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Highlights

S&P Global Ratings considers the institutional framework for Mexican municipalities to be volatile and unbalanced.  Our assessment of the framework reflects Mexican municipalities' limited direct interaction with the federal government, and consequently, their weaker capacity to oppose decisions from higher tiers of government. The following are the main drivers of the assessment:

• The institutional framework limits municipalities' control over their revenue to a greater degree than those of states. Municipalities generate a larger share of own-source revenue than states, but depend heavily on transfers. Delays by state governments in disbursing the federal transfers to municipalities can--and has at times--compromise their liquidity and prevent them from making timely debt service payments, increasing the risk of default. Municipalities also require the state legislative approval in order take on new long-term debt.
• Despite generally balanced fiscal results and low debt levels, low infrastructure investment remains a weakness for the framework. This reflects the framework's rigidities and short-term planning horizon that incentivize cautious fiscal policy and narrows space to invest in infrastructure.
• In our view, there is divergence among municipalities' disclosure of short-term debt obligations and their financial reporting, which increases the risk of default. While most municipalities comply with the FDL, there are inconsistencies in short-term debt reports among municipalities with weak liquidity position and lower fiscal transparency.

Trend: Stable

The stable trend reflects our expectation of continuity in the National System of Fiscal Coordination and Debt (NSFCD) and fiscal discipline policies over the medium term. We expect municipalities to comply broadly with the FDL, which supports generally balanced fiscal results and low debt levels. While this limits the risk of fiscal slippage, it reinforces systemic underinvestment in infrastructure.

Downward scenario

We could revise downward our assessment of the institutional framework if there is a deterioration of the (NSFCD) and fiscal discipline policies over the medium term that could reduce predictability of the framework or if there's greater interference by states in the flow of transfers to municipalities. We could also revise our assessment downward amid weaker fiscal transparency or constraints in accessing financing. In the event of an economic crisis or volatility in oil prices, persistently low funds in in the federal mechanism for revenue stabilization, known by its Spanish initials FEIEF, can pose additional risks to the system.

Upward scenario

We could revise our assessment to a stronger category for the following reasons:

• Infrastructure investment were to rise;
• Municipalities have greater ability to oppose reforms;
• A consistent improvement in fiscal transparency and the financial planning horizon extends beyond the short term.

Predictability Of The Framework: We Expect Broad Continuity

Frequency of reforms and maturity of the intergovernmental system

In our view, major reforms in Mexico's public finance system are infrequent, and the framework is relatively predictable. Mexico's NSFCD, along with the states and municipalities' taxing rights and expenditure mandates, are codified by law and have not significantly changed in more than 40 years. The government established the NSFCD to distribute federal tax revenue to Municipalities, which makes up around 65% of their revenue. The NSFCD distribution formula incorporates each state's and municipalities' population, tax collection efficiency, economic growth, and social needs. Municipalities are guaranteed their share of transfers, which prevents states from blocking the flow (but they can delay the process). The federal government's reforms to municipal own-source revenues at the are also rare.

The framework's last major reform was the enactment of the FDL in 2016, designed to foster financial discipline among LRGs. There are implementation gaps regarding transparency in timely reporting of all liabilities, cash position, and the amortization of short-term debt. In our view, the framework lacks robust enforcement mechanisms, and there are intermittent delays in fiscal reporting. Along with amendments to the Fiscal Coordination Law, the FDL, the Federal Law on Public Debt, and the General Government Accountability Law set rules to prevent fiscal slippage. They had established minimum standards for financial disclosure reporting and a system of controls to generate broadly balanced fiscal results. The framework also had established limits on long-term borrowing (which is subject to a debt ceiling) that require the approval from local legislatures. Short-term debt is also subject to a ceiling, but doesn't require the legislative approval. All LRGs' debt obligations should be disclosed and recorded in the federal public registry.

While the election of mayors for up to two consecutive terms has been permitted since the 2018 electoral process, municipalities continue to operate with a short-term fiscal planning horizon. In general, it does not extend beyond the three-year term, and tends to be for up to one upcoming fiscal year, in line with the federal and state's annual budgeting processes. Municipalities generally execute capital projects on a yearly basis, which limits the scope of projects that tend to be vulnerable to changes in administration. The FDL mandates that municipalities with more than 200,000 residents present the annual budget and fiscal projections for three years. But in most cases, longer-term estimates are not reliable and can have substantial revisions within the same fiscal year.

We do not expect major changes in the public finance framework during the current administration, which will be in power for the next six year. In our view, the January 2024 reform to the Fiscal Coordination Law to partially centralize health spending has a limited impact on the NSFCD. This is because it pertains to only 5% of total federal transfers and provides some space for the states to voluntarily centralize earmarked federal transfers to cover health-related spending needs. Moreover, this reform does not affect other core spending responsibilities such as education, and transfers to municipalities and government-related entities (GREs).

