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Moody's Investor Service Press Release
Moody's Assigns Baa1 Rating and Stable Outlook to $506 Million Commonwealth of Puerto Rico General Obligation Bonds
June 24, 2002
Moody's assigns a Baa1 rating and stable outlook to the Commonwealth of Puerto Rico's General Obligation Bonds, including $506 million of new money bonds to be sold this week to fund various capital projects included in the fiscal 2003 capital budget. A portion of the issue ($40 million Series B bonds) is offered in Puerto Rico only and is not US tax-exempt. The medium-grade rating reflects:
- the island's established political and economic link with the US, which has been the foundation for economic expansion and consistent growth in real income over the last two decades;
- resident income levels that nonetheless remain very low, on average, relative to the US mainland;
- financial operations that have been characterized by low reserves and a trend of operating deficits, reflecting the costs of implementing an extensive healthcare reform program and a revenue structure that has shown high sensitivity to recent economic slowing;
- a government debt load which is very high relative to personal income and high-but-manageable in terms of annual servicing burden within the government budget.
Aided by the robust US economy of the late 1990's, the Commonwealth's economy has adjusted reasonably well to the phase-out of Section 936 tax benefits available to US corporations operating in Puerto Rico, which constitute a major portion of the island's manufacturing base. The ten-year phase-out is currently in its seventh year, and while some US-owned manufacturers have downsized or left the island in recent years, others have continued to expand their operations by using alternate organizational and tax structures for new business lines. In Moody's view, the ultimate economic impact of the 936 phase-out is still developing, and there are signs that it may not significantly alter the island's long term trend of expansion and diversification. Our stable rating outlook reflects this cautiously optimistic view of the economy, offset by the financial stress currently being experienced in the General Fund. In the near term, we expect the island's economy will reflect the slower pace of activity in the US national economy, with a modest additional drag possible if weakness in the tourism sector continues.
CONTINUING ECONOMIC GROWTH AND DIVERSIFICATION, BUT SIGNIFICANT SLOWDOWN EVIDENT IN GDP AND EMPLOYMENT FIGURES
Puerto Rico's economy continues its long-term trend of growth in real gross product and personal income levels, although the pace of growth has slowed significantly over the past two years. The island's economic momentum has been influenced by a favorable combination of forces in recent years, including the robust US mainland economy, generally low oil prices (excluding a spike in costs during fiscal 2001), and very strong business conditions in the pharmaceuticals industry. In addition, a surge in Commonwealth borrowing to fund infrastructure projects began about five years ago, and continues, and there was an estimated $3 billion infusion of funds from FEMA and private insurers to support rebuilding efforts in the wake of a late 1998 hurricane. These factors contributed to a late 1990's surge in construction investment and employment, although other commercial building and housing activity was also strong.
The slowdown in the economy is evidenced by a slowdown in real GDP growth, which the Puerto Rico Planning Board estimates will be barely positive in fiscal 2002. In addition, payroll employment growth was negative 1.7% in calendar 2001 (according to BLS) and further monthly declines of about 1% have continued thus far in 2002. These statistics mainly reflect the loss of government and manufacturing jobs, although most other sectors are also weak. The manufacturing losses reflect several high-profile plant closures during 2001, including Intel (full closure of motherboard assembly facility, 1,300 jobs), Sara Lee (partial closure of apparel facilities, 2,200 jobs), and Star-Kist (full closure of tuna canning facility - 1,300 jobs). Most of these are labor-intensive businesses, and the closures reflect similar trends in the US, particularly in some of the southeastern states. Some other recent measures of the island's economy indicate continued, though slowing, expansion. For example, business conditions appear to remain positive in the important pharmaceutical sector.
