How the financial system can work for climate, not against it: Moving Money
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Welcome to Xero. I am Akshat Rati. This week, back to basics. It's clear that we are in a moment of flux in global affairs.

President Donald Trump's America First doctrine is shaking up diplomacy, trade and markets. The hope that wars across Europe, the Middle East and Africa will ease up isn't really panning out. At the same time, climate change isn't slowing down either. And the impacts in vulnerable countries are growing.

The energy transition isn't taking a break either. Last year, the global spend on energy was $3 trillion, of which more than $2 trillion was on clean energy technologies, according to Bloomberg NEF.

So in trying to make sense of things, I found that sometimes it can help to go back to the basics. There are fundamental forces that shape our world. And especially during a tumultuous time, it helps to understand them a little more deeply to be able to make a better mental map of the future. So for the next three episodes, we're going to explore the basics of finance for climate solutions and continue our Moving Money series.

Developing countries have said the number we need is a trillion. Developed countries have said maybe, but that's not coming from our budgets. There's no space there. That could come from an onion of things. The outer layer might be private sector, the middle layer might be MDBs, and the inner layer may be government budgets.

We're welcoming back Avinash Prasad, Special Advisor on Climate Risks to the President of the Inter-American Development Bank and former Economic Advisor to Barbados Prime Minister Mia Motley. Over the next three episodes, we'll be exploring the role of multilateral development banks and the various innovative financial tools that can unlock private sector investments in the climate transition.

But first, let's take a big picture look at how the global financial order works in the first place and how it can be reshaped for the climate era. We start the conversation by addressing one of the big challenges right now, the cost of capital. Think of it this way. When the cost of borrowing money is cheap, it's easier to build the clean energy projects we need, like solar panels, wind farms and batteries.

Developed countries typically enjoy cheaper costs of capital, meaning stuff can be built with lower borrowing costs. Developing countries, on the other hand, have much, much higher costs of capital, thanks to real or perceived risks of doing business there. This slows their growth, and in the worst case scenario, can lead to a debt trap, where they borrow more money just to make the interest payments on old loans.

So I asked Avinash, how do we flip the script? And how do we lower the cost of capital and make the financial system work for climate action, not against it? Hi Avinash, welcome back to another episode of Moving Money. Thank you. Today we're going to talk about the cost of capital. We've seen a lot of money go into developed countries for renewables and those countries typically have lower income.

interest rates and thus they're able to borrow money and pay small amounts on their interest payments. But developing countries typically have higher interest rates and thus even if they had the capital to be borrowed, they will have to pay more on those interest rates. But surely if the cost of renewables just keeps falling, high interest rate, low interest rate doesn't really matter. It'll scale, right? So the issue of the cost of capital only occurred to me

A couple of years ago. And indeed, if you look at the negotiations, this concept of cost of capital,

It's only now in communiques, in G20, in the last two years. Oh, wow. Even though interest rates are a thing that the financial system cannot work without. People were not thinking those terms. As you and I have talked about before, many of the people involved in this space are not monetarists.

macro people. They are project financiers. So they're not thinking about global interest rates or country interest rates. They're thinking about a particular project they're trying to finance. And I remember I was in a negotiation room and the negotiator of a small European country is saying, finance isn't a problem, he says. And the rest of us are completely bowled over by him thinking this because we're thinking finance is the problem. And

And I'm sitting there trying to understand him. And I pick up my phone and I Google, has his country issued a 10-year bond recently? And it had. And his cost of capital for his government was like 3%.

And he was sitting next to the negotiator from South Africa. So I then Google, what was the last 10-year bond issue for South Africa? 12.5%. And the other next to him was Brazil. And I Google again, and it's like 13%. I'm thinking, okay, that's the thing. He's not experiencing the cost of capital. So for him, finance isn't a problem.

For him, it may be about policies and regulations and how does he tax the right thing and subsidize the right thing. For the other two countries, there's no money flowing. Isn't the cost of capital just simply interest rates? I have a mortgage. I pay a particular interest. Sadly, it's gone up in recent years. Well, what are interest rates? It's the price of money. Which is the cost of capital. It's all circular. Not entirely. So in Europe and the United States...

