In low income countries, both the public and private sectors suffer from original sin, where the domestic currency cannot be used to borrow abroad or to borrow long term domestically. Their borrowing is denominated in hard currency, most often USD.
Original sin has been identified by the IMF as a key variable in debt surges. It is responsible for 35% to 50% of debt to GDP increases in crises when local currencies depreciate, inflating the cost of hard currency debt in local currency terms.
Although the sovereign debt crisis is deep, the African banking sector is currently doing surprisingly well, as noted by Fitch. The question is why, since both sectors—the government and the banks—suffer equally from original sin.
The answer is that central banks impose strict regulations and limitations on the open currency risk that supervised financial institutions may take. In Kenya, this is no more than 10% of equity, 15% in Zambia, and 20% in Rwanda. This is less than 5% of a bank’s balance sheet. By imposing these limits, central banks fulfill their core function of protecting the consumers of financial services.
Not only do central banks apply these limits, but official lenders do so as well. Official development institutions provide loans to local banks providing financial services to domestic corporates and micro, small, and medium sized enterprises. Since official lenders want their money back, they consequently follow local central bank regulations or apply a cap on foreign currency exposures of 25% of the borrowing bank’s equity.
Strikingly, no similar measures are applied to the public sector. No regulator prevents governments from taking large open currency risk positions. No official lenders impose prudential currency risk ratios. They look the other way whilst they offload an increasingly heavy currency risk burden on low-income countries. According to UNCTAD between 70% and 85% of emerging and low income country debt is in a foreign currency.
The double standard is corrosive of otherwise prudent efforts to regulate the banking system. Banks lend to the public sector, where that public sector is exposed to currency risk. A recent World Bank paper finds that banks’ exposure to their governments in low-income countries had increased by 50% over the past 12 years. It concludes that at least 20% of banks with high government exposure would become undercapitalized if just 5% of the government debt is written off. Given that half of these highly exposed banks are in countries with a government facing high debt risks, this is a ticking time bomb.
Debt crises like those in African countries today lead to calls for debt relief and expanded role for official development lenders such as IDA, the World Bank’s arm focusing on the poorest countries. IDA has just received its highest capital increase ever, which suggests that its financial footprint in low-income countries will be even greater going forward. But this only underscores the absence of adequate prudential regulation of its lending to the governments of such countries. It and other multilateral lenders do too little to alert borrowers to currency risk. They do not offer alternatives such as (indexed) local currency loans. By denominating their loans in USD, they offload from their own balance sheets a currency risk that fragile borrowers cannot manage.
A new United Nations report suggests that better capitalized official lenders should be able to shoulder additional local currency risk, especially insofar as they acquire diversified portfolios of local currency bonds. They should ramp up technical assistance and capacity building on foreign exchange risk management in their client countries. And they should provide currency hedging instruments, either directly or through markets and NGOs.
Brazil, last year’s G20 Chair, has ample experience in tackling currency risk. In its roadmap it calls on multilateral lenders to increase the quality and expand the quantity of local currency financing options and to complement this with technical assistance. South Africa, this year’s G20 Chair, could strengthen this dialogue by calling on multilateral lenders to tackle the double standard and apply suitable risk management practices to their lending practices.
Ruurd Brouwer, CEO, TCX
Barry Eichengreen, Professor of Economics and Political Science, University of California, Berkeley
All views expressed by members are their own and not reflective of the views of the Bretton Woods Committee.