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Risk Perception and FX Risk Mitigation in MFI Refinancing

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Risk Perception and FX Risk Mitigation in MFI Refinancing Risk perception and FX risk mitigation in MFI refinancing∗y Christopher Pribernyz Department of Finance University of Regensburg, Germany Gregor Dorfleitnerx Department of Finance University of Regensburg, Germany and CERMi (Centre for European Research in Microfinance), Belgium First draft: February 15, 2011 We study the perception of risks, particularly of FX risk, in MFI refinancing. A survey addressed to MFIs ans MFI funding organizations reveals that MFIs consider several types of risks as rather unimportant, among them FX risk, which is contrary to the common view of the relevant literature. We obtain further in- sights into the FX hedging practice of microfinance actors, and reveal, that many FX risk mitigation strategies and hedging tools are quite rarely used in practice. JEL classification: G21; Keywords: Microfinance; FX risk; risk mitigation; survey; ∗First draft, please do not cite or circulate! yACKNOWLEDGMENT: We thank Daniel Uhlemann for data collection and extensive support. ze-mail: [email protected] xe-mail: gregor.dorfl[email protected] 1 1 Introduction The microfinance sector was subject to rapid growth in the years 2006 to 2010. This de- velopment was mainly enabled by the sector’s ongoing interaction with international capital markets, which made MFIs more and more independent from donations. Many microfinance institutions (MFIs) were transformed from mainly government subsidized organizations into more professional and profit-orientated financial institutions. According to Ledgerwood and White(2006) the refinancing possibilities on international capital markets, allowing MFIs to enlarge their lending capacity, are “widely viewed as the best way to achieve the out- reach needed to substantially increase access to financial services for the world’s hundreds of millions of low-income households”. However, refinancing with international debt titles instead of donations makes MFIs more vulnerable to various risk typs, that are already well known in the commercial banking sec- tor. Taking out micro loans to clients results not only in credit risk, but also due to the own refinancing process in liquidity risk, interest rate risk and foreign exchange risk for the MFI and further more operational risks, like staff fraud.1 Particularly FX risk is still regarded to be a challenging burden for the microfinance industry to overcome in order to archive an stable longterm MFI funding. MFIs, or microfinance in- vestment funds (MFIF) providing MFIs with loans in local currency, are particularly meant to naturally have a large FX risk exposure. According to Barrès(2007) foreign exchange risk occurs due to the mismatch of currencies in which assets and liabilities are denominated, combined with uncertainty about future FX fluctuations. Many MFIs operating in emerging markets face a mismatch between the currency of liabili- ties (funds) and assets (loans given to micro borrowers). The financial markets in developing countries are in many cases not mature enough to provide sufficient funds for MFIs in local currency. Swanson(2008) points out several reasons for this phenomenon: The bond markets in most developing countries are poorly regulated and thin. Local com- mercial banks are often lacking further knowledge how to analyze the risk associated with microfinance and therefore shrink away from investing in MFIs, if they see better investment opportunities in larger corporations or even foreign companies. They might also underlie investment restrictions that exclude microfinance. Holden and Holden(2004) state, that therefore the majority of MFIs is forced to refinance themselves – at least partially – by borrowing in hard currencies (mainly USD and EUR), while offering loans to clients in local currency. Featherston et al.(2006) quote, that many developing countries face reasonably high FX fluctuations, which is backed by analysis on exchange rates in developing countries of Cava- zos(2004) and Abrams and Schneider-Moretto(2007a), the last one updated in Abrams (2008). 1Cf. Churchill and Frankiewicz(2006) 2 Instruments2 to mitigate FX risks are principally: • Swaps • Cross currency swaps • Futures • Options • Back-to-back loans • Foreign currency deposits, Countervailing deposits • currency devaluation accounts However, for many currencies the instruments mentioned above are not available. In these cases a currency exchange fund, like the TCX fund3, could be an appropriate alternative. MFIs can furthermore reduce the FX exposure by the limitation of funds received in foreign currency, and refinancing by dept in local currency. Existing literature has so far clarified in which way the microfinance industry is affected by FX risk4 and which tools can be used to mitigate the exposure.5 However fairly few insights exist about how market participants of the microfinance sector consider different risk types and mitigation strategies is known particularly regarding FX risk. To our best knowlege Barrès(2007) is currently the only author which has published survey results on FX risk management of MFIFs. By conducting a survey on types of risks and FX mitigation strategies in the MFI refinancing process we try to fill the existing gap. In section2 we present the survey methodology, design and samples, and we present the descriptive results of individual questions. In the following section3 we discuss our results on selected issues with the existing literature and conclude. 