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

Governments in emerging markets often behave like a “tormented insurer,” who would like to smooth government outlays given the randomness of public revenues in an imperfect world where the only public debt instrument is a non-state-contingent bond denominated in units of tradable goods. 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 model is used to quantify the dynamics of public debt implied by the competitive equilibrium of a two-sector small open economy subject to exogenous shocks to income given tax and expenditure policies. A government committed to repay must not borrow above the “natural” debt limit set by the annuity value of the “crisis” level of the primary balance, set by the minimum levels of public revenues and outlays. This limit, and the likelihood that the government may hit it along an equilibrium path, are determined jointly by tax and expenditure policies and by endogenous and exogenous variables outside the government’s control. Moreover, liability dollarization (i.e., the mismatch between debt denominated in units of tradables and revenues that are largely collected in units of nontradables) implies that endogenous fluctuations of the real exchange rate alter the variability of public revenues and outlays and thus affect the government’s ability to issue and service debt. JEL classification numbers: E62, F34, F41, G15, H62, H63