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

Listed author(s):
  • Marcelo Oviedo
  • Enrique G. Mendoza

Governments in emerging markets often behave like a "tormented insurer" struggling to smooth government outlays given the randomness of public revenues in a world with "liability dollarization" in which they can only 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 non-insurable 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 paper 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 can deviate sharply from conventional sustainable debt ratios

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 14.

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Date of creation: 2004
Handle: RePEc:red:sed004:14
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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