Sets the trend towards local currency financing.

Case study

From proof of concept to The Currency Exchange Fund

To prevent currency risk from being offloaded to those who can bear it the least, FMO, the Dutch entrepreneurial development bank, experimented with a fund that provided loans in local currency. Subsequently, Cardano Risk Management B.V. conducted a retrospective analysis on a hypothetical emerging market currency portfolio.

It confirmed FMO’s experience that a local currency portfolio can generate a small positive return as it is so well diversified that it can absorb large losses in case of a currency crisis as long as it has sufficient capital buffers.

These experiences led to the establishment of TCX in 2007. The Fund pioneers local currency financing in most frontier markets, where no affordable hedging products or benchmarks are available. As such, TCX is increasing the financial resilience of local businesses and households but is also supporting the development of the local financial sector. The Fund’s work in Azerbaijan illustrates the positive impact of local currency financing.

TCX fully absorbed currency shocks in Azerbaijan

Azerbaijan in the Caucasus was very much an oil-driven middle-income country and, as such, a highly dollarized economy. Fifteen years of high economic growth fuelled by increasing oil prices was brought to an abrupt end when the oil price fell sharply.

Over the course of 2015, the country faced a total (100%) depreciation of its currency the manat. The currency’s peg to the dollar became untenable and was let go. The oil crisis evolved into a currency crisis which in turn led to financial sector upheaval and economic turmoil when local banks were confronted with heavy loan losses. Their clients – households and businesses – were defaulting on their dollar or dollar-linked loans.

The default rate on dollar loans was more than double the default on manat loans. Banks with loan portfolios not highly exposed to the dollar were more capable of sustaining the crisis and recovering. TCX fully absorbed the currency shocks – two depreciations in 2015 – on USD145 million worth of outstanding development finance loans.

The result is that the microfinance institutions and SME banks financed through these loans were able to shield their clients – a great number of businesses and households – from financial distress.

TCX shows local-currency financing is the way forward

Since its inception, the Fund has grown from a USD330 million gross portfolio in 2008 to USD4.5 billion in 2021. In 2021, it hedged USD1.4 billion of external lending in 51 currencies, while the average ‘Difficulty to Hedge’ score was 7 out of 10.

In the past two years, TCX almost doubled its portfolio while increasing the overall percentage hedged from 40% to 48%. The majority of TCX’s hedging transactions still support micro and SME finance but there is a growing interest of providers operating in the infrastructure, climate and renewable energy sectors to secure finance in local currency.

Deepening local financial markets

TCX’s accelerated growth reflects the rising trend to finance in local currency. This contributes to the Fund’s second goal of deepening local financial markets, a goal it shares with its development finance clients.

It also positions itself as a thought leader on the theme of local currency, e.g. through advocacy efforts such as organising webinars, featuring in publications, speaking at conferences, and providing technical assistance to borrowers and lenders – all in support of local market development.

TCX passes on some of the currency exposure that sits on the Fund’s balance sheet to private or institutional investors who have a much higher risk appetite. The volume of these risk transfers is a measure of how the Fund contributes to market development. Since its inception, TCX has sold USD3 billion of frontier currency of which 48% was sold through hedging of 146 offshore local currency bond issuances.

Strengthening supply and demand

To further stimulate the development of local markets, TCX has identified several priorities with regards to strengthening the supply and demand side. On the supply side, the Fund actively promotes local currency financing for the off-grid renewable energy sector.

Households that buy solar lamps, televisions and fridges are often forced to accept a currency risk that comes with energy contracts in dollars or euros. This is comparable to what happened in the microfinance sector in the early 2000s. TCX also prioritises infrastructure, such as water and public transport. The positive impact of taking away the risk of currency volatility on the tariffs of these public services is high.

On the demand side, TCX continues to shift part of its currency exposure to private investors, who are better equipped and willing to take on currency risk. This makes development finance more sustainable, transparent and efficient. The Fund promotes the demand for local currency bonds by engaging more arranging banks that have a large institutional sales network to offset their long positions.

Getting public sector borrowers involved

A strategic priority for TCX is to engage with sovereign borrowers in reasonably developed money markets, such as Kenya and Uganda, to embed currency hedges in their lending and borrowing transactions and to include exchange risk mitigation instruments in their debt management frameworks.

This would not only reduce the currency risk of loans but also make it increasingly easy to use local currency. Governments can start to recycle their own country’s savings rather than rely only on those of developed economies.

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