TOURISM SECTOR SHOWS LONG-TERM GROWTH, BUT STILL REPRESENTS MODERATE SHARE OF ECONOMY
Puerto Rico's tourism sector has seen significant growth over the past decade. The government estimates there are about 9,600 available tourist hotel rooms, up more than 50% since 1993. Hotel registrations by non-residents totaled 1.17 million in fiscal 2001, up 70% from fiscal 1993. In addition, the island benefits from a substantial number of cruise ship visitors. The tourism sector represents a significant, but moderate, percentage of the total economy. Visitor expenditures of some $2.7 billion (government estimate for 2001) represent just over 6% of the island's gross product, and the number of tourism-related jobs probably represents a similar percentage of total employment (though precise numbers are difficult to segregate). These percentages are much lower than, for example, Hawaii.
In the aftermath of the September terrorist attacks in the US, Puerto Rico's tourism sector has experienced a moderate weakening, as measured by tourist hotel registrations and visitor expenditures. For the recent high tourist season, which runs from November to May, registrations have been down fairly modestly (about 2% compared to the year-earlier period), and have been quite solid since February. The Puerto Rico Planning Board preliminarily estimates that visitor expenditures for all of fiscal 2002, i.e. July 2001 to June 2002, will be down almost 3% in nominal dollar terms.
IMPACT OF 936 PHASE-OUT STILL DEVELOPING
Through the end of 2000, the island's economy had shown little evidence of an adverse effect from the 1996 federal legislation phasing-out Section 936 tax benefits available to Puerto Rican subsidiaries of US corporations, other than a moderate loss of manufacturing jobs (approximately 12,000 jobs lost over three years, an 8% decline for the sector, although this increased sharply to 12% by the end of 2001). The job losses have been concentrated mainly in relatively low-pay, labor-intensive industries such as apparel and food products, mirroring similar trends in low-wage industries in the US. At the same time, the growth in value of manufacturing exports increased significantly, primarily attributable to pharmaceutical products, and growth in private-sector wages and Commonwealth tax revenue remained fairly strong (although these softened as well during 2001).
In addition, while some US-owned manufacturers downsized or left the island in recent years, others continued to invest in and expand their operations by using alternate organizational and tax structures for new business lines. More than fifty US-owned entities operating on the island have established so-called controlled foreign corporations, or CFCs, providing a US tax status resembling that of other subsidiaries operating in foreign jurisdictions such as Singapore and Ireland. At the same time, new business expansions by these companies are able to benefit from aggressive tax incentives offered by the Commonwealth government. These strategies, while not as favorable as the old 936 benefits, nonetheless are able to mitigate future tax liabilities on corporate income attributable to Puerto Rico, and thus reduce the impact of the 936 termination. The Commonwealth government has also proposed changes in US tax law that would increase the attractivenes of CFCs incorporated in the US possessions relative to those in other foreign locales, although the outlook for these changes becoming law remains very uncertain.
In Moody's view, the ultimate economic impact of the 936 phase-out is still developing. There are some signs, however, that it may not significantly alter the island's long term trend of expansion and diversification, notwithstanding the most recent spate of manufacturing plant closures and job losses.
GENERAL FUND MARKED BY TREND OF OPERATING DEFICITS, LEADING TO CASH DEPLETION AND DEFICIT FINANCING IN FISCAL 2001
The Commonwealth recorded GAAP-basis operating deficits in the range of $200 million for each of the five years through fiscal 2000, primarily reflecting the costs of an extensive healthcare reform program. In addition, spending in the areas of public education and debt service increased significantly, offsetting a strong trend of growth in income tax collections. The operating deficits were recorded in the General Fund and the former Health Facilities and Services Administration (known by its Spanish acronym, AFASS), an enterprise fund that was merged into the General Fund in fiscal 2000. The AFASS deficits were financed with loans provided by the Government Development Bank (GDB), which in turn refinanced the loans in the public market in the form of Commonwealth appropriation-backed bonds.
A wider operating gap in excess of $500 million (offset by debt restructuring and deficit financing) was recorded by the General Fund in fiscal 2001, reflecting the effect on revenues of a slowing economy, continued escalation of healthcare costs, and the dynamics of an election year and change in administration. The Commonwealth's revenue structure is dominated by corporate and individual income taxes levied at high marginal rates, and these revenues were flat at $4.9 billion in 2001 (net of refunds and $175 million of tax cuts passed by the prior administration). This compares with income tax growth averaging better than 10% in the two prior fiscal years, and a budget assumption of 5% growth.
