Debtor versus creditor principle of interest recording in macroeconomic statistics. A comment – by

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August 31, 2002 Die – France Debtor versus creditor principle of interest recording in macroeconomic statistics A comment – by Philippe de Rougemont 1. This paper intends to suggest additional arguments in favor of the debtor principle 1and against the creditor principle of interest recording in macroeconomic statistics. While recognizing the formidable power of attraction of the creditor principle, both at the conceptual and compilation level, the paper points at some overlooked arguments and recommends sticking to the debtor principle – until financial techniques are such that new levels of wide, massive and systematic use of refinancing by all institutional units warrant a revisiting. 2. Under the creditor principle, the interest flow (D.41) is equal to the current (market) yield to maturity (CYTM) times the current (market) value of the instrument: its amount therefore varies over time in sympathy with market yields changes, even for fix-rate instruments. Under the debtor principle, the interest flow (D.41) is equal to the CYTM at 2time of issue of the instrument times the amount of principal outstanding : its amount is 3therefore fixed at time of issue for all successive future periods . 3. Although the market prices of securities by construction vary inversely with market yields, this is insufficient to ensure a constant product (CTYM times the market price). Such a product will be a function of the current premium/discount ...

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August 31, 2002 Die – France Debtor versus creditor principle of interest recording in macroeconomic statistics A comment – by Philippe de Rougemont1. This paper intends to suggest additional arguments in favor of the debtor principle 1 and against the creditor principle of interest recording in macroeconomic statistics. While recognizing the formidable power of attraction of the creditor principle, both at the conceptual and compilation level, the paper points at some overlooked arguments and recommends sticking to the debtor principle – until financial techniques are such that new levels of wide, massive and systematic use of refinancing by all institutional units warrant a revisiting. 2. Under the creditor principle, the interest flow (D.41) is equal to the current (market) yield to maturity (CYTM)timesthe current (market) value of the instrument: its amount therefore varies over time in sympathy with market yields changes, even for fix-rate instruments. Under the debtor principle, the interest flow (D.41) is equal to the CYTM at 2 time of issue of the instrumenttimes: its amount isthe amount of principal outstanding 3 therefore fixed at time of issue for all successive future periods . 3. Although the market prices of securities by construction vary inversely with market yields, this is insufficient to ensure a constant product (CTYMtimesthe market price). Such a product will be a function of the current premium/discount amortized over the remaining length of the security. This explains why the creditor principle interest flow (D.41) depends on the current market yield rather than the issue yield. Transformation of instruments into quasi-variable rate instruments 4. The creditor principle measures theopportunity costof debt, as if debtors would constantly (every day...) buy-back their debts (at market prices) and reissue new ones. The implication is striking, as the creditor principle de facto transforms “all” fixed coupon

1 By reference to the documents posted, and the terminology used, on the IMF Electronic Discussion Group on Accrual Accounting of Interest.

2 Principal would then mean the issue value plus accrued “interest” not yet paid. “Interest” means coupons and amortized discounts and premium to date. Note the potential circularity in this definition of “principal”; see para 18 and 19 below.

3 In the currency of denomination, and for a fixed coupon instrument.

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4 instruments into “quasi-floating rate” ones , although to different extends according to the remaining maturity. Note the limit case when interest flows (D.41) on “perpetuals” are left unaffected by changes in market yields and indeed are identical under both creditor and debtor principles. 5. Consider a portfolio of same initial maturity instruments, equi-distributed by redemption date. One can see that the differential impact on creditor versus debtor principle interest flows (D.41) of changes in market yield depends upon the maturity of the instrument compared to the length of the accounting period: increasing from zero with maturity, achieving a top when both are equal, and falling back to zero. Hence, debtor and creditor principles yield identical results for two extremes: overnight debts and perpetuals. The difference is maximum for instruments with a maturity slightly longer than the length of the accounting period under consideration: (a) debtor principle interest flows (D.41) for a given period are absolutely inelastic to market yields until instruments are redeemed and reissued, and (b) creditor principle interest flows (D.41) are less elastic to market yields the longer the maturity of the instrument, owing to the fact that the (current) premium or discount increases non-linearly with maturity but is to be amortized over a linearly increasing period. 6. The impact on macroeconomic statistics is therefore tremendous. As a rule of thumb, the elasticity of interest flows (D.41) to interest market yields for a portfolio of securities with a 5 years average maturity might easily be around 1/2 to 2/3, i.e. interest rates moving from 5% to 8% would translate into an increase of about 40% of the interest bill instantaneously. Taking the case of a government debt of 100% of GDP, this would mean 5 an automatic andinstantaneous. Recent experience ofincrease of 4% of GDP of the deficit 6 dramatic increases of spreads on foreign currency debt would point to even larger impacts. 7. The creditor principle leaves the total amount of interest flow (D.41) on a given instruments over the life of the instrument a prioriindeterminate– in contrast to the debtor principle where the interest flow (D.41) is the simple arithmetic sum of all cash flows foreseen in the contract – : it will finally result from the market yield to be observed during the life of the instrument.

