Finding Solutions to the Currency Risk Challenge for MFIs and Investors

Transcription

1 2011 Global Microcredit Summit Commissioned Workshop Paper November 14-17, 2011 Valladolid, Spain Finding Solutions to the Currency Risk Challenge for MFIs and Investors Written by: Brian Cox, President and CEO, MFX Solutions, USA Sonia Mukhi, Senior Analyst, MFX Solutions, USA 1

2 TABLE OF CONTENTS The Problem of Currency Risk in Microfinance... 3 Size of the Problem: How exposed is microfinance to currency risk?... 5 MFI and Investor Strategies to Manage FX Risk: Non-Derivative Approaches... 7 Back to Back Lending... 8 Letter of Credit... 9 On-lending and Loan Indexing Management of Open FX Positions at the Investor level MFI and Investor Strategies to Manage FX Risk Using Derivatives Introduction to Hedging Products and Processes The Currency Exchange Fund (TCX) MFX Solutions (MFX) Conclusion Bibliography Appendix I: Microfinance Swap Transaction Process Map

3 The Problem of Currency Risk in Microfinance The dilemma of currency risk in microfinance arrived with the first hard currency loan from a lender in the developed world to an MFI in a developing country. That loan had to be repaid in hard currency (US Dollar, Euro, etc.) but the ultimate income that would repay the loan the money earned by the micro entrepreneurs would be earned in local currency. If that local currency depreciated, the hard currency loan still had to be repaid in full. The MFI faced a dilemma: it could lend to its micro-entrepreneur in hard currency, thereby passing through the risk, or it could lend in local currency and bear the risk itself. In either case, risk was pushed down to the lowest and most vulnerable link in the value chain. 1 Figure 1 Social Investors $ Funding Currency Risk MIVs $ wholesale loans MFIs $ or indexed microloans Micro-entrepreneurs Local currency revenues Local Economy This fundamental problem remains at the heart of microfinance. As of 2008, the industry s foreign exchange risk exposure is at least US$6 billion, of which US$ 4.5 billion has been onlent in foreign currencies to borrowers. While local currency lending has increased from 10% to 25% over the last 4 years, hard currency exposure continues to grow at roughly USD $50 million per year (CGAP). Microfinance was able to experience significant rates of growth despite this 1 This pass-through risk to micro borrowers will be discussed in a further section, see On-lending and Loan Indexing. 3

4 underlying weakness, partly because of nine years of generally stable emerging market currencies that favored risk takers. In the absence of the usual emerging market shocks, many MFIs borrowed at lower hard currency interest rates and ignored the possibility of depreciation. However, the 2008 crisis changed everything. With many MFI balance sheets having been severely hit by depreciations, the industry now faces a new era of uncertainty in exchange rates and awareness of currency risk. Rapid modernization is also pushing MFIs to meet higher regulatory standards, including risk-weighted capital requirements. This means that they must recognize and quantify their currency risk, whether or not they are actually experiencing the effects of depreciation. Finally, the advent of new commercially-oriented microfinance funds brings a new class of investor much less tolerant of currency risk. In 2009, for the first time, microfinance lenders and investors rated currency risk as their number-two concern in the CSFI Microfinance Banana Skins Survey. To tap this new capital, MFIs must make wise choices about their funding, and limit hard currency borrowing. To illustrate the dilemma outlined above at the level of an institution, let s look at the impact of currency movement on an MFI in Indonesia that had borrowed in hard currency in the period preceding the 2008 crisis. This particular MFI was perceived to be a sound, well managed institution by international investors. A snap shot of their balance sheet in July 2008 indicates a debt-to-equity ratio of 4.6. What the ratio doesn t capture, however, is the composition of the debt which is significantly comprised of hard currency debt (35.8%). Figure 2 Example: Indonesia Jul-Dec 2008 July 31, 2008 Indonesian Rupiah/USD Rate: 9090 % of Total Liabilities 35.8% USD Debt 46.5% Local Rupiah Funding 17.7% Equity USD debt/equity: 2.0 Status: Creditworthy IDR Depreciation 22.3% December 31, 2008 Indonesian Rupiah/USD Rate: 11,123 % of Total Liabilities 43.8% USD Debt 46.5% Local Rupiah Funding 9.7% Equity USD debt/equity: 4.5 Status: Not creditworthy Between July and December 2008, the Indonesian Rupiah (IDR) depreciated by approximately 23%. And the impact that this event had on the balance sheet is seen on the December 2008 balance sheet. The value of the USD debt made a 22.3% leap (to 43.79% of total liabilities). Meanwhile, equity depleted by 45.3%, reflecting the increase in the value of hard currency 4

