A unique study of FX-risk and donor funding

The Expert Group for Aid Studies, EBA, has published a new report that describes how fluctuating currency exchange rates affect Swedish aid funding. The report provides a lot of valuable findings and concludes with a number of recommendations that pinpoint several opportunities that could improve ODA funding. Better predictability can be achieved, but also an increase both in ODA volumes and the values received.

The report was authored by AidHedge Director Númi Östlund.

In this post, we do a quick summary of the report, through a discussion of the most important findings and recommendations. The post concludes with a brief discussion on areas for further research.

(Some of the) main findings

The overall finding might not be a great surprise to development practitioners: fluctuating exchange rates have a significant impact on the value of received ODA. You’ll know this if you work with donor-funded projects: the value of a commitment made in a donor currency changes with the involved currency rates.

As this study focused on Swedish aid, committed in SEK, almost all funding is affected. Implementing partners and recipients just dont know how much funding they will recieve.

The fluctuating rates of the five most important currencies in Swedish-funded ODA. Note: KES: Kenyan Schilling, MZN: Mozambique Metical, TZN: Tanzania Shilling, UGX: Uganda Shilling, ZMK&ZMW: Zambian Kwatcha. Note that a new redenominated Zambian Kwatcha (ZMW) was introduced in January 2013, replacing the previous Kwatcha (ZMK). In the diagram above, rebased value has been used for calculations of the rate changes. Source: EBA report

The result of this uncertainty is, of course, a direct effect on the quality of funded projects. Not knowing the value of the committed funding just does not allow for optimal budgeting or planning.

What donors are doing is, in essence, to say: We would love you to carry out this development activity. Please use (say) USD 10 million to get the best results. But sorry, we can't really promise USD 10 million, it’s really somewhere between USD 7.5–12.5 million. We still expect quality results and impact.

Being able to work with predictable funding has long been a key issue in foreign aid and development. What the study show is that this is something that must be understood from the partner perspective. It is not primarily about how much you spend, it's about what is received. And as it is now, that amount is highly affected by fluctuating exchange rates.

The risk and costs, both financial and operational, are pushed downstream to the weakest actors in the development system.

The figure shows how value fluctuates from the time Sida pledges funds over time. The first measurement (T+0) is the change in value in the disbursement of funds during the pledge year. The progression of years is represented as T+number of years. Source: EBA report

The report concludes that, while the costs and problems are clear, there are several readily available solutions that could improve ODA quality. The challenges of working with multiple partners and multiple currencies and countries are in no way unique to the development sector. There is a massive amount of best practice and lessons learned available, yet to be used.

And donor governments, in addition, have a access to financial services that could vastly improve funding, if used.

Key recommendations

The report provides a number of policy recommendations. All are possible to implement immediately, with no or just minimal administrative costs. We’ll only discuss two of the most important here, so be sure to check the report (or get in touch with Númi).

• Provide funding in working currencies when possible. ODA represents significant amounts of funding, but are only a tiny part of any governments currency transactions. Using established financial solutions donors could provide development partners with predictable funding in all major currencies (such as USD, EUR, GBP, CHF, etc.). Contracting could still be denominated in the donor currency, but with fund disbursements locked to the actual working currency. As major currencies represent most of the implementation costs, this would provide a huge improvement in funding quality.
• Explore innovative financial solutions for smaller currencies. Donors can leverage their guarantee instruments to enable innovative financial solutions for risk reduction in smaller currencies in developing countries. By extending a guarantee to a partner organisation that would provide hedging services for aid organisations, donors could support aid effectiveness while also providing additional liquidity in developing markets.

An illustration of how exchange rates affect the value of funding in a donor-funded project (SEK/USD). The left half of the picture shows outcome in the first half of a budget. The right half illustrates the remaining financial uncertainty.

Areas for further research

This report is a first of it’s kind. But the questions covered are clearly limited compared to those remaining to be understood.

• Understanding more financial flows: While Sweden is an important international donor, the fact is that Swedish funds are just a small part of all ODA. And ODA is only a small part of all financial transactions that are of importance to global development and foreign aid. Remittances are seven times larger, just to mention one. Questions of financial risk and efficiency for these flows is crucial.
• Expanding the analysis to more financial issues: exchange rate volatility is but one of the financial/economic factors that impact the value of funding for sustainable development and aid. Transaction costs, inflation, interest rates are some of the others.
• Exploring lessons learned and best practices. As most organisations are faced with these types of challenges, a wide selection of coping mechanisms has developed. Understanding those would provide others with (often) non-financial mechanisms to increase efficiency.

If you are interested in the report, contact Númi! He’ll be happy to discuss finding and recommendations in more detail. And he’s really interested in finding more examples of financial risk and efficiency in ODA.