Puerto Rico can't pay its debt, governor says. How will it impact investors?

As the world watches with anticipation whether Greece will reach a deal with its creditors, another government may be heading down the fraught path towards debt negotiations.

On Sunday, Puerto Rico’s governor Alejandro Garcia Padilla revealed that the island will not be able to repay its debt.

"The debt is not payable. This is not politics, this is math," Mr. Garcia Padilla told the New York Times in reference to the Island’s $72 billion worth of public debt.

But unlike Greece, Puerto Rico is bound by the US federal bankruptcy code, meaning that like all US states, it cannot file for bankruptcy. Consequently, a failure to find consensus with creditors could begin a long and laborious, and heretofore unknown, process to solve the island’s financial woes. Experts say the resulting fallout could impact the US economy.

"Puerto Rico’s move could roil financial markets already dealing with the turmoil of the renewed debt crisis in Greece," wrote Michael Fletcher for the Washington Post. 

"It also raises questions about the once-staid municipal bond market, which states and cities count on to pay upfront costs for public improvements such as roads, parks and hospitals." 

Over the years, Puerto Rico's bonds have been popular with US mutual fund investors because of their high yields and exemption from federal, state, and local taxes. By 2013, an estimated 3 out of 4 municipal bond mutual funds held Puerto Rican bonds, the Post reported Monday. 

Bonds have traditionally been considered one of the safest bets an investor could make, but the belief in municipal bonds began to falter in recent years after cities such as Detroit and Vallejo, California filed for bankruptcy.

In those cases, however, investors were protected by the US bankruptcy code, allowing them to recover some of their lost funds. Because Puerto Rico cannot officially file for bankruptcy, it is unclear whether these sorts of protections will be extended. It also remains unknown what percentage of Puerto Rican bonds are insured.

Furthermore, Puerto Rico’s bonds are roughly eight times the value of Detroit’s, the largest American city ever to file for bankruptcy, meaning that a call for debt relief from such a behemoth could raise borrowing costs for other local governments as investors grow more cautious about lending.

Puerto Rico’s financial crisis has been dragging on for the past decade, forcing the government to attempt numerous maneuvers to avoid default. Among the methods tried were raising taxes, cutting government employment, and reducing pensions, but these moves have failed to spark economic growth. 

As the island’s credit rating dropped, many hedge funds began buying Puerto Rican debt at high interest rates in an effort to prolong loan payments and drive down the borrowing costs constraining Puerto Rico’s struggling economy. But these efforts also proved insufficient.

Puerto Rico now has more debt per capita than any state in the country, and the resulting economic hardships have led to a mass exodus from the island to the mainland.

Now the government’s Public Finance Corporation, which has previously issued bonds to finance budget deficits, owes a $94 million payment on July 15, and the Government Development Bank, the commonwealth’s fiscal agent, is obliged to pay $140 million of bond principal by August 1.

Puerto Rico’s public agencies also owe a large portion of the debt. The power company alone owes close to $9 billion, and is facing a restructuring as the government negotiates with creditors.

Meanwhile, the island’s mound of debt also includes general-obligation bonds (bonds issued with the faith that the municipality will be able to pay it back through revenue raising), which its constitution says must be repaid before government workers receive their salaries. Each month Puerto Rico’s central government must set aside around $93 million just for general obligation bonds. Similar to Greece, residents have been straddled with the burden of the government’s financial obligations through tax increases and pension cuts.

Now, as Garcia Padilla told the Times, that status quo is unsustainable.

On Tuesday the governor will deliver a speech following the release of a report by former International Monetary Fund and World Bank officials that outlines the full extent of the financial predicament the commonwealth is facing, NPR reported. He is expected to seek concessions from creditors, including deferring some debt payments or extending the repayment schedule.

Meanwhile, the governor has urged the island's creditors to show some solidarity and "share the sacrifices."

“My administration is doing everything not to default,” Garcia Padilla told the Times. “But we have to make the economy grow. If not, we will be in a death spiral.”

Puerto Rico's lawmakers are currently debating a $9.8 billion budget that would include $674 million in cuts and $1.5 billion earmarked to pay off debt. The budget must be approved by Tuesday.

In another effort to raise revenue, Garcia recently signed legislation raising the sales tax to 11.5 percent and creating a 4 percent tax on professional services. The sales tax increase will go into effect on Wednesday, and the new services tax on Oct. 1.