Tuesday, October 15, 2019

The Long Road to Repatriate Puerto Rico’s Capital

By on September 18, 2019

(Screen capture of www.hcalero.com)

Can Puerto Rico create the conditions for local investors to return?

Editor’s note: The following is H. Calero Consulting Group’s “Puerto Rico Economic Pulse” for September.

Abstract

Long before the onset of PR’s current debacle, the economy used to generate consistent savings that in part justified its status as an attractive investment destination. In effect, personal savings ranged between 8% to 15% of personal income during the 1980s (the golden years for S.936 companies) and 1990s (the golden years of construction), most of which were channeled towards financial investment on the Island. Fast forward 15 years and those same assets under management are now almost entirely outside PR, the majority of them under tight institutional restrictions on questions such as geography, risk and return. Despite this, there is still a window of opportunity if the government is able to develop an investment plan articulated through the Opportunity Zones (OZ) initiative. Such a repatriation of capital requires an active risk-mitigation role from the government and, above all, allowing the economy to expand through stimulus rather than austerity. The final decision will have long lasting implications. 

P.R. was once an attractive destination

Since at least the 1950s, investors flocked to the Island in search of preferential tax treatment, both at federal and local levels. The value of Foreign Direct Investment (FDI) went from $8.2 bn in 1971 to $23.1bn in 1980, peaking in 2011 at $102.2 billion (estimates of private FDI are not available after 1982). The Commonwealth’s triple tax exemption on public debt led to large volumes of GOs and municipal bonds. In 2011, 55.6% of all FDI included some public debt. 

Furthermore, Puerto Rico has always had a domestic investing and savings culture. In fact, in 2006, local investors held $40.1bn in investments abroad, an amount that by 2017, had declined by 39% to $24.5 bn. Of those, $13.6 bn were held in short term investments with the majority held in bank balances. Long term investments were mostly held in Federal Government securities and pension funds. Individuals also reported over $500 million in income derived only from capital gains for tax year 2017. The total gain is much higher with other investments that are classified differently. Local capital indeed exists, it’s just not here. 

Repatriation is easier said than done…

It is not enough to say that PR has investments abroad. Assets under management everywhere are allocated to reflect management’s institutional and strategic constraints on issues such as risk, geography, activities and, debt, among others. Portfolios are created to develop a risk profile consistent with management’s ability to mitigate the assets’ exposure to risk.

PR’s fundamentals, unfortunately, have been misaligned for more than a decade. Inflation- discounted personal consumption declined by a yearly average of -0.2% during 2006-2018 due to a reduction in population (an estimated CAGR of -1.9% during 2010-2018, according the Census) while economic activity contracted by 2.2% (CAGR) during the same time. Hence, many strategic and institutional restrictions imply the Island is simply out of the question. Currently, PR is an alternative for either high risks investments, certain infrastructure projects—such as utilities related projects—or initiatives linked to external conditions and the ageing population. It may not sound like a lot, but it can open the door to other investments.

…but a tiny fraction would go a long way

The possibility that reconstruction funds may be stalled or reallocated somewhere else—wall between the US and Mexico—has put the spotlight on other alternatives to jumpstart the economy, such as capital repatriation. Economic activity has not fully gained traction two years after Maria—e.g. the economic activity index’s average monthly growth April-July was 0.03%— highlighting that public revenues have increased for the wrong reasons (higher taxes). Without the investment associated with the recovery efforts, the contraction in real GNP for FY2018 would have been around -6.7%. 

If properly capitalized, repatriating a fraction of domestically-owned capital, currently outside the Island, could go a long way in creating economic growth. The big question, of course, is how to lure it back!

A basic framework is already in place

A new tax treatment under the OZ initiative offers another starting point to allure investors back to the Island. The Tax Cuts and Jobs Act aims to attract investment to undercapitalized regions around the United States, and in PR’s case, covers 94% of the Island. The law offers tax breaks to invest in Opportunity Funds to support projects in real estate, housing, business ventures, and infrastructure projects. Investors get to defer those gains and the tax rates are reduced according to the length they forego the gain. PR adopted resolution 19-01 to guide the approval process of OZs. The government designated 4 priority areas: 1) developing low income housing; 2) investing in real estate; 3) building or improving industrial real estate and 4) substantial improvement of existing commercial real-estate. These priorities are not exclusive of other projects but are eligible to receive a 5% reimbursement in tax credits.

Looking past the initial investments

At this point, PR needs investments that can enable further investment, to create a positive feedback loop of economic activity—a virtuous cycle of economic development. Prime targets are healthcare and social services targeted to our aging population (by 2048, 27% of the population is conservatively estimated to be older than 65 years old), substitution of government services, and tourism.

Investments held in those Opportunity Funds should also be planned to maximize local impact. A comprehensive public investment plan should seek to reinforce economic activity within municipalities and undercapitalized regions. Given its current constraints, the role of the government should be as enabler and guide of what is needed to optimize growth. Regional power grids, boutique hotels outside the traditional areas (such as the new $12 mn investment in a hotel in Puerta de Tierra) and locally sourced restaurants are some examples of viable projects that could be financed.

The risk profile may be unnerving…

There are severe obstacles to any plans. The continued contraction in population, a lame- duck government and the possibility of not receiving all the approved federal recovery funds create significant risks for any investor. If all of these materialize, our pessimistic real GNP scenario, -3.6% by FY2022, could unfold.

Two important risks continue to be overlooked. First, PR’s post-Maria infrastructure has not been truly tested yet and this prevents anyone from ruling out Maria’ similar disruptions. This, coupled with very expensive utilities (cost of electricity to households, is set to increase 28% over the next five years) creates an unappetizing prospect for any long-term investment prospect. Emigration has led to loss of PR’s home-grown skills and talent, opening the possibility of importing specialized labor. Both situations, will add to the minimum required to make any investment feasible.

…but the government can do something

PR’s continued population decline has created an opportunity to transform the use of land throughout the Island. Given that the local Tax Code provides for faster approval and permits for Opportunity Fund projects, the government could facilitate and guide investment towards unproductive land. Instead of residential investments, land use could be designated for agricultural use, clean energy initiatives, healthcare, tourism, social services or any other use that might be in high demand in the future. The US Treasury’s move to end the 4% tax on foreign companies, which raised $1.9 bn in FY 2018 (21% of GF revenues) will directly affect public coffers. Since debt restructuring agreements have so far favored creditors, private sector investment is perhaps the only realistic source of investment.

Facts on the ground must change

Two imperatives are clear: external debt must be restructured, and debt repayment must be financed through economic growth, rather than pension and wage suppression, fiscal austerity and consolidation. Restructuring requires creditors to accept a bigger haircut. There is nothing unfair about not protecting reckless lenders from the consequences of their own folly. Experience has shown that debts are most effectively repaid in a context of economic growth. For ailing economies, that requires fiscal stimulus, not fiscal consolidation. Germany’s written off debt in the 1950s and cap of its loan repayment at 3% of export enabled its subsequent economic miracle. Forcing PR to implement counterproductive economic policies, in exchange for “potential” loans (or bonds) that benefit only creditors is a recipe for continued economic depression and future debt default. This is not the time to feign ignorance about what is really needed.