Addressing Infrastructure Financing Gaps in Emerging Markets
The G7 and other major economies, including the People’s Republic of China (PRC), seek to close the significant infrastructure financing gap that exists in developing economies. The economic impact of Covid-19, climate change, and a looming debt crisis will only increase the need for external sources of finance to meet these needs. The G7 and PRC have also announced several initiatives, including the Partnership for Global Infrastructure and Investment (PGII) and the Global Development Initiative, respectively, that seek to finance development-forward infrastructure projects. For the United States, this means turning to a relatively new agency born out of the Better Utilization of Investments Leading to Development (BUILD) Act of 2018, the U.S. International Development Finance Corporation (DFC), which has become policymakers’ silver bullet to all the problems plaguing emerging economies, or working through multilateral development banks (MDBs) and development finance institutions (DFIs).
Many of these countries in need of further financing are already at risk of debt default, making the taking on of more debt just that more onerous and untenable. Debt financing is typically lent in U.S. dollars, including by the PRC under its Belt and Road Initiative (BRI), and the strengthening dollar will make it much more expensive for developing economies to take on more debt.
Q1: What are concessional financing and local currency lending and why are they important?
A1: Concessional finance is below-market rate financing to developing countries to accelerate development objectives. Projects that receive these types of funding typically fall into buckets around health, education, and climate adaptation and mitigation.
Local currency financing is the practice of issuing long-term debt in the currency of the borrower and helps businesses to avoid currency mismatches. Borrowing in foreign currencies like the dollar exposes clients to the risk that debt and debt service payments (as measured in local currency) increase when their local currency depreciates. By converting to local currency, clients address that risk.
Q2: What does the BUILD Act say about concessional financing and local currency loans?
A2: A concessional loan is a loan made on more favorable terms than the borrower could obtain in the market. The concessional terms may be
- a lower interest rate below the benchmark or base interest rate (in the case of the DFC, this is based on Secured Overnight Financing Rate, or SOFR);
- deferred repayments; or
- income-contingent repayments.
According to the BUILD Act, the DFC can set the interest rate for direct loans and interest supplements on guaranteed loans: DFC typically does this by using the Treasury rate or other widely recognized benchmark.
The DFC can adjust the minimum interest rate to account for changes in the benchmark or base rate.
Loans, guarantees, and equity financing may be denominated and repayable in dollars or foreign currencies. Foreign currency denominated loans and guaranties should only be provided if the board determines there is a substantive policy rationale for such loans and guaranties. This language suggests that the DFC can provide local currency loans if there is a strong argument and economic rationale to support the case.
Q3: What are the risks in providing concessional and local currency financing?
A3: There is a good reason why financial products are in dollars or other convertible currencies such as the euro or yen. These currencies experience much less volatility but are also tied to economies that have a strong rule of law, multiple asset classes in those currencies, liquidity, and convertibility.
Lending in local currencies will almost certainly result in financial loss, meaning a loss in taxpayer dollars if the DFC is lending in local currencies. Borrowing in foreign currencies exposes countries to the risk that debt and debt service payments increase when their local currency depreciates. Conversely, there is also risk the borrower is unable to pay back loans if its currency depreciates so much against the dollar, making repayment much more difficult.
Multilateral financial institutions do lend in local currency. For example, the World Bank can convert disbursed amounts to local currency. The amount clients owe in local currency upon conversion is the amount they will have to repay. The interest rate in local currency will typically be fixed. The interest rate in local currency reflects the terms the World Bank can obtain when hedging the currency risk.
Q4: What are the benefits of providing such financing?
A4: The biggest impact is making financing cheaper for capital-starved markets. Emerging economies’ budgets have already been under severe strain because of Covid-19 and supply chain disruptions, and they now must contend with rising interest rates and a strong dollar. Not only will local currency or concessional lending provide a financial break for these markets, but it will also be a sign of goodwill in acknowledging the financial needs and current situation.
These types of lending can have a significant impact on the local economy, even if the DFC or other DFIs and MDBs were to lose money on a portfolio of loans made in local currency to low-income sub-borrowers. Those sub-borrowers can build a credit history and to own their properties, which can then be used as collateral for future loans to build their businesses. Once they repay those loans, these borrowers (in many cases, small and medium-sized enterprises and women-owned businesses) will likely be able to access credit on better terms moving forward. That means that their cost of capital for future loans likely will be less and will come from private banks.
Additionally, taking on more risk or the riskiest lending tranches would enable more risk-adverse capital to invest. A central question for infrastructure financing has been around how to mobilize private sector money to invest these projects. DFC and other development finance institutions have tools to help de-risk investment, including political risk insurance; however, local currency lending is another tool that could be added.
Finally, these tools will make the United States more competitive. Like other DFIs, the DFC is slow in lending—admittedly, part of this is for good reason because they are undertaking the proper due diligence and analysis to assess if these projects are viable investments—and not particularly competitive except for long loan tenors. The project would have both the backing of a stable and reliable U.S. financial institution and cheaper financing.
Q5: How can the DFC and other MDBs and DFIs reduce their risks?
A5: Financial institutions could cap exposure on local currency loans by lending in dollars, but they could require the borrower to only repay in local currency. DFIs and MDBs could accept the first few million USD in losses on any depreciation against the dollar, helping the DFC to better calculate exposure and mitigate losses. DFIs and MDBs can also consider pursuing blended finance strategies to reduce risk.
Q6: Why should the U.S. government and DFC consider these tools?
A6: The countries the BUILD Act has required the DFC to engage with financially are in precarious financial situations thanks to debt distress, a strengthening dollar, and rising interest rates. Compounding this is that the PRC’s infrastructure projects, and development finance proposals appear more attractive given the speed at which they can be implemented and what appears to be “no strings attached”—i.e., less focus on labor standards, environmental and social impact assessments, and other standards required by the DFC. If the United States wants to address both strategic and developmental issues, it should find ways to be more competitive. Offering concessional loans, local currency loans, or engaging more through blended finance options can both maintain the high standards these projects should possess while providing real benefits for the recipient countries.
Erin Murphy is the deputy director and senior fellow with the Economics Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Conor M. Savoy is a senior fellow with the Project on Prosperity and Development at CSIS.
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