Published on : 30.01.24

By: Marcus Fedder, 

One of FDL's mission is to facilitate an inclusive and diverse conversation around development finance. To achieve this, we regularly invite external experts to contribute summaries of longer reports, blogs or original op-eds, sharing their unique insights and ideas with our audience.

By Marcus fedder

Vice Chair of TCX and former Treasurer of EBRD

In this article, Marcus Fedder delves into the evolving landscape of development finance and the critical challenges posed by foreign currency-denominated sovereign debt. As traditional lending institutions, including the IMF, World Bank, and regional development banks, grapple with the repercussions of currency fluctuations and a strengthening US dollar, a shift towards local currency lending to sovereign borrowers is being explored. The article looks at the consequences of this shift and potential solutions like the Currency Exchange Fund (TCX). It includes discussions on risk management and the role of global financial markets and highlights key issues such as the use of derivatives to hedge currency risk and the importance of developing local capital markets in order to handle large volumes of long-term local currency debt.

Credit: Sammie Chaffin via Unsplash
Credit: Sammie Chaffin via Unsplash
Source: Bloomberg Terminal (2023). Bloomberg Professional. Accessed on: 16-11-2023.
Source: Bloomberg Terminal (2023). Bloomberg Professional. Accessed on: 16-11-2023.

The challenges of foreign currency-denominated sovereign debt

 Finally, the world of development finance is waking up to the negative effects of foreign currency-denominated sovereign debt. The IMF, the World Bank, regional development banks, and other development finance institutions (DFIs) have traditionally lent to sovereign borrowers in US dollars (and to some extent in Euros). However, due to a strengthening US dollar – and often also as a consequence of purely domestic policies - local currencies depreciated, sometimes significantly. The chart on the left illustrates this trend in a number of Sub-Saharan economies.

As a result, foreign currency-denominated debt has massively increased in domestic (local) currency terms for such countries and has become much more expensive to service and repay than originally budgeted. This has resulted in devastating consequences on sovereign budgets as the numbers needed to service debt grew, often to the detriment of other budgetary items like health or education.


Shifting focus to local currency lending

While some development finance institutions like the EBRD or IFC have long been providing loans in local currencies to private sector borrowers who do not generate foreign exchange (FX) income, the focus is now turning to sovereign borrowers. At this juncture, when a country is in financial trouble and requires an IMF bail-out, more US dollar debt is lent to the struggling sovereign. However, increasing the stock of foreign currency-denominated debt even further cannot be a sustainable solution.

  • Is it fair to load all foreign exchange risk onto a sovereign borrower that is unable to manage it?
  • Can this risk be held by other parties?
  • Are local interest rates higher or is there a free lunch?

This issue has now received attention at the highest level of government. A recent G20-commissioned Report, titled Strengthening Multilateral Development Banks, the Triple Agenda, stated clearly that “(…) it would be useful if MDBs could develop a practical offer of an option for local currency lending. If countries chose to exercise such an option, MDB treasuries, in turn, could access global risk markets to pass through this risk.”

Such a pass-through is easier said than done.

What are these global risk markets?

They primarily refer to local money markets and capital markets that allow borrowers, including sovereigns, to raise funds. This is standard practice in developed markets, where governments borrow by issuing Treasury Bonds (USA), Gilts (GB), or Bundesanleihen (Germany), for example. However, most emerging markets are not “deep” enough to take on large volumes of long-term local currency debt that governments require to borrow and DFIs need to raise to on-lend. There are often simply not enough investors, local or foreign, to purchase all the bonds.  It takes time for domestic and international capital markets to develop in local currency. In 1994, the EBRD initiated a practical development by providing the first-ever MDB loan in local currency, in Hungarian Forint, funded via a public bond issue and a private placement in the nascent Hungarian market. And whilst in the last 30 years many emerging bond markets have developed and provided some depth so that DFIs can raise local currency funding to on-lend to projects, the G20 report also states that “today, neither the offshore route, for instance via TCX (connection to international FX risk takers), nor the onshore route (local FX risk takers), can handle the larger sizes and longer maturities that private capital works with.”  If the onshore route is unavailable due to a lack of domestic and international investors interested in buying bonds, the offshore route mentioned by the G20 can be explored.

