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Public Debt, Fiscal Solvency, and Macroeconomic Uncertainty in Emerging Markets: The Tale of the Tormented Insurer

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  • P. Marcelo Oviedo
  • Enrique Mendoza

Abstract

Governments in emerging markets often behave like a "tormented insurer" who tries to smooth government outlays given the randomness of public revenues and in a challenging world in which "liability dollarization" requires them to issue debt denominated in hard currencies, or indexed to tradable goods prices. How can a fiscal authority tell if the stock of public debt is consistent with fiscal solvency in this environment? This paper proposes a quantitative framework that aims to answer this question. The framework emphasizes macroeconomic uncertainty and the transmission mechanism by which this uncertainty affects debt dynamics when asset markets are incomplete. A government making a credible commitment to repay cannot borrow above a "natural" debt limit set by the annuity value of the "catastrophic" level of the primary balance. This limit, and the likelihood that the government may hit it along an equilibrium path, are partly determined by tax and expenditure policies, but they also depend on endogenous and exogenous variables outside the government's control. Liability dollarization implies that endogenous fluctuations of the real exchange rate influence the variability of tax revenues and the government's ability to service debt, and thus affect the natural debt limit and public debt dynamics. The model proposed here quantifies the dynamics of public debt implied by the competitive equilibrium of a two-sector small open economy subject to exogenous shocks to income and the world interest rate, given tax and expenditure policies. The resulting short- and long-run distributions of debt-output ratios deviate sharply from conventional sustainable debt ratios

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 647.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:647

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Keywords: International Capital Flows;

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Cited by:
  1. Hostland, Doug & Karam, Philippe, 2006. "Assessing debt sustainability in emerging market economies using stochastic simulation methods," Policy Research Working Paper Series 3821, The World Bank.
  2. Diego Valderrama & Katherine Smith, 2009. "Why Do Emerging Economies Import Direct Investment and Export Savings? A Story of Financial Underdevelopment," 2009 Meeting Papers 1160, Society for Economic Dynamics.
  3. Philippe D Karam & Doug Hostland, 2006. "Specification of a Stochastic Simulation Model for Assessing Debt Sustainability in Emerging Market Economies," IMF Working Papers 06/268, International Monetary Fund.
  4. Marcelo Catena & Fernando Navajas, 2006. "Oil & Debt Windfalls and Fiscal Dynamics in Bolivia," IDB Publications 22178, Inter-American Development Bank.
  5. Humberto Mora Alvarez, 2004. "Assesing Fiscal Sustainability With Alternative Methodologies," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE.

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