The true value of the Krueger report to Puerto Rico’s economy
By : PHILIPE SCHOENE ROURA & ROSARIO FAJARDO
Edition: July 9, 2015 | Volume: 43 | No: 26
When Gov. Alejandro García Padilla made the statement that "Puerto Rico's debt is unpayable" last week, the dire message went viral to media outlets and made headlines in mainstream newspapers across the world. No sooner had the governor issued those words than the market's confidence in Puerto Rico tanked—all of the credit-rating agencies downgraded the island's credit rating— another two notches—which is now three levels below investment grade. Although the default alarm helped trigger the additional downgrades, the rating agencies have long been pointing to a lack of job creation that has contributed to a shrinking population, dwindling tax base and lack of tax revenue.
The governor's words had a particular urgency to them because they were backed by the report "Puerto Rico—A Way Forward," painstakingly put together by former International Monetary Fund (IMF) Managing Director Anne Krueger (she pronounces it Kreeger) and colleagues Ranjit Teja and Andrew Wolfe. The true value of the Krueger report, certifying that Puerto Rico's debt is unsustainable, is that it brought together all the fiscal challenges and obstacles to economic development and job creation in one roadmap that offers recommendations to help Puerto Rico chart a course back to recovery.
Helping businesses create jobs
"You would have to create a business- friendly environment with sounder fiscal policy and far fewer things that make it more costly and unattractive to do business," said Krueger during an exclusive interview with CARIBBEAN BUSINESS. "Puerto Rico ranks way up in the list of destinations where it is most difficult to do business. On some things, the difficulties are huge and businesses are discouraged. There are many factors that make it less attractive to be in business," she added.
Among the barriers to Puerto Rico's growth are local labor laws and regulations that restrict competition and investment, the report states. "Puerto Rico's ranking in the World Bank's Doing Business Index slipped to 47 of 189 in 2015," having dropped six positions from the previous year. By comparison, the U.S. ranking for 2015 is No. 7.
In 2014, Puerto Rico was ranked 41 in the same index, which evaluates 180 economies in such topics as starting a business, getting credit, dealing with construction permits, labor laws, paying taxes and registering property, among others.
In Krueger's perspective, Puerto Rico, despite having implemented rather hefty spending cuts and tax increases that have levied more than $2 billion in taxes on the business community, continues hemorrhaging jobs and therefore, lacks the revenue stream to meet enormous debt-service payments over the next 20 years. Debt-service payments jump by some $600 million from $1.3 billion to $1.9 billion in 2016 alone. That is a huge burden for an economy that is in a nine-year free-fall, during which time more than 12,000 businesses have closed and more than 225,000 jobs have been lost.
Thus, Krueger's report comes to the inevitable conclusion that there is no way to grow the economy without restructuring the $72 billion in debt. Restructuring the debt isn't an end unto itself, but rather part of a concerted equation that demands economic development through a series of measures. Krueger recommends establishing a business climate that allows job creation— namely through reform of labor laws that make it nearly impossible for empresarios to hire workers.
High labor costs relative to the U.S. mainland have proved onerous for many businesses, and this was pointed out in Krueger's report. "Local regulations pertaining to overtime [costs], paid vacation and dismissal [penalties] are costly and more onerous than on the U.S. mainland," the report states.
"Local labor costs magnify employment costs," the report adds, noting that in Puerto Rico, overtime is paid after an eight-hour day rather than the standard 40-hour week on the U.S. mainland. Other recommendations include cutting paid vacation days for public sector workers from 30 days to 15 days, which again, is the standard stateside. The probationary period for new employees should also be extended from the current three months to a much-longer period of at least one year, according to the report.
Krueger told CARIBBEAN BUSINESS reforms are essential to have any hope of the local economy growing again, just as it is important to have the recourse of orderly restructuring of insurmountable debt. "It would certainly make it a smoother process; let me put it that way. There is going to come a point where it has to happen somehow," Krueger told CARIBBEAN BUSINESS "And with Chapter 9 [bankruptcy], it might come a little sooner and that would be a little less costly for Puerto Rico. So, yes it would make it easier… there will come a point when Puerto Rico can't pay," she added.
