by Chinq Yee Chong - Risks, Trends/Challenges -

MICROCAPITAL STORY: Reducing Foreign Currency Risk In Microfinance Transactions – Observations by MFX Solutions At A Hanson Wade Conference On Microfinance Investments

The importance of hedging against fluctuations in foreign currencies was highlighted on more than one occasion during the recent ‘Investments In Microfinance’  conference that was held in London and attended by a variety of participants in the microfinance sector, including MFIs, investors, bankers, lawyers and researchers. Mr. Brian Cox, Executive Director at MFX Solutions, mentioned that currency risk and mismatches are factors that hinder growth in the microfinance sector. He added that volatility in emerging market currencies, which has become increasingly evident in the current crisis, can be better managed by MFIs. MFX Solutions is a new company that is dedicated to managing global currency risk in the microfinance industry. As highlighted in a previous Microcapital Story, the company aims to make hedging instruments accessible to microfinance lenders in developing markets.

Some commentators at the conference observed that it is much easier to secure a derivative or a hedge against currency fluctuations in the more established markets where there are many dealers who are willing and able to provide such protection at acceptable costs. Lending to MFIs in emerging market economies in hard currencies such as the US Dollar or the Euro comes with a different set of risks than lending to conventional financial institutions in the more developed markets. MFIs typically on-lend the funds received from their lenders to their microfinance clients in the local currency. This exposes the lender or investor to the risk that the local currency may, for political and / or macro-economic reasons, devalue against the hard currency in which the loan was denominated. This in turn would affect the ability of the MFI to repay on the loan given that the MFI would typically receive repayments from micro-borrowers in the local currency.  

Mr. Cox mentioned that the current crisis has had an impact on the balance sheet and creditworthiness of some MFIs. He mentioned that prior to the crisis, many MFIs were ‘accidental’ currency speculators in that they did not have a system in place to deal with currency mismatches and how volatilities in local currencies may affect their foreign denominated loan exposures. Treasury management functions within MFIs were highlighted as being an important priority, particularly in uncertain macro-economic conditions.  

MFIs in the audience agreed that obtaining protection against foreign currency risk in microfinance tended to be a costly exercise as it is often difficult to find a dealer or a company who is willing to provide currency risk protection for small transactions (such as transactions with a notional amount of less than USD 250,000) involving illiquid currencies. Mr. Cox indicated that MFX Solutions will focus on providing such protection in frontier markets and mentioned that the company is willing to consider providing foreign currency hedges for small transactions on a ‘non-deliverable’ (and therefore cheaper) basis. He also mentioned that MFX Solutions may not insist on counterparty collateral for such hedges. In conventional hedging, it is not uncommon for the hedge provider to insist that the counterparty supply collateral in the form of cash or liquid securities.  

During a discussion at the conference, some members of the audience suggested that a better strategy might be to encourage MFIs to diversify their funding sources. MFIs should borrow in the local currency where possible. Some commentators encouraged MFIs that do not currently take deposits to transform into a structure that would allow them to do so. Deposits were regarded by many as a stable source of local currency funding although some alluded to the fact that there have been rare instances since the crisis began of depositors removing their savings on a wide scale. One commentator suggested that institutions such as FMO and KfW Bank should consider issuing paper in the domestic markets in order to boost the domestic capital markets and to provide more local currency to fund MFIs.  

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