Five Strategies to Minimize Foreign Exchange Risk for Microfinance Institutions

The demand for foreign investments has increased manifolds to fuel the high growth rates of microfinance institutions (MFIs) across the world. As a majority of this advance is in hard currency, the balance sheets of such MFIs carry this foreign currency lending and the usually more volatile local currency at the same time, giving rise to foreign exchange risk, which is defined as the probability of loss arising due to the variations in exchange rate between two currencies.

To ensure that MFIs can grow on a sustained and safe manner, foreign exchange risk needs to be mitigated. This paper suggests five ways to mitigate this risk arising through foreign currency borrowing operations of MFIs with relevant illustrations as outlined below:

• Encouraging MFIs to prioritize local currency loans over foreign currency lending by:
  • Approaching local banks or capital markets;
  • Using guarantee mechanism;
  • Negotiating foreign loans in local currency.
• Framing policies on foreign exchange management and exposure before MFIs expose themselves to such risks by:
  • Quantifying standards for risk tolerance;
  • Monitoring and measuring the activities;
  • Developing a written procedure for the former processes.                           
• Converting the risk arising from hard currency loans to local currency risk, thus decreasing the level of risk exposure by:
  • Back-to-back loans;
  • International guarantee;
  • Loan participation.
• Exploring financial instruments which can be designed to hedge foreign exchange risks like forwards, swaps, futures and options.
• Using other options to mitigate foreign exchange risks including:
  • Matching lending to borrowing;
  • Passing on costs to clients through indexing local currency lending and charging a foreign exchange loss surcharge;
  • Establishing a reserve account.