Some unpleasant arithmetic for Puerto Rico

The recent congressional debate about what is to be done about Puerto Rico’s economic and financial crisis seems to lack an air of reality, since it very much avoids trying to quantify the enormity of the island’s economic problems. That avoidance is unfortunate since it downplays the urgency of the need for major debt relief for Puerto Rico. Similarly, it detracts from the urgent need for the establishment of a Puerto Rican economic task force to come up with ideas as to how the island might jump-start its very depressed economy.

{mosads}Any serious analysis of Puerto Rico’s debt problem must start with a recognition of how bleak is the island’s economic outlook on present policies. A continuation of the island’s recent downward economic trajectory will necessarily diminish the island’s capacity to service its $72 billion debt mountain or to honor its more than $40 billion in pension commitments.

Puerto Rico’s past economic performance has been dismal by any standard. The economy has now been in recession for the past decade, with its gross national product (GNP) declining by around 1 percent a year on a consistent basis. Equally troubling is the fact that the island’s population has shrunk by around 10 percent over the past decade, with a high proportion of those leaving for the mainland being the ones who are most economically active and most educated. Sadly, if anything, the exodus from the island now seems to be picking up pace. In 2015, outward migration is estimated to have reached 2 percent of the population.

Simple debt dynamic analysis highlights how devastating a continuation of Puerto Rico’s present economic trends would be for any attempt by the island to stabilize its public debt ratio at its present 100 percent of GNP. In particular, such analysis would reveal that on the assumption that the island would continue contracting at 1 percent a year and that it would need to pay a 5 percent average interest rate on its debt, it would need a primary budget surplus (that is, a surplus excluding interest payments) of around 5 percent of gross domestic product (GDP) to stabilize its debt to GNP ratio.

It would be difficult for any economy to generate a 5 percent of GNP primary budget surplus on a consistent basis. For Puerto Rico, it would be all the more difficult for two basic reasons. The first is that at best Puerto Rico is starting from a balanced primary budget position. This would imply that it would need to undertake around 5 percentage points of GDP in budget adjustment if it is to stabilize its debt ratios.

The second reason that this will be difficult is that, lacking its own currency, Puerto Rico would need to undertake this budget adjustment without the ability to use exchange rate depreciation as a means to providing an offset to the negative effect of budget tightening on the island’s aggregate demand. In all probability, such budget austerity would meaningfully exacerbate the island’s present economic slump in much the same way as excessive budget austerity within a euro straitjacket deepened the economic slump in countries like Greece, Portugal and Spain.

Two clear conclusions would seem to emerge from an analysis of the island’s debt dynamics. The first is that the island desperately needs to generate economic growth if it is to have any chance of stabilizing its debt to GNP ratio. This would be true even if the island were to be granted substantial debt reduction. For this reason, it is particularly to be regretted that to date Congress’s discussion on what is to be done for Puerto Rico has not focused its primary attention on the establishment of an economic task force to come up with a plan for restoring rapid economic growth to the island.

The second conclusion is that Puerto Rico is suffering from a solvency problem in the sense that it is not realistic to expect that it will be able to make anywhere near the budget adjustment required to stabilize its debt ratios. The earlier that this solvency problem is recognized and the earlier that debt relief is granted to the island within the context of an ambitious economic growth program, the better off will both Puerto Rico and its creditors be.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.