FINANCIAL PRODUCTS AND SERVICES O P - PRODUCTS AND SERVICES OCCASIONAL PAPER FOREIGN EXCHANGE RISK MANAGEMENT IN MICROFINANCE control INTRODUCTION Many microfinance institutions (MFIs) fund a ...

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<ul><li><p>FINANCIAL PRODUCTS AND SERVICES </p><p>OCCASIONAL PAPER</p><p>FOREIGN EXCHANGE RISK MANAGEMENT IN MICROFINANCE </p><p>INTRODUCTION </p><p>Many microfinance institutions (MFIs) fund a portion of </p><p>their portfolio by accessing loans or lines of credit in hard </p><p>currency. In doing so, MFIs incur foreign exchange risk, </p><p>which is defined as the possibility of a loss or a gain from </p><p>varying exchange rates between currencies. If not </p><p>properly managed, foreign exchange risk can result in </p><p>losses. Taking on exposure to foreign exchange risk </p><p>makes an MFI vulnerable to factors that are beyond its </p><p>control. In addition to the risk in changing rates, </p><p>incurring foreign exchange risk also includes the danger </p><p>that it might become impossible to carry out currency </p><p>transactions because of government interventions or a </p><p>market disruption.1 </p><p>CURRENCY FLUCTUATIONS: HOW BIG IS THE RISK? </p><p> The word devaluation is sometimes loosely used to </p><p>describe any type of decline in the value of a currency. </p><p>Below are definitions for changes in currency values. </p><p>The purpose of this focus note will be: 1) to provide MFIs </p><p>with ways to evaluate and manage foreign exchange risk </p><p>to minimize exposure and avoid losses, and 2) to </p><p>highlight the role that lenders and donors can play in </p><p>reducing the exposure of MFIs to foreign exchange risk. </p><p>Depreciation: A decline in the value of a currency in </p><p>comparison with a reference currency (e.g., the US </p><p>dollar). Generally, depreciation is a gradual decline, </p><p>usually occurring over several days or weeks due to </p><p>market forces of supply and demand, but in some </p><p>instances, precipitous decline can happen over relatively </p><p>short periods of time (e.g., Dominican Republic, 2003). </p><p>Several WWB network members have borrowed in hard </p><p>currency, and two cases will be described in which foreign </p><p>exchange risk was successfully mitigated using different </p><p>hedging mechanisms. Additional alternatives for foreign </p><p>exchange risk management that may be available to MFIs </p><p>will also be presented. Further, this note will describe </p><p>approaches developed by two lenders seeking to </p><p>minimize this risk to MFIs by providing local currency </p><p>loans under terms and conditions favorable to both </p><p>lender and MFI. Finally, this note seeks to encourage </p><p>and underscore the importance of continued efforts by </p><p>lenders and donors to help MFIs avoid foreign exchange </p><p>risk to the extent possible. </p><p>Devaluation: A sudden fall in the value of a currency </p><p>against other currencies. Strictly, devaluation refers only </p><p>to sharp falls in a currency within a fixed exchange rate </p><p>system.2 In addition, it usually refers to a deliberate act of </p><p>government policy, although in recent years reluctant </p><p>devaluers have blamed financial speculation3, </p><p>highlighting the role of market forces in devaluations </p><p>(e.g., Mexico 1995, Malaysia 1997, Argentina 2001). </p><p>Vol. 1, No. 2 Copyright July 2004 Womens World Banking </p></li><li><p> Appreciation: A gradual increase in the value of a </p><p>currency, usually occurring over several days or weeks as a </p><p>result of market forces of supply and demand in a system </p><p>of floating exchange rates. In contrast, an upvaluation (a </p><p>word less commonly used) is an official government act </p><p>that produces a substantial increase in the value of a </p><p>currency, usually overnight. </p><p>WWB selected a sample of 23 reference countries in Asia, </p><p>Africa, Latin America, Eastern Europe and the Middle East </p><p>to study the performance of their currencies.4 The yearly </p><p>movements and patterns of depreciation/appreciation were </p><p>analyzed based on end-of-year