56602 OccasiOnal paper Microfinance Foreign Exchange Facilities: Performance and Prospects F oreign capital investment in microfinance has been booming over the past four years. Commercial cross-border debt and equity This guide is written for microfinance investors. It presumes a basic familiarity with hedges, swaps, and other mechanisms used to manage foreign invested in microfinance surpassed US$11 billion exchange risk. in 2009, representing an estimated 20 percent Readers who are not familiar with those tools can of the funding base for specialized microfinance find them explained at http://en.wikipedia.org/wiki/ providers.1 Foreign investment brings important Foreign_exchange_market benefits for microfinance institutions (MFIs). It can provide longer term debt maturity and risk capital that often is not available in the local market, but it problem. These projects intend to offer MFIs and can come with a significant string attached: foreign microfinance investors a method to hedge foreign exchange risk. exchange risk, even for currencies for which hedges are not commercially available. These hedging Seventy percent of cross-border, fixed-income facilities represent an innovative, though not risk- investments are denominated in foreign currencies2 free, answer to the challenges posed by foreign (meaning currencies other than the currencies in exchange volatility to MFIs. These hedging options which the MFIs are operating), leaving MFIs with are particularly important to protect MFIs from the significant foreign exchange exposure.3 During turbulence of currency markets during the present the most recent global financial crisis, some MFIs financial crisis. that depend on foreign currency-denominated debt have suffered heavy foreign exchange losses In the longer term, MFIs could reduce their that threaten their overall viability (Littlefield and foreign exchange risk exposure by relying more Kneiding 2009). And local currency hedging needs heavily on local currency deposits and by working for microfinance is estimated at US$1.5 billion in to develop deeper local currency markets in 2009.4 developing countries. The new facilities offer an interim solution for the short term, but if they are Managing foreign exchange risk has been a managed well, they may accelerate the emergence persistent challenge for microfinance donors and of local currency markets. investors. Some have developed their own internal hedging systems to offer local currency loans, while The first section of this paper describes the others, like the Dutch public investor FMO, have aspirations and risk management plans of these sought to establish dedicated vehicles to hedge foreign exchange hedge alternative projects and local currency investments for themselves and traces the unusual conditions under which the other international donors and investors. new facilities are emerging. The second section, largely based on interviews, analyses MFI and In the last two years, three projects (TCX, investor demand and experience with the facilities. No. 17 Cygma, and MFX) sponsored by development The third section looks ahead to future risk April 2010 finance institutions (DFIs), public donors, and management challenges. Finally, the fourth section David Apgar and social investors have emerged to address this considers whether deeper local currency markets Xavier Reille 1 cGap 2009 Funder survey. 2 cGap 2009 Funder survey. 3 That is, if the local currency devalues against the foreign currency, the MFi will need more local currency than it anticipated in order to repay the loan. 4 cygma market assessment for local currency hedging 2009. 2 can, by themselves, solve many of the problems In effect, swaps are the exchange of two loans the facilities are trying to address.5 of equal value in different currencies. However, swaps are not usually available for the less liquid Microfinance Hedging Facility local currencies in which many MFIs make their Aspirations, Operations, and loans (Featherston, Littlefield, and Mwangi 2006; Offerings CGAP 2009). When such swaps are commercially available through international banks, prices can The financial crisis has made it abundantly clear be volatile--as demonstrated during the 2008 that MFIs that borrow foreign currency to fund financial crisis. Others are using back-to-back their operations must protect themselves from lending to hedge against depreciation risk. This the risk that local currency depreciations or structure typically involves the MFI taking a foreign devaluations will substantially increase their cost currency loan and depositing it in a domestic bank. of funding and may eventually leave them unable Using this deposit as cash collateral, the domestic to repay such debt obligations out of their local bank lends in local currency to the MFI. These currency income. The most common commercial strategies have proven to be costly in many markets tools for converting hard-currency funding into as documented in CGAP earlier research (Flaming local currency