More than two years ago, Puerto Rico's government was at a fiscal standstill as lawmakers battled during a partial government shutdown over how to tackle budget shortfalls and rising debt levels. Emerging from that financial crisis required changes - zero-growth budgets and spending cuts, a first-ever 7% sales tax, increased water and energy fees, and less general obligation borrowing.

Yet a recession on the island that has lasted more than two years, along with the softening U.S. economy, have created a $1 billion deficit for fiscal 2009, which began July 1. The island's current governor, Anibal Acevedo Vila, recently talked with The Bond Buyer about his plans to close that gap and address other financial issues if voters on Nov. 4 re-elect the Popular Democratic Party leader for a second term.

Acevedo Vila currently lags in the polls behind the New Progressive Party's candidate, Rep. Luis Fortuño, who serves as Puerto Rico's non-voting congressional representative. Along with running a re-election campaign, the governor is fighting illegal campaign contribution charges and in February will go on trial on corruption charges in Puerto Rico.

If Acevedo Vila is re-elected, the secretary of state would serve as acting governor during the trial. Fernando Bonilla is Puerto Rico's current secretary of state, yet speculation on the island indicates that Acevedo Vila might appoint Caguas Mayor William Miranda Marin to the post in his second term.

In looking at the $1 billion deficit, Acevedo Vila believes leasing the island's lottery system could help shore up the budget gap until Puerto Rico can draft structurally balanced budgets that do not rely on one-time revenues. While current law requires the island to run on structurally balanced budgets beginning in fiscal 2010, Acevedo Vila said that may not happen for another three to four years and that the potential lottery concession revenues could help during the next few years until Puerto Rico emerges from its recession.


"In our plan we are proposing the concession of the lottery" in a public-private partnership, Acevedo Vila said. "It's a way to create a cushion in order for us to be able to have a period of two, three, four years for the economy to recover, but then have the revenues in order to have a balanced budget. So, to us it's a process of perhaps three or four years until we have final resolution of this issue."

Yet the legislature failed to pass the lottery concession, which included leasing the system for 50 years to a private company in return for an upfront payment. Standard & Poor's estimated that the lottery could generate approximately $3 billion for the island's coffers.

Acevedo Vila has said that he would resubmit the proposal in his second term, and said his administration would better educate residents about the initiative in hopes of garnering more support for it. Many residents expressed disapproval over the plan for fear that smaller vendors would no longer be able to sell lottery tickets or their income levels would be reduced due to a change in lottery management.

"And we have discussed that with a possible investor and that's not part of the equation, so it's basically a lack of information and a little bit of fear, and that's something you can deal with in the legislation," the governor said.

At the same time, a federal opinion released last week placed restrictions on potential long-term lottery agreements. The U.S. Justice Department ruling declares that all states must "exercise actual control over all significant business decisions made by the lottery enterprise," and states must retain a majority portion of lottery profits and losses, according to the opinion.

It is not clear how this ruling could affect Acevedo Vila's proposal and lawyers for the Government Development Bank for Puerto Rico are evaluating the opinion, according to GDB spokeswoman, Maria Rosario. That news could decrease states' ability to generate sizeable upfront payment for the long-term management options of their lottery systems.

As Puerto Rico looks towards addressing its budget problems, how the credit rating agencies will respond to the commonwealth's inability to create structurally balanced budgets in the next fiscal year remains to be seen. Standard & Poor's and Moody's Investors Service rate the credit BBB-minus and Baa3, respectively, both with a stable outlook.

"I think it's something that we saw as a positive step when they made that law that they had to come to a structural balance," said Moody's analyst Emily Raimes. "As the recession continues there, it looks less likely that they've be able to achieve that."

Raimes said it was too early to determine if not meeting the fiscal 2010 budget balancing goal would prompt a rating change.

The Acevedo Vila administration has curbed spending and decreased government employee head count by roughly 17,000 in order to rein in government expenditures. The fiscal 2009 budget of $9.48 billion includes a 5% reduction, but mandatory expenditures drove it $260 million higher than the $9.22 billion fiscal 2008 budget. The fiscal 2007 budget totaled $9.48 billion as well.

"Their budget calls for a zero growth in spending and they had zero growth in spending the prior year," Raimes said. "At some point it gets hard to keep cutting - there's less fat to trim off. So they have to look for other things and they instituted the sales tax a couple years ago. There's probably not a lot of appetite for raising taxes or adding new taxes as we see in a lot of other states, so they're looking for other ways to close that gap."

In addition, Acevedo Vila said cutting too deep into the budget could harm the economy as the central government serves as an economic catalyst, especially during this period of slow business growth. The government is the largest employer in Puerto Rico. While reducing staff helps ease budget strains, it adds to the island's unemployment levels, which was 11.7% last month, according to the U.S. Department of Labor.

"The answer cannot be to cut millions of dollars from the budget because that will really, really hurt the economy more instead of helping it," the governor said.

Challenger Fortuño said that he would cut the current budget by 5% "on day one" and reduce government employment even further.

"If it were in a real growth scenario for them, well then they could cut back on government jobs and those people could find other jobs," Raimes said. "When they're in a recession, that's a lot harder and so then you have increased need for the social services and increased spending and all of that kind of thing, so it's put them in a hard position. I think it's pretty commendable that they've kept to it and we haven't seen government employment ballooning back up, but it's something that's hard for them to deal with. And how do you stimulate the economy when you're also holding employment down?"


In addition to scaling back on spending, the next governor will have to face the effects tight global credit markets will have on Puerto Rico's local economy as many residents rely on short-term debt to help maintain household expenditures.

