2025 Public Sector Perspectives

Historically, there has been relatively little local currency lending, as most MDB lending has been in hard currencies. More than 80% of lending to low andmiddle-income countries by MDBs and DFIs is denominated in hard currencies, with US dollars being the most common. 2 In contrast, local currency lending has accounted for a much smaller proportion of MDBs’ lending. Additionally, whenMDBs do lend in local currency (whichmost do, to a small extent), it is often to countries that already have developed financial markets. When local currency is lent, it is also often done through inflexible products such as synthetic instruments that do not contribute to the development of financial markets. 3 Financing projects in hard currencies creates FX risk, especially during times of volatility. Should a local currency depreciate against the lending currency, the mismatch in foreign currency revenues and obligations means that the debt burden is effectively increased, creating challenges for borrowers. Since 1971, one in eight local currencies in developing countries fell by 20% or more against the US dollar in any given year. 4 Over the same period, one in 20 developing country currencies fell more than 50%. To address the currency mismatches and FX risk inherent in local development projects funded by hard currencies, MDB/DFIs have become increasingly focused on the need to strengthen local currency financing as part of broader efforts to foster local capital markets development. Local currency solutions help emerging market borrowers to ameliorate the volatility of debt burdens and foster a more sustainable and efficient financial environment for borrowers. 2 https://www.tcxfund.com/wp-content/uploads/2023/11/TCX-Proposal-for-Mitigating-FX-Risk.pdf 3 https://www.iadb.org/document .cfm?id=EZIDB0000577-986313001-135 4 https://www.ft .com/content/31abf598-03b0-11e9-9d01-cd4d49afbbe3 5 https://www.imf.org/en/Publications/WEO/Issues/2024/04/16/world-economic-outlook-april-2024 6 https://findevlab.org/news_and_event/tcx-2-scaling-up-local-currency-hedging/ The value of local currency solutions is reinforced by today’s myriad geopolitical and economic crises. Many emerging countries are challenged by the aftermath of the COVID-19 pandemic, Russia’s invasion of Ukraine, and the ongoing conflict in Israel and Gaza. Supply chain disruptions and rising food and energy prices, partly due to these events, drove global inflation up to 6.8% in 2023. This led central banks throughout the world to hike interest rates to restore price stability. Although inflation is now starting to decline in some key markets, emerging market borrowers will likely take longer than advanced economies to return to inflation targets. Additionally, according to the International Monetary Fund, forecasts for global growth over the next five years are the lowest in decades. 5 Unfortunately, despite this clear need, local currency is not readily available inmany cases. For perspective, in fiscal year 2022 alone, World Bank Group (WBG) institutions approved new loans worth $104 billion; if just 25% of these loans were denominated in local currency, $25 billion would need to be hedged in the local markets tomeet the needs of just theWBG entities for a single year. 6 Many emerging market countries simply do not have sufficient depth to facilitate cost-efficient hedging on a sufficient scale. One alternative is to issue local currency denominated bonds to raise funds to lend to local projects. This approach also inevitably runs into capacity constraints inmost markets. Many MDBs/DFIs also seek tomaintain a fully dollarized balance sheet, meaning that even where issuance is possible, they require liquid hedging markets. At the same time, pooled capital can be hard to deploy given challenges relating to the timing and structuring of transactions. 42 Cracking the Local Currency Code: How Innovation Can Drive a Breakthrough in Development Finance