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”

Bloomberg Businessweek (North America) - - Contents - -Jonathan Levin

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.

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