Capital is abundant and it is cheap. There's a lot of savings, a lot of capital, and the amount of investment going on is not huge. So investment takes away from the savings and makes the capital more scarce. But there's abundance of capital. The price of money is that prices, demand and supply, demand for the money to invest and supply the money through savings.

You go to a developing country and there's very limited savings because they're poor, they're small, their economies, maybe a big country, big population, but the economic activity is small. And the demand for things that could be done are huge. So, yeah.

Capital is really scarce. So demand high, supply low, prices high. Their cost of capital is high. Now, when you understand it in that way, you realize, well, the solution, because many people say, ah, yes, well, this is because they're having to pay a lot of foreign exchange hedging costs. So why don't we just borrow locally? Yeah.

Borrow locally means more demand for investment in a place with very limited supply of savings. So that's going to push the cost of capital up even more. So what we actually need to do is create a channel, a channel from the place of abundant cheap capital to the place of scarce expensive capital.

And when we build this channel, we're trying to figure out why is this channel not flowing? Why is money not flowing? And there are various obstacles. And one obstacle is that, well, the abundant capital is in dollars and the scarce capital is in a local currency and you have foreign exchange risk. Because one of the interesting things about renewables is, you know, why is this a new problem? Again, foreign exchange is another one of those issues that was not on the communiques agendas anywhere just two years ago.

because fossil fuel investments, for example, are often in dollars because the thing you're investing in is priced in dollars, can be traded in dollars. But when I'm buying a solar farm in Brazil...

I'm not earning dollars. I'm earning local currency, real. So now I have a foreign exchange problem. I'm earning revenues in one currency and I've got this other currency that I've invested in. That's true. If you bought gasoline in Brazil, you would be paying in real. And then somebody up the chain has to pay...

Exxon Mobil, I guess. I can sell gasoline in US dollars, though. I can export the gasoline in US dollars. I can't export my solar farm or wind turbine in US dollars. So it's a fundamentally different problem. And so we want this massive investment and we're coming across this problem. And so the solution is to clear out this channel, to unblock this channel.

And we found that the project financiers think that a solution is to lower the risk of the project. As someone who used to work for a developing country government and sort of like I was a chief investment officer, if you like, for Barbados for a few years, my job was to speak to these investors and try to attract them. And what I was competing with, the governments basically offered the investors a lot of

We tried to deal with all of their uncertainties. They had to pick the right things to invest in, but if they were worried about the currency, we would say, well, we'll try to hedge that from you. They were worried about the change in law, change in tax. They were guaranteed everything, and they still didn't really want to come, partly because of the foreign exchange volatility and uncertainty. So we think the way in which we can reduce the cost of capital in developing countries is

is to unblock the flow from places of abundant capital by managing the foreign exchange. Now, if cost of capital is a problem,

It really frames your approach to many things. So in a rich country, you can think about dealing with the problem of carbon in the environment by saying, I need to tax things that pollute and subsidize things that are clean. And because the cost of capital is low, that price signal will have investors switching. They will stop investing in the high tax thing and they'll invest in the subsidy thing.

Go to a developing country and you impose the same tax and subsidy, but you've got a high cost of capital. They can't do that because they will need lots of money to invest in the new thing. And that's the other thing about renewables is they're very capital intensive. Their operating costs are low, but they're very capital intensive. So you need to have capital and capital costs a lot of money. And that is stopping renewable investments happening in developing countries.

We've talked about how if we want the capital to flow to developing countries, it's going to come from capital owners which sit in developed countries. If they invest that in developing countries, that'll allow for more capital to be there in developing countries and thus will lower their cost of capital. One is currency exchange risk. One is political risk.

What else is there that they worry about? And can they hedge those other risks as well? Economists, we like to break things down into simple things. It's a reductivist science. We'd love to be able to tell people there's only one thing you need to do. The reality is the actual risk

process of investing is quite messy. And so a company will say, why am I going to this place I've never been to before to manage a permitting process I've never managed before? So there's a whole bunch of uncertainties. You know, the difference between uncertainty and risk is risk I can quantify. A lot of these things they can't quantify. Will it take a day to get my permit or will it take me 300 days?

