Inside the push to ease dollar debt and boost local lending

Governments and businesses in emerging economies often borrow in foreign currencies such as the U.S. dollar to fund critical infrastructure or fuel growth. But there’s a fundamental mismatch: the revenue from those projects is earned in local currency. If the exchange rate remains stable, all is well. But when local currencies weaken — as they often do in times of economic stress — repaying that debt becomes far more expensive. It’s a cycle that repeats across the developing world, contributing to financial instability, amplifying debt burdens, and making countries more vulnerable to global shocks. Take Ghana, for example. A growing local business secures dollar-based funding to expand. But then the Ghanaian cedi loses 40% of its value. Suddenly, even though the business is thriving, its debt repayments become crushing — not because the business failed, but because the currency did. The same logic applies to government borrowing. The risk of currency mismatch often falls squarely on the shoulders of local governments and companies — not the foreign lenders. One solution? Borrow in local currency. But for many countries, that’s easier said than done. Local capital markets are often underdeveloped, illiquid, or prohibitively expensive. That’s why there's growing momentum around promoting local currency lending as a way to support development — while insulating borrowers from currency volatility. Brazil made the issue a Group of 20 priority last year. And it’s now a central focus of the World Bank’s Private Sector Investment Lab — a group of 15 global finance leaders brought together by World Bank President Ajay Banga to find ways to direct more private capital into emerging markets. “Borrowing in local currency improves financial stability significantly. And in the long term, if you develop local markets, that creates a more stable financial system, Bruno Bonizzi, an associate professor at Hertfordshire Business School, who recently co-authored a study about MDBs' local currency lending, told Devex. But that begs the question of who takes on the currency risk, which to date largely falls on borrowers through higher interest rates to cover hedging costs. But that risk could be distributed, partly insured, covered by a guarantee, or taken on by multilateral development banks to allow for more affordable financing. “There is a general sense in the MDB community that there needs to be more local currency,” said Annina Kaltenbrunner, professor of global economics at Leeds University and co-author of the recent study. “There’s definitely an awareness,” but some inertia and challenges dealing with some of the constraints. And the challenges are likely to worsen as climate change and geopolitical turmoil create more unpredictability and volatility in international financial markets, Ruurd Brouwer, CEO of TCX, which takes on the currency risk for MDBs. “We see the need to derisk hard currency flows, dollars or others, is only increasing,” he said, noting that recent debt defaults in Africa were often worsened by countries’ high exposure to dollar-denominated loans — with COVID-19, Russia’s invasion in Ukraine, and U.S. political shifts driving up repayment costs. The current reality MDBs don’t take any currency risk on their own balance sheets. When they make local currency loans, they fully hedge or insure the currency risk, Bonizzi and Kaltenbrunner told Devex. “We knew it was going to be limited, but we did not realize it was just a no-go kind of thing,” Bonizzi said. Their recent research set out to assess whether MDBs were mispricing or misassessing currency risks and what models they are using. But what they found was that MDBs simply don’t take any currency risk. They are sometimes constrained by rules or internal pressures that prevent them from doing so. There are differences across institutions, and even internally between different departments — for example, some treasurers they spoke to support taking limited currency risk, but the risk managers are opposed, they said. When an MDB hedges currency risk, the cost is typically passed on to the borrower in the form of a higher interest rate. That makes the cost of hedging a key constraint to increasing the use of local currency loans and drives down demand. In many cases, local currency loans from MDBs don’t make financial sense to public borrowers at current costs, though the private borrowers might still find the prices worthwhile. ‘Unless [MDBs] start taking some of this risk, it will be very hard to actually provide affordable local currency financing because hedging is so expensive,” Kaltenbrunner said. But not everyone agrees. Taking on too much of the risk could reduce pressure on governments to make macroeconomic changes, such as strengthening their banking systems, Erik Berglöf, the chief economist of the Asian Infrastructure Investment Bank, or AIIB, told Devex. What seems clear, either because of regulations or a long-held status quo, is that it’s not likely that MDBs will take on this risk any time soon, if at all, several experts told Devex. Potential solutions There are several ways to reduce hedging costs and increase local currency lending, especially from MDBs. One solution is to bring down the cost of insuring the currency fluctuation risk — both through supporting existing mechanisms and through new ones. That includes changing rules to allow MDBs to seek local hedging, which many can’t do due to restrictions on which financial institutions they can work with, which many local banks don’t meet. MDBs could take on some of the currency risk themselves, provide concessional local currency loans, or adjust their risk and cost calculations to reduce pricing to reflect the improved financial profile, Bonizzi said. Another option is to have some sort of donor guarantee to help pay for the most extreme currency risks. The solution may, in fact, be some combination of a number of different tools — hedging, building local markets, guarantees, and sharing the costs of reducing the risks. In the long run, developing local capital markets — including better funding local development banks — can help, because countries will rely less on foreign currency loans. One heavily used tool is TCX, an entity co-owned by MDBs that absorbs the currency risk through swaps. The cost of insuring risk is essentially the difference between the dollar interest rate and the higher local currency interest rate. If the U.S. can borrow at 7% and Rwanda at 12% — that 5% is the cost of protecting against currency risk. Scaling up TCX will allow MDBs to make local currency loans. TCX has doubled in volume over the last two years, Brouwer said, and last year covered about $3 billion in foreign exchange risk for multilateral and bilateral development banks, including in local currencies in Sierra Leone and Papua New Guinea. It recently received new funding from the European Commission and is selling its foreign exchange risk to private investors, allowing it to do three times more with the same base funding. It is active in about 60 countries — from Vietnam to Honduras to Rwanda, Brouwer said. While most of the risk TCX insures is from MDBs and European development finance institutions, impact investors and even major banks such as Citibank or JPMorgan Chase have also used it. A common criticism of TCX, however, is that it can be expensive, several sources said, not because TCX is mispricing anything, but merely because of the way it works. So there is a need for a complementary tool: something less expensive, that actually provides local currencies and not just swaps, and is designed to help develop capital markets and promote reform, AIIB’s Berglof said. AIIB and the European Bank for Reconstruction and Development are working together on such a venture: Delta. The new platform, co-owned by MDBs, could create pools of local currency funding in-country, enabling MDBs to tap into it — with donor backing to absorb losses. Fifteen to 20 liquidity pools would help diversify and reduce risk, Berglof said. “You need to be on the ground. You need to build a center of excellence that can both help you protect your liquidity needs for the MDBs, but at the same time develop the local financial system,” he said. “It’s not something you do overnight, but it's a long-term agenda.” EBRD has also relaxed some rules that allow it to take on market risk to operate onshore in countries. But many MDBs have rules requiring them to match the terms of their lending with their borrowing, making Delta an appealing workaround. “We are never going to get out of this original sin” of borrowing in foreign currencies and earning in local currencies “unless we are part of building the local capital markets that can help mobilize these domestic resources,” Berglof said. AIIB already offers local currency loans in a handful of countries, but not all where it wants to work. That’s why it sees Delta as a medium-term fix that shares risk without overexposing MDBs, he said.