5 liabilities when they are valued in the depreciated local currency. The MFI s debt-to-equity ratio doubled as a result of the devaluation to 9.3. While this MFI may have performed well on a variety of other metrics, the failure to properly strategically plan its funding and prepare for adverse economic scenarios, was enough to dramatically alter its credit profile. As a result, the MFI was no longer able to borrow funds to finance its growth and the institution found itself in a position of needing to scale back its activities in order to pull itself back into a financially sound position. Without new funding for a period of time, the MFI was unable to serve as many entrepreneurs in the low income communities as it was able to one year prior. This case demonstrates how the failure to manage currency risk can set off a domino effect that prevents microfinance institutions from achieving their maximum potential for social impact in their communities. Size of the Problem: How exposed is microfinance to currency risk? In 2010, MFX Solutions commissioned a research study, RISKY BUSINESS: an Empirical Analysis of Foreign Exchange Risk Exposure in Microfinance, to uncover the extent to which microfinance faces currency risk. While the issue of currency risk in microfinance had been addressed in previous industry publications, this study was the first to empirically document the size of the problem as well as the form in which it has taken shape in various microfinance markets. As mentioned earlier, the publicly available data from over 300 MFIs 2008 audited financials shows that the total size of currency mismatch in the industry stands at approximately $6.1 billion based on this representative sample. Of this amount, $1.6 billion is held as open exposure by MFIs, while $4.5 billion is passed onto end borrowers. In other words, the reporting MFIs held a collective $1.6 billion of currency mismatch directly on their balance sheets so either a positive or negative mismatch would lead to foreign exchange losses depending on the movement of foreign currencies vis-à-vis an MFI s local currency. The bleaker finding, however, is the fact that $4.5 billion of the total industry s exposure is held by end borrowers who are the most ill equipped to handle this type of risk. This finding confirms the prevalence of the MFI practice of loan indexing (which will be discussed in a later section). With the exception of MFI clients operating in dollarized or euroized markets, most of these borrowers are assumed to be operating in local currency and not earning hard currency income. This situation represents credit risk and market risk exposure for the industry which, in the event of currency volatility, could cause hardship for MFI clients and losses to the MFI. The implication from these findings is that the microfinance industry must work together to deal with this risk, which currently rests largely with the borrowers at the base of the pyramid. From a regional perspective, the study found that MFIs in Eastern Europe and Central Asia (ECA) account for more than half of the global total of FX risk exposure and America/Caribbean (LAC) another quarter (Figure 3). 5

6 Figure 3 Regional Composition of Aggregate MFI Net Open Position, 2008 LAC 25% South MENA Asia 2% 1% Africa 10% EAP 8% ECA 54% While measuring the volume and geographic concentration of the exposure is important, it does not answer the central question: how potentially damaging is this exposure to the microfinance industry? For an MFI, the most practical way to measure this is to view the total size of the net open position as a proportion of the institution s equity. This can help signal when an MFI faces a risk similar to the Indonesian MFI described above. While there are various tolerance levels recommended, to be safe form material losses, an MFI should maintain open currency exposure levels below 10% of equity. The study uncovered that 65% of the sample size hold more than this level. 6

