Development finance

Four ways to make development finance fairer and more effective

By Harald Hirschhofer, Senior Advisor, TCX

Low-income country debts are mostly owed to multilateral and bilateral official lenders. Unfortunately, these development institutions’ default practice is to lend – from a borrower’s perspective – in foreign currency, i.e. USD, Euros or Yen. As they are risk conservative, they put the currency risk on the shoulders of low-income country borrowers. Although on concessional terms, such hard-currency development finance frequently turns out to be more expensive than borrowers can afford. The true costs of borrowing are hidden behind a veil of currency risk.  

In addition to transparency concerns, forcing low-income country borrowers to incur currency risk is not efficient. Low-income countries do not have a diversified production and export base, lack foreign currency reserves, and their risk management capacities are limited. Even more important, it is not fair. Currency volatility and risk is all too often caused by external shocks such as USD rate hikes and monetary policy decisions in Washington, or extreme weather events like the recent floods in Pakistan. Currency risk related to climate change is increasing and can low-income countries be burdened with the costs and consequences of historic CO2 emissions?     

I propose four reforms to make development finance fairer and more effective by gradually shifting currency risk from low-income country borrowers to international currency risk markets:

1. Multilateral development banks should offer clients the choice to borrow in (synthetic) local currency  

Multilateral development banks should be required to always offer their clients a choice between funding in their own local currency or foreign currency. Multilateral development banks already have at their disposal a scalable risk-resilient alternative to foreign currency loans: a synthetic local currency loan with interest and principal payments indexed to the local currency. The borrower still receives a hard currency loan but all its debt service payments are fixed to the local currency at the time of the loan agreement. Synthetic local currency debt financing has already been used with much success for micro, small and medium enterprises over the past 15+ years and can be easily applied to public sector finance. The International Development Association (IDA) has made a modest start in this direction and plans to execute at least one local currency transaction in the near future. Pricing is expected to compare favourably with domestic government bond yields and IDA can offer longer repayment periods and larger lending volumes than local funding sources.  

2. Donors should encourage prudent, risk-transparent borrowing

Borrowers tend to make myopic decisions and accept long-term currency risk to reduce upfront interest rate costs. Donors should reconsider how grants are allocated within the lending framework of institutions like IDA, the African Development Fund, and the International Fund for Agriculture and Development. Borrowers need stronger incentives to make prudent and sustainable borrowing decisions. For example, grants can be shifted away from subsidising the credit margin of foreign currency loan and be re-deployed to reduce the costs of synthetic local currency loans or associated hedging operations. The forthcoming Debt Sustainability Framework Review of the IMF and the World Bankis a good occasion to explore such opportunities and re-design grant concessionality.

3. Debt management offices should strengthen risk management

A recent IMF survey documented that most low-income country debt management offices lack the capacity to assess and manage currency risk. These findings call for urgent measures to expand the scope of ongoing technical assistance. As a first step, the IMF or the World Bank should publish some guidance about best practices in the area of currency and interest rate risk management. Based on that guidance, countries can conduct gap analysis and develop detailed capacity development plans, including legal and regulatory reform requirements, improve their technical infrastructure and back offices, and train and hire (market) risk management experts.

4. Create currency risk markets

The most vulnerable countries will continue to rely on external savings to finance development. Therefore, currency risk will remain a dominant risk factor. The creation of currency risk markets to achieve scale should be a policy priority. In combination with collective risk pools such as The Currency Exchange Fund, they will be critical to ensure efficient management and allocation of currency risk to private (international) investors with adequate capacity and appetite for it.