As the number of microfinance institutions (MFIs) that rely on commercial sources of funding grows, the issue of foreign exchange (FX) risk is becoming a more prevalent concern for both investors and MFIs. 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 (Dodd and Spiegel 2005 and Fernando 2006). In this paper, we build on this concept and look for a practical, sustainable solution. Specifically, we propose the creation of a separate entity that would assume the FX risk of microfinance investments. It would manage this risk by: Creating a pool of currency risks that would be managed by financial advisors familiar with FX trading and risk management; and Employing capital sourced from the philanthropic community to create a "backstop" that would allow the portfolio to weather short-term turbulence in the markets.
To achieve optimal FX risk management, it is essential that the microfinance industry benefit from the risk management expertise of the financial sector. We therefore 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.
It would draw upon the established infrastructure and expertise of the former and the patient capital of the latter. Such a collaborative effort will build a portfolio of currency exposures that assumes the FX risks facing MFIs. The partnership will allow MFIs to reduce or eliminate FX risk, thereby alleviating the mismatch between revenue and debt, securing the real value of their debt obligations, and providing added stability to their business models. By effectively leveraging the expertise and resources of one and the financial resources of the other, such collaboration across sectors has the potential to eradicate a major source of risk to microfinance investments.
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Hedging Foreign Exchange Risk in Microfinance Investments