7 Percent Figure 4- Segmentation of MFIs by Aggregate Net Open Position, 2008 (Based on all foreign currencies on an absolute value basis) 100% 90% 80% 70% 60% 145 > 25% 20% - 25% 10% - 20% 5% - 10% 0% - 5% 50% 40% 30% 20% 10% Sixty-five percent of MFIs exceed the recommended 10% foreign exchange net open position as a percentage of equity 0% Number of MFIs per Net Open Position as Percentage of Equity (for all foreign currencies) Furthermore, the bottom line impact of this foreign exchange risk exposure was significant. 183 MFIs reported foreign exchange losses in 2008, averaging 32% of their net income. Losses were incurred in MFIs across all regions, legal structures, sizes, and ages of MFIs. What does this finding imply? It means that many MFIs financial results - profitability, size of equity base, capital adequacy and even solvency are highly dependent on and vulnerable to the movement of exchange rates over which they have no control. Therefore, it is clear that currency risk has become a significant subplot in the story of growth in microfinance. Given this, we can assume that MFIs, investors, and regulators are not sitting idly by but are actively seeking strategies to manage and/or mitigate this risk. While the Study s findings show that large mismatches continue to exist globally, practitioners have employed several tools and strategies in recent years to manage FX risk at the institutional level. The next section will outline these strategies. MFI and Investor Strategies to Manage FX Risk: Non-Derivative Approaches Due to recent developments within the microfinance industry (including, but not limited to the creation of MFX Solutions), MFIs and investors now have access to modern hedging solutions to mitigate FX Risk, notably currency swap and forward contracts. These allow the lender to exchange the reflows it receives on a local currency loan for dollars or euros at a fixed rate which allows it to provide loans that match MFIs assets without incurring currency risk itself. Unfortunately, prior to the financial crisis, this access was much more limited particularly in the low income, developing markets where microfinance activity is most needed. In particular, standard currency derivative products, the mainstay of currency risk management for banks and 7

8 businesses, were for the most part unavailable to MF lenders. This is due to lack of familiarity, small transaction size, perceived poor credit, or the high perceived risks of the frontier markets where MFIs operate. Hence, the microfinance industry has embraced several non-derivative solutions to managing FX Risk. Back to Back Lending Under a back-to-back arrangement, the MFI deposits the foreign/hard currency loan proceeds into an interest bearing deposit account at a local bank, and pledges the hard currency account as collateral to support a local currency loan. Back-to-back lending has been a commonly used method to deliver local currency while avoiding devaluation risk. The local currency loan is typically un-leveraged, as the foreign currency deposit provides complete security for the domestic bank. In this method, the strength of the institution taking the deposit, and the existence and level of deposit insurance is an important credit factor to ensure the borrower's capability to repay the foreign currency loan. Once the MFI repays the domestic loan, the domestic bank releases the foreign currency deposit, which is then used to repay the original lender's foreign currency denominated loan. However, exposure to transfer risk remains unmitigated under this arrangement and if the local government imposes a freeze on withdrawing hard currency assets or transferring them offshore, the MFI may not be able to access the hard currency principal to pay off the hard currency loan. Another issue that may be concern is that if the local currency appreciates, the value of the hard currency principal will decrease and leave the local bank under secured, which may in turn lead the local bank to request additional collateral. Additionally, any mismatch in the maturity and amortization schedule of the US dollar loan versus the term of the foreign currency principal deposit will leave the MFI with an exposure equal to the difference between the outstanding balance of the loan and the amount of the deposit. Back to back lending can be costly because the MFI pays interest on both loans though this cost can be partially offset by interest earned on the foreign exchange deposit. MFIs should also seek to maximize the leverage on the transaction by increasing the size of the local currency loan relative to the amount of the deposit. 8

9 Figure 5 Letter of Credit Another technique that an MFI can use to limit currency risk is the use of a letter of credit. In this situation an MFI supplies proceeds from the foreign currency loan as collateral, customarily in the form of a cash deposit, to an international commercial bank that offers a letter of credit to a local bank. Letters of Credit can guard an MFI against devaluation or depreciation risk as well as convertibility and transfer risk on the loan principal deposited as collateral to the international commercial bank. Unfortunately, in this situation, an MFI still has to cope with foreign exchange exposure on hard currency interest payments. This is another costly way to deal with risk, as letters of credit can be expensive and, on occasion, some local banks will not agree to accept a letter of credit instead of another form of collateral. 9

