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  5. Enhancing MDB Capacity through Local Currency Lending

Research project

Enhancing MDB Capacity through Local Currency Lending

  • Start date: 1 September 2023
  • End date: 30 September 2024
  • Principal investigator: Professor Annina Kaltenbrunner (Professor of Global Economics, Leeds University Business School) and Dr Bruno Bonizzi (Associate Professor, Hertfordshire Business School)
  • Co-investigators: Dr Karina Patricio Ferreira Lima (Lecturer in Commercial Law, University of Leeds School of Law); Dr Karsten Kohler (Associate Professor in Economics, Leeds University Business School); Dr Guilherme Klein Martins (Lecturer in Economics, Leeds University Business)

An assortment of various international banknotes in multiple colors and denominations, arranged in overlapping rows.

Description

Scaling up financing for development is essential to meet the objectives of the 2030 Agenda for Sustainable Development. The financing gap to achieve the Sustainable Development Goals (SDGs) in Low and Middle-Income Countries (LMICs) is estimated at around USD 4 trillion per year. Mobilising both public and private financial resources is crucial to bridge this gap, with Multilateral Development Banks (MDBs) serving as key sources of finance for these countries.

However, increasing the scale of financing alone is not enough to guarantee the sustainability and long-term resilience of the international financial system. LMICs remain significantly exposed to foreign currency debt, which subjects them to the risk of currency depreciation and the high costs associated with managing such risks. As the Bridgetown Initiative highlights, there is a pressing need for additional financing that does not worsen current debt vulnerabilities, especially since 60 percent of low-income countries are already at high risk of, or are in, debt distress.

Given these challenges, the currency denomination in which MDBs provide financing is critical for achieving sustainable development. Despite the G20’s support for developing local currency bond markets, most MDB lending is still in hard currencies, such as the US dollar and the euro. While this practice may initially seem cost-effective due to low-interest rates, it can lead to increased debt burdens for borrowers due to currency mismatches.

Although many MDBs offer some local currency funding facilities, these operations remain limited, and information about them is scarce. MDB lending is constrained by capital requirements, which limit the amount of risk they can assume. Currently, local currency financing is viewed as highly risky, leading to significant risk mitigation costs that reduce resources available for these operations. However, these risks are likely overestimated, partly due to a lack of analysis of what remains a small part of MDBs’ portfolios. Therefore, it is necessary to investigate current MDB local currency financing practices, evaluate the scale and causes of these risks, and reassess whether current risk management frameworks are adequate for the level of local currency financing undertaken by MDBs.

Research overview

This project, funded by the MDB Challenge Fund, investigates the potential for increasing local currency financing by MDBs to LMICs, including low and lower-income countries. The research explores the reasons why MDBs opt for or face constraints in lending in local currencies, identifies the associated risks, and examines how these challenges can be addressed through specific lending practices or the development of institutional, regulatory, and legal frameworks.

The methodology involves a combination of extensive interviews with MDB staff from Treasury, Risk, and Legal departments; a survey of MDB representatives, financial sector experts, and recipients of MDB local currency financing; and legal analysis and advanced macro-econometric analysis of secondary data. This comprehensive approach provides a basis for developing concrete policy recommendations to reduce barriers and risks associated with local currency lending.

The goal is to structure local currency lending to LMICs in a way that maximises benefits for recipient economies while minimising risks for MDBs. The findings of this research will be disseminated through a final report, working papers, and policy briefs, leveraging the research team's existing and new relationships with several MDBs.

Key findings

Preliminary findings from the project highlight the need to expand and improve methods for hedging currency risks, facilitate the acquisition of local currency funding in onshore markets, and reform risk management frameworks.

Additionally, the findings suggest the importance of making local currency lending a central component of MDBs’ developmental mandate and enhancing the technical assistance provided by these institutions to support these efforts.

Publications and outputs