Unlocking Local Currency Financing: A Pathway to Sustainable DevelopmentScaling up financing for development is essential to meet the 2030 Agenda for Sustainable Development. The United Nations Conference on Trade and Development (UNCTAD) estimates that the annual investment gap to achieve the Sustainable Development Goals (SDGs) amounts to $4 trillion. Mobilising these resources is crucial but extremely challenging. The Group of 20 (G20) sees multilateral development banks (MDBs) as key actors in this process and has created a roadmap for reforms to achieve scale and effectiveness.

Empowering Local Economies through Sustainable Financing

Addressing the Foreign Currency Debt Trap

The reliance on foreign currency debt poses significant risks for vulnerable countries. As UNCTAD reported, the number of countries facing high debt levels has surged, rising from 22 in 2011 to 59 in 2022. Developing countries' capacity to service external debt has worsened, with external public debt to exports increasing from 71 per cent in 2010 to 112 per cent in 2021. Interest payments in many developing countries have outpaced public spending on health, education and investment, with 3.3 billion people now living in countries that spend more on interest payments than on health or education.Ghana's recent experience is illustrative. Despite a decade of economic growth, the country defaulted on its external public debt in December 2022, largely due to its reliance on foreign currency borrowing. As of 2021, 48 per cent of Ghana's public debt was denominated in foreign currency, with the World Bank's International Development Association (IDA) accounting for 13 per cent of this through concessional credits amounting to around $6 billion. The sharp depreciation of the Ghanaian cedi in 2022 made it impossible for Ghana to meet its foreign currency debt obligations.

The Perils of Original Sin

The link between exchange rate volatility and foreign currency debt is not new. Economists Barry Eichengreen and Ricardo Hausmann coined the term 'original sin' in 1999 to describe the inability of developing countries to borrow in their own currency. This issue remains prevalent today, with about half of public debt in low- and middle-income countries (LMICs) denominated in foreign currencies, reinforcing the hierarchical nature of the international financial system. The IMF, World Bank and other MDBs contribute to this by predominantly lending in hard currency.The climate crisis has further intensified the need to address the reliance on foreign currency financing. Climate-vulnerable countries are more likely to default on their debt, particularly when it is denominated in foreign currency. Investments in sustainability, such as renewable energy, generate revenue in local currencies, which makes foreign currency debt especially risky. A depreciation of the local currency can jeopardise both these investments and the sustainability of the debt.

The Call for Local Currency Lending

The connection between foreign debt and climate vulnerability is set to be a central issue at the Fourth International Conference on Financing for Development (FfD), scheduled for mid-2025 in Seville, Spain. The United Nations has called for improvements to MDB lending terms, including the provision of longer-term and local currency loans, to offer greater fiscal space for LMICs.Despite the clear need for local currency lending, MDBs remain reluctant to expand their local currency operations due to their aversion to currency risk. This aversion is often formalised in their founding charters and is more frequently reflected in decisions by their governing boards, motivated by a fiduciary duty to protect the banks' capital from the perceived high risk of currency fluctuations. As a result, local currency lending is typically limited to situations where MDBs can mitigate the risk through currency derivatives or by issuing local currency bonds.

Overcoming the Barriers to Local Currency Financing

Relying on market mechanisms increases the cost and complexity of local currency financing, especially since interest rates are typically higher in LMICs. In many cases, these rates exceed the risk of future exchange depreciation. The high costs of hedging and borrowing in these currencies result in MDBs offering local currency financing at rates that may not be attractive to borrowers, particularly sovereigns.Several strategies could be adopted to enhance local currency financing at MDBs. First, reforming MDBs' risk management frameworks is crucial. The perception of elevated exchange rate risk in LMICs often acts as a barrier to such lending. While these risks are real, they may be exaggerated in certain contexts. The success of TCX, a non-profit entity established by a consortium of development finance institutions, and the African, Caribbean and Pacific Investment Facility, led by the EU and the EIB, have demonstrated that currency risks can be effectively managed.MDBs could adopt a portfolio approach to risk management, setting aggregate limits for different risk categories, including market risk, thereby allowing them to manage currency risk across multiple operations. This would enable MDBs to assume some currency risk, provided it does not create excessive volatility for the overall portfolio, thereby expanding the scope for local currency loans.

Diversifying Hedging Sources and Expanding TCX

Second, where hedging is needed, MDBs could diversify local currency hedging sources. MDBs typically source foreign currency hedges from international banks, which can inflate costs due to differences in balance sheet structures and risk assessments. Reducing restrictions on the use of local onshore banks for currency hedging could lower hedging costs and, in turn, the interest rates on local currency loans.Scaling up and subsidising TCX is another important avenue. In many less-developed financial markets, hedges are often unavailable. Expanding TCX's facilities with increased capital from shareholders, along with concessional financing from donors, could provide portfolio risk guarantees and interest rate subsidies, thereby lowering the cost of hedges offered by TCX.

Facilitating Local Currency Sourcing

Another option, particularly for private sector lending, is to allow shareholder countries to pay their equity capital in their own currencies. This would enable MDBs to increase their lending capacity without incurring currency hedging costs, up to the limit of the paid-in capital. This approach would be especially valuable in frontier currency markets in low-income countries, where hedging solutions are scarce or non-existent.Facilitating local currency sourcing in domestic markets is also crucial. One strategy would be for local central banks to purchase MDB local currency bonds in underdeveloped financial markets. Another strategy would involve promoting harmonised transnational securities regulations applicable to MDBs across jurisdictions, reducing transaction costs and simplifying the issuance of bonds onshore.

Embracing a Developmental Approach to Currency Risk

Addressing the foreign currency debt trap is essential for sustainable development financing. MDBs must expand their local currency operations, particularly in the context of the overlapping debt and climate crises. To achieve this, MDBs must shift away from their current reliance on hard currency lending and adopt a more flexible approach to currency risk management. Local currency financing should be seen as a core part of the developmental mandate of MDBs, not merely as an option for a limited set of circumstances.