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Public Debt, Fiscal Solvency & Macroeconomic Uncertainty in Emerging Markets. Enrique G. Mendoza P. Marcelo Oviedo University of Maryland Iowa State University and NBER. The Tale of the Tormented Insurer.

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public debt fiscal solvency macroeconomic uncertainty in emerging markets

Public Debt, Fiscal Solvency & Macroeconomic Uncertainty in Emerging Markets

Enrique G. Mendoza P. Marcelo Oviedo

University of Maryland Iowa State University

and NBER

the tale of the tormented insurer
The Tale of the Tormented Insurer
  • EM governments often act as a “social insurer” trying to smooth gov. outlays in a challenging world:
    • Public revenues are highly volatile
    • Access to capital markets is uncertain
    • Insurance markets are incomplete
    • Can only issue debt in units of tradables but largely leveraged on nontradables sector (“liability dollarization”)
  • How can we tell if the stock of public debt is consistent with fiscal solvency in this environment?
    • We propose a structural framework that incorporates the above elements into a dynamic GE model of a small open economy governed by a “tormented insurer” (i.e., a government “credibly committed” to repay)
coefficients of variation of revenue gdp ratios are significantly higher in emerging markets
Coefficients of variation of Revenue-GDP ratios are Significantly Higher in Emerging Markets
public debt sustainability analysis a review
Public Debt Sustainability Analysis: A Review
  • The starting point:
    • Consolidated gov. budget constraint (GBC)
    • Exogenous trend growth rate of output 
    • Detrend by expressing all variables as shares of output
    • bg debt-output ratio, R gross real interest rate, t public revenue-output ratio, g total public outlays-output ratio
  • Long-run, BB method (Blanchard, Buiter):
    • BB ratio is the steady-state GBC
    • Assumes repayment commitment under perfect foresight
    • Viewed as target debt ratio for given primary balance or as primary balance required to sustain debt ratio
  • Tests of Intertemporal GBC
    • Time series tests of NPG condition
recent methods uncertainty financial frictions
Recent Methods: Uncertainty & Financial Frictions
  • Non-structural time series methods
    • IMF I: Barnhill & Kopits (2003), Value-at-risk approach
    • IMF II: IMF(2003), VAR model of debt dynamics
    • Deutsche Bank: Xu & Ghezzi (2003), “Fair spreads” from continuous-time model driven by exogenous Brownian motions
    • Ongoing projects: IMF III, IADB, World Bank
  • Structural Models with Financial Frictions
    • Incomplete markets: Aiyagari, Marcet, Sargent & Sepala (2001), optimal taxation supports tax smoothing with non-contingent debt & debt limits in a dynamic, stochastic GE model of a closed economy
    • Liability dollarization: Calvo, Izquierdo & Talvi (2003), Sudden Stop causes real exchange rate collapse and this reduces sustainable debt obtained with a two-sector variant of long-run approach
the mendoza oviedo framework
The Mendoza-Oviedo Framework
  • Structural approach: explicit economic model linking macro uncertainty to dynamics of public debt
  • Fiscal sustainability analysis robust to Lucas Critique
  • Can capture effects of liability dollarization and its feedback with incomplete markets & uncertainty
  • Aims to provide quantitative input for policy analysis:
    • Calibrated to country-specific features
    • Short- and long-run debt distributions
    • Conditional forecast & stochastic simulations
    • Time to crisis estimators
    • Effects on private sector & feedback effects
    • Policy simulations with welfare evaluations
basic model exogenous random revenues
Basic Model: Exogenous, Random Revenues
  • Markov process: t={ t <..<tM}, transition prob. matrix P
  • Fiscal crisis: “almost surely”, and
  • Tormented insurer wants to keep as long as it can access non-contingent debt market.
    • Credible commitment to repay imposes natural debt limit:
    • Policy rule governing total outlays:
    • With bog=0, fiscal crisis “almost surely” at date T that solves:
implications of the natural debt limit
Implications of the Natural Debt Limit
  • Revenue variability affects  : t is a multiple of sd(t)
    • Country A with same E[t] as B but lower sd(t) can borrow more
    • BB long-run method sets bg for E[t] but assuming sd(t)=0
    • Mean preserving-spreads of E[t] yield  < long-run estimate (commitment to repay using BB long-run method not credible)
  • Credibility of commitments to repay & to cut outlays during fiscal crisis support each other
    • For same process of t, country with lower has higher
  • But the Natural Debt Limit is not the same as the equilibrium or sustainable debt ratio!
    • Sustainable debt follows this law of motion:
sustainable debt in the basic model an example
Sustainable Debt in the Basic Model: An Example
  • Calibration to Mexico (1990-2002, IMF data):
    • Revenue process:

