Microfinance Foreign Exchange Facilities: Performance and Prospects

This paper discusses the aspirations, impact, and potential of recent methods that help MFIs and investors to hedge foreign exchange risk.

Foreign investment is beneficial to MFIs, but it also exposes them to foreign exchange risk. Some microfinance donors and investors have developed their own internal hedging systems to offer local currency loans. Others have tried to establish dedicated vehicles to hedge local currency investments. Development finance institutions, public donors and social investors have sponsored three projects, namely, TCX, Cygma and MFX, to address this problem. These hedging options:

• Offer MFIs and microfinance investors a method to hedge foreign exchange risk;
• Represent an innovative answer to challenges posed by foreign exchange volatility to MFIs;
• Protect MFIs from the turbulence of currency markets during financial crises.

The new hedging options offer an interim solution for the short term, but if they are managed well, they may accelerate the emergence of local currency markets. In the long term, MFIs could reduce their foreign exchange risk exposure by relying more heavily on local currency deposits and working to develop deeper local currency markets in developing countries.