Restoring Economic Growth in Puerto Rico

Proposing Solutions

There are about eight million Puerto Ricans living in the world; half of them living in the United States of America and half of them living in the Island of Puerto Rico. Puerto Ricans are the second largest Hispanic community in the United States, second only to Mexicans.

Being one of the largest economies in Latin America, Puerto Rico has more population and a larger economy than Panama, Uruguay and Costa Rica—yet the Island struggles to define its economic and political place in the world. It is a puzzle how it is possible that the Puerto Rican economy has reached a stalemate. The latest figures, in fact, show a negative growth in the last two years (well before the U.S. housing slump began in 2007) for the first time in decades. The dire circumstances of the Puerto Rican economy have created and unprecedented scale of brain drain to the United States. As the successful economic development experiences in Singapore and Ireland show, and more recently those of India and China, we know that a ready access to talent is a fundamental component of growth.

At the moment, there are more than 50 graduate and undergraduate Puerto Rican students at Harvard-MIT who want to improve Puerto Rico’s economy and make a difference in the world. They believe that the only way to move forward with the Island’s economic development is by taking charge and assume the responsibilities that leadership entails.

Thus, more than 100 students from more than 25 universities from Puerto Rico and the continental United States gathered at Harvard University in April 2007, to participate in the conference “Restoring Economic Growth in Puerto Rico: Proposing Solutions,” convened by the Harvard-MIT Puerto Rican Caucus. The conference aimed to create links between the present leaders in Puerto Rico and its future leaders to propose solutions and become agents of change.

The Harvard-MIT Puerto Rican Caucus seeks:

• To propose concrete, innovative and fresh solutions to the Island’s problems and go the extra mile to improve the livelihood of the Island and its future prospects.
• To allow students to make their own contributions in jumpstarting the Puerto Rican economy and restoring growth.
• To show both Island and Mainland Puerto Ricans the importance of rejecting complacency and taking action to improve Puerto Rico.

 

About the Conference

The conference featured eight panels and five keynote speakers, including Richard Carrion, CEO and Chairman of Popular Inc. (NASDAQ: BPOP); Antonio García Padilla, president of the University of Puerto Rico; and Hon. Federico Hernández Denton, Chief Justice of the Supreme Court in Puerto Rico. The eight panels ranged from Economy, Finance, Entrepreneurship, Education, Biotechnology and the Pharmaceutical Industry, Health Enterprises, Sustainable Development, to Branding Puerto Rico. The panelists emphasized the importance of reinforcing those aspects of the economy that have been effective, such as the pharmaceutical industry, and reforming those that have proven inadequate, such as the quality of the educational system, the government’s transparency and a set of incentives more global in nature.

The panelists proposed solutions centered on the necessity of a personal commitment to excellence and on motivating Puerto Rican students studying outside of the Island to return home in order to work and to contribute through entrepreneurship initiatives in the public and private sectors. Entrepreneurs emphasized the economic power inherent in the creation of new enterprises both as an economic boost and as a source of employment, since the number of male workers in the island is one of the lowest in the world. It is also essential to increase the amount of resources invested in knowledge creation, and improve the quality of education and training. Puerto Rico’s greatest challenge today is not necessarily the acquisition of more capital and human resources, but their optimal utilization.

 

The Future of Puerto Rico

All of the Puerto Rican leaders, who attended the conference on April, 2007 spoke to us about the importance that young people mobilize to take action in favor of the Island. In fact, many of these leaders asked us to take the Conference to Puerto Rico in 2008. The Harvard-MIT Puerto Rican Caucus is also enthusiastic to report that the University of Puerto Rico students (a system of more than 60,000 students) have joined the Harvard-MIT Puerto Rican Caucus to build a conference in 2008 in San Juan, Puerto Rico. We have joined forces for this year to create Mentes Puertorriqueñas en Acción (Puerto Rican Minds in Action) as a tool to promote mobilization and change among the Puerto Rican student population in Puerto Rico and abroad.

 

About This Article

This article highlights a few of the presentations of the conference speakers. They present an overview of the situation in the island while presenting the speaker’s personal beliefs concerning the best solutions to some of the problems.