are currency forwards and cross- 2007). To address these problems, DFIs have currency swaps (see Box 1). developed their own internal risk management strategies to lend in local currency, and some Box 1: Common Hedging Products have contributed to setting up dedicated foreign Currency forwards are agreements to exchange a exchange facilities in partnership with like-minded future payment in one currency for an equal payment investors. in another. The exchange rate of a forward contract differs from the spot market exchange rate by an In the past three years, several projects have been amount reflecting the expected movement of the currencies, determined by differences in relevant initiated by public and socially oriented private benchmark interest rates. investors to mitigate foreign exchange risk. These projects include two currency hedging funds (TCX Swaps are agreements to exchange loans of equal and Cygma) and one hedging intermediary (MFX value in two currencies. These consist of (i ) an initial exchange of equal amounts of principal at market Solutions). Another hedging project, MICROFIX, exchange rates; (ii ) exchange of interest rate payments that is still to be finalized is being initiated by on the loan; and (iii ) exchange of repayments of the Planet Finance.6 principal at a future date. The interest rates differ to reflect expected currency movements, the fixed or floating rates on the two loans, and the credit quality The Hedging Facilities of the parties in the swap. The Currency Exchange Fund (TCX) Forwards and swaps can either be deliverable, which involves the actual exchange of the agreed TCX is a currency hedging fund created in 2007 amounts in the two currencies, or nondeliverable, by FMO and incorporated in the Netherlands as meaning payment of only the net amounts due to a limited liability company. TCX offers currency either party given prevailing exchange rates at the swaps and forwards to international investors that time of payment. There is no initial payment in a nondeliverable agreement. want to hedge investments that are denominated in emerging market currencies. It is supported 5 This guide is written for microfinance investors. it presumes a basic familiarity with hedges, swaps, and other mechanisms used to manage foreign exchange risk. readers who are not familiar with those tools can find them explained at http://en.wikipedia.org/wiki/Foreign_exchange_market. 6 planis, the advisory service and asset management arm of planet Finance, is planning to establish a MicrOFiX platform to serve as an intermediary between MFis/MiVs and TcX and commercial banks trading desks. MicrOFiX wants to operate as a clearing house with standardized hedging products and transparent pricing information as well as advisory services for MFis and MiVs. 3 Table 1: Microfinance hedging facilities TCX MFX Solutions Cygma Type Currency fund Hedging intermediary Currency fund Size (US$) 590 million (actual) 13 million (actual) 50 million (target) Counter-parties Mostly DFIs with MFIs and MIVs without Mostly MIVs investment-grade investment-grade ratings ratings Risk management Absorbs market risk; Absorbs credit risk; lays Absorbs market risk; bears no credit risk off market risk to TCX credit risk only of MIVs Expected ratio of 3:1 9:1 10:1 hedges to capital Legal structure/country Netherlands (limited Netherlands (limited Luxembourg FIS (specialized, of incorporation liability company) liability company) investment fund) Launch of operation In operation since late In operation since July Launch expected in 2010 2008 2009 Main sponsor FMO MIVs/Omidyar Chatham Financial MIV = microfinance investment vehicle by 19 co-investors (members), including DFIs, part of the hedging risk to commercial markets. such as the German development bank KfW; In the case of swaps, TCX investors and other multilateral institutions, such as the European Bank qualified investors--which may ultimately include for Reconstruction and Development (EBRD); and select local banks--can swap future streams of private microfinance investors, such as Triodos local currency payments from their projects for and Oikocredit.7 TCX has raised US$590 million, predetermined U.S. dollar or euro-denominated of which approximately 15 percent is from the payments from TCX. In the case of forwards, Dutch government. In addition, it has secured a an institution can exchange a single future local US$150 million backstop guarantee from FMO. currency payment due from a project for a U.S. TCX was rated AA- by Standards and Poor (S&P) as dollar or euro payment from TCX. a counterparty for swaps in October 2008. It was, however, downgraded to A- in October 2009 as a Either way, the hedge fixes the local borrower's result of S&P's new rating criteria for government- future obligations in its own currency and allows it related entities. to minimize its foreign exchange risk. TCX intends to make offers only where commercial banks do Institutions are required to invest at least US$5 not provide commercial