Commonwealth of Puerto Rico Affirmed At 'BBB-', On Deficit Reduction Measures

Standard & Poor's Ratings Services has affirmed its 'BBB-' rating and negative outlook on the Commonwealth of Puerto Rico general obligation (GO) and appropriation debt.

The rating is based on what we view as:

• The commonwealth's large and diverse economy of 3.67 million people, albeit with what we see as currently weak economic trends that began in fiscal 2007, including population declines and economic contraction in real terms;

• Puerto Rico's strong ties to the U.S. economy, resulting in a significant flow of trade and income transfers;

• Structural deficits in the commonwealth's general fund for more than a decade;

• Recent willingness to tackle some long-term structural issues, as indicated by enactment of substantial pension reform, elimination of subsidies for its water and sewer authority, and large recent tax increases, which Puerto Rico projects will enable structural balance by fiscal 2016, when combined with restrained increases in spending;

• High level of debt and retirement liabilities;

• A governmental framework that constitutionally places repayment of GO debt ahead of other expenses, and broad legal authority to adjust revenues and expenditures, although the current administration has said it will not institute layoffs;

• Debt market access risk, in light of the need to finance a budgeted operating deficit in fiscal 2014 and a smaller deficit in 2015, as well as refinance GO bond anticipation notes (BANs), negotiate new liquidity agreements for variable-rate demand obligations (VRDOs), refinance floating-rate notes, and potentially deal with swap termination costs. However, Puerto Rico has announced intentions to access the market with higher rated Puerto Rico Sales Tax Financing Corp. (COFINA) debt; and

• Support from the Government Development Bank for Puerto Rico (BBB-/Negative), which in our view provides a source of liquidity and back-up market access for the commonwealth.

In fiscal 2013, Puerto Rico experienced what we calculate as a $2.1 billion general fund deficit of recurring revenues minus recurring expenditures on a budgetary basis, or a large 22% of expenditures, twice what was originally budgeted. In our view, the larger-than-budgeted deficit was primarily the result of economic contraction when the 2013 budget had originally projected economic growth. The operating deficit followed a long string of earlier operating deficits, despite what we viewed as a significant reduction in employee headcount and payroll that occurred in fiscal 2010.

A new administration came into office at the beginning of calendar 2013 and reversed earlier tax cuts, made small mid-year fiscal 2013 reductions in expenses, and significantly expanded the sales and use tax base to new business services, calculated to raise more than $1 billion of new revenue in fiscal 2014. The new administration signed a fiscal 2014 budget that has what we calculate as a reduced $820 million operating deficit that will need to be financed, or 7.9% of appropriations.

"The negative outlook reflects ongoing negative demographic, economic, and fiscal trends, and the possibility that market access concerns could affect the ability to roll over notes, finance operating deficits, and renegotiate liquidity agreements, if recent tax increases do not prove sufficient to lower operating deficits," said Standard & Poor's credit analyst David Hitchcock. In our view, staying close to the $820 million budgeted deficit in fiscal 2014 and substantially reducing the deficit in fiscal 2015 remains critical to reducing the growth in Puerto Rico's tax-supported debt, which has risen in our calculation nearly 49% in the past four years primarily as a result of deficit financing. We believe the current administration has made significant structural pension reform, reduced water and sewer operating subsidies through significant rate increases, and taken important tax-raising measures to restore fiscal balance. However, we believe the resumption of weak economic results limits the government's ability to implement additional revenue enhancements, while expenditures reductions may be constrained by the current administration's goal not to conduct layoffs.

"We could revise the outlook back to stable if the economy gains positive momentum and budget deficits remain close to budgeted projections through fiscal 2015," Mr. Hitchcock added.

We could lower the rating by one notch if the economy deteriorates to the point we believe it significantly hampers the ability to lower budget deficits, the projected deficit for fiscal 2014 widens, it appears that no significant budget reduction will likely occur in fiscal 2015, or the loss of market access significantly hampers the ability to finance deficits or roll over and refinance debt, liquidity agreements, or meet swap termination costs. Although we see the credit strength of the COFINA sales tax security allowing future market access, should this vehicle prove unavailable or unaffordable, it could trigger a downgrade. In addition, given the disproportionate reliance of Puerto Rico's economy on federal transfers, a significant reduction in these transfers, or other federal actions or inactions that could significantly affect the economy or the budget could also have the potential to lead to a downgrade.

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