Lack of access to local currency financing is a key obstacle to closing the large financing gap faced by developing countries. It is high on the agenda in climate finance discussions, and has been the focus of recent papers and opinion pieces. 

While development finance institutions have been targeting this problem for some time now, the solutions put in place have been only partially effective. Most cross-border finance in the developing world is still denominated in foreign currency.

Back-to-back hedging has not been a particularly effective remedy due to its likely offshore nature, limiting size and tenor. Its interest rates are non-domestic and they are often non deliverable. 

The development of local bond markets has proved too shallow and expensive a source of local currency financing. As an alternative, economist Avinash Persaud has proposed that multilateral development banks and the International Monetary Fund form a joint agency to pool local currency risks and offer partial and counter-cyclical foreign exchange (FX) guarantees. 

However, the effectiveness and sustainability of this approach — and those that have been pursued previously — are limited as they have overlooked what is the root cause of the problem: the absence of long-dated local currency finance in the developing world.

The solution requires building financial systems from the ground up. There are no shortcuts. 

The solution requires building financial systems from the ground up. There are no shortcuts. 

Banking on building blocks

We need to focus on essential building blocks for the use of local currency and to improve the risk management capacity of domestic financial systems. The latter is particularly important, given that banks account for 90–95% of most developing markets’ financial systems. As opposed to the bond market approach, this can help win crucial time as building a domestic institutional investor base in developing markets could take decades. 

Well-run local banks will be more effective in intermediating savings flows, conducting low-level credit analysis, performing maturity transformation and in acting as a repository to buffer timing mismatches between inflows and outflows. At the same time, developing the banking system’s ability to manage its balance-sheet risks would provide a ready-made investor base for domestic capital markets while creating the risk-buffering capacity for international investors.

With that in mind, we need to support improvements in domestic macroeconomic and monetary policies, with central bank independence and focus on targeting inflation. This will increase trust in local currencies, which is key for banks to develop attractive products in local currencies. In parallel, we should support domestic banks’ capacity by building tools for them to manage interest rate risk through derivatives, cash products and help improve cross-border channels by building both spot and forward FX markets. 

A proposed solution

As the first step, we propose running a diagnostic on the state of the local markets, using something like the Money Market Diagnostic Framework. This would likely shape the reform agenda to include recommendations to improve implementation of monetary policy; interest rate benchmark reform (to create a transparent local base rate); and legal reform (to ensure close-out netting and collateral agreements are enforceable in the event of bankruptcy). 

Domestic stakeholders could then develop appropriate market regulation and focus on capacity building. Key partners for this work would be central banks, ministries of finance and domestic lenders, working in tandem with international financial institutions.

The next step would be implementing its recommendations to develop a robust domestic risk absorption capacity. The creation of domestic interest rate derivatives is key to this, as they will not only buffer interest and FX volatility associated with capital flows, but will also help price the ‘domestic’ leg of the currency hedges.

With all these factors in place, we stand a much better chance of meeting the pressing global investment needs that climate change necessitates.

Aude Pacatte is head of portfolio management for Europe, the Middle East and Africa at the European Bank for Reconstruction and Development (EBRD) and Axel van Nederveen is treasurer at the EBRD. The authors are writing here in a private capacity.