By Paul Horrocks, Head of the OECD’s Private Finance for Sustainable Development Unit; Callum Thomas, Junior Policy Analyst in the OECD’s Private Finance for Sustainable Development Unit; and Thomas Venon, Executive Director of the Centre for Development Finance Studies.
For emerging markets and developing economies (EMDEs), access to finance too often means exposure to unsustainable levels of currency risk: the risk that an investor will lose money on an international trade due to currency fluctuations. While foreign currency loans may offer lower nominal interest rates, they expose EMDE borrowers to exchange risk that can make businesses more vulnerable in the long term. These dynamics can constrain private investment, heighten financial instability, and undermine economic resilience.
Development finance providers and policy makers must play a central role in expanding the accessibility and affordability of local currency financing, and ensuring that the risks of currency volatility are not borne exclusively by those least able to manage them. Targeted policy measures can help by strengthening domestic financial institutions, improving market infrastructure, and ensuring that multilateral development banks (MDBs) and development finance institutions (DFIs) play a more proactive role in supporting local capital markets.
Read more: Beyond hard currency: A new approach for development financeWhat are some short-term measures that can help?
1. Reassess MDB and DFI risk mandates
Donor countries should leverage their role as shareholders to ask MDBs and DFIs to reassess risk mandates that constrain local currency lending. Some statutes, like the Articles of Agreement of the International Bank for Reconstruction and Development, and the International Finance Corporation Agreement, already impose currency exposure restrictions. These frameworks should be reviewed to ensure they do not excessively constrain MDBs from providing financing in local currency. Donors should continue supporting credit enhancement mechanisms like the European Bank for Reconstruction and Development (EBRD)’s SME Local Currency Programme, which uses risk-sharing instruments to expand local currency lending to SMEs. They should also support system-wide initiatives like the Currency Exchange (TCX) Fund, which provides currency hedging solutions to reduce FX risk in development finance.
2. Improve coordination and treasury operations
MDBs should also work to improve the efficiency of local currency financing. Establishing onshore treasury operations in EMDEs would enhance liquidity and provide smaller DFIs with access to local currency funding. This is what has been proposed in initiatives like the Asian Infrastructure Investment Bank and the EBRD’s “Delta” programme, which seeks to optimise MDB treasury functions by pooling local currency resources and streamlining cross-institutional funding mechanisms. Donors should encourage MDBs to pool resources and share risks in managing local currency operations. This would not only increase the availability of local currency lending but reduce the fragmentation that too often characterises development finance.
3. Mobilise local financial actors
Development finance should prioritise engaging local financial institutions as important players in blended finance initiatives. This means structuring transactions in a way that enables local institutional investors to participate, for example through local currency project bonds that match local currency liabilities with local currency assets. Given that banks play a key role in the creation of money, MDBs and DFIs should also evaluate the effectiveness of their bank-intermediated lending models to ensure that local banks leverage their deposit bases to provide SMEs with sustainable local currency financing. Targeted technical assistance should be provided to local institutional investors to enhance their capacity to assess and invest in risk assets.
These short-term measures should be underpinned by long-term ones:
1. Reform MDBs to facilitate local currency financing
MDBs should integrate local currency financing more systematically into their lending operations, ensuring that DFIs are not inadvertently reinforcing foreign currency dependence in EMDEs.
2. Develop local capital markets
A well-functioning local capital market is critical for financial resilience, offering a sustainable alternative to foreign-denominated debt. Development actors must focus on long-term market-building efforts, acknowledging that the development of robust local capital markets cannot be leapfrogged through temporary interventions. Donors should also conduct a systematic gap analysis of financial infrastructure across EMDEs, tailoring concessionality levels based on market maturity. This means providing more concessional financing for nascent markets and transitioning to commercial instruments as markets mature.
3. Targeted financial infrastructure investments
Strengthening financial infrastructure —including payment systems, clearing and settlement mechanisms, and local credit rating agencies — is essential to improving local capital markets. Initiatives like FrontClear, which provides credit guarantees and technical assistance to enhance money market infrastructure in EMDEs, require further investment to scale effectively. Coordination with regional and international organisations is crucial to harmonise regulations, improve cross-border financial integration, and establish a more cohesive framework for local currency financing.
What’s the big picture?
Ultimately, for EMDEs, long-term financial resilience depends on deepening local financial markets. As the development system looks to handle greater volumes of finance, it will be critical to ensure that more of this financing is in local currency. Development finance actors can help drive systemic change by mobilising domestic capital, assisting with capacity-building for local financial institutions, and supporting market-building initiatives.
Doing so is about more than reducing currency risk. It is about creating the conditions for sustainable financial development and ensuring that borrower governments can chart their own path to sustainable economic growth.
To go deeper, read the report on which this article is based.