Development Finance 2.0: Improving Conditions for Local Currency Financing

By Harald Hirschhofer, Senior Advisor, TCX 1 

Development-Finance-shutterstock_524218915Achieving the UN Sustainable Development Goals (SDGs) will require very large investments measured in the trillions until 2030. To mobilise such amounts, policy makers try to crowd-in the private sector, its financial resources and its entrepreneurial creativity. But private sector engagement will not happen if risk-adjusted returns are perceived to be unattractive. While telecom and mobile banking have shown that achieving development goals also means good business, perceived risks in most other sectors and countries are still too high for expected economic returns.

That is why donors, recipients and development banks have been developing programs to lower and share risks, including policy and structural reform, technical assistance and information sharing, and providing financial de-risking instruments. Especially in situations where private investors perceive risks as higher than they actually are, such de-risking measures can be impactful in catalysing private investment flows. Accordingly, development finance institutions (DFIs) are expanding their focus from mere funding to blending risk tolerant donor funds with commercial capital to offer de-risking services and support for (perceived) high risk activities.

Such efforts are most effective if borrowers and equity investors remain responsible for those risks that can effectively be controlled and share those risks that cannot be controlled. For example, solar photovoltaic (PV) operators are responsible for developing and implementing projects. But overall contract standardisation and sector policy streamlining can facilitate development and reduce implementation risks. Once PV projects are successfully implemented, de-risking instruments should take away off-taker risks, foreign exchange rate risks and inconvertibility risks to enhance the credit quality of the project and facilitate cost-effective re-financing. Importantly, sharing or transferring risk to lenders or specialised third parties should occur at risk-reflective or market reflective prices. Such risks include weather and natural disasters, political risks, and market risks. Correctly pricing risk prevents investing in unsustainable, risky projects and over-indebtedness and allows the emergence of private sector risk-management solutions and markets.

However, practical implementation has been challenging. Take for example how development finance has dealt with foreign exchange (fx) rate risk. Traditionally the fx risk has been put on the shoulders of the borrowers in developing countries by denominating debts in hard currencies. Aside from the moral question of whether we should burden the weakest with risks they cannot manage, evidence suggests that this practice has undermined development objectives by contributing to systemic instability and over-indebtedness, less effective macro policy adjustment, and excessive volatility of local interest rates.

Efforts have already been made to promote local currency financing, but only a few instruments have achieved scale, and the overall fx risk exposure among borrowers in recipient countries remains high. Progress has been made with borrowers from micro-, small- and medium-sized enterprises, which now have better access to local currency funding than ten years ago. Consumer protection legislation acted as a catalytic element and new players such as TCX successfully provided the necessary risk management tools. In contrast, no progress has been made in de-dollarising infrastructure investment and sovereign borrowing still is dangerously burdened with fx risk.

This uneven progress shows how the shift to local currency financing has been hampered by tradition and disincentives:

  • DFIs and their staff are used to offering dollar financing. Processes, systems and performance incentives need to be adjusted to support local currency financing. Moreover, the challenge of collective action remains: A DFI that decides to only offer local currency loans to local currency earners will find itself at a competitive disadvantage. Aside from being less likely to close a deal, it improves the credit risk for other lenders.
  • Borrowers too often underestimate the (complex) fx risk and perceive local interest rates as excessive. They focus on the most recent past, ignore volatility that occurred longer ago and may be tricked by artificial stability backed by unsustainable policy interventions. Moreover, managers or politically appointed agents are likely to have short horizons, pushing costs and risks into the future. Unfortunately, local currency loans typically have higher debt servicing costs in the initial periods than dollar loans, making the latter more attractive for short-term players.

To overcome these obstacles, a DFI code of conduct should require that hard currency financing should only be offered to borrowers with hard-currency income. After all, why continue with practices in emerging and frontier countries that were recognised as harmful? To ensure an adequate supply of local currency funding and hedging solutions, crisis-tested and scalable existing models should be strengthened further to deliver reliable results fast. Economists will need to come up with new macro-modeling and risk pricing methods — especially for long-term risks — to improve the signal quality of prices.

Risk transfer at market or risk-reflective prices will not be feasible in some high-risk situations. Local businesses will simply not be able to pay macro risk-reflective financing costs, and effective subsidy schemes will need to be developed. The recently approved IDA Private Sector Window2  and the forthcoming European Union’s External Investment Plan’s Guarantee Facility3  can provide important resources, but great care needs to be given not to crowd out private sector resources. To minimise damage to potential private providers, donor-supported deviations from risk or market-reflective pricing need to be confined to well-defined circumstances. These include a complete absence of any private supply (and no crowding out), the need to jumpstart or maintain private investment despite prohibitively high risks (such as post-conflict countries), or strong positive externalities of funded activities. Ultimately, managing risk while engaging the private sector through local currency financing is a delicate balancing act.

1.↩ The views in this blog reflect those of Harald Hirschhofer himself and not necessarily those of TCX Investment Management Company, TCX and its shareholders.

2.↩ In 2017, International Development Association (IDA) participants created a USD 2.5 billion private sector window on a pilot basis to expand private investment in IDA-only countries, with a particular focus on fragile and conflict-affected states.

3.↩ In 2016, the European Commission proposed the External Investment Plan to support investments in partner countries in Africa and the European neighbourhood with a special focus on the private sector.