Given the disappointing downturn in Puerto Rico’s April Economic Indicators after several months of relative stability, we decided it was time we made it down to the Island and observed for ourselves what the real situation is on the ground. After all, there’s only so much one can gather from media reports and by analyzing the numbers, such as they are.
On this trip, I was lucky to be a part of a small group of investors whose collective insight greatly enhanced (and in some cases corrected) my own. Over the course of two full days of meetings, we spoke with former government officials turned private consultants, real estate investors, economists from academia, representatives of the pharmaceutical industry, local reporters, tourism and economic development officials and key senior officials within the PR legislature. Naturally, we were well aware that many of these “independent” sources came with their own agenda and biases, so everything was taken with a rather large grain of salt.
On the whole, the picture that emerged from those meetings mostly confirmed our stance to date on PR credits but, in some cases, it did yield some surprising insights, particularly with regard to the public corporations and COFINA. We’ll attempt to share some of our impressions with you in this article as well as in future commentaries as appropriate (actual investment recommendations and actionable trade ideas are, of course, beyond the scope of this public column but feel free to reach out to us privately at research@axiosadvisors.com).
First of all, we do have a “scoop” for you. Regarding the shocking corporate tax shortfall in April (when reportedly more than 20,000 businesses filed for an extension without making estimated payments), a senior member of the PR Senate assured us with a “high degree of confidence” that the majority of the taxes will ultimately be paid. No, this is not just more wishful thinking: apparently, the PR Treasury (“Hacienda”) has contacted the top 100 corporate taxpayers, accounting for about 80% of the expected tax receipts, and received confirmation that they will, in fact, be paying.
Most stunning statistic: The labor participation rate in PR as of April 2014 was estimated at 39.9%.
The dramatic increase in filing extensions was apparently due to all the new documentation and filing requirements that went into effect at the end of last year. Most CPA firms on the Island were unable to produce the additional documentation in time to meet the April 15th deadline. Some were even suspected of deliberately dragging their feet to send a “message of displeasure” to the Treasury. Be that as it may, since the source of the information came from a normally “very pessimistic” member of the legislature, we would tend to give it more credence. Having said that, there is really no way to know for sure until July 15th, when most of the tax extensions expire. In fact, when we talked to one of the companies that filed an extension, they suggested that perhaps many corporate filers, such as themselves, may have already paid much of their tax liabilities through quarterly payments.
Concerned that the tax receipts won’t show up before June 30th and punch a hole in the FY2014 budget? That’s no problem, we were told. Only a minor procedural change would be required to be passed to recognize the delayed payments in the current fiscal year.
Beyond the additional paperwork requirements, the gross receipts tax implemented last year (the “patente nacional”) also had an alternative minimum tax component that didn’t sit well with many corporate taxpayers. We’re told this will be fixed in upcoming legislation.
Without further ado, here are some of the key themes that I was able to pick up on the trip:
Most stunning statistic: The labor participation rate in PR as of April 2014 was estimated at 39.9%. In other words, 60% of the labor force was either unemployed or wasn’t even looking for a job. We were cautioned not to interpret this number as a sign that Puerto Ricans don’t want to work. The reality is that they’re not economically incentivized to seek employment, given the relative generous federal assistance programs available to them and the dearth of decent paying jobs. Of course, this may also be a manifestation of the Island’s very sizeable “underground economy”.
Theme #1: Liquidity remains the key concern over the next six months. Any optimism about PR’s long-term economic prospects must be tempered by the fact that several public corporations are in dire straits from a cash flow standpoint and may require short-term assistance from the GDB, despite the Bank’s insistence that such corporations should stand on their own going forward. The GDB’s own liquidity position is largely unknown at this time, forcing most analysts to assume the worst. The next six months should prove critical in this regard.
Theme #2: There is still no great sense of fiscal urgency on the part of the Administration. As surprising as that may sound, most of our sources complained that the Padilla team still doesn’t grasp the full severity of the current situation. The Governor has already backed himself into a corner with his promise of “no layoffs.” In PR, politicians can’t get themselves re-elected if they pursue massive layoffs, as the former Governor Luis Fortuno found out in the last election. At least for now, the current Administration seems content to fiddle within the current system with changes in work rules and department consolidations, etc…
Interestingly, although the General Fund’s operating expenditures were presumably “cut” by about $762 million between FY2014 and FY2015, the cut only amounts to $185 million if you compare FY2015 with FY2013. In other words, the FY2015 spending “cuts” may be viewed as just a reversal of the large expenditure increase built into the FY2014 budget.
Raising revenues through taxes, not cutting spending, remains the preferred solution, despite its negative effect on the economy. There is widespread consensus that, ultimately, government spending and employment have to be reduced before a viable local private sector can thrive. In that vein, passage of the Fiscal Emergency Act, also known as Bill 1922, over the unions’ vociferous opposition, is deemed a critical first step in giving the government the necessary tools to cut spending. The Bill is slated for a vote by the House by 6/15 and by the Senate by 6/20. Already, PRASA’s unions are calling for a work stoppage on 6/16-17.
Raising revenues through taxes, not cutting spending, remains the preferred solution, despite its negative effect on the economy.
Theme #3: Tax reform is on the way. All sources confirmed that PR is moving toward a consumption-based tax and away from the personal income tax. Also on the legislative agenda: greater reliance on the property tax, which, in the past, has yielded very little revenue in spite of being one of the least “economically-distorting” taxes. This is a very complex subject, which we will revisit in greater depth in a future report.
Theme #4: PREPA remains on top of everyone’s list of “restructuring” candidates, although “restructuring” means different things to different people. Legislators continue to publicly confirm their support for bondholders, however, it’s not clear to anyone at this stage if a restructuring of the Authority’s cost structure (laden as it were with patronage jobs) can occur without the bondholders sharing in some of the potential “pain”.
Theme #5: The tourism and economic development program appears to be operating on all cylinders. We picked up on a much greater sense of urgency here and the staff in charge of these efforts come across as extremely motivated and competent salespeople. Unfortunately, their efforts will take several years to bear fruit and thus far, the new job generation has not been sufficient to offset ongoing job losses. This reinforces our belief that if PR can get its fiscal house in order over the next year or so, the job picture may brighten after 2016.
Overall, there were plenty of reasons for hope even in a sea of negative information. One of our sources reminded us of a local saying, which goes something like this: “Whoever survives last turns off the lights.” If, and this is still a big “if” at this point, Puerto Rico can make it through the next year, we actually believe the lights on the Island could stay on for quite a while longer and shine even brighter for years to come.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
The opinions and statements expressed on this website are for informational purposes only, and 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(s) at the time of publication, 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. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.