Over the past several weeks, the State of Mexico has been quietly pulling together a deal backed by payroll taxes, according to sources familiar with the process. With its unappealing national-scale ratings of BB+/BBB- by Fitch Ratings and Standard & Poor's, the issuer will need juicy enhancements to woo pension funds, which won't touch anything below the double-A level.

Right now the transaction is sized at around Ps2.05 billion (US$200 million) - a bulky size for locals but reasonable given the issuer collected Ps1.6 billion (US$156 million) in payroll taxes over 2001. The take has gone up every year since 1996 and should spike in 2002 following a 0.5% hike in the tax, to 2.5%.

Talk is that banks had until Oct. 4 to bid for a mandate, though the state has not yet made public its decision, said a source who participated in the process. Most of the investment banks active in the domestic market put out bids.

"For now it looks like a reserve account is the most likely enhancement, though there might be others," said a source familiar with the deal.

Since Mexican pension funds are by law prohibited from buying paper below double-A, the state will have to reach at least that rung. A likely maturity of five to seven years will keep insurance companies at arm's length.

The state's high level of indebtedness is a drag on the ratings. The lion's share of its savings goes to service debt, which reached Ps26.3 billion (US$2.57 billion) at the end of 2001. While debt ratios spiked in 2001, the state pushed out its maturity profile by paying down short-term liabilities outside the bank sector.

To date, sub-national entities have stuck to federal co-participation revenues to back bond deals (see ASR 9/9 p. 26). Paper backed by payroll taxes could possibly open the door for states and municipalities to explore other assets. Bankers and analysts say that clean sub-national deals are unlikely to visit the Mexican market in the foreseeable future, partly because the sector is still haunted by a reputation picked up during the mid 90s of being free spenders.

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