10 Figure 6 On-lending and Loan Indexing One of the ways that MFIs achieve acceptable foreign exchange ratios is through on-lending in foreign currency (assets) to their borrowers to offset foreign currency borrowings (liabilities). Unless an MFI s client is earning his or her business s income in a foreign currency, the foreign exchange risk exposure has simply been passed on, adding an indirect but significant credit risk on the MFI s balance sheet. This practice also raises ethical and client protection issues for the MFI vis-à-vis its borrowers. As noted previously, this practice is extremely common and has translated into at least US$ 4.5 billion in on-lent funds to borrowers in When a loan is indexed, if the domestic currency depreciates, interest rates and the principal amount increase. In this way, the MFIs is protected against depreciation risk because it is passed on to the borrower. However, default costs may be incurred as MFI clients are then more 10

11 likely to default on loans if interest rates increase. Additionally, this technique does not offer protection of the MFI against convertibility and transfer risk on hard currency loans. Management of Open FX Positions at the Investor level While many MIVs have strict rules against taking foreign currency exposure, some are able to take currency risk on to their books. Generally, it is not advised that MFIs take on the role of currency speculators, as they don t have the ability to diversify risk across multiple currencies. Investors with more capital cushion and diversified investments are in a better position to make the case for this model. MVIs use a variety of approaches to managing open foreign currency risk. Some simply set a limit for exposure but do not actively seek deals with a view to diversifying currency risk. This requires adequate capital to absorb relatively larger swings in individual FX rates but leaves the MIV free to pursue deals without considering the currency implications. Others use a more sophisticated diversification strategy that models correlations between currencies and sets limits for investments in each currency. This approach is safer from a currency risk point of view but requires careful allocation of loans to fit within currency limits. This model also can be vulnerable in currency crises where normal correlations between currencies converge and diversification loses its effectiveness. To protect against this scenario funds that use a diversification strategy should have strong capital and a first loss tranche or other resources that can sustain the fund through a systemic crisis. Another approach is to view microfinance investments in MFIs as taking positions in certain emerging market currencies. In this case, the MIV strategically offers local currency to an MFI in a specific currency based on a speculative view of that market. The MIV holds the risk of that currency s value throughout the course of the loan. In this strategy, the MIV may make shorter term investments so that it can actively move in and out of markets, similar to a hedge fund. This approach, while innovative, requires a strong appetite for risk on the part of the investor as well as a dedicated currency risk management team that has experience in this type of speculative investing in foreign exchange. The strategy s dependency on short term loans to MFIs also limits somewhat the benefits that accrue to the client. MFI and Investor Strategies to Manage FX Risk Using Derivatives While the strategies and practices outlined in the previous section present viable ways to manage and mitigate FX risk, the most common way to deal with currency risk for companies and financial institutions outside of microfinance is with currency derivative products primarily swaps and forwards. For reasons mentioned earlier, these products until recently were largely unavailable to microfinance practitioners and investors due to a variety of barriers. In recent years, several innovations have occurred that have since changed this landscape and microfinance now has more tools than ever to deliver local currency loans while mitigating the risk of devaluation. 11

