Mitigating currency risk to mobilise private capital in fragile states

Tackling climate change and achieving sustainable development requires enormous and urgent investments in developing countries. Estimates suggest the annual financing gap for the SDGs is US$ 4 trillion, including climate-related investments. In relation to GDP, this gap is largest for fragile and conflict-affected states (FCS) – home to 960 million people worldwide.

Much of the finance will have to be mobilised domestically, and some must be from public sources. However, there is no feasible path to achieving sustainable development without a large increase in external finance for private investment .

The Summit for a New Global Financing Pact (2023) in Paris is a key opportunity for global leaders to discuss how to expand access to finance. Enabling effective access to finance and ensuring it is done responsibly in lower-income and fragile states should feature high on the agenda.

The need for mobilising finance in national currencies

The vast majority of debt financing is presently mobilised by public and private investors, such as international development finance institutions (DFIs), in US dollars or Euros. Foreign-currency debt can pose severe challenges to borrowers without foreign currency revenues if their local currency (LCY) depreciates. ‘Sudden jumps’ in associated debt burdens have been a common feature of debt crises, including the current widespread debt stress. Sri Lanka and Zambia are cases in point.

Given these risks, it is paramount that a growing share of the mobilised finance is denominated in national currencies. To make progress, one needs to first ask why foreign currency lending including by the DFIs is so deeply entrenched.  The reasons include DFI financial policies, operational constraints, and structural challenges in local currency markets. The latter is  further compounded in FCS: high country and credit risks (pertaining to the borrower or hedge provider not honouring their financial obligations), shallow and weak local financial sectors, and a lack of (affordable) hedges. Lending in local currency in FCS  thus becomes more resource intensive (human and capital), while income prospects are limited because projects tend to be fewer and smaller.

How DFIs can scale-up local currency finance

In a new IGC report presented at the DFI Fragility Forum (2023), we put forward proposals to address and overcome these issues and deliver LCY lending at scale. Our proposals build on in-depth review of past and current approaches to local currency financing, and the realisation that collectively these have not yet enabled a significant scaling-up of local currency finance in FCS for DFIs as a whole.

We make two cross-cutting proposals and set out two hedging platform approaches, as detailed in the table below.

Table 1: Proposals to deliver local currency financing at scale

 The cross-cutting proposals

• Providing technical assistance (TA) to central banks to support development of money markets and facilitate their potential role as hedge counterparties, with IMF support in amending the accounting for Net International Reserves.
• A LCY credit guarantee focused on FCS that takes on part of the credit risk of facing the local counterparty in loans or derivative transactions.

To effectively and sustainably deliver LCY lending, DFIs should target more of their efforts at developing local money markets. This implies providing technical support to central banks and gradually enabling local banks to act as hedge providers and providers of LCY liquidity, initially supported by risk-sharing agreements or guarantees to cover counterparty risk. Change will take time, but this is the core of a long-term change programme that will also help them lend larger sizes and on longer maturities.  

In countries without reasonable onshore local market counterparties, nor perspectives to develop a local market, hedging with the central bank remains a cost-effective alternative in FCS. This may involve complex transactions, and we invite the IMF to define a framework under which these can take place in a fair and transparent manner, with full clarity on their accounting treatment.

The platform options

• Onshore route: A shared DFI foreign exchange platform would act as an onshore treasury capability (on behalf of international lenders) in FCS by seeking LCY hedges with local counterparts, managing local market imperfections, setting up the required onshore infrastructure, and acting as an onshore “paying agent” in FCS for interested investors. Related services are offered by Frontclear today - those can be built on. Hedging in the local market would reduce hedging costs, mitigate the convertibility and transfer risk,, and would have the added benefit of increasing momentum for local money market activity. The platform would be backed by a donor loss-absorbing layer of capital.
• Offshore route: The Currency Exchange (TCX) offers currency hedges that are typically “synthetic” or “non-deliverable”, i.e. transactions where all flows are computed based on local currency parameters but settled in US dollars. A TCX Portfolio Return Guarantee would lower the cost of offshore hedging. This existing platform should be supported by a donor-backed minimum portfolio return guarantee that enables TCX to improve the pricing of FCS hedges.

Both approaches are complementary: both onshore and offshore markets need to be developed and are eventually expected to connect. Developing the offshore hedging route with international counterparts – essentially TCX – does not invalidate the development of local hedging capacity.  

Operating through shared global platforms rather than as individual institutions brings fundamental advantages, including:

• Pooling of risks, thereby benefiting from portfolio diversification and the possibility of gains offsetting losses, leading to more efficient use of donor money
• Pooling of liquidity management in local markets, which is particularly valuable in FCS where transactions are less frequent
• Pooling of offshore flows, which facilitates on-selling to international investors
• Market development through the optimised channelling of international flows into the local market
• Transparent and harmonised use of concessionality across lenders

Challenging markets call for a combination of interventions to scale local currency lending.  Our proposals support central bank mandates to stabilise local financial systems and allow international investors to leverage local counterparts, both as lenders and hedge providers. They would support offshore market activity and spur onshore market development. Working with central and local banks to this end will be key to improving access to local currency at a reasonable cost and for mobilising private sector capital.

To learn more about how DFIs can overcome challenges in local currency lending read IGC’s report on Mitigating foreign exchange risk in local currency lending in fragile states.