The importance of orderly debt relief
Importantly, Puerto Rico's municipalities and public corporations were removed from the protection of Chapter 9 of the U.S. Bankruptcy Code, in amendments made to the law by Congress in 1984. Resident Commissioner Pedro Pierluisi sought to address Puerto Rico's lack of bankruptcy relief with the filing of House Resolution 870, which would amend Chapter 9 to include Puerto Rico. That effort seemed to suffer a mortal blow when lobbyists working on behalf of the pro-commonwealth García Padilla administration tried to include all of Puerto Rico's debt in the measure. Members of Congress lobbied by bondholders rallied against the bill to block its progress.
"The problem is that the García Padilla administration has been going about this all wrong because they are only lobbying members of Congress," said one source on Capitol Hill who chose to remain anonymous. "The bondholders have also been lobbying members of Congress. So, you have two forces canceling each other out. What Puerto Rico needs is to lobby the bondholders so that they can understand the importance of orderly debt restructuring for Puerto Rico," the source added.
During oral arguments in the First Circuit Court of Appeals in Boston over the enforceability of the Debt Compliance & Recovery Act of 2014—a locally legislated bankruptcy law—it became painfully obvious that neither the judges hearing the oral arguments nor the lawyers making their cases had a clear idea about why Puerto Rico was removed from the protections of Chapter 9. As this newspaper was going to press, the decision pertaining to the enforceability of the Debt Compliance & Recovery Act, which was deemed unenforceable by Judge Francisco Besosa in the Federal District Court in Puerto Rico, was still pending in the First Circuit Court of Appeals in Boston.
Without the Debt Compliance & Recovery Act of 2014 or the extension of Chapter 9 to Puerto Rico, the island will be forced to restructure massive payments that will become particularly onerous starting in 2016.
"In our view, none of the laws were sufficient to solve the twin problem of maximizing returns to creditors and enabling public corporations to raise capital to continue as going concerns," said Proskauer Rose LLP Partner Martin Beinenstock, who helped draft the Recovery Act and represented the GDB during the proceedings in Boston, during an exclusive interview with CARIBBEAN BUSINESS.
Lawyers for the plaintiffs-appellees, which include Oppenheimer Funds, Blue Mountain Capital Management and bond insurers who are represented by the Association of Financial Guaranty Insurers, argue that Puerto Rico's attempt to enact its own bankruptcy regime, after being excluded from Chapter 9, is prohibited. Officers belonging to bond insurance companies, which are on the hook for some $16 billion, told Bloomberg News that Puerto Rico's attempt to enact a local bankruptcy law could have the effect of having bondholders "feeling like the victims of a bait-and-switch."
"No one anticipated what was going to happen in the Detroit Chapter 9 case. I'm not really sure there is greater uncertainty here [as pertains to creditors] surrounding the Recovery Act," explained Beinenstock. "We believe fundamentally that creditors who object to the Recovery Act are being opportunistic because if public corporations can't use Chapter 9 and have no other orderly procedure, then there's a lot of room for creditor creativity and holdup tactics. This is all about negotiating leverage. It isn't really about the Recovery Act being bad for creditors."
Now that the Krueger report has stressed—in no uncertain terms— the magnitude of the problem, lawmakers and officials at the U.S. Treasury have taken note. At this writing, a growing chorus of voices has come out in favor of extending Chapter 9 bankruptcy protections to Puerto Rico. In a move that could result in the passing of HR 870, New York Sen. Chuck Schumer and Conn. Sen. Richard Blumenthal, both Democrats, are now sponsoring legislation that would allow Puerto Rico government agencies to file for Chapter 9. The Senate bill would be a companion to the one filed in the House by Pierluisi. In the meantime, lobbying continues in both chambers of Congress.
The importance of the orderly restructuring of debt was in evidence during the recent bankruptcy process that helped Detroit to restructure its $18 billion debt.
