Microfinance needs to be funded by local currency loan – MFX

Microfinance Focus, Aug 30. 2010: In an Exclusive Interview with Microfinance Focus, MFX’s President Mr. Brian Cox discussed the susceptibility of microfinance institutions and funders to currency risk and how MFX is working towards reducing the risk. Excerpts:

Microfinance Focus: Tell us something about MFX Solutions, how it came into being and what it works for?

Brian Cox

Brian Cox: MFX really started way back in 2005 when a group of microfinance institutions which included MIVs (Microfinance Investment Vehicles), Foundations, ratings agencies and people who have been into microfinance for a long period of time came together to think of the currency risk in microfinance. MFX is essentially a cooperative of microfinance organizations. We have 22 investors most of which are MIVs. Our largest investors are Foundations who want to support this service

Currency risk is quite written into the DNA of microfinance as lot of it has been funded in dollar or euro based funds, lending in hard currency to microfinance institutions (MFIs) in developing countries. This needed to be changed in the industry and this was before the crisis and there could potentially be a big problem as a lot of MFIs are not managing their risk well. So this group came together to think of what kind of solution can the industry come up with for this problem, trying to turn things around and shift toward more local currency models for international lenders.

One of the problems is that commercial hedging options are really not available to most people in the industry. There were no commercial hedging markets in a lot of high risk developing countries where microfinance was happening. The amount of international microfinance lending has gone primarily to Eastern Europe and Latin America and only about 8% of it goes to Africa. One of the reasons is that currency risk is a very big problem in these high risk markets of Africa. You couldn’t lend in hard currency because it would put too much risk on the MFI and even MIVs don’t want to take the risk. If you could solve this problem you can open up a lot many high risk markets which actually need microfinance.

Microfinance Focus: How is MFX assisting microfinance institutions in mitigating currency risks?

Brian Cox: We provide currency hedging tools primarily Swaps and Forward contracts and we are able to provide them in a much broader range of markets than what banks do because we can provide hedging in most of Africa, Asia or wherever there is a tradable benchmark we can hedge. We don’t charge collaterals so we have US government guarantee that allows us to operate without collateral so we can make it much more affordable for microfinance funds and MFIs to hedge with us. We also do small transactions sizes which are more attuned to microfinance market. These are two of our main activities.

The other activity is education which is primarily directed towards MFIs. One of the key conclusions of this original group was that it is not just a problem that they don’t get to hedge the risk, the problem is that MFIs don’t really understand the risk they are taking by borrowing in hard risk. They don’t have a way to understand that if someone is lending them a dollar at 8% but they can borrow locally at 15% so which one of those is better and how to understand that trade off.

We worked with a company which does act of liability management software for banks and we created a tool directed at MFIs’ Treasurers and CFOs which allows them to essentially do stress testing on their balance sheet and liabilities planning. You can basically model your balance sheet and try different lending strategies and can run them in different economic scenarios. It is a good way for MFIs to understand the risk they are chasing and the idea is that then they can take better decision and we hope that those decisions would shift towards more local currency borrowing.

Microfinance Focus: Can you tell us how currency risk affected MFIs during financial crisis?

Brian Cox: The 2008 financial crisis brought a change in the perception of currency risk as a lot of MFIs got hurt. We had a client which was a fund and they wanted to lend to an MFI in Indonesia. The Indonesia rupiah got devalued by 20 percent and all of a sudden their hard currency debt to equity ratio went from 2 times to 5 times and now they are not even credit worthy anymore and even though we would like to lend with them we cannot lend them. It shows that an MFI which seemed to be in good shape ran into a vicious circle where they are not creditworthy because of valuation and a lot of MFIs got hurt this way.

Microfinance Focus: MFX has also closed its second round of investment. Can you give some details on that?

Brian Cox: We started out with 14 investors which were a mix of funds and MFIs. We have now added 10 new clients all of which are microfinance funds like BlueOrchard, Symbiotics, Triple Jump and others. We function like a cooperative. So to become a client of MFX, if you are a fund, you put in small investment then you can trade as much as you want with us and it is just a way for us to finance our working capital.

Microfinance Focus: Do Hedging facilities provide risk free solutions?

Brian Cox: When you hedge a loan you are obviously not eliminating every kind of risk that you are taking. You are essentially doing two things. MIVs can potentially lend MFIs in hard currency and in this way they are lending to someone who acts in a different currency and if the currency devalues then the borrower is at a credit risk. When they provide a local currency loan they eliminate the potential credit risk which comes from the devaluation.

Microfinance Focus: Do you have any Indian MFIs as your clients?

Brian Cox: We don’t and there are two reasons to that. One is that there is very little international lending in India because of various kinds of restrictions. Mostly the way we operate is that we do the hedge with the lender rather than the borrower. If we have a fund in Europe that can lend Indian rupees to an MFI in India that gives the MFI what they need. We can also do it where an Indian MFI borrows in Euros. We can do swaps for them as well. But there are not a lot of Indian MFIs borrowings from international lenders.

Microfinance Focus: What are some of the efforts to educate your MIVs and MFIs?

Brian Cox: Periodically we do workshops on hedging for both MFIs and MIVs. We will be doing a training in Washington in November. We are also piloting a different training program where we actually go and spend a week with an MFI, so that is our next one in Africa.

Microfinance Focus: What are some of the emerging needs of MFIs and MIVs that you have come across?

Brian Cox: The need to respond to the demand of loans in local currency is coming from MFIs and it is something we are here to address. They need better plans to move into more regulated environment. More and more MFIs want to track deposits and become regulated banks and want to grow. This is the emerging trend and a good one also. At the same time after the 2008 crisis regulations all around the world is becoming tighter which is driving more demand for local currency.

In our trainings with MFIs we do address how to understand their capital adequacy and how to form strategies. But I think there is a need for broader programs to help MFIs make that transition. MFIs are already in the process of transforming themselves into regulated banks but many of them don’t have the idea of what it is or be in a position of planning for it. You need to prepare your balance sheet years in advance in order to do that.

We certainly realize that this transition from international lending being primarily in hard currency to ones in local currency is the key to the maturation of microfinance industry

Ultimately the goal should be that microfinance is funded by local funds generated in the local market and India is one market where it is happening predominantly. But there is a long transition to that and a part of that transition is to first get international lending to shape into local currency and we are here to help more and more people get down to local currency.

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