exchange rates for each of </p><p>these currencies vis--vis the US dollar over the 1997-2002 </p><p>period. The data is summarized in Table 1 below. </p><p> Table 1 </p><p>Rates of Currency Depreciation and Appreciation 1998-2002 </p><p> No. of Years of Currency Simple 5-year </p><p>Average 5-year CAGR Country 1998 1999 2000 2001 2002 Depreciation Appreciation 1998 - 2002 1998 - 2002 </p><p>1 Bangladesh -6.3% -4.9% -5.6% -5.3% -1.6% 5 0 -4.7% -4.7% 2 Benin 6.5% -13.9% -7.4% -5.3% 19.0% 3 2 -0.2% -0.9% 3 Bolivia -5.0% -5.8% -6.3% -6.3% -8.9% 5 0 -6.4% -6.5% 4 Bosnia 7.1% -14.1% -7.4% -5.3% 19.0% 3 2 -0.1% -0.8% 5 Brazil -7.7% -32.4% -8.5% -15.7% -34.3% 5 0 -19.7% -20.6% 6 Colombia -14.2% -19.5% -14.3% -5.0% -19.7% 5 0 -14.5% -14.7% 7 Dominican Republic -9.0% -1.6% -3.8% -2.8% -19.1% 5 0 -7.2% -7.5% 8 Gambia -4.2% -4.8% -22.4% -12.1% -27.6% 5 0 -14.2% -14.8% 9 Ghana -2.3% -34.2% -49.8% -3.7% -13.2% 5 0 -20.7% -23.1% </p><p>10 India -7.5% -2.3% -7.0% -3.0% 0.3% 4 1 -3.9% -3.9% 11 Indonesia -42.1% 13.3% -26.2% -7.7% 16.3% 3 2 -9.3% -12.3% 12 Jordan 0.0% 0.0% 0.0% 0.0% 0.0% n/a n/a 0.0% 0.0% 13 Kenya 1.2% -15.1% -6.5% -0.7% 2.0% 3 2 -3.8% -4.1% 14 Mexico -18.1% 3.7% -0.6% 4.7% -11.3% 3 2 -4.3% -4.8% 15 Morocco 5.0% -8.2% -5.0% -8.1% 13.7% 3 2 -0.5% -0.9% 16 Pakistan -4.2% -11.4% -10.8% -4.7% 4.0% 4 1 -5.4% -5.6% 17 Paraguay -16.9% -14.7% -5.6% -24.7% -34.1% 5 0 -19.2% -19.8% 18 Peru -13.6% -10.0% -0.5% 2.4% -2.0% 4 1 -4.7% -4.9% 19 Philippines 2.3% -3.1% -19.4% -2.7% -3.2% 4 1 -5.2% -5.5% 20 Russia -71.1% -23.5% -4.1% -6.6% -5.2% 5 0 -22.1% -28.5% 21 South Africa -16.9% -4.8% -18.7% -37.6% 40.4% 4 1 -7.5% -10.8% 22 Thailand 28.8% -2.1% -13.4% -2.2% 2.5% 3 2 2.7% 1.8% 23 Uganda -16.3% -9.5% -14.8% 2.3% -6.8% 4 1 -9.0% -9.3% </p><p># countries w/ depreciation 16 20 22 19 13 Simple average of the 23 countries: -7.8% # countries w/ appreciation 6 2 0 3 9 Compounded average of the 23 countries -8.8% # countries - no change in value 1 1 1 1 1 Total 23 23 23 23 23 Notes: </p><p>1 Negative numbers (in gray) denote a local currency depreciation against the dollar. 2 Positive numbers (in blue) denote strengthening of local currency, or appreciation vis--vis the dollar. </p><p> Source: International Monetary Fund Statistics Department, International Financial Statistics, Volume LVI, No. 10, October 2003, Washington, D.C., International Monetary Fund, pages 150-985. </p><p> - 2 - </p></li><li><p> Below are some findings from the data: </p><p>inability to forecast currency exchange rates with a </p><p>reasonable level of certainty makes it a risky proposition </p><p>to enter into such obligations without a mechanism to </p><p>effectively mitigate foreign exchange risk. </p><p> Every year, more than half (57% to 96%) of the countries in this sample experienced depreciation of their currency. </p><p> Nine out of the 23 countries (39% of the total </p><p>sample) experienced depreciation of their currency every year. </p><p>Taking on foreign currency obligations without any </p><p>protection against unfavorable movements in the </p><p>currency exchange rate exposes the borrower to the </p><p>possibility of experiencing serious financial problems, </p><p>including increased financial expenses, reduced </p><p>sustainability and profitability, and even insolvency. </p><p>Prudent management guidelines recommend that MFIs </p><p>avoid speculation to the extent possible. </p><p> The currencies of 15 countries (65% of the total sample) depreciated in at least four of the five years analyzed. </p><p> Twenty-two countries (96%) experienced at least three years of currency depreciation. </p><p> With the exception of Jordan, whose currency has been in practice pegged to the dollar, none of the currencies in the sample was stable or appreciated against the dollar for more than two of the five years analyzed. </p><p> Only one country - Thailand - experienced moderate overall appreciation of its currency over the five-year period. Except for Jordan, whose currency remained stable, the rest of the reference countries experienced overall depreciation of their currencies over the period analyzed. </p><p> An analysis of this data on a regional basis