quotes, so as to avoid million in TCX to gain access to its currency hedging duplicating readily available market alternatives.8 services. These investments provide TCX with the capital cushion needed to meet its obligations in TCX is designed to bear emerging market foreign the event of losses. TCX believes it can safely offer exchange and interest rate risk. It deliberately institutional hedges in nominal values of three to has limited its exposure to counterparty credit six times the value of their hedged investment risk by trading only with investment-grade-rated and still have adequate capital to cover possible institutions that are required to post collateral for hedging losses. Over time, TCX expects to offer their TCX transactions. This decision to minimize hedges with a greater nominal value as it lays off the lender counterparty risk, of course, limits the 7 For a full list of investors, see www.tcxfund.com. 8 although the Us$5 million minium investments that TcX requires is too high for all but the largest microfinance investors, it is not out of line with the collateral or guarantees demanded by commercial hedge funds. 4 number and type of institutions that can deal operations, in particular by structuring loans and directly with TCX and has given rise to the need swaps, handling execution, and managing the for intermediaries, like MFX, that are willing to foreign exchange risk of their investments. A accept greater counterparty credit risk. venture of Chatham Financial, a for-profit company specializing in market risk management for real Unlike the other new facilities, TCX offers hedges estate and private equity, Cygma is focusing beyond the range of debt maturities traded in on microfinance funds, networks, and other some emerging markets, with the aim of supporting intermediaries that lend to or own MFIs. infrastructure projects that can take 15 years to finish.9 During its first year of operation in 2008, Cygma is establishing a currency fund to absorb TCX concluded 34 nondeliverable forwards and the foreign exchange risk of swaps that MIVs swaps in 19 currencies. Those deals fell roughly undertake to make local currency investments in evenly across Sub-Saharan Africa, Asia, and Latin MFIs. It is focusing on currency swaps not available America. There were fewer in Eastern Europe in the wider credit market. Like TCX, this facility will perhaps because of the reliance on the euro in this rely on the diversification of its currency exposures region. Despite TCX's multisector focus, including to hedge the global foreign exchange position of long-term infrastructure investments, nearly half its clients without hedging individual positions. The of the early hedges TCX concluded in 2008 were current plan is to raise US$50 million to support a medium term (4­6 years), and many of them were portfolio of swaps and forwards up to 10 times that undertaken to support microfinance. amount. The International Finance Corporation is planning to invest US$10 million or 20 percent of TCX started diversifying its portfolio by investing in the fund total assets.11 An additional US$25 million short-term forward contracts on some of the more in guarantees will provide credit enhancements liquid emerging market currencies, even before it to enter into swap agreements with commercial began to enter into swaps for clients. It nevertheless banks if necessary. The expected launch date of suffered when many of those currencies depreciated the fund is June 2010. during the fourth quarter of 2008 and sustained US$86 million in losses as of October 2008.10 It Focusing on MIVs rather than MFIs can make the subsequently recovered these losses during the problem of coping with counterparty credit risk first half of 2009 and received an additional euro more manageable. To the extent that MIVs are 40 million in first loss protection from the German organized as special purpose vehicles that are Government. Despite the severity of the crisis, TCX's funded more with equity than debt, they are less losses never exceeded the worst case scenarios likely than MFIs to enter into bankruptcy or informal contained in its financial forecasts. debt workouts. It is also easier to execute swap contracts with MIVs than with MFIs because MIVs Cygma Corp tend to be based in countries with established Since 2007, Cygma Corp has advised microfinance legal frameworks for standard International Swaps investment vehicles (MIVs) on foreign exchange and Derivatives Association (ISDA)12 swap dealer risk policy and has supported their hedging agreements. 9 looking forward, TcX will expand its operations to another 15­20 countries with strong development potential that lack suitable local currency benchmarks, such as interbank rates or Treasury Bill rates. in cambodia, Guatemala, and rwanda, for example, TcX is conducting pilot studies to assess the feasibility of offering swap rates based on macroeconomic models reflecting growth assumptions, inflation forecasts, and central bank policy. 