The reduce the size of the deficit, the new administration took steps to freeze hiring, reduce contract expenses and equipment purchases, and refund a moderate amount of current year debt service ($165 million), and also drew down portions of various special fund balances. However, the General Fund balance was effectively depleted and some $370 million of borrowing from the GDB was necessary to fund current operations. The GDB in turn funds these and other cash needs by using its own balance sheet resources and by issuing commercial paper, as discussed in more detail below. Ultimately, the recorded GAAP-basis operating deficit was just $78 million, reflecting the borrowing and other measures taken. The unreserved accumulated deficit grew significantly, however, in part reflecting a write-off of receivables due to accounting changes (GASB 33).
FISCAL CONTROL IMPROVES IN 2002, ALTHOUGH RELIANCE ON ONE-TIME RESOURCES IS LARGER THAN ANTICIPATED AND HEALTHCARE SPENDING IS OVER BUDGET
The Commonwealth's fiscal 2002 General Fund budget anticipated a moderate economy-related increase in tax revenues as well as positive results from a program of increased tax collection and enforcement (most of which is one-time in nature). Recently updated estimates for the year indicate that revenuse will be close to budgeted levels, although there has been a greater-than-anticipated reliance on one-time resources, primarily balance transfers from several other funds into the General Fund. In part, this reflects a budgeting error in the area of corporate taxes - specifically, a large tax payment made in 2001 by one taxpayer was in fact partially a prepayment of 2002 tax, and thus no payment was made in 2002. Adjusting for this and other one-time items, however, baseline revenue growth will be positive, which is significant at a time when many US states are posting revenue declines. Of the one-time resources employed, $40 million relates to a sale of municipal receivables to the Government Development Bank, a fairly modest reliance on GDB-supplied liquidity to balance the budget.
On the spending side, the budget anticipated lower overall spending in 2002 vs. 2001, reflecting measures to cut education and health spending, as well as savings from a G.O. debt restructuring. At this time, the Comonwealth anticipates that spending will be moderately over the budgeted level by about $130 million (or 2%), reflecting spending pressures in the areas of education, public safety, and health care. However, the spending side is anticipated to be balanced by foregoing planned additions to reserves that were included in the budget as a cushion. The original budget included $140 million of contributions to the budget reserve fund and the emergency fund.
One of the Commonwealth's main policy initiatives over recent years has been a sweeping restructure of the public healthcare system. Substantially all healthcare services formerly provided by the government (through AFASS) are being transferred to the private sector, with the government providing comprehensive insurance coverage for qualifying residents (about 40% of the population qualifies). While the new system has increased the government's overall health expenditures, access to medical services has also increased. To contain costs, the system uses a managed care approach administered by four private insurance companies. With the addition of San Juan during fiscal 2001, the new system now covers all municipalities on the island, though the government does continue to operate some facilities via the Health department.
The new healthcare system is still in the implementation stage, and already has experienced significant issues of utilization and cost inflation. For example, the new administration has identified a large number of "double enrollees" - i.e. individuals who have been enrolled in the new system but who also have private insurance coverage. New eligibility restrictions to reduce these cases, as well as the negotiation of reduced administrative costs, were elements of the government's plan to cut healthcare costs by at least $100 million in fiscal 2002. Ultimately, however, the elimination of double-enrollees proceeded at a slower pace than anticipated (although the target number of cases was met by the end of the year) and health costs increased modestly rather than decreasing as expected. The outlook for 2003, according to the budget, is for overall costs to decrease somewhat.
