The risk of currency shocks in emerging markets is high. Yet, most development finance is still provided in hard currency (predominantly US dollars or euros).
History shows that each year, one out of eight developing countries experiences an absolute depreciation of over 20% and one out of twenty countries sees its currency drop by more than 50%. Since 1971 (end of Bretton Woods system), out of 95 developing countries currencies, nearly two-thirds experienced at least one year with over 50% depreciation, while nearly all currencies had at least one year with over 20% depreciation.
Development finance is predominantly provided in dollars. Even to the microfinance sector, 65-85% of lending is still done in dollars. Financial institutions generally do not retain this currency risk, but match it with dollar on-lending.
However, currency mismatches between funding and revenues result in higher borrower defaults and financial sector instability:
- Foreign currency lending results in financial distress and higher corporate credit defaults after exchange rate fluctuations.
- Households are found to not properly hedge themselves when borrowing in foreign currency therefore exposed to sudden shocks.
- For financial institutions with a large share of foreign currency loan portfolios, this currency-induced credit risk then spills over to a bank crisis, or even a financial sector crisis for countries where foreign currency lending has been common practice among multiple banks.
Therefore, the currency risk mitigation provided by TCX is essential throughout the finance chain to shield all parties involved (investors, institutions and borrowers) from sudden shocks:
- No more currency mismatch for end-borrowers/households: de-risking local enterprises and consumers and de-risking local financial institutions due to lower end-borrower defaults.
- No more currency mismatch for local financial institutions: de-risking (M)FIs by providing tools to come to ‘matched funding’ for MFIs.
- De-risking end-borrowers and (M)FIs lowers credit risk for DFI and MIV shareholders of TCX.