WWB FOCUS NOTE
From Dollar to Dinar: The Rise of Local Currency
Lending and Hedging in Microfinance
Executive Summary
The currency landscape of international microfinance lending is changing rapidly. This
paper highlights recent noteworthy advances in minimizing foreign exchange risk in
microfinance, via both local currency lending by international investors, and risk hedging
by microfinance institutions.
Until recently, foreign lending to microfinance institutions (MFIs) has been
overwhelmingly in hard currencies such as the US dollar or the euro. Now, increasing
numbers of international investors are finding ways to lend to MFIs in local currency, and
in some cases, the local currency investments are being left unhedged on international
investors’ books. In 2004, when Women’s World Banking published one of the first
papers on this topic, titled Foreign Exchange Risk Management in Microfinance,1 hard
currency loans accounted for 92% of all debt funding to MFIs. In 2006, private foreign
lending to MFIs had increased threefold, and the percentage of hard currency loans had
dropped, now amounting to 70% of the total funds.2
Why is this trend towards increased local currency lending such an important
development? MFIs for the most part lend to their client borrowers in local currency,
with certain exceptions in a few wholly or
partially dollarized (or euroized) countries.
When an MFI borrows in hard currency
but lends to its clients in local currency, the
resulting currency mismatch means that the
MFI’s earnings are subject to volatility risk
of exchange rate movements. This focus
note updates the 2004 paper’s analysis
of 23 currencies over time, showing
continued volatility in the movement of the
currencies, leading to uncertainty for MFIs
holding foreign currency loans. Depending
on the extent of depreciation, the effect
of currency movements can be minor or
very significant — but either way, there is
a direct and negative impact on the MFI’s
bottom line earnings. Conversely, if its
local currency appreciates over the course
of the loan, an MFI pays less to a foreign
Part 2 of
WWB’s Foreign
Exchange Risk
Management in
Microfinance
Series
AUTHORS
Julie Abrams,
Microfinance Analytics
Louise Schneider-Moretto,
Women’s World Banking
CONTRIBUTOR
Christina Frank,
Women’s World Banking
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
lender that has lent dollars or euros. This range of possible
scenarios is the gamble of foreign exchange risk. An
MFI has no control over the value of the local currency
against the dollar or euro, which can vary daily. But an
MFI can control how much foreign exchange risk it takes
on. Five MFI cases are examined in which the institutions
had a significant drop in net income solely due to currency
movements.
This follow-up paper examines the significant progress
and new developments in the field since 2004, both by
international investors and MFIs. While there are important
developments to applaud, WWB remains concerned that
many MFIs are still incurring unnecessarily high foreign
exchange risk. The message remains: the optimal MFI
balance sheet will have little to no unhedged foreign
exchange risk.
Fortunately, the convergence of several factors has
brought about increased international investor lending to
MFIs in local currency. These factors include:
•
growing competition among
investors to lend to MFIs,
international
•
increased commitment among lenders not to
saddle MFIs with foreign exchange risk,
•
insistence on local currency debt funding by some
MFIs,
•
growth of several international investment funds
to sufficient scale, enabling partnerships with
commercial financial institutions that can provide
exchange risk hedging, and
•
increasing willingness of investment funds
to mitigate currency risk by applying known
portfolio diversification principles (i.e., holding
“baskets” of uncorrelated currencies) to unhedged
local currency loans to MFIs.
Simultaneous with these developments, many MFIs have
significantly increased their knowledge of treasury and
financial risk management and are now utilizing hedging
products or sometimes even turning down hard currency
loans.
International investors, in particular, have made impressive
strides in developing the capacity to offer MFIs local
currency funding. Until 2006, this was done primarily by
hedging some loans through swaps, as was the practice
of Triodos Bank, or by establishing special exchange risk
reserves and diversifying the loan portfolio, as Oikocredit
did. (Both of these initiatives were reported in the first
WWB foreign exchange risk management paper.) More
recently, international investors that achieved sufficient
scale have established formal partnerships with global
banks to provide market-based foreign exchange risk
hedging capabilities in multiple currencies and tenors.
In 2007, several pioneering investors began taking a
portion of unhedged foreign exchange risk exposure on
nontraditional currencies. Additionally, some international
financial institutions such as the Netherlands Development
Finance Company (FMO) and the International Finance
Corporation (IFC) have responded to the call for local
currency financing and have made headway in developing
new initiatives to address this need.
On the MFI side, this paper reports on three MFIs and
their innovative hedging strategies through purchases of
foreign exchange hedging products, such as forwards,
swaps, futures and options. However, MFI use of currency
hedging instruments is not yet commonplace. Due to
their scale and number of markets in which they operate,
international investors are far better positioned than MFIs
to address the need to eliminate or minimize MFI foreign
exchange risk.
Continued competition and increased awareness among
international microfinance investors may lead to local
currency lending becoming the norm. From the MFI
perspective, many will be in a strong position to demand
only local currency funds from international investors
or pursue local funding sources. Going forward, all
new funds will likely need to offer local currency loans
in order to be competitive. However, considering the
disproportionate balance of hard currency loans from
international investors to date, it is clear that there is
much work to be done. WWB believes the time is ripe for
product development and innovation among international
microfinance lenders.
1.
Introduction
Microfinance has seized the attention of the international investment community. Investors
have taken a keen interest in the social and financial returns that can be achieved by
investing in MFIs. Two noteworthy features of international investment in microfinance
are its rapid growth due to the attractive double bottom line features of investing in an
MFI, and the fact that the majority of lending to MFIs to date has been in hard currency.
As shown in Chart 1, in just two years, privately managed Microfinance Investment
Vehicle funds (MIVs) have tripled in size. As of 2006, 70% of these funds were still lent
in hard currency, down from 92% as recently as 2004.3
During the last several years, there have been increased efforts by organizations like
Women’s World Banking and the Consultative Group to Assist the Poor (CGAP) to
promote awareness of the risks faced by MFIs that are accepting hard currency loans.
In 2004, Women’s World Banking wrote one of the first papers calling attention to the
inherent risks of hard currency borrowing by MFIs. The paper recommended a number
of foreign exchange risk mitigation strategies, and provided an overview of foreign
exchange volatility, an explanation of the mechanics of this risk, and descriptions of
certain hedging strategies.4 The current paper builds upon this earlier work, highlighting
the most recent progress and developments, as well as trends in international investor
lending and foreign exchange risk management by MFIs.5
Chart 1
Privately owned microfinance investment funds have more than tripled in
the past two years...
2004 and 2006 MIV Funding
And hard currently loans represent a
high percentage of total funds lent.
2004 MIV Currency of Debt Funding
MIV PORTFOLIO
Local Currency
8%
Hard Currency
92%
+233%
2 billion
2006 MIV Currency of Debt Funding
637
million
2004
2006
Local Currency
30%
Hard
Currency
70%
* MIV = Microfinance Investment Vehicle
Source: Analysis of CGAP data.
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
From an MFI’s perspective, international investor capital is attractive for several
reasons:
•
Foreign capital typically offers longer loan tenors than debt provided by local
lenders. Longer maturities are important for rapidly growing MFIs, which often
have difficulty obtaining even one-year lines of credit from local banks.
•
International capital is typically offered on an unsecured basis, whereas local
banks usually have onerous collateral requirements, including demands for a
pledge of cash accounts and real estate, or overcollateralization using an MFI’s
client loan receivables.
•
A loan from an international lender is often seen as a seal of approval of having
passed a rigorous due diligence process.
•
MFIs generally seek to diversify their sources of funding from both local and
international lenders as protection against potential turbulence in the local
economy that might curtail local bank lending to MFIs.
•
In certain microfinance markets, domestic banks may be hesitant to lend to
MFIs because of unfamiliarity with microfinance’s risk profile, so loans from
international investors may catalyze local bank lending to MFIs.
Given the vigorous increase in both demand for and supply of microfinance funding,
international lending to MFIs is expected to continue on a rapid growth trajectory. The
challenge lies in making sure that funds are lent out predominantly in local currency in
order to minimize the burden of foreign exchange risk on MFIs.6
There are a number of risks associated with MFIs borrowing in hard currency. First,
foreign currency loans expose an MFI’s income statement to the potential for reduced
earnings or even losses. Second, borrowing in hard currency may place stress on an
MFI’s cash flows and liquidity, as its debt payments increase and become more expensive
if there are unfavorable exchange rate fluctuations or depreciation. Third, a change in
the value of the local currency against the borrowed hard currency creates an assetliability mismatch on the MFI’s balance sheet, whereby the institution is borrowing in
hard currency but lending to clients in local currency. The value of an MFI’s assets and
liabilities must be regularly adjusted to reflect these exchange rate market movements
that flow through to the income statement. In extreme cases, a sudden, steep devaluation
in local currency can lead to large losses and even bankruptcy for MFIs with significant
foreign exchange risk exposure.
Given the importance of exchange rate fluctuations to the financial performance of MFIs
with hard currency borrowings, the next section takes an empirical look at recent currency
trends, updating the analysis of currency fluctuations contained in WWB’s 2004 paper.
Section 3 reviews three international microfinance investment management companies
that are shifting their lending strategies to include local currency funding, and highlights
other new local currency initiatives. Section 4 presents case studies of three MFIs and
their foreign exchange risk hedging strategies, and section 5 offers key conclusions.
Key Terms
Currency Terms
Appreciation
Deliverable
Depreciation
Derivative
Devaluation
Fluctuation
Non-Deliverable
Volatility
Appreciation is an increase in the value of a currency as a result of market forces of supply and
demand in a system of floating exchange rates.
Deliverable means that a local currency can be physically delivered in the local currency market to
complete a predetermined agreement to exchange foreign and local currency.
Depreciation is a decline in the value of a currency in comparison with a reference currency (e.g., the
US dollar).
A derivative is a security, such as an option or futures contract, whose value depends on the
performance of an underlying security or asset. Futures contracts, forward contracts, options, and
swaps are the most common types of derivatives. Derivatives are generally used by institutional
investors to hedge some aspect of portfolio risk.
Devaluation is a fall in the value of a currency against other currencies. Strictly, devaluation refers
only to sharp falls in a currency within a fixed exchange rate system. In contrast to depreciation,
devaluation implies an official lowering of the value of a country’s currency by a monetary authority
which formally sets a new fixed rate.
Fluctuation is a change in prices or interest rates, either up or down. Fluctuation may refer to either
slight or dramatic changes in the prices of stocks, bonds, or commodities.
A non-deliverable currency is not freely tradable, so cannot be physically delivered into the local
currency market. The transaction is based on the change in market value from the time of the
contract, and is calculated and paid in net dollars or another major currency. The transaction can be
completed offshore without need for access to the local currency’s market.
Volatility is a statistical term to quantify the dispersion of variables such as rates or prices around
the mean; also a measure of the variability of the price of an underlying financial instrument, rate,
commodity, or currency. Volatility measures only the quantity of the change, not the direction.