reveals that every region - Africa, Asia, Eastern Europe, Latin America and the Middle East - experienced depreciation of its currencies on an aggregate basis over the five-year period. </p><p>THE IMPACT OF LOCAL CURRENCY DEPRECIATION </p><p> On an aggregate basis, the 23 currencies experienced an average annual depreciation rate vis--vis the US dollar of 7.8%. The average of the compounded annual declines in the value of the 23 currencies was 8.8%. </p><p>The example provided in Table 2 is a simple </p><p>demonstration of how an MFI can incur foreign </p><p>exchange risk due to the volatility of the currency in </p><p>which it operates. </p><p> This example depicts a gradual depreciation scenario. </p><p>Sharp and abrupt devaluation would result in much </p><p>higher hard currency financing costs and foreign </p><p>exchange losses. </p><p>The patterns found in this diverse sample of currencies </p><p>underscore the vulnerability of institutions that, while </p><p>operating in their local currency, enter into financial </p><p>obligations denominated in foreign currencies. The </p><p> - 3 - </p></li><li><p>Table 2 </p><p>Example of Impact on an MFI of Currency Depreciation </p><p>At the end of 1999, a Colombian MFI has the following funding options to borrow US$200,000 or its equivalent in Colombian pesos (COP or pesos) for three years, to be onlent locally in pesos. The terms and the evolution of interest and exchange rates over the life the loans, as well as the resulting cash flows under each of the two loan scenarios are shown below. Please refer to Annex 1 for the data and calculations behind the figures and graphs that follow. </p><p>US Dollar Loan Peso Loan </p><p>Principal Amount: US$200,000 Equivalent to COP 374,754,000 at Dec 1999 exchange rate </p><p>Principal Amount: COP 374,754,000 Equivalent to US$200,000 at Dec 1999 exchange rate </p><p> Interest Rate: Maturity: Interest Payments: Amortization: </p><p> Libor + 5% 3 years Semiannual Bullet at maturity </p><p> Interest Rate: Maturity: Interest Payments: Amortization: </p><p> DTF5 + 6% 3 years Semiannual Bullet at maturity </p><p>Evolution of US$ Interest and Exchange Rates Evolution of COP Interest Rate </p><p>11.20%</p><p>6.38%</p><p>11.13%</p><p>6.96%</p><p>12.00%</p><p>8.91%</p><p>6.98%</p><p>1,874</p><p>2,3992,2992,187</p><p>2,193</p><p>2,865</p><p>2,301</p><p>0%</p><p>5%</p><p>10%</p><p>15%</p><p>20%</p><p>25%</p><p>Dec 1999 June 2000 Dec 2000 June 2001 Dec 2001 June 2002 Dec 2002</p><p>Inte</p><p>rest</p><p> Rat</p><p>e</p><p>0</p><p>500</p><p>1,000</p><p>1,500</p><p>2,000</p><p>2,500</p><p>3,000</p><p>Exch</p><p>ange</p><p> Rat</p><p>e</p><p>Interest RateLibor + 5</p><p>14.47%</p><p>20.30%</p><p>19.09%</p><p>14.86%</p><p>18.07%18.66%</p><p>22.81%</p><p>0%</p><p>5%</p><p>10%</p><p>15%</p><p>20%</p><p>25%</p><p>Dec 1999 June 2000 Dec 2000 June 2001 Dec 2001 June 2002 Dec 2002</p><p>Inte</p><p>rest</p><p> Rat</p><p>e</p><p>Interest RateDTF + 6</p><p>USD Loan Cash Flows Peso Loan Cash Flows </p><p>375</p><p>(35) (38) (36) (34) (28)</p><p>(402)</p><p>(600)</p><p>(500)</p><p>(400)</p><p>(300)</p><p>(200)</p><p>(100)</p><p>-</p><p>100</p><p>200</p><p>300</p><p>400</p><p>Dec 1999 PrincipalReceived</p><p>June 2000 InterestPayment</p><p>Dec 2000 InterestPayment</p><p>June 2001 InterestPayment</p><p>Dec 2001 InterestPayment</p><p>June 2002 InterestPayment</p><p>Dec 2002 Principal &amp;</p><p>InterestPayment</p><p>Cash Flows</p><p>Mill</p><p>ions</p><p> of </p><p>Pes</p><p>os</p><p>COP/USD Exchange Rate</p><p>375</p><p>(26) (25) (20) (16) (17)</p><p>(591)</p><p>(600)</p><p>(500)</p><p>(400)</p><p>(300)</p><p>(200)</p><p>(100)</p><p>-</p><p>100</p><p>200</p><p>300</p><p>400</p><p>Dec 1999 PrincipalReceived</p><p>June 2000 InterestPayment</p><p>Dec 2000 InterestPayment</p><p>June 2001 InterestPayment</p><p>Dec 2001 InterestPayment</p><p>June 2002 InterestPayment</p><p>Dec 2002 Principal &amp;</p><p>InterestPayment</p><p>Cash Flows</p><p>Mill</p><p>ions</p><p> of </p><p>Pes</p><p>os</p><p>- 4 - </p></li><li><p> (Table 2 continued) </p><p>US Dollar Loan Peso Loan </p><p>At the time of disbursement of the loan, every dollar would buy the MFI 1,873.77 