Foreign exchange (FX) risk is a significant barrier to sustainable development in emerging and frontier countries. This risk jeopardises the sustainability of agriculture, food security, SMEs, infrastructure, energy, and environment/climate change projects; sectors critical to achieving the Sustainable Development Goals (SDGs). Social innovators have developed promising solutions to reduce FX risk, but these innovations have not had a material impact – over 90% of cross-border debt to low and lower middle-income countries is denominated in foreign currency, exposing unhedged borrowers to currency mismatch risk between local currency revenues and foreign currency debt.

What can we do to reduce systemic FX risk in developing countries? The most successful, proven innovations have been: (1) reforms to deepen and broaden domestic financial intermediation in local currency and (2) blended finance solutions to ensure FX risk is not transferred to the vulnerable. If a small percentage of the $132 billion of annual Official Development Assistance (ODA) from OECD Development Assistance Committee members and the $30 billion of annual funding from philanthropic sources was channelled to these innovations, the impact on sustainability and the SDGs could be immense. The amount of cross-border financing from the private sector to developed countries would increase and the FX risk in developing countries – specifically the most vulnerable (e.g., farmers, microenterprises, SMEs, and consumers/citizens) – would decrease leading to further sustainable investment and economic development.

The need for cross-border financing

In most developing countries, the domestic financial sector is not able to provide the financing required to achieve the SDGs due to three major challenges. First, the financing needs are too large. The United Nations estimates USD 2.5 trillion of incremental annual financing is required to achieve the SDGs with the greatest potential in high-impact sectors such as infrastructure (power, renewable energy, and transport), telecommunications, and water and sanitation which together have an estimated shortfall of USD 1.6 trillion per annum. Second, too much of domestic financial sector intermediation (e.g., bank assets and liabilities) is denominated in foreign currency. Third, the limited amount of domestic institutional capital tends to invest in low-risk investments in developed countries or local government bonds. As a consequence, developers of economically important projects cannot obtain necessary long tenor local currency financing, in particular for capital-intensive projects dependent on debt such as infrastructure and renewable energy.

While policy reforms and financial and capital market reforms should be pursued to deepen and broaden domestic financial intermediation in local currency in the medium term, a large percentage of the financing to achieve the SDGs by 2030 will need to come from cross-border finance with blended finance instruments to play a critical role to reduce FX risk.

Foreign investment is required. However, macro-risks and resulting exchange rate volatility impede the flow of cross-border finance: If cross-border flows are denominated in foreign currencies, the recipient bears the currency risk (which is mostly the case now), but if they are denominated in local currencies, the nominal interest rates are often perceived as excessively high. For a variety of reasons, including very low foreign currency interest rates, the interest rate differential between foreign currency debt and local currency debt in most emerging and frontier countries ranges from 4 to 14% per annum – leading to significant cross-border foreign currency-denominated lending and a small market of local currency (or FX-hedged) lending.

Public sector debt flows are also invariably denominated in foreign currency. Multilateral development banks, international financial institutions, development finance institutions (DFIs), and official creditors not able or willing to take open currency risk.

Unhedged FX risk is likely to have significantly greater negative consequences on sectors related to the sustainable development goals. At the borrower level, it is often a cause of insolvency – where entities that do not generate FX earnings (e.g., farmers, micro-enterprises, SMEs and infrastructure/renewables projects) are the most vulnerable. These parties should borrow in local currency, but in many countries local currency loans are not available, forcing these ill-equipped parties to bear the risk on an unhedged basis. Take a typical renewable energy project (such as solar) as an example. The International Renewable Energy Association estimates debt service costs typically account for around 40-70% of a solar project. To qualify for financing, such projects require a debt service coverage ratio around 120% typically. If one assumes the debt is provided in foreign currency and the revenues earned in local currency, the table below provides sensitivity analyses for the different levels of local currency depreciation.

In almost all scenarios of currency depreciation, the borrower would be in breach of a conventional debt service coverage ratio covenant leading to technical default. In depreciation scenarios greater than around 4% per annum, the project would not be able to make its debt service payments, leading to payment default (and a non-performing loan). This result is applicable to all unhedged borrowers – from large infrastructure projects to small SMEs loans – depreciations as low as 4% per annum often lead to default. Yet research at The Currency Exchange (TCX) indicates that, for low- and middle-income countries, annual depreciation rates have averaged over 4% over the past 25-40 years. It is no coincidence that the region with the highest rates of FX denominated assets and liabilities in the financial sector (e.g., Central and Eastern Europe) also experience the highest non-performing loan ratios in the world.

Blended finance solutions that shelter developing countries from FX risk

Over the past decade, social innovators have derived solutions to address FX risk and increase the supply of sustainable finance. Despite these innovations, over 90% of cross-border debt financing to low- and lower-middle-income countries is denominated in foreign currency and almost 100% of equity flows are exposed to FX risk. The instrument depends on the region and capital markets development; in Sub-Saharan Africa the market for investment is private equity focused whereas in Asia where capital markets are deeper debt is more important. Though in all regions solutions have not achieved scale – FX debt burdens remain the norm, and achievement of the SDGs is therefore jeopardised.

Blended finance, however, emerges as one high-potential path towards these key SDG objectives: “mobilize additional financial resources for developing countries from multiple sources” (Objective 17.3) and “assist developing countries in attaining long-term debt sustainability …” (Objective 17.4). At its International Conference on Financing for Development in Addis Ababa in June 2015, UN member countries reached consensus on the importance of deploying public funds to attract private sector investment in blended finance: “An important use of international public finance, including Official Development Assistance, is to catalyse additional resource mobilization from other sources. Blended finance instruments serve to lower investment-specific risks and incentivize additional private sector finance across key development sectors led by regional, national and subnational government policies and priorities for sustainable development.”