Huge impact on the cost of this business. And so there are multiple things, but many of them, there is an insurance for it.

So the insurance arm of the World Bank, MIGA, will offer you political insurance. Export credit agencies offer political insurance. So there are a number of types of insurance to reduce that. But a country can't offer you insurance against their own currency. Because that's saying insurance against themselves having a problem, at which point they won't be able to do anything. So it's...

So we need other players to come in and manage that. But I think that's the main obstacle are the kinds of risk that the country themselves can't guarantee because the country is trying to guarantee you everything else. One of the things I found I have to explain often to my friends from developed countries is that developing countries promise investors that they can take them to court in a foreign court for any change in policy.

Now, if you went to Britain or Germany and said as an investor, I want that if you change your policies, that you have to compensate me in full. And if you don't, I'll take you to London. They'll look at you and think you're crazy. They'll say, I can't change policies. What's happened to sovereignty? I have the sovereign. I'm a parliament. I elect people. I change policies. But developing policies.

countries, they've had to give up that to attract investment. So they actually guarantee a lot of stuff, but there are things they can't guarantee. After the break, is cheap money prolonging the lifespan of fossil fuels? And by the way, if you're enjoying this episode, please take a moment to rate and review the show on Apple Podcasts and Spotify. It helps other listeners find the show.

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One way to try and tackle the climate problem is to electrify as much as possible and decarbonize electricity. Now, we're getting pretty good at the decarbonization of electricity part because clean energy is getting cheaper and there are big forces, economic forces, demand levers that are coming for clean power.

On the electrification side, we aren't doing all that much. There is electrification of transport that is happening, but most of the forces of electrification are in countries that are fossil fuel poor.

So countries like China, which does not have very much oil and gas, or India, which does not have very much oil or gas, are electrifying much faster than countries like the UK or Germany. Can I just ask a question there? So you're saying the degree of electrification is more driven by...

whether the country has fossil fuels, as opposed to, I guess, my previous thinking was it was about sectors, right? So industry, which may be hard to abate, is hard to electrify parts of sectors. But you're saying it's less sector driven and more country driven. Correct. You can electrify parts of industry and there are technology constraints on how much you can electrify or how quickly you can do it or what cost you can do it.

But the primary driver of electrification so far has been more tied to what fuels that country has access to domestically, because any fuel that they have to import is more expensive as to trade deficit, etc., etc.,

So it puts developed countries like the UK and Germany and the US below the world average when it comes to their source of energy coming from electricity, which might feel strange to people. But projecting four years further, if America keeps on that trajectory,

which is to not electrify all that much, and the rest of the world like China and India start to electrify more and more, we could start to see America become less of a leader in the future of energy, which is a strange thing to say today because America produces the most amount of oil in the world, the most amount of gas in the world.

But I am talking about the future of energy, which I believe is an electrified future. Well, you're not just talking about the future of energy, Akshat. It's also the future of economic growth in these countries because electrification produces significant efficiencies, which boost growth over and above the benefits that now will be coming from cheaper fuel sources.

And that to me is the central point I want to get to as we explore why energy and economics play an intertwined role. So as I was thinking about whether there's an economic driver for America to electrify, I couldn't find one. It is blessed with fossil fuels. It will have fossil fuels for a long time. That is an energy equation that I can understand pretty easily. Well, couldn't the driver be that it is actually more...

economically efficient. Perhaps, but only if there is an economic constraint on that country to want to be more economically efficient. And you're saying partly through the fact that the fossil fuel market and prices are actually a fairly...

contrived thing. They're partly controlled. Supply and demand can be fairly controlled. That they have enabled them to have a cheaper price than elsewhere, which is actually slowing their shift towards a more fundamentally efficient thing to do. When there was an economic crisis, an energy crisis in Europe after Russia's attack on Ukraine, Europe started to electrify faster.

America tends to face none of these crises. It doesn't have wars on its borders. It doesn't have an energy crisis given how much it's blessed with fossil fuels. And then finally, this is the thing that makes it seem like it's got the most unfair advantage is it's got the world's reserve currency. I think you've actually created a whole other reason why fossil fuel subsidies are bad.

