Microfinance Horizon

Author(s): Julie Abrams (Microfinance Analytics) & Jerome Prieur (MFX Solutions)

Executive Summary:

Currency risk is an everyday fact of life in microfinance in many parts of the world. However, because of lack of systematic reporting by microfinance institutions (MFIs) and the multifaceted nature of currency risk, understanding of this topic to date has been largely anecdotal. This is the first empirical study to measure the volume, extent, and nature of MFIs’ foreign exchange risk. It presents a snapshot, based on 2008 financial data of over 300 MFIs worldwide, representing approximately 60% of the total assets in the industry. By coincidence, 2008 turned out to be one of the most volatile years in global exchange rates that microfinance has seen in its short history. It is hoped that this study will be part of a trend toward more systematic reporting and analysis of currency risk in microfinance that can make the industry more resilient to macroeconomic volatility in the future.

This study looks at currency exposure from different angles to assess its size, the direction of exposure, the potential risk to MFIs’ viability, and the effect of currency fluctuation on earnings. By any of these measures, MFIs are overexposed to foreign exchange risk. Key findings of the study are: total industry foreign exchange risk exposure is at least US$ 6 billion, of which US$ 1.6 billion is directly held by MFIs, and US$ 4.5 billion has been onlent in foreign currencies to borrowers. Ninety-four percent of this exposure is in US dollars and euros.

Sixty-five percent of MFIs hold more than a prudent amount of foreign exchange risk exposure on their books as a proportion of their equity. As measured by asset-liability ratio (A-L), only about one-fifth (21%) of all MFIs had prudent A-L ratios in each of the foreign currencies that they held. While it was assumed that most of the A-L imbalance would show excessive foreign currency liabilities, in fact, excess assets were an equal problem. Forty percent of reporting MFIs disclose that they make foreign currency loans to their borrowers. This figure may also be understated due to lack of financial disclosure.

The bottom line impact of this foreign exchange risk exposure was significant. Three hundred and seventy-nine MFIs reported foreign exchange gains or losses in 2008, totaling US$ 113 million. Notably, nearly as many MFIs gained money as lost it, with gains and losses averaging about one-third of net income. Gains and losses were incurred in MFIs across all regions, legal structures, sizes, and ages of MFIs.

Overall, this study finds that the level, prevalence, and complexity of MFI foreign exchange risk are greater than presumed. Microfinance foreign exchange practices are risky business, with MFIs exposed to currency risk on both sides of the balance sheet, leading to significant gains or losses depending on currency movements. Recommendations to the microfinance industry to address these findings include development and adoption of industry-wide prudent foreign exchange risk exposure guidelines, expanding availability and use of hedging resources, and additional training and capacity building for MFIs in asset-liability management and overall financial risk management. Further recommendations include limiting foreign currency onlending; greater MFI tracking, reporting, and disclosure of foreign exchange risk levels; increased disbursement of local currency loans by cross-border lenders; and regulation at the country level to include mandatory prudent foreign exchange risk limits.

The microfinance industry continues to advance in its understanding of the impact of foreign exchange risk on MFIs. Organizations like MFX Solutions and others are well placed to provide needed foreign exchange hedging products and an increasing array of foreign exchange risk management training and education for MFIs. With participation by all members of the microfinance industry, MFI foreign exchange risk can be better understood and properly mitigated, enhancing long-term access to finance for the poor in developing countries.

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