2003 BUDGET FEATURES TAX INCREASES AND 3% SPENDING INCREASE
The General Fund budget for fiscal 2003 is based on moderate growth in the economy and baseline revenues (+4.3%), plus various items of new tax legislation including hikes in the excise taxes on cigarettes, beer, and sports utility vehicles. The excise tax increases, as modified by the legislature, aggregate to roughly $200 million. The goal has been to improve structural balance between recurring revenues and expenditures, with the latter projected to grow by about 3%. This includes $145 million of reserve fund contributions, so there is some cushion in the event spending exceeds the fairly restrained increase that is planned. Overall, given the high degree of reliance on economically sensitive revenue sources, Moody's views there to be some risk that the 2003 revenue estimate could prove to be somewhat optimistic, particularly in the area of individual income taxes. However, we anticipate that the improved fiscal oversight and control will be maintained.
COMMONWEALTH'S LIQUIDITY POSITION IS FAVORABLE; GDB PLAYS LEADING ROLE
While restoring and maintaining budget balance will continue to be a challenge over the next year, more than adequate alternate liquidity is expected to be available to the General Fund. The most important liquidity source is the Government Development Bank, which is owned by the Commonwealth government, and among its many functions acts as the repository for substantial public sector funds, including those of the central government, government agencies and corporations, and municipalities on the island. The GDB provided $370 million of deficit loans to the General Fund in fiscal 2001 (a large portion of which was subsequently refinanced in the public bond market), and $40 million in receivables purchase financing in 2002.
If called upon to provide liquidity, the GDB may tap its liquid balance sheet resources and/or sell notes under one of its existing commercial paper programs. Cash, marketable securities, and investment contracts accounted for more than $3.2 billion (41%) of GDB's total balance sheet assets at June 30, 2001. Although these resources experienced a decline over the past several years - reflecting a loss of private sector deposits and an increase in loans to the public sector - they still exceeded outstanding commercial paper and other "confidence-sensitive" liabilities by more than $1.5 billion in 2001. During fiscal 2002, the bank has endeavored to improve its liquidity, including steps to recapture some of the public-sector funds that have been invested in recent years in private banking institutions on the island, as well as securing legislation to allow a portfolio of government loans on the bank's balance sheet to be sold in the public market as Commonwealth appropriation bonds. The bank subsequently completed $1.8 billion of such bond sales in December 2001, and priced another $500 million issue this month. While improving available liquidity in the near-term, these actions do add significantly to the Commonwealth's future debt liabilities, as discussed in more detail below. The GDB is not separately rated by Moody's. Its outstanding commercial paper at June 30, 2001 was $1.25 billion, and reported equity capital was $1.7 billion.
Another method of obtaining alternate liquidity for the General Fund, if necessary, is borrowing directly from certain cash balances residing in other government funds and accounts. These funds are deposited with the GDB and under the control of the Secretary. The Secretary is statutorily authorized to borrow from these funds - which include multiple agency and special funds which are temporarily concentrated at the Treasury, and various reserve funds for extraordinary maintenance, tax refunds and other purposes - to meet temporary General Fund imbalances. While the Commonwealth does not provide forward projections of these resources, the aggregate balance at the end of fiscal 2001 was $620 million. The 2001 aggregate balance was down from over $1 billion in prior years, partially due to the slowing economy, but also reflecting the fact that some funds were permanently drawn down to balance the 2001 budget. The accounts available to the Secretary are not limited to certain investments, but fall under general GDB activities and policies. GDB indicates that these accounts are invested in quality short-term instruments. Public pension, employee association, and state insurance funds may not be borrowed by the Secretary.
HEAVY TAX SUPPORTED DEBT BURDEN REFLECTS CENTRALIZED GOVERNMENT, INFRASTRUCTURE INVESTMENTS, AND DEFICIT BONDING
The Commonwealth has a heavy tax-supported debt burden that in part reflects its centralized government - with many functions assumed by the Commonwealth whaich are carried out by localities in most of the fifty states - and also the broad scope of the infrastructure development tasks it has undertaken. The current ratio of tax-supported debt to aggregate personal income is about 47%, more than four times as high as the most heavily indebted of the fifty states. The ratio is affected by the low levels of personal income in Puerto Rico (per capita income is still about one-third the US average) and by the large absolute amount of government debt. At roughly $19.5 billion, the Commonwealth government has more outstanding tax-supported debt than all but three of the states.