The offshore route involves hedging currency using derivatives. Essentially, FX derivatives (such as cross-currency swaps) work like two loans:  I lend you money in the local currency, which you can on-lend to your customer. At the same time, you lend money to me in US dollars for the equivalent amount. This is similar to a back-to-back loan. There is one entity, TCX, the Currency Exchange Fund, that was set up to do exactly that in all emerging market currencies, where the Citibanks or Standard Chartereds may not be willing to operate.


TCX: A potential solution

TCX provides currency hedging in over 70 emerging market currencies[1], mainly to its shareholders and risk capital providers. These consist of 19 DFIs and microfinance investment vehicles, as well as a number of governments and the European Commission. The original idea was that rather than letting each DFI handle its own local currency risk (from local currency lending) on its balance sheet, which they are often unable to do due to restrictive financial policies, the local currency positions of all participating DFIs would be bundled into one institution, allowing them to manage these risks more effectively on a larger portfolio basis.  This way, DFIs, and impact investors can make loans in local currency and lay off the risks through swaps with TCX. The size and tenor of these swaps are determined by demand rather than supply. This means that if a DFI wishes to make a long-term loan in Paraguayan Guarani (PYG), TCX can convert the USD funding of the DFI into PYG funding so that the DFI can on-lend in PYG. TCX can handle large and long-term transactions, but the demand has been predominantly for short-dated hedging as the underlying transactions have mainly been small, short-term loans to microfinance institutions or SME lenders. Whilst TCX is, in principle, prepared to offer long-dated larger volume hedges, it has volume limitations due to finite capital and risk positions.


Requirements for TCX expansion

At present, it could not handle the necessary volumes if the World Bank, the regional development banks, and other DFIs decided to offer local currency loans as part of their standard product range – and if their clients accepted them. To illustrate the volumes, in Fiscal Year 2022, the World Bank and IDA made new loan commitments of USD 33.1 billion and USD 37.7 billion, respectively, and the IFC, the World Bank’s private sector arm, made new commitments of USD 32.8 billion. This amounts to a total of USD 104 billion worth of business. If even a quarter of the new loans were denominated in local currency, it would require about USD 25 billion to be hedged or raised in local markets just to cover the needs of the World Bank Group, not to mention all the other multilateral and bilateral development finance institutions and funds.

Can TCX provide all of these hedges?

Currently not quite. The institution, which is incorporated as a fund in the Netherlands, has USD 1.389 billion worth of capital (at the end of September 2023). This supports a business of USD 4.1 billion of hedges, (or, for the derivatives cognoscenti, “long” positions in local currencies), of which USD 1.8 billion is offset by so-called short positions. These short positions are important as they help TCX lay off some of the currency (and interest rate) risk to private sector third party investors.

How does this work? 

An institution issues a bond in an emerging market currency. These bonds are mainly purchased by institutional investors in developed markets. If the issuer does not need the funds, it can use TCX to convert the local currency bond into a US dollar liability via a cross-currency swap. This is a win-win-win transaction as it allows (a) the issuer to raise dollar funding at attractive levels, (b) TCX to lay off FX risk and therefore create room for more business, and (c) the investors to express a positive view on an emerging market by buying the bonds and holding the risk. It crowds in investors so that risks are more widely spread and not only taken by the official development finance sector.

