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Latin American Local Governments Face Financial Strains Despite Sovereign Aid

2020 was an unprecedented year for LRG finances. Latin America was among the most severely hit regions by the pandemic, which caused the economic activity to fall 6.8% among the region's six largest markets, while COVID-19 rapidly eroded socioeconomic conditions that were already vulnerable before the pandemic. Spikes in sovereign fiscal deficits and debt were common among Latin American countries, except for Mexico. However, according to S&P Global Ratings' analysis, the degree of sovereign financial aid and its effectiveness in alleviating financial stress among subnational governments in Mexico, Brazil, and Argentina varied widely.

Mexico's prioritization of fiscal discipline limited its assistance to LRGs to pre-established mechanisms. Severe financial and economic woes, from which Argentina was suffering before the pandemic hit, constrained its ability to provide support to LRGs. The central government was able to contain fiscal imbalances, but given the local governments' structurally weak liquidity position, this didn't prevent defaults. Meanwhile, Brazil's decisive policy response, generously compensated for the extraordinary pandemic-related expenses and prevented the erosion of LRG revenues.

The scaling back of support measures, depletion of fiscal stabilization funds, and unwinding of other fiscal adjustments made in 2020 will pressure local government finances in 2021 and the medium term. This, combined with a slow recovery in the region and limited access to funding particularly for Argentine entities, will pose challenges for Latin American local governments for the same period.

Magnitude Of Support Varied Despite Similarities In Form

Sovereign support to Latin American local governments can be classified into three broad categories:

  • Extraordinary transfers;
  • Debt relief in the form of debt reprofiling or moratoriums;
  • Extraordinary lending by the sovereign or its financial arms.

Brazil provided the largest aid to LRGs in terms of share of national GDP in the region, at 1.0%, followed by Argentina (0.6%) and Mexico (0.3%). Separately, Brazil provided ample fiscal and monetary stimulus , while Mexico and Argentina did so as well on a lesser scale. All of these measures helped mitigate the recession's impact on consumption and LRGs' revenue, containing fiscal erosion. To assess the degree the economic aid cushioned the pandemic-related impact on LRGs' budgets, we looked at the support amount relative to local governments' operating expenditures. According to our estimates, covid aid in Brazil accounted for 9.8% of LRGs' total operating spending, while in Mexico and Argentina, this figure represented 3.9% and 3.5%, respectively. Extraordinary transfers were in general the preferred type of support.

image

Once the pandemic hit in early 2020, the Mexican government provided support to LRGs through the existing the Fiscal Revenue Stabilization Fund (FEIEF under its Spanish acronym). The FEIEF disburses funds under the revenue sharing intergovernmental agreement during periods of the central government revenue shortfalls. In contrast, Argentina and Brazil provided extraordinary support, following agreements between the executive and legislative branches in a relatively prompt manner despite some implementation delays.

We note that public-sector wage freezes helped mitigate fiscal slippage among Argentine and Brazilian LRGs during 2020 given that payroll is the largest outlay for local governments (58% of total operating spending in Brazil and 50% in Argentina). Freezing public-servant wages in 2020 and 2021 was the condition that Brazil's federal government imposed prior to disbursing extraordinary funds. While in Argentina, delays in salary updates resulted in significant real losses because of high inflation. Out of the local governments' other operating expenditures, goods and services spending was generally muted in the three countries.

Capital spending was also a source of adjustment in several cases, even though levels in the region were already low before the pandemic (8% of total spending in Mexico, 6% in Brazil and 12% in Argentina on average over 2015-2019). Not surprisingly, largest cuts in infrastructure spending occurred among Argentine and Mexican LRGs where sovereign support was scarcer; capex decline in real terms in Argentina was 24% compared with 2019, and 9% in Mexico. Meanwhile, Brazilian subnational governments experienced a real increase in capex of 12% compared to 2019.

Sovereign Fiscal Support Helped Prop Up LRGs' Finances

The pandemic caused a marked contraction in consumption and investment in the three countries. This in turn eroded the local governments' revenues. In the meantime, spending on healthcare services surged 39% in nominal terms in Argentina (inflation was 36%) and 16% in Brazil in 2020 compared with 2019. The rise in nominal health spending in Mexico was at a slower pace.

We believe that without sovereign support in 2020, local governments would have likely spent less, although not significantly, given their narrow spending flexibility. Spending mandates account for a significant share of Brazilian LRGs' expenditures, while legal constraints prevent the reduction of the provincial payroll in Argentina. Comparatively low levels of per capita spending in Mexico constrain spending flexibility. Meanwhile, significant service and infrastructure needs throughout the region further strain LRGs' spending structures.

