The transformational impact of protecting Global South borrowers from currency risk
“So many problems in the world of development finance are difficult to resolve. The FX risk problem, however, is relatively straightforward.”
CEO at TCX
Foreign exchange (FX) risks are consistently cited as one of the biggest deterrents to major investment in developing countries. By providing FX products that protect borrowers from currency risk, including in currencies and tenors that are not or inadequately offered by commercial institutions, organizations like TCX are playing an increasingly pivotal role in ensuring development finance reaches the projects and places it is needed. But as Ruurd Brouwer (CEO at TCX) explains, there is still a long way to go. And some of the biggest barriers to the success of development investments are created by the practices of none other than the development finance industry itself.
Over the eight years that Ruurd Brouwer has been at TCX, he has seen the work they do becoming more valued and understood. “Currency risk has become acknowledged as one of the key challenges in development finance. When I joined TCX, the standard response was ‘Currency risk has always been around and probably always will be.’ Even at FMO. I remember discussing energy finance with them back then and their reaction was ‘But we have a power purchase agreement in dollars so we don’t have currency risk’. Meanwhile, our point was that if you move that risk from point A to point B within a country, instead of being part of the solution you’re simply putting the problem on the shoulders of someone else within that developing country.”
Ruurd contrasts responses then with the New Global Financial Pact Summit in June this year, where foreign exchange risk was on everybody’s lips during discussions about everything from climate risk to financial inclusion. “That’s hugely gratifying for us because that transformation in attitudes is in part thanks to the work of TCX.”
The paradox within
The fundamental problem TCX is trying to address has been set in sharper focus by recent global economic developments. “The US dollar becoming so expensive means that companies and countries that have borrowed in dollars can no longer repay their loans. So they end up in deep trouble. It's not because they are operating inefficiently, overborrowing, or messing up in some other way. It's purely due to the currency risk. That means DFIs who exist to create sustainable economic growth are offloading onto borrowers a risk that the borrower can’t influence, pushing them into these volatile boom-bust cycles. In other words, by using a risky product—hard currency loans— the development finance industry can create crises in the very countries around the world that they're there to support.”
Ruurd’s great frustration is that this is all so unnecessary. “There are so many problems in the world of development finance that are extremely difficult to solve. But the FX risk problem is relatively straightforward.”
But when Ruurd and his colleagues ask DFIs what’s stopping them from knocking on TCX’s door, the answers have been...surprising to say the least. “They range from ‘We’ve done it like this for 75 years’ and ‘I don’t understand your products; they’re too complicated’ to ‘We don’t take the currency risk, we offload it on our end-borrowers.’ Perhaps most shocking response—which came from a leading multi-lateral development bank—was ‘We have preferred creditor status in the countries where we operate. We’ll get our money back anyway.’”
Ruurd says that at TCX, such luddite attitudes are a stimulus. “That's because we know that ultimately, the only appropriate product for a local currency borrower is a local currency loan or a hedged hard currency loan. And we do see the industry slowly but surely moving in that direction, with the recent Paris Summit acting as a catalyst in that respect.”
The concept of currency risk is complex, so TCX is always looking to explain things to people in a way that brings the issue to life. A good example is the HEAR Ratio that TCX has developed. The HEAR (Health & Education At Risk) Ratio visualizes a country’s currency risk in terms of its average annual budget for health and education and shows the disastrous effect on a country’s debt when its own currency falls in value against the US dollar, along with the impact that has on their health and education spending.
“Governments can only spend borrowed money once. If they unexpectedly have to spend it on serving increased debt, they can’t spend it on health or education.”
“When meeting with Western donor governments, the moment you start talking about swaps, FX risk percentages, debt-to-GDP ratios… you see the eyes start to glaze: it’s too abstract. So we wanted to communicate the impact of currency risk in terms of things that matter to our audience. And nothing is closer to the donor’s heart than health and education, which are also the two sectors that receive the most donor support. When they see the currency risk on a government’s books expressed in those terms it really hits home. Because it’s no longer abstract: a government can only spend borrowed money once. And if they’re spending it on serving their debt, they can’t spend it on health or education.”
As Ruurd explains, one important reason to also focus on currency risk in the sovereign book is that the government is the largest exposure of local banks. “Liquidity ratios require banks to keep a significant amount invested in liquid assets, and too often government paper is the only option. So when the government’s payment capacity is unexpectedly hit by a depreciation, the entire banking sector, and thus the entire economy, is at risk.”
