How NPV is used in debt relief to the poorest nations The International Monetary Fund (IMF) and…

How NPV is used in debt relief to the poorest nations

The International Monetary Fund (IMF) and World Bank have designed a framework to provide special assistance for heavily indebted poor countries. It entails coordinated action by the international financial community, including banks and multinational companies, to reduce and reschedule the debt burden to levels that countries can service through exports and aid. Net present value is central to the calculation of the sustainable debt level. The face value of debt stock is not a good measure of a country’s debt burden if a significant part of it is contracted on concessional terms, for example with an interest rate below the prevailing market rate. The net present value of debt is used to find the sum of all future debt-service obligations (interest and principal) on existing debt, discounted at the market interest rate. Whenever the interest rate on the loan is lower than the market rate, the resulting NPV of debt is smaller than its face value, with the difference reflecting the grant element.

Question

Explain to a government official from one of the world’s poorest countries why the NPV approach is an appropriate method for calculating the sustainable debt level.