ALTHOUGH investors are now less jittery about a possible default by the American Treasury, they are rightly still nervous about a drama unfolding in the market for state and local debt. Since May, yields on bonds issued by Puerto Rico, a self-governing American territory, have shot up to between 8% and 10%, despite their (barely) investment-grade rating and tax-exempt interest.

Puerto Rico carries outsized importance in America’s almost $4 trillion municipal-debt market, which includes bonds issued by states and other local authorities as well as by cities. The island’s current debt, between $52 billion and $70 billion (depending on how it is measured), is the third-largest behind California’s and New York’s, despite a far smaller and poorer population. In America’s 50 states the average ratio of state debt to personal income is 3.4%. Moody’s, a ratings agency, puts Puerto Rico’s tax-supported debt at an eye-watering 89% (see chart).

Puerto Rico’s debt has long been a staple of American municipal-bond funds because of its high yields and its exemption from federal and local taxes—of particular appeal to investors in high-tax states. That let Puerto Rico keep borrowing despite its shaky economic and financial condition, until Detroit’s bankruptcy in July alerted investors to the threat of default by other governments in similar penury.

America won control of Puerto Rico in the Spanish-American war of 1898. Its people have American citizenship and receive American government pensions, but pay no federal tax on their local income.

The economy has big structural problems. Participation in the labour force, at 41%, is some 20 percentage points below America’s. The island has the federal minimum wage, even though local productivity and incomes are far lower than in the rest of America, creating a strong disincentive to hire. Inflated benefit payments, for disability for instance, discourage work. Moody’s Analytics reckons the territory’s bloated public sector accounts for 20% of employment, compared with 3.7% for the average state (though it provides some services that the federal government would on the mainland). Growth and investment are hampered by bureaucracy, stunted infrastructure and crime.

Shrinking, sinking

Puerto Rico has been in recession virtually since 2006, when a federal tax break for corporate income expired, prompting many businesses to leave. As Puerto Ricans with prospects emigrate, the remaining population has aged and shrunk. The government has run budget deficits (prohibited for states) for the past decade, averaging 2.5% of GDP from 2009 to 2012. Its pension fund is only 7% funded, which is abysmal even by the standards of other American states and territories.

The current administration has sought to shore up its finances by increasing taxes by $1.1 billion (about 1% of GDP) and raising the retirement age for government employees, as well as the share of their salaries they contribute to their pensions. It has promised to wipe out its budget deficit, projected at $820m this fiscal year, by 2016.

Such austerity could further hobble growth, making it harder to shrink debt ratios. Luis Fortuño, the previous governor, lost his job last year partly because of public anger at the cuts he oversaw. Like Greece in the euro zone, Puerto Rico has no control over monetary policy (the preserve of the Federal Reserve), and so cannot mitigate a fiscal tightening with lower interest rates or a cheaper currency.

Investors meanwhile are so wary, after years of missed deficit targets, tardy financial reports and accounts opaquer than those of other states, that Puerto Rico has had to cut back on new bond issues. It is filling the gap with more short–term bank loans; but they come at punitive rates of interest and must be rolled over more often.

Investors are now openly debating whether Puerto Rico will default. Its constitution requires that its general-obligation bonds ($10.6 billion of the total) get first claim on tax revenues. Other bonds are backed by dedicated revenue such as sales tax and power bills and by a law authorising the government to pay interest ahead of other claims. “Honouring debts is not only a constitutional but also a moral obligation,” Alejandro Padilla, the governor, told investors earlier this month.

Yet politically it may be tough to gratify bondholders if police, doctors and teachers go unpaid. The federal government cannot be counted on for a bail-out: fiscal hawks in Congress would almost certainly balk at the expense and the precedent.

Should Puerto Rico seek to restructure its debts, it would be entering uncharted legal terrain. Unlike a city it cannot declare bankruptcy. It does not enjoy the same sovereignty the constitution grants the states; should it try to renege on its debts, Congress might intervene. Years of litigation would follow.

Puerto Rico’s problems have not yet had much effect beyond its shores. Its debt is held mainly by mutual funds and individuals, although in recent months many have sold to distressed-debt specialists. Some brokers have stopped selling its bonds to their clients. Borrowing costs have risen for a few highly indebted states such as Illinois, but the majority have no trouble selling bonds, says Chris Mier of Loop Capital Markets, which specialises in municipal debt. Happily, state finances are much healthier today than in 2010. But complacency would not be wise. No state has defaulted since 1933. A default by Puerto Rico could come as a wake-up call.