Why a global fund is needed to reduce currency risks in developing countries
The author is the CEO Nordic institute of finance, technology and sustainable development
Currency risk is the Achilles’ heel of developing economies. They borrow debt to invest to increase productivity, reduce emissions, and achieve sustainable development goals.
on 90% Cross-border debt in low-income and low-middle-income countries, Nearly 2 tons, Denominated in hard currencies, mainly in U.S. dollars, most of which come from development banks and other official lenders.
But this makes vulnerable groups sometimes face severe exchange rate fluctuations, which increases economic vulnerability and often triggers debt crises. Nine currencies With the Covid-19 attack, 2020 in developing economies has fallen by more than a quarter, and the other 21 have fallen by more than one-tenth.
This is the failure of markets and policies, forcing those who are least able to take currency risks to take currency risks.only 20 developing economies It is possible to borrow money from international investors on a regular basis in the national currency.
For others who are forced to borrow dollars, even hedging currency risks is not an option. The foreign exchange market has a huge daily turnover of 6.6 tons, mainly G10 currencies, and 100 developing economies account for less than 0.2%. The derivative swap market, which is the backbone of currency hedging, hardly exists outside of large emerging economies.
Given their huge investment needs and limited domestic savings, low-income and low-middle-income countries’ external borrowing needs to increase to $ 4tn- $ 6tn By 2030, if they are to align with the Paris Agreement on climate change and achieve its sustainable development goals.
If the market and policy makers do not take measures to reduce currency risk on a large scale, this funding will not be realized. By 2030, a new multilateral institution is needed to enable the two-way currency market, especially in the longer period when there is no private market, to reduce currency risk by half.
This International Monetary Fund Will be built on the basis of professional knowledge TCX, This is a successful donor funding initiative to price and hedge against currency risks in developing countries. Its pricing and risk management model has successfully passed the stress test of the violent currency market volatility during the Euro crisis and the Covid crisis.
however, TCX On the basis of a moderate capital of 1 billion U.S. dollars, there is only about 5 billion U.S. dollars of hedging capacity. Only a multilateral ICF with a broad membership and a huge capital base can meaningfully reduce currency risk.
ICF will establish markets and offset currency risks by finding and acting as counterparties for investors, borrowers, donors, companies and foreign exchange remitters.
Multilateral recognition and treatment as a priority creditor will reduce the collateral required for transactions and enable it to provide more products that help the development of the local market, increase liquidity and attract private investors to use currency risk as an asset class. This, along with more opportunities to offset risks, will improve capital efficiency, enabling ICF to provide a hedging capacity of $10 for every dollar of capital, twice that of TCX.
When the ICF is launched, it needs to be able to assume a total currency exposure of at least $250 billion in order to show the seriousness of its intentions, attract private venture capital, and begin to reduce currency risks.
To this end, it needs approximately US$25 billion in capital, of which only US$5 billion needs to be prepaid. The balance can be in the form of redeemable capital, which is the World Bank’s commitment to pay when needed.
This small amount of funding will solve one of the biggest sources of risk in financing in developing economies and release hundreds of billions of dollars in additional productive investment. The currency forward market that supports the ICF will be more responsive to changes in policy, politics, and market conditions, and provide better feedback than the dollar-based bond market.
U.S. dollar borrowing is attractive because it has lower interest rates, but if the local currency depreciates, it usually becomes more expensive in the long run. By transparently pricing hidden currency risks, ICF will increase the incentives for borrowers and lenders to switch to local currencies and adopt stronger macro policies, thereby reducing the vulnerability of developing economies. In turn, this will save donors some of the money they are currently losing due to frequent debt write-downs. There are few that use scarce donor funds more effectively and urgently than ICF. It’s time to take action.
NIFTYS researcher Harald Hirschhofer also contributed to this article