Foreign Exchange Risk Mitigation Terms
Credit Enhancement
Currency Swap
Forward Contract
Futures
Hedge
Options
Standby Letter of
Credit
A credit enhancement reduces the risk of a transaction to achieve a higher rating. Essentially, it
improves the credit-worthiness of a borrower or transaction. Credit enhancements take many
different forms, including a financial guarantee such as a Standby Letter of Credit (SBLC), a reserve
account, or cash over-collateralization.
A currency swap is an agreement between two parties to exchange principal and interest payments
between two different currencies over a given period of time. Cross currency swaps, in effect, enable
an MFI to create synthetic local currency financing from US dollar or euro sources of funding.
A forward contract is the purchase or sale of a specific quantity of foreign currency or other financial
instrument with payment and delivery at a specified future date. MFIs may use foreign exchange
forward contracts to hedge foreign exchange risk.
Futures are exchange-traded contracts requiring the holder to exchange a specified amount of a
currency for another, at a specified price, on a specified future date (i.e., exchange-traded forward
contracts). Futures are standardized contracts for a fixed uniform currency amount and set maturity
dates throughout the year.
A hedge is an investment purchased specifically to reduce (or off-set) the risk of another investment.
Hedging is a strategy designed to minimize exposure to an unwanted business risk.
Options are contracts giving the buyer the right, but not the obligation, to buy or sell a currency (or
security or other asset) at an agreed-upon price during a certain period of time or on a specific date.
A Standby Letter of Credit (SBLC) is a Letter of Credit (LOC) designed to be used only when
the applicant defaults on payment. The Standby Letter of Credit (SBLC) assures the lender of the
performance of the borrower’s obligation, and is generally issued by a highly rated bank, essentially
helping to substitute the bank’s risk for the issuer’s risk, thereby providing investors with greater
protection.
Source: Women’s World Banking.
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
Table 1: Rates of Currency Depreciation and Appreciation 2003-2006
This table shows how much the local currency has depreciated against the dollar each year
Country
2003
2004
2005
2006
years of
currency
DEPRECIATION
YEARS OF
CURRENCY
APPRECIATION
Simple
4-yr a
vg
2003-2006
4-yr
cagr
2003-2006
%
%
%
%
%
%
1 Bangladesh
(1.5)
(3.2)
(8.3)
(4.1)
4
–
(4.3)
(4.3)
2 Benin
20.4
7.8
(14.9)
13.6
1
3
6.8
5.9
3 Bolivia
(4.3)
(2.7)
0.1
0.8
2
2
(1.5)
(1.6)
4 Bosnia
20.4
7.9
(13.4)
11.6
1
3
6.6
5.9
5 Brazil
22.3
8.8
13.4
9.5
–
4
13.5
13.4
6 Colombia
3.0
15.3
5.6
2.6
–
4
6.6
6.5
7 Dominican Republic
(43.1)
19.7
(10.8)
3.2
2
2
(7.7)
(11.0)
8 Gambia
(24.4)
4.3
5.5
0.3
1
3
(3.6)
(4.4)
9 Ghana
(4.7)
(2.2)
(0.8)
(1.1)
4
–
(2.2)
(2.2)
10 India
5.3
4.6
(3.3)
1.9
1
3
2.1
2.1
11 Indonesia
5.6
(8.9)
(5.5)
9.0
2
2
0.1
(0.2)
–
–
–
–
N/A
N/A
–
–
12 Jordan *
13 Kenya
1.2
(1.6)
6.9
4.3
1
3
2.7
2.7
14 Mexico
(8.2)
(0.3)
4.5
(0.9)
3
1
(1.2)
(1.3)
15 Morocco
16.2
6.5
(11.1)
9.4
1
3
5.2
4.7
16 Pakistan
2.3
(3.2)
(1.2)
(1.8)
3
1
(1.0)
(1.0)
17 Paraguay
16.2
(2.2)
2.1
(33.7)
2
2
(4.4)
(6.4)
1.5
5.5
(4.3)
7.3
1
3
2.5
2.4
(4.5)
(1.2)
6.0
8.0
2
2
2.1
2.0
18 Peru
19 Philippines
20 Russia
7.9
6.1
(3.6)
9.3
1
3
4.9
4.8
21 South Africa
30.1
17.9
(11.0)
(9.3)
2
2
7.0
5.5
22 Thailand
9.0
1.4
(4.8)
13.8
1
3
4.8
4.6
23 Uganda
(4.3)
8.5
(1.8)
4.3
2
2
1.7
1.6
Number of countries
with LC depreciation
8
9
14
6
Simple average of the 23 countries:
Number of countries
with LC appreciation
14
13
8
16
Compound average of the 23
countries:
Number of countries
with no change in value
1
1
1
1
Note: negative numbers (in blue shading) denote a local currency depreciation against the dollar; positive numbers (no shading) denote
strengthening of local currency, or appreciation against the dollar.
* The Jordanian dinar has been effectively pegged to a trade-weighted basket of currencies, including the dollar, since May of 1989. The dinar
is officially pegged to the SDR (international reserve asset), but in practice, it has been pegged to the dollar since late 1995.
Source: Analysis of IMF International Financial Statistics data.
1.8%
1.3%
2.
Currency Fluctuation is Unpredictable
“The essence of risk management lies in maximizing the areas where we have some
control over the outcome while minimizing the areas where we have absolutely no control
over the outcome…”
—from The Remarkable Story of Risk7
Currencies are fundamentally volatile. Currency fluctuation can have significant negative
consequences for MFIs, or in certain instances—if exchange rates favor the local currency
against a hard currency—may even benefit the institution, but the fact remains: it is an
incalculable risk. WWB’s 2004 foreign exchange risk paper studied the performance of
local currencies against the dollar from 1998 to 2002 in 23 reference countries in Asia,
Africa, Latin America, Eastern Europe and the Middle East. In this paper, the same set of
countries’ annual currency movements and patterns of depreciation and appreciation are
analyzed over the 2003 to 2006 period (see Table 1).
Currency volatility was lower from 2003 to 2006 than had been seen during 1998 to 2002.
Yet, over the course of 2003-2006, increased volatility was seen in several countries for
specific one-year periods, sometimes offset over the three-year horizon (such as when
significant appreciation was followed by significant depreciation or vice versa), masking
the volatility that occurred during the time period. As can be seen in Table 2, the time
period chosen, as well as the type of average computed change (simple or compounded),
will have a significant impact on the computed local currency value fluctuation against
the US dollar.
Table 2: Comparative Rates of Currency Depreciation and Appreciation 1998-20068
(Combining findings from Table 1 and analysis from earlier WWB paper)
1998-2002
2003-2006
1998-2006
Compound average change in value of local currency against
dollar (CAGR)
(8.8%)
+1.3%
(4.8%)
Simple average change in value of local currency against dollar
(7.8%)
+1.8%
(3.7%)
Source: Analysis of IMF International Financial Statistics data.
The tables above show the following trends:
•
On net, the group of 23 currencies appreciated over the latest period, following
an earlier period of net depreciation. From 1998 to 2002, the compound average
value of the 23 currencies analyzed depreciated 8.8%, and declined on a simple
average basis by 7.8%. By comparison, the currency landscape was more
favorable to these emerging market currencies during the 2003 to 2006 period,
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
with an average compound annual appreciation of 1.3% among the basket of
currencies, and simple annual appreciation of 1.8%. This reflects a weakening of
the dollar against these local currencies during the recent period.
•
Net currency appreciation masks cases of significant individual currency
depreciation. In contrast to the widespread local currency depreciation seen
during the 1998-2002 period, only two of the currencies—the Bangladeshi taka
and the Ghanaian cedi—depreciated in each of the four years from 2003 to
2006. An additional nine currencies depreciated in two or three of the four years.
Thus, half of the sample had as many years of local currency depreciation as
appreciation. This underscores the point that currencies fluctuate constantly, and
it is difficult, if not altogether impossible, to predict future trends.
•
Variation in currency direction can pose risks for an MFI, but can be strategically
advantageous for microfinance investment funds. A hard currency loan to an
MFI is risky in that the MFI cannot be certain of the exact amount of principal
and interest that it will owe at any given time. Microfinance investment funds
may lend in multiple currencies, all of which may move in different directions at
the same time. Some microfinance investment funds that lend in local currencies
are using this range of global exchange rate movements to their advantage. They
are leaving their microfinance portfolios partially or fully unhedged, and using
the uncorrelated currency portion of their lending portfolio as a natural hedge
against the fund’s own foreign exchange risk as a form of portfolio diversification.
Examples of this strategy are discussed in section 3 of this paper.
While the currencies in the 23 countries had strengthened from 2003 to 2006 as compared
to 1998 to 2002, both periods were characterized by currency volatility. This volatility and
lack of predictability underscores why foreign exchange risk can have such a significant
impact on an MFI’s bottom line, even if hard currency borrowing works financially in
favor of the MFI for a period of time. Indeed, any foreign exchange gap (caused when
foreign currency assets do not equal foreign exchange liabilities) on an MFI’s balance
sheet creates currency risk exposure. As shown in the examples below, foreign exchange
fluctuation is unpredictable and can cause losses.
The Impact of Currency fluctuation on the MFI’s Bottom Line
Currency volatility is not just theoretical. It can have a substantial impact on an MFI’s
financial performance, and even its liquidity. This section addresses five Latin American
cases­­—and there are many more—in which MFIs incurred foreign exchange losses
to varying degrees based on the size of the foreign exchange asset-liability mismatch
(or gap) and the fluctuation of the exchange rate on their local currency loans against
their US dollar loans and assets. When a local currency weakens, if an MFI does not
Table 3: Actual 2004 Samples of Foreign Currency Losses on Colombian MFIs’ Income Statements
‘000’s of
Colombian pesos
Net Income (prior to foreign exchange loss)
Foreign Exchange Loss
Net Income
Foreign Exchange Loss as Percentage of Net Income
(prior to foreign exchange loss)
Colombian
MFI A
Colombian
MFI B
Colombian
MFI C
Colombian
MFI D
7,279,455
1,899,066
3,222,740
1,636,733
534,953
186,510
320,471
229,191
6,744,502
1,712,556
2,902,269
1,407,542
7.3%
9.8%
9.9%
14%
Source: Women’s World Banking analysis.
In the case of another Latin American MFI, the country in
which it operated experienced a significant devaluation,
with its currency plunging 43% in one year. Chart 2 shows
the case of this MFI whose foreign exchange loss jumped
from zero in 2002 to an amount nearly equivalent to the
prior year’s entire net income, resulting in a 70% drop
in earnings in one year. Because of the MFI’s foreign
exchange gap (US dollar liabilities were greater than US
dollar assets in this case), the MFI incurred substantial
foreign currency losses.9 Given the scale of foreign
exchange losses that MFIs can incur by borrowing
hard currency internationally, it is essential for MFIs to
borrow in local currency and for international funds to
lend in local currency. Doing so avoids losses that could
jeopardize an MFI’s operations and offset its hard-earned
gains in portfolio growth and operating efficiencies. As
shown in the next section, there are increasing signs that
local currency lending is taking root in the microfinance
investment community.