10 TcX Web site and interview with Joost Zuidberg, TcX manager. 11 Microfinance Focus 31 December 2009. 12 isDa is a trade organization of participants in the market for over-the-counter derivatives. 5 MFX Solutions LLC to a foreign creditor into the equivalent amount MFX is a hedging intermediary offering MFIs of a local currency denominated, fixed-rate debt and MIVs access to TCX or other commercial obligation. MFX would ask TCX for a quote. MFX hedging tools available on the market. MFX was then, as an intermediary, would pass U.S. dollar established by U.S. investors in October 2008; it payments from TCX to the MFI and local currency launched operations in July 2009. It is organized payments from the MFI to TCX. MFX would become as a for-profit fund whose principal investors-- TCX's counterparty so that the counterparty risk of Omidyar Network, Calmeadow Foundation, this MFI is assumed by MFX. TCX's risks would be ACCION International, Triodos, and Incofin-- limited to market risk--that is, the risk of changes in are represented on its five-member board. Its the value of the tenge against the dollar and changes initial funding of US$13 million comes from two in dollar floating interest rates. MFX currency swaps sources--MIVs likely to use its services and donors, are illustrated in Figures 1 and 2. such as Omidyar, with no intention to transact with MFX. As a result, MFX plans to allow MIV investors Figure 1. Currency swap with an MFI. to hedge in volumes totaling 10 to 18 times their initial investment. In its role as an intermediary, MFX offers non- deliverable swaps and forwards to MIVs and MFIs that cannot now deal directly with TCX and other more traditional swap dealers because of the MFIs' and MIVs' perceived counterparty credit risk. MFX takes the credit risk of its customers, but hedges their foreign exchange and interest rate risk through TCX or traditional swap dealers. MFX can do this because it itself enjoys a AAA rating as a result of a US$20 million guarantee that it secured MFX receives local currency from an MFI and provides it with the U.S. dollar it needs to repay its hard currency from the Overseas Private Investment Corporation. loan. This rating allows MFX to qualify as an investment- Source: MICROFIX grade counterparty when it engages in hedging arrangements with TCX and other commercial hedging facilities on behalf of its noninvestment Figure 2. Currency swap with an MIV. grade customers. For these services, MFX charges its customers a spread over the difference between the local currency interest rate paid by the MFI and the foreign currency interest rate paid by MFX. It also charges its customers a fee to cover customer credit evaluations that will be performed for MFX by MicroRate, a specialized rating agency. For example, an MFI that lends to its MFX provides local currency to the MIV in exchange for microentrepreneurs in Kazakh tenge may want to U.S. dollar so it can make a local currency loan to an MFI. swap its US$2 million floating-rate debt obligation Source: MICROFIX 6 User Perspective on Microfinance term, a hedging facility that absorbs the risk of local Foreign Exchange Hedge currency swaps would be the best option for the Alternatives MFI to manage its foreign exchange exposure. MFI and MIV Needs Deposit-based funding reduces foreign exchange Consider foreign currency from the perspective of a exposure, but only if the deposits are denominated Cambodian MFI with strong financial performance in local currency. Several MFIs in Eastern European but no license to collect savings. The local capital countries such as Kosovo take deposits in euros market is thin, and the institution funds its growth while making their loans in local currency. with foreign currency from international lenders. The larger microfinance asset managers have Some lenders, such as Dutch-based social investors started to respond to MFIs' increasingly urgent Oikocredit and Triodos, find ways to make floating- need for local currency financing. Blue Orchard and rate loans in local currency. These lenders are ResponsAbility already have over a third of their prepared to absorb losses if those local currencies fixed-income portfolio hedged in local currency. devalue, and they hope to offset such losses at Oikocredit has set up its own local currency fund, least partially through the generally higher rates in addition to investing in TCX. For such MIVs, available in currencies expected to depreciate. a typical transaction will involve both a currency Such local currency denominated loans avoid and an interest rate swap. For example, an MIV foreign currency mismatch on the balance sheet funded in dollars may want to offer a two-year of the MFI, but at a cost--floating-rate liabilities fixed-rate loan in rubles to a Russian MFI. If the can be a problem in a country where interest rates MIV requires an interest rate 500 basis points over jump from 5 percent to 22 percent within a year. the three-month London interbank rate (LIBOR) to compensate for the MFI's credit