Microfinance Horizon

Author: Pankaj Kumar (Research Associate, Indian School of Business, Hyderabad, India)

Abstract:

The demand for foreign investments has increased manifolds to fuel the high growth rates of microfinance institutions (MFIs) across the world. As a majority of this advance is in hard currency, the balance sheets of such MFIs carry this foreign currency lending and the usually more volatile local currency at the same time, giving rise to foreign exchange (FX) risk, which is defined as the probability of loss arising due to the variations in exchange rate between two currencies. The risk to investments posed by currency fluctuations has led many microfinance investment vehicles (MIVs) to lend predominately in dollars or euros. While this practice of lending in hard currency protects investors, it shifts the FX risk to MFIs, which employ the hard currency debt to fund portfolios of micro loans denominated in local currency. This currency mismatch between the MFIs’ loans and the capital that funds MFIs creates risk to the MFI: if the local currency of the country in which an MFI operates depreciates against the U.S. dollar, then the MFI will be saddled with a larger-than-anticipated debt obligation.

Recognizing that MFIs are poorly equipped to manage FX risk, the microfinance industry is currently seeking ways to minimize or eliminate the FX risk inherent to its global business. One proposal in particular, appears promising: creating a “natural hedge” by pooling loans denominated in different emerging market currencies. In this paper, we build on this concept and look for a practical, sustainable solution. We propose a partnership between the private sector and philanthropic community to overcome a major obstacle, which currently prevents the private sector from providing risk management services to the microfinance industry. By effectively leveraging the expertise and resources of the private sector and the financial resources of the philanthropic community, such collaboration across sectors has the potential to eradicate a major source of risk to microfinance investments.

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