Chart 2
Foreign Exchange Loss Effect on
Net Income in a Latin American MFI
60
Millions of pesos
have hard currency assets of an equal amount, it will
incur a foreign exchange loss that has a direct impact on
profitability, reducing net income. Likewise, if a local
currency appreciates and it does not have US dollar
liabilities to match its US dollar assets (i.e., US dollar
deposits), the MFI will also realize a foreign exchange
loss. This occurred in 2004 in four Colombian MFIs
whose US dollar deposit assets exceeded their US dollar
liabilities, thus creating a mismatch. After several years
in which the Colombian peso (COP) had depreciated
against the US dollar, in 2004 the COP appreciated by
15.3%. At the time, these Colombian MFIs were not
fully protected against their foreign exchange gap. Table
3 shows that these MFIs realized foreign exchange losses
that represented a significant amount of their earnings,
ranging from 7% ‑ 14% of adjusted net income (after
adding back the foreign exchange loss).
58
52
45
43
30
17
15
0
23
0
2002
2003
Foreign Exchange Loss
2004
Net Income
An unexpected 43% currency devaluation (against the
US dollar) in 2003 led to significant foreign exchange
losses that caused net income to plunge.
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
3.
Impressive Strides by
International Investors: More
Local Currency Funding
Great progress has been made by international
microfinance funds in providing local currency loans
to MFIs, particularly during 2006 and 2007. Several
converging factors have led to this progress. First, there
is increased competition among international investors
to lend to a finite group of investment-ready MFIs.
Second, there is more widespread acknowledgement by
both lenders and others in the field (such as CGAP and
Women’s World Banking) that lenders have historically
burdened MFIs with unmanageable levels of hard currency
debt, resulting in unhedged foreign exchange risk on MFI
balance sheets. Third, MFIs have become more savvy
consumers of foreign debt, with increasing leverage in
negotiating acceptable loan terms and greater discretion
in which funds to borrow. It should be noted that this is
the case only among the most investment-ready MFIs.10
This section highlights three investment management
companies (which together manage six separate funds)
and details their strategies for providing access to local
currency lending. The funds include BlueOrchard’s
Dexia Fund, BBVA Codespa Microfinanzas, and the
BlueOrchard Loans for Development funds (BOLD-1
and BOLD-2, which were created jointly with Morgan
Stanley and are addressed in a separate section); the
Global Commercial Microfinance Consortium (GCMC),
a Deutsche Bank managed fund; and Developing World
Markets XXEB and its role in the SNS Institutional
Microfinance Fund. Each of these international funders
has achieved sufficient scale and established partnerships
with large financial institutions with foreign exchange
hedging capability. Funds that successfully partnered
with foreign exchange hedging providers had greater
flexibility and ability to provide local currency loans. A
noteworthy and important benefit to international lenders
is that making local currency loans reduces MFIs credit
risk. Specifically, an MFI’s repayment risk is lower if it is
not incurring foreign exchange risk. Local currency loans
can also potentially increase the fund’s profitability, when
10
these loans carry higher rates of interest that exceed the
anticipated foreign exchange depreciation, as is often the
case. The section concludes with a description of a new
independent local currency fund in Latin America called
LOCFUND, as well as other recently launched funds
such as TCX that merit close tracking by MFI managers.
Counterparty Risk: a Challenge to Accessing FX
Hedging Instruments
Counterparty risk can be a bottleneck to microfinance foreign
exchange risk hedging. Counterparty risk is the risk that one
party in a transaction or contract (either the buyer or the
seller, thus the MFI or the bank) defaults and does not fulfill
its obligation under the terms of the transaction. For example,
the counterparty risk for an MFI that has purchased a foreign
exchange hedge is that the bank commissioned to deliver a
foreign currency payment cannot deliver on that obligation
and consequently, the MFI cannot make good on its own debt
payments (interest and principal) in the agreed upon currency.
Likewise, the MFI is the counterparty to the bank and must
also make good on its promise to deliver currency payments.
Counterparty risk is important because, “although hedges can
be put in place to protect positions, they are only worthwhile
if the counterparty actually delivers when it is required to do
so.”11 For this reason, banks usually require that MFIs have a
line of credit established so that there is credit availability to
sell the hedge instrument and assume this counterparty risk.
Given existing constraints on MFIs’ access to local bank lines
of credit, this additional “credit” need is a frequent constraint
to MFIs’ ability to purchase hedging instruments. Microfinance
investment funds and their investment vehicles generally need
similar counterparty credit approval from a bank and several,
such as BlueOrchard, described below, have been successful in
obtaining this counterparty approval.
Dexia Micro-Credit Fund (managed by
BlueOrchard)
BlueOrchard Finance (BO) is a Swiss company
specializing in the design and management of microfinance
investments amounting to US$ 450 million to date. It was
one of the first private international investment managers
in microfinance.
Dexia Fund’s Breakthrough Development: Access
to a Major Bank’s Foreign Exchange Desk
BlueOrchard broke a significant barrier in 2006 when it
began to work with Citibank’s foreign exchange desk to
hedge local currency loans. The funds raised by the Dexia
Micro-Credit Fund are all in hard currency (US dollars or
Swiss francs). Fund by-laws do not permit any unhedged
foreign exchange risk in its loan portfolio.12 Until 2006,
all of Dexia’s loans were issued in hard currencies (either
US dollars or euros). BlueOrchard arranged with Citibank
to provide currency hedging for the Dexia Micro-Credit
Fund, which had reached over US$ 100 million in size.
For Dexia, the underlying loans are now fully hedged,
and Dexia assumes no exchange risk, thus complying
with Fund guidelines. As a result of this arrangement,
BlueOrchard now quotes loans to MFIs priced in local
currency whenever possible, and had issued more than ten
local currency loans as of early 2007. BlueOrchard expects
to substantially increase the local currency component of
its Dexia portfolio, and anticipates that local currency
lending will become the norm for this fund. BlueOrchard
has been pleased with Citibank’s strong global presence,
expertise on swaps, and quick turnaround for price quotes.
Mechanically, when BlueOrchard wants to issue a local
currency loan from the Dexia Fund, it asks Citibank’s
foreign exchange desk for a quote based on BlueOrchard
charging an MFI the LIBOR13 rate plus a certain premium
in US dollars in order to return LIBOR plus 1-2% to BO
investors. Citibank’s exchange desk then submits the
quote to BO within 24 hours. All of the hedging follows
industry protocol and standards.14
BBVA Codespa Microfinanzas Fund
(managed by BlueOrchard)
Blue Orchard’s second breakthrough in offering both
hedged and unhedged local currency loans came through
partnering with the Spanish-based Banco Bilbao Vizcaya
Argentaria (BBVA) Codespa Microfinanzas Fund,
launched in February 2007. The Fund’s target size is
US$ 50 million, and 80% of the fund will consist of local
currency loans, with authorization for up to 30% of the
local currency funding to remain unhedged. Borrowers are
limited to MFIs operating in Latin America. BlueOrchard
will manage the Fund’s risk for BBVA through country,
currency, and institutional diversification, while BBVA
will provide all necessary foreign exchange hedges,
leveraging its local office capabilities in Latin America.
The Fund also helps BBVA manage currency mismatches
on its own balance sheet by lending out Latin American
currencies to MFIs (assets), to offset its Latin American
offices’ local currency deposits (liabilities) or loans
owed. Unlike the Dexia Fund, the BBVA Fund’s ability
to leave some currency risk unhedged means it can lend
in markets (approved on a country-by-country basis) such
as Guatemala and Honduras that currently do not have
foreign exchange hedging mechanisms available.
International Swaps and Derivatives Association
(ISDA)
The International Swaps & Derivatives Association
(ISDA) is an organization whose purpose is to
promote the development of sound risk management
practices, including prudent development of derivatives
and its documentation.15 ISDA goes extensively into
the issue of counterparty risk, and has a protocol and
set of criteria for it. Most banks will only enter into
a derivatives contract with a corporate counterparty
once an ISDA Master Agreement has been agreed
upon. The Master Agreement is an umbrella document
that covers the full range of derivatives transactions.
BlueOrchard’s Local Currency-Lending Challenges:
Bank Partnerships and Counterparty Risk
One of Blue Orchard’s biggest challenges has been
convincing international banks to partner in lending
local currencies to MFIs.
BlueOrchard submitted
requests for proposals to several banks asking that they
propose the provision of currency hedging services to
enable Dexia to issue loans to MFIs in local currency.
Only Citibank responded, and won the bid. The fact
11
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
that Citi has a dedicated microfinance team with senior
leadership and corporate support enabled it to pursue this
MFI hedging opportunity. For both the Citi and BBVA
partnerships, BO did numerous portfolio simulations to
model a diversified portfolio of currencies. Negotiating
these partnerships typically took up to a year and
required BO to identify potential partners, prepare and
submit proposals for prospective partnerships, prepare
numerous documents, including ISDA swap documents,
and negotiate final terms. Any microfinance investment
manager or fund wanting to partner with financial
institutions to provide foreign currency hedging should be
prepared to pass an exhaustive due diligence process by
the prospective partner. Another question to be addressed
is which institution would assume counterparty risk. In
BlueOrchard’s case, the counterparties thus far have been
Citibank or Morgan Stanley, or in the case of Dexia MicroCredit Fund, the fund vehicle serves as counterparty. In the
BOLD transactions (described below), the counterparty
was the Special Purpose Vehicle (SPV) itself.16
More Local Currency Funds on the Horizon
and thus plans to offer new local currency products and
maintain a strong competitive position as a microfinance
lender.
BlueOrchard Loans for Development 1
and 2 (BOLD-1 and BOLD-2)
BlueOrchard and Morgan Stanley together blazed new
trails in local currency funding to MFIs by issuing two
microfinance collateralized loan obligations (CLOs)17
in 2006 and 2007. The two transactions were named
BlueOrchard Loans for Development (BOLD-1 and
BOLD-2). The CLOs provided long-term (5-year) debt,
predominantly at fixed rates, with a substantial component
of the funds issued in different local currencies. All local
currency lending in the CLO was fully hedged. Standard
& Poors rated portions of the BOLD-2 transaction.
Prior to closing BOLD-1, Morgan Stanley faced challenges
relating to currency hedging, two of which are described
below:
BlueOrchard has two additional new local currency funds
under development, each with a different bank partner
and a different level of allowable unhedged currency
risk. There appear to be signs of growing bank interest
in supporting the microfinance sector with local currency
lending. BlueOrchard expects most microfinance
investment funds to offer local currency loans in the future
•
Maturities: Morgan Stanley faced the challenge
of finding hedges to match the tenor of the 5-year
CLO loans. These obligations were often longer
than the coverage available in the local market.
For example, while Morgan Stanley was able
to price a 5-year non-deliverable cross-currency
Table 4: Summary of BOLD-1 and BOLD-2 Transactions
Transaction Transaction
Date
Size
no. of MFIs &
countries in
transaction
percentage &
amount of ClO in
local currency
Local
currencies included
in ClO
BOLD-1
April 2006
US$ 99.1 M
21 MFIs in
13 countries
25%
(US$ 25 M)
Colombian pesos, Mexican pesos, and Russian
rubles
BOLD-2
May 2007
US$ 110.2 M
20 MFIs in
11 countries
35%
(US$ 39 M)
Colombian pesos, Peruvian nuevo soles,
Russian rubles, and Mongolian tugr ik
Source: Morgan Stanley data.
