The Urgent Need for Sustainable Financing: Addressing Foreign Currency Debt in Developing Economies

In an increasingly interconnected world, the complexities of foreign exchange (Forex) markets and the implications of currency volatility are critical issues for developing nations. As the global economy grapples with the challenges posed by climate change and economic instability, the need for sustainable financing has never been more urgent. This article delves into the intricacies of foreign currency debt, the risks it poses to vulnerable economies, and the potential pathways toward enhancing local currency financing.

The Context: A Growing Investment Gap

According to a September 2023 report by the United Nations Conference on Trade and Development (UNCTAD), achieving the Sustainable Development Goals (SDGs) requires an annual investment of approximately $4 trillion. However, mobilizing these resources is fraught with challenges, particularly for developing countries that often rely on foreign currency borrowing. The Group of 20 (G20), under Brazil’s presidency, has identified multilateral development banks (MDBs) as pivotal players in addressing this investment gap. Yet, the current landscape reveals a troubling reliance on foreign currency debt, which exacerbates vulnerabilities in already fragile economies.

The Risks of Foreign Currency Debt

The reliance on foreign currency debt poses significant risks for developing nations. A stark illustration of this is Ghana, which defaulted on its external public debt in December 2022 despite a decade of economic growth. By 2021, nearly half of Ghana’s public debt was denominated in foreign currency, making it susceptible to exchange rate fluctuations. The sharp depreciation of the Ghanaian cedi in 2022 rendered the country unable to meet its foreign currency obligations, highlighting the precarious nature of such borrowing.

The UNCTAD report underscores a worrying trend: the number of countries facing high debt levels has surged from 22 in 2011 to 59 in 2022. This situation is compounded by the fact that interest payments in many developing countries now exceed public spending on essential services like health and education. With 3.3 billion people living in nations that prioritize debt servicing over critical social investments, the need for reform is urgent.

The Concept of ‘Original Sin’

The term ‘original sin,’ coined by economists Barry Eichengreen and Ricardo Hausmann in 1999, describes the inability of developing countries to borrow in their own currencies. This phenomenon remains prevalent today, with about half of public debt in low- and middle-income countries (LMICs) denominated in foreign currencies. The International Monetary Fund (IMF) and other MDBs often contribute to this issue by predominantly lending in hard currencies, reinforcing the hierarchical nature of the international financial system.

Climate Change: A Catalyst for Debt Vulnerability

The climate crisis further complicates the landscape of foreign currency debt. Countries vulnerable to climate change are more likely to default on their debts, particularly when those debts are denominated in foreign currencies. Investments in sustainable initiatives, such as renewable energy, typically generate revenue in local currencies. However, when these investments are financed through foreign currency debt, the risk of currency depreciation can jeopardize both the sustainability of the investments and the ability to service the debt.

The Role of Multilateral Development Banks

Despite the clear need for local currency lending, MDBs have been hesitant to expand their operations in this area due to concerns about currency risk. This aversion is often rooted in their founding charters and is reflected in the decisions made by their governing boards. As a result, local currency lending is typically limited to situations where MDBs can mitigate risk through currency derivatives or by issuing local currency bonds.

For instance, the International Bank for Reconstruction and Development (IBRD) has issued local currency loans fully hedged by corresponding local currency bonds. However, this reliance on market mechanisms increases the cost and complexity of local currency financing, often making it unattractive for borrowers.

Strategies for Enhancing Local Currency Financing

To address the pressing need for sustainable financing, several strategies could be adopted to enhance local currency lending by MDBs:

1. Reforming Risk Management Frameworks: MDBs must reassess their perception of exchange rate risk. Successful examples, such as the TCX Fund, demonstrate that currency risks can be effectively managed, allowing for more robust local currency lending.

2. Diversifying Hedging Sources: MDBs typically source foreign currency hedges from international banks, inflating costs. By reducing restrictions on using local onshore banks for hedging, MDBs could lower costs and interest rates on local currency loans.

3. Scaling Up and Subsidizing TCX: Increasing the capital of TCX and providing concessional financing from donors could enhance MDBs’ local currency lending capabilities, making hedges more accessible and affordable.

4. Facilitating Local Currency Sourcing: Encouraging local central banks to purchase MDB local currency bonds could provide necessary funding while diversifying their portfolios.

5. Creating Off-Balance Sheet Funds: Establishing a fund that pools local currency assets could help distribute exchange rate risk across MDB portfolios, reducing idiosyncratic risks.

Conclusion: A Call for Action

Addressing the foreign currency debt trap is essential for sustainable development financing. MDBs must expand their local currency operations, particularly in light of the overlapping debt and climate crises. By shifting away from a reliance on hard currency lending and adopting a more flexible approach to currency risk management, MDBs can align their operations with their developmental mandates.

As we move toward the Fourth International Conference on Financing for Development in 2025, the urgency of these reforms cannot be overstated. The time for action is now, and the future of sustainable development hinges on our ability to create a more equitable and resilient financial system for all.

Authors’ Backgrounds:
Bruno Bonizzi is an associate professor of research at the University of Hertfordshire Business School, focusing on macro-finance in emerging economies. Karina Patrício Ferreira Lima is an assistant professor at the University of Leeds School of Law, specializing in global economic governance. Annina Kaltenbrunner is a professor of global economics at the University of Leeds Business School, with research interests in financial dynamics in developing economies.