People think fossil fuel subsidies are bad because of the fact that we're subsidizing a polluting industry, but it's also subsidizing economic inefficiency and slowing the adjustment.

And the fact that the U.S. has reserve currency status, you're saying, allows them to do that for longer, allows the frog to be in the boiling water for longer than it might otherwise be able to do if it didn't have those crutches. Now, reserve currency status is something that many people find hard to understand.

to grasp. And I find a useful way of saying it, especially for people of my age who remember writing checks, is that reserve currency status is like writing checks to pay for things that nobody ever cashes. They're quite happy to hold your uncashed check because your uncashed check is a reserve currency that they could use in the future when they're in a difficult situation.

And so that allows them to consume more than they produce, to run a current account deficit, run a fiscal deficit. But countries with reserve currency status, where people are happy to sell goods but not cash the checks, can run these deficits. But it might be worth taking even one more step back to understand why we ended up in this situation in the first place. My understanding is...

Currency used to be tied to the gold standard. If you didn't have gold, you couldn't produce the currency. And then at some point that was taken off. And so a currency just became a fiat, which is it is backed by the status of that government. And you have to trust in that government to provide you the value of that currency. And because America was the world's hegemon at that time, the dollar started to become the reserve currency of the world today.

Maybe there's a better way of understanding this. Yes, I'm not entirely sure that's the way I would view it. Before the dollar was a reserve currency, sterling was the world's reserve currency. The Roman currency was a reserve currency. You're finding Roman coins thousands of miles away from where the Roman Empire was because clearly their currency was a reserve currency. So the key to being a reserve currency is you are a big trader and

And there's value in people holding your currency and being able to buy your goods in the future. So they are happy to hold your currency. If you don't produce anything and they don't sell you anything, that's not very valuable. So we've never really had a small country or a non-trader ever become a reserve currency.

currency country. So it's a function of your position in the world trade, and it kind of amplifies your position. So if you're the world's biggest trader, you then become even bigger in international finance. So the US may be one side of 50% of global trade, but the US dollar is one side of almost 80% of financial transactions.

because it has this reserve currency status. Ali Zaidi, who is the National Climate Advisor to President Biden, said that if under Donald Trump, America doesn't pursue the technologies of the 21st century, which are mostly electric, it would be economic malpractice because...

As a result, America will start to fall behind the rest of the world. And as it does so, it may have to trade less with the world. And maybe the reserve currency status of the dollar starts to weaken. But that would be hell. I mean, I think that we have some experience of that. So if becoming a reserve currency is like writing checks to buy stuff and no one ever cashing your checks...

losing reserve currency status is all those checks come back to be cashed at the same time. This is what happened in the UK from the mid-1960s. It led to the sterling devaluation of 67, the so-called Basel Accords of 1968, which were when there had to be an international agreement to stop people sending back

their sterling and asking for it to be repaid in gold or other things. They had to have a special agreement. The irony was the minute they announced this international agreement to save sterling, it woke everyone up to the fact that sterling was in grave challenge and it collapsed afterwards. So the September Basel agreements in 68 were a real problem. It's like the Streisand effect, but...

playing out in the 60s. Now, one thing I enjoy about our conversation is that we start from one place and we typically start to unspool more and more complicated things. One thing that comes up again and again is the international system. Now, what is a way to define the international system? I think we all have a sense of it, but is there a clearer way of understanding it? I think it actually comes back to

the international reserve currency aspect. So the international system, to me, you see it most when there is a global fright of some kind, a shock. It could be a war. It could be some natural disaster. You see that investors get scared and investors who get scared run to safety.

And what we're finding that they run to the same place. That's the international reserve currency. And that's today is the U.S. dollar. So you see by the system, we had this ebb and flow of capital to and from U.S. dollars. And that's the system.

And now that's partly a function of history, a function of the size of the U.S. economy, that it has the capacity to use, absorb your dollars that you've kept as reserves. It also then becomes morphed into conventions.