4 and not only zeros as sometimes (curiously) believed.

5 Instead of a very gradual increase in sympathy with the gradual natural refinancing of the portfolio, spread over numerous years.

6 Spreads over “risk-free” sovereign risks have in many circumstances moved from 5% to 15% or 20% in a matter of months, and even much higher in recent and particularly difficult situations.

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Revaluation entries 8. It is universally recognized that interest flows (D.41) recording in national accounts (SNA 93/ESA 95) follows the accrual principle. Hence, being compensation in return for providing funds, the appropriatetimeof recording interest is continuously, not when due or paid. The accrual principle is a time of recording issue, not a valuation issue (amount to 7 record). Hence, the debtor versus creditor principle is not an accrual question but a 8 classification issue relating to the adequate delineation of flows : is the observed change in balance sheet a transaction or a revaluation? It is also sometimes argued that the creditor principle does not respect the accrual principle since it does not leave the valuation of the transaction unchanged (Laliberté 2002 para 61). Again, this reinforces the point that the creditor/debtor principle issue is merely a classification issue and, in the first place, an understanding of the delineation between revaluation account versus financial account. 9. It is often argued that the debtor principle exhibits a major conceptual flaw as it entails revaluation entries even when market interest rates have not changed during the accounting period (owing to the fact that the financial account then captures the amortization of the premium/discount at issue instead of the current premium/discount). This appears a seemingly particularly powerful and disturbing argument. However, one observes that those revaluation entries (amortization of a current premium, for instance) are only the counter entry of an initial revaluation entry (apparition of that current premium). This observation in turn suggests a useful and more specific interpretation of the revaluation account. 10.The revaluation account is meant to capture “surprise” changes in value, i.e. those changes that were not expected at time of contract. Under this definition, revaluation entries can occur despite unchanged market rates: suffice that the change in value of the instrument during a period be different from the expected change at time of issue for that same period. Owing to market yield curves (observed with the swap curve for instance), at any given point in time, expectations are generally that market rates will change over future periods rather than remain rigorously constant. Hence, unchanged rates are generally a “surprise” rather than the reverse. 11. This corresponds to the spirit ofSNA 93where foreseen or expected value changes are viewed as volume changes, not price changes. This is particularly clear with the example of zeros (and premiums and discounts) – see for instanceSNA7.98, 7.100, 7.101 or 7.103.

7 We find an enlightening analogy in the modification of theESA 95to cater for the recording of taxes unlikely to be paid. This modification, sometimes viewed as a generalization ofSNA 93para 8.50, was not a departure of the accrual principle because it was question of valuation as well as of classification of flows.