12 Introduction to Hedging Products and Processes Before discussing these new industry projects to tackle currency risk and make hedging accessible to microfinance, it helps to briefly explain how simple hedge products work. The standard products are currency forwards and cross currency swaps. In the foreign exchange market, a forward is a contract that locks in the price at which an entity can buy or sell a currency on a future date. A forward can be used to hedge the exposure to foreign exchange in a microfinance loan when the client only wants to protect principal repayments at a specified loan tenor. In a cross currency swap, the parties exchange a stream of payments in one currency for a stream of cash flows in another. The typical cross currency swap involves the exchange of both recurring interest and principal (usually at the end of the swap) and thus can fully cover the risk of a microfinance loan transaction. Conceptually, cross currency swaps can be viewed as a series of forward contracts packaged together. In a cross currency swap, the entirety of the loan, interest payments and principal, is protected. See Appendix 1 for a visual process map of how a cross currency swap on a loan works. From the perspective of an investor purchasing a hedge, these products allow her to fix the cash flows of the loan she is disbursing to the MFI at a specified value, insulating the value of the loan from movements in foreign exchange throughout the period of the loan tenor. She pays a premium for this certainty which is a price that is set by the market based on the interest rate differential between her hard currency (EURO or USD) and that particular local currency she wants to provide to her client. In simpler terms, she is converting a variable rate revenue (assuming there is volatility in the exchange rate which affects the value of the loan) into a fixed rate revenue. Typically, these products are offered by banks that play an active role in the foreign exchange market. They sell to their clients (or counterparties) the hedge contracts at prices that are based on market conditions. In order for a bank to serve as a provider of a forward or swap to a particular company or institution there needs to be a legal agreement in place known as an ISDA (International Swaps and Derivatives Association) Master Agreement. This agreement governs the relationship between the two parties, protecting each from adverse events such as defaults. Additionally, banks will generally ask these companies to post collateral before hedge products are sold, with the size of the collateral requirements depending on the creditworthiness of the company. Generally, banks tend to view microfinance as a riskier industry given the nature of the markets being served by the sector and size of the companies involved. Therefore collateral levels can be in the range of 20-30% of the notional amount of the hedge (e.i. the loan amount) and in some cases banks may be reluctant to take credit risk on microfinance lenders. Small perceived transaction sizes (hedges under $5 million are considered small by most banks) also limit access to banks for some funds. While these unique aspects of the industry have traditionally posed barriers to microfinance players trying to access hedge products, another major problem is that many MFIs are located in countries where banks don t offer hedging products at all. While some microfinance investment 12

13 is made in standard emerging markets, a substantial amount of activity takes place in countries whose currencies are not commercially traded. For example, in Latin America a bank would offer a forward in Mexican Peso, but would not in Honduran Lempira, which is considered too exotic given that the bank would not be able to find any other counterparties with whom they could offload that risk. This limitation in terms of what currencies are and are not commercially available has strong implications for microfinance, as it limits the industry s ability to deliver local currency to the poorest countries. Providing lower risk loans to MFIs in those markets is central to the mission of more inclusive finance globally especially in high risk countries that face enormous barriers to capital. In the next section we will discuss the initiatives that have began in recent years to address these challenges. The Currency Exchange Fund (TCX) This article has focused on currency risk in the microfinance industry, but it must be noted that the challenge of how to provide local currency financing to projects and companies in developing countries has been a problem for the international development industry as a whole. The large Development Finance Institutions (DFIs) and International Financial Institutions have grappled with the issue on an even larger scale than microfinance, given the size of their investments in banks, corporates, and infrastructure companies throughout the developing world. To address this larger problem, in 2007, the Dutch Development Bank (FMO) spearheaded an initiative to address the need for more local currency in development finance. FMO established The Currency Exchange Fund (TCX), a hedging facility which holds and manages the currency risk from development loans. It operates differently from a bank in that it holds the local market risk it takes from development lenders and manages that risk through careful diversification much like an emerging market currency hedge fund. Since TCX does not need to sell its risk into a commercial swaps market, it can provide hedging in a much wider range of commercially unavailable currencies (such as Honduran Lempira in the earlier example). Based on its $600M in capital provided primarily by DFIs, TCX can provide roughly $2.5 billion in swaps and forwards in exotic currencies. TCX acts as a cooperative. An initial investment of $5M is required in order to access TCX s hedging services, and TCX trades primarily with its investors who are investment grade credits. In addition to its large capital cushion, TCX has substantial first loss financing from the Dutch and German governments to carry it through crises. The establishment of TCX presented an interesting opportunity for the microfinance industry. While the typical microfinance player (investor or MFI) would probably not be able to make $5M investment and meet TCX s stringent credit standards, the potential to access hedging in exotic, illiquid currencies was exactly what microfinance needed. It became clear that the industry could pool resources together to make a collective investment in order to access the hedging facility. This idea led the creation of MFX Solutions discussed in the next section. 13

