How Does Foreign Exchange Risk Occur Who Is Exposed

Foreign exchange risk occurs when there is a mismatch in the currencies in which assets and liabilities are denominated (either at the MFI level, the MFIF level, or both), coupled with uncertainty about foreign exchange fluctuations. In theory, foreign exchange risk - or currency risk - is taken either by the MFI, the MFIF, or both, depending on their asset and liability structure.

4 Guarantees are almost exclusively in the currency of the MFIF and enable the MFI to obtain local currency loans. FX risks are absent unless the MFIF offers guarantees in currencies that are different from its funding currency (i. e., FIG issues guarantees in USD, EUR and CHF [Swiss francs]), or if the MFI defaults on the loan to the commercial bank and the local currency appreciates vis-à-vis the currency of the guarantee (resulting in a claim on the MFIF that is larger than the amount of the guarantee). See Freedman, Paul L., Designing Loan Guarantees to Spur Growth in Developing Countries, USAID, 2004, page 11.

The most common foreign exchange risk possibilities are summarised in Table 1. These combinations involve positions in Euros (EUR) and local currency, US dollars (USD) and local currency, and between EUR and USD, that comprise the currencies in which assets and liabilities are held by MFIs and MFIFs. Generalising, we assume that before the MFI receives funding, it has no currency mismatch. Its "operating currency," the currency in which its assets are denominated, is the same as its "funding" currency, which is the currency in which its liabilities are denominated.6

The funding and operating currencies are defined as follows:

• MFIF funding currency: the currency in which the MFIF borrows to fund its operations - the currency of the MFIF's liabilities;

• MFIF operating currency or MFI funding currency: the currency in which the MFIF lends to the MFI or the currency in which the MFI borrows from the MFIF to fund its operations, i. e., the currency of the MFIF's assets and the MFI's liabilities;

• MFI operating currency: the currency in which the MFI lends to its clients, i. e., the currency of the MFI's assets.

Table 1 assumes that the MFIF is funded in only one currency, it lends to 100% of its MFI clients in only one currency, and the MFI lends to 100 % of its clients in only one currency.7 This simplification is made to illustrate the mechanics of currency risk, and to identify who would be most likely to bear the risk of foreign exchange fluctuations. Another assumption is that the local currency will depreciate compared to the hard currency, even though in some cases the local currency appreciates and therefore creates a gain for the MFI that has foreign currency exposure.8

The example of change in value of the EUR against the USD is an interesting one to examine. Over a 2-year period, the EUR gained close to 40 % of its value against USD. This large change in the relative values of two "hard" currencies was underestimated by many MFIs and MFIFs. The EUR was launched in 2002 at USD 1.17, and subsequently fell to less than USD 0.90. Recently, however, the

6 A mismatch between funding and operating currencies introduced by new funding will therefore necessarily increase FX risk. In reality, a new mismatch in the funding and operating currencies can offset an existing FX risk.

7 The MFIFs listed as examples in the following section fall within that category: they are funded in one currency and lend in one currency only. In reality, because the MFIFs and the MFIs can be funded and operate in several currencies at a time, the overall risk to the MFIF and the MFI will depend on the proportion of assets and liabilities in each currency. Appendix 3 presents the breakdown by main funding currency and theoretical operating currency for the MFIFs studied in this chapter.

8 See Women's World Banking, Foreign Exchange Risk Management in Microfinance, Occasional Paper, page 2, for analysis of past currency trends.

Table 1. Who Bears Currency Risk? Common Scenarios

Who bears the FX risk?

MFIF funding currency

MFIF operating cur-rency/MFI funding currency

MFI operating currency

USD

Local

Local

MFIF

EUR

Local

Local

EUR

USD

USD

USD

EUR

EUR

USD

USD

Local

MFI (a)

EUR

EUR

Local

EUR

EUR

USD

USD

USD

EUR

NA - No risk

USD

USD

USD

(no asset/liability cur

EUR

EUR

EUR

rency mismatch)

Local

Local

Local

EUR

USD

Local

MFI and MFIF

USD

EUR

Local

Or

Through contractual arrangement

a) It is important to note that in this case, although the MFIF does not incur FX risk due to nominal exchange rate fluctuations, real exchange rate fluctuations in the MFI's country might affect its competitiveness and capacity to repay.

a) It is important to note that in this case, although the MFIF does not incur FX risk due to nominal exchange rate fluctuations, real exchange rate fluctuations in the MFI's country might affect its competitiveness and capacity to repay.

EUR has appreciated considerably against the USD, and many European MFIFs operating in EUR and lending in USD in dollarised countries in Latin America have incurred significant losses from the transactions.

The sharp appreciation of the EUR against the USD has created significant exchange losses on the EUR loans of many MFIs, which in some cases will require restructuring. The ASN-Novib Fonds is an example. It is an MFIF in the Netherlands that lends in hard currency (both USD and EUR), with most of its portfolio concentrated in Latin America. It is seeking opportunities in Asia and Africa if the foreign exchange risks can be hedged. In the past, the ASN-Novib Fonds made EUR loans to MFIs operating in dollarised economies, but the lack of hedging by its client MFIs and subsequent losses have forced ASN-Novib Fonds to discontinue unhedged EUR funding, which it considers too risky for the MFIs.9 On the other hand, MFIs borrowing in USD and on-lending in EUR have experienced currency gains - their Euro-equivalent USD repayments of principal and interest have diminished considerably.

9 For example, EUR loans were issued in 2002 to ANED and FADES in Bolivia, and Confianza and Proempresa in Peru.

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