Over the last few years, the IDB has contributed to the expansion of domestic currency bond markets by issuing its own debt in the currencies of the member countries. In April 2004, the IDB became the first institutional issuer to launch a global bond denominated in Mexican pesos, offering a new asset class for domestic and international investors. This was the first international bond issue made available in the domestic capital market under the new financial regulatory framework adopted by Mexico in 2003 and the first AAA bond issued in the Mexican capital market. Since this first issue, the IDB has issued 18 other bonds in the currencies of Latin American countries, raising a total of approximately 1.3 billion. While most of the issues tapped the Mexican peso market (for a total of more than US$900 million), the bank has also issued bonds denominated in Brazilian reais, Chilean pesos, and Colombian pesos.

The IDB’s issues in domestic currencies may serve two purposes. First, they may provide funding that can be used for local currency loans to its member countries, which is a sensible option for many projects whose revenues are not at all related to the exchange rate. Second, given its prime borrower rating, the IDB expands the range of available credit risks in local currencies, in both domestic and international markets. This can help attract more investors to local currency instruments and develop a benchmark yield curve, which is valuable for pricing and giving liquidity to instruments issued by a range of borrowers.

Of particular interest is the potential use of local currency bonds to finance local currency lending. As the IDB cannot take on currency risk, it cannot “create” local currency lending but must simply act as a financial intermediary. It has two options for doing so: borrowing from savers in local currency and on-lending the proceeds, or borrowing in a foreign currency, lending in local currency, and hedging the exchange rate risk.

The effects of local currency financing on the aggregate level of available credit and distribution of currency mismatches throughout an economy are complex and will depend on

1. how IDB intermediation in the local currency markets (for debt and derivatives) affects the currency composition of the domestic supply of credit in the country;
2. how IDB intermediation in the local currency markets affects the allocation of local currency debt across firms and government;
3. how substituting intermediation in local currency markets for intermediation in foreign currency markets affects the total (domestic and foreign) supply of credit available to the country.

In the best case, the IDB could fund itself in a way that increases the willingness of savers to lend more in local currency or take on local currency risk and contributes to assigning available local currency credit where it is most needed in a way that reduces balance sheet currency mismatches, all without reducing the total supply of credit available to the country. In the worst case, the IDB would tap into the existing supply of local currency debt, favoring its clients but crowding out other borrowers. If these other borrowers, in turn, are more currency mismatched than the IDB clients, this might render the entire operation counterproductive, as aggregate vulnerability to exchange rate shocks will increase.

IDB (2005a) suggests that the positive effects of its participation in local currency markets are likely to dominate the negative ones. In particular, the IDB suggests that as its assets are default risk free, they will lead to increased saving by domestic residents. Since domestic residents hold a portion of their savings in local currency, this will translate into an expansion of local currency savings, supporting local currency debt. This effect will be largest in countries with the highest default risk. Furthermore, domestic residents may replace foreign assets in their portfolios with IDB local currency bonds, generating a capital inflow that reverses previous capital flight. In particular, pension funds may choose to shift from foreign-currency-denominated AAA assets to local currency AAA assets. This shift in the currency composition of domestic savings will have a positive effect on the aggregate supply of local currency credit. The reduction in the risk associated with local currency assets may also increase the demand for these assets by foreigners (who may have previously been reluctant to lend in domestic currencies because they were bundled with default risk). IDB local currency instruments may also play an indirect role in increasing the supply of local currency financing by fostering the development of domestic financial markets. Furthermore, in those countries with low monetary credibility, issues indexed to inflation linked to a consumer price index certified by a credible institution could benefit the local bond market.

On the negative side, an expansion in the supply of local currency credit in a particular country may result in a contraction in the supply of dollar credit to the extent that the traditional funding sources of the IDB (foreign international investors) are not tapped and remain inaccessible to that country. Countries with easy access to foreign savings will not experience measurable negative effects on dollar credit supply and in fact may actually benefit from tapping increased domestic onshore dollar savings. Countries with difficult access to foreign savings, however, may lose the allocation ensured by the traditional IDB intermediation through dollar lending and end up with less total credit available.