Research project
Currency risk-sharing facility for scaling up local currency climate finance in Uganda
- Start date: 1 March 2025
- End date: 31 December 2026
- Primary investigator: Professor Annina Kaltenbrunner (Professor of Global Economics, Leeds University Business School) and Dr Bruno Bonizzi (Lecturer in International Political Economy, City St George’s University of London)
- Co-investigators: Dr Karina Patrício Ferreira Lima
- Postgraduate research fellows: Iván Weigandi Martínez (Research Fellow, Leeds University Business School)
Currency risk is a structural constraint on scaling sustainable climate finance in low-and middle-income countries (LMICs).
Climate and infrastructure projects typically generate revenues in local currency, while financing is largely provided in foreign currency, transferring exchange rate risk to borrowing countries and institutions. This transfers exchange rate risk to borrowing countries and institutions, exposing them to potentially sharp increases in debt servicing costs when their currencies depreciate. Large currency depreciations have been a recurrent driver of debt distress, yet development finance models continue to place most of this risk on vulnerable borrowers. Addressing currency risk more systematically is therefore essential to enable long-term local currency financing and strengthen the resilience of development finance.
Uganda provides a particularly important case study in this regard. The country needs over USD 28 billion by 2030 to meet its climate action commitments, including investments in renewable energy, climate adaptation, and sustainable infrastructure. Mobilising this finance requires long-term funding in local currency, since the revenues generated by these projects are almost always domestic and denominated in Ugandan Shilling (UGX).
The Uganda Development Bank (UDB), Uganda’s national development finance institution, already provides climate loans in UGX through its Climate Finance Facility. However, Uganda’s development finance system faces a structural dilemma. High domestic funding costs, combined with a lending cap of 12 per cent across UDB’s portfolio, make it difficult for the bank to provide local currency loans at affordable rates. This cap reflects UDB’s development mandate, as many climate and infrastructure projects generate relatively modest and long-term returns and would become financially unviable at higher lending rates. In a context where inflation in Uganda is currently in the low single digits, the cap still implies a positive real lending rate while remaining broadly compatible with the viability of climate and infrastructure investments.
To maintain affordability for borrowers, UDB therefore relies on concessional credit lines from international partners, typically denominated in foreign currency (USD or EUR). This funding model creates a currency mismatch: UDB lends in UGX but borrows in foreign currency. When the UGX depreciates, the cost of servicing this debt rises sharply in local currency terms, putting pressure on the bank’s balance sheet and financial position.
Traditional hedging instruments exist, but they are costly and often difficult to access for the long maturities required for climate and infrastructure projects. In practice, comprehensive hedging for long-term exposures typically involves double-digit costs in UGX terms, far above the concessional interest rates UDB pays on its foreign currency credit lines. Without affordable and long-term risk mitigation tools, UDB must absorb the currency risk on its own balance sheet, limiting the scale of local currency lending and making climate investment structurally vulnerable to exchange rate volatility.
This project addresses that challenge by developing a currency risk-sharing facility for scaling up local currency climate finance in Uganda. Funded by the Finance in Common (FiCS) Innovation Lab, it is a partnership between UDB, the Climate Policy Initiative (CPI), the University of Leeds, and City St George’s, University of London.
The project seeks to design, test, and refine an innovative mechanism that reduces the cost of managing currency risk while enabling development finance institutions to expand long-term local currency lending for climate investments.
Research overview
The project develops a first-of-its-kind currency risk-sharing facility to support UDB’s local currency operations under its Climate Finance Facility. The facility is designed as a middle-ground solution between two unsatisfactory alternatives: full exposure to currency risk on the one hand, and costly full hedging on the other.
Its core innovation lies in distributing currency risk across three layers. First, a hedge provider such as TCX covers part of the exposure through a traditional hedging instrument, such as a currency swap. Secondly, UDB retains the currency risk on the remaining portion up to a predefined loss threshold. Thirdly, a donor provides tail-risk protection beyond that threshold (hereafter referred to as a ‘guarantee’ for simplicity). By combining a partial hedge with donor-backed protection against extreme depreciation, the facility lowers UDB’s cost of managing currency risk while significantly reducing its downside exposure.
Visual representation of the currency risk-sharing facility
The following figure is a visual representation of the currency risk‑sharing facility. A full description of the diagram is available in a separate webpage.
The project combines financial and legal analysis to design and evaluate the facility, focusing on the structure of the risk-sharing mechanism, the calibration of its parameters, and its operational feasibility in the Ugandan context. It builds on policy proposals developed in our earlier research project Enhancing MDB Capacity through Local Currency Financing, which explored mechanisms through which development finance institutions could absorb limited currency risk while receiving protection against extreme depreciation events. The present project translates those policy recommendations into a facility tailored to the Ugandan context.
Preliminary modelling suggests that large depreciations exceeding the proposed threshold occur relatively infrequently, on average around once every seven years. The modelling uses option models based on market UGX and USD interest rates combined with historical UGX exchange rate volatility. Using historical rather than implied volatility avoids the risk premia embedded in FX option prices, which reflect the illiquidity of these markets and the risk aversion of private investors. On this basis, guarantee calls are expected to remain limited.
The proposed design also incorporates symmetric risk sharing, meaning that the guarantor benefits if the currency appreciates beyond a certain level. Under this structure, and depending on the guarantee premium, the facility can remain financially sustainable for the guarantor and may even generate positive returns over time. These modelling assumptions and parameters will be further refined during the pilot stage of the project.
Key findings
The project’s findings suggest that the proposed facility offers a balanced and cost-effective approach to managing currency risk in local currency climate finance. Its main contributions can be summarised in five broad points:
- Reducing risk at lower cost
The facility lowers the cost of managing currency risk relative to full hedging, while significantly reducing downside exposure relative to full retention of currency risk on UDB’s balance sheet.
- Allowing flexible calibration of cost and risk
The model can be calibrated to reflect different operational preferences and institutional constraints. By adjusting the proportion of exposure that is hedged, the depreciation threshold retained by UDB, and the point at which the guarantee is triggered, the facility can be tailored to different cost-risk profiles.
- Protecting development finance institutions’ balance sheets
By limiting exposure to large depreciations, the facility helps protect UDB’s capital adequacy and financial position. This may free balance sheet capacity for additional lending, enabling UDB to expand its support for climate and infrastructure projects in local currency.
- Targeting donor support more efficiently
The guarantee is designed to cover only extreme exchange rate movements beyond a predefined threshold. This allows donors to focus their support on tail risks, rather than absorbing the full currency exposure or broader credit risks. The structure also does not require an upfront capital commitment, since the guarantor provides contingent protection and only makes payments if predefined depreciation thresholds are exceeded.
- Providing a scalable and replicable model
Although the facility is being developed in the Ugandan context, its underlying logic is adaptable to other countries and institutions facing similar currency mismatches. A pilot implementation with UDB would help demonstrate the model’s operational feasibility and generate evidence to support broader adoption. Over time, the approach could be replicated across multiple currencies and development finance institutions, contributing to a broader shift towards more sustainable and resilient local currency climate finance in LMICs.
By addressing a key structural barrier to local currency lending, the facility delivers strong developmental additionality, enabling development finance institutions to expand long-term local currency financing for climate investments while reducing vulnerability to exchange rate shocks.