By Ruurd Brouwer, CEO, TCX, and Barry Eichengreen, Professor of Economics and Political Science, University of California, Berkeley
Private-sector funding will be essential for raising the trillions of dollars needed to finance climate-change abatement and adaption projects in emerging and developing countries. The question is: will that finance be forthcoming?
Last Wednesday, the FT’s Gillian Tett identified foreign exchange risk as a key factor preventing Western investment funds from helping to finance these climate projects at scale. World Bank and IMF research has similarly identified currency risk a factor in sovereign debt sustainability. No private investor will invest in renewable energy if the country raising the finance is at risk of not being able to repay owing to an adverse exchange rate movement. No private investor will invest if the country is in default owing to that adverse exchange rate movement.
This makes getting a grip on currency risk crucial for the future of our planet.
Luckily, there is a precedent for resolving debt distress resulting from currency risk. At the start of this century, banks in Eastern Europe offered their retail customers home mortgages in hard currency, mainly Swiss francs. Homebuyers in Poland, Hungary, Croatia, Romania, and Serbia were attracted by low interest rates on these so-called hard currency loans on which the lender did not charge a currency-risk premium. Low interest payments made the mortgage more affordable or allowed them to buy a bigger house. But it also turned homeowners into currency speculators. The currency risk did not go away: it was just shifted from the balance sheets of the banks to those of households, who were in fact less well positioned to manage it. Not surprisingly, the practice of offering hard currency mortgages ended right after the GFC in 2008, when exchange rates moved against the borrowers and repayment problems became severe.
The parallel with developing countries and emerging markets seeking to tap climate finance is obvious. Low-income countries are like the Eastern European homeowners, holding 70 to 85% of their long term debt in hard currency. Again, this does not eliminate currency risk: it just shifts it from the balance sheet of the lender to that of the borrower. In effect, the world’s poorest borrowers are forced to bet against the US dollar, in favour of the Zambian kwacha and Bangladesh taka. But unlike East European households, developing countries cannot choose between currencies. It is a hard currency loan or no loan at all.
When depreciation of the forint, leu and zloty set in, homeowners learned the hard way what poor countries are learning today: currency risk is unpredictable and unforgiving. In Eastern Europe, debt distress hurt families, threatened financial stability, and even fostered the rise of the populist far right.
Governments did not stand idly by. In 2014 Hungary forced lenders to redenominate more than USD 10 bn of mortgages into forint. The measure was controversial, but it became overwhelmingly popular when, within 3 three months, the Swiss franc appreciated by 20%.
In 2015 the Croatian Consumer Lending Act forced banks to convert Swiss franc mortgages into kuna or euros at the exchange rate on the date of signing or disbursement of the mortgage. The costs for the Croatian banking system was estimated by the Croatian National Bank at US $1.25 billion, or 3 years’ profits.
In Romania, mandatory conversion to lei at the exchange rate on the date of the loan agreement was unanimously approved by parliament, but later ruled unconstitutional. A voluntary conversion programme was then substituted. Many cases ended before the European Court of Justice, which ruled in 2017 that:
the consumer is in a position of weakness vis-à-vis the seller or supplier, in particular as regards his level of knowledge (…)
so therefore
financial institutions must provide borrowers with adequate information to enable them to take well-informed and prudent decisions and should at least encompass the impact on instalments of a severe depreciation (…)
so that the average consumer (…) would be aware both of the possibility of a rise or fall in the value of the foreign currency in which the loan was taken out, and would also be able to assess the potentially significant economic consequences of such a term with regard to his financial obligation.
Compare poor-country borrowers:
- The position of many poor-country borrowers is inferior to that of Eastern European borrowers, in that they have no choice of product.
- Poor-country borrowers lack the borrower protection mandated for Eastern European borrowers by the courts.
- Poor countries have an equally severe problem of inadequate information and risk-management capacity: a 2021 IMF survey of debt management offices in emerging markets and developing countries found evidence of inadequate knowledge of currency risk-management techniques and made the case for extensive technical assistance.
- While conversion of hard currency loans into local currency, often at rates that imply losses for lenders, is a standard remedy in circumstances of debt distress, this has not been offered to poor-country borrowers. The latter do not receive comparable relief because their lenders are often foreign governments and supranationals that do not answer to national courts.
The World Bank IMF meetings in Marrakesh this week are an opportunity to take remedial steps. There should be serious discussion of adjusting the intergovernmental and multilateral debts of poor countries for the extra burden created by currency fluctuations (specifically, by the depreciation of local currencies against the dollar). Going forward, there should be a commitment to use multilateral resources – those of the IFC, World Bank, IMF and regional development banks – and donor funds from advanced-country governments to provide poor countries with currency-hedging instruments on a scale and at a duration commensurate with their climate financing needs.