risk, it would ask There are no appropriate interest rate benchmarks swap dealers for quotes on the fixed ruble interest for pricing floating local currency loans in rate it would have to pay in exchange for a dollar Cambodia. As a result, most international lenders floating rate payment of LIBOR plus 5 percent. offer MFIs hard currency loans. When the MFIs exchange the proceeds of those hard currency That fixed rate would normally include four loans for the local currency that it lends to clients, components: the hard currency loans leave the MFI with a net open position: its foreign currency assets are · The rate on three-month, risk-free ruble insufficient to cover its foreign currency liabilities loans. The difference between this and the (or potentially vice versa). comparable dollar rate reflects the difference between expected ruble and dollar inflation. As a rule of thumb, lenders tend to ask MFIs to · The spread between three-month and two- limit their net open positions to 20 percent of year risk-free ruble loans. equity. Foreign guarantees for local bank loans13 · The premium for the MIV's credit risk to the would be more efficient from this Cambodian swap dealer. institution's perspective, but few international · The five percentage point spread over LIBOR, lenders are offering such guarantees. In the near reflecting the dollar rate charged by the MIV. 13 For example, Grameen Growth Guarantees fund is an innovative program offering local currency funding to MFis through local banks. 7 Swaps are currently available only to MIVs that Also, there is worry about the financial soundness meet international bank standards and only for of the hedging facilities. Users look at TCX's losses currencies of countries with well-developed last year and wonder about MFX's decision not to credit markets. MIVs recognize that commercial cover its credit risk with collateral. More generally, and investment banks shy away from the small they ask whether the equity base of the hedging sizes and illiquid currencies that are characteristic facilities will be large enough to cover the credit of many MFI transactions. But when hedging and foreign exchange risk they take on. At the instruments are available MIVs would like to same time, many users want hedging products get more transparent swap pricing and quicker with longer maturities, even though this raises the responses to their quote requests.14 There would facilities' risk profile. be strong demand for a service that aggregates Lastly, some investment funds want advice on swaps on a daily or even weekly basis. foreign currency hedging. Cygma is helping MIVs structure hedges, sign swap agreements with banks, and negotiate the terms of swaps--services that Experience with Hedge Providers some MIVs have found useful. MFX intends to offer and Facilities free foreign exchange training for MFI officers. This section summarizes MFI and investor experience with the facilities based on CGAP research.15 Some Managing Hedging Risks users say that the hedging facilities could make their services more attractive to the microfinance The hedging facility faces two kinds of risk: market sector by expanding their range of currencies, risk from fluctuating exchange (and possibly making their pricing more transparent, and interest) rates, and credit risk from MFI and even lowering the minimum capital requirements for MIV counterparties that may be unable to meet their counterparts. Users sometimes find it difficult their obligations to the hedging facility. For to understand how currency hedges are priced, their part, MFIs and MIVs need to manage the and why the costs are sometimes so high. One DFI additional risk, however small, that the provider of reports that the TCX quote for a seven-year African their swap or forward may be unable to meet its cross-currency swap jumped to 25 percent from 15 obligations. In both swap and forward contracts, percent within two weeks, reflecting the impact that the MFI or MIV generally exchanges future local even small amounts of new data can have on rates currency payments for future U.S. dollar or euro derived from models for countries with very few payments. Whether the counterparty is one of observable interest rates. The institution instead the new hedging facilities or the swap desk of took a loan at 18 percent from a local bank that may a commercial bank, there is a risk that it will be not have fully adjusted to local inflation data. unable to make its scheduled payments, leaving the MFI or MIV partly unhedged against changes Some MIVs find the US$5 million investment in exchange rates. required by TCX too high--as they do the US$5 million collateral required in standard swap dealer Market risk and diversification agreements and the investment proposed by TCX and Cygma plan to manage the market risk Cygma. Noting these concerns, MFX intends to of their hedging contracts and other local currency dispense with such requirements. investments through currency diversification. 