INTERVI EW
OFQ : Turning to climate finance, how can developing countries manage the energy transition given all these constraints? AK: This is a fundamentally difficult question to answer. In some cases, the climate transition may create opportunities for catch-up development, for example in renewables or electrification, where latecomers can enter new industries. Larger economies may lead, but other countries could also integrate into these value chains – China is a massive example, but we also have Mexico and Brazil faring well. Even smaller economies like Uganda are now developing electric buses and scooters. At the same time, many of these countries will face substantial adaptation and mitigation costs because they are also the most climate-vulnerable. Relying on mobilizing large volumes of private capital – billions or even trillions – is unrealistic, because private capital seeks profits, while many climate investments simply do not generate them. That’s the bottom line. We therefore need to rethink catch- up development finance and how best to mobilize that. Ultimately, domestic
MDBs are therefore extremely important because they are among the few institutions that can work against these structures, thanks to their countercyclical mandate. They can provide long-term lending and have the balance sheets to make a difference, while accessing relatively cheap funding. So, yes, they are part of the problem, but also part of the solution. We are working on how to shift international lending from US dollar- and euro-denominated lending to local currency lending, where exchange rate risk is at least partly borne by international lenders. Only then can we begin to break these structural cycles. If we keep rolling over the risk to borrowers, we reproduce the same vulnerabilities, including exchange rate volatility and the lack of trust in local currencies. OFQ : Local currency lending does not eliminate currency risk. It simply shifts it elsewhere. AK: That is a good point. One idea is to create intermediaries that provide temporary risk-taking capital to create space and time for domestic capital markets to develop. The international development community could provide short- to medium-term support, allowing domestic financial institutions to develop this critical lending capacity and for interest rates to come down because of lower risk. We are also exploring risk-sharing mechanisms. For example, working with the Uganda Development Bank we are designing a scheme that spreads risk
across different tranches and thresholds. Another important issue is how exchange rate risk is priced into interest rates. Our modeling suggests that a substantial premium is added based on expectations of depreciation rather than realized movements. There is some room for catalytic risk capital to help break existing structures and reduce interest rates, but the ultimate aim is for domestic financial institutions and development banks to provide lending themselves. OFQ : Would that not reduce profitability for development banks? AK: We are aware of the constraints. MDBs need to maintain their ratings and cannot take on unlimited foreign exchange risk within their frameworks. However, for highly impactful projects in low-income countries, where foreign exchange risk can determine whether lending happens at all, MDBs should consider taking on some of that currency risk. It is also not clear that local currency lending necessarily reduces profitability. While it introduces currency risk, it may reduce credit risk. If borrowers are not exposed to foreign exchange fluctuations, project sustainability improves and default risk may decline. There is evidence from philanthropic capital that when currency risk is absorbed by the lender, credit risk falls and there are fewer defaults. If that is correct, the assumption of lower profitability does not necessarily hold. It may even allow the financing of projects that are otherwise profitable but constrained by macro risks.
“Regional integration is likely necessary in the medium to long term as many countries are too small to support the use of their currencies and build deep financial systems on their own.”
Annina Kaltenbrunner, Professor of Global Economics, Leeds University Business School
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Photo: Courtesy of Annina Kaltenbrunner
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