The climate–currency nexus: currency conversion as a means of reducing exposure to currency volatility in vulnerable economies

The increasing intensity and frequency of extreme weather events disproportionately affects emerging markets and developing economies (EMDEs) and small island developing states (SIDS). With this increasing vulnerability to the effects of climate change comes greater exposure to the risk of currency depreciation.

This policy insight focuses on a specific financing risk faced by EMDEs and SIDS: their exposure to currency depreciation arising from hard currency debts held with multilateral development banks (MDBs) in the aftermath of domestic climate-related shocks. Drawing on the latest evidence on the climate–currency nexus, the authors make recommendations for MDBs, their shareholders and debt management offices.

Around 80% of lending by MDBs is in ‘hard’ currencies, exposing borrowers to exchange rate risk. If a borrower’s local currency depreciates following a climate-related shock, debt service costs can increase sharply, adding pressure on the debt management offices (DMOs) of EMDEs. Currency conversion clauses can be used to convert hard currency loans into local currency to reduce EMDEs’ exposure to currency risk following climate-related shocks. While many MDBs now offer currency conversion clauses, their uptake remains low, and many DMOs continue to manage debt in hard currency in the aftermath of climate shocks.

Recommendations

Multilateral development banks:

• MDBs not lending in local currency should consider incorporating local currency conversion clauses in as many debt products as possible.
• MDBs should actively offer DMOs the option to convert hard currency debts to local currency after a country has suffered a climate-related shock.

Debt management offices:

• Where MDB hard currency debt has a currency conversion clause, DMOs should convert the loan when the yield curve difference is in their favour.
• At the point of a climate-related shock, if hard currency debt has not been converted into local currency, DMOs should negotiate conversion as early as feasible to limit further exposure to currency depreciation and volatility.
• When assessing the terms of loans, DMOs should focus on the foreign exchange adjusted rate for the duration of the loan, not the absolute interest rate on local versus hard currency, which will almost always be lower by design.

Shareholders in multilateral development banks:

• Shareholders should encourage MDBs to lend in local currencies. Where not feasible, MDBs should be encouraged to include currency conversion clauses in their debt products.
• Shareholders should support DMOs by providing technical assistance and grant support around the cost of currency conversion in the aftermath of climate-related shocks.

DOI: 10.21953/researchonline.lse.ac.uk.00141062