Download Public Debt, Fiscal Solvency & Macroeconomic Uncertainty in

Public Debt, Fiscal Solvency & Macroeconomic
Uncertainty in Emerging Markets
Enrique G. Mendoza
University of Maryland
and NBER
P. Marcelo Oviedo
Iowa State University
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

–
–
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–

 btg1  btg Rt  (tt  g t )
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
The starting point:
Long-run, BB method (Blanchard, Buiter):
bg 
tg
R 
– 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

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: tt  t “almost surely”, and g t  g
 Tormented insurer wants to keep gt  g as long as it
can access non-contingent debt market.
– Credible commitment to repay imposes natural debt limit:
g
t 1
b
 
t g
R 
– Policy rule governing total outlays:
g t  g if
btg1   1 btg R  g t  tt   
otherwise g t  min  g ,   tt  btg R 
– With bog=0, fiscal crisis “almost surely” at date T that solves:
T
(R   )
i
i 0

gg
gt
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 g 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:
 btg R  gt  tt 
g
bt 1  min  ,




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:
g  0.224
g  0.835g  g  0.0358
– 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)
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:
T
N 1

 1
1 t C (ct , ct )
max E0    

{ctT ,ctN ,bt 1 }
1


0
 t 0

subject to :
ctT  ptN ctN   bt 1 
(1   )  etT y T  ptN etN y N   etR R bt  trt
with :
T 
N  

C (c , c )    ct   1     ct  


bt  btg  btI
T
t
N
t

1


The public sector (the insurer’s torment!):


  etT y T  pˆ tN etN y N   g T  pˆ tN g N  w

  T inf
{e ,e N ,e R , pˆ N } 
etR R  

g
t 1
b
 


 btg etR R  d t 
 min   ,




d t  g tT  ptN  g tN  trt     etT y T  ptN etN y N 
trt  wt  t ,
w  welfare  entitlements,  rebates revenue if btg1  0
 max  g T ,    btg etR R  d t  g T   if  is binding 




g tT  

T
 g

otherwise


 N
  btg etR R  g T    etT y T  ptN etN y N  
T
T
 max  g  w,
 if g t  g 
N
N
pt


g t  wt  



N
 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  e y  g   b  b e R 



e yN  g
  

T
t

T
T
t
N
t
I
t 1
N
t


I R
t t
 pˆ tn

  etT y T  g T  pˆ tN  etN y N  g N  w

  T inf
N R N
{e ,e ,e , pˆ } 
etR R  

 


 bˆtg etR R   gtT   etT y T   pˆ tN  g tN  wt   etN y N  

bˆtg1  min   ,





Application to Mexico (quarterly frequency)

Calibration of deterministic steady state:
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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

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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