In recent months, several Mexican state and municipal governments have considered the possibility of funding themselves by issuing debt in the Mexican local capital markets. Such debt issuances would be secured by tax revenues, collected by the Mexican federal government, and redistributed to the states and municipalities through the federal revenue-sharing system. Funds from this revenue-sharing system are known as tax participations and are made up of the flows coming from the General Participation Sharing Fund (GPSF) of the "Rubro 28," a section of the Federation budget.

The idea is to use these incoming flows from the federal government to isolate the transaction from the risks associated with the general creditworthiness of the state or municipality. Standard & Poor's considers that the rating of state or municipal debt backed by tax participations, if structured correctly, could be rated higher than the issuer's credit rating. However, Standard & Poor's also believes that, in most cases, the issuance rating will still be related, to a certain extent, to the issuer's credit rating.

The general participation sharing fund

The Fiscal Coordination Law, first published in 1980, regulates the tax revenue-sharing system of Mexican states and municipalities. The law established the GPSF, which is funded by 20% of the federal revenue eligible for revenue sharing (Fondo General Participable). The GPSF comprises total tax revenues collected by the federal government plus oil and mining levies, less some other taxes.

The federal treasury shares the GPSF among the states according to the following formulas:

*45.17% is distributed in direct proportion to the population in each state every fiscal year;

*45.17% is distributed in direct proportion to the revenue-sharing coefficient per capita of the previous year, adjusted by growth in fiscal revenues in that state in the past two years; and

*9.66% is allocated in inverse proportion to revenue sharing per capita in each state (see chart below).

States distribute among their municipalities at least 20% of the flow they receive from the GPSF. Each state legislature has its own procedures and formulas.

Tax participation revenues as a guarantee in debt issuances

Tax participations can only be used as a guarantee for debt instruments with the authorization of the local legislatures. Likewise, state and municipal debt guaranteed by tax participation must be registered in the List of State and Municipal Debt (Registro de Obligaciones y Emprestitos de Entidades Federativas y Municipios) at the SHCP.

Historically, the principal creditors of state and municipalities have been Mexican development and commercial banks. Before March 31, 2000, the debt contracts established by state and municipalities allow the creditor, in case of arrears or threat of default, to request the Federation to deduct debt service payments from the issuer's tax participation flow before funds are transferred to the state. As a result, creditors in these transactions have considered them equal to the federal government debt.

Starting March 31, 2000, the federal government fostered the development of a master trust (Fideicomiso) contract that will regulate and establish payment procedures for debt issuances guaranteed by tax participations.

The current draft of the master trust includes the following payment priority:

*Transfer a minimum of 20% of tax participation flows to municipalities.

*Pay debt service for debt issued through the master trust after March 31, 2000; and

*Transfer excess tax participation flow to the state.

It is important to mention that although the master trust can receive the full amount of tax participation that belongs to the state, the debt issued after March 31, 2000, has no priority over the debt issued before. Payment priority of the debt issued by states and municipalities is determined by chronological order, while payment priority among the debt issued under the master trust will depend on the state's legal framework.

If a creditor of a state or municipality under a debt contract with the implicit federal guarantee decides to execute its guarantee by requesting the federal treasury to deduct the amount owed from the tax participation, the federal treasury will deduct the amount before transferring the tax participation to the master trust. Therefore, under this scenario, the debt service of contracts issued before March 31, 2000, is covered before the debt service of issuance made after that date.

Analysis of debt guaranteed by tax participations

The legal analysis is crucial to assess the probability that a state government will try to deviate GPSF flows to cover expenses different from the debt service of the issuances made after March 31, 2000.

In the case of states, for cash-flow analysis purposes, it is important to analyze the expenditures that state governments cover with flows from the GPSF. In general, they are related to education and health. As these expenditures would hardly be covered by other accounts in the state budgets, Standard & Poor's believes these expenses must be subtracted from the tax participation flow in the analysis.

Subsequently, Standard & Poor's imposes on the tax participation flows, stress scenarios that assume that states and municipalities will default on their outstanding financial obligations and debt contracts will enter into early amortization.

Standard & Poor's considers that the rating of a debt issuance guaranteed by tax participation is directly related to the credit quality of the state or municipality. However, debt guaranteed by tax participations issued by states and municipalities with low ratios of debt to total tax participation revenues will have a higher probability of being rated above the issuer's credit rating.

The next step

In this transition toward a system of state and municipal debt regulated by market discipline, Standard & Poor's believes that state and municipal governments with low debt relative to income from the GSPF are in an excellent position to successfully access the capital markets. Nonetheless, such states and municipalities are also the ones that currently are in less need of issuing debt. Once the final draft of the master trust is written, the next step will be to define the type of financial instrument that states and municipalities can issue, as there is no clear legislation for these entities on direct issuance to the capital markets. During 2000, there was an important increase in the number of ratings that Standard & Poor's assigned to states and municipalities. This increase derives from recently enacted rules that outline a rating-based system of risk weighting for banking institutions that perform credit transactions with public sector entities. Standard & Poor's believes that a higher volume of rated states and municipalities, will cause, in the medium term, debt issuances guaranteed by tax participation to be a core part of the states and municipalities' strategy to access local capital markets.

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