So when you look at credit ratings, when you look at accounting standards, the U.S. dollar and dollar assets are given special status because the convention writers will say, well, that is more liquid if you've got it in dollars. And so the world has safe assets and these safe assets are in U.S. dollars.

And it's a very interesting dimension of development is that the U.S. is an exporter of safe assets and developing countries are importers of safe assets. And that's the international system. But if China is now running a trade surplus, substantial one, and has been running it for many, many years now,

It's also starting to wield a lot of power with this yuan. So the Chinese central bank has created a digital yuan. And I have heard from suppliers in Europe that get their solar panels or other electricity related infrastructure from China directly, find it easier to pay electricity.

the Chinese supplier through the digital yuan rather than having to go through multiple banks where the euro will be converted to a dollar, will be then converted back to a yuan and go through costs at every transaction. The cost of transaction falls, the speed of transaction falls and more and more yuan gets traded. That's an important development but you know the measure of whether it is having global impact is when China starts running deficits.

China running a surplus is a sign that people are not really hoarding yuan. When people start hoarding yuan internationally, then China goes into that place where they are consuming stuff, writing checks to pay for it, checks in yuan, and people aren't cashing the checks. So they can consume more than they're producing and running a current account deficit.

And clearly that's not where we are today, but we may not be a million miles from that.

So our future, if the future is Chinese, then that future contains big Chinese deficits. So this power imbalance where America acts as a fossil fuel state because it has so much fossil fuels and has this reserve currency that gives it essentially an unlimited checking account, how does that make it easier or harder for developing countries to move to clean energy, to increase the amount of climate finance that we are going to need where money is?

BNB dollars flows from America to developing countries. Now, it is actually strongly linked, but I need to build that story a little bit. So firstly, if we want the big middle-income countries, India in particular, Brazil, Mexico, Indonesia, South Africa, to...

shift into renewables. And the planet needs them to shift massively and rapidly. The future energy demand in India is about to explode. And if those are fossil fuel fired, that's going to be a problem. We're expecting massive investment. We need massive investment. By definition, more than they have domestic savings. If they have enough domestic savings to match the investment, we know we're not doing enough investment.

because we're requiring this massive global-sized investment boom. So they have to get the money from abroad. The international system has to work for the planet and for climate, and it's not.

because of this imbalance. And as a result, we have these very different costs of capital. The cost of capital in India, even India, big country, deep liquid markets, would be about 8% to raise money, 8% plus, while it may still be 3%, 4% in Europe. So we need to bring capital from places where it's abundant to places where it's scarce. And this channel is blocked.

The channel is blocked because investors are concerned about this reserve currency status and the impact of that. And they don't think in terms of reserve currency status, but what they're thinking about is currency volatility.

Because if you are an import of safe assets, what happens is your currency is very volatile. When things are going well and people don't need safety, people are flooding into your country and your currency is booming. When things are looking uneasy around the world, it may have nothing to do with your country. It may be your neighboring country. Then money is fleeing. And so the currency is going up and down and you can do nothing about it.

And international investors see that. They see that volatility and they're saying, well, I can't manage that volatility. That volatility is not even to do with your country. It's to do with the international system. And what can you do about it? Now, when you have problems in a country with reserve currency status, they can do stuff about it.

You know, when the economy is hit badly, they can cut interest rates. They can expand spending. Investors are still there. They're not fleeing.

They're not worried about your policies. This imbalance in the system is blocking the flow of money from places where the capital is to places where we need the capital. So we need a solution that takes away this imbalance, that actually means that for renewable energies, we can count these middle-income countries as being part of

of the reserve currency zone and not subject to this kind of volatility. And that's something we're working on with the foreign exchange liquidity facility using the fact that the multilateral development banks are also AAA. So they are safe assets.

And so we will spread our cordon of safety around projects involved in renewable energy so that the international investor knows they can rely on a AAA development bank to be lending the project dollars at times of this international stress. The project has to pay it back.

but they're less subject to the volatility of the international financial system and the volatility of the currency markets. That's a stunning explanation for a thing that

I came across in my very early days of journalism. I joined a news organization called Quartz. And on the very first day of my job, there was a betting round going on in the general Slack channel. And it was on how many jobs in the U.S. will the jobs numbers say.