Mexican municipalities have very limited ability to influence or oppose reforms

Moreover, federal and municipal fiscal interactions are rare, and most of the federal transfers intended for the municipalities flow first through the states' fiscal accounts and systems. Municipalities' ability to oppose reforms from federal and state governments are influenced by the indirect control that states exert over municipalities through the transfer flows. Although the distribution criteria for the flow of funds from states to municipalities are generally similar to the one that the federal government applies to states, state governments that experience financial distress can delay the pass through of federal transfers to municipalities.

Revenue And Expenditure Balance

We expect divergence in fiscal results, with limited flexibility and growing pressure to cover infrastructure needs

Municipalities' own-source revenue and federal transfers have generally been sufficient to cover their operating expenses. However, cities have struggled to cover the growing costs of public services, such as trash collection and waste management, and maintenance of infrastructure and its expansion. Although municipalities' revenue is less dependent on transfers than that of states, federal transfers to municipalities still represent about 64% of their operating revenue. Infrastructure projects are usually funded with a mix of earmarked transfers, extraordinary transfers, and own-source revenue. In the past, cities had relied on extraordinary federal transfers, but those have been cut under the AMLO administration, decreasing their flexibility to cover such spending.

Chart 1

The capacity to increase own-source revenue varies widely among municipalities. It depends on the breadth and depth of the local economy and the degree of administration's fiscal sophistication. In addition, changes in tax rates and fees need the approval from state legislatures. Tax collection capacity should play a key role in budgetary performance since Mexican municipalities still have a significant room to increase their own-source revenue compared with other municipalities worldwide. However, neither municipal nor state governments have shown the political willingness to raise taxes on a significant scale. This has generally led municipalities to rely on effective management and updating of local private property values to raise revenue, along with other efficiency measures.

Chart 2a

Chart 2b

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Chart 4

Mexican municipalities' debt levels remain lower than those of global peers, at about 16% of operating revenue in 2023, down from 31% in 2015. The FDL has enabled this trend. However, other more factors restrain debt levels, for example, shortages of qualified administrative staff, procedural hurdles to approving and contracting debt, a prevailing political preference for fiscal austerity, and very limited financial flexibility.

Domestic commercial lenders were the largest financing source for Mexico's municipalities in 2023, given that bank loans accounted for 44% of their debt, of which only 4% was short term. Since 2017, private banks' exposure to LRGs has been slowly diminishing, while the government-owned lender Banco Nacional de Obras y Servicios Publicos S.N.C. has been expanding its share of this lending segment. The latter finances 49% of LRGs' debt, while bond issuances account for 7%.

Fiscal policy framework

The framework has promoted financial discipline, harmonization in financial reporting, and transparency in LRGs' fiscal profiles. However, it hasn't always prevented payment defaults, and it constrains spending on public services and infrastructure. Under the law, local governments, including municipalities, are required to post balanced fiscal results or surpluses, and may only run deficits amid an economic contraction, a natural disaster, or if the expenditure that's driving the deficit will cause spending to drop or revenue to rise in the near future. This keeps deficits and debt accumulation low. However, the decline in extraordinary or discretionary transfers is squeezing municipalities' budgets and restricting their ability to finance public works and services, which we view as detrimental to economic growth over the medium term.

To promote fiscal discipline, the FDL had implemented limits on debt accumulation through a system of debt-sustainability alerts. This alert system takes into account the LRG's debt level, debt service burden, and account payables. The FDL requires local governments that have gone heavily into debt (as defined by the system as having a debt level of more than 200% of non-earmarked revenue or having either a high debt-service burden or large short-term debt obligations and debt owed to suppliers) to present a debt reduction plan in exchange for a federal guarantee on its outstanding debt. Municipalities are required to present actuarial studies of their pension systems every three years. The FDL also stipulates municipalities should maintain a contingency fund to partly finance recovery costs after natural disasters, reducing dependence on emergency transfers from the federal government in such cases.

As of the end 2023, only two municipalities had "non-sustainable" debt levels, while 168 municipalities (6.8% of total of all municipalities) are "under observation" (as defined by the system as having a debt level higher than 100% of non-earmarked revenues but below 200% of such revenues or presenting a low debt level but a medium to high debt-service burden and/or short-term debt obligations and suppliers debt as per the FDL's requirements). The rest of Mexican municipalities are deemed as having "sustainable" debt levels.

According to the FDL, if the local government debt is classified as:

• "Sustainable", the cap on additional net borrowings is 15% of discretionary revenues;
• "Under observation" the cap on additional net borrowings is 5%; "High" no new debt can be taken out until indicators return to the second category.

The FDL also caps short-term borrowing at 6% of the municipality's annual budgeted revenue, which in our view, can still be subject to payment risks for municipalities with weak liquidity.

By law, all municipalities must report all debt-type obligations including long- and short-term debt, public-private partnership obligations, debt payment guarantees through the Consolidated Public Registry, known by its Spanish acronym of RPU. Compliance, however, with this rule varies across municipalities.

