Bailout and austerity are sideshows. Puerto Rico’s failing economy is the main event
▶▶Without growth, it can’t hope to pay off its debt ▶▶Tax breaks for investors could spark “tremendous resentment”
On the day after Puerto Rico’s latest debt default, one of the island’s richest men, developer Nicholas Prouty, is less concerned about his $110 million building project in the heart of San Juan than he is about the emptiness that surrounds it. “Those are the only cranes you’ll see on the skyline,” Prouty says in his office next to the condominium construction site. While politicians are preoccupied with a debt deal, he sees little attention being paid to Puerto Rico’s real problem: its stagnant economy. “There’s talk of either a bailout or austerity, and I think those are false choices,” Prouty says. “You need to have a growth-based model here in order to emerge.”
Puerto Rico’s debt debacle entered a new phase with its $370 million default on May 1. Washington is gearing up to put the island’s finances under federal oversight, so a deal can be worked out with bondholders and more revenue can be raised to pay them. Missing from the effort so far is a plan to end the economic malaise that’s lasted a decade— even though a return to growth is creditors’ only chance to get some of their $70 billion back.
If that sounds familiar, it’s because it pretty much describes the situation in Greece, says Desmond Lachman, a resident fellow at the American Enterprise Institute and former deputy director of the International Monetary Fund’s Policy Development and Review Department. As with Greece, policymakers have set out to squeeze extra cash from a country without its own currency or central bank. “We saw in Greece that all that does is, it weakens the economy,” he says. “Then the budget doesn’t improve like you thought it would. The debt ratios keep rising.”
In the past, Puerto Rico has been able to use its limbo status as neither a sovereign nation nor a U.S. state to its advantage, mostly through tax gimmicks. For decades, pharmaceutical companies flocked to the island to avail themselves of a federal rule that allowed them to get a tax break on profits. The incentive was eliminated in 1996, although companies were given a 10-year grace period to move elsewhere before taxes went up. They did—and in 2006, Puerto Rico’s slow-motion economic collapse began. “Since then, the Puerto Rican government has been improvising,” says Antonio Fernós Sagebién, an economics professor at the Interamericana
University of Puerto Rico in San Juan.
Among the latest tax breaks the government has tried is a controversial provision from 2012 that sought to attract wealthy foreign investors by offering a tax exemption for interest and dividends. That’s partly what led Prouty to move there in 2013 from Connecticut, where he’d set up a distressed real estate fund in Greenwich. As an owner mostly of real estate rather than financial assets, Prouty says he doesn’t personally gain much from the tax program, but that Puerto Rico could be benefiting more from the investment it does attract. “It’s hot money,” he says, warning that some in the program may simply move on when a better deal appears elsewhere. “Those people need to become engaged in Puerto Rico, or that program runs the very real risk of creating tremendous resentment.”
Although wealthy migrants enjoy their tax breaks, Puerto Ricans who run domestic businesses feel they get stuck with higher taxes, says Ricardo Alvarez-Díaz, who runs an architecture and interior design firm and is chairman of the island’s builders association. “Every day there is another permit they need to open their business,” he says. “It gets to a point where you either close your business or you leave.”
Puerto Ricans have the right to live on the mainland, and as the economy slumps, they’re exercising it. The population fell 7 percent, to 3.5 million, from 2010 to 2015, according to U.S. Census Bureau data. Recent migrants to the U.S. have tended to be less educated, but many professionals are leaving, too: Doctors departed at the rate of more than one a day last year. Stemming the outflow will require fixing the economy. For now the focus is on finding revenue to prevent further defaults. As a result, everything, including water bills and sales taxes, has been increased.
The next important date in Puerto Rico’s crisis is July 1, when a $2 billion payment comes due. Puerto Rican authorities project a 2 percent decline in gross national product for the year starting on July 1, which would be the fifth straight, after a projected 1.2 percent drop for the fiscal year that ends on June 30. Unemployment is running at 11.7 percent, and the labor participation rate—the portion of the labor force that’s economically active—is barely above 40 percent.
Local business leaders say Puerto Rico must again make use of its in-between status. In tourism, for example, it has the white-sand beaches of a Caribbean island but with an infrastructure that’s closer to U.S. standards than that of some competitors. It has a bilingual professional class and labor costs that are low for the U.S., if not for Latin America. Fernós Sagebién, the economics professor, says Puerto Rico can get back into manufacturing sophisticated products such as medical devices by taking advantage of its engineering programs to make products for the U.S. market. Prouty says the island can lure retirees with a combination of mainlandlike emergency medical care and year-round sunshine.
One step that Congress will probably take in its rescue package is a reduction of the minimum wage to below mainland levels. Lachman, the former IMF official, says that makes sense. But he also says the U.S. will probably have to take more drastic action to revive Puerto Rico’s economy—“give them some sort of tax break,” or maybe even inject funds, though only to stimulate the economy, not to pay off creditors. Congress is adamant that whatever measures it adopts won’t be a “bailout.”
Prouty says he’s pushing for a growth-friendly plan for Puerto Rico by knocking on every door he knows. That includes lawmakers in Washington, and even Hillary Clinton: Prouty has a photo of himself with the Democratic presidential candidate on display in his office. “Businesses like certainty, and there’s a lot of uncertainty for sure,” he says. But Prouty says he doesn’t regret his decision to move to the island and invest there. “I don’t make those decisions based on my gut,” he says. “I also believed—and still do—in the Puerto Rican economy.”
The bottom line Puerto Rico’s $370 million debt default exposes structural weaknesses of an economy that’s smaller today than a decade ago.