The global transition to net zero is likely to hit a ‘structural wall’ in emerging economies where debt repayments are often tied to foreign currencies, according to new analysis by the World Economic Forum.
As it noted, while many emerging and developing countries are investing in renewable energy, sustainable transport and climate adaptation, much of this activity continues to rely on debt issued in foreign currencies such as the US dollar and euro.
Developing economies will require around $2.4 trillion annually by the end of the decade to support energy transition projects, climate adaptation measures and natural capital restoration, yet many find themselves in what the World Economic Forum describes as a ‘green debt trap’ – when local currencies depreciate, the value of debt obligations rises in domestic terms, increasing debt burdens and reducing fiscal flexibility.
Currency risk-sharing facility
The World Economic Forum has proposed the establishment of a multi-layered currency risk-sharing facility (CRSF), which would distribute exchange-rate risk across multiple parties, rather than leaving governments exposed.
“Its core innovation is simple: rather than asking one actor to absorb all currency risk – or pay to eliminate it entirely – the CRSF distributes volatility across three tiers calibrated to the probability and severity of exchange rate movements,” commented report authors Mohamed Maait, executive director, Arab Group and Maldives, International Monetary Fund (IMF), and Seham Farouk, senior expert, sustainable finance and PFM, Minister of Finance Technical Office, Egypt Government.
“Routine fluctuations are handled by markets. Moderate shifts are absorbed by the sovereign, compressing the cost of protection for the whole structure, while extreme devaluations are backstopped by international partners through a digital guarantee executed instantly via smart contracts, with no upfront capital required unless the threshold is breached.
“The result? A self-reinforcing architecture that is cheaper than full hedging, safer than full exposure, and structured to attract long-horizon institutional capital from pension funds, life insurers and sovereign wealth funds looking for green financing.”
Pilot market
The Forum’s report highlights Egypt as a potential pilot market for this new model – the African country has already secured more than $10 billion in financing through its Nexus of Water, Food and Energy (NWFE) programme, and is targeting 10 gigawatts of renewable energy capacity by 2028.
As the authors noted, the establishment of a risk-sharing mechanism could help Egypt attract additional investment while protecting public finances from currency-related shocks.
“By distributing currency risk across tiers rather than accumulating it at the sovereign level, the facility protects Egypt’s entire public debt portfolio,” they said “Even a modest reduction in the sovereign risk premium translates into hundreds of millions of dollars in annual financing cost savings. A structured, multilaterally-backed currency risk facility signals fiscal discipline to credit rating agencies and bond investors alike, compressing the risk premium demanded on all Egyptian sovereign issuances – Eurobonds, green bonds, and sukuk – and reducing the overall cost of public financing.”
In turn, this model could be replicated across Sub-Saharan Africa, Latin America and Southeast Asia, where the “structural trap is identical”, with countries facing similar challenges balancing climate ambitions with debt sustainability. Read more here.