8 Peter Hill (1996 – page 2) seems to agree, but Chris Wright may be not (2002 – page 6).

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The analogy with a wine that matures and gains in value is also quite illustrative (SNA12.110). YTM or expected return ? 12. It can be observed that the expected return during a given period will differ from yield to maturity (YTM), owing to the existence of any non-flat yield curve. By arbitrage, first period expected returns will move in sympathy with money market yields, while YTM follows bond market yields. Hence, one may note that using a YTM at issue for the debtor principle is a simplification in comparison to a pure recording where “expected changes in value” would be considered. However this concerns both the debtor and the creditor principles. 13. The draft standard (Joint Working Group of Standard Setters, an IASB supported project) allows the recording of interest on the basis of expectedcurrentreturn for the period instead of the CYTM. Such a recording, though intellectually particularly appealing, is radical as itde factotransforms all instruments into short term ones. One remarks that, similar to the debtor principle, this recording triggers holding gains and losses even when realized market yields are constant over the period, as long those constant market yields had not been expected. It is worth noting that, the two methods allowed by the draft standard yield very different results owing to the substantial difference in usual amplitude (bottom to top) of short term rates in comparison to long term rates (in a proportion of as much as 1 to 2 9 or to 3) under normal market circumstances . Revaluation account using the perspective of derivatives, index-securities and dividends 14. This proposed interpretation of the revaluation account is also the implicit view behind the recording of financial derivatives. Consider a plain vanilla swap. Its market value does not change as long as the market expectations embodied in the yield curve existing at time of contract does realize (the swap still acquires market value, but then only on the basis of exchanged cash flows, and interest earned on those) and despite the fact that market yields do change. Alternatively, forcing changes in swap “prices” except at time of stable yields would in fact require that “interest” on swaps be non-financial transactions as was the case in 10 ESA95, before its change, embodying a completely different view of what the revaluation account captures. 9 With short term rates mowing rapidly from 4% to 8% and long term rates moving simultaneously from 5% to 7%, the average interest flow (D.41) would double under the expected current return option but would only increase by about 30% only (assuming a portfolio of 5-Year average maturity) under the CYTM option.

10 As well as inSNA93before its change. However, the first version ofSNA 93did not recognize swaps as financial assets (despite “interest payment” being recognized as interest D.41), creating another type of anomaly.

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15. Such an interpretation of the revaluation account may also shed light on the way to tackle “indexed securities”. It is widely assumed that the correct interpretation ofSNA7.104 and 11.78 is that all changes to the principal due to changes in the index occurringduringan accounting period would be recorded as interest (D.41) – see the Eurostat’s Manual on Government Deficit and Debt (III.3.3.b). While such an interpretation is acceptable in case of smoothly changing index such as consumer prices, for highly volatile index prices such as gold, currencies or commodities, this interpretation seems at odds with an essential feature of theSNAsystem, since large “price-type” changes in valuation would be captured as income instead of holding gains and losses. In addition large amounts of negative interest (D.41) would regularly appear. Some countries with substantial outstanding of indexed securities (mostly indexed on foreign currencies) could not possibly apply such treatment without 11 creating an extraordinary volatility of the government interest bill and deficit . Note that, to the extend that exotic debt issued by government units are commonly immediately swapped back into a more conventional instrument – in the process tapping a niche market and thereby capturing a lower total yield –,SNA 93treatment of indexed would preferably need to be in line with derivatives. 12 16. It seems appealing that in case of volatile index , the expected change in value of the index at time of issue, as measured by its forward, be considered interest (D.41) and accrued over the life of the contract. Other changes in value arising from unexpected movements of the index would then appropriately be entered under the revaluation account. 17. At that stage, it is not completely irrelevant to mention that the revaluation account as it is inSNA 93is far from pure. In particular, by allowing income recognition on the basis of distributed dividends instead of profits earned,SNA 93generates substantial anomalous revaluation flows: holding loss at time of distribution of dividends (instead of a more logical recording of financial transaction), holding gains accruing over the period from profits (instead of a more logical recording of financial transaction matched by imputed property income). Surely,SNA 93foresees such a more logical alternative recording for direct foreign investments (Reinvested earning on direct foreign investments – D.43) but not for other institutional units. The generalization in the USA, and more recently in Europe, of a trend of substitution of dividends by “buy-backs” programs, for fiscal reasons notably, has created a substantial risk of distortion of households’ income and saving rates. Similarly, the proper 11 Much in excess of the volatility created by the creditor principle. A government having issued 20% of GDP in indexed on foreign currency confronted with a depreciation of 50% would face an interest bill of 10% of GDP additional to the 1% (before depreciation) or 2% (after depreciation) of GDP already kicked in. In case of following re-appreciation (overshooting), substantial negative interest would be generated.

12 Along with a Eurostat decision, taken in the context ofESA 79, that discriminated instruments according to the volatility of the index.

