Effect of an Income Shock on Subnational Debt : Micro Evidence from Mexico

This paper examines how the borrowing decisions of local governments, often financially constrained, respond to a shock that affects the distribution of revenue from the central government. The shock stems from the discrete updating of population census data that is plausibly uncorrelated with short-term financing needs. For a one-standard-deviation increase in the population shock, I find that federal transfers to Mexican municipalities increase by 2% over the first two post-census years. Using supervisory loan-level data, I show that the probability of municipalities being indebted declines by 0.1 percentage points over the same period. The response is driven by governments with relatively more ownsource revenue, less dependent on transfers, which lenders perceive as more creditworthy. These findings reveal a small capacity to smooth shocks in credit markets, restricted to few governments with a diversified revenue base. In general, there is no evidence of a positive effect of grants on local debt, not even when the lender is a public bank. The additional revenue mostly goes to finance short-term, current expenditures, with limited potential to alter the path of local development