Detroit's orderly bankruptcy process
Detroit's $18 billion bankruptcy process lasted about 17 months and concluded on Nov. 7, 2014, which was "lightning speed by bankruptcy standards," according to the Associated Press (AP).
Judge Steven Rhodes, who is now retired, confirmed the plan after Detroit and its major creditors, including retirees who agreed to accept smaller pensions and bond insurers who wanted the city to sell some of its valuable art, reached a deal.
The plan approved by Rhodes, who has now been hired as an adviser to the Puerto Rico government, included reducing pensions of most city retirees by 4.5%, "forgiving" $7 billion of debt and Detroit spending $1.7 billion to demolish dozens of abandoned buildings, improve public safety and upgrade basic services to residents.
"The most unusual feature of the plan [was] an $816 million pot of money funded by the state [of Michigan], foundations, philanthropists and the Detroit Institute of Arts," the AP reported. "The money will patch holes in Detroit's pension funds, prevent even deeper cuts to retirees and avert the sale of city-owned art at the world-class museum."
As part of Detroit's orderly bankruptcy process, Michigan Gov. Rick Snyder appointed Kevyn Orr as "emergency manager" in March 2013, to oversee the process. Orr was also involved in Chrysler's 2009 bankruptcy process.
With the decline of the auto industry, Detroit has been in a downward spiral for years. In 1980, its population was 1.2 million. In 2014, its population had dropped to 688,000, representing a nearly 30% loss from 2000. As a result, the city simply didn't have the tax base to generate the required revenue to meet its financial obligations.
The vision of Judge Rhodes
With Puerto Rico on the verge of default, it would be helpful to learn from Detroit's example. In an April 22 speech in Ann Arbor, Mich., Rhodes outlined the vision he followed during the Motor City's bankruptcy process.
Rhodes said the case was completed quickly and effectively because of judicial management, persistent and innovative mediation, good lawyers and a strong belief in Detroit's overall mission of service to residents.
Instead of a long, drawn-out process, Rhodes believed in moving quickly. "My judicial-management philosophy was pedal-to-the-metal," he said, as quoted by Michigan Live. "I thought that was appropriate in the automotive capital of the world."
The mediation efforts between the city and its creditors were "miraculous," he added. "It's unprecedented in the history of mediation and unprecedented in the history of bankruptcy."
While the lawyers worked "zealously" for their clients, they were also professional and civil to one another, Rhodes noted.
Finally, he said Detroit's case was made easier because the parties involved believed in the city's mission to help residents and provide basic services. "I believe that this basic mission to help people is what compelled the city's creditors, the state of Michigan and the foundations to help the city," he said. "To help the city was to help the people of the city, who desperately needed it."
New York City survives near bankruptcy in 1975
A second example worthy of examination is the case of New York City in the mid-1970s, when the city was nearly bankrupt. Fiscal mismanagement was the main cause of New York's problems: the city spent too much, borrowed too much money to pay for this spending and gave big concessions to labor unions. As a result, the city couldn't pay its bills and then-Mayor Abe Beame went to the White House seeking help.
After the infamous "drop dead" response from then-President Gerald Ford, then-New York Gov. Hugh Carey created the Municipal Assistance Corp. to provide financing assistance. A state Financial Control Board was put in charge of fiscal oversight. Board members of the newly created entities represented both the public and private sectors.
In exchange for financial assistance, the city agreed to reforms. The corporation, which refinanced $6 billion of the Big Apple's debt, helped change the way New York City governed itself. For example, expenses were cut, city sales and income taxes were increased and about 60,000 city jobs were lost. Pension contributions were increased, but the pensions themselves weren't affected. The city was no longer allowed to borrow money to pay for day-to-day operations.
New York State also helped by taking over the cost of the New York City university system, as well as a portion of the city's welfare and court system.
Despite the initial "drop dead" message, the federal government loaned $2.3 billion to New York City.
