Property 101: How much do financial markets value government balance sheets?

Staff reporterOctober 27, 20160 min read

The sovereign net worth implied by market prices tends to be on average about 20 percent of GDP higher than its accounting value for a sample of 31 advanced economies and emerging market economies, according to IMF's latest report.

Differences between market and accounting values are more positive for countries with weaker fiscal fundamentals and have increased disproportionately for euro area countries over the past two years.

Sovereign credit indicators (such as credit default swap spreads and bond yields) offer valuable information about the size and riskiness of government balance sheets, as perceived by the market. Higher credit spreads, which measure the default risk borne by public bond holders, indicate that a government’s financial solvency has deteriorated.

This occurs when the government net worth declines and eventually becomes negative—at which point government assets become insufficient to fully cover outstanding liabilities.

This box relies on a finance model that builds on the contingent claim analysis framework of Jobst and Gray (2013). The model’s purpose is to infer a market-implied estimate of government assets, which are mostly unobservable, from the (observed) amount and maturity structure of outstanding debt securities and their prevailing market valuation, under the assumption that available credit indicators imply an accurate assessment of sovereign risk.

The market-implied sovereign net worth is then computed and compared with the accounting data reported by statistical agencies. The framework is applied to monthly observations between April 2012 and the end of 2015 from 31 advanced and emerging market economies for which comprehensive accounting balance sheets are available.

Overall, the analysis shows a significant gap between market- and accounting-based assessments. Results for 2014 suggest that market-implied sovereign net worth exceeds its accounting equivalent by about 20 percent of GDP on average, with considerable cross-country variation (Figure 1.5.1).

The market assessment is forward looking and thus may reflect various factors, including valuation effects and the acknowledgment of unobserved or unmeasured effects that have an impact on debt sustainability but are not recorded by statistical offices (such as future primary balances and implicit guarantees received or granted by the government).

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Moreover, the gap between the market and accounting measures of sovereign net worth is positive and widens for countries with weaker fiscal positions (in Figure 1.5.1, fiscal stress is defined as debt ratios exceeding debt sustainability analysis thresholds, but the result is consistent with broader measures of fiscal soundness).

Because the model controls for changes in sovereign risk, this means that for these countries, market prices would justify a significantly higher net worth than measured by accounting data. Conversely, accounting balance sheets would be consistent with sovereign credit spreads above those currently observed.

Interestingly, euro area countries have experienced a much higher increase in market-implied net worth than other countries in the sample since mid-2012.

In these countries, net worth rose by more than 30 percent of GDP on average between mid-2012 and the end of 2015, with half of the surge occurring in the months following European Central Bank President Mario Draghi’s July 2012 pledge to do “whatever it takes to preserve the euro” (Figure 1.5.2).

Over the same time period, expected losses on public debt, which underpin the estimation of market-implied net worth, declined sharply (Figure 1.5.3). Fiscal consolidation efforts and overall financial conditions are certainly part of the story, but they are not sufficient to explain such a sharp increase in a short period of time.

Other factors are also at play, most likely monetary policy actions and perceptions about future monetary stance, suggesting benefits from coordinated policy measures (IMF 2016c).

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Staff reporter

Balance Sheets
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