in the case of Greece bonds, trading at $100 in 2008, had touched 18 cents in 2011).
It’s quite simple. Puerto Rico’s $70 billion debt currently carries a 9% interest rate. That is, a $6 billion in interest expense, annually. The commonwealth happens to have a $10 billion of annual budget. Even at, 4.5%, the annual interest cost would come to $3 billion, or 30% of the total budget. That’s quite a proportion, considering the island is trying to improve on its fiscal deficit situation.
With the new $3 billion tax-exempt GO bond issuance coming from Puerto Rico, with effective yields as high as 8-9%, and not without its bag of austerity measures such as pension cuts, privatization of public assets that includes the energy sector, and raising taxes, Puerto Rico is definitely starting to resemble Greece.
© 2013 Market Realist, Inc.