12
Chart 3
BOLD-1 and BOLD-2 Local Currency Volumes (2006 and 2007) in US Dollars
40
US$ Millions
5
30
15
20
20
6
10
0
Mexican Pesos
3.6
2
11
BOLD-1 2006
BOLD-2 2007
Peruvian Soles
Russian Rubles
Colombian Pesos
Mongolian Tugrik
Source: Morgan Stanley data.
swap for the Colombian peso, that length maturity
was not commonly available, whereas there was
more widely available liquidity in the Colombian
market for shorter (2-3 year) maturities.
•
Non-deliverable currencies added complexity:
The BOLD-1 transaction worked with two nondeliverable currencies, the Russian ruble and the
Colombian peso. Due to local regulatory factors,
“non-deliverable” currencies cannot be transferred
from one account to another abroad. The number
of currencies and the fact that some were nondeliverable added greater complexity to the deal.
As of 2007, the Russian ruble is now a deliverable
currency, greatly simplifying hedging the ruble
loan within BOLD-2.
Appendix 1 contains further details about additional
aspects of BOLD-1’s local currency lending and the
transaction’s hedging strategy from Morgan Stanley’s
perspective. Appendix 2 provides a list of 43 currencies
in major microfinance markets, noting whether they have
5-year hedges available, and designating which currencies
are deliverable or non-deliverable. In numerous countries,
a 5-year swap rate simply does not exist, making it difficult
for MFIs in these countries to participate in hedged longer
tenor CLOs such as those by BOLD-1 or BOLD-2. Very
few currencies in these microfinance markets both offer
5-year hedges and are deliverable, making transactions
such as BOLD particularly complex.
Global Commercial Microfinance
Consortium
The Global Commercial Microfinance Consortium
(GCMC), sponsored and managed by Deutsche Bank
(DB), is a US$ 80.5 million, 5-year fund created in
November 2005. Funded by 18 investors, it was the first
global microfinance investment fund with an overriding
goal of offering local currency debt funding so that
MFI borrowers would not carry open foreign exchange
exposures on their books. GCMC is also the first fund
to use in-house hedging capability, provided by Deutsche
Bank’s foreign exchange desk. The Consortium’s
emphasis is on providing local currency, but the MFI
13
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
ultimately picks the currency it prefers (occasionally, an
MFI does not prefer local currency). As shown in Chart
4, GCMC has issued the majority (62%) of its loans in
local currency. It should be noted that the US dollar is the
local currency in dollarized countries (such as Ecuador),
and the euro is either closely linked or the effective
currency in several other countries (such as Bosnia), so
the “local currency” percentage may in fact be higher than
the figures shown in Chart 4. As a US dollar fund, GCMC
has no currency risk allocations or exposure. According to
its underwriting guidelines, all principal must be hedged
while currency exposure on interest is allowed.
Notably, GCMC has never had to refrain from lending
to a creditworthy MFI because it could not offer a local
currency product. The Consortium purchases commercial
currency hedges at in-house rates from DB’s foreign
exchange desk through accessing Deutsche Bank’s
extensive currency hedging capability (such as DB’s
active swaps desk), which has proven to be an important
competitive advantage. For example, DB offers 5‑year
swap rates for many of the local currencies of the
borrowers in the GCMC. This allows the fund to offer
local currency loans to MFIs, while hedging the foreign
exchange risk on its own books. The Consortium mitigates
this risk by purchasing swaps, guarantees, letters of credit,
and participations. These hedging methods are described
below in greater detail:
•
Swaps. This is the most common of GCMC’s
foreign currency risk hedging products. GCMC
extends a local currency loan to an MFI, hedging
its own foreign currency exposure by entering
into a swap agreement with Deutsche Bank or
another bank. GCMC effectively exchanges the
local currency loan cash flows it will receive
from the MFI borrower for US dollar cash flows
at predetermined terms, i.e., a fixed US dollar
principal amount, and a fixed interest rate spread
over LIBOR.
•
Financial Guarantees and Standby Letters of
Credit (SBLCs). In cases where a swap may
not be available, GCMC can utilize an SBLC,
through which DB issues an internal guarantee
or a SBLC to one of its overseas branches or to
another local bank in the MFI’s country. The
local bank receiving the internal DB guarantee
then extends a loan to the MFI in local currency.
GCMC encourages the local bank to leverage
GCMC funds on a greater than 1:1 basis, and uses
its negotiating leverage to convince the local bank
to offer as close to a risk-free rate as possible.
Local DB branches require a 100% guarantee,
so GCMC does not get internal leverage, but
most importantly, the MFI borrower benefits by
receiving a local currency loan.
•
Participations in local bank loans. Bank participations (or participation financing: sharing of a
loan by more than one bank) are an underutilized
mechanism for international investors seeking to
make local currency loans. Participations combine
the best of local and international lending. GCMC
has completed two bank participations to date, in
Peru and Colombia. In the Peruvian case, GCMC
worked with a local Peruvian bank through
a participation of a US$ 1 million equivalent
Chart 4
GCMC Currency Composition
of Loan Portfolio
Euros
Euros
10%
10%
Local
LocalCurrency
Currency
62%
62%
US Dollars
28%
Source: Global Commercial Microfinance Consortium.
14
loan in local currency issued by the bank to an
MFI. GCMC approached the local bank and
asked to buy half of the loan from the bank. The
Consortium bought its participation in US dollars,
and expects to be repaid in US dollars. GCMC
participates in the loan, and shares the interest
received. Mechanically, the bank receives the
interest payments from the MFI. GCMC and
the bank split the interest payments (since they
each own half of the loan). In this case, the local
commercial bank manages the exchange risk
exposure by lending in nuevo soles (Peruvian
currency) to the MFI, while repaying GCMC in
US dollars.
GCMC can also structure loans in ways that address the
specific exchange rate environment of a given MFI. For
one MFI, GCMC issued a loan in dollars, but the loan
contract stipulates that the MFI has the option to prepay
the loan if the dollar strengthens beyond a pre-specified
band of exchange rates of local currency against the
dollar.
Developing World Markets—
Hedging Local Currency Loans in
Collateralized Debt Obligations
Developing World Markets (DWM) made its first foray
into local currency lending only because its MFI clients
insisted on it. DWM is a US-based firm that structures
capital markets transactions for MFIs and other socially
responsible businesses. To date, it has raised about
US$ 400 million in long-term hard currency capital to
finance MFIs around the globe. Until 2007, DWM had
only provided three local currency loans, which composed
about US$ 10 million (or 4%) of DWM’s microfinance
portfolio. These loans were hedged using Standby Letters
of Credit (SBLCs) and swaps. As noted by the principals
at DWM, it had been easier for DWM to make dollar
loans exclusively, until MFIs demanded otherwise.
Local Currency Lending: Loans to Paraguayan and
Peruvian MFIs via SBLCs
Before 2006, DWM did not offer any local currency debt
products. In mid-2006, MFIs in Paraguay, Peru, and
Colombia each requested that loans included in DWM’s
Microfinance Securities XXEB Collateralized Debt
Obligation (CDO) be issued to them in local currency.
DWM sought ways to respond to these requests and
successfully provided funding in Paraguayan guaraníes,
Peruvian nuevo soles, and Colombian pesos.
The XXEB CDO included a US$ 3 million loan to a
Peruvian MFI, of which the borrower requested US$ 1 M
in local currency funding. DWM arranged for a New
York-based bank to issue an SBLC to a local Peruvian
bank which, backed by the SBLC, made a local currency
loan to the MFI on a 1:1 basis (i.e., loan amount is equal
to SBLC amount, thus no leverage). In the same XXEB
transaction, DWM provided a US$ 1.5 M loan to a
Paraguayan MFI. DWM worked with the same bank in
New York and issued two SBLCs to two different banks in
Paraguay, given the MFI’s interest in developing two new
local bank relationships. In this case as well, the local bank
provided no leverage on the SBLC, while the local branch
of the foreign bank offered 2:1 leverage, thus increasing
the ultimate size of the local currency loan delivered. By
accommodating these MFI requests and issuing SBLCs,
DWM developed a strong relationship with the New
York bank that has since provided it with a credit line
for future SBLC issues at attractive pricing. This in turn
will help DWM to meet MFI local currency demands.
DWM prefers SBLCs to swaps for local currency loans,
as SBLCs do not require DWM to assume counterparty
risk. DWM expects to do more local currency lending,
largely through collaboration with local banks, and with
other mechanisms such as the new SNS fund, described
below.
15
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
SNS Institutional Microfinance
Fund (managed by Developing World
Markets)
As of May 2007, DWM became investment manager of the
SNS Institutional Microfinance Fund, a US$ 170 million
fund based in the Netherlands which will make debt and
equity investments in MFIs. Thirty percent of the debt
funds may be deployed in local currency, all of which
may remain unhedged. The fund has made its first two
local currency loans to MFIs in Peru, for US$ 2 M and
US$ 3 M equivalents respectively. Using this vehicle,
DWM is now able to make local currency loans directly
to MFIs without needing to engage a third or fourth party
in the transaction (such as the New York bank and/or the
local bank).
LOCFUND
LOCFUND began in March 2007 as the first purely local
currency regional microfinance fund for Latin America
and the Caribbean. It provides local currency financing to
smaller MFIs, and to MFIs in the process of transforming
into regulated institutions. LOCFUND’s loan sizes
will range from US$ 250,000 to US$ 1.5 million in
local currency equivalents. The fund was capitalized
at US$ 25 M (with an expected cap of US$ 35 M) by
IADB’s Multilateral Investment Fund, FMO, Norfund,
Gray Ghost Microfinance Fund, responsAbility, and the
Corporación Andina de Fomento (CAF). The fund has
already approved three loans and has a strong pipeline
in place. LOCFUND will use the following strategies to
mitigate its foreign exchange risk exposure:
•
The fund will maintain a portfolio of loans
in diversified Latin American currencies. Its
research has shown that correlation between
Latin American and Caribbean currencies is low,
and portfolio diversification serves as a natural
hedge to mitigate foreign exchange risk.
•
LOCFUND plans to eventually issue debt in
several Latin American markets in order to better
match the fund’s liabilities with assets.
•
It will reduce its long-term devaluation exposure
by charging floating local interest rates, under the
assumption that currency devaluations would be
offset by a rise in local interest rates.
•
The Fund will use currency hedging instruments
such as swaps or back-to-backs as available.
•
Fund managers will create a cash reserve in
case of a major devaluation crisis in the target
countries.
Getting the Best Price on Foreign Exchange Hedges
When seeking bids for foreign exchange hedges, it is useful
for an MFI to solicit bids from both local and international
banks, as often local commercial banks can under-price
their international competition. During 2006, a “pricing war”
developed for the US dollar-Colombian peso swap business
of a microfinance loan under the DWM XXEB CDO loan.
