PAPER WRAP-UP: Foreign Exchange Rate Risk in Microfinance: What Is It And How Can It Be Managed?, A Focus Note by the Consultative Group to Assist the Poor (CGAP)

Published by CGAP, January 2006, 16 pages, available for viewing here.

Because most microfinance institutions operate in developing countries where risk of currency depreciation is high and debt restructuring occurs periodically, they are particularly vulnerable to foreign exchange rate risk. A recent CGAP survey not only revealed that 50 percent of MFIs have no protection mechanisms in place, but also indicated a general lack of understanding of both foreign exchange risk and the extent to which MFIs are exposed. This paper seeks to raise awareness of the issue of foreign exchange rate risk within the microfinance sector first, by providing a brief overview of the different components of risk, second, by looking at current techniques employed by microfinance institutions (MFIs) and investors to manage these risks, and finally, by making recommendations on mitigating or avoiding exposure to exchange risk.

The three components of foreign exchange rate risk are: devaluation or depreciation risk, convertibility risk, and transfer risk. The first arises in microfinance when an MFI acquires debt in a foreign currency (usually USD or EUR) and then on-lends in a domestic currency (DC). Because the MFI then has a liability in a hard currency and assets in DC, resulting in a “currency mismatch”, fluctuations in the relative values of the two currencies may threaten the financial viability of the institution. The second component of foreign exchange rate risk is convertibility risk, which refers to the risk that the national government will not sell foreign currency to those with hard currency debt. Finally, transfer risk is the risk that the national government will not allow foreign currency to leave the country, regardless of its source. In both of the latter cases, while the MFI has the capacity to make hard-currency payments, they are unable to do so due to restrictions imposed by their government.

There are several options for organizations exposed to foreign exchange rate risk. One option is to “hedge” against their exposure by using a number of conventional hedging instruments. One of these is a forward contract, an agreement to exchange or sell foreign currency at a certain price in the future. Another is a swap, an agreement to simultaneously exchange or sell an amount of foreign currency now and resell or repurchase that currency in the future. Lastly, options are hedging instruments that provide the option to buy or sell a foreign currency in the future once the value of that currency reaches a previously agreed price. While all of these conventional hedging methods usually protect MFIs against all three components of foreign exchange rate risk, they are often not easy to obtain in the shallow financial markets in which many MFIs operate.

Because hedging is not without challenges, both in terms of cost and availability of instruments, organizations may also choose to only partially hedge against their exposure to foreign exchange rate risk. Back-to-back lending is the method most commonly used to hedge against devaluation or depreciation risk, but one that often fails to protect the MFI from convertibility and transfer risks. Under this hedging option, the MFI takes out a foreign currency loan and deposits it in a domestic bank. This foreign currency deposit provides the collateral for the MFI to take out a DC loan from the local bank to fund its loan portfolio, and is released upon repayment of the DC loan. A similar option is the letters-of-credit method, in which the domestic bank uses a Letter of Credit from an international commercial bank, instead of a foreign currency deposit, to extend a DC loan to the MFI.

In yet another hedging method, the MFI converts a hard currency loan into local currency to build its loan portfolio. Throughout the lifetime of the loan, in addition to regular interest payments, the MFI also deposits pre-determined amounts of hard currency into a “currency devaluation account”. At loan maturity, this account compensates for any shortfall after the principal has been repaid according to the original exchange rate. However, if there is not enough in this account, the lender suffers that loss. Under this arrangement, risk is shared between the MFI and the lender. On the other hand, regular interest payments and deposits may become a financial burden if the DC depreciates, and the MFI may still be exposed to convertibility and transfer risks if the currency devaluation account is held domestically.

Organization may also choose to deal with foreign exchange rate risk in a number of other ways. The first is to do nothing and accept the consequences, an approach not recommended for substantial exposures. The second is to limit their exposure to foreign currency liabilities. The paper recommends that the level of prudential limits should correspond directly to the level and strength of an MFI’s equity capital. However, limiting exposure to risk also obscures the advantages of hard currency loans. Finally, MFIs can pass on foreign currency risk to their clients in the form of higher interest rates, such that the MFI bears no devaluation or depreciation risk. However, this method has been shown to increase client default rates in the case of DC depreciation and still does not protect the MFI from the other two components of foreign exchange rate risk.

The paper concludes with general recommendations for the different players of the microfinance sector. First and foremost, MFIs should give priority to domestic sources of funding or foreign funding in local currency. If a foreign currency debt is obtained, MFIs should analyze and adopt suitable hedging instruments or methods to mitigate risk. CGAP also advises that MFI seek training or legal counsel to enable them to negotiate the best terms with foreign and domestic lenders. Managing bodies of the MFIs also need to establish and evaluate appropriate risk parameters and policies. The paper suggests that because investors are typically more financially sophisticated than their borrowing MFIs, they should shoulder the responsibility of ensuring that their borrowers understand and have recourses for managing the risks that they are taking on. Finally, the microfinance sector as a whole should work to promote the development of local capital markets in order to increase MFI access to local currency funding. In addition, by including foreign exchange risk in ratings of MFIs, rating agencies can encourage both MFIs and investors to educate themselves on the issue.

By Mary Fu

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