“Puerto Rico Releases Report Calling For Concessions From Creditors” is a Wall Street Journal story that says “The U.S. commonwealth owes about $72 billion, nearly 70% of its economic output.” Puerto Ricans don’t have to pay federal tax so they aren’t responsible for federal debt. Thus the territory is less indebted, as a percentage of GDP, than the U.S. as a whole (chart for U.S.). If the U.S. debt isn’t a crisis, why is the Puerto Rican debt a crisis?
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The difference is that the bond market is currently demanding about a 12% interest rate for long-term Puerto Rican bonds, but only demands a 3% interest rate for long-term U.S. Treasuries. At current rates, the U.S. interest rates is less than the rate of GDP growth (in nominal dollar terms). So, the U.S. debt would naturally shrink as a fraction of GDP if the federal government were to run even a tiny primary surplus. For Puerto Rico, on the other hand, the only way to keep the debt-to-GDP ratio stable is to send a really sizable fraction of GDP (7% or 8%, maybe?) to its creditors.
Why the difference in interest rates? Because lenders to the U.S. Treasury know that their bonds will be paid back exactly by their terms (unless Congress does something stupid to make repayment illegal, as almost happened during the debt ceiling business last year), because if necessary the federal government can print the necessary money to pay them at will. They run the risk that those dollars they receive are substantially devalued due to inflation, but that’s a risk you run with just about any sort of bond, and the market appears to judge that risk to be very low at the moment. By contrast, lenders to Puerto Rico know that they run a large risk of default and at best partial repayment.
Neil: So could the problem be solved if the U.S. Treasury promised to pay whatever the Puerto Ricans did not? Then their interest rate should go down to the same 3%, right, and, since they actually owe less as a fraction of their GDP than do the rest of Americans, they shouldn’t have any trouble repaying (though I guess we never repay anything but instead keep borrowing more).
(Maybe after the guarantee add some rules like the Germans have been trying to impose on Greece, e.g., that PR actually does have to run a budget surplus and at least begin to pay down the debt. I’m not sure if the Federal Government has more control over PR than the EU does over Greece…)
Unlike PR, US 1) can print $$$ and 2) helps major economic powers abroad (militarily) if needed and in return those economic powers buy US debt. 3% on long term treasuries is about or higher US GDP growth in recent years and if history is a guide 3% return on investment will eat in real principle value of treasury security. Maybe not so for large state an sovereign agents that value return against price of other commodities such as gold and crude which is not necessary is expected to grow over next few years. Also treasury is used as collateral in other complex financial industries due to reasons 1) and 2) and there is still demand for it as a reserve currency (reasons 1) and 2) along with stable monetary policy) and this brings interest rates down
The problem is that 70% of GDP for a sovereign is not really comparable to 70% of GDP for a state (or a territory or commonwealth). That’s because Puerto Rico has very limited ability to tap into that GDP through taxes, and as others have pointed out, cannot print money. Note that PR has experienced a “brain drain” for quite a while now, which only makes things worse.
PR does enjoy limited sovereign immunity however, which reduces creditors’ recourse. Of course that increases the probability of default.
Phil: If the markets believed that the federal government would guaranty repayment of Puerto Rico’s debt, that would bring interest rates down dramatically. It works for Fannie Mae and Freddie Mac, who only pay a fraction of a percent more for long-term debt than the Treasury does, and the federal government’s guarantee of Fannie and Freddie is only an implicit guarantee (there hasn’t been a statutory guarantee for their securities since the 1960s). But, I don’t see the federal government stepping in here. It doesn’t guarantee state debts.
Even if their interest rates went down, Puerto Rico’s debt would probably be a bigger problem than the mainland’s. As other’s have noted, the island has been suffering a brain drain and nine straight years of recession, largely related to the expiration of a federal tax provision that encouraged U.S. companies to build factories there. That long-term downturn is the reason the debt has ballooned and–because the market doesn’t see a way for them to repay–interest rates have ballooned.
Greece’s situation is similar in many ways: A prolonged economic contraction which caused a growing debt. A brain drain as a result of people who (like Puerto Ricans) have a legal right to freely migrate to much more prosperous neighbors. Using a currency issued by more powerful neighbors, meaning that it is unable to devalue its currency to solve the problem. And just like the U.S. government doesn’t guaranty state or territory debts, the European Central Bank is legally prohibited from paying back member state debts.
The European solution has been to have the ECB, IMF, and others buy all of Greece’s debt that was previously held by private banks and individuals, so that when it all comes crashing down, the European governments get stuck holding the bag, but German banks don’t fail. I don’t see a similar solution happening in the Puerto Rico case. Fortunately, Puerto Rico’s debt is only about 20% of Greece’s. And Puerto Rico can probably default without going off of the dollar or pulling out of its relationship with the U.S.