One of the XXEB borrowers requested that its US$ 3 million,
5-year loan be issued in local currency, but wanted a swap,
not an SBLC. DWM arranged for the swap to be provided
by the New York based international bank that had done the
above-mentioned SBLCs for DWM, but the MFI suggested a
local Colombian bank to provide the hedge. The local bank
was able to underprice the international bank’s swap to win
the business. The MFI got lower pricing, and DWM was also
pleased that the local bank assumed the counterparty risk,
which DWM would have been required to take on had it
worked with the New York bank.
16
LOCFUND will also have US$ 700,000 in grant funding
available to MFIs for technical assistance related to assetliability management training and capacity building for
its client MFIs, since it is expected that many of its MFI
borrowers will be smaller institutions whose treasury
management capacity may not be well developed.
Recent Developments and New Funds
In addition to the established funds described above, the
impetus to rapidly develop more local currency offerings
has also led to some promising upcoming initiatives. The
Currency Exchange (TCX), sponsored by FMO, closed in
September 2007. Several other local currency funds are
expected to start up by the end of the year, including a
new unhedged fund called Match, which is sponsored by
the IFC.
The Currency Exchange (TCX): Access to Hedges
for Illiquid Currencies
“TCX provides, for the first time, a solution to the
‘original sin’ currently practiced by international
investors globally, i.e., providing hard currency
loans to developing country institutions that have
predominantly local currency income and assets.”
­—From TCX Fact Sheet, July 2007.
To date, TCX is the largest and only broadly accessible
currency exchange facility designed to hedge foreign
exchange risk for non-liquid currencies. TCX is a
specialized fund focused on providing long-term local
currency and interest rate derivatives in emerging
market countries. It will include, but is not be limited
to, microfinance investments. Founding shareholders
include many European development finance institutions,
a number of multilateral development financiers,
microfinance investment funds, donor institutions and
commercial banks active in emerging markets. TCX is
currently capitalized at approximately US$ 300 million
of equity (and may rise to US$ 500 M). These funds
can be leveraged up to four times (e.g., for a maximum
of US$ 2 billion if US$ 500 million in equity is raised.)
The fund size will provide a maximum capacity of
approximately US$ 100 M per currency, and expects to
have a basket of approximately 20 currencies. TCX is
open to nearly all emerging market currencies worldwide,
as long as its products are demonstrably outside of
those offered by commercial banks. According to TCX,
currently existing sources of currency and interest rate
hedges operate on a matched book principle, constrained
to products for which there is both demand and supply.
In most developing markets, long-term currency exposure
hedging products are rare to non-existent. TCX seeks to fill
this gap by offering derivatives in a number of developing
market currencies. TCX will provide a hedge to the funder,
who then uses it to provide local currency financing to its
own client (such as an MFI). Its primary risk mitigation
instrument will be its exposure diversification with a
portfolio spread over a large number of currencies and
interest rates.18
While the focus of TCX is not limited to microfinance,
microfinance investment funds have access to its services
(a number of its sponsors have a demonstrated focus on
the microfinance sector, notably Oikocredit, but also KfW,
FMO and others). The investors will dictate the extent of
the fund’s work in different sectors such as microfinance.
A consortium of microfinance practitioners and investors
has been looking into the feasibility of investing equity
in TCX to ensure access to foreign exchange hedging for
microfinance investment funds and MFIs. Discussions
are being held regarding potential access through a TCX
specialized window for microfinance. Regrettably, TCX
cannot transact with parties that are not shareholders
in the first three years. It is structured to comply with
capital ratios affiliated with AAA rated securities. Rating
agencies that TCX consulted have advised the fund to
defer formal ratings for at least one year until operations
are more defined.
Match Program, International Finance Corporation
The International Finance Corporation (IFC) recently
approved the launch of a pilot program that will enable
it to extend local currency funding on an unhedged basis.
The program is called “Match,” an acronym for Matching
Assets through Currency Hedging. Until now, the IFC has
lent to MFIs predominantly in hard currency, except in
countries where there are developed derivatives markets
that allowed the IFC to hedge its local currency exposure in
17
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
US dollars. Over the last few years, IFC found that many
MFIs and potential borrowers in other sectors operate
in countries that lack developed capital markets, greatly
limiting its ability to provide local currency products to
these potential clients. To overcome this obstacle, the
Match Pilot Program was created and will be tested for a
2-year period. It will operate via a diversified portfolio of
uncorrelated currencies that can work as a natural hedge
against foreign exchange risk. Once the 2-year pilot is
completed, IFC will evaluate the results, and determine if
and how it might expand the program in scale, number of
currencies, and sectors (i.e., housing, infrastructure) going
forward. At inception, the Match Pilot Program will
target microfinance; micro, small and medium enterprise
banks; and the health and education sectors. Each loan
will be capped at US$ 5 M equivalent for a tenor of up to
seven years. The Match Program will complement IFC’s
existing product offerings. Match loans will be used only
when all other existing IFC local currency products have
been exhausted.
To pursue this unhedged strategy and price the local
currency loans, IFC will research prevailing local market
pricing to the extent available and construct a synthetic
yield curve, both for its own lending and as a potential
benchmark for other lenders that wish to follow its lead.
As such, the Match Pilot Program will also help to create
local pricing benchmarks. In this way, IFC hopes that the
Match Pilot Program will have a demonstration effect, to
entice and encourage other lenders to follow suit, both in
lending and in adding to market pricing data.
Through Match, the IFC will take direct currency
risk onto its own balance sheet for the first time. The
diversification of the local currency loans is intended to
mitigate foreign exchange risk fluctuations in any one
country within IFC‘s aggregate unhedged portfolio. IFC
will take a capital allocation for this program, including a
risk-adjusted premium to account for the unhedged local
currency component of the loans.
4.
MFIs: Making Progress Despite
Limited Access to Foreign
Currency Hedging
This section examines a number of types of foreign
exchange risk hedging mechanisms used by microfinance
institutions. The 2004 WWB paper presented a number
of MFI strategies for managing foreign exchange risk,
including use of reserve funds, back-to-backs, forward
contracts, and swaps.19 This section will present three
recent cases in which MFIs accepted hard currency loans
and then hedged these loans through swaps, forwards,
Table 5: Summary of MFI Cases: Foreign Exchange Risk Hedging
Hedging
Mechanism(s)
• Balance sheet
matching
• Swaps
FMMB (Colombia) • Non-deliverable
forwards
• Deliverable
forwards
Compartamos
(mexico)
Loan Tenor
Foreign Exchange Risk Exposure
Long term
5 years
1 year
6 months -1 year
6 years
FMMB has exposure to FX fluctuations at: 1) end of
year five and six on the swap, and 2) at 6 months and
12 months on the renewals of the smaller forwards for
interest payments and $1.3 million principal.
• Futures
• Generally 1 year
• Options
• 5 years
FORUS (russia)
Source: Women’s World Banking.
18
•
•
•
•
Hedge Tenor
Various loan
maturities >1 year
6 years
Exposure at time of each 1-year futures rollover
(strategy prior to conversion to becoming a bank).
Unhedged exposure for US dollar interest payments
and last year of amortizing principal under BOLD-1 in
year six.
futures, options, and the use of existing hard currency
assets on their balance sheet (“natural hedge”). It was
more difficult than expected to identify MFIs that had
purchased foreign exchange risk protection; this is still
far from the norm. Although local currency lending has
increased, the bulk of foreign lending to MFIs is still in
hard currency (at least 70%),20 and a substantial amount of
these loans remain unhedged on borrowers’ books. With
few exceptions (e.g., countries such as Mexico or South
Africa), MFIs typically operate in countries in which
domestic capital markets are shallow to non-existent,
often making it impossible or economically unfeasible
to purchase foreign exchange hedges. When hedges are
available, banks often do not want to take the credit or
counterparty risk of a hedge provided to an MFI.
As shown in Table 5, even when an MFI is prepared to
purchase full coverage, the local market may not offer
the right instrument to fully match the underlying MFI
liability. Examples of three MFIs that successfully
pursued different foreign exchange risk hedging strategies
are reviewed below: Fundación Mundial de la Mujer
Bucaramanga (FMMB) in Colombia, Compartamos in
Mexico, and FORUS in Russia.
FMMB Bucaramanga: a Multiprong
Approach
Despite the fact that the loan was in hard currency (US
dollars), FMMB accepted the larger size and longer tenor
funding to support FMMB’s high growth needs. The
funding also had no collateral requirements, in contrast to
the local Colombian banks which require collateral (even
including MFI portfolio over-collateralization of credit
lines), which freed up the MFI’s assets as collateral for
loans from Colombian commercial banks.
Based on the limited currency derivative product offerings
in Colombia at the time, FMMB was able to creatively
hedge its foreign exchange risk at a reasonable cost
through the four mechanisms described below:
•
Balance sheet matching of foreign currency
assets and liabilities: FMMB had an excess of
US dollar assets over US dollar liabilities totaling
US$ 1.2 million (taking the form of US dollar
investment deposits), which provided a natural
hedge for US$ 1.2 M of the total US$ 5 M
borrowed.
•
Swap: Purchase of a US$ 2.5 M swap with 5year tenor,21 4-year grace period (to match the
underlying loan’s grace period), and principal
amortizing in year five in two semi-annual
payments.
•
Forward, non-delivery: Purchase of a US$ 1.3 M,
1-year tenor forward. As 6-year swaps were not
offered in the Colombian market, and the forward
market was liquid for tenors of up to one year,
FMMB used a 1-year forward to hedge its loan
principal with maturity after year five. FMMB
plans to renew the forward annually to hedge this
principal. FMMB selected a non-delivery forward
to hedge this amount of principal because it would
not require delivery of the dollar principal at the
annual maturities of the forward, since the loan
principal would not be due at that time anyway.
•
Forward, delivery: FMMB still needed to consider
the US dollar interest payments it was obligated
to make. Interest payments were covered with
The experience of FMMB Colombia (one of WWB’s
Colombian network members) is an example of how an
MFI can mitigate foreign exchange risk at the lowest cost
through the creative combination of natural and purchased
hedges.
In an effort to diversify its funding sources and fuel its
growth, FMMB considered international investor lending
proposals and participated in Blue Orchard/Developing
World Markets’ (BOMFS I) 2005 Collateralized Debt
Obligation. FMMB received a US$ 5 million loan with a
6-year maturity. The repayment structure featured semiannual interest payments and semi-annual amortizations
in years five and six.
19
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
6‑month and 1-year deliverable forwards. FMMB
also plans to enter into new forward contracts
as these mature to hedge the upcoming interest
payments. FMMB chose forwards with delivery
of the dollar amount at maturity since it needs the
currency to make interest payments at that time.
Table 6: FMMB Bucaramanga Coverage of
US Dollar Liability
US$ Liability Exposure
US$ Hedging Coverage
US$1.2 M Deposit
US$ 5 M Loan
US$2.5 M Swap
US$1.3 M Forward, non-delivery
Source: Women’s World Banking.
Compartamos­­—Evolution of a Funding
Strategy and Foreign Exchange Risk
Management
The case of Compartamos in Mexico shows how a
strong MFI can successfully evolve its funding strategy
away from hard currency borrowing over time. It also
demonstrates proactive management of its foreign
exchange exposure under limited foreign exchange
hedging alternatives, and how a change in legal structure
can increase the level of scrutiny and limits on its foreign
exchange exposure.
