(Bloomberg View) -- Puerto Rico bonds have been the best-performing fixed income investment thus far in 2018. Following the devastation of last year’s Hurricanes Maria and Irma, and the expected migration to the mainland of more than 10 percent of the island’s population, how can this be?
The answer lies in the tens of billions of emergency reconstruction dollars appropriated by Congress, including $18 billion in housing grants alone, and in the dangerously optimistic forecasts of Puerto Rico’s own government. We are convinced that the emergency funds should be used to rehabilitate the island’s economy, as Congress intended, and not diverted to create a windfall for the island’s creditors.
Last October, after surveying the wreckage on the island, President Trump said of the island’s $74 billion in debt, “We’re gonna have to wipe that out.” However, despite the devastation caused by the hurricanes, Puerto Rico’s government now inexplicably projects that it is in a better position to pay off its debts than it was a year ago.
Prior to the hurricanes, the government’s fiscal plan, certified by the Financial Oversight and Management Board for Puerto Rico established by Congress in 2016, assumed that Puerto Rico could make debt service payments equal to 25 cents on the dollar. Now, notwithstanding the virtual destruction of its electrical grid, serious damage to other productive infrastructure, the shuttering of many of its businesses and the exodus of many workers and taxpayers, the government is happily forecasting that it could make payments up to 40 cents on the dollar. It is doing so by unrealistically assuming that increased healthcare and reconstruction funds being appropriated by Congress will spur the kind of economic growth not seen on the island in more than a decade, even as it proposes steep cuts to government services and agencies that employ about one-quarter of its formal workforce.
Puerto Rico should be encouraged to plan for a better future. However, excessive optimism that understates the risks associated with fiscal austerity and the eventual withdrawal of reconstruction support will result in a debt restructuring on terms inconsistent with Puerto Rico’s capacity to pay. That will only set Puerto Rico on course for a second debt restructuring.
In making its latest economic forecast, the Puerto Rican government seems to be turning a blind eye not just to the island’s devastation but also to its dismal economic track record over the past decade, when its economy declined by 15 percent -- a steady descent punctuated by only one year of growth following a large tax cut. Instead, it seems to have taken the view that a hurricane of epic proportions is in fact a form of divine intervention that will effectively result in a positive shock to near-term growth by way of increased congressional financial support.
One year ago, Puerto Rico’s certified economic plan forecast that a prolonged period of budget austerity would cause the island’s economy to decline by more than 10 percent. Now it is predicting an output level by 2023 that is 10 percent higher than in the previous plan. The government is doing so even though the economy was hit by a Category 5 hurricane, and even though it is proposing less economic reform than in its previous plan and a similar level of budget adjustment.
The island’s infrastructure can be rebuilt with large-scale funding from Washington, but at best its productive capacity would only be restored to its pre-hurricane level. By itself, this funding provides little basis for the hope that the island’s economy can now somehow do very much better than it could before the hurricane. The influx of federal reconstruction dollars certainly could temporarily raise the rate of growth and pull up the level of output. However, once recovery spending wanes, that effect should largely go into reverse -- leaving in place long-standing problems like high unemployment and the highest poverty rate in the United States.
Economic research on a wide range of countries that have experienced similar natural calamities over the past 50 years suggests that per-capita GDP is typically lower than projected pre-disaster. It also shows that a crisis-hit economy generally takes a decade or two even to regain its former trend rate of growth.
Importantly, structural reforms such as changes to “ease of doing business” and labor laws -- issues on which the governor and oversight board disagree -- cannot by any reasonable economic analysis be powerful enough in themselves to offset the loss of federal Medicaid funding, the potential drag from recent changes to the corporate income tax code, and the eventual withdrawal of disaster aid. Yet both the government and oversight board rely on a range of controversial structural reforms to produce decades of sustained growth -- a perilous projection.
Yet another factor that would make Puerto Rico’s rosy economic scenario appear highly implausible is population flight to the mainland. The government itself is estimating that as a result of the hurricane, the island will lose more than 10 percent of its people over the next few years. The loss of that large a part of its economically active population is likely to result in a permanent downward shift in the island’s productive capacity.
Puerto Rico’s oversight board, which now must assess the government’s plan, has the responsibility to take a more realistic view, one that accounts for the substantial downside risks to economic growth that remain. One must also hope that it will recognize that Congress intended that U.S. taxpayers’ money should help Puerto Rico recover and should not be used, in effect, to bailout the island’s creditors.
It is our view that the public-sector debt, which consumes roughly 30 percent of the island’s tax revenues annually, must be written down to the maximum extent allowable under the law. This should be done in the interest of getting the island back onto its feet and of avoiding a second debt restructuring.
This week, the oversight board appointed by Congress meets to review the new fiscal plan. For the sake of the island and all U.S. taxpayers, let us hope that its approach to the island’s daunting economic challenges is more prudent than that of the Puerto Rican government.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
Brad W. Setser is the Steven A. Tananbaum senior fellow for international economics at the Council on Foreign Relations.
Antonio Weiss, a senior fellow at the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government, served as counselor to the secretary of the Treasury until January 2017.
To contact the authors of this story: Antonio Weiss at antonio_Weiss@hks.harvard.edu.
To contact the editor responsible for this story: James Gibney at jgibney5@bloomberg.net.
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