Time to trim the hedge costs #CashNews.co

Last year, I travelled to Barbados to interview one of the most original thinkers working in climate finance. Avinash Persaud, who was then the island nation’s special envoy on climate, had built unusual momentum around a set of ideas to unlock more private spending on the green energy transition in developing countries.

The Bridgetown Initiative, championed by Barbados’s Prime Minister Mia Mottley, is an effort to reform the international financial architecture on more favourable terms for low- and middle-income nations. Leaders, from French President Emmanuel Macron to Brazil’s Luiz Inácio Lula da Silva, leapt at the opportunity to be associated with it.

Persaud continues to be one of the most innovative voices in development finance. Today, I dug into a proposal he is championing to help unblock the flow of capital for green energy projects in emerging markets.

The case for multilateral action on currency risk

Investors in developing nations have long faced a far higher cost of capital than richer countries. The conventional wisdom among economists holds that poor governance is to blame, including factors ranging from bad data and shallow markets to low credibility of institutions and poor rule of law.

A recent IMF paper on the particularly acute mark-up paid by sub-Saharan African countries, for example, argued that more transparent budgeting and more efficient institutions could improve investor confidence, reducing the risk premium.

But Persaud, now special adviser on climate at the Inter-American Development Bank (IDB), thinks this analysis is missing a vital angle. He argues that foreign investors in large emerging markets appear to be overpaying to hedge against swings in those countries’ currencies.

What’s more, he argues, development banks could shoulder some of the currency risk that stems from the global financial cycle, thereby catalysing more foreign investment to support emerging markets’ green plans.

It’s an idea the IDB, World Bank and Brazil’s finance ministry are trialling with a new “liquidity platform” that will give green project investors a cheaper means of hedging currency risk. With Brazil holding the presidency of the G20 this year, Persaud hopes upcoming meetings in Rio de Janeiro can generate critical support.

Persaud, who launched his career at JPMorgan analysing currencies, does not claim that the risk premium on emerging markets’ currencies is a fiction, or a mark-up invented out of thin air. He contends, rather, that it reflects risk embedded, not in the institutions of any particular country, but in the volatility of the international financial system.

But he will be fighting upstream against an overriding narrative that ascribes poor countries’ higher cost of borrowing overwhelmingly to bad management.

A prohibitive cost

“Most development financiers are project finance people,” Persaud told me. They tended to hyper-fixate on the risks of an individual hydropower dam or solar farm, he said, and to blame poor countries for failing to develop credible projects with standardised terms and conditions.

A typical response is to mobilise a small army of management consultants and legal experts — with a risk of driving up project costs, rather than bringing them down.

Persaud believes that emphasis misses a bigger slice of what drives up the cost of capital: currency risk.

Mines and fossil fuel extraction tend to generate dollar returns since they produce commodities that are priced and traded in international markets. Not so with renewable energy projects, which typically collect revenues from domestic consumers and utilities in local currency. When international investors convert that revenue, they face the risk of exchange rate fluctuations, which can be severe in many developing countries.

Some specialist investors in emerging markets have teams dedicated to managing that risk. But many institutional investors see currency hedging as beyond their core expertise and pay commercial banks to hedge against swings in currency prices. That cuts into project returns, often making renewable developments that are otherwise competitively priced look unattractive.

If those hedging costs reflected the actual risk of currencies falling dramatically, Persaud said, “there would be little that could be done”.

However, when examining historical data from foreign exchange markets, which are used to hedge currency risk, he found that currencies were unlikely to fall as hard as markets had predicted.

In fact, he found, over the past two decades, in the five largest emerging economies — Brazil, India, Indonesia, Mexico and South Africa — investors had been quoted costs reflecting currency depreciation per year of almost 3 percentage points more than ultimately occurred.

Volatility — specifically, the outflows of capital from emerging markets during times of global financial stress — aggravated the dynamic. The overcharge to hedge currency risk rose to an average of 4.7 percentage points per year, he found, if the hedge was priced during a downturn in the financial cycle.

A new approach

The concern here is not so much that investors could be overcharged — won’t somebody think of the asset owners — but that high hedging costs dampen the appetite for green investment in large middle-income countries. Persaud focuses on those regions because their emissions trajectories will determine the fates of many smaller, climate-vulnerable states such as his home country of Barbados.

Commercial banks were badly positioned to “absorb” currency risk because of their own short-term liquidity constraints, Persaud said. Periods of financial stress tended to trigger a flight from emerging markets to countries that issued reserve currencies. Commercial banks couldn’t manage that dynamic, Persaud said, “because they’re part of it”. Development banks, he argues, are better positioned to lend counter-cyclically.

The IDB, along with the government of Brazil and the World Bank, is already trying this. Last month, it invited investors to apply for a liquidity platform, to which it has committed $5.4bn, which will provide insurance against extreme currency price movements. It could be a model for additional liquidity facilities to be housed at regional banks such as the Asian and African development banks.

At present, however, some development finance officials are pushing for the G20 to back a renewed emphasis on developing detailed country-level plans for the energy transition — a priority Persaud sees as overstated.

“This emphasis on plans stems from an entrenched idea that markets will solve all problems, and if they aren’t, it must be because you haven’t made clear what’s going on,” Persaud told me. He viewed the insistence on more detailed plans and data as bias in favour of the idea that “you don’t need money, you need information”.

The liquidity platform, if it gains wider support, would test his competing hypothesis, reopening the question of whether developing countries are consistently producing dodgier projects — or whether they are being overcharged for risks that often fail to materialise.

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