Public Debt, Fiscal Solvency, and MacroeconomicUncertainty in Latin America: The Cases of Brazil,Colombia, Costa Rica, and Mexico

The ratios of public debt as a share of GDP of Brazil, Colombia, and Mexico were 12 percentagepoints higher on average during the period 1996-2005 than in the period 1990-1995. CostaRica's debt ratio remained stable but at a high level near 50 percent. Is there reason to beconcerned for the solvency of the public sector in these economies? We provide an answerto this question based on the quantitative predictions of a variant of the framework proposedby Mendoza and Oviedo (2006). This methodology yields forward-looking estimates of debtratios that are consistent with fiscal solvency for a government that faces revenue uncertaintyand can issue only non-state-contingent debt. In this environment, aversion to a collapse inoutlays leads the government to respect a \natural debt limit" equal to the annuity value of theprimary balance in a \fiscal crisis." A fiscal crisis occurs after a long sequence of adverse revenueshocks and public outlays adjust to their tolerable minimum. The debt limit also representsa credible commitment to remain able to repay even in a fiscal crisis. The debt limit is not,in general, the same as the sustainable debt, which is driven by the probabilistic dynamics ofthe primary balance. The results of a baseline scenario question the sustainability of currentdebt ratios in Brazil and Colombia, while those in Costa Rica and Mexico are inside the limitsconsistent with fiscal solvency. In contrast, current debt ratios are found to be unsustainablein all four countries for plausible changes to lower average growth rates or higher real interestrates. Moreover, sustainable debt ratios fall sharply when default risk is taken into account.[...]