MICROCAPITAL STORY: Does Microfinance Performance Correlate with Other Emerging Markets Investment, Part 3 of a 4-Part Series on the Cracking the Capital Markets III Conference Hosted By ACCION and Credit Suisse

On March 10-11, 2008, ACCION International and Credit Suisse held the third Cracking the Capital Markets conference on microfinance investment. The conference brought together hedge fund managers, institutional and private investors, leading rating agencies, and microfinance institutions (MFIs) to discuss the challenges, successes, and future of microfinance investments. The first and second articles of this series can also be found on the MicroCapital website.

As a follow up to a presentation at last year’s conference, Nicolas Krauss presented an update to an initial study on the correlation of microfinance to other emerging markets investments. In addition, he discussed whether the correlation (or lack there of) position microfinance as an attractive investment for portfolio diversification. Presentations from this panel can be found here.

The study by Dr. Ingo Walter and Nicolas Krauss, both from New York University’s Stern Business School, had the following key results. Firstly, MFIs showed consistently insignificant correlation to the S&P 500, while emerging market institutions and emerging market commercial banks showed significantly higher correlations. However MFIs demonstrated significant exposure to their domestic economies, especially regarding profit margin.

MFI’s low exposure to international markets maybe due to several general and bank-specific factors. Firstly, MFIs are mainly private-held companies, whose owners tend to have long-term interests and thus less sensitivity to market signals. In addition, MFIs clients have lower international exposure not being integrated into the formal sectors of the economy. Customers also often move “downmarket” to cheaper, domestic goods during times of crisis, likely adding to the contra-cyclicality of microfinance. Regarding bank-specific factors, many MFIs loan mainly to women, who have better repayment discipline. Furthermore, the MFIs’ lower operational and financial leverage; the shorter average loan maturity; and the close ties to and knowledge of borrowers also likely provide some insulation.

From these results, Dr. Walter and Mr. Krauss concluded that microfinance should be able to reduce portfolio volatility for international portfolio investors with the ability to diversity country risk. However, it is not a miracle investment and does not show negative or zero correlation with global capital markets.

The revised study made several key adjustments including: using 2 more years of data, using significantly higher quality data, accounting for subsidies received by MFIs, and including emerging market institutions as a benchmark. While the results were significantly more solid than in the preliminary study, Krauss advocated treating the results cautiously due to the use of accounting data for the MFIs. The full paper entitled “Can Microfinance Reduce Portfolio Volatility?” can be downloaded here.

Panelist Samuel Fox, VP of Structured Finance at Fitch Ratings, gave a rating agency’s perspective. While not surprised by the study’s findings, he raised concerns about how correlations will change in the future and what could lead to an increase in correlation. For instance, a larger capital base could increase MFI dependency on capital markets, while the percentage of capital investments done in hard currencies could lead to foreign exchange risk. From an origination and servicing perspective, maintaining servicing excellence and the close ties to borrowers will be essential in periods of rapid loan growth, and deterioration in this area could exacerbate MFIs’ credit risk.

However, Mr. Fox’s largest concern was the country exposure of microfinance investments and the correlation between MFI performances and the domestic economies. In addition, he points out that the study covers a period of benign sovereign markets, questioning how financial models will behave in periods of great emerging market distress. Currently, Fitch Ratings place a large emphasis on country exposure and not just individual MFI risk.

Rod Dubitsky, panelist and Credit Suisse’s Asset Back Securities Head of Research, addressed proposed several other factors to consider for further investigation. For instance, does the correlation change if looking at urban or rural MFIs, or if one considers the size of the MFIs? Is there a cross-correlation from borrowers using multiple lenders? Also does the type of loan product- individual, housing, etc.- affect the correlation? Or are there cultural influences which have led to greater social security networks in some regions over others? Finally, he stressed the importance of standardized default and performance measures, questioning how much the group-lending system covers up for delinquent individuals and thereby skews the performance metrics. The industry needs to track future deterioration of default risk and determine whether or not it could be masked by refinancing or a particular MFI’s definition of delinquency or default.

The last panelist was David Gough, Investment Partner at Grassroots Capital, who utilized anecdotal evidence of MFIs. Through his three examples, he emphasized the importance of preserving what has made MFIs successful in the past, in particular the focus of providing access to capital to poor people who do not have other alternatives. He believed that if microfinance remains true to this social component, the industry would likely continue to succeed.

While the panelists brought up thought-provoking discussions regarding future correlations, the constraints of the study remain in the data available for MFIs. In response to Mr. Dubitsky’s comments, Mr. Krauss noted that the lack of mark-to-market data does not allow the study to test separate sub-groups. Finally, the ultimate question for single-minded investors is whether or not the reduction in portfolio volatility and risk is enough to make microfinance an attractive investment given that it historically has provided below market rate returns of roughly 250 basis points.

ACCION is a private, non-profit microfinance organization, specializing in global micro-enterprise loans, business training, and other financial services. Credit-Suisse Group is a global financial service company, headquartered in Zurich. Credit-Suisse’s participation in microfinance can be found on the company’s website.

by Jennifer Lee

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