Mitigating foreign exchange risk in local currency lending in fragile states

Achieving the Sustainable Development Goals and tackling the climate crisis are pressing challenges for fragile and conflict-affected settings. Like other countries, they require a very large step-up in investment and financing, to which the private sector will have to contribute significantly given fiscal constraints. Development finance institutions (DFIs) have a key role to play in these contexts, by catalysing private investment and promoting sustainable development.

DFIs provide finance mostly through equity and debt. Equity investments are typically left un-hedged, and subject to local currency risk. DFI lending, due to operating constraints, mostly takes place in foreign currency. This may shift currency risks onto borrowers and constrain DFI investment pipelines. Challenges to scaling up local currency lending are, on the one hand, rooted in the complexities of fragile and conflict-affected environments, which increase local currency lending risks and costs. But on the other, they are also rooted in DFI risk-management policies, and in the dearth of cost-effective local currency options.

This paper presents a systematic review of existing strategies to tackle these challenges, which can be grouped by (1) reforming DFI internal processes, culture, and risk-management frameworks, (2) expanding options to source and deliver local currency, on and offshore, and (3) lowering the all-in lending rate in local currency. Building on the existing approaches and in-depth consultations with DFIs and market players, this report sets out forward-looking proposals for further exploration by the DFI community that could deliver local currency financing at scale.