Financiera Compartamos—Futures
As a non-bank financial institution and prior to its
conversion to a bank in June 2006, Compartamos accessed
US dollar debt funding from various international investors
and sought to cover its foreign currency exposure.
Among the instruments available for foreign exchange
risk management in the derivative markets, Compartamos
selected futures to hedge its US dollar exposure.
20
Futures are exchange-traded contracts requiring the
holder to exchange a specified amount of a currency
for another, at a specified price, on a specified future
date (i.e., exchange-traded forward contracts). Futures
are standardized contracts for a fixed uniform currency
amount and set maturity dates throughout the year.
Based on the maturities available in the peso futures
markets, Compartamos generally used futures with a
1-year maturity to cover its foreign exchange position.
Therefore, the maturity of the hedge did not necessarily
coincide with the maturity of its obligations. Every year,
Compartamos purchased new futures to roll over its
foreign exchange hedge. One of the limitations of this
strategy was that it did not provide a perfect hedge over
the life of the US dollar obligations. Another disadvantage
was that it could require frequent margin calls depending
on exchange rate fluctuations.
However, this hedging mechanism mitigated
Compartamos’ currency risk to a level that the institution
considered prudent and that complied with its risk
management policies. Furthermore, for financial reporting
purposes, this hedge was treated as though it covered
the foreign currency exposure of Compartamos, and the
accounting treatment was simpler than that required for
other derivatives.
There was another advantage of this hedging strategy:
while other derivatives such as forwards and swaps
would have used up availability under credit lines, this
was not the case with futures. Futures were purchased
through a broker and traded on an exchange. A further
benefit from the point of view of the Compartamos
management team was that futures diversified the credit
risk among multiple parties, whereas in a forward or
swap contract, credit risk would have remained with a
single counterparty. A number of standardized contracts
of MXP 500,000 (Mexican pesos) were placed among
different counterparties through the Chicago Mercantile
Exchange.
Banco Compartamos
As a bank, Compartamos was subject to more stringent
foreign exchange regulations than it had been previously
as a non-bank financial institution. The central bank of
Mexico (Banco Central de México) did not consider futures
to be a perfect hedge for the foreign currency position of
Banco Compartamos since the futures did not fully match
the maturities of the US dollar obligations. Thus, from
the perspective of the Central Bank, the foreign currency
obligations of Compartamos represented an “open
position,” even though these positions were covered with
futures. Any foreign exchange exposure is required to be
reported on Compartamos’ financial statements.
Banco Compartamos has now prepaid most of its foreign
currency debt, and has also negotiated local currency
funding from its foreign lenders. Additionally, the fact
that there is more local funding readily available for
the Mexican microfinance sector, combined with the
increased ability of international investors to lend in local
currency, has allowed Compartamos to pursue a funding
strategy almost exclusively funded by Mexican peso debt.
As such, Banco Compartamos is likely to consider only
new obligations from foreign funders in local currency.
FORUS (Opportunity International
Russia)—The Use of Options
Opportunity International’s Russian partner, FORUS,22
is an example of an MFI that has used options to cap the
exchange rate it is subject to when repaying its foreigncurrency denominated loans. By doing so, FORUS has
limited its downside loss potential, and controlled its
exposure to exchange rate movements.
FORUS participated (along with FMMB) in the 2005
BOMFS I transaction, receiving a US$ 3.5 million loan
with a 6-year maturity and a 4-year grace period. Upon
accepting this obligation, FORUS retained a (Russian)
firm specializing in currency and interest risk management
products, to serve as advisor on the foreign exchange
risk management strategy for the US dollar obligation.
The approach selected by FORUS and its advisors
involved a series of options to purchase US dollars
over the last 2-year amortizing periods. Since FORUS
had US dollar exposure from other loans, management
purchased US$ 4.3 million worth of hedges to cover this
US$ 3.5 M and other existing US dollar loans. Proposals
were requested from two major international investment
banks. The MFI accepted the lowest price of the two.
The hedging mechanism selected consisted of a series of
Primer on Foreign Exchange Options
Options are contracts giving the buyer the right, but not the obligation, to buy or sell a currency (or a security, or another asset) at
an agreed-upon price during a certain period of time or on a specific date. A call is an option to buy; a put is an option to sell. In
FORUS’s case, call options were purchased in order to repay dollar obligations. The cost of options is paid upfront as a premium.
Where available, options can be an attractive alternative for MFIs to mitigate their foreign exchange risk; the bank selling the option
does not need a credit line for the MFI purchaser because there is no credit profile involved (versus a swap or forward purchase).
pros
cons
• Limits worst case scenario or downside, and allows participation
in upside
• Can be complicated to evaluate
• No counterparty credit approval needed
• Often not available in emerging markets
• Holder has no obligation to exercise the option
• Requires close monitoring of foreign exchange rates
21
wwb focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
calls, or options to buy US dollars, at 30 rubles per dollar.
FORUS chose 30 as the call option trigger based on an
internal analysis of the financial risk FORUS was subject
to if the exchange rate rose above this level, taking into
account the cost of the call options. The cost of this hedge
was paid upfront in the form of a premium. In this case,
the premium amounted to US$ 112,000—or 2.6% of the
US dollar loan principal which was being hedged. The
premium thus amounted to an equivalent annual charge
to FORUS of 52 basis points annualized over a 5-year
maturity.23 When FORUS included this additional annual
premium into its average costs of US dollar funding, the
adjusted interest rate still compared favorably against
ruble interest rates at that time, making the transaction
appealing.
an option has an upside potential, allowing FORUS to
purchase US dollars in the market less expensively when
the ruble has appreciated, as opposed to being locked into
a contracted forward or future rate that would not allow
this flexibility.
Options give an MFI such as FORUS the right to purchase
the US dollars it needs to make regular semi-annual loan
payments over a 2-year period at a predetermined price.
For each amortization, FORUS has two alternatives. It can
exercise its option to purchase US dollars at an exchange
rate of 30 rubles per dollar, or purchase US dollars at the
prevailing exchange rate in the market. If the prevailing
exchange rate at the time of the loan is less than 30 rubles
per US dollar, then it will not exercise its option and will
purchase the dollars in the market. If the market exchange
rate is higher than 30 rubles per US dollar, FORUS will
exercise its option and purchase the dollars at 30 rubles
per US dollar.
MFI Guidelines for Incurring Foreign Exchange Risk
Through the use of options, FORUS capped its exposure
to the US dollar to a maximum exchange rate of 30 rubles
per US dollar. In May 2005, when FORUS received
the loan, the ruble per dollar foreign exchange rate was
approximately 27.9. As of September 1, 2007, the ruble
had appreciated against the dollar and was 25.6. While
there are still two years left before FORUS begins its
semi-annual amortizations, if the ruble remains steady at
this foreign exchange rate or appreciates further, FORUS
will not exercise the “call” options (as it is cheaper to
buy the needed US dollars in the market). The options
purchased by FORUS effectively limit its risk in a scenario
of a depreciating ruble against the US dollar. And, in
contrast to the protection provided by a forward or future,
22
Guidelines for MFI Foreign Currency
Hedging
The three cases described above show ways in which
MFIs can mitigate hard currency risk through the
purchase of hedging mechanisms combined with the use
of partial natural hedges. The box below highlights key
guidelines for MFIs addressing foreign exchange risk.
•
•
•
•
•
MFIs must have clear policies on financial risk management, including foreign exchange risk (measured against
core profitability and ability to absorb losses on the
balance sheet).
Ideally, MFIs should avoid foreign exchange risk, but if that
is not possible, then feasible alternatives must be sought
to mitigate the risk.
Based on the availability of hedging instruments or
derivatives in its market, an MFI should seek a balance
between the level of protection and the cost, emphasizing
protection against loss.
MFIs must only enter into derivative contracts with solid
and trustworthy counterparties.
MFI should know if the lender allows prepayment, and if
so, if there is a severe penalty, including compensating the
lender for any cost of canceling foreign exchange hedges.
MFIs purchasing foreign exchange coverage need to
consider the cost of such coverage in determining whether
it is economically feasible and advisable to take a hard
currency loan. Some MFIs make the distinction between
hedging principal and interest. When considering the
costs of foreign exchange risk coverage, some MFIs may
choose a structure that may not fully cover the currency
risk, but results in minimizing exchange risk exposure
at a cost that still makes the underlying loan transaction
attractive. The bottom line is that MFI managers need to
carefully evaluate the capacity of their annual earnings
and capital base to absorb any unhedged exposure, and the
MFI’s willingness to assume this risk. MFIs should also
consider other important external factors, summarized in
the box below.
External Factors for an MFI to Consider That May
Affect an International Loan
•
•
•
•
•
Local currency volatility, past and future
Country risk volatility: political, economic, and other
Local banking system reserve requirements on the
international loan
Other regulatory restrictions on external borrowings and
holding hard currency
Withholding taxes on interest payments and overall tax
regime
The regulatory environment can have a significant
impact on an MFI’s approach to borrowing in different
currencies. As seen earlier in the case of Compartamos,
a change in legal structure may impose more restrictive
regulations limiting exchange risk exposure. In at least
one microfinance market, local law requires that 40%
of any foreign loan received be held idle, earning no
interest for a six-month period. Clearly, regulations such
as this may make foreign currency funding prohibitively
expensive regardless of the availability of hedging
derivatives. Another consideration that for-profit or
transforming MFIs must evaluate is the tax implication
of foreign borrowing. While most MFIs are familiar with
the tax rate MFIs pay on profits earned, in some countries
there are also withholding taxes levied against interest
payments made to parties outside of the country (such
as international microfinance funds). Both MFIs and
microfinance investors need to calculate the “grossed up”
cost of these types of taxes in order to determine the all-in
cost of a foreign loan.
Lastly, an MFI should be aware of the political and
country risk environment in which it operates, both for
the impact on its own operations and the perception of this
risk by the international investor. For example, in light of
the changing political landscape in Bolivia during 2006
and the potential implications of the new administration’s
policies for the microfinance industry, one investment
fund did not renew loans to MFIs in Bolivia as they came
due. In Benin, increased concern by international lenders
about unfavorable economic developments during 2006
caused an MFI to prepay its foreign loans when the MFI’s
foreign investors began making nervous inquiries weekly
and sometimes more frequently. This became distracting at
a critical time when management needed to focus on core
operations. The MFI was able to prepay its foreign loans
from existing liquidity. Management also felt that that the
MFI could manage with loans from local Beninese banks
that were more comfortable with current local economic
challenges.
5.
Conclusions: Much Progress, but
Still Far to Go
Enormous strides have been made since Women’s World
Banking first reported on microfinance foreign exchange
risk management in 2004. While the majority of foreign
loans from investment funds (70% or more) are still in
hard currency, that rate has dropped from 92% just a few
years ago. MFIs continue to seek foreign loans as part of a
diversified capital structure strategy. This is due to foreign
debt’s longer tenors, typical lack of collateral requirements,
and larger loan sizes, as compared to more restrictive local
bank loans. It is not yet clear whether increased local bank
lending to MFIs will have a significant dampening effect
on MFI demand for foreign debt.
