Inside the black box of sub-national debt limits: The case of Mexico

Fiscal discipline is again in the spotlight as countries debate how to best respond to the current COVID-19 crisis. Throughout the pandemic, many governments have relied on debt to support households and firms. In the years ahead, the need to discipline public debt will likely lead to cuts in public spending. So how will these cuts impact economic recovery?

Previous episodes of fiscal reforms can provide us with some answers. In a recent paper, we study one such episode. In April 2016, the Mexican government enacted the Law of Financial Discipline to States and Municipalities (FD Law), which set limits to local public debt.

Background of the FD Law

The FD Law aimed to reduce the rise in local public debt that followed the 2008-09 global financial crisis. Three indicators to monitor the financial health of local governments were introduced, with the main one being the ratio of public debt to freely disposable income. Based on these indicators, an 'alert system' was established to classify the indebtedness of subnational governments as sustainable, under-watch, or high.

Starting in April 2017, these debt classifications began determining how much debt local governments can obtain. Each year, local governments with a sustainable and under-watch indebtedness can borrow up to 15 and 5 percent of their freely disposable income, respectively. Highly indebted governments have been virtually banned from obtaining financing. Importantly, the debt classifications of local governments -and consequently, the ceilings limiting their debt- have remained largely stable given the long maturity of government liabilities (on average 15 years).

We exploit the introduction of the FD Law to analyze how economic activity responds after the imposition of limits to public debt. When the Law was introduced, public indebtedness varied significantly across states (see Figure 1). As such, the Law placed greater constraints on more indebted states.

Figure 1 - Public Debt of States in 2016Q1 and corresponding debt ceilings

This figure plots the ratio of public debt to freely disposable income of Mexican states in 2016Q1 -one month before the implementation of the FD Law- along with the first public debt classification of states (and associated debt ceilings) under the alert system in April 2017.

We shed light on the following questions using variation in ex-ante indebtedness across states (as well as variation in the balance sheet exposure of each bank to loans of more indebted local governments).

What is the impact of public-debt ceilings on economic activity?

To answer this first question, we examine changes over time in the GDP, employment, and poverty rates across states. We find that states with ex-ante more indebted governments experience faster economic growth following the FD Law -both in terms of GDP and employment. However, the impact of the FD Law on poverty rates is mixed. While states with ex-ante more indebted governments experience a contraction in moderate poverty rates, the population share living under extreme poverty increased.

Why is extreme poverty increasing in states with more ex-ante indebted governments after the Law?

One explanation may be found in the fiscal measures adopted. When local governments can no longer use debt to finance their spending, they have to cut certain components of public spending. We find that more indebted state governments reduced their public expenditures afterward -including cuts in social protection. Importantly, we confirm that this contraction in public spending only begins after the Law is enacted. That is, the evolution of fiscal components across states of varying indebtedness followed parallel trends in the pre-Law period.

Why is economic activity increasing in states that contract public spending?

One mechanism we explore is that of credit allocation. Local governments in Mexico fund themselves almost exclusively through banks. The restrictions to local public debt introduced by the FD Law could have pushed banks previously lending to the public sector to reallocate credit towards previously credit-constrained firms. To establish if the FD Law indeed induced this reallocation, we examine the evolution of bank lending to local governments and private-sector firms before and after the Law. For this, we look at aggregate data from the balance sheets of banks and loan-level data from the credit registry.

We find that in states with ex-ante higher public indebtedness, local governments contracted their bank borrowing after the FD Law (see Figure 2). In turn, bank lending to private firms headquartered in these states increased. Was the credit adjustment the same for all banks and firms? We find it was not. Credit reallocation was more significant among banks with a higher balance sheet exposure to loans of more indebted local governments. Consistent with the credit allocation mechanism, we find that firms headquartered in municipalities with branches of these banks grew relatively faster (e.g., liabilities, assets, and sales) after the Law.

Figure 2 - Impact of FD Law on Bank Lending to Local Governments given ex-ante Indebtedness
This figure displays the quarterly coefficients of state-month level regressions where the dependent variable is the value (in logs) of bank loans to local governments. The coefficients in the figure correspond to interactions of quarterly indicator variables for states being more indebted in the quarter before the FD Law's enactment. The regressions further include bank and month fixed effects. Standard errors are doubled-clustered at the state and month level. The blue vertical bars represent confidence intervals of the coefficients at the 90 percent significance level. The red vertical lines in both panels mark the introduction of the FD Law.

Does the impact of sub-national fiscal discipline law depend on the ex-ante composition of fiscal spending?

We compare the effect of the FD Law across state governments that, before the Law's enactment, channeled varying shares of their budget on infrastructure projects, which tend to increase productivity. We find that the FD Law has a greater impact in states with ex-ante larger public spending shares on non-infrastructure items (e.g., on social protection). These states experience more economic growth in terms of GDP and employment - albeit with increases in extreme poverty -and a more significant reallocation of bank credit from the public to the private sector.

These findings suggest that private firms benefit more from the unwinding of the crowding out in credit markets in states spending more on non-infrastructure areas (rather than on public infrastructure projects). That is, the marginal return of the reallocation of capital from public towards private firms is higher in states that were channeling more funding to non-infrastructure spending.

Altogether, our results suggest that imposing ceilings on subnational governments' debt can reduce the crowding out of private firms from the credit market, with positive effects on aggregate output. The unwinding of crowding out in credit markets is larger for i) firms headquartered in locations with more indebted local governments, ii) firms borrowing from banks more exposed to local public debt, iii) firms operating in sectors less dependent on government spending, and iv) more financially constrained firms. However, the trade-offs of these debt ceilings are worth highlighting. While the measures under the fiscal discipline framework implemented in 2016 can benefit aggregate economic activity, ill-targeted public expenditure cuts may hurt the most vulnerable individuals.

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