What is local
currency finance?
Everything you need to know about local currency financing.
All around the world developing countries need access to fair and affordable finance to build strong economies and financial markets. Continue reading to learn about local currency finance, why it is essential for financial market development and how lenders can use it to protect local businesses and people against financial risks.
- What is local currency finance
- Why local currency finance?
- How are local currency loans issued?
- What kinds of local currency financing do Cardano Development companies use?
- What are the risk of hard currency loans?
- What are the benefits of borrowing in local currency finance?
- What are the downsides to local currency financing?
- How can we develop access to local currency finance?
- How is Cardano Development creating local currency finance solutions?
- Who offers local currency finance solutions?
- What are some successful examples of local currency financing?
- Does local currency financing contribute to the UN Sustainable Development Goals?
- Would you like more information on local currency finance?
What is local currency finance?
Why local currency finance?
Historically, businesses in developing countries rarely have access to loans denominated in their own currency. The loans offered to them in international markets are usually issued in hard currency such as USD or EUR. This leaves borrowers exposed to foreign exchange (FX) risk. For example, if their own currency depreciates due to financial shocks, borrowers may no longer be able to service their debts. This happens because their currency depreciates far below the value of the hard currency loan issued. Providing loans in the currency of the borrower protects businesses and people against financial risks and creates security against future financial shocks.
Why is local currency financing important?
The reason local currency debt is an important topic is that most long-term debt provided to borrowers in small developing countries are provided by development banks in hard currency. Local currency debt is in short supply in these markets.
The nature of local currency financing reaches far beyond businesses, to users at the Base of the Pyramid (BoP). For example, if debt is issued in hard currency to a utility company (e.g. providing water or electricity to consumers), tariffs may be adjusted upwards after a currency devaluation, causing instability in household financial planning. This creates uncertainty that can threaten quality of life, especially in low-income households.
How are local currency loans provided?
Local currency loans provided by financial institutions can originate in three ways: local banks may have local currency deposits which fund these loans (i.e. no currency mismatch); international banks may not have such local currency deposits but may still provide local currency loans (i.e. the financial institution absorbs the currency risks); or the international bank provides local currency loans and hedges the currency risks through the derivatives or swap markets.
In practice the second option, where the banks absorb the risks, does not happen much. This means that the swap markets are very important for local currency loans from international institutions. Financial players come together in these marketplaces and make an agreement between two parties to exchange terms and/or interest payments of a loan in one currency for an equivalent loan in another currency.
What are the risks of hard currency loans?
Hard currency loans offered by international financial institutions leave borrowers exposed to (FX) and interest rate risks due to unexpected currency depreciation and global financial shocks. Over the years there have been significant currency crisis events that severely impacted economic prospects globally and on a regional basis.
What are the benefit of borrowing in local currency finance?
Most parties in an economy have local currency income (governments receiving local currency taxes; public utilities receiving income from households and businesses for providing water, electricity or transport services; microlenders providing small loans to households; banks lending to SMEs; companies taking loans to fund their businesses). The benefits of borrowing in local currency, in comparison to hard currency, helps them develop businesses, markets and infrastructure without experiencing disruption when the currencies move.
- LCY stakeholders
- Governments
- National or Sovereign Companies
- Financial Markets
- Benefits
- Governments in some emerging markets can finance themselves domestically or internationally through government bonds issued in local currency. This balances the obligations with local currency income such as from tax revenue and helps support government planning for spending and budgeting its future obligations.
- Long-term local currency loans protect companies and projects against currency fluctuation. Borrowing in local currency can help the creditworthiness of a project, as the borrower can be measured on their ability to pay their debts based on their own currency without the risk of currency volatility.
- The adoption of innovative local currency finance techniques helps to foster the overall development of the financial markets in developing countries, many of which are not as sophisticated as the markets in the OECD. Resilient markets resist financial shocks, deal with global challenges and support growth on a sustainable basis. Once markets are developed, they can provide attractive investment opportunities and alternative sources of funding to financial markets across regions. They can also contribute to the financial stability of small and medium-sized enterprises (SMEs) which are particularly vulnerable to currency fluctuations.
- LCY stakeholders
- Governments
- Governments in some emerging markets can finance themselves domestically or internationally through government bonds issued in local currency. This balances the obligations with local currency income such as from tax revenue and helps support government planning for spending and budgeting its future obligations.
- National or Sovereign Companies
- Long-term local currency loans protect companies and projects against currency fluctuation. Borrowing in local currency can help the creditworthiness of a project, as the borrower can be measured on their ability to pay their debts based on their own currency without the risk of currency volatility.
- Financial Markets
- The adoption of innovative local currency finance techniques helps to foster the overall development of the financial markets in developing countries, many of which are not as sophisticated as the markets in the OECD. Resilient markets resist financial shocks, deal with global challenges and support growth on a sustainable basis. Once markets are developed, they can provide attractive investment opportunities and alternative sources of funding to financial markets across regions. They can also contribute to the financial stability of small and medium-sized enterprises (SMEs) which are particularly vulnerable to currency fluctuations.
What are the downsides to local currency financing?
Debt in any currency is provided with an obligation to pay interest, which is a combination of the time value of money plus a risk premium. Local currency finance can suffer from two weaknesses both increasing the interest cost: the time value of money is high due to high expected inflation and macro-economic instability, and risk premia may be high due to unsophisticated markets. The result is that interest rates used for local currency finance frequently are much higher than the interest rates in hard currencies.
In fact, when comparing the two, borrowers should factor in the expected devaluation of the local currency into the cost of the hard currency debt (devaluations will increase the obligations to pay back the debt when calculated in local currency). In most cases, the cost of devaluation is equal of higher than the difference in interest rates.
How can we develop access to local currency finance?
The development of a well-functioning financial system in a developing economy requires many factors to operate efficiently. This includes a trustworthy monetary policy pursued by a stable government, solid prudential regulators that oversee well-capitalized financial institutions that can withstand economic shocks, a minimum of diversity in providers of debt capital (banks, insurance companies, pension funds, asset managers, and retail investors), each with their own interests and preferred terms, and efficient trading platforms to allow investors and lenders/borrowers to transact fluently.
Development institutions such as Cardano can act as local currency financing innovators by promoting good policies with regulators, removing transaction barriers, de-risking transactions where needed and injecting start-up liquidity into the system.
How is Cardano Development creating local currency finance solutions?
Who offers local currency finance solutions?
- GuarantCo helps domestic investors participate in local infrastructure finance by providing credit guarantees
- TCX Fund helps international investors provide local currency loans by providing currency risk hedging
- Agri3 helps banks provide longer-term local currency loans by providing local currency tenor-extension guarantees
- Frontclear helps local and international banks trade with each other by guaranteeing local currency collateral value
- IMFact provides local currency working capital to SMEs
- Nyala Venture helps start-up equity fund managers by providing scale-up local currency funding
What are some successful examples of local currency financing?
This collection of case studies provides insight into some of the best local currency financing examples in the market.
Does local currency financing contribute to the UN Sustainable Development Goals?
By de-dollarising local debt markets, they become financially more resilient against macro-economic shocks. By issuing finance in local currency, borrowers can avoid (FX) risk which threatens the sustainability of SMEs, infrastructure, energy and environmental/climate projects. These sectors are key to achieving the UN Sustainable Development Goals (SDGs).
Would you like more information on local currency finance?
For your information we have compiled a list of detailed reports on local currency finance. If you would like to reach out to our team for further information, please contact [email protected].