Summary

The Uganda Development Bank (UDB) intends to expand local-currency climate lending through its Climate Finance Facility (CFF) by introducing the Currency Risk-Sharing Facility (CRSF). This instrument is designed to reduce foreign exchange (FX) exposure assumed through the CFF in an affordable manner. The CRSF combines partial hedging with a tail-risk FX guarantee to protect UDB against the depreciation of the Ugandan shilling (UGX) beyond a specific dynamic threshold. Developed via the FiCS Innovation Lab, the instrument is tailored to UDB but remains adaptable for other public development banks (PDBs) in emerging markets and developing economies (EMDEs) that borrow in foreign currency and lend in domestic currency for climate-related projects.

Instrument purpose

The primary purpose of the CRSF is to mitigate FX risk by allowing context-specific risk sharing. Preliminary modelling suggests that FX guarantees can be more capital-efficient than conventional hedging instruments, potentially mobilising greater climate finance. International financial institutions lending to UDB could provide these guarantees to deploy capital more efficiently than through loans alone. Back-testing from the year 2000 onwards indicates that large local currency depreciations exceeding the proposed activation threshold occur infrequently in Uganda—on average once every seven years—and that a guarantor would have earned profits in almost all years.

Core problem addressed

High domestic funding costs in Uganda, alongside a 12% statutory lending cap for UDB, make it difficult to provide long-term finance at affordable local-currency rates. The bank relies on concessional credit from multilateral development finance institutions (DFIs) denominated in US dollars or euros, which is then on-lent in Ugandan shillings. This exposes UDB to significant losses when the UGX depreciates. Traditional hedging options are often too costly or unavailable for the long maturities required for climate projects. The CRSF addresses these challenges by directly managing balance sheet exposure to FX volatility.

Key insights

The incubation process yielded several insights: layered risk-sharing arrangements are more affordable than conventional hedges; guarantees can attract additional concessional funds through dedicated trust funds; and the instrument can be calibrated to different cost-risk preferences. By capping extreme FX losses, the CRSF stabilises UDB’s capital position, supporting the continued provision of local-currency climate finance.

Context

Uganda must mobilise more than USD 28 billion by 2030 to meet its climate adaptation and mitigation goals. Current climate finance levels are far below what is required, and the investment gap is exacerbated by high long-term domestic borrowing costs. International climate finance is vital but exposes the country to FX risk; over 50% of Uganda’s public debt was denominated in foreign currencies at the end of the 2022/23 financial year. UDB’s CFF, launched in 2023 with UGX 50 billion in seed capital, serves as the bank’s dedicated green financing vehicle, targeting sectors such as agriculture, clean energy, and sustainable waste management.

Theory of change

The CRSF theory of change aims to increase affordable local-currency climate lending through improved management of currency risk. Immediate outcomes include effectively addressing FX risk through partial hedging and tail-risk guarantees. In the medium term, this is expected to increase the volume of UGX climate loans and reduce volatility in UDB’s cost of funds. The ultimate impact is that climate-aligned borrowers can access affordable long-term credit, private and concessional capital is mobilised, and local capital markets are strengthened.

Instrument structure and strategy

The CRSF distributes currency risk among three actors: a traditional FX hedge provider, the Uganda Development Bank, and a guarantor (a donor or DFI). Under an illustrative USD 10 million credit line, UDB hedges 50% of its exposure through a traditional currency swap. For the remaining 50%, UDB absorbs annual depreciation up to a 5% threshold. If depreciation exceeds this level, the guarantor covers the excess losses. Conversely, the mechanism is symmetric; if the UGX appreciates beyond the 5% threshold, UDB shares the upside with the guarantor. This “collar” structure improves financial sustainability and affordability for the bank.

Incubation and implementation

The 9-month incubation process involved financial modelling, stakeholder mapping, and legal feasibility assessments. Modelling results show that while an unhedged position has the lowest average funding cost (8.39%), it has the widest volatility. Full hedging has a fixed cost of 10.96%. The CRSF provides a middle-ground solution with an average funding cost of 9.82% and a much narrower spread of outcomes. Implementation follows a 24-month roadmap, including setup, pilot activation, monitoring, and final evaluation.

Replication and catalytic potential

The model is highly replicable for PDBs facing similar constraints. Successful replication requires institutional buy-in, access to concessional credit lines, and measurable FX volatility for modelling. Adaptable aspects include depreciation thresholds, the share of hedged versus unhedged exposure, and facility size. Fixed elements include the core layered risk-mitigation structure and the principle that the PDB retains small, expected FX movements.

Legal characterisation of the CRSF

Legal analysis concluded that the CRSF’s symmetric risk-sharing design should be characterised as a derivative (an option collar) rather than a guarantee. In English law, guarantees are typically one-directional obligations. The reciprocal contingent payment obligations of the CRSF make an ISDA Master Agreement the most appropriate contractual framework. This framework addresses issues such as payment netting, settlement flow alignment with debt-service obligations, and insolvency protection.