Puerto Rico Economic Outlook 2008

By Monica Perez Nevarez

Economist Gustavo Velez reveals the mechanisms at work behind the current recession.

BPR: How did we get into this mess?
GV: Puerto Rico’s economy has been in a recession for the last 24 months. There are several events that influenced the situation: back in 2005 there were increases in costs for basic public services and a structural deficit; in 2006, the recession began in March, then the government shut down in May, the IVU tax was implemented in November, and the price of a barrel of oil rose to above $90 by year’s end, all of which contributed to making inflation skyrocket. In 2007, 60,000 jobs were lost, and participation rates in the labor market were at its lowest levels in the last 27 years. There has been an increase of 43% in bankruptcies over the last twelve months, and in that same time frame, the Puerto Rico stock index lost 40% of its value. The end of the “Ley de Incentivos Contributivos” (Tax Incentives Law), coupled with expiring patents, led important pharmaceutical companies with operations in the Island to announce closings or reductions in their operations, and there was a massive layoff of 3,000 employees in the months between October and December 2007. Early in 2008, the price of oil hit $111 per barrel, and the price may keep rising.

BPR: What are some local contributing factors to the recession?
GV: Political events (such as the upcoming elections and the Governor’s legal woes) are going to continue to influence consumer confidence as well as the investment climate; the continuing banking crisis (non-performing mortgages, sub-prime crisis, bankruptcies, low interest rates and decreasing exchange rates), as well as the fact that our government may yet again face budgetary problems are some of the larger challenges we face.

BPR: What influence will the global economy have on the local situation?
GV: We are part of the global economy. Unfortunately, those external forces may make the local economic situation deteriorate even further. There is a real possibility that the economy of the United States will fall into a recession, or that the global financial markets weaken, or that the value of the dollar keeps decreasing, and that the price of petroleum keeps going up. Any of these measures would have a negative impact, and if taken together, their influence will have an exponentially harmful effect. But a very interesting fact is that this recession happened independently of what was happening in the United States; for the first time in our history, we created this situation ourselves, it is not the result of what is happening in the US. Let me explain. As you can see from my graph (below), the local economy has historically mirrored the US economy, so that when it did well, so did we, to a lesser extent. If it did poorly, so did we, to a greater extent. But in 2006, we see clearly that the US economy began to recover, whereas the Puerto Rican economy went into a steep decline.

BPR: So what is the short term outlook?
GV: We are facing the most severe recession in recent history. The main economic indicators predict that the local economy will remain stagnant in 2008 with a negative growth (contraction) that will fluctuate between -1% and -1.5%. If these decreases materialize, all the other macroeconomic indicators will follow suit. Even more worrisome is the fact that both the manufacturing and construction sectors, deprived of new investment, will fall into a descending spiral. Consumer spending, which represents 80% of aggregate demand, also shows a declining trend due to the weak spending power of the consumers.

BPR: What can be done to alleviate the situation?
GV: At the moment, 15 local enterprises have banded together with the Chamber of Commerce and are working on a legislative project directed to reduce individual and corporate tax contributions. Also, on June 30th the new Tax Incentive Law comes into effect, a move that will be vital to attracting investment in the short term. There is also a program in the works for tax credits for housing, which together with lower interest rates will help the housing sector. And with the new elections, we might see an end to the so-called “shared government”, which has been an exercise in futility.

BPR: Let’s get to specifics. What is happening in each sector?
GV: We lost 60,000 jobs in 2007 according to statistics published by the Labor Department. Specifically, in January 2007 there were 1,276 million jobs. By December 2007, there were only 1,216 million. This is the lowest number of jobs registered for a month of December since 2003. You must remember that this is within a context of a population of four million people. 1.8 million working-age people are not included in the labor market statistics because they are chronically unemployed, and only reflected in the separate Participation Rate. In December 2007 the rate of unemployment (for the 1.2 million that are employed) was 10.5%, a 1% increase with respect to the same period in 2006. Nevertheless when analyzing the average rate of unemployment for 2007, we see it was 10.9%, or two tenths smaller than that registered in 2006. In spite of the loss of 60 thousand jobs, the rate of unemployment did not increase because the labor pool was reduced by 57 thousand people and the group of unemployed people increased by 3 thousand. This reduction reflects the unprecedented migration for better job opportunities outside Puerto Rico, and to the 3,000 that were employed and now receive unemployment benefits.

The Participation Rate lost 2.4 percentage points in 2007: 44.8% versus the 47.2% registered at the beginning of year, for a contraction of 5%. The rate of participation in the month of December was the same as the one registered in that same month in 1987; and taken for the whole year, the rate of participation was 46.1%, the same as in 2000. So, in a retrospective analysis of the total labor market in Puerto Rico, 2007 is the third time since 1980 in which a loss in total participation during a natural year is registered, and that loss is the most significant of the three: in 1981 22 thousand jobs were lost, and in 1997 a reduction of 11 thousand jobs was registered. These reductions have a direct impact on Puerto Rico’s fiscal health: net income in the General Fund fell from 3.1 to 3.0 billion.

