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  5. Enhancing MDB Capacity through Local Currency Financing

Research project

Enhancing MDB Capacity through Local Currency Financing

  • 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)

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Description

Scaling up financing for development is crucial to achieving the 2030 Agenda for Sustainable Development. The financing gap to meet the Sustainable Development Goals (SDGs) in low- and middle-income countries (LMICs) is estimated at USD 4 trillion per year. Bridging this gap requires a concerted effort to mobilise both public and private financial resources, with multilateral development banks (MDBs) positioned to play a critical role.

However, while increasing the scale of financing is essential, it is not, in itself, sufficient to ensure debt sustainability. Currently, 60% of low-income countries (LICs) are at high risk of—or already experiencing—debt distress, reflecting a broader deterioration in LMICs’ debt-servicing capacity, as external public debt to exports rose from 71% in 2010 to 112% in 2021.

A key factor contributing to these vulnerabilities is the currency denomination of debt, with roughly half of public debt in LMICs denominated in foreign currency (FC). This renders LMICs vulnerable to currency depreciation, which can significantly increase debt servicing costs. Despite these risks, MDBs continue to predominantly lend in FC, exposing LMICs to exchange rate risk and further heightening default risks.

Local currency (LC) financing could mitigate these vulnerabilities by reducing currency mismatches on LMIC balance sheets and lowering the need for FC repayments in countries often grappling with balance of payments constraints. For LMICs with access to LC financing, MDB participation could extend borrowing maturities and foster the development of local financial markets. For projects generating LC revenue—such as infrastructure or renewable energy—LC financing is particularly well-suited.

Recognising these advantages, the United Nations has recently called for MDBs to improve their lending terms by expanding LC financing options and offering longer maturities. The World Bank, through its Evolution Roadmap implementation process, has likewise acknowledged the importance of expanding LC financing. However, despite these policy developments, systematic analysis of MDB LC financing remains limited. Concrete policy solutions to enhance MDBs’ capacity to provide LC financing are still underdeveloped.

This project, funded by the MDB Challenge Fund, addresses this gap by offering a comprehensive overview of MDBs’ existing LC financing practices, the challenges they face, and the associated risks. It concludes with a set of policy recommendations aimed at enhancing MDBs’ capacity to engage in LC financing without exacerbating current debt vulnerabilities for LMICs.

Research overview

Building on previous research and policy discussions, our project investigates the potential for increasing LC financing by MDBs to LMICs, including LICs. Our methodology involves a mixed-method approach, combining:

  • Secondary data analysis and legal analysis,
  • Primary data collection through semi-structured interviews and a survey of MDB representatives from Treasury, Risk, and Legal departments,
  • Macroeconometric analysis of currency and credit risk data across 29 MDBs, collectively holding over USD 2.2 trillion in assets and USD 620 billion in capital.

Our sample covers organisations worth approximately 10% of the total asset size of Public Development Banks (PDBs) globally. This breadth of coverage enables us to draw robust conclusions about the scope and scale of MDB LC financing, as well as the systemic challenges that hinder its wider adoption.

The project’s findings are structured into six chapters:

  • Chapter 1 reviews existing literature on MDBs’ LC financing, setting out the study’s justification, methodological framework, and scope.
  • Chapter 2 provides a detailed overview of the LC financing instruments currently employed by MDBs. It demonstrates that, despite existing frameworks for LC lending, these operations remain relatively limited compared to FC lending. Interviews and survey data reveal that key constraints include the limited availability and high costs of currency hedging tools, as well as insufficient internal familiarity and expertise regarding LC financing among MDB staff.
  • Chapter 3 analyses the legal and regulatory constraints that impede MDBs’ efforts to expand LC financing. Internally, statutory and non-statutory MDB provisions frequently mandate strict hedging to manage foreign exchange risk, thereby restricting LC lending activities. At the domestic level within LMICs, complex or uncertain capital markets laws, underdeveloped financial infrastructure and settlement systems, and regulatory frameworks misaligned with MDB operations significantly raise the cost and complexity of providing LC financing. The chapter underscores the need for targeted legal reforms to facilitate the expansion of LC financing.
  • Chapter 4 examines the exchange rate risks associated with LC financing. It finds that unhedged LC lending tends, on average, to yield positive excess returns, yet remains vulnerable to periods of sharp depreciation—particularly during times of global economic instability. The chapter identifies global commodity prices as a crucial predictor of these depreciation events, with the effects being particularly pronounced in LMICs that have a high presence of non-bank financial investors in domestic bond markets.
  • Chapter 5 focuses on credit risk, showing that LC debt generally carries a lower credit risk than FC debt for domestic borrowers. However, credit rating agencies (CRAs) underestimate the lower credit risk of LC debt. The chapter argues that appropriately recognising LC debt’s lower credit risk could positively influence MDBs’ capital adequacy evaluations and improve affordability for borrowers.
  • Chapter 6 synthesises these findings into policy recommendations designed to enhance MDBs’ ability to offer LC financing. These recommendations address both institutional reforms within MDBs and legal and regulatory reforms in LMICs to reduce transaction costs, limit risk exposures, and improve the affordability of LC loans.

