Fitch Ratings said it has placed the BBB-plus general obligation bond ratings of the commonwealth of Puerto Rico debt on Rating Watch Negative.
Fitch also put on negative watch the Puerto Rico Building Authority government facilities revenue bonds guaranteed by the commonwealth; the Puerto Rico Aqueduct and Sewer Authority (PRASA) commonwealth guaranty revenue bonds; and Employees Retirement System of the Commonwealth of Puerto Rico pension funding bonds.
The Rating Watch Negative reflects Fitch's expectation of a significant increase in the commonwealth's estimated operating imbalance for the current and coming fiscal years, based on reported revenue results through the first half of the current fiscal year and public statements by the new administration. Fitch expects to resolve the Rating Watch early next month following meetings with representatives of the commonwealth.
The GO bonds are a full faith and credit obligation of the commonwealth of Puerto Rico that benefit from a constitutional first claim on commonwealth revenues. The ratings on the building authority and PRASA bonds reflect the guaranty of the commonwealth's full faith, credit, and taxing power. The pension funding bonds are payable from and secured by a pledge of statutorily required employer contributions to the system; the commonwealth is the largest contributor.
The Negative Rating Watch is based on the economic and revenue underperformance which Fitch believes has meaningfully increased the size of the operating imbalance for the current fiscal year and the gap the commonwealth will need to address as it develops a budget for 2014. Fitch does not believe that a balanced budget will be achieved in fiscal 2014, and meeting this goal will remain challenging thereafter.
The commonwealth's economy is limited but closely linked to that of the U.S. The downturn in Puerto Rico started earlier, was deeper, and lasted longer than the U.S. national recession. After signs of stabilization in 2012, recent performance has shown some weakening.
Puerto Rico's bonded debt levels are exceptionally high and pension system assets are expected to be depleted in the foreseeable future absent significant reform. These high liabilities both limit Puerto Rico's ability to use additional leveraging for capital improvements or as a budget solution and create spending pressures that will be difficult to absorb within slowly growing revenues.
Commonwealth financial operations historically have been weak, with a record of large budgetary and GAAP deficits, overestimation of revenues, unfunded overspending, and a reliance on borrowing to meet budgetary gaps. The last administration took dramatic steps to restructure fiscal operations and stimulate the economy, and demonstrable progress was made. The new administration appears to be continuing this focus.
Future rating action will be driven by Fitch's assessment of additional information the agency expects to receive in the near term regarding the scope of the commonwealth's current fiscal challenge and the new administration's plans to address it.
Puerto Rico's GO rating reflects the somewhat limited nature of its economy, its strong ties to the U.S., a history of weak financial operations, and very high liabilities including outstanding debt and unfunded pensions. Strong legal provisions for GO debt include a constitutional first claim on commonwealth revenues, including transportation-related and rum excise tax revenues that are dedicated to specific authorities and other bonds.
Despite four years of aggressive cost cutting and other fiscal restructuring measures by the last administration, economic recovery and budget balance have proven elusive. Fitch has noted steady progress in stabilizing the commonwealth's finances; however, with a reduction in near-term expectations for the economy and revenue underperformance in the current fiscal year to date, the budget challenge facing the new administration has expanded considerably compared to original estimates. The current-year deficit appears to be well above the $1.1 billion originally forecast (including debt refinancings for budget relief). Fitch will be meeting with representatives of the commonwealth early next month and expects to receive detailed updated information on the fiscal situation and the administration's plans at that time.
A proposal on pension reform also seems to be forthcoming. Pension funding is exceptionally low.
System contributions are defined by law rather than by actuarial requirements and payments have not been covering the actuarially determined annual required contribution or even current benefit payments. The commonwealth's ability to take action that supports the solvency of the pension system without significantly increasing the demands that pensions place on the budget will be critical to long-term rating stability.
Puerto Rico's debt levels are very high, partially reflecting the consolidated nature of the central government's role, and have increased as the commonwealth has used deficit financing as part of its fiscal stabilization plan. The commonwealth utilizes a complex debt structure that includes GO, sales tax, guaranteed, and public corporation debt, and has relied heavily on borrowing under its various bonding programs in order to fund operations. Although such borrowing has been reduced, continued reliance on capital markets to refinance debt for current-year budget savings introduces risk to operations and increases the already high debt burden. The commonwealth benefits from its relationship with the Government Development Bank for Puerto Rico, which provides a degree of flexibility and liquidity.
Puerto Rico faces a longer term question of how to grow and diversify its economy, increase employment and workforce participation levels, enhance wealth and income, and address contraction in its existing pharmaceutical and electronic-producing industries. The ultimate test of the success of future policy will be whether or not Puerto Rico is able to find a sustainable path to economic growth, growth that is necessary to support the commonwealth's high debt levels and other long-term liabilities, as well as to achieve and maintain a structurally balanced budget.
