Best practices for scaling foreign financing in sustainability projects: Navigating foreign exchange risks

In the face of pressing sustainability challenges, the global sustainable development sector is increasingly turning to foreign financing as a crucial lifeline, particularly for developing nations. The 2024 Financing for Sustainable Development Report highlights that developing countries need an additional US $4 trillion annually in investments to satisfy sustainable development goals (SDGs). This represents an extra than 50% growth over pre-pandemic estimates.

Developing countries struggle with financing and implementing climate technologies due to limited expertise, capacity, and resources. They face challenges in accessing and utilizing international climate finance, hampering their ability to develop projects and integrate adaptation strategies. To address the technology gap and support global climate action, enhanced international cooperation is crucial. This includes technology transfer, increased financial support, and capacity-building initiatives from developed nations. While multilateral development banks and climate funds aid, streamlining processes could further improve access to adaptation finance for developing countries.

However, a tremendous hurdle in scaling up this crucial financing is foreign exchange threat. This threat occurs when investments or loans are in a different currency than the one in which the project makes its money. For instance, a renewable power assignment in India may secure financing in US greenbacks however generate earnings in Indian rupees. If the rupee depreciates in opposition to the dollar, the assignment’s potential to pay off its debt may be critically compromised.

In the realm of sustainable development financing, several significant challenges emerge when

navigating the complex landscape of foreign exchange risks. These obstacles not only impact the feasibility of crucial projects but also influence the overall flow of capital into developing nations. These challenges are as follows –

Increased borrowing costs: The perceived risk of currency fluctuations frequently results in better interest prices for borrowers in developing nations. This increased fee of capital could make sustainable projects financially unviable, hindering their implementation. Also, exchange rate volatility can significantly increase the value of outstanding debt and debt-servicing costs for countries with foreign currency-denominated debt

Investor hesitation: investors can be reluctant to devote capital to initiatives in international locations with unstable currencies. Project sponsors typically hesitate to take on foreign currency debt to finance projects whose earnings are mostly in local currency. This hesitation can result in a large shortfall in funding for sustainable development

Uncertainty of project revenue: A project’s revenues are often in local currency, creating a risk that they will not be enough to pay back foreign debt if the local currency loses value. This uncertainty can threaten the financial sustainability of long-term projects. This is especially seen in sectors such as renewable energy and sustainable infrastructure

Limited local currency financing: Many emerging countries lack liquid capital markets in their own currencies. This restriction forces project developers to rely on foreign currency financing. This makes the risk of change even more severe. The lack of local currency financing options can spell disaster for projects, as long-term investments may face currency value changes of 50% or more

Macroeconomic fragility: Developing countries are often sensitive to economic changes that can cause exchange rate fluctuations. This loophole can create a situation where exchange rate risk hinders investment. As a result, the economy and the currency will depreciate further, creating a vicious cycle. Emerging market and developing economies face significant downside risks to growth, including policy uncertainty, trade tensions, financial market disruptions, and spillovers from weaker-than-expected growth in major economies

These challenges can pose significant risks for sustainable development initiatives, potentially undermining long-term economic stability and growth prospects.

Several innovative financing strategies have emerged to address the challenges posed by foreign exchange risks. These approaches not only mitigate financial uncertainties but also promote the growth of local economies and the development of sustainable projects. They are:

Natural hedging: Natural hedging aligns project revenues and costs in the same currency, buffering against exchange rate fluctuations. Sourcing local materials and labour reduces currency exposure while supporting local economic development, benefiting both the project and its host community. For example, Australian gold mining companies that sell bullion into world markets in US dollars can achieve a partial natural hedge through the correlation between gold prices and the Australian dollar exchange rate

Using exchange hedging instruments: Hedging tools, such as futures, options, and currency swaps, allow project managers to lock in rates and protect against adverse currency movements. Specialized funds like The Currency Exchange Fund (TCX) provide tailored hedging solutions for developing country currencies, enabling project financiers to navigate volatile emerging market currencies with greater confidence and stability. The M-Kopa project, which connected 500,000 homes in Kenya, Tanzania, and Uganda to solar power, worked with TCX (The Currency Exchange Fund) to manage currency risks

Blended financing: Blended finance structures combine public and private capital to manage currency risks in sustainable projects. Development finance institutions provide guarantees to attract private investors, mitigating risks and mobilizing additional capital. This approach creates a multiplier effect on investment in critical sustainable development projects. IFC–Sida Managed Co-lending Portfolio Program allows for cross-border debt and equity investment in developing countries, using blended finance strategies to mitigate currency risks

Leveraging local currency: This approach, a possible alternative to foreign currency borrowing, reduces exchange rate fluctuations. The local currency-denominated green bonds are gaining significant momentum in emerging markets. The size of local currency bond markets in emerging East Asia increased from $866 billion in 2000 to $23.2 trillion by the end of 2022 . EBRD’s ETC Local Currency Loan Programme, launched in 2011, helped countries like Armenia, Georgia, Kyrgyz Republic, Moldova, Mongolia, and Tajikistan to overcome high costs of EBRD’s local currency funding. The Programme created a donor-funded risk sharing facility that allowed the EBRD to price its ETC local currency loans closer to market rates, aiming to increase local currency lending share in ETCs

Multilateral development banks (MDBs): MDBs provide invaluable support through loans and guarantees in local currency. This effectively bridges the gap between project needs and investors’ concerns. MDBs are also at the forefront of developing innovative risk-sharing mechanisms like guarantees, co-financing and syndication and Blended Finance Solutions. This is fundamental to attracting private sector capital for more sustainable projects in emerging markets. For example, the Asian Development Bank (ADB) led a $121.55 million financing package for Dynamic Sun Energy Private Limited to build and operate a 100-megawatt grid-connected solar photovoltaic power plant in Pabna, Bangladesh.

Development of supporting policies: Successful foreign exchange risk management rests on a strong policy and regulatory framework. Governments play an important role in implementing policies that promote financial stability and reduce market volatility. At the same time, a well thought out regulatory framework can facilitate this. For example, Colombia established the Financiera de Desarrollo Nacional (FDN), a government-owned development finance institution that operates under a strong corporate governance framework. FDN has played a crucial role in lowering perceived project risks and facilitating infrastructure financing

In conclusion, the challenge of foreign exchange risks in sustainability projects remains a significant barrier to scaling foreign financing, particularly in developing economies. The issue intersects with broader challenges in global finance, including underdeveloped local capital markets, macroeconomic fragility, and the persistent funding gap for sustainable development initiatives. The ongoing evolution of financial mechanisms and policy frameworks will be instrumental in overcoming the complexities of foreign exchange risks and ensuring the successful scaling of sustainable finance in emerging markets.

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