E(t) = 0.229 sd(t) = 0.185% (t) = 0.65

    • Rules for government outlays:
    • R-1 = 6.5%, -1 = 3.7%
    • Natural debt limit (with t set 2 sd’s below E(t)): = 0.5
natural debt limits with low real interest rate mexico e t 0 229 r 1 6 5 1 3 7 g 0 217
Natural Debt Limits with Low Real Interest Rate(Mexico: E(t)=0.229, R-1=6.5%, -1=3.7%, g=0.217)
how does dge model differ from basic model
How does DGE model differ from basic model
  • Tax revenue is endogenous since it depends on the equilibrium relative price of nontradables
  • Gov. debt dynamics depend on private sector behavior
    • Capturing this interaction is necessary in order to account for the effects of liability dollarization and incomplete markets
application to mexico quarterly frequency
Application to Mexico (quarterly frequency)
  • Calibration of deterministic steady state:
    • bg = 45.9% annually (average 1990-2002 IMF (2003a))
    •  = 23%
    • bI = -35% annually (Lane & Milsei-Ferreti (2002)
    • c = 68.2% g = 9.2% i = 21.6% (1970-1995, WDI)
    • -1 = 3.7% percent per year
    • yT/yN = 64.8% (Mexico’s NIAs 1988-1998)
    • cT/yT = 64.5%, gT/yT = 1.6%, iT/yT = 31.4%
    • cN/yN = 70.8%, gN/yN = 14.1%, iN/yN =15.1%
    • Normalization: yT = 1, pN = 1
    • R-1 = 6.5% per year, σ=1.5(Cooley & Prescott (1995))
    • 1/(1+η)=0.76, η=0.316 (Ostry & Reinhart (1992))
    • Implied parameters: ω = 0.334, w = 12.5%, β = 0.998
Calibration of exogenous Markov processes
    • Simple persistence, two-point chain for (eR,eT)
    • Tauchen & Hussey (1991) quadrature method for (eR,eT,eN) with two values for eR & eT and three values for eN
    • Moments from cyclical components of the data:

sd(eT)=3.37% (eT)=0.553 [Mexico’s tradables GDP]

sd(eR)=0.88% (eR, eT)=-0.116 [Eurodollar-G7 inflation]

sd(eT)=2.741% (eN)=0.657 [Mexico’s nontradables GDP}

    • Restrictions from parsimonious Markov approximation

(eR)=0.553, (eN,eR) = (eN,eT) = 0

  • Revenue ratios are more volatile & debt ratios smaller in EMs
  • This stylized fact can be explained by modeling fiscal solvency as a problem of social insurance with financial frictions
    • Credible commitment to repay induces endogenous law of motion with a “natural debt limit”
  • Uncertainty & market frictions alter significantly quantitative estimates of “sustainable” public debt
    • Long-run debt ratios much higher than sustainable debt!
  • Structural DGE framework allows forward-looking policy analysis of sustainable debt
    • Results robust to Lucas Critique
    • Useful to study regime changes in policy or in capital markets
    • Incorporates effects of incomplete markets & liability dollarization
  • Long average time to fiscal crisis with low debt, but much shorter for repeated, non-zero-prob. low realizations of revenue
  • Need fiscal reforms to produce higher, more stable revenue & enhance flexibility of outlays