Enhancing Local Currency Lending by Multilateral Development Banks: a critical reform agenda

Abstract

This policy brief highlights the crucial role of local currency lending by Multilateral Development Banks (MDBs) in achieving the Sustainable Development Goals (SDGs), particularly in low- and middle-income countries (LMICs). While current policy discussions emphasise the need to increase MDBs’ lending capacity, this alone may not ensure sustainable lending practices. It is vital to provide financing that aligns with recipients’ absorptive capacity and minimises macroeconomic vulnerabilities. A key aspect of this discussion is the currency denomination of financing arrangements, which has gained attention in policy agendas such as the Bridgetown Initiative. This framework stresses the need to avoid currency mismatches that could exacerbate debt crises in LMICs. Despite growing consensus on the need to increase local currency lending by MDBs, there remains a significant gap in systematic analysis and understanding of these practices. This brief aims to bridge the gap by discussing the advantages of borrowing in local currency and analysing the reasons for MDBs’ reluctance to lend in these terms. The central argument is that the risks associated with local currency lending are often overestimated, resulting in insufficient financing. This overestimation stems from perceived risks in LMICs, which drive up the costs of risk management, particularly for exchange rate risk. Moreover, local currency lending could unlock untapped opportunities and benefits for MDBs. We offer several policy recommendations to the G20 to enhance MDBs’ capacity to lend in local currency. These include scaling up and improving methods for hedging currency risks, facilitating local currency funding in onshore markets, and reforming risk management frameworks. Additionally, we advocate for integrating local currency lending into the core of the developmental mandate of MDBs and strengthening the technical assistance provided by these institutions to support these efforts.