 

About The Harvard-MIT Puerto Rican Caucus

The Harvard-MIT Puerto Rican Caucus is a group of Puerto Rican undergraduate and graduate students and alums from Harvard and MIT committed to improving the quality of life in Puerto Rico. For more information, please go towww.harvardmitcaucus.com. Ana Franco (Harvard B.A. ’10), Israel Figueroa (B.A. ’09), Maria Fernanda Levis (Harvard M.P.A.’07, M.P.H. ‘08, Carmen Oquendo-Villar (Harvard Ph.D.’ 07), G. Antonio Sosa-Pascual (MIT Sloan M.B.A. ’08), Michelle Quiles (Harvard B.A. ’10) and Juan Villeta (MIT B.S. ’10) contributed to this article. We would also like to thank all the students who contributed to making this effort a reality and all our strategic partners, in particular the Center for the New Economy in Puerto Rico, La Organizacion de Puertorriquenos de Harvard (La O) and the Association of Puerto Rican Students at MIT (APR). We would like to give special thanks to our Co-Founders, including Luis Martinez, former President of La O at Harvard and Katia Acosta, former President of APR at MIT for their unconditional support and vision.

 

The “Rich Uncle” Syndrome

An Analysis by Richard Freeman

Germany and Puerto Rico may not have a lot of similarities, but there is a part of Germany that looks just like Puerto Rico: East Germany. Southern Italy also looks just like Puerto Rico in terms of labor force participation and some other problems. East Germany has been bailed out by West Germany. Southern Italy has been bailed out by the successful northern Italy. Puerto Rico, on the other hand, has been somewhat bailed out by the United States. Part of this is what Richard Freeman has called “having the rich uncle” syndrome. The rich uncle is very nice to you in some ways, but in other ways, what the rich uncle does is destroying employment, among other things.

In East Germany, they also have higher capital-labor ratios than the rich uncle has in the mainland because that is where all the big investments are in these very capital-intensive sectors. What the rich uncle has done is to give incentives for people to invest in the eastern part of Germany, so people put in very capital-intensive things. The positive aspect of this crisis is that this is not a Puerto Rican-specific crisis. This is a general economic phenomenon that we see in other places in the world.

The parallel between Puerto Rico and Germany is also on the migration side. There is free migration between East and West Germany and between Puerto Rico and the mainland. That has both positive and negative consequences. Many people can come to New York and elsewhere and make higher earnings than they could make back on the island. If one did a different calculation about Puerto Rico, you could re-calculate the GNP or GNI based on the income accruing not to the island, but to people who were born on the island. Everything then would look much better.

There are other ways in which this rich uncle phenomenon operates. One is that Puerto Rico has the United States minimum wage and there are now discussions about raising it. One of the reasons to raise it is because of poverty, but the current US minimum wage applied in Puerto Rico is obviously a very high minimum wage for a place that has lower incomes. Second, many people are on benefit programs where a certain amount of the funding comes from the mainland. As in the German situation, Puerto Rico has also imported its patterns of trade and it is the rich uncle who has established the comparative advantage. The only way in which one is going to break this is to pick the good parts of the rich uncle, but not buy into the other parts that can be debilitating to the economy.

 

Puerto Rico’s Advantages

Puerto Rico has a couple of advantages. One of them is that it is very small. If you look at Sweden, Sweden had a crisis ten years ago which was as bad as or worse than Puerto Rico. They had a fiscal crisis and a complete meltdown, which was a major disaster. Like Puerto Rico, Sweden has a large government sector but as Ericsson (a major firm in Sweden) did better, Sweden also did better. Puerto Rico may just need one sector, one large growing firm. The creation of 300,000 jobs would turn the island around. That is only a few blocks in Beijing or Mumbai; this is not turning around a billion people and moving a huge thing. Another country that has dealt with this kind of situation was Ireland, which was a disaster case in the 1970s. They had the worst unemployment rate and they also had the rich uncle phenomenon. There has always been a free open border between Ireland and the United Kingdom. Ireland was a place where everybody was leaving and the notion that it would become a great success was just ridiculous.

The striking thing from most of these small country comparisons, be it the Scandinavians or the Irish, is that they have incredibly efficient governments. Ireland has a low share of workers in the government sector, whereas Puerto Rico has an extraordinarily large share of people in the government sector. The Scandinavians managed to bring about an efficient government sector so it did not become a drag on the economy. When they had their crisis in the mid-90s, they cut benefits and let people off. They really squeezed their public sector and managed to pull themselves to where they are now. They have about a 10% unemployment rate, but they had very good growth over a period of time.

Puerto Rico has another advantage: having so many people in the United States. It has a natural constituency or group that should be extremely helpful. I do not know how many among the students will go back to the island or how many will in fact live in the States, but wherever one does it, one has to think of ways to establish economic connections. This has been the case of the Indian immigrants who came to the United States. A total of 1/10 of 1% of the Indian population now lives in the States and they earn 10% of the GDP of India. They have been doing a good job of sending businesses back to India.

