Wednesday, July 07, 2010

Private vs. Public Debt: Explaining Borrowing Patterns of Mexican Cities

The Problem

“State and local authorities are hedging and issuing debt in order to deal with the financial crisis,” José Manuel Arteaga reported in an August 13, 2009 article in El Universal, a Mexican daily. Because of our shared border and close relations, the US financial crisis has largely affected our neighbors to the South, in particular Mexico. One of the places where the crisis is profoundly demonstrated is in local public finances. Whereas nascent democracies in Latin America are starting to take hold, so are the challenges to subnational governments with the constant demands on local public services. With severe budget constraints, now is time to analyze how Mexican cities and towns can be more autonomous in order to meet those demands.


Since the 1997 Legal Reform of Article 9 of the National Fiscal Coordination Law (NFCL), which allowed municipalities the right to take out commercial bank credits, there has been a new emphasis on public debt in Mexico. The reform passed successfully within congress and began implementation in 2000. It aimed to better utilize the national bank reserves for development projects. The law requires two private rating agencies to appraise municipal budgets by evaluating their financial systems, operational activities, economic profiles and another eight rating criteria (such as economic, liquidity, debt, finances, systems support, etc.). The four major rating entities in Mexico include Standard & Poor's, Moody's, Fitch and HR Ratings, a local rating agency. Furthermore, it is estimated that within Mexico there are some 2,439 municipalities in 32 states and of which only 155 have accessed commercial banks and 40 have active private bank credits. For example, to-date S&P has analyzed 82 public entities. Why nearly ten years since the enactment of the law, local governments avoid to taking out private sector loans? To what extent is it useful for the municipalities to use private debt to finance their public services?

The Theory

The concept of autonomy has often been discussed in academic literature within the context of decentralization. Scholars argue that the process of decentralization is of a sequential nature, which begins with administrative reforms (devolving authority), goes through political framing (local elections) and, ends by establishing autonomous municipalities with fiscal capacity to manage their own resources (Falleti 2005). Selee (2007) argues that the election of Vicente Fox in 2000, Mexico has transformed its administrative and political measures to empower local governments. Most recently, specific attention has been focused on fiscal aspects of decentralization (Willis, Garman and Hagard 1993, Bahl and Johannes 1994, Escobar-Lemmon 2001, and Gibson 2004). The World Bank defines fiscal decentralization as “the transfer of expenditure responsibilities and revenue assignments to lower levels of government.” This final element that is setting up decentralized financial reforms, promoting fiscal incentives, and encouraging revenue systems to emerge from below, has proved to be difficult to implement (Falleti 2005). Mexico has seen large amounts of sector decentralization but this has not been followed by revenue adjustments.

Therefore, many development economists have concentrated their arguments on fiscal federalism or the allocation of national transfers to local governments as inter-governmental transfers. New research on budget constraints grew out of Colombia, Brazil and Argentina’s economic recessions in the 1990s. Much of the literature today focuses on hard and soft budget constraints to prevent local governments taking out too much debt, consequently jeopardizing the national government’s balance of payments and mandating bailouts (Wibbels 2000, Rodden 2002 and de Mello 2004). While fiscal federalism is important for balancing the national budget, the appropriate level of fiscal autonomy is still undetermined. One such way to understand how local governments are taking steps towards autonomy is by studying their financial incentives, revenue flows, debt capacity and decision-making.

The Significance

The proposed research seeks to study how and why municipalities in Mexico acquire public debt with a particular emphasis on analyzing the circumstances and conditions under which municipalities should assume indebtedness. More specifically, I will analyze when and why municipalities take on debt; the best offers (in terms of tenors and interest rates, public or private services); the purpose of the loans (investments in infrastructure, economic development, covering operating expenses); and the rates of repayment and/or default. The main objective is to better understand the borrowing patters of Mexican cities and whether they acquire public or private debt.

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