Posted by Tim Irwin[1]
How should government debt be valued?
Three answers are common: face value, market value, and amortized cost. But, as this paper argues, none of these answers leads to reliable indicators of the burden of the debt.
To be specific, suppose a government issues a five-year bullet bond with a face value of $1 billion and a coupon of 5 percent a year paid annually; that investors pay $1.045 billion for the bonds because they think the government’s creditworthiness justifies an interest rate of 4 percent; and that the risk-free rate of interest is 2 percent. How much debt should the government record in its accounts?
The three common answers are:
- Face value: $1.000 billion until the bond is repaid.
- Market value: $1.045 billion initially. Thereafter the reported value fluctuates with the market value of the bond and thus the interest rate that investors demand.
- Amortized cost: $1.045 billion initially, with the $0.045 billion premium above face value being amortized smoothly over the term of the bond.
There are problems with all three answers. Face value bears no necessary relation to the burden of the debt, and it can be manipulated. In fact, a determined government could borrow as much as it wanted while recording virtually no debt at all at face value. And amortized cost and market value both have consequences that make them perverse indicators of the burden of the debt. Consider, for example, two governments that issue bonds with identical terms: the government that is more creditworthy will report more debt than the one that is less creditworthy, even though the two governments have identical obligations. And, if debt is recorded at its market value, the government will report less debt if it gets into fiscal trouble and more debt when its finances improve.
The paper that discusses these issues benefited from comments and information from many people in the IMF and elsewhere, including Andreas Bergmann, Sagé de Clerk, Marvin Phaup, Maximilien Queyranne, Junji Ueda, and Frans van Schaik. None of them should be presumed to agree with the paper’s arguments or the alternative method of valuing debt that it puts forward for consideration. That method is to value debt at its policy value, which is the cost to the government of carrying out its policies. In the example above, if the government’s policy is to honor its debt, the government would record debt of $1.141 billion, which is the present value of the government’s promised payments at the risk-free interest rate.
[1] Tim Irwin is a consultant and former staff member of the IMF’s Fiscal Affairs Department.
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