Mexico’s Financial Discipline Reform: Breaking the Riddle of Subnational Debt

Mexico’s state governments have a tendency to perceive cash shortfalls as a consequence of debt instead of the cause of it. For this reason, state governments repeatedly engage in debt refinancing to reduce the cost by decreasing interest and capital payments. However, refinancing gains fade quickly while management and budget control problems persist. Financial discipline can only occur if the secondary law reform encourages public financial management modernization at the state level of government, especially by upgrading and streamlining management processes for budget control, financial programming, revenue, expenditure, and debt management.

High debt burdens triggered financial discipline reform plan

In 2010 and 2011, forced by major debt burdens, several Mexican states engaged in ambitious refinancing operations. Though none of the states defaulted on their debts, the situation raised the debate for  subnational debt representing a risk for the financial system, especially after the 2009 financial crisis. For this reason, the national legislature passed a constitutional reform in February allowing the federal government to enforce financial discipline in state and municipal governments, soon to be complemented with secondary law reform.

Secondary law reform will change the way subnational governments make borrowing decisions and achieve financial discipline by avoiding over-borrowing. However, the secondary law reform debate relies on strong assumptions about public financial management capacities at the subnational level that may be far from reality.

The 2009 financial crisis is key to understanding the root of the subnational financial discipline challenge

During the 2009 financial crisis, when decreasing federal transfers created a significant cash flow problem, short-term debt became an important financing source for state governments. In that fiscal year, Mexico had federal stabilization funds available, which eliminated the need for fiscal adjustment. Therefore, most of this short-term debt was arrears payments to providers and revolving credits for liquidity.

Despite the federal transfers, state governments engaged in a permanent short-term debt rollover because of lack of budget control. By 2010, short-term debts imposed pressure on the cash flow and some states converted short-term debt into long-term debt. This way, Mexico’s state debt levels doubled despite federal stabilization funds compensating entirely for the subnational revenue fall.

From 2006 to 2011, Mexico’s state debt-to-GDP aggregated ratio—including bonds issued through special purpose vehicles such as debt repayment trusts—increased from 1.2 to 2.3 percent because of this refinancing operation. Some analysts did not consider this figure worrisome, especially compared to Mexico´s subnational debt burden levels with the benchmark set by the IMF-World Bank, which raises a cautionary flag at 50 to 60 percent of debt-to-GDP ratio.

However, in addition to the short-term debt problem, during that period the states already experienced persistent negative primary balances indicating a reduced repayment capacity. In fact, primary deficits were underlined the fact that states needed more debt in order to pay the interest cost of existing debt. Even at lower debt-to-GDP thresholds, some states’ debt became unsustainable. This situation cannot be solved solely by continuous debt refinancing but rather with robust budget control and fiscal discipline. Strengthening public financial management capacities is crucial for achieving fiscal equilibria.

To induce financial discipline it is important to reinforce transparency

The current legal framework inhibits transparency and reporting which affects banks’ risk assessment. Since credit risk assessment is sensitive to debt burden and available revenue flow projections, a lack of clarity in reported information could mislead banks’ repayment capacity assessment. For example, there are loopholes in the legal framework that lead to dissimilar information reported to the federal authorities.

For instance up until now, federal law does not require states to register debt guaranteed with non-federal transfers in the Ministry of Finance. In addition, the amount of subnational short-term debt is not reported either. In 2011, subnational short-term debt was estimated to fluctuate between 1.5 to 3 billion USD, but financial institutions did not know the exact amount in each state. Furthermore, despite the federal government’s efforts to improve subnational accounting standards, hidden debts and dissimilar accounting methods overestimated the available revenue base.

If information is opaque and hidden debt is significant, borrowing beyond the government´s financial capacity eventually reduces the fiscal margin. For these reasons, the reform initiative should enforce accountability, reporting, and auditing, which continue to be a major challenge on the subnational level.

The role of the federal government as guarantor could have a contrary effect

Furthermore, the constitutional reform allows the federal government to grant a guarantee for subnational debt if necessary, which may create market distortions by generating an interest rate subsidy. If this issue is not well-addressed in the secondary laws reform, it could induce moral hazard and have a contrary effect on financial discipline.

Currently, Mexico City’s debt legal framework creates a federal subsidy that biases its credit rating. City’s debt is rated AAA but shadow rating is between BBB and A. For Mexico City, debt is cheaper than it is supposed to be according to its shadow credit risk. This may be one of the causes of Mexico City’s ever-increasing borrowing strategy, despite achieving high fiscal surpluses in the last years.

Additionally, interest rate subsidies may give the wrong incentives for borrowing. For example, before 1995, banks could require subnational debt repayment by the federal government, creating a guarantee that reduced borrowing cost. In 1995, subnational over-borrowing resulted in bailout and forced reforms to eliminate the federal guarantee.

Should the federal government use its credit rating umbrella to give a subsidy or rely on existent market instruments? Will there be clear rules to access the subsidy or would access be subject to federal government discretion? Does this create a contingent problem for the federal government? This situation has sparked an interesting debate about the federal government role as guarantor.

Where do we go from here?

Financial discipline will only materialize if reform encourages an extensive plan for public financial management modernization, by reinforcing budget control, improving debt management, and increasing expenditure control.

The basics of public finance administration remain a major challenge for state governments. Most of them lack proper integrated information systems to link management functions such as budget, treasury, and accountability. For example, some states currently lack integrated processes to link procurement with budgetary processes, decreasing the governments’ capacity to avoid cash diverting.

The subnational debt problem is a reflection of the poor financial management capabilities for budget control.  Some subnational governments reflect fiscal equilibria only in the authorized budgets but not by the end of the fiscal year when unplanned debts continues covering overspending caused by the lack of integrated management systems.

If public finance soundness and fiscal sustainability remain a must-do for subnational governments, including public financial management in the secondary law reform is key to solve the subnational debt riddle. Otherwise, financial discipline at the subnational level still has a long way to go.

Gabriel Yorio-Gonzalez is a Public Sector Specialist at the World Bank. The views expressed in this article do not necessary represent those of the World Bank.

Feature Photo: CPeralta

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