Devex Invested: There’s a push to lend more in local currency. But how?

Emerging markets are feeling the pinch of borrowing in foreign currencies. When governments or companies in Ghana or Sri Lanka take out loans in U.S. dollars or euros but earn revenue in cedis or rupees, it sets up a mismatch that can quickly become a crisis when local currencies depreciate — a scenario playing out repeatedly amid rising global volatility.

Multilateral development banks and development finance institutions have long favored foreign currency lending, in part because it reduces their own financial risk. But that approach shifts the burden onto borrowers — many of whom are now struggling to repay debts not because of poor project performance or even poor policies, but because of currency shocks beyond their control.

“At the moment, the narrative is that the currency risk is the developing country’s fault. It’s not. It’s a problem of the way the monetary system is structured. It’s there because the dollar is dominant,” Bruno Bonizzi, an associate professor at Hertfordshire Business School who recently co-authored a study about MDBs’ local currency lending, tells me.

The challenges have led to growing momentum around expanding local currency lending as a way to strengthen financial resilience, promote investment, and reduce vulnerability to global crises. The question now is how to make that work — and who bears the cost?

Why it matters: Currency mismatch is a chronic issue in development finance. When debt is in dollars but income is in local currency, devaluation can quickly make repayment unaffordable. It’s the “original sin” in infrastructure investment, Erik Berglof, the Asian Infrastructure Investment Bank’s chief economist, tells me.

This problem has amplified recent defaults in several African countries and is increasingly viewed as a structural barrier to sustainable development finance. Local currency lending is seen as part of the solution — but scaling it up involves complex trade-offs between cost, risk, and institutional mandates.

Where things stand: MDBs generally don’t take on currency risk. When they make loans in local currencies, they fully hedge — or insure — against currency risk, passing the cost to borrowers through higher interest rates. That makes local currency loans more expensive and in some cases less attractive, according to Bonizzi and his co-author Annina Kaltenbrunner, a professor at Leeds University. That’s in part because many MDBs are restricted by internal rules of risk frameworks that prohibit or discourage them from holding currency exposure on their balance sheets.

But there is pressure for MDBs to find ways to solve these challenges, and there has been a focus on local currency both by the Group of 20 largest and emerging economies under Brazil’s leadership and in the World Bank’s Private Sector Investment Lab.

Potential solutions:

• Reduce hedging costs by supporting and expanding mechanisms like TCX, which provides currency swaps and takes on currency risk on behalf of MDBs and DFIs. Changing MDB rules to allow them to work with more partners for local hedging is also an option, as are donor-funded subsidies to offset high hedging costs.

• MDBs could take on some risk themselves, either by offering some concessional local currency loans or by changing their risk models to take into account the advantages of hedging the currency risk, Bonizzi says.

• New funding models can also play a role. Delta, a new initiative being developed by AIIB and the European Bank for Reconstruction and Development, aims to build in-country liquidity pools that MDBs can tap for local currency loans. It would be co-owned by MDBs and have some donor funding to help it absorb losses.

• In the long term, building up local capital markets, including better funding local development banks, can help reduce the reliance on foreign currency borrowing.

Read: Inside the push to ease dollar debt and boost local lending

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Big flex

Thanks to a rule change, EBRD will soon be able to lend and invest more using its existing funding. It’s the latest in a movement among MDBs to stretch their balance sheets, driven in large part by growing demand from their shareholders.

In EBRD’s case, a statutory constraint prevented the bank from making loans, investments, and guarantees that go beyond the total of the bank’s capital and reserves in order to ensure financial stability. But that rule has now been removed, which means EBRD can use its capital more flexibly and starting in June, it will be able to lend and invest more. By 2030, the bank expects to invest about €2.7 billion more per year, without impacting its credit rating or capital strength.

“Over the last seven or eight years, we’ve been keen to remove the statutory constraint because we see it as a kind of out-of-date way of risk managing our portfolio and placing a limitation on the lending that the bank can do,” Shaun Brown, the director of capital and liquidity planning at EBRD, tells my colleague Jesse Chase-Lubitz. Now, the bank will rely on its own internal risk assessment policies to measure how much shareholder capital or funds it needs against the loans it gives out.

Brown said that part of the reason it has taken almost a decade for EBRD to make the move is partly because other banks weren’t making the move. “If you’re taking that kind of unilateral step, there could be a nervousness to do that,” he says. But it seems that moves in recent years by the World Bank and the Asian Development Bank to stretch their balance sheets helped pave the way.

A clear path

At the United Nations’ COP29 climate summit, global leaders set an ambitious new target to mobilize $1.3 trillion in climate finance annually by 2035, including $300 billion for lower-income countries. The “Baku to Belém Roadmap” lays out how to get there — but the success of this plan hinges on unlocking private capital at scale. 

In a recent opinion piece for Devex, Wendy Walford of Legal & General and Erich Cripton of CDPQ — both co-leads of the Net-Zero Asset Owner Alliance, or NZAOA, policy track — argue that asset owners are not only well-positioned but highly motivated to deliver. NZAOA members, who manage $9.5 trillion globally, already had $555 billion in climate solution exposure by the end of 2023. But persistent regulatory and policy barriers continue to limit their ability to deploy capital where it's most needed — especially in low- and middle-income countries facing severe financing gaps.

To move from ambition to action, the road map must create an enabling environment for private finance: clear policies, better risk-sharing mechanisms, and stronger alignment with national climate goals, they write.

Opinion: The public-private key to unlocking $1.3 trillion in climate finance

What we’re reading

Argentina secures $42 billion from the IMF, World Bank, and Inter-American Development Bank as it lifts currency controls. [Al Jazeera]

U.S. President Donald Trump’s trade war spawns a debt market squeeze in Africa. [Bloomberg]

Saudi Arabia plans to pay off Syria’s World Bank debts, sources say. [Reuters]

Boom and bust: How Sierra Leone lost faith in foreign aid. [The Dial]

Jesse Chase-Lubitz contributed to this edition of Devex Invested.