Negative signals from Puerto Rico

January 27, 2014

The condition of Puerto Rico’s economy is a key concern for bond investors and rating agencies. Although its tax revenues have risen sharply as the government has increased various taxes, the economy has been contracting. From a recent Morningstar report:

The contracting economy remains a core concern for us, as Puerto Rico has now experienced 12 consecutive months of economic contraction relative to last year, and the monthly decline in economic activity in the first half of fiscal 2014 has been the most rapid since fiscal 2010.

Puerto Rico measures its economy using the PR Economic Activity Index. The EAI is made up of four components: payroll employment, cement sales, gasoline consumption and electricity generation. Although most December economic figures have not been publicly released, Standard & Poor’s ominously placed Puerto Rico general obligation and appropriation debt on “CreditWatch with negative implications” on January 24th. S&P rates Puerto Rico BBB-, its lowest investment-grade rating:

Standard & Poor’s Ratings Services has placed its general obligation (GO) and appropriation debt ratings on the Commonwealth of Puerto Rico on CreditWatch with negative implications.

Standard & Poor’s has also placed its debt ratings on Puerto Rico’s Employee Retirement System, the Puerto Rico Infrastructure Financing Authority, the Puerto Rico Convention Center District Authority, and the Puerto Rico Highways and Transportation Authority on CreditWatch with negative implications. We have not taken a rating action on sales tax-secured debt of the Puerto Rico Sales Tax Financing Corp. (COFINA).

“These CreditWatch actions follow our placement of the Government Development Bank for Puerto Rico issuer credit rating on CreditWatch with negative implications (see the research report published Jan. 24, 2014, on RatingsDirect), and our view that GDB’s ability to provide liquidity for Puerto Rico is weakened,” said Standard & Poor’s credit analyst David Hitchcock.

The S&P CreditWatch of the Government Development Bank is extremely important. From S&P:

In our view, GDB could have limited liquidity by fiscal year-end June 30, 2014 without access to the debt market by either GDB or the commonwealth. While we believe the commonwealth may place a sizable sales tax-secured bond issue through COFINA, in our opinion, current market conditions for Puerto Rico debt issuances will require relatively high yields and a limited pool of specialized buyers.

Which leads S&P to conclude (emphasis mine):

The negative CreditWatch placement on Puerto Rico reflects our negative CreditWatch on the GDB. Should we downgrade the GDB, we could lower the rating on Puerto Rico’s GO and appropriation debt.

In S&P’s view, the Government Development Bank is facing “limited liquidity” (i.e. running out of funding sources).

We have scant data on Puerto Rico’s December economic performance other than collapsing cement sales. Total sales of cement were off 16.5 percent year over year. Here are the November figures for the three other Economic Activity Index components (payroll, gasoline consumption and electricity generation). The red boxes show the year over year change for the period of July through November and December:

Puerto Rico’s economic contraction has caused non-corporate tax revenues to come in below projections, while corporate taxes have ballooned due to tax rate increases. From Morningstar again:

The weak labor market in Puerto Rico has had an adverse impact on individual income tax and sales tax revenue streams, both of which tend to be more volatile than other tax sources during economic downturns. For the current fiscal year through December, net general fund revenue from individual income taxes is $51 million, or 5.5 percent, below estimates, while sales taxes are $26 million, or 100 percent below estimates.

I have been most interested in the data related to Puerto Rico’s commercial banking sector. If the island’s banking system is unable to make loans to individuals and businesses, it will be very difficult for the economy to grow. Note that banks capital is down 4.2 percent from the third quarter of 2012 to third quarter of 2013.

News is My Business reported that Puerto Rico government officials are meeting in New York this week with the three major rating agencies. Although the government reformed the pension systems, few savings will be realized immediately. Even with the liquidity created by increased tax revenue. Since the Government Development Bank has not reported its financials since June 30, 2012, it’s difficult to know how liquid it is.

Chart source: Morningstar

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