14 cGap interview with leading MiV asset managers, 2009. 15 interviews with eight leading DFis, and MiVs conducted in the summer of 2009. 8 Both funds hope to reduce the risk of currency necessary for those with regional concentrations. volatility by investing in a broad range of second- Cygma's model, drawing on over 10 years of data, tier currencies, expecting that declines in some suggests that 30­40 currencies may be necessary.18 currencies will be balanced by strength in others. Capital and safety Some bankers worry, however, that the capacity TCX, Cygma, and the gateway fund MFX plan to for emerging currency movements to balance one limit their market or credit risk in order to assure another is limited . They feel that these second- counterparties that they will be able to meet their tier currencies tend to rise and fall together in the commitments throughout the term of their swaps. long run, or at least in times of financial turmoil. TCX is limiting its exposure to three times its The hedge facility managers interviewed for capital, Cygma and MFX to 10 times capital. The this research do not agree. They say that these question for MFIs and MIVs is whether these limits concerns do not take into account the income they make sense. receive from facilitating swaps. MFIs and MIVs pay high local currency interest rates in exchange for As noted earlier, TCX lost US$86 million in 2008 dollar or euro payments, which serve to prefund as the global financial crisis deepened and spread, expected losses arising from devaluation of those subsequently recovering these losses in 2009 after local currencies over time.17 conditions stabilized somewhat. The facilities expect this interest income will produce Cygma believes its risks will be smaller than gains over the long run, if not for every quarter. They those of TCX compared to the nominal value of also expect that diversification of their exposures its hedges. First, its transactions will be smaller should help smooth out their losses and gains from and more granular than those of TCX--and thus quarter to quarter. The question then arises as to how easier to diversify--because it will not have to many currencies they need to diversify their portfolios hedge large infrastructure and other development of exposures. Minlam, a microfinance hedge fund projects that tend to involve longer maturity debt. that takes speculative positions in emerging market Cygma expects its average transaction size will be currencies, thinks 10­20 currencies can be enough. no more than one-third of TCX's. Second, unlike For funds that do not actively manage their currency TCX it will not offer swaps beyond the maturity positions for profit, 20­30 currencies may be needed. of existing reference rates in the currencies it Based on its econometric model, Joost Zuidberg hedges. Shorter maturities of emerging market of TCX agrees that 20­30 currencies are necessary debt will limit Cygma to shorter term transactions, for diversification, with the crucial provision that the while TCX undertakes some swaps beyond that actual number depends on regional diversification. constraint to hedge longer term projects. Cygma Twenty currencies may be enough for portfolios with expects an average maturity of roughly a third of good regional diversification, while 30 are probably that of TCX. Under these scenarios, Cygma thinks 16 interview with two international banks offering foreign exchange hedging instruments in microfinance (summer 2009). 17 suppose, for example, that the local currency amount owed to TcX or cygma falls by 10 percent in a year when measured in dollars--as it would if a local currency debt worth Us$1,000 at the beginning of the year is worth only Us$900 at the end. However, if the interest rate on the local currency part of the swap is 10 percentage points higher than the interest rate on the dollar part paid by TcX or cygma to its counterparty. Then the counterparty pays TcX or cygma roughly Us$100 more in interest than TcX or cygma pays to the counterparty. in that case, the extra 10 percent of interest on the local currency debt compensates for the fall in value of the local currency debt. 18 it is as yet uncertain as to whether TcX will be able to offer affordable swaps in second-tier currencies beyond the range of maturities of any local currency reference rates--for example, five-year swaps in a market with no regularly traded bonds due in more than three years. TcX nevertheless hopes that some of its hedges will create longer term local-currency liquidity, that that local-currency liquidity will encourage longer term local- currency lending, and that that lending will provide interest rates on which to base longer term swaps. 