Both competitive pressure and industry imperatives are
motivating microfinance investors to lend in local currency.
Almost all of the major international microfinance lenders
now offer some element of local currency loan access, in
contrast to just a few years ago when this was pioneered
by a few funds. Several investment funds have now
reached a scale to negotiate ongoing access to major bank
currency hedging desks, enabling them both to lend in
local currency and fully hedge exchange rate risk on their
23
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
balance sheets. At least one fund had not planned to lend in local currency, but was
pushed to do so by unexpected demand from its MFI clients. Several investment funds
recently started lending in unhedged local currency, applying market principles of natural
hedging using a portfolio of uncorrelated currencies. This strategy, while riskier than full
currency hedging, also has upside potential for higher returns. It remains to be seen what
type and extent of investor interest will be generated by partially or wholly unhedged
local currency funds.
Some MFIs are hedging part or all of their foreign exchange risk through a range of
commercially available local hedging products. Given the level of hard currency debt, it
is not clear why more MFIs are not hedging currency risk. It remains to be determined
whether MFIs’ willingness to accept foreign exchange risk exposure is driven by a lack
of market availability of currency hedging mechanisms, the high cost of these hedges,
or a complacent willingness to bear the risk. Best practice dictates that MFIs should not
leave any unhedged foreign exchange risk on their balance sheets. Second best would be
to have partial foreign exchange risk coverage. It is vital that MFIs set foreign exchange
limits as part of their financial risk management policy. These limits should take into
account liquidity needs as well as the capital cushion and earnings capacity required to
absorb any potential exchange risk losses. An MFI’s Board of Directors should have
oversight of both setting and monitoring foreign exchange risk exposures, or “gaps.”
Women’s World Banking continues to design training workshops and tools on financial
risk management for MFIs and to advocate for increased understanding and use of hedging
products to manage foreign exchange risk. In partnership with Citibank, WWB has to
date delivered seven training workshops on financial risk management around the world
(including workshops for “training of trainers”) to further leverage industry learning and
capacity-building.
The strong momentum for increased international local currency lending bodes well for
microfinance institutions, putting investment-ready MFIs in a strong position to negotiate
for desired loan terms, including selection of currency. WWB strongly encourages MFIs
to demand and negotiate for local currency loans from international lenders. Going
forward, it is likely that all new microfinance investment funds will have to offer local
currency loans to be competitive. Three years from now, will WWB be able to report that
the concern that MFIs are bearing too much foreign exchange risk is a thing of the past?
Increasingly, investors and MFIs alike are better able to tackle this issue. Investors are in
the best position to shift into local currency, and move away from hard currency. WWB
and others will be tracking their progress closely; we look forward to celebrating their
progress and publicizing their innovations.
24
Appendix 1: The Morgan Stanley Currency Hedging Process
for BOLD-1
Key findings
•
BOLD transactions used existing hedging products, but the combination of the
simultaneous use of multiple hedging products and longer tenors created great complexity
and work.
•
Each added currency in the CLO added significantly more time to close the transaction.
•
Hedging non-deliverable currencies (such as the Russian ruble in 2006) required the most
extensive effort.
•
Local regulation and currency restrictions can add a great deal of time and work to a
given currency hedge.
•
The local currency aspect of the transaction is replicable, but very labor intensive.
All of the local currency hedging instruments used in BOLD-1 were familiar products to anyone
working in foreign exchange markets. But the number of derivatives, and the number of currencies
that Morgan Stanley had to hedge, was unusual and unique. In fact, BOLD-1 was the first time
Morgan Stanley (MS) had used so many derivatives with so many exotic currencies all at once.
A unique aspect of BOLD-1 included incorporating two non-deliverable currencies, the Russian
ruble and Colombian peso, discussed further below.
Sample challenges in structuring the Russian ruble
currency hedging:
•
To hedge Russian rubles, MS provided the derivative in the form of an offshore dollarruble non-deliverable cross-country swap, and had to manage the conversion of the actual
cash flows within Russia. This required opening a bank account in Russia in order to
have the ability to work with the ruble. The account was needed to make payments to the
MFI and receive payments from the MFI.
•
It took MS three to five months, working with its office in Russia, to open this account.
In fact, one MS staff member in Russia spent approximately half of his work time on the
transaction just on the ruble foreign exchange arrangements.
•
In order to open the account, each of the many necessary transaction documents had to
be translated into Russian.
•
The effort required far surpassed what MS usually does for a financial transaction.
25
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
Example of a challenge faced in Colombia:
In Colombia, MFIs are not allowed to receive foreign currency funds unless the lender is on a list
of authorized and registered lenders at the Central Bank. The BOLD-1 Special Purpose Vehicle
(SPV) was not on this list, since it was a newly traded company. Thus, Morgan Stanley had to find
another financial institution to give and receive funds from the CLO in Colombia, as well as to
handle legal and contract aspects of the transaction. FMO, which was assuming the junior portion
of the CLO, was on the authorized list in Colombia, hence Morgan Stanley was able to disburse
the loans in Colombia using FMO’s approved channel.
Every local currency added further complexity
In hindsight, it was fortunate that Morgan Stanley was asked to hedge only three local currencies
in BOLD-1. Whether or not a currency was hedgeable was only a small part of what was required.
There were also timing constraints—Morgan Stanley had to finish each aspect of the transaction
by a designated close date, as the MFIs had specific time-sensitive funding needs. Although this
was the first time for many aspects of the transaction, Morgan Stanley was able to do a second
transaction just one year later (BOLD-2), adding two new currencies, and obtaining Standard &
Poors ratings on two tranches of the CLO.
The mechanics of the swaps
Mechanically, the aim of a derivative is to turn a US dollar loan into a local currency loan. The
derivatives enabled MS to convert US dollars into local currency to lend to the MFIs, and local
currency interest paid to it by the MFI into US dollar interest. This is called a cross-currency
swap, in which principal and interest are converted with a way in and way out. MS applied the
same type of transaction to each of the local currencies in the portfolio. Thus, over the 5-year
life of the CLO, Morgan Stanley receives local currency interest every three months and converts
it back into US dollars using derivatives embedded in the deal. This entails twenty quarters of
at least 50 cash flows each, or over 1,000 cash flows over the life of the CLO. In this process,
Morgan Stanley must ensure that all of the netted cash flows produce the correct amount of dollars
or euros on the correct dates. For future transactions, Morgan Stanley could consider semi-annual
interest payments, rather than the quarterly payment structure it used in BOLD-1, to lower the
total number of cash flows needed each year and over the life of the CLO.
Because of the complexity of the operational issues in BOLD-1, and because each new currency
adds many additional steps, a potential future idea is to set up a rolling structure whereby there
is not a single transaction closing date (as in BOLD-1 and BOLD-2), but rather a permanent
structure created by an investment bank in which MFIs and respective currencies could be added
to the structure as each individual collateralized loan was completed.
26
Appendix 2: List of Currencies that Can and Cannot be Hedged for
5-Year Tenors
(As of July 2007)
Country
Is a 5-year
hedge
available?
Is currency
nondeliverable?
Country
Is a
5-year
hedge
available?
Is currency
nondeliverable?
1
Albania
No
Deliverable
29
Mongolia
Yes
Non-deliverable
2
Argentina
Yes
Non-deliverable
30
Montenegro
Euroized
Deliverable
3
Armenia
No
Deliverable
31
Nicaragua
Dollarized
Deliverable
4
Azerbaijan
Yes
Non-deliverable
32
Pakistan
No
Deliverable
5
Bangladesh
No
Deliverable
33
Paraguay
No
Deliverable
6
Bolivia
No
Deliverable
34
Peru
Yes
Non-deliverable
7
Bosnia
Euroized
Deliverable
35
Philippines
Yes
Non-deliverable
8
Brazil
Yes
Non-deliverable
36
Poland
Yes
Deliverable
9
Cambodia
No
Deliverable
37
Romania
Yes
38
Russia
Yes
39
Tajikistan
Yes
Deliverable
Deliverable
(since 2007)
Non-deliverable
40
Tanzania
No
Deliverable
41
Uganda
No
Deliverable
10
CFA countries in Africa
(Examples: Benin,
Senegal)
Not directly, but
African Development Bank could
hedge if MFIs would
accept hedge pricing
Deliverable
11
Chile
Yes
Non-deliverable
42
Uzbekistan
No
Deliverable
12
Colombia
Yes
Non-deliverable
43
Zambia
No
Deliverable
13
Costa Rica
No
Deliverable
14
Dominican Republic
No
Deliverable
Note: non-deliverable currencies will obviously have implications for structuring and
documentation if the currency is used in a CLO.
15
Ecuador
Deliverable
Source: Morgan Stanley
16
Egypt
17
El Salvador
No
Yes—if permitted by
regulator
Dollarized
18
Georgia
No
Deliverable
19
Ghana
No
Deliverable
20
Guatemala
Dollarized
Deliverable
21
Honduras
Deliverable
22
India
23
Indonesia
Dollarized
Yes—if permitted by
regulator
Yes
24
Jordan
No
Deliverable
25
Kazakhstan
Yes
Non-deliverable
26
Kenya
No
Deliverable
27
Kyrgyzstan
No
Deliverable
28
Mexico
Yes
Deliverable
Deliverable
Deliverable
Non-deliverable
Non-deliverable
27
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
Bibliography
Ahmed, Syed Aftab. Local Currency Financing for MFIs. (EFSE Annual Meeting 2007).
Washington, D.C.: IFC, 2007.
http://www.efse.lu/annual_meeting/docs/track%20a/Panel%204/Panel4_Ahmed_IFC_070504.
pdf
Allen & Overy. An Introduction to the Documentation of OTC Derivatives: Ten Themes.
London: Allen & Overy, May 2002.
http://www.isda.org/educat/pdf/ten-themes.pdf
Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New York: John Wiley,
1996.
Cavazos, R., Abrams, J., and Miles, A. Foreign Exchange Risk Management in Microfinance.
New York: Women’s World Banking, July 2004.
http://womensworldbanking.org/files/pub_19_e.pdf (English)
http://womensworldbanking.org/files/pub_19_s.pdf (Spanish)
http://womensworldbanking.org/files/pub_19_f.pdf (French)
Cross, Sam. All About the Foreign Exchange Market in the United States. New York: Federal
Reserve Bank of New York, 1998.
Dexia Asset Management. Dexia Micro-Credit Fund Prospectus. Dexia: Luxembourg, June
2005.
http://www.blueorchard.org/jahia/webdav/site/blueorchard/shared/Products/Dexia/
AnnualReports/June30th2005.pdf
FMO. The Currency Exchange (TCX) Information Memorandum. The Hague: FMO, May
2007.
FMO. The Currency Exchange Fact Sheet. The Hague: FMO, July 2007.
Ivatury, Gautam and Julie Abrams. The Market for Foreign Investment in Microfinance. CGAP:
Washington, D.C., August 2005.
http://www.cgap.org/docs/FocusNote_30.pdf
Littlefield, Elizabeth. MIVs and DFI Investment Examined. Washington, D.C.: CGAP, March
2007.
http://www.cgap.org/portal/binary/com.epicentric.contentmanagement.servlet.