If the government is ineffective and not functional, then who will be the doers? I am a little dubious of the finance sector because I keep thinking of them as those who smoke big cigars and make lots of money, and those are not normal people. The government can take a lead in implementing an industrial policy, but it needs some serious planning, as well as some group of leaders who are able to take the lead and all you need is just one kick.

Richard B. Freedman is the Herbert Ascherman Professor of Economics at Harvard University and a collaborator on the Center for the New Economy’s book The Economy of Puerto Rico: Restoring Growth. Freedman is also Senior Research Fellow on Labour Markets at the Centre for Economic Performance of the London School of Economics.

 

Manufacturing Powerhouse

An Analysis by Antonio García Padilla

Puerto Rico’s present ascendancy as a manufacturing powerhouse arose from United States tax incentive strategies favoring corporate investment and job growth. Today, Puerto Rico is struggling to make the transition from a manufacturing powerhouse into an R&D powerhouse. Can Puerto Rico shift its development emphasis to both generate its own Research and Development (R&D) and attract outside firms to locate there? What steps should Puerto Rico take to strengthen university research capabilities? What kind of tax incentive strategies should it design to promote R&D at a large scale? How can we attract back world-renowned researchers of Puerto Rican descent, Hispanics and other nationalities?

 

Keynote Address Summary

For several generations of Puerto Ricans, Congress has had the responsibility of taking care of Puerto Rico’s economic well-being. Its focus was on maintaining section 936 in the Internal Revenue Code of the United States, which has been the Rosetta Stone of our development strategy.

Section 936 has become much more than just a favorable federal tax treatment for corporate income generated in Puerto Rico. Because of it, the tax departments of many United States corporations became the main promoters of Puerto Rico as a manufacturing center. However, the environment has changed. Our development strategy will no longer be federally codified. The fight is no longer in Congress; the fight is in our hands now.

Puerto Rico based its strategic moves on economic development and made the investments necessary to accomplish its objectives. Since the 936 days, Puerto Rico has had an industrial base in the life sciences. The University of Puerto Rico receives 18-20,000 admission applications yearly, with 40 % for science and engineering programs—twice the percentage of U.S. science and engineering applications. These are the vocational aspirations of our people, which are in line with the needs of our industrial base.

One third of our GNP is produced by the pharmaceutical industry. Puerto Ricans have developed high-level skills in drug manufacturing, allowing us to host a pharmaceutical industry of a density unrivaled in the world. More than forty companies operate in the commonwealth, creating more than 26,000 high-paying direct jobs and contributing another 50,000 jobs indirectly. Three quarters of the twenty top-selling prescription drugs in the United States are manufactured in Puerto Rico.

 

Moving-Up The Value Chain

However, manufacturing alone will not secure our economic success. We will be facing increasing competition from Asia and Latin America in the coming years. China and India will be capable of manufacturing drugs with our level of proficiency and at lower costs. Thus, we need to move up the value chain of our industrial base. Puerto Rico must utilize its trained people not only to manufacture, but also to research, design, develop and test products. We should play a role in scientific discovery.

The United States National Academies conducted a survey that examines the factors affecting a company’s decision when choosing where to locate R&D activities. The conclusion was that companies locating R&D in emerging economies are attracted to high market growth potential, high-quality R&D personnel, a high level of university faculty expertise and ease of collaboration with universities. Companies locating in developed economies are attracted to high-quality R&D personnel, good intellectual property protection, a high level of university faculty expertise, and ease of collaboration with universities. Hence, universities and their people are important for both emerging and developed countries, but more so for the latter.

 

Providing A Scientific Environment For R&D

We must strengthen university research capabilities in order to make Puerto Rico more attractive to R&D investments. Knowledge innovations are best achieved when and where creative people come together. Creative people attract one another and the benefits that flow from these creative interactions spill over to society as a whole. This is why we have exerted efforts to attract world-renowned researchers to lead and to further the recruitment of world-class talent.

This effort must include incentives in order to allow Puerto Rico to become as competitive as possible in terms of costs. But how can we revamp our incentive structures to support the new R&D agenda? Puerto Rico’s incentive structures, designed to attract manufacturing in order for Puerto Rico to become a world-class manufacturing center, achieved their goal. Manufacturing centers are profit centers; manufacturing comes at the end of the creation line, when profits are realized. In order to attract manufacturing, Puerto Rico exempts profits from taxation. However, R&D is different. R&D in itself does not generate profits. R&D centers are not profit centers; R&D centers are cost centers or investment centers.