From the mid-1970s to the mid -1990's, the Commonwealth's debt policy sought to maintain a stable relationship between increases in debt and economic growth. Over the past governor's two terms in office, the Commonwealth implemented a major effort to improve the island's infrastructure, focusing on highways, mass transit, water aqueduct and sewage treatment facilities, and electric power plants. At the same time, the government has generated, and bonded, significant operating deficits in healthcare and other areas. These issues have totaled close to $3 billion in recent years, including a $500 million issue this month via the Puerto Rico Public Finance Corporation - see our separate report recently issued on the PFC). As a result, outstanding tax-supported debt has increased by almost $9 billion over the past sx years - as calculated by Moody's, and excluding self-suporting enterprise debt such as that of the Electric Power Authority - and the pace of growth in debt has been roughly twice the pace of personal income growth.
The Commonwealth estimates that debt service on general obligations and other debt paid from the General Fund will exceed $1 billion in fiscal 2003, representing roughly 14% of the budget for the year. This includes the effects of a proactive series of debt restructurings completed in the past year. It does not include all tax-supported debt, particularly the substantial issues by the Highway and Transportatio Authority and the Infrastructure Finance Authority that are paid from revenues accounted for outside of the General Fund. Overall, the debt service has remained in the manageable range due to the Commonwealth's ability to mpose high local tax rates on individual and corporate incomes, given the absence of federal income tax on the island. The General Fund debt profile has also been restructured significantly through recent issues, flattening the annual servicing requirements in the coming years, but also increasing total future debt service payments. Total payments are close to $28 billion over the next 35 years, while, by comparison, the current annual operating budget is $7.5 billion. In spite of this recent trend, we do not see a long-term debt affordability issue developing.
COMMONWEALTH ALSO FACES SUBSTANTIAL UNFUNDED PENSION LIABILITIES
The Commonwealth also faces substantial unfunded liabilities in its two principal pension systems, covering public employees and teachers, a result of years of inadequate contributions. As of June 2000, the combined funding ratio was 35% and the unfunded liability was $8 billion (with assets at fair market value). Of the two, the teachers' system is in significantly better shape. In January 2000, the government enacted a major reform of the public employee retirement system's benefits and funding. This substitutes a defined contribution-type plan for new employees rather than the old defined benefit plan. In addition, funding will be accelerated for the old plan through greater government contributions as well as a subsidy from a portion of investment earnings under the new plan.
These changes, if adhered to over time, should reduce the growth rate of new unfunded pension liabilities; however, the actual funding ratio is not expected to begin to improve for some time. In the meantime, the low funding ratio and poor investment results over the past two years (the plan is heavily concentrated in equities) have caused a cashflow problem during fiscal years 2001 and 2002. A local banking institution had to advance $100 million to the system to meet retiree benefit payments, and was repaid earlier this year with proceeds from the sale of a portion (15%) of the government's remaining stake in the local telephone company to a Verizon subsidiary (for $172 million). Proceeds from the eventual sale of the government's final 28% stake are also expected to be dedicated to the pension system. However, with the continuing very weak performance of the investment markets, the system could continue to be under some cash flow pressure in the near term.
The Commonwealth's rating outlook is stable. The outlook reflects Moody's view that adequate liquidity is available to cushion the General Fund in the near term while the government works to restore and maintain budgetary balance, against the backdrop of a slower pace of economic activity. We note the anticipated close of fiscal 2002 with only a modest reliance on GDB-supplied liquidity, as well as a package of moderate tax increases in the 2003 budget in order to improve structural budget balance.
Longer-term, the economy's continued adaptation to the phase-out of 936 tax benefits is key, and there are emerging signs that the end of such benefits (after 2005) may not significantly alter the island's long-term trend of economic expansion and diversification.