WHEN Alejandro García Padilla, the governor of Puerto Rico, announced on June 29th that its $72 billion public debt was unsustainable, he warned that the only alternative to a comprehensive restructuring “would be the unilateral and unplanned non-payment of obligations”. It would be a drastic step for the autonomous American territory, which the United States regards as a commonwealth. Mr García Padilla was presumably hoping to intimidate Puerto Rico’s recalcitrant creditors into accepting their inevitable losses, thus averting disaster. Just a month later, the worst-case scenario has started to become a reality.
On August 3rd Puerto Rico’s Public Finance Corporation (PFC), a government agency, was scheduled to transfer $58m to its bondholders. However, the PFC depends on the island’s legislature to appropriate funds for its debt service. And its lawmakers had conspicuously failed to do so, for one simple reason: in the words of Víctor Suárez, the governor’s chief of staff, “we don’t have the money”. As a result, the PFC only managed to send off a token $628,000. The market’s enforcers did not hesitate to render their judgment: as soon as the business day ended, Moody’s, a rating agency, announced that it considered the security in default.
The PFC’s 99% missed instalment is unlikely to set off an immediate cascade of lawsuits or further defaults. Its paper is technically nothing more than a “moral obligation”, without any legal mechanism to force payment, and is mostly held by pliant local investors such as credit unions. The government insists that the missing transfer should not be considered a default at all, since the bond contract only obliges the PFC to pay what the legislature has appropriated. Just three days before the PFC stiffed its lenders, Puerto Rico’s Government Development Bank duly made a $170m payment on its own debt. Nonetheless, the PFC’s default sharply accelerates Puerto Rico’s debt crisis. It extinguishes any hope that the island’s creditors might all emerge unscathed, and cuts off whatever access to short-term financing the government might have had left.
It may well have been Mr García Padilla’s intention to provoke a sense of urgency. Puerto Rico’s awkward status, both within the United States and apart from it, can leave it in an unenviable position. Because Puerto Rico is not a state, it cannot make use of the public-sector version of federal bankruptcy law known as Chapter Nine, which has been invoked by insolvent governments on the mainland (such as Detroit) to reduce their liabilities. After the island passed its own version of Chapter Nine last year, federal courts struck it down, on the grounds that municipal bankruptcy falls exclusively under federal jurisdiction. That left the governor with no choice but to beseech America’s Congress to bring his territory under Chapter Nine, a plea that has so far fallen on deaf ears. By letting the weakest link in its payment chain snap, Puerto Rico has made the spectre of a chaotic, piecemeal default—which once seemed remote—immediate. In theory, that could spur Congress into taking swift action.
Even if the ploy of taking-oneself-hostage were to succeed, however, the extension of Chapter Nine to America’s overseas territories would not be a cure-all. That law would not cover the restructuring of Puerto Rico’s $13 billion of “general-obligation” (GO) debt, which is protected by a constitutional pledge that it must be paid before all other obligations. And if Congress fails to charge to the rescue, precious little time remains to work out a contingency plan. Puerto Rico is not even scheduled to make an initial restructuring offer until August 31st, and servicing debt in December and January alone will cost $1.3 billion, 1.5% of GNP. In their public statements the island’s biggest creditors, the American mutual-fund families OppenheimerFunds and Franklin Templeton, have shown little willingness to cut a deal. Puerto Rico has long been prone to hurricanes. The PFC’s default puts a terrible legal and financial storm squarely on the horizon.