A note to New York Fed President William Dudley
Dear President Dudley:
Although it is a longstanding policy of the Federal Reserve not to intervene in the finances of state and local governments, it may be time to reconsider this policy in the case of Puerto Rico. A member of your board of directors, Richard Carrión the CEO and Chairman of Banco Popular de Puerto Rico, wrote to The Economist about the state of Puerto Rico’s finances:
You said that the effect on economic activity by new levies on businesses would negate half of the expected increase in revenues, but you overlooked easily available data showing that net government revenues were $350 million during the first fourth months of the current fiscal year, $120 million higher than forecast.
Mr. Carrión is correct about Puerto Rico’s success in increasing tax collections, but its economy continues to contract. From Reuters:
Monthly data from the Government Development Bank tracking employment, gasoline sales and other indicators on the island declined 5.2 percent in September and 5.4 percent in October from a year earlier.
Through October, Puerto Rico’s economy has shrunk by 5.3 percent in the fiscal year that began July 1, according to the GDB’s Economic Activity Index.
A big issuer of municipal bonds, the island has been in or near recession for eight years as it suffers from a loss of U.S. federal government economic support, cuts in Puerto Rican government spending, high oil prices and population loss.
The Puerto Rico Planning Board recently pulled back from a forecast of 0.2 percent growth for the current fiscal year to a prediction of a 0.8 percent contraction.
Puerto Rico’s banking system continues to contract. Total assets shrank 4.9 percent year over year in the third quarter. Commercial and industrial lending declined by 17 percent in the same period.
Last December, Moody’s downgraded the island’s three major banks, including Mr. Carrión’s Banco Popular, to non-investment grade (Ba1), based largely on concerns of diminished economic activity. Moody’s wrote last year:
Moody’s said the downgrades of the banks’ standalone ratings were driven by Puerto Rico’s difficult operating environment. The island is in the midst of a deep, protracted recession that began in 2006. Moreover, the prospects for a sustainable recovery are constrained by the commonwealth’s poor finances, which are characterized by a severely underfunded retirement system and an increasingly heavy debt load.
Actions to address these issues in the coming years will likely put additional stress on Puerto Rico’s already weak economy, which is characterized by high unemployment, a declining population and a lack of clear growth drivers. This will continue to threaten the banks’ asset quality. The banks’ problem assets remain extremely high relative to US mainland banks, which could lead to significant losses if the recession continues. This would negatively affect the banks’ profitability and capital.
The Government Development Bank (GDB) – the sovereign bank of Puerto Rico – is undergoing its own liquidity challenges. GDB Chairman David Chafey, speaking at the Bloomberg Muni Link conference (~4:30 minutes) in November, said that the GDB had “manageable” liquidity to last through the end of the fiscal year without having to access outside borrowings. Chafey said that the GDB has an investment portfolio of $2.2 billion and the GDB has deposits of $2.9 billion within the system. Chafey said that they believe they could bring some of those deposits back to the GDB. He also said that commercial banks have been lenders to them throughout this time.
Like Greece several years ago, Puerto Rico faces increasingly onerous interest rates to borrow. The banking system in Puerto Rico is weak. The pattern of increased government revenues overlaid on a contracting economy resembles Greece, which had to restructure its sovereign debt.
The Federal Reserve Bank of New York is responsible for Puerto Rico. It could take the lead in easing the liquidity woes of the GDB. Under Section 14b of the Federal Reserve Act, short-term securities for the GDB could be purchased in Fed open-market operations.
This would relieve short-term liquidity challenges and allow the GDB more time to resolve solvency issues. More importantly, it would signal confidence in the Puerto Rico government and may allow borrowing costs to come down.
Puerto Rico has been working very hard to right its fiscal ship and reduce its reliance on borrowing to fill budget deficits. Some support from the Federal Reserve would go a long way to helping the Commonwealth manage its fiscal realignment.