2Those instruments have already been discussed and explained in detail by Holden and Holden(2004), Cavazos(2004), Bhatia(2004) andFeatherston et al.(2006). 3See http://www.tcxfund.com. 4Cf. e.g. Featherston et al.(2006), Abrams and Schneider-Moretto(2007b). 5Cf. e.g. Abrams(2008), Holden and Holden(2004), Cavazos(2004), Bhatia(2004) and Featherston et al. (2006). 3 2 Survey From July 8th, 2010, to August 11th, 2010, we conducted a web-based survey asking ap- proximately 900 organizations involved in microfinance, how they asses the market situation regarding different types of risk, in particular FX risk, and hedging possibilities. The ad- dressees of the survey were affiliated to MFIs and institutions refinancing MFIs (in the following summarized as MFIFs). Furthermore, we allowed answers by experts consulting these organizations. We used a standardized online questionnaire to facilitate anonymity. 164 persons participated, which results in a response rate of approx. 18%6. The survey design differentiates between MFIs and MFIFs, as we suspect differences regard- ing the risk perception of both groups. This methodology allowed us to slightly adjust the questionnaire for MFIs or MFIFs. So were MFIs additionally been asked about their total loan portfolio size, number of employees or average loan size or country of operation. This additional data allowed us to form suitable subsamples fur further investigation in section 3. Theses key figures characterizing the MFI sample are shown in Table1. The results are presented using frequency tables and are shown in the appendix. Thereby the different levels of categorized data follow a numeric rating scale, in rare cases were also comments of responses allowed. In addition to the purely descriptive view, we apply the Wilcoxon signed rank test7 to test for significance. Regarding the responding experts as a representative sample, the test allows us to make conclusions on the whole microfinance investment scene. Whereas most questions asked the participants about how often instru- ments are used or how significant they consider different risks, we test for both directions (e.g. rare vs. often) with a significance level of α=10% and the comparative neutral value corresponding to the null hypothesis. 3 Selected issues and discussion Which types of risk are considered as significant for microfinance actors? The results (Table3 for MFIs) on this questions indicate, that MFIs consider refinancing risk due to fluctuations of donations as rather unimportant (statistically significantly). Likewise they asses risks concerning political stability and – what’s surprising – fX risk. Especially the last finding is in deep contrast to the prevailing opinion, already mentioned in section 1. One possible explanation might be that the sample contains some MFIs that are not exposed to FX risk. To check this point we create a subsample of 47 MFIs8 that are all exposed to FX risk in the following way: We consider an MFI to be exposed to FX risk if some portion of its liabilities is denominated in foreign currency and the local currency is not plegged to the foreign currency. The results of the subsample regarding the same question are shown in Table4. Regarding FX risk a clear shift in the distribution towards importance is now observable, although this could not be proven by the significance test. The only risks seen by both samples, MFIs and MFIs exposed to FX risk, as statistically significantly important are driven by 6In fact 198 persons responsees were registrated. However 34 surveys were terminated after question 1, which just indicates the type of organization, and have therefore been excluded from the sample. 7Cf. Crawley(2007). 8The key figures of the subsample are displayed in Table2 4 macroeconomic factors, e.g. unemployment, inflation etc. The results regarding the MFIF sample, shown in Table 15 (and in Table 16 for a subsample that is exposed to FX) risk9, are in contrast to those of the MFIs. Even though MFIs and MFIFs come to the same opinion regarding the dependency on donations and macroeconomic factors, MFIFs consider also counter party, or credit risk and political stability as (statistically significantly) important means. Furthermore we test for differences regarding the judgment of MFIs and MFIFs considering the different types of risk by using the Mann-Whitney U test10. Again we test in both directions with a confidence level of α=10% . The results are displayed in Table 25. Notice that that MFIs consider liqidity risk as more signifactly than MFIFs. What can be said about lending currencies? Table5 shows in which currencies lia- bilities of MFIs are denominated, while Table 17 displays the currency structure for loans to MFIs made by MFIFs. The large portion of MFIs that receive funds in local currency is remarkable.
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