The COVID-19 pandemic has heightened fiscal pressures on Mexican subnational governments, while the number of negative rating actions by S&P Global Ratings on these entities has increased. In our view, the ability of rated local and regional governments (LRGs) to enhance their financial management policies and medium-term planning capacity will enable them to avoid further slippages in 2021 amid an incipient economic recovery.

The following report answers frequently asked questions about factors that impact financial performance of Mexican states and municipalities, and the key structural challenges and opportunities they will face after the pandemic.

Frequently Asked Questions

How has COVID-19 affected Mexican LRG ratings?

Since the beginning of the outbreak in Mexico, we have taken a larger number of negative rating actions on domestic LRGs than in 2019. Since March 2020, we have downgraded three entities, and revised nine rating outlooks to negative, and one to stable from positive. We haven't downgraded any rated entity to default during this period. The rating actions mostly capture economic and fiscal woes, including the contracting revenues and greater expenditure pressures. The rating actions this year have shifted the outlook balance. Nevertheless, as of Dec. 7, 2020, 72% of rated Mexican LRGs have a stable outlook, while 25% have negative outlooks, up from 6% at the end of 2019.

The outlook revisions to negative partly stemmed from the rating action on the sovereign in March 2020. At that time, we lowered our long-term foreign currency rating on Mexico to 'BBB' from 'BBB+', and in November 2020, we affirmed the ratings and kept the negative outlook. Mirroring the rating action on the sovereign, we revised the outlook to negative from stable on the highest rated LRGs, including the states of Queretaro, Guanajuato, and Aguascalientes, while we revised the global scale rating outlook on the city of Queretaro to negative from stable and kept the national scale rating outlook unchanged. Given LRGs' heavy dependence on transfers from the federal government, we believe that they can't have a rating higher than on the sovereign. And we also like to point out that potential negative rating actions on the sovereign would result in the same actions on 11% of the rated LRGs.

A large portion of rated subnational governments has shown resilience amid the pandemic, and we expect them to manage the fiscal impact while preserving their creditworthiness. Their ability to do so will continue to depend on the pace of economic recovery, as weaker-than-expected growth would exacerbate financial pressure on LRGs, potentially impairing their credit quality.

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Which mechanisms have been implemented to cushion the impact from the economic crisis and for how long could they benefit LRGs?

The pronounced hit to the Mexican economy in 2020, following the combined shocks of COVID-19 and collapse in global oil prices, has eroded the sovereign's revenues, and consequently, federal transfers to subnational governments. We currently estimate a drop in non-earmarked federal transfers to LRGs of about 5.6% (see note 1) in 2020. Given the structure of the Mexican fiscal federal system and the states and municipalities' historically weak tax collection capacity, they heavily rely on federal transfers, which account on average for 90% and 65%, respectively, of total operating revenues. Therefore, a sharp decline in transfers could dent LRGs' budgetary performance and liquidity positions.

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To compensate for the reduction in federal transfers, the federal government facilitated a scheme to leverage the Stabilization Fund (FEIEF, for its Spanish acronym), which aims to increase its balance by up to MXN110 billion (see note 2), to prop up LRGs' finances. FEIEF fund was established in 2006. The federal government has disbursed funds from FEIEF often in the past 10 years and increased the funding to it during the financial crisis of 2009. In addition, changes to FEIEF's operating rules were passed in August 2020 to allow for monthly and complete compensations of non-earmarked federal transfer shortfalls, which replaced the quarterly disbursements and 75% compensations of the shortfall.

In our opinion, the new changes in FEIEF have mitigated the impact of the pandemic on LRGs' budgetary performance and alleviated liquidity pressures in 2020. Transfers from FEIEF are less likely in 2021 because the law stipulates that they can only occur if federal transfers drop throughout the year from the federal budget estimate. The federal budget proposal for 2021 incorporates a 6.4% real reduction (3.2% in nominal terms) in non-earmarked federal transfers from the 2020 level. As a result, LRGs' ability to cut expenditures, boost own-source revenues, and/or increase borrowings will be limited amid an incipient economic recovery.

LRGs' own-source revenues will fall because of the pandemic and lockdown measures in 2020. They're likely to rebound in line with the economy's gradual recovery and revenue collection measures. The latter include relief to the population vary from raising rates on payroll and property taxes since the beginning of the year to deferrals on tax payments and forgiving some tax payments. We expect overall own-source revenues to decrease about 5% thank to such measures, which haven't been coordinated between the federal government and the LRGs.

