Network Voices is a series where Convergence amplifies blended finance opinions and activities from our network.
By Oxana Binzaru, Regional Director at Finance in Motion
The pandemic has made stark many of the challenges and inequities faced by developing markets around the world, slowing down the momentum towards achieving the United Nations Sustainable Development Goals by 2030.
One of the challenges faced by smaller markets that has been exacerbated by the pandemic is foreign currency risk, which refers to the losses incured due to currency fluctuations.
Many of these markets have been hit harder by the pandemic because they have fewer resources to protect their economies compared to larger EU markets. They are facing the twin challenges of increased debts and reduced exports, which leaves them with a reduction in their stocks of foreign currency which then increases their risk of a budget deficit. The currency exchange risk is also higher because there is more volatility in the market. At the same time the tourist economy which many countries depend on, has all but disappeared. In 2020, Ukraine, for example, saw its local currency depreciate almost 20% against the US Dollar as its economy contracted.
To get back on track, these countries will need to manage their exposure to foreign currency risk.
Understanding Exchange Rate Volatility
In smaller markets where lending in foreign currency is common, businesses and households typically face a trade-off between upfront borrowing costs and exposure to exchange rate risk. Global economic uncertainty and heightened exchange rate volatility in these markets make economies sticky, slowing down lending from the biggest bank to the smallest household, both in foreign and in local currency, as neither party feels comfortable with the risks involved.
Often, businesses and households unfavourably compare the published borrowing rates for foreign currencies – which are typically lower – with their local currency and believe it would be cheaper to borrow in Dollars or Euros. For example, the average interest rate in Georgia for household/private loans in local currency can be as high as 17%, in comparison to roughly 6% in foreign currency. This decision can leave them vulnerable to economic shocks and local currency depreciation that can wipe out any benefits from a lower interest rate and lead to challenges in repaying a loan.
Exposure to foreign exchange risk is not spread evenly across borrowers. Larger clients such as corporates might have foreign currency denominated income or can find other ways to balance or hedge their risk, while smaller firms and households, earning their income in local currency, are left exposed.
A new funding mechanism to address foreign exchange risk
Addressing foreign exchange risk is critical for the Green for Growth Fund (GGF). GGF is an impact investment fund that mitigates climate change and promotes sustainable economic growth by investing in measures that reduce energy consumption, resource use, and CO2 emissions. GGF’s lending agreements with partner institutions can span several years, and loan periods to the end-clients can be even longer, so predicting currency exchanges on such a timescale is fraught with uncertainty.
The GGF’s new initiative offers partner banks and lending institutions access to local currency finance. This gives them the confidence to lend domestically without the risk of currency fluctuations, while simultaneously investing in a greener and more sustainable future. This is particularly important for businesses and households that would otherwise be impacted by currency considerations.
To improve access to local currency finance, GGF created a new funding mechanism, known as “L shares,” which acts as a buffer share class to absorb any losses due to the depreciation of the local currency before any other share classes are jeopardized. This takes away the exchange rate risk from the partner banks and lending institutions, spurring green finance, to help businesses and households mitigate and adapt to climate change faster. Moreover, boosting affordability will be crucial as economies recover at different rates from the pandemic, while still needing to make ambitious progress towards climate goals.
The L shares mechanism as part of the fund’s blended finance scheme was launched in 2020 with an investment of EUR 42.5 million from the EU and the German Federal Ministry for Economic Cooperation and Development. Through these L-shares, financing in local currency plays a vital role in promoting responsible green finance and contributing to sustainable economic growth across Southeast Europe, the European Eastern Neighbourhood Region, and the Middle East and North Africa.
GGF Capital Structure
Additionally, the L shares sit between the junior shares (C shares) and senior shares (A and B shares), providing increased protection for the private investors who are at the ‘top of the pyramid’ and would suffer a net loss only when all other share classes are depleted. (See waterfall distribution below)
Financial Institutions Eligible for Local Currency Financing
Banks, leasing companies, and microfinance institutions that are keen to expand their green lending activities are encouraged to apply for finance in local currency and follow the existing GGF partner institutions that are already receiving such funds. As an impact investor, the GGF is dedicated to developing a diversity of partner institutions, ranging from large banks to small lenders that are embedded in local communities. Last mile clients can often be overlooked due to their modest size, but small energy efficiency loans, for example, are among the most impactful measures per their cost.
GGF combines its lending with tailored technical assistance to help partner institutions build capacity in green lending and make them effective champions for supporting climate action. As part of these efforts, several partner financial institutions are currently running awareness-raising campaigns to inform businesses and households of the benefits of borrowing in local currency, which have only been underscored by the challenges of the past year. These efforts play an important role in delivering a green recovery that places resilience and sustainable livelihoods at its heart.
Ultimately, GGF’s use of blended finance ensures the strategic leverage of concessional capital. “Strategic” refers to mobilizing additional private capital for underserved regions or topics. It also refers to pushing innovation and employing versatile approaches to address key aspects in responsible finance. Local currency finance is one example. Supporting the ability of the local financial sector to provide businesses and households with financing in their market’s own currency means contributing to sustainable growth on both an institutional and individual level.
Finance in Motion is the Advisor to GGF