As developing nations sink in overseas debt, Bruno Bonizzi describes why local currency debt may be part of the solution.
After a decade of sustained growth, Ghana defaulted on its external debt repayments in December 2022. And a year and a half on since its default, the west African country’s government is yet to reach a deal on debt restructuring.
This is a story repeated in many developing countries.
A key contributing factor to the crisis has been Ghana’s high reliance on foreign currency debt.The fall came as increasing inflation and rising interest rates left the country struggling to repay its accumulated debts. Servicing its external borrowing, including loans from private bond investors, became too hard following the global economic impact of the pandemic and Russia’s invasion of Ukraine.
As of 2021, 48% of Ghana’s public debt was, according to the database by Arslanalp and Tsuda, denominated in foreign currency – largely US dollars. With the global strengthening of the US dollar and Ghana’s domestic economic troubles, the Ghanaian cedi depreciated significantly over the course of 2022. As a result the effective burden of Ghana’s foreign currency debt soared, to the point of unsustainability.
This vicious link between exchange rates and foreign currency debt arising from the inability of developing countries to borrow in their currency was dubbed by economists Barry Eichengreen and Ricardo Hausmann, in a 1999 paper, the “original sin hypothesis”. In their view, this explained well the catastrophic financial crises in East Asia in 1998. Twenty-five years later, foreign currency borrowing remains widespread across developing countries.
Foreign currency borrowing remains widespread across developing countries.
This reliance on foreign currency borrowing is particularly damaging when considering the substantial funding required to achieve the United Nation’s Sustainable Development Goals (SDGs). The United Nations Conference on Trade and Development has recently estimated that the annual SDG investment gap is $4tn. Mobilising these resources is itself very challenging. But filling this gap entirely with foreign currency debt can exacerbate the problem for already vulnerable countries.
There are clear links between environmental and debt sustainability. Catastrophic climate events are extremely costly putting strains on government fiscal resources. On the other hand, debt distress can hinder the capacity of governments to invest in climate change adaptation and mitigation. Zambia’s President Hichilema in March 2024 urged lenders to conclude debt their restructuring process quickly as the country declared a drought as a national emergency. Furthermore, there is evidence that the most vulnerable and least resilient countries are more likely to default on their debt, and that this link is stronger for developing countries.
The need to invest in climate resilience is therefore pressing, but it needs to avoid generating further debt traps by overly relying on foreign currency debt. This is particularly so as many investments in sustainability, such as renewable energy production, generate local currency revenue, which is ill-suited torepaying foreign currency debt. A depreciation of the local currency may jeopardise both these investments and the sustainability of debt.
The need to invest in climate resilience is pressing, but it needs to avoid generating further debt traps.
Sustainable development therefore needs sustainable finance, including a way to reduce the risk of foreign currency debt in developing countries. An important actor in these respects are Multilateral Development Banks (MDBs), which are key lenders to developing countries, especially low-income ones. These institutions also provide lending in local currency but are constrained in doing so. Typically, they cannot take on foreign exchange risk, so when they make loans in local currency they are forced to hedge these risks. Such hedges have a cost, which MDBs add to the lending rates that they offer to their borrowers. As a result, local currency lending comes with high borrowing costs that make it unattractive to borrowers.
This problem is under scrutiny as part of the global climate finance agenda. Economist, Avinash Persaud, launched the Bridgetown Initiative, calling for the creation of a foreign exchange guarantee agency. This agency would provide a guarantee against depreciation at a cost lower than that currently provided by the market. Lenders such as MDBs could then lend in local currency to developing countries at lower rates.
Sustainable development needs sustainable finance.
Equivalently, it could boost the returns to private investors, which would otherwise see their net investment returns significantly eroded by hedging costs. This Specialised fund, TCX spell this out the first time it is used, that provides hedging for developing countries’ currencies, similarly called for additional capital from donors and MDBs so that it could scale up its operations.
There may be other ways to enhance local currency lending. MDBs could be allowed to take on at least some foreign exchange risk, either individually or jointly. The example of TCX is instructive: by providing hedges it effectively assumes foreign exchange risk and reportedly obtained a positive annualised return of 1.6% over 15 years of operations.
Other institutions also take direct foreign exchange risk, such as the investment facility, African Caribbean and Pacific, led by the European Union and the European Investment Bank, which can provide loans in local currency without external hedging. The facility charges a premium for foreign exchange risk when lending in local currency, but does not hedges its exposure with external parties.
These examples testify that currency risk, while real, can be manageable. And they suggest that there may be a need to rethink the current extreme aversion towards it by MDBs and other lenders.
Whether through upscaling hedging capacity or direct exposure to exchange rate risk, it is clear that financing climate resilience will also require sustainable financing sources. The danger of foreign currency debt is all too visible in the current phase of debt distress in developing countries.