9 it needs roughly a third as much capital as TCX: its MFIs should also improve their asset and liability swap limit will be 10 times capital compared with management and rein in their appetite for foreign three times for TCX limit. This seems reasonable, currency exposure. Since shorter term funding but it is challenging to quantify the effect of the from MIVs and DFIs means more frequent loan differences between the two businesses. negotiations, MFIs understandably try to extend the term of their borrowings where possible to six and even seven years. However, the average The Local Currency Market maturity of their microloans tends to be short Alternative term--a year or less in most cases. This leaves MFIs with a significant maturity gap and consequent The larger question for MFIs and MIVs, however, exposure to a mismatch between the pricing is whether more foreign exchange hedging will behavior of short-term local currency assets and retard or supplant the development of local long-term hard currency liabilities. currency markets to the point where they can meet the needs of the microfinance sector. There In fact, the difficulty of completing swaps in the is reason to hope the new facilities might actually amounts and currencies MFIs need might be a accelerate this development. sign that the deals should be avoided in the first place. Some socially oriented investors, such as In the best of all worlds, local markets would make the Grameen USA Foundation Growth Guarantee local savings available to MFIs, while international fund,19 are already guaranteeing the repayment development investors would bear foreign by an MFI of a local currency loan from a local exchange risk by making local currency investments. bank rather than provide a hard currency loan It is worth asking how the new hedging facilities will directly to the MFI that it should, but may not affect international investors' willingness to bear be able to, hedge. The answer from the hedging currency risk and the development of robust local facilities is that exotic currencies suffer from currency and credit markets. a market conundrum. Reference rates will not emerge without deals; deals will not be concluded If the development community could persuade without reference rates. The new facilities, runs the more international investors to bear local currency argument, are the instrument by which DFIs can risk, some MIVs might not have to rely on the new potentially contribute to a solution. hedging facilities to avoid foreign exchange risks. Indeed, one might argue that socially oriented The potential of these facilities to open up local investors or donors could leverage more private currency markets may go beyond the swap capital into the microfinance sector if they were to activities of commercial banks. This is because help address foreign exchange risks, rather than these facilities rely on a theory of foreign exchange credit risks, particularly in markets with exotic hedging quite different from that of commercial currencies. In any case, with the current outlook swap dealers. for the U.S. dollar and the euro, some MIVs might be tempted to take some speculative positions on Commercial dealers make money from the gain emerging market currencies. And MFIs should be that occurs when two borrowers can raise funds bolder in asking foreign investors to shoulder more more cheaply in one another's currencies. If an currency risk. MFI wants to swap a future stream of payments 19 The Grameen growth guarantee fund has raised over Us$10 million from high net worth individuals in the United states to guarantee local currency loan to MFis. 10 in Kenyan shillings for U.S. dollars, for example, insulate those currencies from hard-to-manage the swap dealer will essentially look for a second capital inflows and outflows. counterparty, such as a Kenyan exporter who · Its activities also can improve local institutions' wants to swap U.S. dollars for Kenyan shillings. understanding of market risk. The ability of a commercial bank to give attractive quotes on swaps depends, in other words, on the In 2009, TCX rolled out deliverable contracts in existence of similar swaps.20 10 Sub-Saharan African countries, entailing actual delivery of the currencies involved. These cash The new facilities are based on a different theory-- transactions can help provide the volume needed namely that, in the long run, interest rate differences for local banks to develop robust local currency among currencies compensate investors for any markets. depreciation or devaluation. If it is right, the theory gives some comfort that a dealmaker with Cygma hopes that its activity will promote these sufficient patience can offer swaps even in markets markets and eventually eliminate the need for its where there are no similar transactions. This then own fund. After all, the most stable alternative provides a basis for developing those markets. for MFIs would be access to domestic resources, whether through direct deposit taking or through Indeed, all of the new hedge providers are local banks, pension funds, or the debt market. optimistic that their activity will promote the Accordingly, Cygma expects its advisory services development of local currency markets; they to be as important as its hedging services. differ only in their expectation about how long