pesos. On one hand, the MFI pays lower interest rates on the dollar loan than it would on the peso loan. On the other hand, as the peso depreciates over the life of the loan, the MFI needs an increasing amount of pesos to purchase each dollar it requires to make its interest payments every six months. Part of the benefit of the lower dollar interest rates is offset by the depreciation of the peso versus the dollar. At maturity of the loan at the end of 2002, the COP/US$ exchange rate was 2,864.79 pesos for each dollar. The MFIs pesos had depreciated against the dollar by 35%. While the MFI had received the equivalent of 374,754,000 pesos at inception of the loan, at maturity, it will need 572,958,000 pesos to repay the dollar loan, or 153% of the loan amount received in pesos. In other words, a 35% depreciation of the peso means that the MFI requires 53% more pesos than it received at disbursement to repay the dollar loan at maturity. (Please refer to Annex 2 for a discussion of the difference between the rate of depreciation of a currency over a period of time, and the percentage of incremental currency required to purchase a certain amount of the reference currency at the end versus the beginning of the period.) The effective interest rate of the US$ loan in pesos is 26%. </p><p>Higher peso interest rates mean larger interest payments on the peso loan as compared to the dollar loan. However, the impact of the depreciation of the peso on the interest payments on the dollar loan limits the savings on interest vis--vis the peso loan. Furthermore, both Libor and DTF drop significantly during the life of the loan, reducing the amount of the interest payments in both loan scenarios over time. Over the life of the loan, the MFI pays 75,258,710 pesos more in interest on the peso loan as compared to the dollar loan. The higher interest payments on the peso loan are more than compensated for by the difference in principal amount in pesos to be repaid at maturity of the loan between the COP and the US$ loan. Under the COP loan scenario, the MFI owes the original COP 374,754,000 received at disbursement of the loan, or COP 198,204,000 less than the COP amount required to repay the principal on the US$200,000 loan. Even though the benefit of a lower peso principal amount is realized at the end of the three-year period, in this case it is substantial enough to make the COP loan more economically advantageous to the MFI. The effective interest rate of the COP loan is 19%. </p><p>Had the MFIs currency appreciated over the 2000-2002 period (this was the case in two of WWBs 23 reference countries), it would owe less of its local currency in dollars, at maturity of the loan. However, hoping for the currency to stay at a steady exchange rate or to appreciate is a gamble, and the research shows the odds are against this occurring. MFIs should manage foreign exchange risk prudently and avoid speculation as it is not their core business. </p><p> The example above illustrates a way in which an MFI can evaluate the cost of hard currency vs. local currency borrowing. In </p><p>addition to potential foreign exchange rate movements, interest rates could improve or deteriorate depending on </p><p>macroeconomic conditions and monetary policy over the term of the loan. Therefore, important considerations are: 1) </p><p>Managements view on interest rates, including the potential impact of interest rate movements on the MFIs net interest </p><p>margin and its ability to pass on interest rate increases to clients; 2) The MFIs Foreign Exchange Risk Management Policy </p><p>setting limits to exposure and ways to mitigate the risk. </p><p> - 5 - </p></li><li><p>Furthermore, country risk considerations and the strict </p><p>credit requirements of the derivative financial markets </p><p>may prevent even the strongest institutions in developing </p><p>countries from gaining access to foreign exchange </p><p>derivative products.7 The provider of the derivative </p><p>product needs to assess the risk that its counterparty in </p><p>the transaction will not fulfill its obligatio...</p></li></ul>

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