ONCE known for its pristine beaches and balmy weather, Puerto Rico, an island of 3.5m people, is today more often associated with financial woe. Almost half of its residents live below the poverty line. Its unemployment rate is around 12%, more than twice the American national average. More than 200 Puerto Ricans migrate to the mainland every day. After a decade-long recession, the government has racked up $72 billion in debt, which its governor Alejandro García Padilla says is “unpayable”. On May 2nd the American territory defaulted on a debt payment of $422m. How did this happen? The island’s troubles have their origin in an era of corporate tax incentives in the 1970s that exempted firms from paying federal taxes on profits earned in Puerto Rico. This was done to prevent tax-allergic American companies from setting up shop outside the country. Pharmaceutical, textile and electronics companies flocked to the island to spark a manufacturing boom that lasted for around two decades. In 1996, the American government, under the Clinton administration, started weaning Puerto Rico off these tax breaks to offset some of the country’s federal deficit. The largesse disappeared entirely in 2006 and its economy has suffered since. The Puerto Rico government continued to borrow recklessly to balance its budget by issuing bonds that are exempt from state, local and federal taxes in America. Investors lapped them up. The bubble burst in February 2014 when three leading credit-rating agencies downgraded the island’s debt to junk. This kicked in “acceleration clauses”; debt that would otherwise have been due in years became payable within days.

Puerto Rico’s awkward position as an “unincorporated territory” and not a “state” means that it cannot abrogate its central government debt without getting sued in federal court. Neither does it qualify for Chapter 9 bankruptcy protection. Since it is not a sovereign country, it cannot seek help from the International Monetary Fund. As it does not control its money supply, it cannot print money to finance its budget shortfall. Puerto Rico’s creditors include hardy hedge funds that own around a third of the island’s securities. Far from agreeing to cut a deal, last year a group of billionaire hedge-fund managers called for laying off teachers and closing down schools to recover some of the island’s debt. The government also owes $13 billion worth of “general-obligation" bonds protected by a clause in the constitution that guarantees their holders first claim on tax revenues.

The island needs rescuing. Its Government Development Bank has been operating on emergency footing since April 9th. Its biggest retirement programme has just about enough funds to cover 0.7% of future obligations. Last year the cash-strapped government responded by raising the sales tax from 7% to 11.5%, the highest in America. Puerto Ricans pay three times as much for water and electricity as those on the mainland. Even hospitals have struggled to keep their lights on. Any more austerity will drive the island deeper into recession. Puerto Rico needs a scalping of a “haircut” (debt write-down) on its $72 billion debt, to be followed by painful reforms and spending cuts. This week Congress will debate a bill that proposes to set up a federal control board to restructure the island’s debts. The clock is ticking; another $2 billion will be due in July.