At the moment, about USD 659 million of TCX’s capital is an available capital cushion to expand its business. However, the amount of business that TCX can take on depends on a number of factors:

  • (i) the maturities of new transactions: longer maturities require more capital;
  • (ii) the volume of new transactions: large-size transactions eat up capital and reduce diversification;
  • (iii) diversification: the more diversified the portfolio over the regions from SE Asia to Africa, Europe and Latin America, the better, as not all emerging markets were highly correlated in the past;
  • (iv) interest rate basis: fixed-rate loans bind additional capital to cover for the interest rate risk;
  • (v) correlation: if correlations of emerging market currencies merge towards one, then the diversification effect weakens.
  • (vi) off-sets:  this is crucial. At the moment, about 40% of the long portfolio of hedges is off-set by short positions as explained above. This risk transfer frees up capital and thus capacity for TCX and contributes to the growth of international markets for emerging and frontier market currency risk. If more end-investors purchase such bonds, TCX could off-set more of its long positions – a crucial precondition to expanding the business volumes of the institution. This will become even more important when larger-volume future sovereign transactions need to be hedged as part of TCX’s portfolio management and capital usage optimization.
  • (vii) maturity mismatches: alas, there remains the problem of maturity mismatches as DFI loans, for instance for infrastructure projects and general sovereign lending, usually have longer maturities whereas investors in emerging market paper prefer shorter-dated maturities. Yet, TCX has been able to grow its tenor transformation function by accepting long-term risk, selling it on a rolling short-term basis.

Moving from providing a large number of small transactions to fewer lumpier hedges -typically associated with a DFI’s sovereign lending – would pose a certain challenge to TCX’s operating model. It would take time to build up a stable portfolio of a large number of long positions in various currencies.

There is another aspect that needs to be taken into account when dealing with local currencies: local currency interest rates are frequently higher than US dollar rates. If local interest rates were the same as dollar rates, there would be a free lunch. Alas, that does not exist. This interest rate differential has led some decision-makers to prefer borrowing in dollars, kicking the can of depreciation and the resulting higher debt service burden down the road.

So how are these interest rates in local currency determined? 

Some markets have a yield curve that is based on money markets and traded instruments. Such a yield curve can be extrapolated for longer maturities. Other markets, however, are illiquid. To determine the prices for the valuation of hedging transactions, TCX has installed a unique feature in its governance model, an independent Valuation Committee. This committee decides on the benchmark curves that TCX uses as the basis of its transactions. TCX, therefore, aims to provide realistic market prices even in currencies that do not have functioning money markets and capital markets.


Future prospects and challenges

Looking forward, it is possible that TCX will become less additional in the future in the short-term markets where microfinance loans get converted from USD or EUR to local currency. However, as the institution continues to provide hedging for DFIs’ growing local currency loan portfolios, TCX will have to expand. This means that TCX needs more equity to cover for the market and maturity-mismatch risks it takes on its balance sheet. Since FX and interest rate markets are volatile, such equity would have to come in the form of paid-in cash and not as callable capital, which supports the lending businesses of the World Bank and some other DFIs. TCX aims to earn a small return on equity – not the returns that private equity investors would require for such risky investments. As such, equity will have to come from development budgets, even though these budgets are already stretched. However, simply providing DFIs with more capital so that they can lend more dollars to indebted countries is neither responsible nor sustainable development.

How much additional equity is required is difficult to predict. Currently, USD 1 billion allows for about USD 5 billion worth of hedges. This 5:1 ratio is based on historical experience and stress-testing of TCX’s portfolio, where the underlying assumption is that even under worst-case scenarios, i.e., a massive, across-board, devaluation of emerging market currencies, TCX would have enough equity to cope with the resulting losses and survive. A higher leverage would, in principle, be possible if more of TCX’s long positions could be off-set through short positions that hedge (ideally longer-dated) bond issues. With an additional USD 1 billion of equity, TCX could potentially enable DFI sovereign local currency lending to the tune of USD 5 to 10 billion. That may be a drop in the billions to trillions ocean, but it should, realistically, be good to get going.

In addition, building functioning onshore money markets, bond markets and derivatives markets remains a key development objective that will take time. Institutions like the IMF, EBRD, and others have been active in this field for decades. Local markets will be the ultimate and crucial long-term foundation for the scaled-up local currency lending required to achieve climate and development goals. Until that is achieved, DFIs will need a TCX2.




[1] TCX normally provides non-deliverable swaps where all cash flows are settled in USD, thus creating a synthetic local currency loan;