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representation of the relationship between government units and public corporations in both directions (capital injections and super dividends) is made more difficult under the present 13 SNA 93rule. Principal, volume and nominal value 18. It is sometimes argued thatSNA 93, by defining interest as “the amount that the debtor becomes liable to pay to the creditor over a given period of time without reducing the amount of principal outstanding”, supports the creditor principle as “principal would be taken to mean the value of the financial instruments at market value” (Joisce/Wright 2001 and 14 Wright 2002 page 6). This might find some support inSNA10.14. However, such a statement does not square well withSNA12.110 and even more so 13.72, among others. Arguably,SNA 93seems instead to equate “principal” with size or volume or quantum of an instrument – not with market value. Alternatively, “principal” would more simply and neutrally refer to that part of the payments that is viewed as a “reimbursement” as opposed to that part that is the remuneration of the capital. But what the signification of “principal outstanding” would then be, once it is agreed that the stock of accrued interest is to be assimilated to the principal? 19. Hence the market value of an instrument can be seen as its volumetimesits price. At that point, the notion of price of an instrument mightseemsomehowcircular: it all depends upon what is the size. However, the size or volume seems clearly the cumulating of 15 transactions (and other changes in volume): issues, interest accrued, redemptions (seeSNA12.110). Only the debtor principle can truly fit with this requirement, because the creditor principle will generally not be able to ensure that the size of the instrument at maturity be equal to the redemption value of the instrument. It stands to reason that a requirement be that when the instrument has been definitively redeemed both its market value and its volume be zero in the system – but this will generally not be the case under the creditor principle. The

13 See notably the Eurostat’s Manual on Government Deficit and Debt (II.1.2 and II.3.1). In a laborious way designed to mimic what a D.43 treatment generalized to public corporations would have automatically generated, the Eurostat manual foresees a series of rules that might appear somehow seemingly arbitrary. Super dividends are to be treated as capital withdrawal (financial transactions), while “capital injections” are to be treated as capital transfers instead of “equity injections” (transactions in equity) when to cover past losses (SNA10.141-b) or when there is no expectation of satisfactory return on the capital.

14 Note that such would point to the current expected return option, note to the CYTM option – see para 12 and 13 above.

15 Redemptions include “coupons paid” in addition to the (common view of) “principal repayments” to the extent that accrued interest is deemed to be added to the principal in the system.

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failure of the creditor principle to be compatible with the notion of volume of instrument directly derives from the fact that the delineation of transactions and holding gains/losses departs from that of the debtor principle (where, in the latter, the sum of entries,for each account,over the contract equals zero). 20. WhileSNA 93values instruments at market value, it is argued here that it implicitly also recognizes the volume of financial instruments such as securities. It now looks attractive to define thenominal value(of debt) as that size, volume or principal just defined. For some analysis, notably in government finance, nominal value of debt has analytical merit (as long 16 as properly defined ): in case of confidence crisis, it is likely that the market value of government debts falls, sometimes considerably, which would somehow be misleading. The Government Finance Statistics Manual 2001adequately follows the market valuation of instruments for its framework, but in addition shows the debt at nominal value as memorandum item. Nominal value is then defined in this manual (in footnote 8 of chapter 3) as the issue price plus accrued interest not yet paid or alternatively, and giving the same result, the sum of remaining discounted cash flows using the initial yield as discount factor. Economic behavior 21. Macroeconomic statistics’ ambition is to provide analytical tolls useful to describe the economic behavior of actors. To the extent that the creditor principle measures the opportunity costs of debt, as if debtors would constantly (every day...) buy-back their old debts and reissue new ones, it is questionable whether the economic behavior of actors is indeed properly described. 22. It is often argued that the creditor principle manages to address the question of the more and more frequent buy-backs of debts by governments. It is true that buy-backs are deficit neutral under the creditor principle, but deficit-impacting under the debtor principle (they affect future deficits) and that this latter characteristic is a clear weakness. At the same time, such buy-backs have tended to remain relatively small as a percentage of the total amounts outstanding. Hence the switching to the creditor principles seems at this stage a rather radical solution. 23. Issuers – in particular governments – are often advised to increase the duration of their debts: by increasing maturity, to prevent liquidity squeezes, and by opting for fix-rate instruments to reduce interest rate sensitivity. The applying of the creditor principle inSNA 16 A European Council Regulation of 1993 (3605), revised in 2000, explicitly defines the nominal value (the valuation rule of government debt is defined in the Maastricht Treaty as the nominal value) as being the “face value”. The awkward implications, among others, is that the Maastricht value of zeros is dissuasively high, while the consolidation rule of elements of strips on government bonds purchased back by government units cannot be properly accounted for.

