Muni Credit News October 18, 2016

Joseph Krist

Municipal Credit Consultant

Last week, The Association of Financial Guaranty Insurers (AFGI) held a conference on the subject of how best to move the economy of Puerto Rico forward as it attempts to address the current debt default and provide for a sustainable economy. We heard many ideas, most of which reflected the particular interests and political views of the participants. This motivated us to offer the following perspective  as free of ideological biases and economic motivations as possible.

AN INVESTING PERSPECTIVE ON WHAT THE P.R. ECONOMY NEEDS

As the Puerto Rico debt crisis has unfolded, there have been many suggestions about how to fix the Puerto Rican economy. While the primary focus has often been on the role of debt restructuring, it has been in the context of the debtor/creditor relationship. There has not necessarily been enough discussion of this restructuring as just one of many interrelated components that would comprise a plan to create a long lasting economic environment which benefits all of the Commonwealth’s stakeholders – residents, businesses, creditors, and the government.

This reflects the fact that the problems have too often been viewed through the prism of antagonistic points of view. The fact is the interests of business, the residents, the creditors, and the government are the same. They are in effect one team with each representing a player playing their position with its individual responsibilities within the concept of a single goal.

So what is needed. The primary need is to create an environment where business can thrive, grow, and expand private employment. Without such an environment, there will be no way to expand and sustain the aboveground economy. Without such an economy, the government will not be able to finance the service needs of its people and the debt service needs of its creditors, present and future. To do that business needs certain resources. A reliable and capable workforce; reliable modern infrastructure; reasonable and capable administration and regulation are the minimum needs. So the question is how can this be done within existing limitations – physical, financial, and cultural/political.

A good starting point is to talk about infrastructure. Recent events have unfortunately served to highlight many of the weakness and vulnerabilities of the island’s basic infrastructure. The issues faced by PREPA and PRASA over the years are well known and have been unfortunately highlighted in recent weeks. The focus needs to be on improvement. To do that, there needs to be a change in approach to the management, administration, and finance of those services. Fortunately, there are successful templates to view which provide possibilities for PR to address the need to meet those service challenges while addressing the need to deal with their debt.

For the utilities, the need to reduce debt service on existing debt and allow for the finance of additional capital investment is clear. The Long Island Power Authority is a good example of one way for a public agency to deal with the issues of service provision, refinancing, management, and regulation in an environment of high debt and a politicized management environment. LIPA’s use of securitization financings secured by fixed portions of end user rates allowed for the cost effective refinance of existing debt in a non-coercive manner through use of the tender process. The plan lowered the near term annual debt service burden without haircuts and was accomplished voluntarily. It was facilitated a change in philosophy by the political establishment which  was convinced to see the merit in the concept that oversight and operational control were not mutually exclusive from maintenance of ownership by a government entity.

Both PREPA and PRASA have been and will continue to be handicapped by the non-acceptance of that concept. These utilities both have an opportunity to continue to be owned by the government – the people – but to partner with the private sector to achieve an optimal result for all stakeholders. There are qualified able private entities with management and operational expertise who would enable each utility to benefit from objective assessment of the management, administrative, and physical needs of the utilities. Once that process is complete, private management contractors are out there who oversee management without necessarily impacting the use of local personnel. This would minimize the warping impact of politics and increase the confidence of business in the results of any such review. That confidence is key to the process of attracting those businesses.

In the area of future growth, the utilities must be open to the use of new renewable technologies. Much is made of PR’s geographical limitations as they impact their operations, especially at PREPA. At the same time, PR has virtually unlimited sun, wind, and mountains. These provides strong opportunities for renewable energy development. Not only would it reduce fuel dependence, its installation and expansion would provide employment and skills development on both a macro and micro level. The financing mechanisms for these sources exists in the public finance market and the increasing market for green bonds should be exploited by both utilities.

For both utilities, Promesa could effectively be used as an agent for change in the oversight and regulation of utility prices and finances. Obviously this is a sensitive issue in PR and we do not ignore that. But the fact of the matter is that current events have only highlighted the weaknesses of the current structure. Much as was the case in Long Island, issues of politically influenced management and ratemaking threatened the viability of the credit. The linkage of the securitization refinancing to outside rate review and privatized operational management were key to generating business support for a program and confidence that efficiency, cost effectiveness, and disincentives for corruption were the pillars of operations.

What can the general Puerto Rican government do to support business growth? It can assure that a reasonable tax, regulatory, and administrative environment exists that allows business to have reasonable expectations about what can be consistently expected from a timing and cost perspective. It is the government’s role to establish priorities and policies that meet the needs of all of its constituents including the Promesa board  in an effort to maintain and grow the population. In addition to these basic management and governance issues, it must improve its information capabilities. The Congressional Task Force is concerned about the relative lack of reliable data pertaining to certain aspects of the economic, financial, and fiscal situation in Puerto Rico, which are necessary for productive analyses that may lead to sound public policy recommendations.

