Many borrowing microfinance institutions (MFIs) are not adequately managing their exposure to foreign exchange rate risk. There are at least three components of foreign exchange rate risk: (1) devaluation or depreciation risk, (2) convertibility risk, and (3) transfer risk.
Devaluation or depreciation risk typically arises in microfinance when an MFI acquires debt in a foreign currency, usually U.S. dollars (USD) or euros, and then lends those funds in domestic currency (DC). The MFI then possesses a liability in a hard currency and assets in a DC (in which case, an MFI’s balance sheet is said to contain a “currency mismatch”). Fluctuations in the relative values of these two currencies can adversely affect the financial viability of the organization.
Convertibility risk is another possible component of foreign exchange risk. For the purposes of this note, convertibility risk refers to the risk that the national government will not sell foreign currency to borrowers or others with obligations denominated in hard currency. Transfer risk refers to the risk that the national government will not allow foreign currency to leave the country regardless of its source.
Since MFIs operate in developing countries where the risk of currency depreciation is highest, they are particularly vulnerable to foreign exchange rate risk. And, as any veteran of the sovereign debt restructurings of the 1980s and ’90s is likely to observe, convertibility and transfer risks, although less common than devaluation or depreciation risk, also occur periodically in developing countries. However, a recent survey of MFIs conducted by CGAP indicates that 50 percent of MFIs have nothing in place to protect them from foreign exchange risk.