Extraordinary support is limited, while the FEIEF fund remains at a historically low level

In our opinion, the federal government does not have an extensive record of rule-based extraordinary support. Over the last few decades, there have not been instances of debt relief to distressed municipalities. Instances of extraordinary support for natural disasters is limited, centralized, often in-kind, and provided on case-by-case basis. Local governments have access to extraordinary support through the federal program Apoyo Parcial Inmediato (API) when they have declared a state of emergency validated by a federal agency. For example, in November 2023, the federal government provided extraordinary support through the API to two municipalities out of 47 originally that have declared state of emergency in the state of Guerrero after Hurricane Otis hit Acapulco. Likewise, the federal government provided MXN61 billion (through its relevant agencies and the army) to some affected areas within the state of Guerrero for infrastructure and social support.

On the other hand, the FEIEF fund was established in April 2006 to offset the fall in participaciones transfers. But its balance has been relatively low, constraining its scope to offset volatility in transfers. Its use is triggered when the participaciones transfers fall below the budgeted levels, supporting finances of the local governments, including municipalities, during economic downturns and volatility in the oil market. FEIEF's balance remains dropped to only MXN11.8 billion as of December 2023 (0.03% of GDP) from MXN76.3 billion at the beginning of 2019 (0.3% of GDP). Moreover, to obtain additional resources in 2020, the Permanent Commission of Fiscal Officials agreed to request that the Mexican Ministry of Finance and Public Credit facilitate the creation of Fideicomiso CIB/3484 to leverage the FEIEF fund through the private trust fund CIB 3484 subscribed on July 24, 2020, in CI Banco. This private trust fund is in charge of contracting bank financing and receiving the flows needed to meet the financial obligations. While its structure has enabled leveraging FEIEF in 2020 and 2023, if the FEIEF funds are insufficient or the reserve account is below its target balance, the transaction has a mechanism whereby the Ministry of Finance, on behalf of each Mexican state, will pay to the Trust CIB/3484 the missing amounts. It will do so using the resources equivalent of up to 4% of the General Participations Fund annually, corresponding to each Mexican state.

Transparency And Accountability

Approach to budget setting and maintaining accountability.

While the delineation of the municipalities' fiscal roles and responsibilities is relatively clear, the budgetary process remains politicized and depends on each city's level of financial sophistication. The treasurer (or its equivalent) of every municipality prepares the annual budget, with the priorities of the elected officials heavily influencing the final form of the budget. Comparatively low public salaries and significant staff turnover generate divergence in the quality of administrative management at the municipal level.

Although the FDL was intended to foster predictable budget planning, the quality of budgetary assumptions rely on each municipality's fiscal data report to the Ministry of Finance and Public Credit and depends on the individual city's degree of financial sophistication. In general, financial planning tends to be short-term oriented. In our view, budget projections are more reliable on a short-term basis because the annual budget is usually in line with the federal and state governments' economic policy general criteria, which are published on a yearly basis. Likewise, generally financial planning can vary from one year to another based on political cycles at the federal and state levels.

Disclosure and accounting standards

Minimum financial reporting standards have improved since the FDL's enactment and implementation, but there are information gaps, and standards are weaker than of international peers. Under the FDL, municipalities are required to present information on their discretionary surplus (defined as discretionary revenues minus discretionary expenditures) and financial obligations (including public-private partnerships and financial leasing payments). By law, the local governments' financial reporting occurs quarterly (financial information must be publicly available no later than 45 days after the end of every quarter, unless there are exceptional circumstances). The statements are generally transparent and require standardized government financial reporting, but we still see inconsistencies between financial statements and balance sheets, differences in accounting standards at a greater degree than among states. Likewise, consolidated information on GREs is patchy. Apart from municipalities' debt level reports to the RPU, there's no timely consolidated information of their financial reporting available.

Given the Ministry of Finance's limited enforcement powers, some municipalities do not comply with disclosure of information. However, this occurred only among 5% of municipalities as of December 2023 across six states. This narrows access to external funding and reflects transparency constraints in these cases.

Control and reliability of information

Although the framework is intended to foster fiscal transparency and accountability, we consider its enforcement as weaker than those of global peers. Lags between budget execution, delays in periodic publication of financial reports, and frequent revision by local and federal auditors hamper visibility and prevent enforcement. The FDL implemented an alert system to monitor local governments' debts and the use of federal funding, prompting LRGs to comply with the National Anti-Corruption System. On the other hand, the Federal Audit Authority audits federal transfers to states and municipalities. Likewise, the municipalities' public accounts are subject to local auditors and are reviewed by local legislatures on annual basis. However, there are cases of local governments with weak institutions misusing abuse public funds. External audits are not mandated.

Municipalities have internal control entities (OICs) with the power to investigate and assess administrative failures. If the fault is minor, the OIC can impose sanctions. Otherwise, OICs have the obligation to bring their complaints to the court. However, OICs could be insufficiently autonomous, suffer from subpar administrative quality, and lack legitimacy in how the comptrollers are appointed because of political appointees, resulting in transparency gaps.

Related Criteria

• Criteria | Governments | International Public Finance: Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., June 18, 2024
• City of Queretaro, Feb. 20, 2024