If broken down by sector, public transportation, utilities and communications; retail; and finances, insurance and real estate; had small increases in available jobs, whereas agriculture, manufacturing, construction, government and services had significant reductions, as you can see in the graph (below). It is interesting to note that in December 2007 the retail sector, while it posted a gain of two thousand jobs overall, was still 8 thousand jobs below the numbers generated for that same month the previous year.

Construction

The reduction in the construction sector reflects the fact that as of last September there were 7.5% less construction permits granted and 23% less new housing units, as well as a decrease of 8.7% in total dollar amount of permits.


Bankruptcies

There were also considerably more bankruptcies in 2007. In spite of the new regulations established in 2005 that diminished the benefits of declaring bankruptcy, there was an increase of 43% in bankruptcy filings. Between January and December 2007, 7,740 requests for bankruptcies were registered, whereas for the same period during the previous year there were only 5,425,481 commercial bankruptcies show a 70% increase over the 283 bankruptcies of 2006. The five types of businesses with the greatest amount of bankruptcies were: construction contractors (39); cafeterias (29); restaurants (27); clothing stores (24) and mechanics (17).


Pueblos con Más Radicaciones
San Juan Mayagüez
Carolina Arecibo
Ponce Bayamón
Caguas Toa Alta



Negocios con más radicaciones
Contratista de Construcción 39
Cafetería 29
Restaurante 27
Tienda de Ropa 24
Mecánicos 17
Salón de Bellaza 16
Panaderías 15
Doctores en Medicina 15
Agricultores 15


According to information compiled by the Bankruptcy Courts, the total accumulated debt added up to $1.3 billion dollars, which represents a 94% increase over December 2006’s $671 million. Consumer requests increased 66% for a total of $734 million, and commercial bankruptcies increased 153% for a total of $583 million. There were a total of 84,066 defaulting debtors in 2007, 60% more than in 2006, when there were 52,543.

Manufacturing

In the Manufacturing sector, downsizing and closures, and the controversy over the Tax Incentive Law, prevailed over the sector’s agenda in 2007. Up until September 2007 there were 23 closings or significant downsizing events, of which eight were in the pharmaceutical industry. These events caused the dismissal of 2,343 employees, of whom 845 were in the pharmaceutical industry. Some of the reasons for this decrease include reconstruction, reductions in sales and transfer of operations to other parts of the world, among others. One of the municipalities most affected by the downturn is Cidra, whose Mayor will see himself forced to restructure the municipal budget after losing nearly $5 million dollars in patent income after the Ivax, Ciba Vision, Millipore and Glaxo operations left the county.

After several months of bitter controversy between the House of Representatives and the private sector, a compromise was reached which establishes that the new Tax Incentive Law must be approved by the House on or before the 15th of May 2008 and in the Senate on or before the 25th of May. If some discrepancy were to arise between the House and the Senate, then a Conference Committee must decide the outcome before May 31st. Not renewing or approving the new statute would mean the loss of 96,000 direct and indirect jobs, and an economic loss of $2.9 billion in income and wages.

Interest rates

As a result of the stock market volatility, the Federal Reserve announced a new interest rate cut to 3.50 %. They also trimmed the discount rate to banks down to 4.0%. The Fed cut occurred little more than a month away from the December 11th 2007 cut of 4.25%, and a discount rate of 4.75%. This cut was particularly unexpected because it happened between meetings. It is the first time since September 2001 that the Federal Reserve has lowered the interest rate in between its regular meetings.

Perspectives by Economic Sector

The Retail industry will benefit from lower interest rates, and will see modest gains of 2% to 2.5%. The Banking sector will be negatively affected by the erosion in economic activity. The consolidation trend will continue, so there will be fewer brands of banks on the island. The banks will see some relief from lower interest rates. The Construction sector should recover somewhat, as the approved credits are stimulating consumers. Lower interest rates are also favorable for the sector. In Manufacturing, the approval of a new Tax Incentives Law will determine their future, and the development of the Pharmaceutical industry will be a determining factor. China and the Asian nations will continue to instill competitive pressure on this sector. The Services sector will continue to be an important sector of the economy. Businesses such as insurance, advertising, marketing, and legal services will continue their strong presence.
Retail

Winners and Losers

Winners
• Pharmacies (9.7%)
• Meat and Fish stores (9.3%)
• Variety Stores (8.3%)
• Food retailers (7.3%)
• Office Equipment and Toy retailers (7.1%)
• Gasoline Stations (6.1%)
• Other General Stores (4.4%)

Losers
• Electronic retailers (radios, tv’s, pc’s) (-17.8%)
• Jewelers (-12.2%)
• Women’s Clothing (-10.8%)
• Motor Vehicles (-10.5%)
• Construction Materials (-7%)
• Shoe Stores (-5.2%)
• Men’s Clothing (-5.2%)


Automotive



Banking


Projected Growth


BPR: So we are in a recession and prices have gone up; there’s been a marked increase in bankruptcies, so we know that people are feeling the pinch; the government cannot keep spending money they way they have, many people have left the island to find work elsewhere, and the private sector lost jobs that are going to be hard to replace. What can be done?