The tax incentives that we now offer are irrelevant to attracting R&D to Puerto Rico. We must strengthen our appeal to researchers and direct our tax incentives to this area. We must grant exemptions to the personal income of highly competitive researchers and grant tax credits to companies doing research in Puerto Rico. Now that Puerto Rico has moved its state income taxation to the taxing of consumption, this makes more sense.

In the 1960s and 1970s, we heard a lot about Puerto Rico becoming the bridge between the two Americas. We were talking then about orienting our economy to the service sector. That opportunity was lost: Florida became the provider of health, support, education, entertainment, and many other services to Latin America. As we approach our current challenges, the outcome is going to be different. The difference stems from the fact that Puerto Rico’s agenda is not only the agenda of government, nor exclusively the agenda of universities, but the agenda of the young people.

Antonio García Padilla has been the president of the University of Puerto Rico since 2001. He received his undergraduate degree and his law degree from the University of Puerto Rico before completing an LL.M. from Yale Law School. In 1999, he was elected to the Council of the American Law Institute.

 

The Puerto Rican Banking System

An Analysis by Arturo Carrión

The financial sector in Puerto Rico is one of the backbones of economic development. The size and sophistication of the financial sector in Puerto Rico offers a competitive advantage that must be adequately leveraged as Puerto Rico moves forward and out of its current economic crisis.

From 1996 to 2006, growth in financial assets was tremendous, from $31 billion to close to $100 billion. There was a slight decrease last year, but that was mainly due to a restructuring of the asset base. In terms of loans, the growth was impressive, despite some sectors saying that the Puerto Rico banking system has emphasized investments in securities more than in loans. If you look at the loan product comparison, we have commercial, industrial, construction, and conventional lending, which have been growing the most. From $16 billion in 2000, real estate-backed lending has increased up to almost $50 billion. Back in 1996, we had a smaller amount of loans than of deposits, but in the last three years, loans have exceeded total deposits. This does not take into account the so-called broker deposits, which have been financing a great deal of our lending activity. The Puerto Rico banking industry has shown a great commitment to the Puerto Rican economy in terms of financing its economic demands and activities.

Deposit growth has grown steadily in the last two or three years, and this is mainly because of the lack of incentives for local or core-based deposits. For the core deposits, the Puerto Rico Bankers Association has now introduced a bill in the local legislature to bring down the income tax that should be charged to the interest received on interest-bearing deposits. We expect that bill to be approved by the end of this legislative session.

We have engaged in a local media campaign where we are emphasizing the importance of financial planning, the maintenance of good credit records, good saving habits. This campaign has been going on for the last four months and it has been a complete success. We trust that when the legislation is finally approved, we can engage in a more aggressive bank-by-bank campaign.

Capital is also a very important part of the Puerto Rican economy, having grown from $2.3 billion in 1996 to $6.5 billion in 2006. This is very important because one of the main sources of capital is retained earnings. And retained earnings are those profits that are retained in the Puerto Rican economy by our local banking system. The leverage is 10 to 1, which means that for every dollar of capital, we can create $10 in loans.

Besides the deposit and lending functions, banks in Puerto Rico play a very important part in the island’s financial infrastructure. Puerto Rico has one of the most efficient financial infrastructures in the hemisphere. We have 550 branches, 1400 automatic teller machines, and 47,000 point-of-sale terminals.

In terms of the number of transactions and items, in volume, by the clearing house, the number of local checks in 1999 was 70 million and, in 2006, it was 58 million. That means we are processing fewer local checks. The dollar amount of those checks, however, increased from $84 billion to $94 billion, which means that the process is much more efficient. Our banks have strongly promoted debit transactions and direct deposits to try to get banking operations to be more efficient.

The banking infrastructure is as vital for the Puerto Rican economy as water resources, electricity, and communications. We are emphasizing not only traditional deposit and lending functions, but the infrastructure as well. A recent analysis performed by our economists indicates that bank loans in Puerto Rico contribute nearly 90% to the national gross product. Almost 75% of commercial loans are for less than $250,000, meaning that credit is available to all sectors of the Puerto Rican economy.

In conclusion, our commercial banks continue to provide the necessary financing so that our economy continues to be vigorous in an extremely competitive global market. It has also been able to stay at the forefront of the most modern technologies. We are ready to continue participating in the economic development of Puerto Rico and we welcome the contribution our young people will have to our economy in the near future.

Arturo Carrión is the Executive Vice-President of the Puerto Rico Bankers Association, a non-profit organization dedicated to the representation of commercial bankers in Puerto Rico in governmental, legislative, and executive forums.