It must address the basic issues that all people in all cultures at all economic levels require – safety, housing, education, and economic success. Obviously, safety and education are usually the province of local government. But there are real issues associated with those services. Education can be achieved through a variety of models. Fortunately for Puerto Rico, the public finance market has experience with all of the various forms of educational provision from pre-K right through the full university level, both public and private. The ability to finance new and different modes of education at all levels should not be held back by concerns over the ability to finance them.

Once the issues of methods of provision and finance of education are dealt with, the issues of the quality of the product must be addressed. This is another issue which lends itself to collaboration amongst all of the stakeholders including investors. A trained, multilingual workforce is essential. None of this implies an effort in any way to limit or denigrate the longstanding and beautiful culture of Puerto Rico and its people. The fact of the matter is that all around the world, on all of its continents and countries and cultures and races, English has become the lingua franca in nearly all forms of commercial activity as well as technological advancement and applications.

As for the issues of tax and regulation, the suggestions as to which taxes and regulations are best are not really appropriate to this particular discussion. What is appropriate is to emphasize the need for these policies to be well thought out on a consultive basis with all stakeholders using reasonable economic assumptions. In many ways it can be argued that this may be the most effective area in which the federal government could make an affirmative active difference. While Promesa may be unpopular among the local body politic, it does provide an opportunity to develop a coordinated tax and policy approach for PR that allows for Puerto Rico’s unique needs and situation.

It is through this process that the best opportunity exists to address questions like the earned income tax credit, the level of available Medicaid funding, the level of the minimum wage and issues such as the continued applicability of the Jones Act. The arguments in favor of equalization of Medicaid funding, the availability of the earned income tax credit, and for at least some period of the time exemption from the limitations of the Jones Act are compelling. Each of them would have some role in lowering costs to business and increasing the attractiveness and availability of “legitimate” employment opportunities for residents. Each of them requires federal action.

Medicaid is especially important as it not only addresses the obvious issue of healthcare availability  for all regardless of economic status but also addresses the issue of reasonable compensation for professional service providers. The question of the relative gap between the amount and type of resources available for equipment as well as the economic potential for doctors, nurses, and technicians is an undeniable factor in the current negative demographic trends on the island. The need and desire for a viable healthcare system is universal whether it be for the poorest resident or the highest level executive.

The case for the earned income tax credit is undeniable. Studies have found that EITC expansions are the most important reason why employment rose among single mothers with children— the EITC was more effective in encouraging work than either welfare reform or the strong economy. It creates an incentive for people to leave welfare for work and for low-wage workers to increase their work hours. It encourages large numbers of single parents to leave welfare for work, especially when the labor market is strong.

All of these issues I have discussed factor into the decision as to whether or not one can and should invest in Puerto Rico. They all address the issue of will I be paid, how much will I be paid, and what is the relative risk of the investment in Puerto Rico. These are not unique to Puerto Rico and it is unrealistic for Puerto Rico to hope or expect that investors will not apply these most fundamental tenets of their decision process as it pertains to Puerto Rico. Without outside investment in debt issued by the Commonwealth and its various entities, none of the economic goals of the Commonwealth and its people can be achieved.

The issues which I have addressed in this discussion would remain regardless of  whether Puerto Rico remains a Commonwealth or becomes a State. The issues of health, education, infrastructure, and economic expansion will still have the same importance. To the extent that Commonwealth status provides opportunity – flexibility in terms of thing like the minimum wage, access to a broader bond market through triple tax exempt financing – these opportunities must be maximized. Status itself should not be the determinative issue in deciding the course of action required to generate economic growth.

We take no position on the question of statehood versus commonwealth status. We do note that statehood alone can in no way be viewed as a panacea. Statehood would provide some additional certainty and volume of resources but it would also limit some benefits that Puerto Rico receives. It certainly does not address issues of good and efficient government. All one has to do is to look at states like Illinois or Louisiana to see that state government can be corrupt and inefficient as well as any other governmental entity. It will only retard the expansion of the economy in Puerto Rico to allow, in the short-term, issues of status to determine what is best for Puerto Rico and its economic stakeholders.

Of course, any or all of the ideas expressed to help Puerto Rico rebuild its economy and credit require a serious governmental and political environment. As of the moment, that does not exist. The Padilla administration has made it abundantly clear that it is bankrupt in terms of ideas, practicality, and courage. Its latest presentation to the Promesa fiscal oversight board was simply not a serious proposal. It follows on its policies grounded in the crudest forms of populism and disrespect for established institutions. Asking the Commonwealth to run an efficient government is not a call for austerity. It is not a threat to sovereignty or an attempt to impose a new cultural construct. Yet the Padilla administration continues to push this line.

As a result it has forfeited any serious policy role, harming the economy and destroying the credibility of institutions like the Government Development Bank. The GDB under this administration has been stripped of its ability to act as any sort of honest source of data, ideas, and financing. By turning the GDB into a facilitator of opacity and obstruction, the Padilla administration has made the process of recovery exponentially more difficult. The trust which has been so cavalierly discarded will not be easily recovered but the exit of the current administration and its mindset will be a constructive start.

Disclaimer:  The opinions and statements expressed in this speech are solely mine, who is solely responsible for the accuracy and completeness of it.  The opinions and statements expressed are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author at this time, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Listeners are encouraged to obtain disclosure information on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

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