Keeping it Local: Key to Scaling Up Climate Finance Reforms

Kartikey Sharma, June 7, 2024

In a significant milestone, the New Development Bank (NDB), an institution established by the BRICS nations, made history by issuing its inaugural local currency bond in South Africa, raising $79 million through its issuance in August 2023[1]. This achievement is a testament to the commitment made by BRICS nations in their 2017 agreement to provide credit facilities denominated in local currencies to both sovereign and corporate entities across member countries[2].

The concept of local currency lending has been a recurrent theme in political discourse for more than two decades. It gained substantial attention in the mid-2000s following major setbacks such as the Mexico peso crisis, the Russian debt default, and the Asian financial crisis. These events instilled a sense of caution among investors and borrowers alike, highlighting the risks associated with currency mismatches. In response, borrowing countries, particularly in Asia, have intensified efforts to bolster their foreign exchange reserves, spurred by sizable current account surpluses.

Local Currency Lending and Climate Finance

To answer the question about the relationship between local currency lending and climate finance reforms we must first understand, why does currency mismatch occur and why do governments and firms alike feel the need to borrow from international markets?  Currency mismatch and the need for institutions to tap overseas markets typically occurs because there is a dearth of local financial resources, too short tenors (maturity), lower interest rates, and the ability to explore a seemingly advanced and mature investor pool. While developed economies experience little to no roadblocks when it comes to accessing international finance, emerging economies don’t fare well on that scale.

This is the exact issue which is currently plaguing the global climate finance industry. Financial instruments such as green and sovereign bonds in India typically have a maturity tenor of 5-10 years. This is quite short when you compare it with global sovereign green bond issuers such as  Germany and France whose maturity tenor hovers anywhere between 15-40 years[3]. Additionally, bond borrowing cost in India is extremely high with corporate bond borrowing cost for 2024 standing at 7.1% [4] and state cost standing at 7.4% [5]. In contrast, the OECD debt borrowing cost as of 2023 stood at 4% [6]; almost half of that of India. This is an imperative reason behind the low inflow of international climate-based finance in India.

Local currency-based financing efforts are crucial for developing economies with weaker currencies. These economies face currency risks due to foreign exchange fluctuations, domestic inflation, and lower returns for international investors. Lenders often add a hedging cost to debt agreements to counter these risks, increasing interest rates for project developers and exacerbating debt issues, especially in the global south where debt crises currently stands at $400 billion [7]. Local currency lending could help ease the global south’s debt crises burden by enabling the curation of lending options that are not susceptible to currency mismatches and don’t come bundled with additional hedging costs lamented on the lender.

In India, debt has been a primary instrument for green finance, accounting for over 49% of total tracked green finance, according to analysis by Climate Policy Initiative during FY2019 and FY2020 [8].

Potential Reforms

Expanding the monetary capacities of MDB’s

While MDB’s are a strong source for long term finance with a lower risk quotient attached to their lending behavior, they are quite conservative when it comes to opting for riskier lending options. In 2021, the G20 set up an expert panel to review MDBs’ financing capacity through a review of their ‘capital adequacy frameworks’ (CAF). In 2022, the panel published their report, which asked MDBs to loosen their lending restrictions and thereby provide much more money without threatening their financial stability or AAA credit rating. Given that a total $1.2 trillion exists[9] in callable capital across 15 MDB’s, the CAF review panel believes that this monetary risk appetite is not built into their risk mitigating strategies. Thus, MDBs should look to take on calculated risks and increase the amount of money they lend in the form of local currency bonds.

Broadening the investor base

India needs approximately $2.5 trillion till 2030 for NDCs and 10.1 trillion to achieve Net-Zero emissions by 2070 [10]. By conservative estimates, the current tracked green finance in India represents approximately 25% of the total requirement across sectors just to meet the NDCs. Encouraging institutional investors, such as pension funds and insurance companies, can help contribute to the development of long-term bond markets. Although domestic institutional investors hold much less assets in most emerging markets they tend to play an increasingly important role in the bond market. Facilitation and the comprehensive development of a dedicated local currency bond market can go a long way in enhancing the investor base for climate change based development activities.

Strengthening the supportive market infrastructure

There needs to be a cohesive development towards standardised credit rating systems, risk management products, and a functioning trading and settlement system. Additionally, the strengthening of legal and regulatory frameworks can help deepen the markets and investors trust alike within the currency infrastructure. Further, targeted efforts need to be undertaken to mitigate cross border barriers to regional currency integration. India  has recently taken some radical steps in this direction. In 2023 the Reserve Bank of India and the UAE signed a memorandum of understanding aimed at promoting rupee and dirham use in cross-border transactions while also nudging Indian firms to use the rupee or dirham in cross-border transactions with Emirati firms [11]. The country is also looking to sign similar deals with the governments of Argentina, Brazil and South Africa[12].

The issuance of local currency bonds by New Development Bank South Africa has reinvigorated the dialogue around lending in local currency in a world which is at the praecipes of a debt crises. The approach of aligning local currency lending with climate finance reforms not only addresses he high borrowing costs and short tenors prevalent in countries like India but also mitigates the risks associated with foreign exchange fluctuations. Expanding the monetary capacities of Multilateral Development Banks (MDBs), broadening the investor base, and strengthening supportive market infrastructure are essential reforms to catalyse sustainable development financing. These efforts, coupled with strategic international partnerships, underscore the importance of local currency bonds in achieving long-term economic and environmental goals for emerging markets.