 

Pharmaceutical Manufacturing: Key to Economic Growth

An Analysis by Daneris Fernández

The pharmaceutical industry of Puerto Rico was established almost 40 years ago, when there was no knowledge base and no infrastructure. Forty years later, the pharmaceutical industry has become one of the key elements in Puerto Rico’s economic success. Global pharmaceutical manufacturing has not grown as it has in the past, but it definitely is not dead. The pharmaceutical industry remains a growing industry.

The pharmaceutical industry represents an important segment of Puerto Rico’s economy. Pharmaceutical manufacturing, specifically, represents:

• 24% of the GDP
• 60% of exports, or $36 billion
• 45% of imports, or $14 billion
• 50% of corporate taxes
• 25.5% of employment in manufacturing, or 30,000 jobs and more than 100,000 indirect jobs

Fourteen out of the top 20 pharmaceutical products are sourced from Puerto Rico and that represents a lot of income. Out of those 14 products, 11 will lose their patents within the next couple of years. We will have to replace those products so that we can continue to generate revenues for the island. Two companies have already lost $10 billion worth of sales. Fortunately, we have replaced those with biotech investments, so that it is netting off to zero. However, because we have to attract investment, it does not mean that the Puerto Rico government will keep receiving equivalent revenue from the pharmaceutical industry. It is therefore a huge challenge for the Puerto Rican economy to attract business and to keep growing, while facing the need to be competitive in a global market.

 

Critical Issues In The Pharmaceutical Industry

Research has been very challenging. R&D costs have been increasing. Success rates have gone down considerably. We see global over-capacity, lower return on investment, and forced cost reductions.

Fewer products are going to be reaching the blockbuster criteria—the billion-dollar drugs. Most of the companies are working on the same therapeutic areas. The times when we had an exclusive product for three to four years is gone. The structure of the pharmaceutical industry and what we do in Puerto Rico needs to change; there will be a lot of challenges. A lot of money will be required to develop drugs that are truly differentiated and those that will meet medical needs because that is the only way anyone will survive in the market.

One particular phenomenon in the pharmaceutical industry in Puerto Rico is that while everything was moving because of our tax structure, a lot of the technology that is required for the new drug platforms did not get to Puerto Rico. This is because we have labor-intensive requirements to operate in the island; hence, all the technology and all the knowledge around that technology were installed and created in other jurisdictions.

We have built a strong infrastructure. We also have the knowledge base for chemical and pharmaceutical operations, but is it focused on the right technology? Do we have the right knowledge base so that we can compete in the market in the future? That is the biggest challenge. We need to bring the knowledge to the island so that we can compete and can prove to our companies that there is a good reason to invest in Puerto Rico. It is not solely about the taxes or the tax breaks anymore, but we do need to keep those; otherwise, we will lose our competitive edge. We need to make sure that those incentives are still there, but we also need to understand that we need to create the knowledge base.

 

Achieving Global Competitiveness

We need to focus and change the way we have been approaching the industry. Instead of focusing only on manufacturing, we have to expand that and look at the whole supply chain; we have to move toward an end-to-end approach for the business. We also have to promote research and development activities in Puerto Rico through tax incentives. Companies should be able to get funds for some of their research and development work, and that should be incorporated in the process so we could create a critical mass of scientists who would go into research and development, expanding our supply capabilities.

With regard to marketing, we have to find a way to be able to export to Latin America. Most of our exports go to the United States. There is no reason for that. We need to be more competitive and make sure that we can provide services not only to the United States, but also to the rest of Latin America. We also need to assume leadership in emerging drug development platforms.

Further, we have to look at our cost structure. Two issues figure in cost structure: energy and payroll. In tackling the issue of energy cost, we have to stop the dependence on oil or look for ways to reduce that dependence. And, this does not mean that the government has to invest in creating the infrastructure; there are people who are willing to invest in it.

 

Opportunities For Growth

Puerto Rico has to set its economic development priorities in areas for which it has proven expertise and high potential. For this, we must:

• Identify a limited number of high-technology and high-productivity niches that maximize our present capabilities.
• Capitalize on the healthcare industry and related sectors (biotechnology, medical devices, scientific instruments, and electronics) and expand beyond manufacturing.
• Increase knowledge-based investment models to replace labor-intensive operations with high-technology, high-salaried, capital-intensive operations.
• Promote clinical research and development to strengthen scientific research capabilities.
• Make the best of our geographical and cultural assets to better serve emerging regional and global markets with our enhanced capabilities.
• Last but not least, we must change our complacent mindset in order to make way for a competitive culture. We have lost our ability to compete, so we have to build that back. This is one of the things we need to bring back to Puerto Rico—the true belief that we can compete in a global market.