Multilateral development banks have long focused on developing local currency bond markets, acting as icebreakers, supporting stock exchanges and central securities depositaries as well as engaging with banks, brokers and investors on best practice.

Assistance is delivered through dedicated capital markets policy-based loans, technical consultancies and by the multilateral development banks issuing their own bonds in emerging market currencies such as Indian rupees, Mexican pesos or South African rand. This work is important to provide savers and borrowers with alternatives to the banking system, as well as to insulate against currency risk.

 The topic of foreign exchange (FX) risk mitigation has snowballed into a major deliverable for developing countries, from the 2011 Cannes Summit to the 2024 Brazilian presidency of the G20. In April, the Finance Ministers and Central Bank Governors group acknowledged local currency financing and FX risk mitigation as a top priority for multilateral development banks.

This is partly consequent to the normalization of US dollar interest rates, in which the secured overnight financing rate has reached 5.31% but also to the resurgence of the US dollar. To put this into perspective, we have only to look at Türkiye, which has suffered a 608% devaluation of the lira in the last five years.

This means that for every dollar borrowed by Türkiye in 2019, they must repay six dollars in 2024 – assuming that borrowed monies were converted into local currency for policy or project purposes, as is typical. Clearly, this type of experience makes borrowing in mainstream currencies expensive irrespective of the interest cost and has catalyzed efforts to develop capital market infrastructure and instruments.

Developed countries like the United States, Japan and Australia only borrow (issue government bonds) in their own currencies. This is because they are highly rated, their financial market architecture is transparent, efficient and trusted and their currencies serve as a good store of value.

This insulates them from FX risk, while encouraging foreign portfolio investment. Although the development of similar local currency bond markets is an important objective for the developing world, they are not always an automatic panacea, as demonstrated by the debt crises of Sri Lanka (2022), Zambia (2020) and Russia (1998) when governments defaulted not only on their foreign creditors but also on their domestic government bonds.

Most developing countries continue to borrow from multilateral development banks in mainstream currencies, particularly the US dollar.

However, these defaults are not caused by market failure so much as by fiscal ill-discipline combined with external factors.

Yet most developing countries continue to borrow from multilateral development banks in mainstream currencies, particularly the US dollar. In some cases, such loans are a source of scarce convertible currency, in others it may be a question of financial education. But  the biggest challenge is in the ability of multilateral development banks to source sufficient funding or hedging in local currencies themselves.

Fortunately, this handicap is gradually dissipating. The advent of offshore currency-linked-bonds has been a gamechanger for financing solutions, whilst derivatives markets have evolved to provide more opportunity for FX risk management. But it still requires a change of mindset for many low-income countries to opt for local currency borrowings over US Dollars, Euros or Japanese yen.

In some developing countries, particularly in Pacific small island developing states, structural liquidity surpluses exist, either because the government bond market is inactive or because of trapped liquidity, due to the unavailability of FX.

In these cases, issuing bonds in the local currency through multilateral channels would reduce the need for expensive monetary sterilization by central banks (to best manage imbalances in the money supply) and direct extra funds toward development projects.

The most fragile countries, as classified by the World Bank, are eligible for loans at highly concessional interest rates via special drawing rights, but these loans are issued in international currencies such as the US dollar, Euro, Chinese yuan, Japanese yen and British pound. All result in FX risk exposure, but most borrowers choose the US dollar, which ironically is where the FX risk is often the greatest.

The G20 is focused on mobilizing private capital investment into developing countries through local currency finance. This is undisputedly a key performance indicator for multilateral development banks, however  the elephant in the room is surely the delivery of local currency lending and hedging to sovereign and sovereign-guaranteed borrowers; to end the constant cycle of debt restructurings and the corresponding damage it inflicts on national economies and societies.

Developing robust local currency bond markets is essential for the financial stability and growth of developing countries. By reducing dependency on foreign currencies and mitigating exchange rate risks, these markets can foster more sustainable debt burdens and help to beat the boom-bust cycle that plagues the developing world.

This blog post is based in part on panel discussions held at ADB’s 2024 Annual Meeting in Tbilisi which brought together deputy finance ministers of Armenia and Georgia with ADB and World Bank executive directors, as well as local market participants from Georgia, including the central bank. It is also based on a local currency forum hosted by ADB’s Treasury Department, co-hosted with the National Bank of Georgia, which included at least 38 senior officials from 12 multilateral and bilateral organizations’ treasury departments.