Carlos Vargas-Ramos, researcher at the Center for Puerto Rican Studies at Hunter College in Manhattan, said that regardless of who is governor on Jan. 1, addressing the potential lack of credit for Puerto Rican residents will dominate the agenda.

"Puerto Rico is exceedingly reliant on credit, and particularly liquid credit," Vargas-Ramos said. "I keep making mention of how often you seen these financing companies advertising in the newspapers, on television, and the radio. People rely heavily also on credit union loans to just make ends meet. So, with a tight credit market I think that that is going to have a very, very bad impact on the Puerto Rican economy."

To help ease household and individual finances, Acevedo Vila said he would introduce legislation to cut personal income taxes on the island. Fortuño also promises income tax cuts if he is elected, and both candidates believe the added cash for residents will help boost spending on the island. That would eventually benefit the government through additional sales tax receipts and business tax revenue.

As for corporate tax breaks, Acevedo Vila said his first priority is lowering the personal income tax before decreasing taxes for the business community. Conversely, Fortuño has said he would pursue reducing the island's corporate income tax to 30% from 39%.

"My first commitment is to decrease the personal income tax, especially for the middle class," Acevedo Vila said. "I think that's the best way to jump-start the economy because you will put money in the pockets of people and that will have a positive affect and, yes, we are willing to consider reviewing the corporate tax but the first, first priority is personal income tax."


The governor would also like to alter the sales tax by reducing it to 2.5% from 7% and implementing a revamped 6.6% excise tax. Like the lottery initiative, his plan to bring back the excise tax failed to pass in the legislature. Acevedo Vila said he would re-file the proposal in his second term, while the Government Development Bank for Puerto Rico has said that the sales tax is putting a drag on the economy.

Of the sales tax, the first one percentage point secures $2.6 billion of Puerto Rico Sales Tax Corp. bonds. Acevedo Vila's proposal would still keep that dedicated revenue stream in place, but he calls for dedicating excise tax revenues if additional revenue0 was needed to cover debt service costs on the sales tax bonds.

"The law will include all the guarantees so that revenue stream will not be affected," the governor said. "No doubt about that."

In looking at Puerto Rico's overall debt, the island is heavily leveraged, with approximately $46 billion outstanding. Of that amount, $8.16 billion is general obligation debt.

Keeping borrowing at a minimum while also investing in needed infrastructure improvements is a challenge. The Acevedo Vila administration has decreased its use of new-money GOs, cutting the annual GO deal to $250 million for fiscal 2008 after the legislature rejected $175 million of new-money bonds to pay back debt the central government owes to the GDB.

In fiscal 2007 the island sold $408 million of new-money GO debt, down from fiscal 2006's $675 million total. Both of those deals included $175 million of debt to pay the GDB.

Acevedo Vila said if re-elected, he plans to continue keeping the island's debt levels steady and strengthening its credit rating.

"The first commitment we have shown is to our fiscal responsibilities and to our obligations with bond buyers," Acevedo Vila said. "I have been very clear how important it is to protect Puerto Rico's credit. I have made tough decisions, politically tough decisions, in order to save the credit of Puerto Rico, and in that [investors] can see that that commitment is there, that's number one."

In addition, the GDB, the president of which is a gubernatorial appointee, structures the island's debt issuance. The bank generated $301 million of debt savings by refinancing $7.54 billion of GO,appropriation, and public authority debt in fiscal 2007 and 2008, according to the GDB.

Officials succeeded in separating the Puerto Rico Electric Power Authority and the Puerto Rico Aqueduct and Sewer Authority from the central government's operations and increasing rates to allow both entities to issue debt on their own and manage themselves.

While residents pay higher water and electric bills, the agencies no longer rely on commonwealth subsidies. Yet problems still remain, as there are flaws in both authorities' billing and collection operations and some government agencies are delinquent in payments to the agencies.

"They are also suffering from people not paying their bills," Vargas-Ramos said. "You have many government [agencies] that may be lagging behind or actually not paying their utility bills. That is a problem and not just with energy but also with water, and people stealing electricity through illegal hook-ups, or what have you. That is an issue; that is a problem."

Along with lost and delinquent payments, PREPA relies heavily on oil to generate electricity, with 72% of Puerto Rico's electricity coming from petroleum. A new natural gas pipeline is scheduled to begin operating in February or March in the southern region of the island and lower that percentage to 62%, Acevedo Vila said. In addition, the legislature just approved a wind-farm project that will help the island improve its use of renewable energy sources.

"We just signed a contract with the private sector to produce energy from wind for PREPA so we're moving forward and we have many other projects in the pipeline," the governor said. "Some of them are P3s, some of them are from the private sector, and some of them are going be [executed] by the power authority, so that's a huge step. When I came to office four years ago there wasn't even one project in the pipeline to reduce our dependency on oil, not even one."

Acevedo Vila and his party prefer strengthening the commonwealth's autonomy by reducing federal oversight as opposed to Fortuño's party's pro-statehood stance. While becoming the 51st state in the union would allow Puerto Ricans to vote in presidential elections and give the jurisdiction voting power in Congress, being a territory allows exemptions from federal taxes and other tax perks.

The governor says would still like to strengthen Puerto Rico's powers in the Caribbean and make the island a leader in the region. One specific example would be to re-evaluate the 1920 Jones Act, which stipulates that everything transported via water within the U.S. has to be on a U.S. vessel, a restriction that is very costly for Puerto Rico.

"We are an island and everything that we get from the mainland is through that law and the U.S. maritime ships are the most expensive," Acevedo Vila said. "So we could sit down and create some types of exemptions that will foster more economic development for Puerto Rico. It's something that we need to sit down with Congress; it's not something that can be done unilaterally. But when we talk about alternatives, that's a specific example of how that will foster more economic development for the island."




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