OREANDA-NEWS. Fitch Ratings believes the Feb. 17 approval of constitutional reform by the Mexican Senate will strengthen the institutional framework of the country's subnational governments.

In July 2013, the House of Representatives (Lower House) introduced a constitutional reform initiative with the purpose of regulating and establishing prudential borrowing rules on local governments (LGs). The main policy goal is to monitor the debt levels of LGs as well as to add transparency and accountability on the process of hiring debt and on the usage of those monies. Indebtedness levels in Mexican LGs have increased in the last few years.

On Feb. 17, the Senate approved by majority the proposal of constitutional reform and the addition of various provisions in the Political Constitution of the United Mexican States on financial discipline and fiscal responsibility for states and municipalities. However, for this reform to become law and be signed by the President of Mexico, the majority of the state legislatures have to approve it.

The new regulation introduces prudential rules on short- and long-term debt and also establishes greater guidelines on surveillance, transparency and accountability in the management of public resources. Fitch expects a positive impact in the medium term on ratings of local governments if these new rules on subnational borrowings are thoroughly implemented and followed.

According to Fitch's 'International Local and regional Governments Rating Criteria - Outside the United States', the assessment of the institutional framework in which LGs operate is a relevant factor when assigning an Issuer Default Rating. The intergovernmental setting provides a clear view on the regulations, debt rules, equalization mechanisms, and how LGs deliver public services. Therefore, the institutional framework directly drives the financial performance of subnational governments.

While the approval of this reform by both Houses is a positive development, the implementation of this reform could be slowed by the legal amendments that need to be carried out as to align secondary laws and regulations to the constitutional reform, thus the effects will likely be felt in the medium term rather than immediately. Especially, the Congress will have 90 days to prepare the Regulatory Law on Fiscal Responsibility. Therefore, the House of Representatives shall have the law proposal ready for approval before the end of the regular sessions in April. If this is the case, this proposal could be voted in an extraordinary period, prior to September 2015 when the new elected members of the lower house will take over.

Subsequently, the local legislatures have 180 days to harmonize and align accordingly State regulatory frameworks. This could be a protracted process since there will be local elections in 17 states during 2015.

Fitch underscores that the discussions and formulation of the Regulatory Law should further deepen and clarify some nuances and definitions that the decree doesn't specify. For example, the law should establish a clear threshold to define 'high-debt levels' and what should be understood as 'market conditions'. Furthermore, it also should explain the process of contracting debt by LGs such as the bidding process, debt limits and conditions, and how the federal transfers are going to be pledge for debt servicing. In addition, the law should clarify the process for contracting short-term debt, mainly to finance working capital shortages.

On this regard, Fitch believes that this constitutional reform is a necessary condition, but not sufficient to achieve the desired policy effects. Both the formulation of the Regulatory Law and the alignment of State legal frameworks are conditions that need to be fulfilled as to thoroughly implement the constitutional reform on financial discipline of subnational governments.

According to the latest figures on LGs outstanding debt released by the Ministry of Finance (Secretaria de Hacienda y Credito Publico/SHCP), two indicators showed a historical trend at the end of 2014. The first is the total outstanding debt of subnational governments, which peaked at MXN509.7 billion. The second, which is the most important, is related to the slowdown in growth rate of subnational debt, the annual increase was 5.6%. This rate is lower than the compound annual growth rate (CAGR) of 17.2% for the period 1993-2014. The outstanding debt balance represented 3.1% of Gross Domestic Product (GDP), a percentage which Fitch considers low compared with that observed in other countries.

Fitch believes that the slowdown in the trend on subnational outstanding debt could end in 2015. This would be mostly because of the electoral process that is right around the corner and by which some local congresses, mayors, governors and all members of the lower house are going to be renewed in different parts of the country. In addition, the amount of federal transfers to LGs could be lower than the budgeted figure as a result of the fall in oil prices. A further driver could be the potential increase in financial costs linked to the withdrawal of monetary stimulus in the U.S. All these factors could pressure financial flexibility of subnational governments and lead them to incur in new debt.

Finally, the pace by which this constitutional reform unfolds will be determinant to lessening the pressure that debt and other liabilities put on public finances of subnational governments.

The following 10 points summarize the core points of this constitutional reform:

Financial Stability as a Development Principle: Financial stability is one of the most important principles that must be observed in the formulation and implementation of the Development Plans at the National and Subnational tiers of government.

Congress Competent in the Subnational Debt Issue: The Congress will legislate on subnational debt topics and will enact secondary laws to strengthen LGs public finances through financial stability. These law enactments should cover the following core factors: a) rules, limits and conditions pertaining to how LGs will pledge their federal transfers to service their debt obligations; b) LGs will be obliged to publish their outstanding debt levels and to register new debt incurred in a public debt register; c) a warning system on debt management; and d) sanctions applicable to the public servants who do not abide by these laws and regulations.

Federal Government as Guarantor of Subnational Public Debt: The Federal Government will implement policies to strengthen the public finances of highly indebted LGs through bilateral agreements. LGs that are not highly indebted may also adhere to these bilateral agreements with the Federal Government.

Bicameral Commission as Observant of the Federal Strategy: Through this Commission, the Mexican Congress will analyze the adjustment strategies, proposed by the Federal Government, on strengthening the public finances of LGs that are highly indebted. These adjustment strategies will be incorporated in the bilateral agreements and will guide how the Federal guarantees are granted, and if necessary, the commission may formulate recommendations. In addition, this commission must be notified of the bilateral agreements signed by highly indebted LGs (or any LGs) with the Federal government.

Greater Control and Transparency of Public Monies: The Auditoria Superior de la Federacion (ASF) will be in charge of auditing revenues, expenditures and debt of LGs as well as the debt guarantees granted by the Federal government. On debt guarantees, the ASF will audit and monitor the use of debt funds. At the subnational level, the local commission of audit will be in charge of monitoring the public finances and debt levels of LGs.

Accountability of Public Servants: Public servants at the local government level will be accountable for any mismanagement of public funds including debt.

Debt Rationale and Getting Good Market Conditions: Subnational governments may only incur debt for capital expenditure purposes or debt restructuring plans, in both cases they should look for the best market conditions. The Regulatory Law will set the rules and conditions for obtaining debt through an open tender mechanism, and will ensure best market conditions for LGs. These credits cannot be used to pay current expenditures in any case.

Debt Authorization by Consensus: Maximum debt levels will have to be authorized by local congresses with the approval of two thirds of its present members. In addition, new debt proposals will have to be incurred under the best possible market conditions and previous assessment of its application, capacity to pay, payment source, and the existence of any debt guarantee.

Rules on Short-Term Debt for Financing Working Capital Shortages: LGs may incur in debt to cover their short-term needs, without exceeding the maximum limits and conditions established by the Regulatory Law. Short-term loans must be fully paid at least three months before the incumbent administration ends, and no new loans may be obtained during this period.

Transparency and Ease of Access to Information on Subnational Debt Data: A public register will be created. The Regulatory Law will monitor that, at least, the following information is recorded: debtor, creditor, loan amount, maturity, interest rate, type of guarantee, payment source, and any other relevant information that enhances transparency on this topic.