Economic Analysis - Recession To Remain As Consumption Continues To Weaken - JUNE 2014


BMI View: W e expect recessionary conditions in Puerto Rico to prevail through f iscal y ear 2015 at least, as declining household spending, driven by weak labour market dynamics, will continue to weigh on overall economic activit y. In addition, as the government attempts to improve a precarious debt position, fiscal pressures will drive authorities to cut back on spending, further hampering private consumption.

We forecast real GNP in Puerto Rico to contract by 2.1% in fiscal year (FY) 2014 (July 2013 - June 2014) and also fall by 1.0% in FY2015, compared to an estimated 0.3% contraction in FY2013. The commonwealth economy has been in a recession since FY2007, except for a brief period of growth in FY2012, when headline growth came in at 0.2%, and we do not expect a significant improvement in the coming years. Indeed, structural deficiencies in the labour market will continue to lead to sluggish private consumption levels at best, which will discourage fixed investment. Moreover, a challenging fiscal position, with low tax revenue growth and high levels of debt, will prompt the government to continue implementing austerity measures as it seeks to avoid restructuring its bond obligations, which will further constrain household spending.

Still A Long Way Out Of The Recession
Puerto Rico - Economic Activity Index

Weak Economic Activity Suggests Recession Still Has Legs

Ongoing contractions in the Economic Activity Index (EAI), which tracks real GNP growth closely, represents the first clear sign that Puerto Rico remains deep in a recession. In the first eight months of FY2014 (July 2013 to February 2014), the EAI contracted by 3.8% year-on-year (y-o-y) on average, down from a 1.1% y-o-y average expansion during the same period of the previous fiscal year. Economic activity has been weak across most sectors of the economy. For instance, retail sales expanded by only 0.1% y-o-y on average during the referred period, down from an average 1.6% y-o-y in the same period of the previous year, reaffirming our expectations for private consumption to remain subdued in the coming years. Also, turning to the construction sector, cement sales contracted by 12.1% y-o-y on average during the first eight months of FY 2014, a deterioration from the 3.1% y-o-y average decline seen a year prior. We expect the construction sector to continue to face significant challenges as ongoing recessionary conditions continue to discourage fixed investment.

Labour Market Will Take Years To Recover

One of the main reasons we expect the economy to remain in a recession for the next couple of years, and then see only sluggish growth at best, is a highly uncompetitive labour market. Indeed, Puerto Rico's minimum wage ranges between US$4.10 and US$7.25 per hour depending on the industry, which is significantly higher than the commonwealth's Caribbean peers. High wages, combined with an expiration of a tax benefit for manufacturers, has seen a significant number of pharmaceutical firms, which used to be a key sector for employment growth, leave Puerto Rico. As a result, unemployment has averaged above 14.0% in recent years, compared to below 10.0% before the 2007 recession, which has been a main driver of weak household spending. Moreover, the labour force participation rate has fallen from 48.0% in 2007 to nearly 40.0% this year, and outdated skills in the workforce will further contribute to the labour market's low levels of competitiveness. Exacerbating the issue is a significant amount of emigration due to lack of employment opportunities in the commonwealth, which has seen the labour force shrink by 0.7% since 2007, and will further weigh on economic activity in the coming years.

Low Participation Rates Point To Protracted High Unemployment Rates
Puerto Rico - Labour Force Participation Rate And Unemployment Rate

Fiscal Pressures Add Further Downside To Economic Activity

Weak economic activity has weighed on tax revenue growth, which has prompted several credit rating downgrades by major credit agencies in recent years, challenging the sustainability of Puerto Rico's debt position, and increasing pressure for additional austerity measures. Indeed, relatively low tax intakes has seen the Puerto Rican government finance current government operations with newly-issued debt at rising borrowing costs, and has made it increasingly difficult to meet bond payments. While we see declining risks of a technical default within the next couple of years due to a recent bond issuance that increased the government's liquidity, ( see 'Successful Debt Issuance Significantly Lower s Risk Of Default', March 19), the government will likely adopt additional austerity measures to ensure the commonwealth maintains much-needed access to capital markets. The government has already taken steps such as increasing the retirement age and mandatory pension contributions, and implemented tax hikes on consumption. We expect these measures, combined with additional fiscal prudence in the coming years, to further constrain household spending and weigh on overall economic activity growth.