ContentDeliveryServlet/Documents/DFIsACCION03-18-07.ppt
Reddy, Rekha. Microfinance Cracking the Capital Markets II. Insight Series Number 22.
Boston, MA: Acción, May 2007.
http://www.accion.org/insight/
28
Treasury Today. Derivatives Documentation: The Role of the ISDA Master Agreement. London:
Treasury Today, June 2004.
http://www.treasurytoday.com/
Treasury Today. Managing Exotic FX Risk. London: Treasury Today, March 2005.
http://www.treasurytoday.com/
29
WWB focus note
From Dollar to Dinar: The Rise of Local Currency Lending and Hedging in Microfinance
Additional References on Microfinance Foreign Exchange
Risk
Bhatia, Romi. Working Paper on Mitigating Currency Risk for Investing in Microfinance Institutions
in Developing Countries. Washington, D.C. Social Enterprise Associates, January 2004.
www.socialenterprise.net/pdfs/soc_ent_mitigating_curr_risk.pdf
CGAP. Foreign Exchange Risk Mitigation Technique: Structure and Documentation, A
Technical Guide for Microfinance Institutions. Washington, D.C.: CGAP, 2006.
http://www.cgap.org/portal/binary/com.epicentric.contentmanagement.servlet.
ContentDeliveryServlet/Documents/TechnicalTool_ForeignEx.pdf
Crabb, Peter. Foreign Exchange Risk Management Practices of Microfinance Institutions.
Journal of Microfinance Volume 6, Number 2 (Winter 2004): 51-63.
http://marriottschool.byu.edu/esrreview/articles/article108.pdf
Dodd, Randall and Shari Spiegel. Up from Sin: A Portfolio Approach to Financial Salvation.
Geneva: United Nations, January 2005.
http://www.unctad.org/en/docs/gdsmdpbg2420051_en.pdf
Featherston, Scott, Elizabeth Littlefield, and Patricia Mwangi. Foreign Exchange Risk in
Microfinance: What is it and How Can it be Managed? Washington, D.C.: CGAP, January
2006.
http://www.cgap.org/docs/FocusNote_31.pdf
Fernando, Maheshan. Managing Foreign Exchange Risk: The Search for an Innovation to
Lower Costs to Poor People. Microfinance Matters, Issue 12. New York, NY: United Nations,
2005.
http://www.uncdf.org/english/microfinance/pubs/newsletter/pages/2005_05/news_managing.php
Holden, Paul and Sarah Holden. Foreign Exchange Risk and Microfinance Institutions.
Washington, DC: MicroRate and The Enterprise Research Institute, July 2004.
http://idbdocs.iadb.org/wsdocs/getdocument.aspx?docnum=550616
MicroCapital Institute. Currency Risk in Microfinance. San Francisco, CA: MicroCapital
Institute, 2005.
http://microcapital.org/downloads/whitepapers/Currency.pdf
Miles, Ann. Microfinance and Foreign Exchange Risk: A perspective from a Microfinance
Investment Adviser. Geneva: BlueOrchard, October 2005.
www.seepnetwork.org/files/3387_file_F10d._not_on_list_051027_SEEP_AGM_FOREX_
Miles_BlueOrchard.ppt
SEEP Network. Five Strategies to Minimize Foreign Exchange Risk for Microfinance
Institutions. Washington, D.C.: SEEP Network, October 2005.
www.seepnetwork.org/files/3110_file_Progress_Note_13_Michelle.Jennifer_.pdf
Sicard, Catalina. Microfinance Institutions and Foreign Exchange Risk: The Experience of
ACCION’s Latin American Affiliates. Boston, MA: Acción, January 2006.
http://www.accion.org/insight16e/
30
Notes
1. Cavazos, C., Abrams, J., and Miles, A. Foreign Exchange Risk Management in Microfinance. New York: Women’s World Banking, July
2004. http://womensworldbanking.org/files/pub_19_e.pdf.
2. 2004 data from Ivatury, Gautam and Julie Abrams. The Market for Foreign Investment in Microfinance. CGAP: Washington, D.C., 2005,
pages 3 and 11. 2006 data from Littlefield, Elizabeth. MIVs and DFI Investment Examined. Washington, D.C.: CGAP, 2007, slides 3
and 11.
3. Ibid.
4. Cavazos, C., Abrams, J., and Miles, A. Foreign Exchange Risk Management in Microfinance. New York: Women’s World Banking, July
2004, pages 6-12.
5. This paper focuses solely on currency aspects of international debt, as equity investments in MFIs are by their nature in local
currency.
6. A key aspect of “local currency lending” is matching the currencies of an MFI’s assets and liabilities. Thus, if an MFI is lending in a hard
currency, such as the dollar or euro, its assets and liabilities in those currencies should match. As such, “local currency” refers to the
currency in which MFIs issue loans to its clients, and the currencies on its balance sheet.
7. Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New York: John Wiley, 1996, page 197.
8. As can be seen in Table 2, the choice of whether an analyst computes the simple or compound average annual change in a
currency or basket of currencies, can affect the depreciation or appreciation calculation by a difference of more than 100 basis
points (1%). Thus, when comparing currency fluctuations, the analyst should make sure to know the computational method used.
9. Any foreign exchange loss should be avoided, both from an accounting/”book” basis or cash basis. Foreign currency fluctuations
(losses and gains) will be reflected on an annual basis in the MFI’s financial statements. MFI managers should avoid book losses,
and also be aware that any significant exchange rate movements against the local currency occurring when a hard currency loan
comes due could place liquidity stress on the MFI. If this occurs, the MFI must struggle to find the liquidity to pay out hard currency
obligations with cash that is no longer worth as much given a currency depreciation (e.g., more local currency needed to pay back
a US dollar loan).
10. There is still a large universe of younger, smaller, or more nascent MFIs (i.e., Tier 2 & 3) that have less access to sufficient sources of
funding.
11. “Derivatives Documentation: The Role of the ISDA Master Agreement.” Treasury Today, London, June 2004, page 12.
12. Per Dexia Fund’s prospectus, local currency loans will only be allowed if the country in which the micro-bank is established has (as
much as possible) a convertible currency and no foreign exchange restrictions. Source: Dexia Asset Management. Dexia MicroCredit Fund Prospectus. Dexia: Luxembourg, January 2005, page 10.
13. LIBOR stands for London Interbank Offered Rate, the rate charged by one bank to another for lending money.
14. Swaps and derivatives follow the International Swaps & Derivatives Association’s (ISDA) protocol. Please refer to ISDA box on
page 11 for further explanation.
15. Allen & Overy. An Introduction to the Documentation of OTC Derivatives: Ten Themes. London: Allen & Overy, May 2002, page 1.
16. A Special Purpose Vehicle (SPV) is a limited-purpose organization that serves as a pass-through conduit in creating securities
backed by mortgages, credit card and auto loans, leases, and other financial assets (such as microfinance loans). An SPV is a
bankruptcy remote subsidiary corporation designed to serve as counterparty for swaps and other credit sensitive derivative
instruments.
17. The term CLO stands for collateralized loan obligation. They may also be called CDOs, or collateralized debt obligations.
18. FMO. The Currency Exchange (TCX) Information Memorandum. The Hague: FMO, May 2007, pages vi and 21.
19. Foreign Exchange Risk Management in Microfinance, pages 6-12.
20. Due to the lack of available investment data and the typically long tenors of international loans to MFIs, it may take some time to
be able to determine if there has been a fundamental shift in lending from hard to local currency.
21. Five years was the longest tenor available for swaps at the time, although the Colombian market now has ten-year swaps available.
This is a positive market development, as a few years ago, the maximum swap tenor was 4-5 years.
22. FORUS was previously named FORA. Upon converting to a bank in 2006, it was renamed FORUS. All local and currency options
were transferred to the new commercial bank FORUS upon conversion.
23. 100 basis points are equal to 1%. The premium was approximately 58 basis points when discounting the premium by the US
interbank rate.
31
About WWB
Our mission is to improve the
economic status of poor families in
developing countries by unleashing
Subheading_Main
the power inherent in women.
Text_Main
We believe that when a woman
is given the tools to develop a
small business, build assets, and
protect against catastrophic loss,
she is empowered to change her
life and that of her family. Drawing
on our diversity, resources and
experience, WWB’s global team of
advisors helps to strengthen the
Acknowledgements
The authors and Women’s World Banking would like to thank the following people who were
interviewed for or contributed to this focus note: Ann Miles and Jean-Philippe de Schrevel, Blue
Orchard; Ian Callaghan, François Thomas, Annette Burgard and Ana Sandra
Ruiz
Back_Blue
BoxEntrecanales,
Headings
Morgan Stanley; Asad Mahmood, David Gough, and Michael Rauenhorst, Deutsche Bank; Peter
Back_Blue Box
Text Back_Blue
Box
Johnson, Developing World Markets; Tomás Miller, IADB; Joost Zuidberg,
Maurice
Scheepens,
and Maria Verheij, FMO; André Laude and Zina Sanyoura, IFC; Fernando
Sanchez,
LOC
Fund;
Text Back_Blue Box Text Back_Blue
Lizette Escamilla Miranda and Jose A. Plascencia Santos, Compartamos; Edison Mejia and Teresa
Text Back_Blue
Box Text
Eugenia Prada Gonzalez, FMMB Bucaramanga; and Rick Halmekangis,Box
Opportunity
International.
Additionally, our thanks to Rocío Cavazos for her help in drafting the MFI cases and to Robert
Back_Blue Box Text Back_Blue Box
McNeill, Donald Creedon and Petra Tuomi from the WWB Communications team for their help
in the editing and layout process.
Text Back_Blue Box Text
This publication is made possible in part by the generous support of theBack_Blue
Multilateral
Investment
Box Headings
Fund of the Inter-American Development Bank.
Back_Blue Box Text
microfinance organizations and
banks in our network that share
Back_Blue Box Text
our commitment to helping poor
Back_Blue Box Text
women access financial services
Back_Blue Box Text
and information.
Women’s World Banking was
created in 1976 to be a voice and
Back_Blue Box Headings
change agent for poor women
Back_Blue Box Text
entrepreneurs. Our goal is to
continue to build a network
Back_Blue Box Text
of strong financial institutions
Back_Blue Box Text
around the world and ensure
that the rapidly changing field of
Back_Blue Box Text
microfinance focuses on women as
Women’s World Banking
clients, innovators and leaders.
8 West 40th Street, 9th Floor
Contact WWB
New York, NY 10018, USA
Women’s World Banking
Tel: (212) 768-8513, ext. 209
8 West 40th Street
9th Floor
Fax: (212) 768-8519
New York, NY 10018
E-mail: [email protected]
Tel: 212-768-8513
Fax: 212-768-8519
Email: [email protected]
www.womensworldbanking.org
Copyright © 2007 Women’s World Banking
All rights reserved
www.womensworldbanking.org
No part of this focus note may be photocopied, translated or reduced to any electronic medium or
machine-readable form without the prior written consent of Women’s World Banking.