Effect of a transfer shock on subnational debt: Micro evidence from Mexico

This paper examines how a shock to the distribution of federal transfers to Mexican municipalities affects their demand for long-term loans aimed at funding productive investments. Transfers are municipalities’ main source of debt payment and collateral. Using granular supervisory data, I find a positive effect on municipalities’ loan volume, normalized by the country’s total municipal loans, driven by obligations with private lenders. However, I find little or no average effect on take-up — despite many governments being unbanked —, repayment, or volume at the intensive margin. Governments with lower payment capacity and other preexisting debt are more sensitive to the shock. In particular, those with short-term debt are more likely to start borrowing from private lenders, while those with bonds turn to the development bank. The additional revenue mostly funds current rather than capital expenditures. These findings highlight that the policy goal of deepening subnational credit markets in developing countries must also address weaknesses in local investment capacities.