VG: I suggest the following measures for overcoming the recession:
• lowering taxes,
• lowering costs,
• approving the new Tax Incentives Law,
• joining CAFTA and other regional markets,
• reducing welfare benefits,
• strengthening the local private sector,
• retaining and developing the local manufacturing sector
• developing an alternative energy investment program

BPR: Lowering taxes will ease the burden a little bit, but will also lessen the government coffers. GV: There is excessive spending right now, and there comes a point where you cannot ask for more taxes or the economy will suffer. High taxes are a disincentive for people that work as well as for private industry, so it lessens the amount of people that are looking to start a new business and for people that want to get off welfare.

BPR: Lowering costs sounds idyllic, but with the new IVU tax, any drop in price is not going to have much of an impact for the consumer.
GV: That’s right. There has to be a breathing space for the economy to catch up, so that the new salaries translate into disposable income which generates new sales, and is invested in productive activities.

BPR: Approving a new tax incentive law might attract foreign investment, but if it is not broadened so the benefits also include local businesses, the situation will improve only marginally.
GV: Absolutely. We have to balance the needs of foreign investors as well as local merchants, and give them both the incentives they need.

BPR: Joining CAFTA sounds reasonable, but we would also have to be very careful not to step into the “race to the bottom”, with low salaries and cheap products; shouldn’t we strengthen our local private sector and extend it to include more micro-businesses, as well as embrace doing business on the web?
GV: Yes, and the way to do that is to identify those industries that are best suited to exporting, and help those out first. For example, the service industry, professional services, banking, construction, architecture, technology. Right now there are several local companies that are doing just that. They have started projects in the Dominican Republic and Costa Rica, and are opening up their markets outside Puerto Rico.

BPR: As to reducing welfare benefits, you suggest that measure as a way of moving the 50% of our population that is chronically unemployed to either start businesses of their own or find employment somewhere. But if there are no adequate private sector jobs, and not enough of them to fill the demand, how will cutting their benefits work?

GV: I understand that there are not enough jobs and not the right kind of jobs to fill the gap right now. But we must start somewhere. We must use every tool at our disposal to educate the community as to what needs to be done and how it is going to happen, and this is politically very risky, because it is taking away a measure of security that the government has given the citizenry for many years. But it must be done, because right now there is simply no incentive for them to get off welfare. We are late arriving to this game. We should have done this a long time ago. So it is even more important to do it now and do it as fast as we can. There are some technological gaps, for example, many people might be able to use the internet to form their own businesses, but to use the internet, you need to know a little English, and a bit about computers, so there is a gap between what people can do and the needs that this new economy has. The government has to make sure that they help close these loopholes, and help get our people involved. Also, we have to change all these things at once. Doing a little at a time will not work. We must strengthen the private sector and develop a thriving local manufacturing base: one part that builds things we consume here, while at the same time helping those companies that are already set up for it, to export their wares and open markets abroad. And creating our own energy from alternative sources like wind and solar power will take away our dependence on fossil fuels, and keep a large percentage of our money inside the island budget, as opposed to giving it to foreign oil companies.

BPR: Finally, new technologies are supplanting old ways of doing business as a reaction to the groundswell of grassroots interest in healthier food, healthier transportation, healthier lifestyles, manageable waste disposal and alternative energy sources. I realize that with the economic situation so hard right now, it’s a little naïve to hope that we immediately go into using green accounting (counting the social and environmental costs of our business actions). But shouldn’t we try to start acting on these opportunities, making the challenges into victories?

GV: Yes, and we should start with producing our own renewable energy and recycling our wastes. We are one of the countries in the world with the least amount of recycling being done, and, because of our limited size, we are a country that really needs to recycle. Landfills are closing, and we are running out of room for landfills. So we need to recycle and reuse: start a secondary market for all things recycled. As far as industry is concerned, there are gains to be had by using recycled materials. Also, there is great opportunity in alternative sources of energy, like wind and solar. These are great opportunities for local businessmen to start a new business. Another interesting idea is creating financial mechanisms that fund environmental businesses. Merril Lynch has a capital fund oriented toward green businesses, just as Dow Jones has the Environmental Index, and Vinod Khosla invests his venture capital in green businesses. The new Incentives Law should incorporate green incentives, to help new local businesses as well as established companies go green.