Another essential element for recovery was that New York City's economy has always been competitive. With world-class sectors such as Wall Street, the largest financial complex in the world; many Fortune 500 companies, advertising and tourism, the Big Apple's tax-revenue base remained strong, even during the 1970s crisis.
Puerto Rico going backward
Puerto Rico, in the 1950s and 1960s, on the other hand, went from the poorhouse of the Caribbean to a model of industrialization that drew the entire world's attention, when its first elected Gov. Luis Muñoz Marín, recruited a team of New Deal economists who were brought in from all over the world, and made it their mission to increase the standard of living of all Puerto Ricans.
Despite lagging job creation at the beginning that fell far short of projections for their grand industrial plan, Muñoz Marín met regularly with the New Dealers, providing the benefit of continuity—their mission wasn't cut short after four years, but extended for a generation. "Economist Hugh Barton brought in at least 15 other people from the mainland U.S.," recalled economist Mohinder Bhatia, who was brought in from India and was among the New Deal economists who came to Puerto Rico to help draft the economic blueprint underpinning Operation Bootstrap. "These guys moved to Puerto Rico with a shared ideology that they had to improve the standard of living of the poor people; they weren't just looking for a job. There were plenty of jobs for these guys back in the States and in other countries," he added.
The combination of visionary minds and an effective public-relations strategy for pushing the tax incentives helped grow Puerto Rico's roster of manufacturing operations from 24 at the end of 1948 to 300 by 1955. The island's industrialization continued under Gov. Luis Ferré in the early 1970s with promotions in nine Fomento offices, including Japan and London.
In 2015, that model of industrialization seems but a distant miracle. It will take another transformation on that level mandating the integration of talented Puerto Rican economists and business leaders to join forces to create jobs.
Working group created
During his televised message last week, García Padilla announced the creation of the Working Group for the Economic Recovery of Puerto Rico, to be led by La Fortaleza Chief of Staff Víctor Suárez, Government Development Bank President Melba Acosta, Justice Secretary César Miranda, House Speaker Jaime Perelló and Senate President Eduardo Bhatia. The group has been tasked with initiating the talks to achieve a public-debt restructuring. The goal will be to negotiate with bondholders a moratorium of debt payments for a number of years, so those funds can be invested locally.
The working group will have until Aug. 30 to develop a plan, including the creation of a new fiscal board to guarantee "continuity and compliance with the commitments made in the restructuring process."
Specifically, the working group will have the task of preparing, in coordination with the legislative branch, a long-term fiscal agenda geared toward:
1. Establishing the parameters for a five-year fiscal plan;
2. Proposing additional cuts in spending—including cuts in some services—to avoid an increase in taxes;
3. Restructuring the Treasury Department to increase the efficiency of income gathering;
4. Promoting alliances with the private sector to provide some of the services that are today provided by the public sector, such as the successful projects of Teodoro Moscoso Bridge, Luis Muñoz Marín International Airport and the PR-22 highway to Arecibo;
5. Radically changing the way in which Puerto Rico works with government finances and economic statistics, to establish greater transparency and credibility;
6. Guaranteeing residents' essential services and pensioners a "just" income;
7. Creating a Fiscal Board that, outside political considerations, will guarantee the continuity and honor of the commitments agreed upon during the restructuring process. This board must carry out its responsibilities in an uninterrupted fashion and outside of electoral cycles.
In the event that Puerto Rico doesn't obtain the orderly relief mechanisms available through either Chapter 9 or a decision by the First Circuit Court of Appeals in Boston declaring the Debt Relief & Compliance Act enforceable, the fiscal group would do well to heed Krueger's counsel.
Puerto Rico's fiscal challenges must be tackled together with its structural problems and those of job creation. Restructuring must go hand in hand with labor law reforms. "Creditors wouldn't look terribly favorably on restructuring unless there were reforms," she said in closing. n
Editor's note: After this edition of CARIBBEAN BUSINESS went to press, the First Circuit Court of Appeals in Boston upheld a federal district court decision in Puerto Rico declaring the Recovery Act unenforceable.
Who is Anne Krueger?