14 MFX Solutions (MFX) In January 2008, a group led by ACCION International, Calvert Foundation, MicroRate, Global Partnerships and Calmeadow Foundation, along with many of the most prominent organizations in microfinance created MFX Solutions (MFX), an organization dedicated to providing microfinance lenders with affordable and accessible hedging instruments and the know-how to better manage currency risk. The founders vision was to create a full-service industry initiative, serving both MFIs and MIVs with education and hedging products. It was designed to solve the key problems that microfinance lenders face in accessing modern currency management tools. 1) Access to exotic currency hedging: MFX raised capital from a wide range of microfinance stakeholders in order to make a collective investment into TCX on behalf of the industry. MFX s role would therefore be to serve as an access point for the microfinance industry to the TCX facility and for the first time to give the entire industry access to hedging in frontier markets. 2) Better access to commercial markets: MFX acts as a credit intermediary for MIVs and MFIs who cannot receive good terms from banks. Bringing to bear its AAA credit guarantee (see next section), and larger transaction volume, MFX can get substantially better terms for hedges in liquid currency than many of its microfinance clients. 3) Eliminating the burden of collateral: Since the need to post collateral presents a major barrier to hedging for many microfinance lenders, MFX operates without a collateral requirement. It is able to do this thanks to credit guarantees form OPIC (the Overseas Private Investment Corporation) and FMO. Figure 7 presents a process map of how all of these industry players come together to provide hedging products to the microfinance industry. 14

15 Figure 7 Investors (incl. MIV clients) Investment Investment ROI/exit TCX MIVs/MFIs swaps (spread) No collateral MFX swaps (spread) Collateral Local currency loans $20M guarantee OPIC MFX is a way for MIVs that need a dollar or euro return to deliver the local currency their clients need without incurring extra risk themselves. It can also be a management tool for local currency funds to hedge off risk that might otherwise throw their diversification model out of balance. Conclusion This workshop paper presents an overview of how the microfinance industry has addressed the issue of currency risk as it has matured, and continues to professionalize into a commercial asset class. Through an actual MFI case study, this paper provided an overview of how failure to properly manage these risks can prevent MFIs from achieving operational sustainability, and thus limiting their ability to impact the lives of low-income borrowers in their communities. In addition the case studies presented on the creation of TCX and MFX show how donor agencies and microfinance industry practitioners have been forward thinking on the issue and have been proactive about pooling resources for a common good. There is wide consensus that local currency is critical to building sustainable and ethical investments in microfinance and other development sectors, and these industry initiatives have been positive signs of the ability of donor agencies, investors and practitioners to turn talk into action. While challenges remain in unlocking capital to new microfinance markets, the problem of lack of access to local currency is now being addressed in ways that are unprecedented to microfinance, and the development industry more broadly. 15

16 Bibliography Centre for the Study of Financial Innovation, Microfinance Banana Skins 2009: Confronting Crisis and Change Abrams, J. and MFX Solutions, RISKY BUSINESS: An Empirical Analysis of Foreign Exchange Risk Exposure in Microfinance MFX Solutions, Microfinance Practitioner Guide: How to Identify, Quantify, and Manage FX Risk MFX Solutions, Microfinance Practitioner Guide: Understanding FX Forwards MFX Solutions, Microfinance Practitioner Guide: Understanding Cross Currency Swaps MFX Solutions, Microfinance Practitioner Guide: Understanding Non-Derivative Hedging Alternatives. 2008

17 Appendix I: Microfinance Swap Transaction Process Map CASE 1: CURRENCY SWAP WITH AN MIV CASE 2: CURRENCY SWAP WITH AN MFI Underlying loan LC equivalent $1 M principal MFI Interest at LC Loan Rate Convert at spot rate $ Equivalent MIV Original LC principal $ equivalent Swap with client Interest at LC Swap (in $) Interest at $ rate (- credit spread) MIV Net out payment MFX Original LC principal $ equivalent $1 M principal Swap with TCX/Bank Interest at LC Swap Interest at $ rate MFX Net out payment TCX/ Bank Original LC principal $ equivalent $1 M principal 17