In our view, the ability of rated LRGs to enhance their financial management policies and medium-term planning capacity will prevent further slippages in their financial performance. Their capacity to face more difficult financial conditions varies and will influence creditworthiness accordingly.

What are S&P's expectations on LRGs' debt performance in 2020 and 2021?

Their debt has risen slowly in the past five years. In terms of GDP, Mexican LRGs' debt will likely drop to 2.8% in 2020 from 3.1% in 2015. Given that LRGs' revenue will remain subdued in 2020-2021, and despite some capacity to delay capex or use cash reserves, we expect an overall increase in financing needs in the short term. As a result, we expect LRGs' debt to rise 10% in 2021 and remain slightly below 3% of GDP. The debt planning strategy will likely influence creditworthiness of LRGs we rate. In the recent past, whenever we have seen a sharp rise in short-term financing without prudent financial planning, the risk of downgrades has increased.

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In our view, the bulk of LRGs' borrowings will come from commercial banks in the short to middle term. However, in the past three years, the development bank--Banobras--has increased its share of lending to LRGs through new loans and refinancing of existing ones. Despite the increasing financing needs, lower interest rates--thanks to competition among lenders to disburse credit to LRGs--will limit debt service costs, in our opinion.

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What are the concerns ahead of the 2021 elections?

Mid-term elections in June 2021 for the entire federal Chamber of Deputies, 15 of 32 state governors, and 1,926 municipalities across 30 states will be the largest ones in Mexico's history. Elected officials at the municipality and state levels will take office between August and December 2021 amid severe fiscal troubles. In our view, commitment to disciplined financial policies, ongoing efforts to strengthen own-source revenue collection, and contain operating expenditures will enable LRGs to overcome financial strains. Moreover, the re-election possibility of existing municipal officials could strengthen public policy continuity and enhance intermediate-term financial planning, which in many cases has been difficult to implement during a three-year term.

During the political transition among subnational entities, an additional challenge for some governments will be to pay all of their short-term debt three months before leaving office, which the Fiscal Discipline Law (FDL) stipulates. In this regard, given that short-term debt has provided a relief for immediate budgetary pressures during the pandemic, its use has been expanding among Mexican LRGs. As of September 2020, short-term debt surged 48% compared with the same date of 2019, reaching MXN21.5 billion (below 0.1% of GDP). We expect issuances of such debt to accelerate at year-end given larger liquidity pressures as a result of LRGs' fiscal slippage.

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How the reform of the FDL will alter conditions for LRGs' debt?

The FDL was enacted in April 2016 to strengthen LRGs' fiscal framework. Since April 2020, modifications to the law have been in discussion in Congress, in order to provide more flexibility to the subnational entities in response to the public health and economic crises. Among the proposed amendments to the law, which the ruling Morena party supports, are the following:

• Provide a larger scope for natural disasters in order to include public health emergencies;
• Allow short-term debt issuances and development banks to lend short-term loans;
• Increase annual debt ceilings by considering capital payments during the current year, as well as the debt required to finance infrastructure projects approved by the SHCP (mainly those considered to have a large social impact and/or benefits an LRG's budget);
• Include a cost comparison of direct capital projects' execution and Public-Private Partnerships (PPPs) to approve capex projects;
• Allow for a temporary increase in payroll because of the health emergency;
• Increase until 2023 the maximum amount allowed for suppliers' arrears;
• Deferral of long-term debt service payments for up to 12 months; and
• Delay short-term debt maturities until December 2021.

According to the ongoing reform, the debt restructuring measures are not mandatory and require creditors' consent. Short-term debt relief would be considered only if Mexico's economy has contracted by more than 5%. The 2020 GDP figure will be released by the National Statistical Institute within the first two months of 2021. For long-term loans, once the reform is approved, subnational governments would be allowed to negotiate with their creditors on the debt payment deferrals as long as these are justified due to the impact of the pandemic shock.

Although we expect to see some modifications in the FDL in the short term, we don't believe they will materially change the law in terms of restraining LRGs' debt increases and fostering accountability standards and transparency.

Notes

(1) Non-earmarked federal transfers expected contraction without revenues from FEIEF leverage.

(2) As of November 2020, MXN80 billion has been contracted, still pending to issue up to MXN30 billion. Funds from the leverage are added to FEIEF balance of MXN63 billion by the end of July 2020.