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93wouldde factocancel the latter objective. It would somehow go into a similar direction taken bySNA 93, which already tended to demote the importance of maturity in national accounts (SNA 93, para 11.58). The powerful liquidity squeezes observed in the second half of the 90s and also recently, affecting both government and private operators, might suggest this demotion was somehow a little premature. 24. In view of the potentially considerable impact of changes in market conditions on the interest bill under the creditor principle, it is likely that fierce opposition emerge on the part of users. This concern of avoiding what could easily develop into a pro-cyclical deficit impacting device was indeed probably an important consideration for the adoption by the 17 FAWP and the CMFB of the interpretation of theESA95as following the debtor 18 principle . 25. Unless debt buy-backs becomes a generalized financial technique – similar to the refinancing (early reimbursement) option on their real estate loans that US households exercise regularly and massively – it is difficult to argue that the creditor principle best describes the actual behavior of economic players. Extension to other assets 26. In addition to the fact that the elasticity of interest flow (D.41) to market yields depends upon the maturity of securities, the creditor principle would also treat interest flows (D.41) differently for securities and for loans (and deposits and other receivables/payables), which may be a cause of concern for international comparisons. This might appear all the more strange that there are currently attempts to reduce the gap between those categories of instruments in terms of valuation rules (see EDG on Non-Performing Loans). Could it be that the creditor principle would be also applied for loans, in case a new valuation rule for loans were to be recommended and deemed to reflect price changes? 27. The application of the creditor principle to other types of assets’ income, likely to be dramatic, would also need to be explored (Laliberté). The example given by Joisce/Wright (2001), which involves the subsequent sale of a rental agreement by the tenant indeed suggests potentially considerable consequences (para 67-74); in that example, they seem to envisage that market rentals/rent be booked in the system, rather than the actual payments, and to foresee that the amortization of the independent value acquired by the transferable

17 Financial Accounts Working Party; Committee on Monetary, Financial and Balance of Payment Statistics.

18 See the Eurostat Manual on Government Deficit and Debt (III.3.3.a).

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19 lease be booked as income . Those innovations, while appealing in many respects, would impart some substantial rewriting of the system. Compilation issues 28. It is often argued that the creditor principle is easier to implement than the debtor principle, in particular for the Rest of the World sector. This seems unlikely. To start with, it is not likely that own accounts of institutional units provide easy to use sources data without substantial retreatments. For government finance statistics, own accounts of government units are often on a cash basis. For national accounts, interest on the portfolio would often incorporate the acquisition view, and banks’ profit and loss statements may only report the net gain and loss on the “trading book”, leaving the statistician the task to carve out the appropriate interest flow (D.41) to be incorporated in national accounts. 29. If the compilation of sectorized interest flows (D.41) involves a security by security database, both the debtor and creditor principle interest flows are reasonably simple to compile. The former requires maintaining the issue price; the latter requires maintaining 20 reasonably high frequency market prices (up to daily...) or at least average prices . 30. If the compilation of sectorized interest flows (D.41) does not involve a security by security database but uses aggregated data involving specific breakdown, there will be a need for “average apparent yields”. Such average apparent yields in turn can be compiled, with no more difficulties for the debtor principle; indeed, in a national accounts context, “debtor creditor based average apparent yields” are a by-product of compilation of interest payable (D.41) across sectors. This information in turn can be used on the asset side. 31. It is however true that “apparent average yields” for foreign securities owned by residents would generally not be by-products of the work of each local national accountant. In the absence of precise information, it is plausible that in this case the creditor principle be more precise to implement than the debtor principle, unless an appropriate channel of communication exists to provide reasonable “average apparent yields” on liabilities calculated by foreign national accountants for their own domestic needs. It is therefore recommended, particularly in case the debtor principle were to be elected, thatan adequate format of compilation of such “average apparent yield” on liabilities be agreed and adequate sharing arrangements be put in place. 19 They omit to mention that the payment of subsequent tenants to previous tenants are transactions in non-financial assets (K.2) – seeSNA10.130 –, and the resulting assets (AN.222) is not amortized in the non-financial accounts in the system.

20 and not end of period prices.

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The author of this contribution to the discussion group on this site bears the sole responsibility for both the substance and the style of the contents. The purpose of the discussion group is to elicit comments and to promote debate on specific topics. As such, the views expressed on any of the issues raised are not to be attributed to the IMF.