Original sin: can concessional finance help escape it?
Governments and firms borrow in foreign currency although it exposes them to exchange rate risk. And, strikingly, most foreign currency debt is in a handful of currencies: between 2010-2020, 60% of foreign currency debt was denominated in dollars and about 23% in euros.¹ In emerging and developing (EMDEs) countries large depreciations, raising the cost of debt in foreign currency, have caused corporate and sovereign borrowers much distress.² So why don’t EMDE borrowers better manage their liabilities by hedging foreign currency risks or by borrowing in their own currency? In fact, many countries suffer from what has been termed “original sin”- they cannot borrow abroad in their own currency as lenders do not wish to take on foreign exchange risk.
Borrowers face significant constraints in managing exchange rate risk: the costs of hedging foreign currency risk, even if hedging instruments exist, may be very high, or the instruments and markets simply may not exist for a particular currency. In order to hedge a currency risk, there needs to be a counterparty that is willing to hold the asset and an instrument that transfers that risk. Moreover, if the counterparty is in the same country, hedging will not lower that EMDE’s country exposure to foreign exchange risk.
Development finance institutions also, for the most part, do not lend to EMDEs in local currencies. The Currency Exchange Fund (TCX) was established in 2007 with concessional finance from multilateral and bilateral donors to hedge currency risk faced by DFIs in support of an increase in their lending in local currencies. Since its inception in 2007, TCX has hedged around USD 12 billion in over 70 currencies.³ The amounts are not large. There have been calls to increase its scale but a substantial increase may not be feasible; nor is it clear what level of insurance would be large enough to satisfy investors in volatile, risk-off situations. Neither does TCX provide hedging services to private lenders in these currencies.⁴
Another recourse is to borrow in local currency from domestic financial institutions. When borrowers have a choice, however, they do not always choose to borrow in local currency. Inflation, costs of intermediation and policy risks, amongst other things, may keep domestic interest rates much higher than what they pay on dollar debt.⁵ So, they may choose to borrow in dollars, discounting the additional risk of depreciation of their home currency and its potential effects on their income and wealth. There is evidence that firms may also choose to borrow in foreign currency to signal that they are more creditworthy relative to peers in their home country. Firms that have earnings in foreign exchange may also borrow in the same currency as a hedging strategy.
Recent research on bond markets does find that EMDE borrowers, particularly sovereigns, have increasingly borrowed in their own currencies during the early 2000s, in an effort supported by development of local currency capital markets. A study⁶ of 25 EMDEs by the Bank for International Settlements finds, however, that, in the last decade in the face of depreciating currencies, the lure of local currency bonds has fallen.⁷ Foreign investors are more likely to lend to countries in their local currency where they perceive risks to be lower, where financial markets are larger and more liquid, where indexed bonds are available, where GDP is growing, in larger EMDEs, and importantly, in risk-on global macroeconomic conditions. Firms-as opposed to governments- have found it much harder to obtain this funding.⁸ In addition, research demonstrates that flows into local currency bonds are more volatile and have more downside risk.⁹ In periods of market stress, local currency bonds tend to be sold off faster and new loans tend to dry up faster.¹⁰
Whilst it is efficient for capital to move across borders to fund higher-return activities,¹¹ it is also true that developed, and well- governed financial systems, will attract higher domestic savings and be able to finance more investments through the domestic financial system in local currency, than others. The World Bank’s financial development index¹² shows that the mean bank credit to GDP ratio in developing countries is only 44% of that in advanced economies and stock market capitalization to GDP is only 47% of that in advanced economies. Financial systems develop along with other aspects of economies that support private investment: a sound macroeconomic environment, a solid contract enforcement regime, predictable regulation, stable politics, and better information.
Where does this leave EMDEs in their quest to use local currency financing for investment? Firstly, if past experience is heeded, many EMDEs and/or their firms will continue to borrow in foreign currency and must better manage debt. Secondly, the amount of official concessional finance available to investors to hedge EMDE currency risk is small AND the higher the risk in global and local markets, the greater the amounts needed. Thirdly, higher risk and inefficiencies in the domestic economy, translate into higher local interest rates, larger demand for foreign currency borrowing, larger concessional finance needs, and greater spreads on dollar borrowing. Thus, to have lower cost of capital (including foreign capital) and lower investment risk over the longer term, macroeconomic policies, governance of the financial system, and the business climate need to improve. It is important to remember that concessional finance is best used as a complement to such reforms, rather than as a substitute for them.