The Financial Oversight and Management Board for Puerto Rico (“FOMB”) announced yesterday that it “reached an agreement in principle with several creditor groups to lower Puerto Rico’s debt to sustainable levels after a successful mediation process.” As a result of that agreement, the FOMB asked the court to extend the deadline for filing an amended plan of adjustment (“POA”) until March 8, 2021. That POA would modify the terms and conditions of the central government’s debts with various groups of creditors. These debts include General Obligation bonds, bonds issued by the Public Buildings Authority, and obligations to various groups of unsecured creditors. In total, the POA would restructure approximately $35 billion in central government debt.
The previous FOMB offer to creditors sought to reduce this debt to approximately $11.9 billion, consisting of (1) $6 billion in cash; (2) $4.9 billion in new General Obligation bonds; and (3) $1 billion in the form of a Contingent Value Instrument (“CVI”). According to the FOMB, the combined recovery rate for all creditors would range from 31.3% (not including CVI payments) to 34.1% (including all CVI payments), although there is a wide range of variation among the different types of creditors. The terms of the new agreement have not been disclosed yet.
Now, the important point is that all this restructuring scaffolding is anchored in medium and long-term economic projections, which in turn are used to estimate the income available to the government and to calculate the primary surplus (the money that remains after paying the government’s operational expenses) that can be used to service restructured debt. According to media reports and documents published by the FOMB, some creditors are objecting to the FOMB’s economic projections because they consider them too pessimistic. This should not come as a surprise given the adversarial nature of the restructuring process. And also because making long-term economic and fiscal projections (20 years or more) is difficult during the best of times. And we are certainly not in the best of times.
I believe we can stipulate with a high degree of confidence that the government of Puerto Rico faces a level of uncertainty not seen at least since the end of World War II, due to the fact that the island’s economy has been stagnant, contracting or growing minimally, for 15 consecutive years. And to this weak economic base we have to add the adverse economic impact of a concatenation of unfortunate events, such as the reduction in population; the government’s own bankruptcy, which affects investment; the hurricanes of 2017; the 2020 earthquakes; and the COVID-19 pandemic.
The macroeconomic scenario, then, is complicated. It is true that in the short term a modest rebound is in sight, a growth rate between 1 and 1.5% of GNP, due to increased public spending (financed mainly by the federal government) for the reconstruction of infrastructure damaged or destroyed by hurricanes and earthquakes and to make up for the losses suffered by many businesses and to help those who are now unemployed due to the pandemic.
However, this projected short-term rebound is not guaranteed and may be adversely affected by various causes. The economic stimulus will largely depend on the availability of federal funds, which in turn is subject to political and bureaucratic ups and downs in Washington, DC and the (in)capacity of the Puerto Rican government to execute complex operations. In addition, much of that spending will be on goods and services produced by foreign entities and individuals, which reduces the multiplier effect on the local economy.
Even if this short-term growth projection holds, we must remember that this modest rebound is due to the replacement of destroyed capital or the compensation for income losses and does not change, transform, or modify in any way the underlying dynamics of our economy’s long-term secular stagnation.
To reverse this trend, a coordinated economic growth strategy must be implemented, which includes, among other things: increasing domestic and foreign fixed investment; strengthening local small and medium-sized companies; promoting exports by Puerto Rican companies; and making significant investment in research and development activities to create innovative, locally produced goods and services.
In addition, a series of public policies must be implemented to promote (directly or indirectly) total productivity. For example, a thorough overhaul of our mediocre educational system; reducing the costs of electricity, as well as improving the reliability of the electrical system; reforming outdated institutions that impede economic growth; and eliminating rent-seeking practices by the private sector.
Implementing this type of strategy takes time and is fraught with risk. That is why we recommend creditors accept conservative economic projections when preparing the POA. This is simply the most prudent course of action. The unprecedented level of uncertainty in modern times makes long-term economic and financial projections essentially unreliable.
This situation makes it very difficult for Puerto Rico to present in good faith a POA that is binding for thirty years. However, given clear instructions from Judge Taylor Swain, the FOMB must file in court at least a detailed outline of the POA in short order. For this reason, we recommend that the CVI component be increased, while reducing the consideration paid in the form of new General Obligation bonds in the POA. The CVI allows investors a greater recovery, should the economy perform better, while protecting Puerto Rico in the event that government revenues fall below expectations. Thus, it helps mitigate prevailing uncertainty, makes it easier for the government to submit a viable POA, and reduces the likelihood of a liquidity crisis.
In the final analysis, this is a win-win proposition, since investors participate in any potential upside economic scenario; Puerto Rico is left with a sustainable debt load; and both parties mitigate the risk of a new default in the short and medium term.