Africatalyst calls  for IDA-Led Local Currency Loans to Protect Low Income Countries from Exchange Rate Risks in new report

Dakar, 25th November- A new report by AfriCatalyst reveals that multilateral development banks (MDBs) could provide an immediate-term solution through sovereign local currency loan offerings to help low-income countries (LICs) address challenges arising from the mismatch between local currency revenues and foreign currency-denominated debt repayments. This mismatch has placed immense pressure on low income countries(LICs), as fluctuating exchange rates intensify the local currency cost of external debt, worsening their debt burdens.

Titled  Local currency financing and multilateral development banks: A case for IDA leadership , the report highlights  that fluctuating exchange rates significantly increase the local currency value of debt owed to external lenders, placing huge pressure on governments in low-income countries (LICs) that primarily collect revenues in their domestic currencies. 

By using Ethiopia as a case study, the analysis  demonstrates how this situation worsens the debt burden for low income countries (LICs), which often lack the tools and capacity to manage such risks effectively.

Focusing on the World Bank’s International Development Association (IDA), the report evaluates both the challenges and opportunities of local currency financing as a multilateral initiative. It underscores the need for IDA to take a leadership role in offering local currency loans, thus helping low income countries (LICs) avoid worsening debt positions.

Key Findings

• The accumulation of foreign currency-denominated debt poses a major challenge for low-income countries (LICs), unlike emerging market economies that benefit from well-developed local currency bond markets enabling them to borrow in their own currencies.
• The underdevelopment of local currency bond markets limits short-term options for external actors like MDBs, even though currency hedging solutions could support the growth of local capital markets in LICs.
• Current MDB initiatives to scale up local currency financing primarily focus on non-sovereign (private sector) lending, with limited willingness to take on the risks of expanding local currency loans to governments, despite the risks LICs face from foreign currency-denominated debt.
• As one of the largest multilateral lenders to LICs, IDA is uniquely positioned to lead the transition to local currency lending. Offering sovereign local currency loans on preferential terms could significantly ease debt servicing and enhance financial predictability for LICs.

In light of the growing global calls for MDBs to “develop a practical offer for local currency lending,” especially for public sector projects, the report suggests that IDA is uniquely positioned to lead efforts in this direction. As one of the largest multilateral lenders to LICs, IDA’s involvement in sovereign local currency loans could provide a more predictable and manageable approach to debt servicing for these countries. It emphasizes the importance of LIC governments creating regulatory conditions conducive to asset-liability management, enabling MDBs to scale up their efforts.

The paper also argues that MDBs should shift their lending portfolios to incorporate more local currency loans, recognizing the risks involved but also proposing ways to mitigate them, including project-specific loans, liquidity pools, and cross-currency swaps.

“MDBs should  shift their portfolios towards more local currency loans, while acknowledging the risks this entails. Potential avenues for mitigating these risks include offering loans on a project-by-project basis, creating liquidity pools, and engaging in cross-currency swaps. The public policy mandate to support LICs’ development aspirations should compel MDBs to assume more of the currency risk, as these countries already have limited capacity to manage it” the report outlines

“We need to reduce Africa’s reliance on foreign currency debt, as it exposes many countries to significant risks, such as exchange rate volatility,” Jean-Claude Tchatchouang, Senior Advisor at AfriCatalyst remarked.AfriCatalyst CEO Daouda Sembene echoed this sentiment, highlighting IDA’s critical role. “This report highlights the critical role IDA could and should play in mitigating foreign exchange risks for eligible borrowers,” he stated.