Total support led to different effects on local government overall fiscal results and cash flows. Balances after borrowings relative to revenues reflect the how much more or less cash entities accumulated or lost. In general, support moderated financing needs among the region's local governments, and notably led to cash accumulation among Brazilian entities, because severe uncertainty over the impact of the pandemic resulted in a larger-than-needed sovereign fiscal support and relatively cautious executionof extraordinary spendingby the states (for more detail, see the Brazil section below).

Chart 1

image

Fiscal Woes Will Reemerge

While the impact from the public health crisis on Latin American local government budgets has been less severe than initially expected, we believe that fiscal pressure is likely to mount this year. As central governments curb fiscal support for LRGs, their credit quality will depend on the economic recovery's trajectory, as well as on their financial performance. GDP of Mexico and Argentina will likely return to the pre-pandemic levels only by the fourth quarter of 2022 and even in 2023. Moreover, spending pressures remain because the region is still severely affected by the pandemic given the slow vaccine rollout.

The Mexican federal government's transfers will be lower due to the depletion of the stabilization fund in 2020 and other factors. In Argentina key pressure will stem from public unions' push to raise salaries after a real loss of nearly 10% in 2020, while support from the sovereign moderates. Meanwhile, the phaseout of sovereign financial support could dent the extraordinary cash reserves that Brazilian states accumulated in 2020.

Despite Low To Moderate Debt, Heavy Borrowing Is Unlikely

Local governments in all three countries have debt levels that we consider as low to moderate, although this is unlikely to result in a significant amount of fresh funding. Even though debt is usually the first approach that governments opt for to soften shocks, access to private funding is generally limited. The Brazilian and Mexican institutional frameworks prevent LRGs from issuing debt in the international markets, leaving them to rely on local banks' willingness to lend to the sector. While the Argentine framework allows international debt issuances, access is currently uncertain due to recent defaults at the sovereign and local government levels, making the provinces heavily reliant on sovereign funding.

The bulk of Mexican LRGs' borrowings in the next couple of years will likely come from commercial banks, with increasing share of lending from the government-owned bank, Banobras. However, weak fiscal planning capacity could limit some states' access to financial markets. We expect the rated Mexican LRGs' debt levels to stabilize at about 20% of operating revenues by 2021, compared with 17.5% in 2019, which we consider as relatively low.

The recent, but transitory, improvement in the Brazilian LRGs' finances enhanced the federal government's assessment of their creditworthiness, enabling some new borrowings with a federal guarantee. This excludes the financially distressed states that are under a specific fiscal recovery framework. The LRGs' debt levels are likely to remain relatively high, averaging 113% of operating revenues. Recent court rulings allowing the LRGs' debt payment suspension could reduce appetite among private banks to lend to LRGs. This in turn could increase reliance on loans from public banks and multilateral lending institutions. Brazilian LRGs can't issue debt in the international or domestic debt markets.

Meanwhile, Argentine LRGs will face more difficulties, given that international markets remain virtually closed after recent debt restructurings, and domestic markets remain very shallow because of competition for funding between the provinces and central government. While the recent debt restructurings provided significant relief to LRGs in the short to medium term, fiscal imbalances will persist, increasing the debt service rollover risk amid tight credit conditions. Debt levels are generally moderate at about 40% of operating revenues, but are still vulnerable to foreign-currency fluctuations.

Below, we provide an in-depth analysis of financial assistance to LRGs in each of the three countries.

Mexico Opted For A Minimalist Approach

Unlike its peers, Mexico already had fiscal distribution mechanisms to compensate for LRGs' revenue shortfalls in place. This is one of the reasons that enables us to assess the Mexican LRGs' institutional framework as more predictable than those of its peers in Brazil and Argentina. This is particularly important for Mexican local governments given transfers from the sovereign represent about 90% of the states' operating revenues, and about 64% that of municipalities.

The most significant of these mechanisms is FEIEF, which was established in 2006 with the aim to compensate for the reduction in non-earmarked federal transfers relative to the estimated amounts in the federal budget. The FEIEF helped shore up LRGs' finances in 2009, 2019, and most recently in 2020. FEIEF resources are non-earmarked and distributed among the 32 Mexican states, which in turn disburse a share to their municipalities. Total support to LRGs in 2020 from the FEIEF represented 0.3% of GDP or 3.9% of expenditures among rated states.

Chart 2

image

Transfers from the FEIEF are unlikely in 2021, because the fund is now almost depleted and the 2021 budget incorporates conservative recovery assumptions. The federal budget for 2021 incorporates a 6.4% real reduction (3.2% in nominal terms) in non-earmarked federal transfers to LRGs from the 2020 level.

Given the uncertainty over the pandemic's harsh impact on the economy, we assigned a negative outlook to a significant number of Mexican LRGs between March and June 2020. Following our review of the pandemic's fiscal impact, which the FEIEF mitigated, we have revised outlooks on several entities to stable.