The Sustainable Development Goals and Addis Ababa Action Agenda point towards deploying blended finance to reduce FX risk in developing countries to achieve long-term sustainability, including (1) reducing the percentage of cross-border flows where the borrower bears FX risk on an unhedged basis, and (2) increase the amount of domestic financial intermediation (in the financial and capital markets) in local currency.

Often definitions of these transactions can be confusing, but we see three signature markings of a best-practice blended finance transaction:

• 1. The transaction – whether a project, company, fund, or structured offering – is intended to yield a financial return.
• 2. The venture or activity contributes toward meeting the SDGs in an emerging or frontier market. Not every investor in the transaction will have that intent; there may well be participants who are drawn instead by diversification, returns, or a strategic opportunity to enter a new market.
• 3. The public and/or philanthropic parties in the transaction are catalytic and additional – the private sector involvement/investment is additional to the project and would not have been mobilised without the blended finance intervention.

Many good solutions exist, but have not yet achieved scale

In an effort to unpack some of these FX risk challenges and blended finance as a potential solution, the European Commission, the OECD, the European Development Finance Institutions, TCX and Convergence convened more than 60 private, public, and philanthropic organisations in Brussels in February 2017 for the largest-ever workshop of experts and practitioners dedicated to FX risk reduction in developing countries and development finance. The participants investigated existing innovative solutions to reduce FX risk, identified best practices and discussed how these can be scaled up to achieve the SDGs. The workshop concluded there are five high-impact uses of blended finance to reduce FX risk and increase sustainability that are already proven:

• 1. Technical assistance to fund reforms to deepen and broaden domestic financial intermediation in local currency. Public sector donors and DFIs are working with national authorities (e.g., central banks) in developing countries to improve domestic financial and capital markets regularly. There is lots of research demonstrating that this must be a long-term objective.

• 2. Credit enhancement and risk-sharing instruments to facilitate domestic capital being invested in domestic projects. Organisations like GuarantCo and the Credit Guarantee and Investment Facility have proven instruments such as issuing guarantees that allow borrowers to gain access to local currency capital at sustainable terms. Meanwhile, domestic investors achieve their local risk-return requirements. With growing wealth and investable capital in developing countries, these instruments should be scaled up.

• 3. Credit enhancement and risk sharing instruments to facilitate cross-border debt and equity investment. Vehicles like the Sida Guarantee Instrument and the IFC–Sida Managed Co-lending Portfolio Program allow investors and lenders to benefit from a full or partial guarantee from an investment grade guarantor. With the growing supply of institutional capital in developed countries out-stripping investment opportunities, these instruments hold great promise to crowd-in debt investors from developed countries.

• 4. Currency risk hedging instruments to improve the management and allocation of FX risk. TCX has underwritten around USD 5 billion of currency risk in more than 50 developing countries over the past decade, allowing around 3-5 million SMEs to access local currency financing at viable rates. TCX has earned a positive return – albeit with the high volatility expected from its business model. The MIGA Guarantee Instrument cross-currency swap arrangement allows borrowers to swap out of FX debt obligations into local currency obligations. These instruments represent best-practice innovations to manage currency risk in developing countries.

• 5. Financing and guarantee instruments that bear FX risk. The European Investment Bank–European Union ACP Facility is the best-known sizable program within the DFIs where the lender takes open currency risk and charges a premium to cover FX losses. After 10 years of financing around EUR 600 million in loans, the cumulative FX premium has been around five times greater than FX losses. The ACP Facility has demonstrated that a DFI can bear open currency risk, price the risk and earn a positive return.

We’ve gathered the most interesting observations – both positive and negative – from reviewing these instruments and evidence over the past decade.

Achieving scale in reducing FX risk going forward

So long as domestic financial intermediation is insufficient to finance the SDGs and cross-border financing is required, FX risk will be present in all transactions. It cannot be eliminated, but rather only transferred. Prevailing practices too often cause the most ill-equipped parties to bear that risk – for example farmers, micro-enterprises, SMEs, as well as the customers of unhedged utilities (and ultimately in many cases, taxpayers). The innovative solutions described above shift FX risk to parties that are best able to manage and bear the risk (e.g., professional financiers, DFIs, and developed country public and philanthropic sector parties). The organisations at the workshop agreed the prevailing practices where the most ill-prepared bear the risk is one of the worst practices in development finance, and that blended finance should play a transformative role to shift this risk to those most equipped.

In the current International Development Association (IDA) replenishment, the World Bank Group and the IDA donors are taking an innovative and leading role to address this risk. The new Private Sector Window is expected to provide around USD 500 million to assist IFC provide FX-risk-reduced financing.

Additionally, the new European Fund for Sustainable Development is expected to allocate European Union funds to reducing FX risk in developing countries. These new sources should contribute tangibly to shifting FX risk to the most equipped and sheltering the least equipped.

The good news across the 10 instruments profiled at the workshop is the significant impact and catalytic leverage of public and philanthropic funds. Less than USD 1 billion of public and philanthropic funds have been committed to support around USD 10 billion of financing (10 times leverage). With losses infrequent, almost all funds are still available to support the next generations of financings during the SDG implementation period. Indeed, a combination of committing a small percentage of annual ODA flows and redirecting some existing public sector funds in the system (e.g., DFI retained earnings) could drive one of the most systemic, permanent, and impactful transformations during the SDGs. Further, the sectors which benefit the most – agriculture, food security, SMEs, infrastructure, energy and environment/climate change – are those most critical to the SDGs and human development.

ABOUT CONVERGENCE

Convergence is an institution that connects, educates, and supports investors to execute blended finance transactions that increase private sector investment in emerging markets. Learn more at www.convergence.finance.