Could Puerto Rico Be the Next Debt Crisis?

Nobody knows in America/ Puerto Rico’s in America!

Photo by Luis Robayo/AFP/Getty Images

This is a little bit off people’s radars, but something I’ve heard some quiet buzz about lately is the problematic debt situation in Puerto Rico. You can basically think of this as being a North American version of the story in Spain.

Bond buyers notice that the returns are higher than for lending to the U.S. proper but figure the risks aren’t really higher. Local authorities enjoy the influx of cheap capital but don’t really manage to spend it in ways that enhance the country’s long-term growth prospects. Financial crisis hits, households and firms cut back on their sunny destination travel spending, so the economy takes a blow. Investors also realize that the politics aren’t quite what they thought, and actually lending to Puerto Rico is quite a bit riskier than lending to the U.S. Now you enter a bit of a downward spiral, where to cover the costs of past borrowing you need to implement austerity measures that only hurt the growth outlook, and each blow to growth makes investors lose even more confidence. Meanwhile, other vacation destinations hit with a loss of investor confidence suffer currency depreciation, which causes problems of its own but at least makes them attractive places to visit. Now you’re in a bit of a death spiral, where the bad economy makes the debt situation worse, and all efforts to cope with the debt situation further kill confidence in the economy.

So who cares? Well, Puerto Ricans for starters. But it’s also interesting to wonder what will happen if Puerto Rico were to end up defaulting on its debt. American mutual funds will be exposed to some substantial losses, since some quirks of the tax status of Puerto Rican debt made them very attractive vehicles. But it’s not such a big deal that you’d see a mass financial panic.

The real question is about contagion. No American state has ever gone bankrupt, in part because there is no provision in the bankruptcy code for a state to go bankrupt. But a number of states are in a pretty dire fiscal position. Illinois is de facto defaulting on its pension promises, following up on some earlier action in Rhode Island. Insofar as even these solidly blue states choose to stiff pensioners without making bondholders share in the pain, perhaps everything will be fine for holders of state debt everywhere. But honestly while the political and economic logic of pension cuts makes sense to me, the logic of strict bondholder priority does not. “Stiff retired cops and teachers so Wall Street can get paid” doesn’t really sound like a sustainable long-term political agenda for me, especially because (unlike in the Spanish context) there’s no sweetener in terms of a bailout from Washington. If Puerto Rico manages to make bondholders share the pain, I imagine you’ll hear more talk of that option in some other debt-burdened jurisdictions. The market reaction to that would be pretty interesting, in a Chinese curse kind of way.