Inside DFID's £31M investment in the Currency Exchange Fund

LONDON — In his first major speech as head of the U.K. Department for International Development, Rory Stewart announced £31 million ($40 million) for a facility that supports development finance by de-risking lending to low-income countries in local currencies. The Currency Exchange Fund, or TCX, was founded in 2007 by the Dutch government to mitigate foreign exchange risks — a major cause of financial instability for lenders and borrowers in low-income countries. Because currencies in emerging markets tend to be highly volatile, international lenders prefer to lend in a more stable currency such as U.S. dollars — but this leaves borrowers earning revenue in the local currency extremely vulnerable to changes in the exchange rate. TCX aims to change that. Stewart unveiled DFID’s support for the fund during a speech at the Africa Financial Services Investment Conference in London, United Kingdom, last Thursday. “We’ve identified one of the biggest problems for people operating in Africa [as] the issue of currency. DFID wants to get into that space. There is no silver bullet, but it is going to be a very important part of unlocking potential, particularly of pension funds,” he said. It is DFID’s first major support for the fund. A spokesperson for the department told Devex it expects the £31 million to enable more than £200 million of investments in lower-income countries to be translated into domestic currencies. It also expects the funding to be recycled into other programs since TCX charges investors for its hedging services, the spokesperson said in an email. Stewart also provided more details about a recently launched partnership between regulators from the Bank of England and some African finance ministers to help drive reform. The moves are part of a broader effort by DFID to attract more sources of private finance into the aid sector, especially in Africa — an approach that has raised concerns for some. DFID is not the only donor putting new money into TCX. The Dutch and German governments are contributing an additional $220 million in total, and another five governments are in negotiations about contributing, Harald Hirschhofer, senior adviser at TCX, told Devex. The increased capital could see TCX double its risk-carrying capacity from $2.5 billion and start supporting bigger ticket infrastructure investments, Hirschhofer said. To date, most of its hedging has served to protect small- and medium-sized local businesses and people borrowing from microfinance institutions against currency risks. TCX has hedged approximately $5 billion worth of loans to borrowers in more than 70 local currencies to date, according to its website. “It will allow us to do ... better what we are already doing, and on a bigger scale,” Hirschhofer said. TCX was founded to respond to the problem that foreign development financiers do most of their lending in “hard” or stable currencies, and not in the currency of the borrower. This is due to concerns about currency volatility in emerging markets, but it passes the risk on to the borrower. According to Judith Tyson, an expert on financing for development at London-based think tank the Overseas Development Institute, cross-border lending in hard currencies contributed to the financial crises in Asia and Latin America and, more recently, increased risks in Nigeria, Ghana, and Zambia. “Foreign exchange risk has been a repeated driver of financial crisis and can lead to unsustainable debt levels, capital outflows, and currency devaluations that create a vicious circle that deepens crisis,” she said, adding that the negative spillovers disproportionately impact poorer households. In Africa, approximately 70% of international lending is denominated in either dollars or euros, contributing to the continent’s growing debt burden, experts say. Netherlands-based TCX encourages development finance institutions to lend in local currencies by selling hedging products to its clients which insure them against currency risks. This helps “crowd in private investment in a way that is safer and lowers the risk of debt unsustainability and financial instability for the host country,” Tyson explained. It also helps create jobs, TCX’s Hirschhofer said, since “eliminating currency risks makes businesses stronger and healthier.” But while TCX’s scale-up is good news, Tyson said, more financial innovation is needed in the sector if the “billions to trillions” agenda is to become a reality, including in the interest and credit risk markets. “We need more innovation in the way in which we mobilize private finance and we need to recognize and scale the [models] that are successful. TCX is one example of success and the additional funding is great news,” she said. Claire Godfrey, head of policy and campaigns at Bond, the U.K. network for NGOs, said she welcomed the news but warned that while financial investment can play an important role in poverty alleviation, it must be done in a way that “respects and promotes human rights and environmental protection, and prioritizes the needs of those countries and their people.” Update, May 16: This story was updated after TCX provided new figures on its risk-carrying capacity