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

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

Public debt ratios are smaller in countries with more volatile revenue ratios

Public debt ratios are smaller in countries where output is more volatile

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

1 ( )g gt t t t tb b R t g

g t gb

R

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

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

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:

11

min ,

g gt t t t t

gt t t

g g if b b R g t

otherwise g g t b R

tg g

1gt

t gb

R

0

( )T

i

i

g gR

g t

tt ttg g

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:

g

1 min ,g

g t t tt

b R g tb

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

0.835 0.0358g g g

0.224g

Natural Debt Limits with Low Real Interest Rate(Mexico: E(t)=0.229, R-1=6.5%, -1=3.7%, g=0.217)

Time to a Fiscal Crisis (or time before hitting debt limit)

Mean Forecast Debt Ratio for b0g=30 percent

Simulated Samples of Debt Ratios for b0g=0.1

The Dynamic GE Model with Liability Dollarization

Private sector:

1 0

11

0{ , , } 0

1

1

( , ) 1max

1

:

(1 )

:

( , ) 1

T Nt t t

T Nt

t t

c c b t

T N Nt t t t

T T N N N Rt t t t t t

T N T Nt t t t

g It t t

C c cE

subject to

c p c b

e y p e y e R b tr

with

C c c c c

b b b

The public sector (the insurer’s torment!):

ˆ{ , , , }

1

1

ˆ ˆinf

min ,

, , 0

max ,

T N R N

T T N N N T N Nt t t t

Re e e pt

g Rg t t tt

T N N T T N N Nt t t t t t t t

gt t t t

T g Rt tT

t

e y p e y g p g w

e R

b e R db

d g p g tr e y p e y

tr w w welfare entitlements rebates revenue if b

g b e Rg

max ,

Tt

T

g R T T T N N Nt t t t tN T T

tNNtt t

N

d g if is binding

g otherwise

b e R g e y p e yg w if g g

pg w

g w otherwise

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

1

1

ˆ{ , , , }

1

1ˆ

ˆinf

ˆ ˆˆ min ,

T N R N

T T T I I Rnt t t t ttN N N

t t

T T T N N N Nt t t

Re e e pt

g R T T T N N N Nt t t t t t t tg

t

e y g b b e Rp

e y g

e y g p e y g w

e R

b e R g e y p g w e yb

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

Moments of the Stochastic Steady State

Conclusions 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