Why is Puerto Rico in hot water over its debt obligations?

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William Dudley’s update on the economic situation in Puerto Rico 

“Puerto Rico’s economy has been in a slump for nearly a decade. After declining for five straight years, real (inflation-adjusted) gross national product (GNP) rose 0.9% in fiscal year 2012 and only 0.3% in 2013, rates considerably below the respective U.S. mainland growth rates,” said New York Fed chief, Dr. William Dudley in a speech to the Certified Public Accountants of Puerto Rico, San Juan, on June 24.

Dr. Dudley pointed out that the low labor force participation rate and high rates of unemployment were the “biggest challenges” for Puerto Rico’s economy.

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Puerto Rico’s labor force participation rate was about 40% in April, 2014. Compare that to mainland U.S. which had a participation rate of about 63%. Of course many economists and analysts believe the U.S. figure is too low (including Fed Chair Janet Yellen) and labor force participation in mainland U.S. is a major concern.

Similarly, the unemployment rate at 13.8% in May, 2014, was over twice the national average at 6.3% (Source: Bureau of Labor Statistics). A key trend has been reductions in government payrolls. While private payrolls have increased, the increase isn’t apparent due to declining government payrolls. Another key trend is worker migration to places offering better job opportunities, leading to a decline in the workforce.

Impact of economic malaise on Puerto Rico debt

Despite the economic slump, government debt as a percentage of GNP, ballooned from 60% in 2000 to over 100% in 2013, due to sub-par economic growth and persistent fiscal deficits. Debt servicing was also an additional burden on the Commonwealth’s finances. “Debt ratios in this range can inhibit economic growth in that they generally lead to higher financing costs, which in turn, can lead to constraints on access to further financing,” said Dr. Dudley in his speech.

Due to these factors, Puerto Rico’s debt was downgraded to below investment-grade in February by the three big credit ratings agencies. Below investment-grade implies a rating of BB+ or below. The VanEck Vectors High-Yield Municipal Index ETF (HYD) is an example of an ETF investing in municipal debt that is rated below investment-grade. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), is an example of an ETF that invests in below investment-grade debt issued by corporate borrowers like Sprint and Tenet Healthcare. Both Sprint and Tenet Healthcare are part of the S&P 500 Index (SPY).

Exchange-traded funds (or ETFs), like the VanEck Vectors Long Municipal Index ETF (MLN), are examples of ETFs investing in investment-grade munis, while the Core Total U.S. Bond Market ETF (AGG), invests primarily in U.S. investment-grade debt, both Treasuries and corporate debt.

In the next section, we’ll discuss the steps that Dr. Dudley recommended for improving the island’s fiscal position.

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