Foreign Exchange Risk Management Practices of Microfinance Institutions

Publication Date: Mar 2003
Published by: Opportunity International
Document Type: Paper (Microsoft Word)

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Foreign exchange risk management of microfinance institutions - A proposal for alternative practices

This paper reviews current practices in the management of foreign exchange risk for and by microfinance institutions (MFIs) and states that:

• Many potential sources of funding for MFIs remain untapped due to the high risks of currency devaluation faced by funding sources;
• Currently, the most common foreign exchange management programs involve either indexation of loans to clients, or local currency lending backed by hard currency deposits or guarantees;
  • The former practice passes the risk of exchange rate devaluation on to the client;
  • The latter involves substantial assistance from commercial banks and/or government agencies.

In order to increase the amount of lending to MFIs, the paper suggests:

• The diversification of both the source and the use of debt financing - this involves borrowing across a few different hard currencies and lending across many different currencies.
• Lending in many different countries and the purchase of insurance products designed to protect against catastrophic loss from political and economic risks.
• The use of currency swaps, wherein a borrower swaps her/his debt obligations in one currency for the obligations of another borrower in a different currency.

The paper concludes that the opportunity to minimize foreign exchange rate risk for MFIs exists but there remain limitations to their implementation. There is, therefore, a need to quantify both the advantages and costs of each practice.