Brazil Provided Generous Covid Aid

Brazil implemented one of the largest fiscal stimulus packages in emerging markets (8.3% of GDP), which was key in propping up economic activity and soften the pandemic's impact. Among the fiscal measures, the federal government provided ample support to finance the LRGs' extraordinary spending needs and compensate for the revenue erosion. The Brazilian LRGs' institutional framework doesn't have existing channels for extraordinary support, so the content of the financial assistance evolved with the pandemic and involved lengthy negotiations in Congress.

In addition to a provisional measure to align automatic transfers at the same nominal value of 2019, Congress approved the largest piece of the Covid aid in May 2020. The bill contemplated additional transfers totaling R$56 billion (0.8% of GDP) and the suspension of LRGs' debt payments to public lenders between March and December 2020, which was part of a broader scheme to prop up the Brazilian economy. The financial regulator's compensation for the suspension of LRGs' debt payments to the banks was adequate, in our view. Therefore, we didn't consider such suspensions as defaults.

The federal government's massive support enabled LRGs to balance their revenues and expenditures despite the pandemic-induced economic crisis. Moreover, uncertainty over budgetary impact from the pandemic and its duration resulted in a larger-than-necessary fiscal aid to states and municipalities. We estimate that LRGs' healthcare expenditures increased R$17 billion in 2020, which only represented 30% of total extraordinary transfers. At the same time, the drop in local revenues was less severe than initially expected, given the federal government's substantial aid to the economy. At the end of 2020, Brazilian LRGs' fiscal and cash position was stronger than before the pandemic: accumulated cash was equivalent to 4% of operating revenues, compared with 0.1%.

Chart 3

image

The phaseout of the support measures at the end of 2020 raises budgetary pressures, given the massive resurgence of COVID-19 infection rates that forced most local governments to reimpose social-distancing measures in the first months of the year. We estimate that fiscal operating balance will slip to 3.9% of operating revenues and deficits after capex will be at 1% of total revenues by 2021 (see chart 3). At the same time, LRGs have resumed servicing debt owed to the federal government and public banks. Absent sovereign support, we expect the Brazilian subnational governments to use up most of their accumulated cash to finance their 2021 budgets, while borrowings are likely to accelerate.

Despite a temporary improvement in the Brazilian LRGs' fiscal accounts, structural weaknesses remain. This is because revenue sources are narrow, expenditure mandates account for the bulk of spending, debt levels are high, and external funding sources are limited.

Argentina's Limited Support Didn't Prevent Defaults

The Argentine central government's aid to the provinces consisted of extraordinary transfers, debt service relief, and additional loans to mitigate the impact from the Covid-19 pandemic. Nonetheless, it was relatively limited due to the sovereign's strained finances: total aid represented 0.6% of GDP or 3.5% of LRGs' operating expenditures, with extraordinary transfers accounting for 43% of total support. The economic aid package was disbursed outside the existing intergovernmental framework. Allocation of extraordinary transfers to local governments generally followed the coparticipation distribution formula, although with some discretion.

LRGs' fiscal results improved in 2020 following decline of operating spending of almost 6% in real terms due to public-sector wage freezes amid very high inflation, mitigating the fiscal hit. Provincial administrations individually opted to these due to the highly stressed conditions. Given that payroll overall represents slightly more than 50% of LRGs' total spending, public servant salary negotiations are generally influencing fiscal results. In addition, we highlight that the improved fiscal performance is also a result of lower interest payments following various provincial defaults.

Chart 4

image

While LRGs' fiscal deficits weren't significantly wider than in the past, low spending flexibility and limited liquidity buffers placed local governments in a very vulnerable position in confronting the pandemic. Except for the city of Buenos Aires , all local governments that issued debt in the international markets undertook debt restructurings and 12 provinces defaulted. Notably, the province of Buenos Aires has yet to complete its restructuring for $7.1 billion, which accounts for roughly half of all Argentine provincial debt under renegotiation. We believe debt restructuring provides relief to provincial finances, but low liquidity and limited access to external funding sources poses a key risk in 2021 and 2022. This is because Argentine LRGs will likely need to raise spending due to public-sector wage increases and the withdrawal of the sovereign's financial assistance.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Carolina Caballero, Sao Paulo (55) 11-3039-9748;
carolina.caballero@spglobal.com
Constanza M Perez Aquino, Buenos Aires + 54 11 4891 2167;
constanza.perez.aquino@spglobal.com
Secondary Contacts:Sarah Sullivant, Austin + 1 (415) 371 5051;
sarah.sullivant@spglobal.com
Omar A De la Torre Ponce De Leon, Mexico City + 52 55 5081 2870;
omar.delatorre@spglobal.com

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