The French have a saying: “The more things change, the more they stay the same.” That seems quite applicable to Puerto Rico’s current fiscal situation. We are now more than two years into a full-blown debt crisis (to us, the current crisis dates back to April 2012, when credit spreads on Puerto Rico (PR) debt started to widen out significantly). And yet, so far, the formula has remained the same: “more taxes and more debt.” After all the market commotion of the past two years, the fact remains that PR’s crippling debt burden has continued to increase, with the Commonwealth being forced to finance its activities at usurious rates and on increasingly onerous terms, while the island’s economy continues to contract.

The GDB’s liquidity is, of course, the lifeblood of all the Commonwealth’s operations and anything that jeopardizes it has the potential of bringing down the whole PR debt complex.

More debt is on the way. At this writing, Governor Padilla has called a special session of the legislature to push through a dramatic rise in fuel taxes to shore up the moribund Highway & Transportation Authority (PRHTA) and provide the security for a new $2.9 billion bond issue by PRIFA. As you may recall from our previous columns, the initial proposal was to divert the fuel tax increases that were passed in June 2013 (and intended to shore up PRHTA) to secure a new bond issue to be floated by PRIFA. Why? Because the GDB’s liquidity position has declined to critical levels and its biggest loan portfolio exposure is to none other than PRHTA, to the tune of $2 billion. The proposed PRIFA issue will, in theory, help restore GDB liquidity and also repay some short-term debt owed by the HTA.

There is much at stake here, as usual. The GDB’s liquidity is, of course, the lifeblood of all the Commonwealth’s operations and anything that jeopardizes it has the potential of bringing down the whole PR debt complex. In contrast to PREPA, the HTA’s operations are much more tied to the central government’s, making “credit ring-fencing” efforts much more problematic. Hence the current attempt at cleaning up the GDB’s exposure to the Authority.

When this proposal was first reported by the media, we expressed concern about its potentially negative impact on the existing PRHTA debt, much of which is insured. In fact, we were quite alarmed that this would set up the HTA for an eventual debt restructuring. Apparently, the bond insurers were also paying attention and they must have applied pressure behind the scenes to force La Fortaleza to propose a much steeper fuel tax increase to keep the HTA whole. (Along the same line, in a recent interview with Caribbean Business, newly-appointed GDB President Melba Acosta gave the strongest signal yet to date that the Administration will try to work out the HTA mess without resorting to a restructuring.)

In fact, the insurers have reportedly agreed to credit-enhance part of the deal. While it is certainly in the financial guarantors’ best interests to make sure the new deal will get done, one cannot but wonder how the insurance regulatory authorities would view an expansion in their PR exposure at this juncture. Be that as it may, potential investors should expect the insured portion of the PRIFA loan to be quite attractively priced, particularly on a risk-adjusted basis.

If passed, the proposed legislation would raise the petroleum excise tax from $9.25 to $15.50 per barrel, a 68% increase. Since this levy had been increased from just $3 last year, the effective increase over the last two years would be more than five-fold. Imagine what this will do to the PR economy, which has already seen new auto sales crater by 15.7% in June and gasoline consumption decline by 8.6% in September (according to the latest GDB Economic Activity Index). In effect, this fuel tax increase may prevent PR residents from enjoying any potential benefit from the recent global decline in oil prices. Thus, what could have been a welcome stimulus to the Puerto Rican economy has turned into yet another round of contractionary tax increase.

PR consumers may still get some indirect benefit from lower oil prices. The proposed measure does specifically exclude crude oil used by PREPA to generate electricity. PREPA has, in turn, announced an 8% reduction in its rates to just under 26 cents/kwh. While this will only have a modest impact on the island sky-high power costs, it is nevertheless a step in the right direction with much symbolic value.

Speaking of PREPA, the besieged utility recently released a report from FTI Advisors which is a must-read for all PR observers. While the report contains no startling new revelations, it does confirm our worst fears about the current state of the utility’s operations. For one, the amount of accounts that are more than 120 days delinquent has more than doubled over the past two years (would you pay your bills to a quasi-bankrupt entity?). It also turns out that PREPA’s worst deadbeat accounts are none other than the other public corporations: the Port Authority, the public transit system and even PRASA, which stands to lose its energy subsidy under some recent proposals.

The FTI report also deals with another important topic: the Contributions-In Lieu-Of-Taxes (CILT) made by PREPA to local governments. Historically, the municipalities have been allowed to offset their energy bills due to PREPA with their CILTs. Due to the way the CILT liability has been computed, PREPA has ended up incurring a net CILT liability of about $420 million. In other words, the value of the electricity used by the municipalities far exceeds the amount owed to them by PREPA. Because the municipalities effectively end up with free electricity, there has been very little incentive for energy conservation and great incentive for abuses. FTI did offer various recommendations on this subject, subject to approval by the new Energy Commission that is to be formed under Act 57.

Some of the anecdotes about billing procedures are also quite telling. For instance, service that has been shut off for non-payment can be restored on the same day that the account is brought current, thus providing an incentive for clients to delay payment as much as possible. One of the positive conclusions one may draw from the FTI report is that there are definitely some low-hanging fruits out there in terms of operational efficiency and revenue collection.

Puerto Rico’s dilemma continues to be: “how to get past short-term fiscal issues so that long-term economic development solutions can be implemented.” Unfortunately, in the short term, the Commonwealth remains trapped in this vicious circle of rising debt and increasing taxes: in order to preserve whatever market access it has left, the Island has to keep borrowing and taxing more to service that debt.

In all fairness, there is much to look forward to in the long run: we view tax reform efforts as Puerto Rico’s best chance to eventually regain its economic footing. At the end of the day, any tax reform effort must include significant tax relief and hiring incentives for locally-owned businesses. The old approach of trying to import jobs by giving away tax incentives to foreign citizens and corporations clearly has its limitations since, by definition, it does not directly generate new tax revenues.

… in order to preserve whatever market access it has left, the Island has to keep borrowing and taxing more to service that debt.

While we’re on the subject of tax reform, there appears to be some uncertainty, if not confusion, in the marketplace about how the Cofina debt will be handled as the Commonwealth switches its sales tax structure to a Value-Added Tax (VAT), with taxes levied at each phase of distribution instead of just on the end consumer. Although bondholders certainly have plenty of reasons by now to question the Administration’s motives, we do believe this change, if and when the final details are released, will be to the benefit of current Cofina senior lien bondholders. First, GDB head Melba Acosta has steadfastly confirmed that any change to the SUT would hold Cofina bondholders harmless. Secondly, since a VAT structure gives the government a way to indirectly tax the so-called “underground economy,” it should result in improved revenue collections and improved debt service coverage on the Cofina senior lien bonds. Not that we should necessarily take government officials at their words but because it would be fiscal suicide for the Commonwealth to do anything to jeopardize its cleanest financing tool, the Cofina (and soon to come, Cofim) bonds. That said, the Commonwealth’s efforts to implement this tax change since September have been plagued with operational glitches, presumably due to vendor software shortcomings, but those appear to be resolvable.

With the next election cycle already looming on the horizon, there is only a narrow window of opportunity, perhaps over the next 6 months, to break out of this vicious circle. Unfortunately, the Commonwealth’s new “best friends,” the hedge funds, may be giving the current Administration a false sense of security about its market access. Whatever the answer to Puerto Rico’s financial woes may be, it can no longer be: “more borrowing.”

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