Puerto Rico doesn't just have a liquidity problem — it may have a solvency problem.
History is littered with examples of ill-designed debt restructuring exercises that soon unraveled at great economic and human cost. Judging by the recently agreed debt restructuring arrangement for Puerto Rico's sales tax-backed bonds (COFINA), the island's economy risks joining those ranks.
The COFINA restructuring doesn't go nearly far enough. It saddles Puerto Rico with escalating debt payments for the next 20 years, even though the economy has been in a decade-long slump. It also sets a dangerous precedent. If Puerto Rico's government and the oversight board created by Congress agree to similar terms with creditors who hold General Obligation bonds, it will be just a question of time before the commonwealth is forced to default yet again or curtail public pension payments upon which more than 325,000 workers depend.
By far the most important condition for a successful debt restructuring is a realistic assessment of the economy's growth potential and its capacity to repay its debtors. Overly optimistic assessments of those prospects are a sure recipe for failure. They set up the economy for another debt restructuring and, as the economy labors under the weight of a debt overhang, they undermine investor confidence.
Anyone doubting the adverse consequences of such unrealistic assessments of an economy's ability to pay might want to look at Greece's recent sorry experience.
The Greek economy has paid dearly for the failure of the International Monetary Fund in 2010 to recognize that Greece had a solvency problem rather than a liquidity problem, and that its economy was likely to contract sharply by attempting draconian budget belt-tightening within a Euro straitjacket. The net result of such wishful thinking: After almost a decade since the first restructuring, the Greek economy is still deeply depressed and in need of further debt restructuring.
The Puerto Rican government and its oversight board similarly appear to be unrealistically optimistic about the island's economic growth prospects and thus its ability to pay. The proposed COFINA debt restructuring arrangement, which covers around $17 billion, or one-third of the island's bonded debt, initially reduces Puerto Rico's debt service payments. However, those payments eventually double and then remain at a high level due to the inclusion of an insidious "capital appreciation bond," which rapidly increases in value while the other bonds are being paid off.
Although an influx of federal disaster relief and Medicaid funding is temporarily boosting Puerto Rico's economy, it would be irresponsible to expect these benefits to last and support a rising debt service burden. Indeed, federal budget transfers are due to fall off a cliff in five years. Moreover, the island's economic growth will be impeded by poor demographics, as the economically active population likely will continue to move to the mainland in search of better opportunity.