And it made no sense to me as somebody with a science background, not an economics background, why the world cares about the US economy producing a few hundred thousand jobs in a monthly basis.

Now, I know because when something happens to the U.S., when it sneezes, everybody cares because of the dollar, because of the reserve currency, because tiny volatility of the U.S. economy has much bigger ripple effects in the rest of the world. And, you know, what happened during COVID is a very interesting way of matching something that everyone experienced and so know a little bit about with this international financial system. So COVID happens, impacts us all roughly around the same time.

The developed countries with their reserve currencies are able to slash interest rates. We go back towards zero. They're able to expand fiscal policy and investors don't flee because they see governments reacting. Investors flee from the developing countries who are unable to act that way.

So they have to start raising interest rates to keep money in and they have to cut back their spending. Their currencies are falling and they deepen their recession because that's the only way they can respond. Then as a result of them deepening the recession and the developed countries being able to respond quickly, the developed countries have the recovery quicker. So now what they've got to do is they've got to raise their interest rates so that they're recovering faster, inflation is coming up, so they raise interest rates and

and sending their currencies up. And again, money's fleeing from the developing countries because they're now being attracted from these higher interest rates available in the safe haven. So again, the recovery slowed in developing countries because they've got to respond to money leaving. So when they should be recovering, the recovery is delayed because they're raising interest rates before their economy's recovered. And they're having to cut back spending before their economy's recovered.

So what you saw was the response of the developing world was they were unable to respond fast enough in terms of policy on the way down, and they were unable to recover fast enough on the way up. And that was because nothing to do with what they were doing in their country. That was to do with the international financial system and the way it works.

And in some way, as climate change plays out and more and more disasters are felt, let's hope it's never as extreme as the pandemic was at any given time, but we will sustain that level of impact over a longer period and we'll see developing countries suffer through the same cycle, perhaps in a lengthier timeframe.

developing countries, especially finance ministry officials, central bank officials, they have long seen this and long wondered what can we do about it. It's been very hard to do something about it because they were never very significant in the international economy. Now they are.

They are looking, so for example, the BRICS countries are thinking about, well, maybe we should create our own reserve currency. And because the BRIC countries are big traders, they actually have the potential of doing something in a way that they couldn't have done, say, 20 years ago.

I'm not sure they have a solution yet, but there's a potential that they could do something. And it would seem to me that it would be in the interest of the beneficiaries of the existing system to prolong that system by trying to make the system work better for everybody. And if they don't do that, the system will at some point be usurped by another system.

Could you imagine what that other system might be? The future of international reserve currency status will be determined by who is the biggest trader.

And we're in a world increasingly where China is exporting and importing from developing countries and maintaining its increasing share of international trade. And so they are potentially the next beneficiary. And, you know, India is an alternative as well because India,

The one challenge that China has, has a few, but one of the main ones. And often you hear people say that China will get old before it gets rich. That the one child policy meant that China has an acute demographic and it's aging heavily and that aging will slow its growth and growth.

slow its economic presence globally. India is still at a sweet spot on demographics and expanding and that divergence will increase. And so we will be in a world at some point in this century in which India is the world's largest economy and the largest trader. And so India or China may become the next

reserve currency. Wait, what? I mean, I thought it would be either an American century or Chinese century. I'm an Indian, but did not expect India to become the world's largest economy. And it's not something they're intending to. You know, whilst America and China have been quite deliberate about their international role, it will be in somewhat typical Indian fashion, haphazardly and happening just out of some crazy evolution.

Thank you, Avinash. Thank you very much.

That's the sound of Japan's Maglev train performing a test run at 500 kilometers per hour. This episode was produced by Oscar Boyd. Bloomberg's head of podcast is Sage Bauman and head of talk is Brendan Newnham. Our theme music is composed by Wonderly. Special thanks to Maitli Rao, Somersadi, Moses Andem, Blake Maples and Siobhan Wagner.

I'm Akshat Rati, back next week for another episode of Moving Money.