The currency market shuts out developing countries, hampers green investments, and makes debt swell

An air of despair hangs over the UN’s General Assembly and the Summit of the Future on meeting the flagship Sustainable Development Goals and tackling the existential threat from climate change. Only 12% of the development goals are on track at the halfway mark, and it is an open secret amongst climate scientists that the maximum 1.5 degree warming target is now impossible. 

The annual SDG investment gap faced by developing economies has risen by 60% from USD 2.5 trillion in 2015 to USD 4 trillion now, with several trillions in addition required annually to mitigate climate change, and adapt to its devastating consequences. A significant proportion of this, at least half for many low, and lower middle-income economies, would need to come from external sources. 

While reams of policy papers and countless political shindigs have been dedicated to maximising the quantity of external funding that can be mobilized, the poor quality of external sources of finance has got far less attention. In particular, the significant risks posed by funding denominated mostly in foreign rather than local currency was largely ignored until we elevated it to the policy agenda of the EU and the G-20 in 2021. 

As of 2024, nearly 80% of the more than USD 2 trillion in outstanding external debt to low and lower middle-income countries is still denominated in hard currencies, mostly dollars. This currency mis-match has been the single biggest driver of debt distress in developing economies. If the necessary external funding for SDGs and climate action does materialize, even partially, already destabilizing levels of currency risk could triple to USD 6 trillion by 2030, as the largest component of this funding will once again take the form of hard currency denominated debt.

This currency risk is pernicious, not just when it triggers crises, but also as one of the main impediments to the scale-up of climate and development finance in the first place. It is one of the top impediments to increased mobilisation cited by both investors and countries seeking investments. Building on our original work, the urgency of finding a solution to the problem of currency risk has been prominently flagged by the European Commission, the IMF, World Bank and G-20. 

It is now clear that there is no way to meet the development goals and climate targets that does not first require an urgent and immediate solution on mitigating currency risk. The IMF, for example, has analysed more than 200 instances of debt surges to show that currency risk alone has caused the debt/GDP ratio to balloon by 35%-50% during crises.

The G-20’s flagship Debt Service Suspension Initiative (DSSI) program postponed USD 12.9 billion in debt repayments by low-income economies such as Ethiopia, Zambia, and DRC Congo during the Covid-19 pandemic, but currency depreciation increased their debt burdens by an eye-popping USD 34 billion over the same period, easily drowning out any relief they got from DSSI. 

As I wrote in the Financial Times in 2021, “Currency risk is the Achilles heel of developing economies that borrow to make investments to increase productivity, reduce emissions and meet sustainable development goals.”  Despite the attention and headlines currency risk has garnered recently, if belatedly, most external funding from private (institutional investors), multilateral (MDBs) or bilateral (DFIs) sources to poor economies continues to be dollar denominated, and currency risk is on the rise. 

The default option for MDB and DFI support is hard currency lending, which imposes currency risk on the already overstretched and under-resourced finance ministries and central banks of poor economies rather than being managed by the deep-pocketed and sophisticated treasuries of the international financial institutions. While ad-hoc solutions such as the local currency facility of the IDA private sector window exist, they depend on scarce subsidies, they have had only limited success, and they don’t scale. 

At USD 7.5 trillion in daily trading volume, the currency market is the largest market in the world, but it is highly concentrated; the USD is responsible for nearly half of all trading and rich economies dominate. For example, the daily trading volumes of tiny Norway’s Krone are larger than those in the Rupee, the currency of giant India. In fact, trading volumes of the Swedish and Norwegian Kroner are a multiple of the trades in all low and lower-middle income economy currencies combined.

Not only are lenders such as the World Bank unwilling to lend in local currencies. The fact of being shut out of currency markets means that most low and lower-middle income economies do not even have the option of hedging themselves against the currency risk, something that most entities in rich economies take for granted. Their ability to borrow in their own currency, or to hedge currency risk, is why Norway and Sweden have not faced economic distress despite seeing dramatic declines in their currencies against the dollar. The NOK, for example, has more than halved in value against the dollar since the global financial crisis. But for poor economies, currency volatility almost always leads to economic distress. 

Step in TCX

Step in the Amsterdam-based TCX, a specialized DFI that was launched in 2007 which counts Germany, France, the UK, and the EU as shareholders or supporters. TCX aims to make currency hedging markets for poor economies that had been locked out of the global financial system. Since its establishment, TCX has hedged nearly USD 15 billion in currency risk across more than 70 low and lower-middle income country currencies in more than 5,000 transactions.

While the actual reduction in currency risk is valuable, though still very small compared to the magnitude of outstanding currency risk, the making of markets and transparent pricing of currency risk is perhaps even more impactful as it helps turn an undefined uncertainty into a measurable and manageable risk. By design, TCX only makes currency hedging markets where no such market exists, so it is additional with both the hedging support it provides and the new information on currency risk its pricing introduces into the market.

TCX pricing of currency risk creates a feedback mechanism for actions and policies being considered, creating strong incentives to make better policy, thus reducing macroeconomic risk and improving the terms of financing for the country. This ensures that TCX’s intervention has the potential to reduce risks far beyond just the direct amount of currency hedging it can provide, which remains small.

With its proven 17-year track record of market creation, operational efficiency, no loss of capital, and fair pricing, TCX has won the confidence of the providers of development and climate finance, the markets, and the developing economies that need external funding. That is why it is time to scale up TCX’s very modest current capital base of USD 1.5 billion enhanced to USD 5 billion as per a near term “resilience plan” that has been presented to the G-20. As TCX does not depend on subsidies these modest commitments of capital will not eat into scarce development aid budgets.

Given their reputation for development friendliness and climate leadership, and their own experiences of dealing with currency risk and volatility as small open economies, the fact that the Nordics do not currency support TCX, is a glaring omission that needs to be set right. In fact, scaling up TCX is an essential first step to mobilising external funding for the SDGs and climate action for developing economies that all the Nordic economies have prioritized as part of rejigged development policies. 

Even modest contributions of a few hundred million dollars to TCX capital by each of the Nordic economies would be a game changer in enabling a successful scale up of development and climate finance globally. Norway, as a G-20 guest country in 2024, is well poised to take the lead, catalysing this G-20 priority, having an outsized impact, and earning goodwill from both G-20 countries and the low and lower-middle income countries it champions through its generous development aid budget. 

In an era of scarce development aid, when everyone is on the lookout for maximising the development impact of every dollar, I would be hard pressed to think of a bigger bang for the development buck, and more additionality than a contribution to scaling up what is, to all intents and purposes, the main tool for tackling the Achilles heel of development and climate finance – currency risk. 

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Sony Kapoor is the Interdisciplinary Professor of Climate, Geoeconomics, and Finance at the European University Institute and CEO of the Nordic Institute for Finance, Technology, and Society