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Moody’s: Commonwealth Budget Deficits Trigger Negative Outlook For Credit

Tax collections fail to meet estimates


September 30, 2004
Copyright © 2004 CARIBBEAN BUSINESS. All Rights Reserved.

New information on poor budget practices prompted Moody’s Investors Service to change its outlook on $15 billion in outstanding Commonwealth bonds to negative from stable.

While Moody’s lowered the outlook on Commonwealth bonds, the credit-rating service left unchanged the Baa1 rating, classified as a low investment grade, on $442.7 million of general obligation bonds sold last week in tax-exempt markets.

The Commonwealth’s failure to balance its budgets for the last two fiscal years has raised concern, said Moody’s Public Finance Group analyst Timothy Blake. In its analysis of Puerto Rico’s fiscal condition, Moody’s expressed concern over the Commonwealth’s tendency to borrow from the Government Development Bank (GDB) to plug gaps in the General Fund, the central government operating budget which pays the salaries of teachers, policemen, and other government employees.

Late in fiscal year (FY) 2004, the government was forced to borrow $233 million from the GDB to balance the budget and ensure repayment of outstanding tax & revenue anticipation notes (TRANs), according to Moody’s. TRANs are short-term obligations incurred to smooth seasonal cash flow shortages.

In FY 2003, the Commonwealth borrowed $250 million from the GDB to balance the budget. "Expenditures exceed ongoing revenue by a wide margin," Moody’s noted about the current year’s budget. The $8.9 billion budget, nurtured by taxes and other internal revenue, has a built-in deficit of $550 million. This shortfall is to be funded by yet another loan from the GDB.

"Fortunately, the GDB’s liquid resources, though reduced over the past year due to its loan activity, remain more than adequate to fund this additional [loan] requirement," Moody’s noted.

"The Commonwealth’s budgets since fiscal 2001 have been strained by tax revenue performing below estimates and expenditures exceeding budget estimates," said Moody’s analysis. In both FY 2003 and 2004, the Department of Education’s spending demand was the source of financial stress, while earlier fiscal woes stemmed from healthcare expenditures, which apparently have been brought under control.

Puerto Rico’s credit rating is under scrutiny by the major bond rating services Moody’s and Standard & Poor’s (S&P) because of the Commonwealth’s negative financial management and a huge pension system liability that keeps growing. The most recent actuarial valuation of the Government Employees Retirement System, more than three years old, doesn’t take into consideration the steep decline in the stock market. As of June 2001, the total pension obligation was $9.9 billion–25% of this amount is funded. As of June 2003, the pension system obligation is estimated at $11.3 billion, with only 17% funded.

Besides representing a serious financial problem, a large unfunded liability could also produce unexpected cash needs in the near future, Moody’s said. Indeed, following the dot-com bust, the pension system experienced cash-flow shortages.

Last year, S&P assigned a negative outlook on a single-A minus grade, because of the Commonwealth’s habit of using nonrecurrent revenue to balance the budget. Rating agencies use a change in outlook to signal a likely downgrade of the credit rating in the medium-term future–a horizon of one to three years–unless a plan can be made to correct the particular problem.

The administration is banking on a new tax on consumption to make the FY 2006 budget revenue positive. The need for some form of sales tax has the support of both the New Progressive Party and the Popular Democratic Party. Nonetheless, the rating agencies aren’t taking it as a done deal.

"We’re looking for the tax reform to be clearly defined and implemented," said Kenneth Gear, S&P analyst. The administration hasn’t filled in the particulars of how the plan will be implemented.

Last week (Sept. 23), the Commonwealth sold an $800 million TRANs issue, which must be repaid by June 29, 2005. Funds from the TRANs cover the Christmas bonuses and other large payments that have to be made before the seasonal flow of income taxes into the Treasury Department make the April 15 deadline. Moody’s rated the notes MIG-1, its highest short-term rating, taking into consideration the ample cushion provided by the GDB which has established an $800 million credit line earmarked for the 2005 TRANs, in favor of the secretary of Treasury.

Both Moody’s and S&P provide investors with an independent opinion of the credit-worthiness of various government entities as well as their ability to manage their finances. In rating the long-term bonds last week, here are several of the factors that Moody’s took into consideration:

The island’s established link with the U.S., which has been the foundation for economic expansion and growth in real income over the past two decades.

Resident income levels that remain very low on average, relative to the U.S. mainland.

General financial operations that have been characterized by a trend of operating deficits and tax revenue that until recently hasn’t met budget estimates.

Significant net liquid resources available in the Commonwealth-owned GDB, which have been tapped to support the General Fund over the past several years.

This Caribbean Business article appears courtesy of Casiano Communications.
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