Currency risk is the Achilles heel of developing economies that borrow to make investments to increase productivity, reduce emissions and meet the sustainable development goals.
Some 90 per cent of cross-border debt for low and lower-middle income countries, nearly $2tn, is denominated in hard currencies, mostly dollars, much of it from development banks and other official lenders.
But this exposes vulnerable populations to sometimes wild fluctuations in exchange rates that increase economic fragility and often trigger a debt crisis. Nine currencies of developing economies fell by more than a quarter and a further 21 by more than a tenth in 2020 as Covid 19 hit.
This is a failure of both markets and policy that forces currency risk on those least equipped to bear it. Only 20 developing economies can regularly borrow from international investors in their own currency.
For others forced to borrow in dollars, even hedging currency risk is not an option. The foreign exchange market has a huge daily turnover of $6.6tn, mostly in G-10 currencies, with 100 developing economies accounting for less than 0.2 per cent. Markets for swaps, derivatives that are a mainstay of currency hedging, hardly exist beyond large emerging economies.
Given their large investment needs and limited domestic savings, external borrowing by low and lower-middle income countries will need to rise to $4tn-$6tn by 2030 if they are to align with the Paris Agreement on Climate Change and meet sustainable development goals.
This funding will not materialise without markets and policymakers stepping up to mitigate currency risk at scale. A new multilateral institution which makes two-way markets in currencies, especially for longer durations for which no private market exists, is needed to cut currency risk by half by 2030.
This International Currency Fund would build on the expertise of TCX, a successful donor-funded initiative that prices and offers hedging of developing country currency risk. Its pricing and risk management models have been successfully stress-tested through wild swings in currency markets experienced in the euro crisis and the Covid crises.
However, TCX only has a hedging capacity of about $5bn, on a modest capital base of $1bn. Only a multilateral ICF, with a broad membership and large capital base, can reduce currency risk meaningfully.
The ICF would make markets by finding and acting as a counterparty to investors, borrowers, donors, corporates and remitters of foreign exchange with offsetting currency exposures.
The multilateral imprimatur and treatment as a preferential creditor would reduce collateral required for trades and allow it to offer more products that aid local market development, increase liquidity and attract private investors to currency risk as an asset class. This, together with more opportunities to offset risk, would increase capital efficiency, allowing ICF to offer $10 of hedging capacity for every $1 of capital, double that of TCX.
The ICF would need to launch with an ability to carry a minimum of $250bn in gross currency exposures to demonstrate a seriousness of intent, attract private risk capital and start making a dent in currency risk.
For this it would require to have around $25bn in capital, of which only $5bn would need to be paid up front. The balance can take the form of callable capital, a commitment to pay up, if needed, also used by the World Bank.
This small amount will address one of the largest sources of risk in financing for developing economies and unlock additional productive investments of hundreds of billions of dollars. ICF-enabled forward markets in currencies would be more responsive to changes in policy, politics and market conditions, providing better feedback than dollar-based bond markets do.
Dollar borrowing is attractive because it carries lower interest but typically turns out more expensive in the long term if local currencies weaken in value. By transparently pricing hidden currency risk, the ICF will improve incentives for both borrowers and lenders to switch to local currencies and adopt stronger macro policies, thereby reducing developing economy fragility. In turn, this would save donors some of the money they currently lose in frequent debt writedowns. There are few more efficient and urgent uses for scarce donor funds than an ICF. It is time to act.
Sony Kapoor, Harald Hirschhofer, Dimpal Kapoor and Nanno Kleiterp
This piece appeared in the Financial Times on the 13th of July 2021 here