By Harald Hirschhofer, Senior Advisor, TCX [1] 

Achieving the Sustainable Development Goals (SDGs) will require an enormous increase in external financing flows to developing countries. Development Finance Institutions (DFIs) have gradually started to shift their business model towards de-risking services to crowd in long-term, low-risk private capital. However, the targeted scaling up of private investment from billions to trillions to realise the SDGs contains massive risks for stability. And good macro-policies are needed, in turn, to address such underlying risks. Countries that need the greatest amount of development finance are often those that have domestic financial resource constraints and underdeveloped markets. Financing their growth and investment opportunities makes the management of exchange rate risks, which are inherent in development finance, a critical challenge.

How so? In how development finance is practiced today, borrowers are burdened with the foreign exchange rate risk since external debt repayments are denominated in hard currencies. This is inefficient and unfair. Borrowers are the weaker partners in most cases given their abilities to manage risks and withstand losses. Moreover, hard-currency financing hides the underlying macro-risks to which borrowers are exposed. Resulting neglect or underestimation has repeatedly contributed to wrong investment decisions and over-indebtedness. This applies to micro, small and medium enterprises as well as sovereign borrowers. Wrong incentives make matters worse: so-called concessional rates — close to zero percent in US dollar terms — lure borrowers into quickly accepting hard currency loans without considering depreciation effects and true borrowing costs. In short, development finance encourages those who typically lack the information and training to speculate on future currency fluctuations.

Reaching development objectives should not come at such a cost. Wrong allocation, wrong incentives and poor understanding of risks have made defaults, credit restructuring, and wild swings in growth rates and income a regular occurrence in the history of development finance. While unpleasant for bankers and rich countries, it is most painful for the poor where it matters most.

So what’s the solution? A relatively straightforward way to address these challenges would be to denominate a growing share of development loans in local currencies in which borrowers can earn income. Local currency finance makes the price of macro-economic risks explicit and contributes to better investment decisions. Risk-quantification is the first step to better management. This applies to sovereign and private borrowers alike, protecting them from currency swings.

What would help are policy reforms. The G-20 Guidelines for Sustainable Financing are a useful start, but they do not yet discuss exchange rate risk or how to manage it. For example, principles of development lending in foreign currencies could propose how lenders protect their borrowers and shareholders from the consequences of currency risk. The OECD Development Assistance Committee uses a commonly agreed approach for the grant element of a loan, which encourages official development lending in hard currency. However, for those countries with high inflation levels, the grant element of loans in local currencies will not be truly representative. However, at least a partial solution exists: Donors extending a loan in local currency and hedging through a cross-currency swap may use the terms of the loan in donor currency to calculate the grant element.

In a nutshell, providers of development finance are much better placed than their customers to take on currency risk. At the same time, they are mostly unwilling to simply carry this risk on their balance sheet without any hedging instrument. Specialised entities already exist to promote local markets and provide long-term hedging tools. TCX, for example, provides long-term currency hedging contracts in more than 70 currencies. Shifting exchange rate risks to globally diversified specialists and emerging risk markets is one efficient and scalable way to manage the inherent currency fluctuation risks in development finance.

Merely supplying development finance is not enough. It needs to be done in socially and economically sustainable ways, where risks are allocated to those who can best manage and sustain them. Efficient use of limited public resources, through improved policies and regulatory processes, is required to achieve the SDGs and related efforts. Governments around the world must work together to offer feasible business opportunities to the private sector that are in line with domestic and international development objectives. Only with such coordinated action will we succeed in moving from billions to trillions to realise sustainable progress for all.

[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.