The research thus provides a pathway for MDBs to scale up local currency financing, enhancing developmental benefits for recipient countries while effectively managing risks to MDBs’ financial stability.

Key policy recommendations

Our key policy recommendations fall into four broad areas:

  1. Bringing LC lending to the core of MDBs’ developmental mandate
    • Develop capacity in LC borrowing and lending: MDBs should integrate LC financing more centrally into their operations rather than defaulting to hard currency loans. Capacity-building efforts should involve sharing expertise and training across the MDB system—particularly between larger and smaller MDBs.
    • Enhance the quality and availability of information on MDB local currency financing: Enhance the quality and availability of information on MDB local currency financing: Assessing the benefits and risks of LC lending requires more comprehensive data on existing operations, including both quantitative loan data for modelling—such as through expanded public access to detailed information via the Global Emerging Markets (GEMs) database—and qualitative case studies.
    • Move beyond back-to-back hedging frameworks: Strict requirements that LC operations be fully matched by liabilities in the same currency and maturity constrain MDBs’ ability to provide affordable LC financing. A portfolio-based risk management model could enable MDBs to engage in effective maturity risk transformation and take on measured currency risk while preserving financial stability.
    • Reassess counterparty risk rules: MDBs’ operations are often restricted by rules that exclude onshore entities. Allowing careful engagement with local financial institutions could expand LC hedging opportunities.
       
  2. Scaling up and enhancing means of hedging currency risk
    • Scale up and subsidise TCX: Strengthening the currency exchange fund TCX by increasing shareholder capital, leveraging concessional donor resources, and allowing higher leverage ratios would significantly enhance hedging capacity. Over time, this could evolve into a treaty-based organisation with preferred creditor status, providing sustainable and cost-effective hedges in LMIC currencies.
    • Consider country-specific hedging mechanisms: Complement international hedging solutions by developing targeted, donor-supported onshore hedging mechanisms that address specific exchange rate risks in individual LMICs.
       
  3. Promoting onshore local currency operations
    • Develop onshore hedging sources: MDBs should expand onshore hedging capacity by establishing partnerships with local financial institutions and supporting initiatives such as the Delta platform, which offers cost-effective hedging through sustained local liquidity pools.
    • Engage local central banks: In countries with underdeveloped financial markets, MDBs could engage with local central banks, either individually or through joint onshore platforms.
    • Harmonise legal and regulatory frameworks: Establishing a harmonised framework for MDB operations—including securities regulations, local derivatives laws, repo eligibility, capital requirements, and taxation—would significantly reduce transaction costs and legal complexities associated with onshore LC financing.
       
  4. Addressing the pricing problem directly
    • Reflect the lower credit risk of LC debt in pricing: MDBs should reflect the lower credit risk of LC loans in the interest rates they charge on LC loans. Further, encouraging CRAs to differentiate clearly between LC and FC exposures in their assessments would help reduce lending rates.
    • Offer concessional rates for LC loans: Expanding concessional financing options for LC loans, particularly in debt-distressed settings, would significantly enhance affordability and promote developmental goals.
    • Allow MDBs to take on some currency risk: Permitting MDBs to take limited currency risks, aligned with their developmental mandate, could expand LC financing opportunities. Two mechanisms could support this:
      • Fund structure: Establishing a ring-fenced, off-balance-sheet vehicle (similar to TCX, but covering both credit and currency risks) could facilitate unhedged LC financing at more competitive rates. This fund could operate either through a single MDB or as a joint MDB initiative.
      • Risk-sharing mechanism against extreme depreciation: A trust structure, potentially funded by rechannelled SDRs, could function as a counter-guarantor for extreme currency depreciation. MDBs would bear standard currency risk but receive backstop coverage for tail-risk scenarios in exchange for appropriate fees.

Publications and outputs

Final project report:

Policy briefs:

Media coverage and blog posts:

Background working papers:

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