The way forward
TCX currently takes on the currency risk of mainly private sector borrowers in some 70 emerging and frontier countries, with all those risks concentrated in the Fund in Amsterdam. And until recently, they had to sit on those risks for as long as the underlying loan was outstanding in order to protect the borrower throughout the loan’s tenure. “This made us a fairly inefficient, capital-constrained vehicle.”
So about five years ago, TCX started looking for ways to decrease its risk and free up ‘space’ to take on more risks and grow its impact. “We went out and found parties willing to buy some of the risk from our books. For example, we have quite some exposure to the Sierra Leonean Leone (SLE) and knew there were a number of serious parties — pension funds, fund managers and other institutional investors — keen to buy the risk on the SLE for 3 years. Though they would never themselves dare to go ‘on shore’ in Sierra Leone because of the credit, legal, transfer and numerous other risks involved.”
So TCX asked its AAA-rated investors, including FMO, to do them a favor: if they could issue a bond of, say, USD 10 mln in SLEs for 3 years at the current Sierra Leone interest rate of 12%. TCX had found investors willing to buy it from them and the Fund would then hedge the bond back to US dollars.
“So everyone’s a winner: assuming the issuer is a DFI, that money becomes part of their normal funding, at a competitive price. And as the hedge is the exact opposite of our risk at TCX, by hedging that bond we have ‘freed up’ USD 10m with which we can do more business in Sierra Leone. Meanwhile, the professional investor now has an asset with the best possible credit risk combined with the market risk of the SLE at 12%.” The additional attraction for a professional investor, such as a pension fund, lies in a combination of the potential yield and the diversification of their portfolio, but also the positive impact of their investment.
For Ruurd, this is part of the future. “The ultimate way for us to protect borrowers in developing countries from currency risk at scale is to take the risk away from them, temporarily manage it at TCX, and then sell it on to professional investors in the world’s major financial markets. The options for professional investors to get access to emerging economies market risk are pretty limited. So there’s now more demand for this kind of product than we can meet at TCX, which is another incentive for us to really scale up the amount of risk we’re taking away from borrowers in developing countries.”
Sum you win…
When it comes to helping borrowers in emerging markets get access to funding in their own currency (ideally on the international capital markets, which are bigger and offer longer tenures), Ruurd gives the example of Uzbekistan, where some of TCX’s AAA-rated investors, such as FMO, have now issued around 30 local currency bonds.
“It was clear that there was offshore market interest for bonds denominated in Uzbek Sum. And after 30 bond issues, the Sum has emerged from relative obscurity on international markets to a currency whose prices are shown on Bloomberg, for example. The Uzbekistan Ministry of Finance, seeing how we had successfully placed bonds in Uzbek Sum of up to USD 50 mln, decided to go to the international capital markets themselves in their own currency, something they’d never done before. And there was indeed market appetite for Uzbekistan’s own bonds issued in their own currency. So for the first time ever, the Uzbekistan government was freed from the limitations of their own capital market and found investors not only willing to take on the market risk of their currency but also the credit risk of the government itself.
“So yes, you have to develop local capital markets. But at least as important — in particular for smaller countries that will never have a large enough capital market to support large, long-term borrowing — is that countries get access to the international capital markets in their own currency. This comes with the ultimate consequence that there’s no longer a role for us or someone like FMO as lenders, which would be fantastic! Ultimately I want TCX to be obsolete.”
Creating the right climate
By removing the negative impact of FX risk on major infrastructural projects, TCX can help create an environment where climate action projects in developing countries are possible. “Any borrower in debt stress is unlikely to be investing in climate action. How can an energy supplier even be thinking about investing in major climate initiatives when they don’t know how much they’ll need to spend on servicing their existing debt next month? As long as we offload currency volatility onto borrowers, they’ll remain trapped in a boom-bust cycle, unable to plan any sort of long-term investments, which means serious climate action initiatives simply aren’t going to happen.”
When you consider on the one hand the disastrous impact currency risk is having on countries across the Global South, and on the other the fact that FX risk is a problem that’s apparently relatively easy for us to solve, it does beg Ruurd’s question to resistant DFIs, ‘Why aren’t you doing this?’
So long as we offload currency volatility onto borrowers, they’ll remain trapped in a boom-bust cycle, unable to plan long-term investments, which means serious climate action initiatives simply won’t happen.”