strategy where treatment is continuous and corresponds to the ratio of a state’s total public debt to its free disposable income in 2016Q1.<sup>4</sup> That is, the treatment status of states is fixed over time and determined by their indebtedness one quarter prior to the implementation of the Law.<sup>5</sup> To examine the impact of the Law on fiscal consolidation, we match data on the indebtedness of local governments with information on their public expenditures and revenues. We also match to this data information on poverty rates as well as GDP and employment growth to analyze the impact of the reform on economic activity of states. Finally, we use exhaustive loan-level credit register data matched with information on bank and firm balance-sheets. This data helps us explore if the debt restrictions imposed by the FD Law trigger a reallocation of bank lending away from local governments and into private firms. Importantly, as local governments in Mexico fund themselves almost exclusively through banks, our loan-level data allows us to examine the effect of the Law on the supply of credit.<sup>6</sup> We find that following the FD Law, ex ante more indebted states undertake larger fiscal consolidation, in the form of higher tax rates and larger public expenditure cuts—including in areas such as infrastructure and social protection. Regarding fiscal adjustments, we find that a onestandard-deviation increase in state ex ante indebtedness is associated with a 10 percent increase in tax rates, while on spending adjustments, there is a 4.4 percent contraction in the ratio of public spending to GDP, driven in part by a reduction of spending on both social protection and on infrastructure projects (though there are stronger effects on non-infrastructure projects).

> 4 One key identifying assumption to estimate the causal effects of the introduction of the FD Law is that all outcomes of interest would have followed parallel trends across states in its absence. While we cannot explicitly test for this assumption, we check if all our outcomes of interest (at the state, bank, firm, and loan levels) follow parallel trends across states prior to the introduction of the Law. We find no differences in pre-Law trends, lending credibility to our identification strategy. Using impulse response functions, we corroborate that all our results only happen after the introduction of the Law, not before, suggesting that local governments do not change their behavior in anticipation of the implementation of the Law.

> 5 Due to the long maturity of states’ debt (of roughly 15 years), the indebtedness of states varies little throughout our sample period. For example, within a state, the average correlation of indebtedness one quarter and one year prior to the Law is 0.98. Thus, our results remain quantitatively similar if we use the indebtedness of states one year prior to the Law. For the same reason, the indebtedness of states varies little immediately following the implementation of the Law. As such, states with higher indebtedness at the time of the Law continue carrying higher levels of debt in the subsequent years.

> 6 In the quarter preceding the implementation of the Law, 90 percent of the funding of state governments was obtained from private banks. This dependence on bank financing is a feature of many emerging economies, given the scarcity of alternative sources of financing (Beck, Demirgüç-Kunt and Maksimovic, 2008).

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