A spokesman for the Spanish club confirmed Schuster's imminent appointment on the day Pellegrini moved closer to finalising his Eastlands switch.
Issues over unpaid wages and compensation have stopped City officially announcing the Chilean as Roberto Mancini's successor.
But those problems are close to resolution, according to Sky sources, and in the meantime Malaga have secured former Real Madrid boss Schuster as their new boss.
The German, who has also managed Xerez, Levante and Getafe in Spain, has been out of work since leaving Besiktas in 2011.
Schuster has agreed a five-year deal with Malaga, who finished sixth in the Spanish league but are banned from European competition next season.