development will take.21 Some of the new facilities Even if some local currency markets develop hope that by managing foreign exchange and rapidly, however, it is not clear that all will. In many credit risks carefully, they can increase emerging markets, MFIs are not able to source domestic market liquidity. While such liquidity may not be capital or mobilize savings. As a temporary solution essential to microfinance and may even be a poor until these markets develop, the three facilities substitute for the mobilization of domestic savings, may represent a welcome, though not risk-free, it is probably essential for economic development innovation. more broadly. Moreover, there are substantive reasons to expect For example, TCX believes its activity can address the facilities to accelerate the development of local three reasons for the stunted development of local currency and credit markets in emerging markets. currency markets: The most important one is that, by helping to establish relevant interest and foreign exchange · Its deals can help local institutions price their rates, the facilities will make it easier for local own loan and foreign exchange transactions financial institutions to price and offer local savings and thus help establish the reference rates products and foreign exchange transactions. needed to develop an effective local credit market. Conclusion · Its activities may conceivably create incentives for local regulators to support the convertibility MFIs may be able to hedge the risk that the value of their currencies--offsetting the incentive to of their local currency assets will fall against their 20 it may even become more difficult to find counterparties like the exporter in this example if the current crisis reduces demand for exports from emerging markets. 21 cGap research and interviews with TcX, MFX and cygma (Fall 2009). 11 hard currency obligations to creditors by arranging The development of deeper and more widespread swaps and forwards with a hedging intermediary local currency markets represents the best solution like MFX. By covering the credit risk of the MFI, to the foreign exchange risks of MFIs. The facilities, MFX will be able to lay off the market risk of nevertheless, represent a useful interim solution as these hedges through parallel swaps with TCX or those local markets develop--particularly because commercial banks. they have the potential, if they manage their risks carefully, to accelerate the development of those Cygma is raising a fund to help MIVs hedge the markets. market risk that arises when they provide local currency loans to MFIs out of their hard currency References capital base. MIVs that want to hedge such risk will be able to enter into swaps and forwards with CGAP. 2009. "Foreign Exchange Risk Mitigation Cygma. Cygma will manage its own market risk Techniques: Structure and Documentation; a by diversifying its currency exposures and will Technical Guide for Microfinance Institutions." address its credit risk by limiting its counterparties Technical Guide. Washington, D.C.: CGAP, June. to intermediaries that it understands well and that typically have little leverage. Featherston, Scott, Elizabeth Littlefield, and Patricia Mwangi. 2006. "Foreign Exchange Rate TCX has already started to offer hedges to DFIs Risk in Microfinance: What Is It and How Can It and foreign investors seeking to make local Be Managed?" Focus Note 31. Washington, D.C.: currency investments. In time, it may also hedge CGAP, January. the market risks of MFIs and MIVs, either directly or indirectly through the gateway funds MFX. TCX Flaming, Mark. 2007. "Guaranteed Loans to will manage the market risk of its positions through Microfinance Institutions: How Do They Add diversification and expects to bear very little, if Value?" Focus Note 40. Washington, D.C.: CGAP, any, credit risk. 2007. MFX has proposed sound strategies to manage the LittleField, Elizabeth, and Christoph Kneiding. credit risk of its MFI counterparties, as have Cygma 2009. "The Global Financial Crisis and Its Impact and TCX to manage the market risk of their swaps on Microfinance." Focus Note 52. Washington, and forwards. MFIs and MIVs will nevertheless D.C.: CGAP, February. need the utmost transparency from these facilities and diligence in monitoring them to ensure safety Microfinance Focus. 2009. 31 December. as market conditions evolve. No. 17 April 2010 Please share this Occasional Paper with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org © CGAP, 2010 The authors of this Occasional Paper are David Apgar and Xavier and Jeanette Thomas (both of CGAP) for extensive comments and Reille of CGAP. The authors wish to thank Deborah Burand, Irene guidance in writing this paper. Rodriguez, Jurgen Hammer, Damian Milverton, Rich Rosenberg, The suggested citation for this Occasional Paper is as follows: Apgar, David, and Xavier Reille. 2010. "Microfinance Foreign Exchange Facilities: Performance and Prospects." Occasional Paper 17. Washington, D.C.: CGAP, April.