UNITED NATIONS CAPITAL DEVELOPMENT FUND    Microfinance

Issue 12 / May 2005

Issue Table of Contents

Update

on the International Year of Microcredit 2005

Marketplace

Made by Microentrepreneurs

Upcoming Events

Conferences, events and trainings.

Links

New websites and publications.

Share your news!

If you have a current news story or know of an upcoming event that would be of interest to the network,
please email the Editor, Vanessa Ward.

Sign up

to receive Microfinance Matters by email

Past Issues

By Maheshan R. Fernando, Consultant, MicroVest*

There is currently much debate over whether commercial investments in microfinance pass foreign exchange risk exposure to poor clients through high interest rates - i.e., whether foreign investment in microfinance is expensive for poor people. But what makes foreign currency exposure such a problem? "The largest sources of non-donor foreign capital to local microfinance institutions (MFIs) are generally denominated in hard currencies such as the US dollar and euros. However, MFIs must make loans to the poor clients in the local currency, immediately exposing MFIs to foreign exchange rate risk. Furthermore, microfinance operates primarily in developing countries where the risk of local currency devaluation is the highest."[1] Therefore, the repayment of the hard currency denominated foreign capital (the majority is in US dollars) could be significantly more expensive to the MFIs relative to a local currency resulting in high interest rates to the poor clients.

On the other hand, "MFIs today reach only a fraction of the estimated demand for providing affordable financial services to poor people. New resources must be tapped to meet the estimated US$300 billion demand worldwide. (Market supply is relatively a meager US$4 billion)".[2] International donors who contributed initial capital to many existing MFIs cannot individually or collectively supply all the resources needed for scaling up services to satisfy demand. The commercialization of microfinance would have to play a significant role to close the funding gap. The capital markets hold great promise but as yet have not realized their potential. Microfinance, a new asset class, would provide a double bottom line return to investors thereby taking poor clients from poverty and welfare to fair and well.

There are ongoing deliberations in microfinance that describe potential areas of foreign exchange risk management. These discussions also explain that hedging foreign currency exposure across local currencies is very expensive and that there are minimal hedging instruments for emerging market currencies where MFIs operate. Furthermore, the industry is slow to respond while the largest international microfinance donors do not appear prepared to develop a risk mitigation vehicle to resolve the foreign currency exposure. Recently, several capital market transactions have evolved in the microfinance industry, but nothing substantial to address foreign currency risks. The solution is not a simple one but the possibility exists within the capital markets with the emergence of commercial microfinance funds such as Accion Investments in Latin America and Caribbean, AfriCap in Africa, Blue Orchard in Switzerland, Dexia Microcredit in Luxembourg, Oikocredit in Netherlands and MicroVest in the USA.

So how do you manage foreign currency risks in microfinance without passing the buck to poor people? Recent financial economics research discusses the potential to greatly improve the ability of developing countries to reduce their exposure to other countries' interest rate and exchange rate volatility and to lower their cost of raising capital abroad. One researcher says, "Diversification among the sources of funds and distributing across many different currencies could be a possible solution to manage exchange rate risks."[3] Another proposes, "The key to achieving these goals is for developing countries to borrow in their own currencies and for investors to lend by creating portfolios of local-currency government debt securities that employ the risk management technique of diversification to generate a return-to-risk that competes favorably with other major capital market security indices."[4] These studies imply that diversification through local currencies (which do not require using hedging techniques to mitigate the currency risk) could be a feasible and less expensive solution with substantial benefits to the microfinance industry. The creation of a microfinance investment fund capitalized with a combination of hard currencies (e.g., US dollar, euros, and/or yen) and lending across a diversified basket of emerging market currencies in the form of debt to MFIs could substantially reduce foreign exchange risk exposure and provide a higher yield per unit of risk for the fund. The MFIs could borrow in the local currency and the interest rate to an MFI would include a risk premium (similar to any corporate bond) to compensate for the credit spread relative to a local currency sovereign bond.

Whilst on the face the added local currency risk may flag additional risk, the reality is rather different. The reason is that the volatility of the whole is less than the sum of its parts. "There is a very high correlation between domestic bonds and the fixed income markets of the most developed world except in Japan (Japanese bonds in general do not correlate with the bonds in developed markets). Emerging market bonds have a low correlation with US Treasury bonds because they essentially provide a credit spread. Investing in emerging markets securities would add diversification to the portfolio and some protection against changes in US markets. However, most of the diversification that foreign bonds provide to investors comes from taking on currency exposure."[5] The historically low correlations between emerging market currency fluctuations could be used as a unique cost-effective self-hedge strategy to mitigate currency risk through diversification across different countries' local currency MFI debt. "The emerging market local currency debt universe can offer investors lower risk than dollar denominated emerging debt, but also high returns in an environment of rising emerging currencies or generalized dollar weakness."[6] This is evident from the recent high performance of Asian local currency and emerging market bonds against dollar denominated bonds. A diversified local currency fund portfolio comprising microfinance investments capturing emerging market premiums offered in local rates, and risk reduction through low correlations between currency exchange rates, could perform as well as a hard currency denominated debt portfolio.

"There will remain some skepticism about currency devaluations. A sudden devaluation in local currency is rarely an altogether unforeseen event. Not least as the macro-economic factors that eventually lead to such drastic policy action builds up over a period of time and can be foreseen."[7] The higher nominal rates in local currencies (compared to US rates) could offset devaluations in such currencies. The depreciation of a currency in a country or region can also be offset by the appreciation in another country or region. Furthermore, analyzing the historical local currency exchange rates relative to a hard currency could determine the risk factor of devaluation. The expected premium to compensate the market risk (interest rate and exchange rate uncertainty) during the investment horizon could be forecasted based on these exchange rate relationships. Medium to long-term lending, tracking interest and exchange rate relationships, and rebalancing the currency exposure in the portfolio could further mitigate unexpected events.

The United Nations designated 2005 as the International Year of Microcredit to draw attention to major issues in the industry and to encourage international action to address concerns that have global importance and ramifications.[8] This is the best opportunity for the capital market experts to experiment with strategies that would lead to a groundbreaking solution. An innovation resulting in lower costs to poor people and increased access to foreign commercial investments would be a winning combination. After all, foreign exchange risk remains a significant problem in microfinance that cannot be further ignored.

References:

Jerome Booth: "The Attraction of Local Currency Emerging Debt." The Emerging View, February 2005.
Peter Crabb: "Foreign Exchange Risk Management Practices of Microfinance Institutions." Journal of Microfinance, Winter 2004.
Randall Dodd and Shari Spiegel: "Up From Sin: A Portfolio Approach to Financial Salvation." Financial Policy Forum - Derivatives Study Center, August 2004.
Guorong Jiang and Robert McCauley: "Asian Local Currency Bond Markets." Branch of International Settlement Quarterly Review, June 2004.
Robert McCauley and Guorong Jiang: "Diversifying with Asian Local Currency Bonds." Branch of International Settlement Quarterly Review, September 2004.
Jennifer Meehan: "Tapping Financial Markets for Microfinance." Grameen Foundation USA Publication Series (2005)
"A Windfall from Foreign Bonds" - Interview with Arthur Steinmetz of Oppenheimer International Bond Fund (2004)

*All of the views expressed in this article reflect the author's personal views and/or obtained by reviewing other research papers and published reports. All errors and omissions are author's own. The author was, is or will not be compensated by any party for the specific recommendations or views expressed in this article. It is not the intention of the author to incriminate any party directly or indirectly with respect to the contents written in the article. The author claims no responsibility with regard to the use of information in the article for the benefit or detrimental to others.