The June 29 report "Puerto Rico—A Way Forward" by a team of former officials from the International Monetary Fund (IMF) and World Bank, led by economist Anne Krueger, outlined a long list of economic woes for Puerto Rico, reaching the conclusion that the island's $72.2 billion isn't sustainable. Put simply, since the local economy has been stagnant or contracting for nearly a decade, the island hasn't been able to generate enough revenue to repay its debt.
Many Puerto Ricans are now familiar with the so-called Krueger report, which was commissioned by the Government Development Bank, but few people have a clear idea about her academic and professional background, as well as her views as an economist.
A professor of international economics at the Johns Hopkins School of Advanced International Studies in Washington, D.C., Krueger is a distinguished fellow and past president of the American Economic Association, a member of the National Academy of Sciences, and a research associate of the National Bureau of Economic Research.
She is also a former professor at University of Minnesota, Duke University and Stanford University.
The former World Bank chief economist and first female managing director of the IMF is the recipient of a number of economic prizes and awards. She is also the author of several books, papers and articles about economic reform, financial and fiscal policies. Some were written on India, Turkey, Latin America and the world in general.
Krueger's latest book, "Struggling with Success: Challenges Facing the International Economy," a collection of essays and speeches published in 2012, received rave reviews from her colleagues around the world.
However, Krueger is most known for "A new approach to sovereign debt restructuring," a paper she wrote in 2002.
Debt restructuring
In the 40-page paper, Krueger stated that the absence of a robust legal framework for sovereign-debt restructuring generates important costs. She insisted sovereigns with unsustainable debts often wait too long before they seek a restructuring, leaving both their citizens and their creditors worse off.
When sovereigns finally do opt for restructuring, she said the process is more protracted than it needs to be and less predictable than creditors would like.
"The international financial system lacks an established framework for restructuring that is equitable across all the sovereign's creditors. There are few effective tools to address potential collective-action problems that threaten to undermine restructuring agreements acceptable to the debtor and most of its creditors," Krueger said in her 2002 paper.
Holdout creditors may be able to use the threat of litigation to seek to avoid concessions that the majority has agreed to make. All this, she insisted, explains why it is important for the official community, sovereign debtors and market participants to discuss how to improve the sovereign-debt restructuring process.
"This paper has laid out a possible approach. An international legal framework could be created to allow a qualified majority of the sovereign's creditors to approve a restructuring agreement, and to make that decision of the majority binding on a minority," she explained.
The vote would need to include all the relevant creditors of the sovereign, not just the holders of a single debt instrument, Krueger warned. Broadening the majority voting process beyond a single debt instrument vastly simplifies the process of creditor coordination and would facilitate the negotiation of a deal that treats all creditors fairly, she said.
"This approach draws on the principles of well-designed corporate bankruptcy regimes, and is similar in concept to the decision-making procedures among holders of a single bond issue that contains a majority restructuring clause," Krueger said, outlining a framework that protects the debtor's assets and capacity to pay while working with creditors to reach an agreement.
In such a framework, Krueger noted the decision whether to give legal protection for the sovereign and provide seniority for new private financing could to be left to the debtor and a qualified majority of its creditors. Similarly, the sovereign and a qualified majority of creditors would agree on the terms of the ultimate restructuring.
The primary purpose of an amendment of the IMF's articles, she added, would be to provide the statutory legal basis to make an agreement between the debtor and the requisite majority of creditors binding on all relevant creditors.
A number of questions would need to be fleshed out before such an approach could be made operational, Krueger pointed out.
"Perhaps most crucial, and also most difficult, is the scope of the debt to be included in the voting process. It will also be important to explore with debtors and market participants how best to protect general creditor interests during the negotiating process, as well as how to structure the dispute-resolution process. These questions won't be easy to answer. But it is important not to shy away from the challenge," she said.
Krueger indicated there is now widespread agreement that a new approach is necessary, and that a fairer, more efficient process for sovereign-debt restructurings would represent a substantial strengthening of the international financial system.
"We should press ahead to achieve it," she said
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